Tremendous Value Found in China North Eastern Petroleum

Includes: CNEP, PTR, SHI
by: Nawar Alsaadi

China North Eastern Petroleum (CNEH.OB) is a highly profitable low cost oil producer based in Harbin China. The company is part of the nascent private Chinese oil industry which was born about 5 years ago due to Chinese government deregulation of the sector, which was (and still is) mainly dominated by the Chinese majors such as PetroChina (NYSE:PTR) and Sinopec (NYSE:SHI).

The company business model is quite simple: the company leases and develops small proven oil fields from PetroChina for 20 years, against a royalty payment of 20% of the oil produced the first 10 years, and 40% of the oil produced the last 10 years.

The company currently owns leasing rights in the Jilin Qian’an oil field in northwestern China, and the leased area has estimated geological reserves of 75 million barrels of oil. However, the proven reserves (on already drilled wells) stands today at 2.5 million barrels, but this number is expected to rise significantly in March 2009 when the company updates its proven reserves estimates, as it accounts for the expansion of its established wells from 157 at the end of 2007 to an expected 240+ wells by the end of 2008. The company ultimately aims to have over 675 wells drilled on the leased area by late 2010.

Key Management:

China North Eastern Petroleum is headed by Mr. Wang Hongjun. Mr.Wang has over 15 years experience in the oil industry and has previously worked for PetroChina at the Jilin oil field (where China North oil fields are currently located), Mr. Wang owns 35% of the company outstanding shares (those shares are currently held as part of the collateral to the $15 million debenture financing obtained in February 2008).

Zhang Xiang, Chief Geological Engineer. Mr. Zhang has operated as the company geological engineer since 2004. He has worked in the field of oil drilling for over 20 years, and with the majority of his experience gained in the Jilin oil field where he worked previously for PetroChina.

Zhang Yang Dio, Chief Financial Officer. Mr. Zhang has worked for the company as CFO since January 2006. He has a degree in Accounting from London South Bank University and a degree in business from London College of International Business.

The company also has a 6 member board of directors, with 3 independent board members.

Strong Execution

The company, led by a well versed management team, has delivered exceptional results over the last 3 years, as apparent from the following:

Production (net of royalty to PetroChina) :

  • 2006: 90k barrels.
  • 2007: 267k barrels.
  • 2008: 623k barrels (e) (already 422k were produced for the first 9 months of 2008).

Based on the above, the production growth rate stood 296% for 2007 and 233% for 2008. Production growth is expected to slow down going forward due to the larger volumes produced, and possibly to due to lower drilling activity in 2009, if oil prices remain depressed.

  • 2006: $5.3m USD.
  • 2007: $19.5m USD.
  • 2008: $55m USD. (e) (Already the company generated $44.1m USD for the first 9 months of 2008)

Based on the above, revenues grew at 368% for 2007 and 282% for 2008, revenue growth however should slow down or flatten for 2009 if oil prices remain at current levels.

Net Income / EPS:
  • 2006: 950k USD. $0.03 per share
  • 2007: 5.1m USD. $0.21 per share
  • 2008: 14m-15m USD. (e) $0.60-0.65 per share (e)

Based on the above, net income grew by 536% and EPS by 700% for 2007, and 297% for net income and 297% for EPS for 2008. However, net income and EPS growth should flatten this year, if oil prices remain at current levels.

In addition to the above strong numbers, the company has achieved a 49% ROE, 25% ROA and 36% ROC over the last 12 months, which is substantially higher than the industry average, and near the upper end of the company historic performance.

Key Events for 2008:

2008 was a transformational year for China North Eastern Petroleum. Despite the fact that the company had strong results in 2006 and 2007, last year was a key year in the development of the company, and so for the following reasons:

  • The company was able to raise $15 million dollars in a 5 year debenture, this financing combined with very strong oil prices (especially for the first part of the year) greatly improved the company financial position and significantly accelerated the development of its oil assets.
  • Listing Progress: the company declared in 2008 that it plans to list on a major stock exchange (NASDAQ or NYSE Alternext – formally AMEX) by the end of fiscal year 2008 or by the end of February 2009 (as agreed in the debenture financing); toward that goal the company greatly improved its corporate governance, enhanced its board of directors and worked to increase its visibility within the financial community.
  • Hiring of ICR Incorporated: The company hired the well known ICR Inc, which is an investor relations firm. The firm has been retained to manage the company relations with its investors and potential investors, as well as to enhance the company visibility within the financial community.

Outlook & Why China North East Petroleum is a good investment?

