NEP could be a BUY

1.5 years ago, almost to the day, I projected that NEP was nearly at a peak, and would suffer poor returns for the following 2-3 years. Unbeknownst to all the investors, there were several negative developments that arose from NEP, including accounting problems which led to a trading freeze and near delistment from the AMEX. As I anticipated from the charts, volume, and sentiment, price has since performed extremely poorly, averaging returns of –60% annually. All things come to an end, however, and NEP seems to have weathered the storm. It appears attractively priced, and I’m buying around $3. Here’s why:

1. NEP had $75m in cash as of 3/31/11, and currently has a market cap of $105m. If the auditors are not lying, then this is a pretty good valuation at which to buy NEP.
2. The accounting issues that plagued NEP are out of the way.
3. The lawsuits which sprung out of the trading halt and claimed that NEP breached its fiduciary duty to its stockholders have been dropped.
4. Volume is mostly down-trending as price declines (see chart below), indicating a decreasing level of interest in the stock. This is preferable to seeing volume increase as the stock tumbles which indicates lack of confidence in the company.
5. There was a significant basher article by “Bigfish” research which cause the stock to drop significantly on volume of about 3m shares). Then, the next day, there was a massive short squeeze on 3m shares as well. This price action is simlar to what happened in Dec 2009, except opposite (see chart). Back then, price spiked up in the direction of the uptrend on 3m shares, reversed violently the next day on 3m shares, and then proceeded to retest and exceed the previous highs. Now we’re seeing the same pattern. Call me paranoid, but it seems like someone is playing those spikes, and it tells me that we’re near a turn.
6. Finally, from an Elliot-wave perspective, we had a complex 3-wave down trend (see chart). This tells me that we could see a basing pattern and a rise out of NEP.
7. I conclude that NEP’s return prospects going forward are now positive.

BigFish disappoints with 2nd post, NEP should be fine

Yesterday a new blogger named Bigfish came out with a very negative report on NEP, which I responded to here. Later he said he was going to come out with something this morning which was even worse, and so he has...or at least tried really hard to. Unfortunately for him, his argument today was much weaker then the one yesterday, and is much easier to counter. At least yesterday he pointed out a couple obvious and specific errors in some of NEP's filings. I pointed out that neither error is in the company's favor.

In any case, yesterday he argued that the drilling business must be a fraud because NEP paid too little for such a successful business. I agreed that the price did seem quite good, but also pointed out that NEP added additional value by buying the company (namely the ability to sign more drilling contracts with PetroChina), allowing it to increase its revenues and profit margin.

So today, Bigfish comes out and argues that NEP is a fraud because they are going to pay TOO MUCH for the rights to explore and produce on the Durimu oilfield over the next 24 years. I guess Bigfish is like Goldilocks and needs every deal to be "just right."

Bigfish does do a good job showing how many companies are going to be between NEP and the original owner, but I don't understand why this is terribly unusual. Yahoo user stinky6987 explained it well in reply on this post:

Not much here, but buying a company (Shengyaun) that owns the right to drill an oilfield doesn't sound the least bit suspicious to me. Also, while the report asserts that Shengyaun didn't pay for the right to drill and is turning around and selling that right to NEP, there are many reasonable explanations for this, none of which involve fraud:


(1) Exploratory drilling is inherently hit-or-miss, once Shengyaun hit oil with their exploratory wells, the value of their contract with Jiangyuan went way up.


(2) As the price of oil goes up, the value of Shengyaun's contract with Jiangyuan also goes up.


(3) "State-owned" Jiangyuan didn't get a good price when making the agreement with Shengyaun.


(4) The people in charge of "state-owned" Jiangyuan wanted to steal money from the government, so they gave a no-bid contract to Shengyaun and took bribes or have an ownership interest in Shengyaun (note this does not affect the actual value of the contract to NEP).

All four of these are great reasons why NEP would pay the $43mil. I can think of a couple more as well:

5. Bigfish didn't show any proof that the previous owner didn't pay anything for the rights. Its possible they didn't, but not guaranteed.

6. Obviously business in China is done somewhat differently then here in the US (although I'm sure not that differently), so I wouldn't be at all surprised if at least part of the $43mil is a bribe to certain people somewhere along the supply chain. Bigfish makes a good point asking why NEP didn't try to get the rights directly from the state owner enterprise. Obviously that would have been better, but perhaps there wasn't any way to do so. The oilfields are located in a different state then NEP, so perhaps only companies from that state were allowed to receive the rights directly from the government. I unfortunately have no idea if my postulations are true or not, but this seems just as plausible as Bigfish's arguments.


The bottom line for NEP stockholders is that this $43mil acquisition would tremendously increase the potential production capacity of NEP, and as such represents an excellent long term direction for the company. The biggest concern in my mind, and one that I can't believe BigFish didn't mention, is that there is the possibility that the field isn't actually close to as productive as NEP tells us it should be. This is a risk that investors take when putting money with any oil company.

Also note that most of the transaction is being done in stock ($10.6mil in cash, the rest in stock when it was trading around $5). Personally, I think this is a good sign because it indicates that the previous owner believes in the strong potential of the field and wants a share of the profits.

Is Bigfish right or wrong about NEP. Is NEP really a fraud?

This morning NEP dropped about 20% due to a newly posted questioning of a part of their operations by a new blog called Bigfish Research. (edit: This link won't work because the site has been suspended)

I read through their article and am now looking at all the 10-Ks myself to confirm or deny the accusations. While BigFish is correct on all his statistics, he paints the data in an extremely negative fashion to "prove" that NEP is a fraud and improve his short position. I have no problem with this as he is allowed to have his opinion and share it, however, I do think that investors should also have an opinion from someone who is long the stock.

