In January 2009, I published an article on Seeking Alpha entitled Tremendous Value Found in China North East Petroleum. Today I will attempt to review the company's progress since January and contrast it to my earlier projections. I will also assess whether China North East Petroleum (NEP) remains an exceptional investment.
My assessment will cover the following areas:
- Financial performance.
- Oil production.
- Oil reserves.
- Major stock exchange listing.
- Current and expected oil prices.
- Valuation ratios
- Future catalysts.
At the time of my January 2009 article, the full revenues for 2008 were not yet released. In March 2009, China NEP released its financial performance for Q4 2008 and the results were ahead of my expectations:
As a result of those numbers, China North East Petroleum finished 2008 with the following set of numbers:
The above numbers were much better than the expected $55m in revenues for 2008 and the 60c-65c EPS highlighted in my previous article, and it is indeed a testimony to the company's ability to operate very efficiently in both a high and low oil price environment. Based on the final 2008 results, China North East's net margin stood at 33.5%, despite the Chinese windfall oil tax (which goes as high as 40% of the price of barrel above $60) vs. an average net profit margin of 11.8% for the industry last year.
Furthermore, in May 2009, China NEP released its Q1 2009 results, which were naturally lower than its results in Q1 2008 due to the 60% decline in oil price in comparison to the previous year. Nonetheless, China NEP managed to generate $2.27m in net profits (11c EPS) or 25% net profit margin with $40 average price per barrel.
In February 2009, China NEP announced its production level for Q4 2008. Production was much stronger than anticipated, with 223,000 barrels produced for the quarter, presenting a whopping 30% quarter on quarter increase compared to the 172,000 barrels produced in Q3-2008, and leading to 141% increase in yearly production in 2008 to 645,000 barrels, compared to 267,500 in the prior year.
In Q1 2009, quarter on quarter production remained flat as the company conserved cash with oil crashing to $40 per barrel. Nevertheless, production was 93% higher than Q1 2008.
However, as of May 2009, the company has restarted its drilling program at a rate of five wells a month, with a goal of expanding the company's total wells to 303 by early 2010 from 247 today. It is worth noting, however, that this drilling plan is based on $40 oil; thus it is very likely that China NEP will significantly expand its drilling plan in the near future if oil continues to trade in the $60-$70 range, which is 50% to 75% higher than the company's initial expectation at the start of the year.
However, even if China NEP was not to speed up its drilling plans for 2009, the current plan puts the company well within the target of producing 1 million barrels for 2009, presenting a 55% increase over 2008, and a 10 folds increase in production since 2006.
As mentioned in my prior article, China NEP geological reserves stand at 75 million barrels, with an estimated probable net reserves to the company of 16m to 17m barrels net of the PetroChina (NYSE: PTR) royalty production and based on an expected 35% recovery rate. However, China NEP is extremely conservative and it reports only proven reserves on existing and producing wells in its SEC filings; those reserves stood at 2.5m barrels at the end of 2007. In January I expected them to increase by at least 50% when the company reported the updated reserves for 2008, but the company surprised again to the upside, reporting a 200% increase in proven reserves to 5.4m barrels and this is despite the 645k barrels produced in the year.
It is very likely that proven reserves will exceed 6m barrels in 2009, once the company finalizes the installation of the new 35 wells for the year, and possibly increase even more if oil drilling is accelerated as a result of the higher oil prices.
Major Stock Exchange Listing
On Monday June 15th, China NEP moved from the OTC market (symbol: CNEH.OB) to the NYSE Amex (symbol: NEP). This switch present the most important milestone for 2009, making the company the first non-state Chinese oil producer to be listed on the NYSE Amex, other than the state owned majors Petrochina (NYSE: PTR), Sinopec (NYSE: SNP) and CNOOC (NYSE: CEO).
The listing on a major exchange will radically change the perception of the company by the financial community. The added credibility, prestige and liquidity resulting from this listing should contribute significantly to the development of the company by offering China NEP wider and cheaper access to capital, as well as offering warrants holders the ability to exercise their warrants, thus netting the company close to $13m in additional funding.
The listing should play a key role in bringing the company's valuation closer to the average valuation in the oil and gas sector.