  • As the fortune of all oil companies, the fortune of China North is tied to the price of oil, and wherever oil goes the stock is likely to go, so if investors continue to be bearish on the outlook for oil, the stock is not likely to outperform the market. However if you are bullish on oil (which I am), investing in China North makes perfect sense, and so for the following reasons:
  • The company continues to expand its production through a combination of drilling new wells, as well as applying secondary recovery techniques such as water flooding and CO2 injunction among others. The combination of new wells and enhanced recovery is putting the company on the path to produce 1 million barrels of oil in 2009, which is quite an accomplishment for a company that produced only 90k barrels as recently as 2006.
  • The company has ample oil reserves, while the geological reserves stand at 75m barrels (with about 26m recoverable), proven reserves (reserves in established wells) have increased steadily despite steady production. Reserves have risen from 1.4m barrels in 2006, to 2.4m barrels in 2007 and are expected to be at 3 million to 3.5 million barrels for 2008, based on the additional 83 wells added through the year. (The next reserve update will take place in March 2009.)
  • Acquisitions: In the area where China North operates there is a total of 36 private oil extractors working for PetroChina, many of those companies have much more limited financial resources then China North and none is a publicly listed company, management has indicated an interest in acquiring a competitor for sometime now. It is worth noting that China North has a chance to emerge as a consolidator to the 36 other private oil producers that operate in the Jilin oil field, and if this turns out to be the case, the valuation of the company and its prospects will be change dramatically in the market place.
  • New Leases: The China North model is a very profitable model for both China North as well as PetroChina, as this model allows PTR to develop its small fields at zero cost while getting on average 30% of the extracted oil through the life of the leases. PTR prefers to deploy its assets on larger and more consequential projects, rather then deal with the roads, staff, housing and management of small fields like the ones managed by China North. Smaller fields can be managed much more efficiently by a company like China North, and accordingly PTR is considering awarding new leases to companies with proven operational success such as China North and the company has been in discussions to secure such leases.
  • Friendly political environment: the Chinese government considers the resource sector as a key strategic sector and has been encouraging domestic oil producers to increase production in order to insure much needed future oil supplies and reduce dependency on foreign oil.
  • Listing: the company continues to work aggressively to obtain listing on a major US stock exchange (which is likely to be the NYSE Alternext), the listing, once obtained, will greatly enhance the credibility and visibility of the company. This should impact favorably on the stock price, and allow the company to use its stock as currency to expand its footprint through the acquisition of smaller competitors.
  • Shareholder friendly management: The company CEO already owns over 35% of the shares, and has recently announced his intention to purchase an additional $300k worth of the company stock. Furthermore, the company announced on November 24th, 2008 a buyback program to purchase $2 million dollar worth of stock, or about 1 million shares over the next 12 months based on the current share price.
  • Extremely low valuation: the company currently trades at a P/E of under 3, against a P/E of over 7 for the industry, while the company price to cash flow is 1.5 against an average of about 8 for the industry. Finally, the company has a price to book of about 1, against an average of about 2 for the industry.
  • Cheap oil reserves: The company has around 25m barrels of remaining extractable oil, out of which about 17m barrels is net to the company and the balance is to be paid to PTR as royalty. Based on the company’s current market capitalization of around 40m, the price of each barrel in the ground is under $2.5 per barrel, in comparison to about $20 per barrel to the likes of Exxon (NYSE:XOM). Also, the price per barrel of reserves is much lower than companies of a similar size in the US such as Pyramid Oil (NYSEMKT:PDO) at $27 per barrel and Mexco Energy (NYSEMKT:MXC) at $13.92 per barrel.
  • Continued low costs: The cost to drill a well in the Jilin oil field is around $360k (and trending lower today due to lower steel costs). This cost is about 10% of the cost to drill a well in the United States, and the cost to operate and maintain the well is much lower due to low labor costs. For example, production cost in the last reported quarter was just $5.18 per barrel.
  • Warrants: The company has 1.5m warrants and 2.1m warrants outstanding at an exercise price of $3.2 to $3.45 respectively. Should the stock price rise above those levels, the company stand to generate over 12m in additional financing to fund its drilling program and possible future acquisitions. The potential dilution of those warrants is already included in the EPS calculations for 2008.
  • Potential oil production: By the end of 2010 the company has the potential to produce over 1.5m barrels per year (net of PTR royalty) for revenues ranging from 75m per year to 150m per year based on $50 to $100 oil, and thus could generate between $0.93 and $1.87 per share respectively in EPS based on 24m share count.

In summary, China North Eastern Petroleum is perfectly positioned for the next oil bull market. The company is extremely profitable, fast growing, efficiently managed, has ample oil reserves and is severely undervalued. With a proper valuation the stock could trade anywhere between $7.5 at 8 forward P/E for 2010 at $50 oil at the low end, and $22.5 at 12 forward P/E for 2010 at $100 at the high end. While many may consider those assumptions very optimistic, even at a P/E of 5 and oil at $40 for 2010, the stock has the potential to trade at $3.75 in the next 12-18 months, which represents a 100% return from current levels.

In the 1980s T. Boone Pickens had this to say about oil stocks:

It has become cheaper to look for oil on the floor of the New York Stock Exchange than in the ground.

By looking at the likes of China North Eastern Petroleum, I believe this statement has never been truer.

Reference material:

In addition to the above, I have had direct discussions with the company management concerning various aspects of their operations.

Disclosure: The author is long CNEH.OB.