All the information Bigfish put out in his blog is verified by what is in the specific reports he mentions he pulled it from. However, if you look at different filings, then the numbers are different. This presents a catch-22 for current and potential NEP investors.
On one hand, maybe the company isn't a fraud because the numbers make a bit more sense in other reports. On the other hand, why can't this company seem to be consistent across their filings. Is their accounting department really bad at making sure their statements match, or are they actually hiding something?

Analyzing Red Flag #1

If you look at the Q3 2009 amended report, the numbers that Bigfish talks about are true. For example, check out Page 18. You'll see that the company does in fact show that their combined revenues for the first nine months of 2009 would have been $76m, if Tiancheng was part of NEP the whole year. This is different then what was posted in the previous 10-Q for Q309.

However, if you look at the 2009 10-k, then the numbers match the initial numbers that NEP posted in the initial 10-Q after the acquisition.
Based on the information on page F-19, NEP would have had $79,362,000 revenues in 2009 if Tiancheng had been part of the company all year. NEP's production division made $51,081,000 in 2009, so Tiancheng had revenues of $28,281,000 for 2009. This means that their total revenues in the first 9 months was $14,704,000.

Note that in 2008 Tianchang's full year revenue was about $14.4mil, so before NEP acquired them they were growing at a reasonable pace, but not one that was extraordinary. The Q409 revenue figure of $13.6mil is certainly a massive jump, and I do agree with Bigfish that NEP very well may have asked Tiancheng to hold off booking revenues in Q3 so that they could be booked in Q4.

Analyzing Red Flag #2

NEP's business did not need to be SAVED. The oil production business profits were just fine, and Tiancheng was simply an additional bonus when it was announced. Its true that Tiangcheng was about half of NEPs business in 2010, but a big reason for that was due to the flooding in Jilin which drastically reduced NEP's oil output for a large part of the year.
Also, it makes sense to me that Tiancheng is able to generate more revenue being joined with NEP compared to operating alone. NEP already had contacts with PetroChina and thus were able to get drilling contracts that Tiancheng couldn't on their own. Tiancheng's margins also should be expected to improve with higher revenues due to economies of scale. Their margins would also go up once integrated with NEP because of cost savings for G&A.

Tiancheng's revenues have gone from $14.4mil in 2008, to $28.3mil in 2009, to $44.9mil in 2010. These are very impressive increases, but many companies have seen these growth rates when they were as small.

Analyzing Red Flag #3

I will agree with BigFish that it seems strange that they didn't mention Beijing Junlun Runzhong Technology Co. Ltd. (“JLRZ”) in the 2010 10-K. It seems like they should have drilled some wells for them, or at the very least, they should have let us know that drilling was delayed or completely canceled.

However, I don't see any issues with the rest of their operation. PetroChina is obviously a real company, and I don't see how they would let NEP pretend for 3+ years that they first sell petroleum to them, and now drill for them.

Also, I don't see why it's unusual that NEP didn't create a press release about the wells drilled for Daqing Shunwei. They drilled 54 for them all year, or about 14/Quarter. Its very plausible that Daqing signed a series of small 5 or 10 well contracts, which would not warrant a press release.


Analysing Red Flag #4

As for the total meters drilled figure listed multiple times in the 2010 10-K, I agree with Bigfish that there is something incorrect, because the company clearly only drilled 306k meters for clients during 2010, but for some reason lists 374k in multiple places in the 10-k. I can think of three explanations for this figure:

1. The company made a mistake in their calculations somehow and didn't catch it. Obviously this would be good and bad. (Bad because it should have been caught by the auditors).

2. The company included drilling done for themselves in the final figure. This seems unlikely because the company only drilled 6 wells for themselves in 2010.

3. The number could be fraudulent as Bigfish believes. The issue for me is that showing this higher number doesn't help NEP look better. Their revenue figures stay the same, so they list the avg revenue/meter as $120, when in reality it was about $147. This makes their operation look WORSE, not better!

Finally, I also noticed the higher revenue/meter drilled in Q4 compared to the rest of the year. Personally, I don't see why this is a red flag. Inflation in China during 2010 was high, and I would not be surprised if NEP was able to negotiate better terms for the wells it drills in Q4, vs the earlier deals they set up in early 2010.

Red Flag #5

This is probably BigFish's worst argument. When NEP bought Tiancheng, their Quarterly depreciation was about $375k. If we assume that they bought their rigs in a reasonably even manner since they started in Dec 2007, then we can assume that they had taken about $1.3mil in depreciation charges already when NEP bought them ($375k/Q x 7 Qs = $2.625m. Divide by 2 to account for gradual purchasing = $1.3mil)

Thus, their initial costs for the 7 rigs were about $13.5million. Lets assume the 4000m rig NEP purchased after the fact was a brand new rig and that the other rigs were purchased somewhat used. I will state that I have no idea how much more a 4000m rig costs then a 3000m or 2000m one, but I'm making guesses here which seem plausible:

3 2000m x $1.45m = $4.35m
3 3000m x $2.10m = $6.30m
1 4000m x $2.80m = $2.80m

Total cost is $13.45m.

These estimates seem completely plausible, at least to me. Of course we could also argue that the amounts are low, and perhaps we could get an opinion from someone which actually know the prices for these things, but to me I don't see how this is a Red Flag.

