China North East Petroleum Catapults to the Next Level

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.

Financial Performance

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:

• Revenues: $14.5m
• Net Income: $7.6m
• EPS: 37c (partially impacted by a decrease in depreciation charges)

As a result of those numbers, China North East Petroleum finished 2008 with the following set of numbers:

• Revenues: $58.6m
• Net income: $19.6m
• EPS: $0.98c

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.

Oil Production

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.

Oil Reserves

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 15^th, 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.

Valuation Ratios

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 18^th 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.

Future Catalysts

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.

Conclusion

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.

Disclosure The author is long NEP shares.

Comments

[Rai:]

Thanks for your great article about NEP, same goes for your previous article. Good research as usual.

Let's hope for the sell-on-good-news to stop, NEP belongs to higher ground for its 30% margin and rising production, especially compared to the peers. New leases would definitely help...

Jun 18 11:12 AM

[Richard Wigley:]

Thanks Nawar for the article. When the PTR royalty rate changes in 2012 from 20 to 40%, I think. How do you calculate the affect of profitability. 20% off the gross margin?

Thanks

rich

Jun 18 01:13 PM

[Nawar Alsaadi:]

Rich, if we assume that the business will remain as is in 2012, the effect of the change in the royalty will mean lower production growth or stagnant production growth, margins should not be effected much (more on this later), it is worth noting that NEP reports its numbers net of the PTR royalty, meaning the company actual production numbers are actually higher then what is reported, since NEP pays the royalty in crude and not in cash.

Based on the company business plan of having 675 wells on the fields, a target that should be achieved by the end of 2012, the company production will be much higher then where it stands today by 2012, after that date expansion drilling is likely going to stop in those fields, with drilling kept at a rate just enough to maintain production as long as physically possible, the effect of stopping expansion drilling will counter the increase in the PTR royalty as the company biggest expense is drilling the new wells, the current fields after 2012 will probably be used as a cash cow to finance new leases or expand into related oil extraction fields such as drilling.

Regards,
Nawar

Jun 18 01:36 PM

[Atticvs Res...:]

Well done Nawar. NEP is a terrific little company, very undervalued, has great potential and an exemplary management group. Whilst the stock price has fallen back this past couple of days I have no doubt it will be well into double digits early 2010. Keep up the good work.

Jun 19 09:15 AM

[Nawar Alsaadi:]

Attic, thank you for your comments, the article maybe fine, but not as good as your articles on the company, when will you update us with a masterpiece!?.

Regards,
Nawar


On Jun 19 09:15 AM Atticvs Research wrote:

> Well done Nawar. NEP is a terrific little company, very undervalued,
> has great potential and an exemplary management group. Whilst the
> stock price has fallen back this past couple of days I have no doubt
> it will be well into double digits early 2010. Keep up the good work.

Jun 19 09:26 AM

[thedivot:]

Nice article Nawar. I believe it is responsible for the $14 million jump in their market cap today!!

I've been in this stock for a long time now and have also enjoyed your comments on the Yahoo message board. I just keep adding on any big dips as the long-term value has been evident for quite a while.

Thanks for the great research.

Jun 19 03:40 PM

[gdlk09:]

Thanks for the great article. NEP is in my hometown and I think it has a great potential to grow.

Jun 19 04:19 PM

[Max Petrisek:]

Newar, Class job of reporting on NEP. You have covered the essentials as well as showing a good insight as to what "might be!" Thanks. I'm long NEP

Jun 20 05:59 AM

[jack foley:]

what do you make of the SEC Filings Friday after close? Are those a lot of shares? Ans is it usually this long after the event? are they connected to the huge sell off right after the move to the NYSE Amex?

I, too, am very long and bullish - but not sure what these 3 filings say about the last week or so.

thanks so much for your fine work


On Jun 19 09:26 AM Nawar Alsaadi wrote:

> Attic, thank you for your comments, the article maybe fine, but not
> as good as your articles on the company, when will you update us
> with a masterpiece!?.
>
> Regards,
> Nawar

Jun 20 10:14 AM

[Nawar Alsaadi:]

The Friday filing was just a standard filing by the warrant holder Lotus Investments, since NEP is an NYSE Amex listed company, over 5% beneficial owners need to file with the SEC.

Regards,
Nawar


On Jun 20 10:14 AM jack foley wrote:

> what do you make of the SEC Filings Friday after close? Are those
> a lot of shares? Ans is it usually this long after the event? are
> they connected to the huge sell off right after the move to the NYSE
> Amex?
>
> I, too, am very long and bullish - but not sure what these 3 filings
> say about the last week or so.
>
> thanks so much for your fine work

Jun 20 06:06 PM

[User 434763:]

On the day it started trading on AMEX, I see a price of $2000 P/Share!!!!!!!!!!!!!! Was this a glitch¡?
Can anyone verify?