The listing has also satisfied one of the key requirements for the February 2008 debenture financing, thus further reducing the company's risk profile.
Current and Expected Oil Prices
In January 2009, global oil prices were languishing in the $30s, and the world economy was staring at the abyss as the financial markets melted down and the world's largest economies shrunk at the fastest pace since the Great Depression. Today, however, the picture has improved significantly. The world economy seems to be stabilizing. Asia continues to grow at a brisk pace, while the US and the European economies are slowly mending.
The improvement in the world economy, as well as the sharp oil production cuts by OPEC in combination with the reduced investment in the oil industry, have joined forces to bring supply and demand into a more sustainable balance, thus leading to a doubling in oil prices since January, and leading the likes of Goldman Sachs to predict oil prices as high as $85 by late 2009 and over $95 by the end of 2010.
The revival in oil prices and their expected continued increase have a radical impact on China NEP's revenue and earnings outlook over the next 12 months, as the dynamics of rising oil prices and the company's rising oil production should combine to generate very strong revenue and EPS growth in the next few quarters.
China NEP shares have appreciated by close to 200% since January 2009; nonetheless, the company remains extremely undervalued and is significantly lagging the average valuations in the oil and gas exploration and production sector.
As of June 18th the valuation stood as such:
- P/E: 5 vs 9.8 for the industry.
- P/S: 1.9 vs 4.2 for the industry.
- P/B: 2 vs 2.25 for the industry (it is worth noting that the current price to book is based on the 5.4m proven reserves and not the 16m proven + probable reserves).
- P/C : 3.4 vs 9.7 for the industry.
This undervaluation could not be explained by the company's execution and financial performance as China NEP enjoys better gross margins, better net margins, higher revenue and EPS growth, as well as better ROE, ROA and ROC than the industry. Thus it is more logical for the company to enjoy a premium valuation to the sector, and it is very likely that the added exposure on the NYSE Amex will help achieve this premium valuation overtime.
Some of the catalysts mentioned in January have taken place, such as the major stock exchange listing, as well as the increase in the oil price, however other catalysts remains:
New Leases: The China North East model is a very profitable model for both China North East and 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. The company is continuing discussions to secure such leases.
Acquisitions: In the area where China NEP operates, there is a total of 36 private oil extractors working for PetroChina, many of whom have much more limited financial resources then China North East and none is a publicly listed company. Management has indicated an interest in acquiring a competitor for some time now. It is worth noting that China North East 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 change dramatically in the market place.
It is also worth noting that in May the company mentioned the possibility of expanding into related businesses such as oil field services (probably drilling). An expansion in this direction will offer the company better control on its biggest cost (drilling), as well as a new revenue stream which is somewhat less dependent on the short term volatility of the oil price, while making the company also less dependent on the timing of obtaining new oil leases to ensure long term growth.
Friendly political environment: The Chinese government considers the resource sector a key strategic sector and has been encouraging domestic oil producers to increase production in order to ensure much needed future oil supplies and reduce dependency on foreign oil.
In this regard there has been some discussion about the upping of the Chinese windfall tax threshold to $60 from its current $40. Should this development take place, China NEP's profitability will get a significant boost in the coming years.
Production and Reserves: As was highlighted earlier in this article, China NEP's production growth plan for 2009 was based on $40 oil. However, the significant increase in oil price over the last two months should prompt the company to accelerate its drilling plan, thus significantly increasing its oil production and expanding proven reserves as more wells are installed. Any announcement of increased drilling should positively impact the stock price.
In summary, China NEP continues to execute perfectly on its business plan. The recent increase in oil prices will have a strong favourable impact on the company's balance sheet, production and growth profile over the next few quarters, while the added NYSE exposure will play a crucial role in bringing China NEP story to the forefront by introduce an exciting way for global investors to participate in the private Chinese oil industry.
Based on an expected oil price of $75 to $85 per barrel for 2010, China NEP is likely to generate $101m to $115m in revenues next year based on 1.35m barrels per year in production for an EPS of $1.26 to $1.44. Based on 24m share count and an expected 30% profit margin, should the market award the company an inline valuation multiple, the share price is likely to trade between $12 and $14 over the next 12 months.