Red Flag #6

I have not done any additional research on drill rig capacity, but BigFish didn't give a great argument here. First off, we know that they drilled 306k meters, not 374k. So their production was only 1.8 times Eurasia's stated capacity, not 2.6.
The other point is that with 207 rigs, its very likely that Eurasia has many older rigs which are not as efficient as the NEP rigs, which are likely newer.
I don't have the time right now to look deeply into the issue, but BigFish should have used more datapoints.

Red Flag #7

BigFish's argument here is that 42% net margin is impossible. I would argue that it is not, especially when you consider that Tiancheng is doing this as part of a larger company. This means that this net margin doesn't include the additional overhead that they would need to pay if they were on their own.

Also, the oil and gas drilling industry has high gross margins. I took a look at RIG and its competitors and there they show that the average gross margin in the industry was 56%! Tiancheng's gross margin in 2010 was 61%. Thats only 10% better then the industry average.


Putting Everything Together

1. I will admit that the Tiancheng deal has been so good that it could be viewed as "too good to be true." No one can debate this and I wish that NEP would come out with a reasonable explanation for why the previous owner sold. I can think of a couple scenarios though. Perhaps the company was in a cash flow crunch, and the owner sold it because it was either lose it to bankruptcy, or collect $13mil for it.
Also, its clear that NEPs contacts have helped generate additional drilling contracts in 2010, so Tiancheng likely would not have done nearly as well alone.

2. I also agree that the numbers in the financials aren't adding up in all cases. The 374k meters drilled figure is clearly wrong and yet is posted multiple times in the 2010 10-k. Tianchengs 2009 revenues are also unclear because the amended 10-Q and the 2009 10-K have different numbers.
Personally, I believe that the reason for the discrepancy in both cases is user error, rather then fraud. Still, it is not a good sign that neither NEP's accounting departing or their auditors caught these differences in their reviews of the reports.


My personal opinion is that this is a great buying opportunity. Unfortunately I don't have extra cash to take advantage of it, but for me here are the possible outcomes:

1. The company is a fraud. Bagholders lose their full investment. Likelihood: 10-20%

2. The company is legit. In this case they will complete their purchase of the new oil field, and in 2-3 years will start producing large amounts of oil from it. From the $3 level the price of the stock could easily go to $30 in 5 years. Likelihood: 80-90%.

Personally I like those odds and feel that its worth speculating some money you can afford to lose on.

AAPL’s Triangle

AAPL just completed a very nice triangle formation. I think this indicates that AAPL is about to start an extended downtrend. The upside target is 360-361, and could drop to $300 or lower.

Notice in the chart above the clean triangle pattern that formed in the past few weeks. According to Robert Prechter’s Elliot Wave Theory:

A triangle always occurs in a position prior to the final actionary wave in the pattern of one larger degree, i.e., as wave four in an impulse…

On the basis of our experience with triangles…we propose that often the time at which the boundary lines of a contracting triangle reach an apex coincides with a turning point in the market.

Check out the examples below to see how triangles led to nice reversals.

EUR/USD Before and After:

NEP Before and After:

  

I believe it is time to become cautious with AAPL.

Outta NEP

A few months ago, before NEP was halted, I went long based on trendline support. Today, I sold that long position for a small profit. I believe NEP could face continued headwinds for some time to come.

Check out the daily chart above: first, notice that NEP is running into the combination of three trendline resistance levels, around 6.60-7.00. Furthermore, I think it will take additional time to unwind the excesses that were generated in the parabolic run into Jan. 2010. NEP’s business is looking good, but supply and demand of shares always rules. I think enough people got shafted in the $8-12 zone that they will provide nice supply, holding the price lower.

Taking a Bet with NEP

Back in Jan, 2010, when NEP was rising exponentially, I made several posts clearly explaining that price would soon top, and that it would start a downtrend and poor returns going forward. I think NEP’s intrinsic value is between $9.70 and $13 (using 24% or 15% discount rate, respectively) so today I’m taking a risk and purchasing some shares into the recent downtrend, with a stop @ 4.77.

You can see on the 3y daily chart above that there is a very long-term trendline which has supported price action ever since it broke higher with the news that it was uplisted to AMEX. By going long here, I’m betting that the trend will continue, and that NEP’s management will get its s*hit together and correct the company’s financial statements! Regardless of what happens, though, if price breaks below the trendline and goes below 4.75, I’ll take a loss and stop myself out, as this would indicate a longer-term trend reversal.

NEP's earnings restatements - What do they mean?

If you are like me, then you've been trying to figure out why NEP has had so many issues with their accounting, and what those issues actually are. A couple weeks ago I got a good lesson about how and why companies have to take a loss based on the change in fair value of warrants. Today I read up on the other big write-down, which is related to the impairment of oil properties.

NEP had to take a $13.2mil impairment charge on their oil properties in Q4 of 2008, and another $13.8mil charge for Q1 of 2009. I did not understand what these were for, but after doing some reading up on the subject, I think I understand what happened.

In short, accounting rules require companies to make sure that the capitalized oil and gas properties as listed in their balance sheet are not higher then the current "SEC" value. This value is figured out by the company based on their current proved reserves, current oil price, and expected future production schedule. If the oil and gas assets are higher then their current "SEC" value, then the company must immediately write-down the difference and take it as an expense in the current quarter.

What this means is that if oil prices plunge, as they did in Q4 and Q1, then the "SEC" value of oil and gas properties will decline, and thus an impairment charge might be necessary. In NEP's case this resulted in a $27mil combined charge for the two quarters.
What is interesting about this charge is that the company cannot add back to the value of the properties later on if oil prices do go back up, which we know they did. Thus the company has charged off $27mil of its oil assets which would usually have been taken over a period of years as Depletion.

So what does this mean?
NEP's future stated income will be higher because there will be less future depletion expenses.
We also know the NEP's future stated income will be higher when the warrants are exercised.

When all is said and done, nothing has changed operations wise for NEP. They accounting department clearly needs some improvements, but I would argue that they actually hurt themselves more then anything because the company paid about $7mil more then it needed to in income taxes over the last couple years due to their understating non-cash expenses.

Updated NEP Q4 and 2010 projection

China Northeast Petroleum (NEP) announced their preliminary Q4 production and drilling results today. The results were slightly better then their projections back in November, which I have come to expect from the company as they do a great job of giving solid yet conservative projections. Below are the results for both divisions of the company:

Oil Production

Back in November I projected that the company would produce about 231,000 barrels based on how many new wells they were projecting to add. The company managed to add 5 more wells then expected and must have also completed them more quickly, because actual production was 236,774, about 2.5% higher then my projection. Oil prices during Q4 were also higher then NEP's estimate of $65 for their projections. If we use the average Cinta monthly price from to approximate the price NEP will receive, they should average about $70/barrel for Q4, which translates to revenues of about $16,575mil. Assuming approximately 30% profit margin, their operating profits from production should be about $5mil.

Drilling Services

Tiancheng completed drilling contracts for 60 wells with total drilling depth of 99,161 meters (325,331 feet) in the fourth quarter of 2009. This is very impressive considering that before NEP acquired it, the company had only drilled 80 wells totaling about 106,000 meters during the first three quarters of the year! Assuming that their revenue per meter remained the same in the 4th Q, revenues will be about $13.75mil. Thus I expect profit for this division to range from $4.6mil to $5mil, depending on the profit margin.

Combined Q4 Results

Overall, the company should announce revenues between $30mil and $30.5mil for Q4. Before all the restatements that will happen, I would have projected net income to be somewhere from $9.5mil to $10mil, or about $.35-.36 EPS for the Q. These numbers are clearly better then the estimates I came up with in November. It's nice to see the company continuing to impress in their operations.
Restatements and Potential Dilution

Unfortunately, because of the restatements that NEP will have to do, it will be harder to compare results. Personally, I don't like the way that FASB requires companies to handle in the money warrants because it actually makes it much harder for potential investors to analyze past results. Hopefully the company will do a good job breaking out their operating earnings from the expenses they will be taking on the warrants. I wish I had an idea of how much it will be, but looking at the information given in the press release only made me realize that I have no idea how to figure out the potential impact. I do expect it to be quite large though because we saw the price of the stock almost double during Q4.

One thing that the restatements did cause me to do was to look back through NEP's previous quarterly reports to figure out exactly how many warrants and options are outstanding and at what prices. As of 12/31/09, NEP had 27,715,818 shares outstanding. We know that Lotusbox exercised another 867,438 warrants in January, which I've assumed is all the exercising that will occur in Q1. If I'm correct, then below are all the remaining options and warrants which have not been exercised.



Updated 2010 Revenue and Earnings Estimates

Based on their results and on oil prices so far this year, I have updated my 2010 estimates to reflect my current expectations. I've increased the number of wells I expect NEP to drill in 2010 from 65 to 70, as well as increased to average oil price from $65 to $70 (note that Q1 oil prices are already set at about $73/barrel).
Finally, I've assumed that Tiancheng will drill 100,000 meters each quarter and get paid about $138/meter.



If we throw a PE of 10 on NEPs non-diluted EPS, the price of the stock would be about $13.50. Throwing a PE of 12-15 on their fully diluted EPS would lead to a price of $14-17.50. I think that by the end of this year NEP will be trading above $15 unless we see a tremendous drop in oil prices again like what happened in the late 2008.

Please feel free to post any questions or comments

NEP’s Volume: Something to Consider

You can see here that I was bearish on NEP’s price prospects while it experienced a massive parabola. We’ve now seen a 34% drop since the high. I am not sure exactly what will happen on the short term, but I wanted to share an observation that I take as bearish for the continued longer-term prospects for this stock’s price.

Above you can see NEP’s monthly chart. There are two striking features. First, notice that December’s volume was about 27m shares, approximately equal to the company’s entire outstanding stock. Based on the massive breakout, one might argue that because November closed above $5, institutions bought this stock in quantity (the ENTIRE company) which was responsible for the huge rally. So, following this logic, it would be bullish since large players are accumulating this stock.

Well, one month later the picture has flipped 180° in my opinion. January’s volume came in higher than December’s, and the month closed at a lower price than it did in December! What this tells me is that someone (or group) successfully executed a manipulation of this stock to unload a massive position above $5. The up move attracted enough retail/public buyers that the shares could be distributed well above the breakout point at a nice profit.

However, we have not yet seen many high-volume down days. I believe these are yet to come, and may be accompanied with more Form 4 filings. In fact, according the Reminiscences of a Stock Operator, a book which many NEP supporters have fondly quoted, “stocks are manipulated to the highest point possible and then sold to the public on the way down.” (pg. 246). I think this is because the hype created by the run-up creates solid demand to absorb large amounts of shares on the way down, as the dip-buying public steps up to the plate.

If this analysis is correct, it would imply that my thesis for poor returns over the next couple years is supported, because if a large portion of the stock is distributed among many smaller investors, an aggressive up-move will be harder to accomplish.

The Dec-31 institutional holdings report will shed more light on this hypothesis, but in the meantime, I’m curious to hear what others think! Good luck!

Comparing 2009/10 NEP to 2007 NEP

NEP: Aug ‘07 to Sep ‘07

NEP:Dec ‘09 to Jan ‘10

Look at the two charts above comparing NEP’s current parabolic run to it’s previous parabolic run from Aug to Sep, 2007. Notice the similar progression of sharp rallies, followed by short correction. If my read is correct, and this similar “climax pattern” takes place, we should print the ultimate top in a few days. This supports my theory that NEP’s move will top out in the next few days.

NEP should top within the next couple DAYS

Reviewing NEP’s chart today, I remembered a very important chart principle regarding triangles. NEP just broke out of a triangle, and I believe this thrust will be terminal and should end within the next 1-5 days.

Here are the relevant principles regarding triangle formations from Elliot Wave Theory by Robert Prechter:

A triangle always occurs in a position prior to the final actionary wave in the pattern of one larger degree, i.e., as wave four in an impulse…

On the basis of our experience with triangles…we propose that often the time at which the boundary lines of a contracting triangle reach an apex coincides with a turning point in the market.

(note: bold emphasis added)

Now let’s look at NEP’s chart to see where we stand. The first chart was taken from a post written several days ago and shows that NEP definitely did break out of a triangle formation. And as you can see from the labeling, this is likely a 4th wave triangle. Thus odds suggest that this recent rally is terminal in nature.

The second chart below shows the detail of the triangle and subsequent breakout. I have highlighted the apex of the boundary lines of the triangle, and you can see that this point in time will be reached within a few days. As the quote mentions, the market will often reverse at this point in time.

Therefore, given the excessive bullish sentiment currently surrounding this stock, the parabolic nature of the rally, and the Elliot Wave principles, I am inclined to believe that the stock will begin a reversal within the next few days. Good luck to all!

NEP is still undervalued

The title above may come as a surprise considering that this blog's last couple posts have been decidedly negative towards the prospect of further price appreciation from NEP. But its simply explained by the fact that my brother and I have a difference of opinions on NEPs future returns.

My brother is technically right when he says that "long-term (1-3years) share-price prospects for NEP are substantially lower at this price", but NEP will still have excellent returns going forward, especially on a longer term horizon (5-10 yrs). Will it return 5288% in the next 3.5yrs? NO. So in that sense my brother is right. Still, I think that it will still return at least 25%+ per year over the next few years.

My brother is a chartist and based on the chart I too agree that this move from $5 to $10 has happened very quickly and at some point I think we will see a substantial correction. But this correction might not happen until the shares reach $11, 12, or even $15. I did finally take some profits because NEP had become 75% of my portfolio, but I still hold most of my shares and plan to for a long time if the underlying business continues to improve like it has over the last several years.

I took a quick look at NEPs historical earnings on Morningstar. Their combined profit from 2004-2006 was about $.03/share, or 1 cent per year. This year we expect earnings to be $.73, and for them to jump to $1.20+ next year. So I would argue based on this that the price of the stock still has catching up to do, since its "only" up 5288%, while earnings are up 7200%.

I've spent some time the last several days creating a detailed long term valuation model for NEP. It's close to being finished, but I'm trying to figure out how to post the data succinctly in an easy to follow way. However I will post a couple main points now:

- Based on what I believe was a conservative scenario which assumed no further leases are signed and only slow growth in the drilling segment, NEP has a Present Value of $13/share if you apply a discount rate of 15%. This means that an investor wanting to receive a 15% annual return on his investment from now until 2022 would be will to pay $13/share assuming that NEP issued their free cash flows back to him each year.

- I will post details later this week, but its important to realize that this valuation assumes that management will fail to acquire more leases or other value-adding acquisitions. Management has proven to be quite good over the last few years, so I believe that there will be new acquisitions within the next year or so that will add more value.

- I assumed that oil prices would only increase by 7%/year over the next 13 yrs. I think they will in fact increase much more, which would also increase the PV.



The Bottom Line is that while I agree with my brother that the price of the stock is becoming extended on a technical basis and may retrace a portion of the incredible gains we have seen this last month, NEP is most certainly still UNDERVALUED. Thus if your horizon is longer then a few months, I feel confident that the stock is still a good purchase at $10/share. Just don't go all in.

You be the Judge

I stand by my previous hypothesis that the long-term (1-3years) share-price prospects for NEP are substantially lower at this price. Is this not a parabolic chart?

NEP is one of the Biggest Bubbles, Ever!

You can see my previous posts about NEP here. As you can see, I’ve been wrong about where NEP’s rally will stop. These have been short term calls, so I believe I will be vindicated in the longer-term price action. I am going to prove to you that NEP is the biggest bubble ever, and that after the kind of move that we've seen in the stock price over the past 3.5 years will likely be followed by some years of stagnation, regardless of where this current spike peaks. The question will be whether you can sell in time to lock in your profits.

Let’s begin by examining NEP’s price action for the past 3.5 years (see the chart below which shows NEP’s weekly price candles).

The first aspect to which I’d like to draw your attention is a revised wave count. After reconsidering my previous wave count analysis, I believe we’re actually in the final thrust of a 5-wave sequence that began in 2006. This makes more sense, because the triangle from which we just broke out is normally a terminal pattern, meaning any rally is often fully retraced.

The second aspect deals with NEP’s raw price performance. In mid-2006 (7/17/06), NEP bottomed at $.17. Today, NEP closed at $9.16: a 5,288% return in just under 3.5 years, or 210% annualized growth for 3.5 years straight. No big deal, right? Many great companies out there have seen these kind of returns in their early years, right? This kind of growth should be possible, shouldn’t it? Let’s look at some facts: here is a list of great companies followed by their best lifetime stock performance, as well as their best 3.5y performance:

Company	Max Lifetime Gain	Time Period (y)	Best Annualized Gain	Best 3.5y performance
Amazon (AMZN)	9,187%	12.5	43%	1,503%
Hovanian (HOV)	1,042%	13	18%	1,437%
Research in Motion (RIMM)	9,283%	9	63%	1,397%
Apple (AAPL)	7,273%	25	18%	1,254%
Wal-Mart (WMT)	122,940%	27	30%	1,011%
Microsoft (MSFT)	59,538%	14	59%	693%
Barrick Gold (ABX)	10,946%	23	23%	686%
Proctor & Gamble (PG)	10,460%	38	13%	205%
China Northeast (NEP)	532%*	6	28%	5,288%

*(Note: NEP’s lifetime gain is so low because the stock started trading at $1.50, significantly above it’s lowest price of $.17, 3.5 years ago)

To be fair, I looked to see if AMZN did have similar growth over a smaller period. In fact, in the first 2.5 years after going public, AMZN did appreciate by 5,423%! But there are two key differences between AMZN and NEP: 1) this performance occurred at the height of the tech bubble; 2) AMZN was introducing a revolutionary service that warranted being rewarded with faster stock appreciation, while NEP is a simply drilling oil (what’s the big deal?).

Thus my conclusion from this data is that NEP’s 3.5y price performance has been ABSOLUTELY EXCEPTIONAL AND ABNORMALLY HIGH, given the un-uniqueness or lack of novelty in the business that would normally spur bubble-like performance.

My next thought related to price performance is that perhaps since it was a penny stock, such a massive move is not out of the ordinary, as you’ll often find 1000%+ moves in pump/dump stocks. Here are a couple such bubble charts that came to mind immediately (JRJC and MXC):

Notice the typical reaction is long-term downtrend, and these stocks only rallied 1,000%-1,500%. Now let’s compare these charts to a non-log NEP chart, and tell me if you don’t see a similarity:

NEP has been profitable since 2006/07. How is it possible that the market has mispriced this company so severely? An Oil-drilling company especially? What is so amazingly unique about this company that the market misjudged its profit potential at the beginning? How could it have been discounted this low? How is it possible that NEP was so underpriced to begin with that early shareholders have enjoyed 210% return per year for 3.5 years???? Has the market really been so inefficient, or is there something else going on?

Therefore, if you’re a long-term investor, ask yourself if buying at this point, after such a massive run over a relatively short period of time, makes sense. Sure, with the momentum of this move, it could double again, but this wouldn’t really change things much in the longer-term picture. When a stock goes parabolic, it will often retrace to the beginning of the parabola before starting a new run up. This indicates a retrace to $4-5.

In conclusion, make your NEP decisions knowing that history does not reward these kind of rapid moves over the next couple years. Ask yourself where the market went wrong such that it allowed the company to be so undervalued to begin with. Or, on the other hand, maybe you are part of the most obvious 10-bagger in the world (everyone has been touting NEP for a long time, well done!!). One thing I’ve noticed is that the market never rewards the obvious point of view in the long run.

Everyone, please find flaws in my logic, I'm all ears. Thanks for reading! I am wishing everyone best of luck in being able to sell their stock at high prices and booking the 'profits' that everyone has been bragging about! GOOD LUCK!

P.S. You can tell me all about P/E, valuation, etc. but I believe raw price performance will be the final factor in determining supply/demand, as history has shown in many other cases!

NEP Technical Picture

NEP just broke to new highs today. Everything about this looks great! We know the company is excellent, as you can see from my brother's posts (Is NEP Buying More Drilling Rigs, NEP 2010 Earnings Projections, NEP's Newest Addition--Tiancheng Drilling and Oil Services, and NEP Update after Q3 Results). However, in my experience when everything is perfect, and optimism abounds, it's time to take at least short term profits. I expect a drop to $5 from the $7.00-7.50 level.

On the daily chart above, you can see that we just broke out of a massive triangle consolidation. However, these types of thrusts are often quickly retraced, even if just part of a correction. I could see a retracement to the $5 range, which should correct most of Wave-(i) of Wave-iii.

On this chart, you can also see that the up move has been quite parabolic, and the breakout has come after the overall stock market has made a big up-move. Clearly NEP isn't playing a leadership role. If this stock was breaking out to NEW highs near the beginning of the rally, I would trust this price action more. However, when it's one of the last stocks, I think this stock is getting ready to wipe out all the optimism :).

Good luck!

Is NEP already buying more drill rigs?

In my previous post, my 2010 projection for NEP, I based my revenue projections for newly acquired Tiancheng Drilling on the assumption that the company was going to operate 7 rigs for the duration of 2010. In figured this made sense to be conservative even if NEP bought more rigs at some point during the year.

I've been looking through the 10-Q again as I work on my long term projections and I noticed that on Sept 30th 2009 the company showed prepaid expenses for:
Deposits paid for puchase of drilling equipment $3,363,753



I can't think of any scenario other then Tiancheng had already contracted to purchase more drill rigs. I have no idea how much one of these would cost, but based on the $12mil in fixed assets they gained buying Tiancheng, I'm guessing a Rig costs anywhere from $1.5-2mil. In this case its possible that NEP is buying 2 or 3 more rigs, assuming a 33-50% prepayment.

Any thoughts or further information on this?

NEP 2010 Earnings Projection

Introduction

Even though we haven't finished 2009, China NorthEast Petroleum (NEP) has given us a solid, yet conservative guidance for Q4, so I am looking forward to 2010 with my projections in this post. I've come up with four scenarios to present, based on what oil prices might do next year. My nature is to be conservative when I create forward looking projections, so just know that when looking at the numbers.

In order to make the projections I've split NEP into their two operating segments, Drilling and Oil Production. We don't have much more information on the Drilling segment then what I presented in my last post on NEP, so I will be basing my estimates mainly on info from the press releases and the 10-Q.
As for the Oil Production numbers, I have been keeping a detailed spreadsheet of NEP's past financial results, as well as projections based on those past results, for two years now. At this point I feel that I have a very good handle on what levels of expenses to expect based on oil production and oil price levels. In my projections I won't be showing all the details, just the projections for producing wells, average oil price, revenues, and net income. But know that these numbers come from my more detailed spreadsheet.

Lets quickly look at the major factors to consider when projecting revenues and expenses. This only applies to the oil production as for Tianchiang I've simply assumed they will drill 220 wells, receive about $185k per well, and have a 30% profit margin.

Revenues
Obviously the main consideration is the average oil price. My brother (see his last post here) and I believe that the US Dollar will strengthen in the coming months, and I also expect the US to relapse into a 2nd recession next year, so I'm not one of those people expecting oil over $100 again next year. The other factor is the level of production. I've assumed increasing production as the year progresses based on NEP's stated plan to add another 60-70 wells.

Expenses
Cost of Sales:
Production Costs: NEP incurs about $5/barrel
Depreciation: This numbers ran between $9.50 and $10 per barrel in 2009.
Government Oil Surcharge: China charges a tax on on oil revenues when oil is higher then $40/barrel. This tax starts at 20% and increases to 40% on the price over $60. See NEP's explanation on page 29 of their 10-Q
General and Admin:
NEP has low G&A costs. Typically they have about $1mil in general operating costs, and then another $750-1000k interest and amortization expenses on the loan they received in 2008.
Taxes:
NEP's tax rate this year has been about 32%.

Scenarios:
Now that we've gone over my assumptions, here are the four scenarios:

1. Oil stays in a tight band all year between $60-70, averaging $65 each quarter (extremely unlikely but a nice base scenario). In this case NEP would have about $1.21 EPS in 2010.


2. Oil moves down in the first half of the year and then back up, but finishes next year lower then it is today. This is my favorite conservative projection. In this case NEP would have about $1.07 EPS in 2010.


3. The world enters another serious recession and deflation hits. Oil drops from current levels to about $35/barrel in the 2nd half of the year. I really doubt this would happen, but wanted to put it in to show that NEP will still earn about $.60 EPS even in this "shit hits the fan" scenario.

4. Continued inflationary pressures and a greater concern by the market that peak oil has arrived pushes prices up throughout the year to end 2010 at about $100/barrel. This would be ideal for us and NEP would have about $1.45 EPS in 2010 if this happened.


2010 NEP price expectations

Having been invested in this great company for two years now, I have come to realize that the stock will never move like you would expect it to. Still, 2010 seems primed to become the company's best year yet, and thus I do expect the stock to have a nice run-up in the next 12 months. Assuming that NEPs meets their projections of $.80/share in 2009, today we have a stock with a TTM PE of 6.5 ($5.20/$.80), that will likely earn between $1.05 and $1.10 next year even if oil drops 15% from today's prices, and will earn $.60 even if oil tanks back down to early 2009 levels.
I find it hard to believe that we will still sport a PE under 10 in a year (although its not impossible), so I think that we should see this stock hit $10 by next fall. that's a 100% gain from today's levels. If more institutions find the stock and it gets on a roll, it would not be out of the question to see a PE of 15-20 on it, which would move the stock to $15-20. This is what all of us owners are dreaming about, but I'm certainly not expecting this yet.
Of course, caution is also warranted because if oil prices move down to the $35-40 range again, I'm sure we could see this move under $3.50 again, and possibly down to $2.50. Just know that at that level you'll be picking shares up for 4x their worst earnings potential.

The bottom line is that this a very well managed company that isn't taking crazy risks in order to increase their stock price. Management is clearly thinking long term and I believe that that in 10-15 years any stockholders that have held the stock the entire time will be very happy, but I will go more into that in my next post.

NEP's newest addition, Tiancheng Drilling and Oil Services

On October 1st, China Northest Petroleum (NEP), announced that they acquired another company, Tiancheng Drilling Engineering Co. Ltd. As NEP put it in their press release, the "Acquisition Expands Company's Vertical Integration Within China's Oil E&P Industry." At the time I was interested to see the purchase, but also curious as to what the net financial effect would be, so I decided to wait until the Q3 10-Q before coming to a conclusion.

In the initial press release we received some nuggets of info on the new company and what it might add to NEP's overall revenues and earnings. Some highlights are listed below:

-NEP paid $13mil in cash for the entire company
-Seven rigs in operation.
-320 employees
-Capacity to drill 220 wells annually
-One of three PetroChina- licensed private drilling operators
-NEP has not utilized Tiancheng for drilling services in the past.
-2008 revenue of approximately $14.7 million, net profit of $5.2 million
-cash flow positive from operations.

For me the two key points from this release were the $5.2mil profit and the fact that they were also cash flow positive from operations. $5.2mil is extremely good considering it only cost $13mil to buy the whole company, so I wondered if perhaps 2009 was not being so kind to Tiancheng and thus I couldn't wait for the 10-Q to come out.
On Monday we were finally able to see Tiancheng's results during the first nine months of the year, and NEP also provided us with some addition pieces of information about their acquisition throughout the 10-Q. I've copied some from pages 28-29 below:

"Tiancheng enters into drilling contracts with PetroChina and other private oil companies to provide oilfield drilling services, and generates revenue based on the depth of each well drilled for clients. Clients will typically pay 30% of the total projected drilling costs as a down payment to start the drilling process, and pay the remaining balance within 12 months according to the specific contract term.

In the first nine months of 2009, Tiancheng has completed contracts to drill 80 shallow wells, which include 74 wells for state-owned PetroChina Jilin Branch and six wells for non-state-owned Daqing Shunwei Energy Development Co. Ltd. The total drilling depth accomplished this year is 105,896 meters (~347,428 feet), with the revenue of $14,700,455 and net income of $4,820,661 or $0.22 in fully-diluted, pro forma EPS for nine months ended September 30, 2009. Tiancheng currently has existing contracts to drill 86 additional wells, and more contracts are under negotiation to increase the utilization of rigs and continue to grow sales revenue"

Page 8 also shows the combined 3-month and 9-month results of the two companies. Below are three tables showing revenues and net income for NEP and Tiancheng as separate entities, and then results of the combined company if the transaction had occurred at the beginning of 2009.

A couple things also popped out at me looking at the numbers:
1. through the first 9 months Tiancheng completed 80 wells, generating $14.7mil in revenues, or about $185k per well.
2. NEP expects to generate about $13mil in Q4, which would mean completing 70 wells if the average revenue per well stayed the same.

It will be interesting to find out how almost as many wells will be done in the 4th Q as during the rest of the year. I assume that they are fully booked at the moment and that earlier some of their rigs were not being fully used, or perhaps some of the rigs were only purchased mid-year. Another possibility is the fact that drilling can be difficult during the rainy season.

What is clear to me is that this was a phenomenal purchase by NEP's management. Not only does this diversify the company's source of revenues, the purchase also increases the top line of the combined company by about 50% and the bottom line by 65% for 2009 (using Q4 est provided)!! NEP now has another steady source of cashflows that will allow it to continue its expansion program even if oil prices fall into the $40s again.


PS: Watch for my 2010 pr0jections post coming in the next couple days.

NEP update after 3Q results

China Northeast Petroleum (NEP) announced their 3rd Q earnings this morning, along with 4th quarter and full year guidance. As usual, the company set another quarterly production record and had solid positive earnings.
In this post we will examine the company's performance over the last few years. I am also working on a 2nd post which will present my projections for the company in 2010 and future years.

I have had a substantial (for me anyways) position in this stock for two years now and what has been very interesting for me to see is that so far the performance of the actual company has far outperformed the stock performance. That is pretty impressive considering that the value of my position has doubled.

Historical Performance

The table and chart below show actual results for NEP's last 15 Qs, as well as projected data for the 4th Q09 based on estimates provided by the company in their recent earnings release. It is important to note that the estimates for Q4 DO NOT include projected revenues ($13mil) and net income (est about $4.6mil) of NEP's newest acquisition, Tiancheng, an oil drilling and services business. I have expressly left this new source of revenue and income out of the Q4 Est in order to show only the oil production results. The new company will be an important source of new revenues which I will discuss in the 2nd post.

Q4 estimates assume $65/barrel average oil prices based on the Mean of Platts Singapore index during the months of Sept, Oct, and Nov (this is because NEP is paid the previous month's price for oil delivered each month). This index requires a paid subscription, but thanks to Nawar on the Yahoo MBs, we can use the average price of Cinta crude on the Indonesian Crude Price index as an appr0ximation (recently Cinta has been about $1/barrel higher then the MOPS price received by NEP as per their recent 10-Q).



The company has clearly done an excellent job exponentially increasing both revenues and net income over the past four years. This growth has come mainly due to a 12-fold increase in production, with some help from higher oil prices. During the middle of 2008 the company was clearly helped by record oil prices, but it also proved that it could earn a reasonable profit even with oil averaging $40 as it did in Q1 2009. As can be seen by the chart below (courtesy of Stockcharts.com), investors were worried that the company would have serious issues making a profit on $40 oil, driving the price of the stock down to $1.25/share in March 2009. An $.11 EPS for Q1 2009 was enough to show investors that their fears were unfounded, and subsequently the stock price moved from $1.25 to over $5 in the next three months.



Today the stock trades at $5.16, with TTM earnings of $.78/share, meaning that the company trades at a trailing PE of about 6.6. Not a bad deal for a company whose revenues and earnings are both at least 12 times higher then they were 3 years ago.

In the next couple days I plan to post my projections for 2010 earnings, as well as look at what we could expect this company to look like in 5-10 years.

If anyone has any questions they would like answered in the next post or comments, feel free to leave them.


PS: Thus far, I have not fulfilled my part of the plan my brother and I had when we started themarketbrothers blog. Going forward I am planning to continue making contributions. You'll notice quickly that my posts will tend to be more fundamentally oriented, while my brother prefers technical analysis.

Update on CNEH (NEP)

In my last post on CNEH (now on the AMEX as NEP), you can see that I was a bit early in callling for a correction. However, I unloaded the rest of my position on the way up, and have been buying back in on the recent correction. I think we have some more downside on NEP before hitting a correction low. My estimate would be that price bottoms within the $2-$3.50 range, so I will be acculating within this zone.

You can see that the rally from $1.25 to $6.33 was in 5-waves. I believe the fundamentals of the company are strong enough to warrant further upside, but I also think we need to see some further corrective action to washout some more weak hands. We should get another down wave to complete a 3-wave correction. You can see that there are some strong long-term trendlines that are controlling price action, which should act as good support as NEP bases for the next rally.

Why would NEP drop being as profitable and valuable as it is? Because the people who know this want to accumulate as many shares as possible. How do you do that at a good price? Drop the share price and hold it low for some time to scare people out of their shares.