Jun 21 06:35 PM

[Nawar Alsaadi:]

Indeed the first day it traded on the NYSE Amex 1600 shares traded at $2000, however I believe this was an error.

Regards,
Nawar


On Jun 21 06:35 PM User 434763 wrote:

> On the day it started trading on AMEX, I see a price of $2000 P/Share!!!!!!!!!!!!!!
> Was this a glitch¡?
> Can anyone verify?

Jun 22 02:33 AM

[peachberry_tea:]

Hey Nawar, thanks for the great article.

Wanted to get your thoughts on how reliable their reserve numbers are or where those numbers come from. Do they hire 3rd party engineers to determine the reserves? Or did they know how much oil was in the ground when they got they leased the stuff from PTR or whoever? If you could shine a bit of light on that that'd be great.

Thanks again

Jun 24 03:02 PM

[peachberry_tea:]

Hmm one more question.. where does that 35% recovery rate come from? Is that typically how much they expect to recover from their fields or is it just some very conservative number used to estimate reserves? If it's a very conservative recovery rate then what's a more realistic recovery rate?

Jun 24 03:47 PM

[peachberry_tea:]

Hmm I'm going to try and answer my own question now that I've actually gotten a chance to look at their 10K

Their proven developed reserves were determined by an independent party.. and that's 5.4mil barrels like you mentioned. How bout their probable/possible reserves? Were those management estimates or where did those reserve figures come from?

Jun 24 07:46 PM

[Nawar Alsaadi:]

Peach, indeed it seems you found some of the answers in regards to the proven reserves, in regards to the probable, this is based on the total amount of geological oil in leased areas, management has mentioned this number in their various presentations, here is a link to one from November 2008:

irpage.net/cneh/docume...

In regards to the recovery rate, this is based on the average recovery rate in the world as well as in China, PTR usually aims for 40% recovery for their Chinese based oil reserves, also the 35% recovery number is what NEP management expects to recover.

Here is also a more detailed study of their proven reserves:
www.cnepetroleum.com/r...

Regards,
Nawar


On Jun 24 07:46 PM peachberry_tea wrote:

> Hmm I'm going to try and answer my own question now that I've actually
> gotten a chance to look at their 10K
>
> Their proven developed reserves were determined by an independent
> party.. and that's 5.4mil barrels like you mentioned. How bout their
> probable/possible reserves? Were those management estimates or where
> did those reserve figures come from?

Jun 25 06:29 AM

[Max Petrisek:]

Just letting you know I'm appreciative of all the details you provide- Thanks again. In due time we will get the stock move you are predicting- double digits!

Jun 29 04:31 AM

[User 3842:]

Hi Nawar,

Thank you for finding such a great company. I like the company, however I have one burning question.
There seems to be just one customer for this company, which to me is a big risk. I know that they have guaranteed their purchase for the next 20 years. But maybe that is one of the reason, NEP is not able to achieve the valuation you feel it should. Also what I fail to understand is, what is the inherent competitive advantage the company has? Is there something that this company does that other's cannot do, or is it something that pretty much anyone can come in and do. Do they really have a moat in the business they are in. Also what happens after the 20 year agreement is up? Hopefully by then they will be big and doing something different. But what is the disaster scenario in that case?

Thanks for your help in advance.
Vish

Jun 30 03:20 PM

[Nawar Alsaadi:]

Vish, this customer is tied by the royalty agreement to purchase all the produced oil, and PetroChina is not just any customer, this is one of the world largest oil companies and was the largest in 2008, the quality of the customer is not an issue in my opinion, and even if they stopped buying, selling their crude to someone else should not be an issue.

In regards to their competitive advantage, the oil business is a commodity business, thus the competitive advantage of players in this industry is cost, and NEP has one of the lowest cost structures in the industry as evident by their ROE/ROA and ROC, as well as their gross and net profits margins.

As for what happen in 2022 after the current lease expires, the company is looking to expand its production through the signature of new leases, the acquisition of a competitor or the move into a related business such as oil drilling, I believe the company has enough resources to expand beyond current leases way before 2022 and probably starting this year.

The biggest risk to the company is the price of oil, if oil price dip under $30 and remain under $30 for an extended period of time, the company may not be able to fund its operations without additional debt or heavy dilution.

Regards,
Nawar


On Jun 30 03:20 PM User 3842 wrote:

> Hi Nawar,
>
> Thank you for finding such a great company. I like the company, however
> I have one burning question.
> There seems to be just one customer for this company, which to me
> is a big risk. I know that they have guaranteed their purchase for
> the next 20 years. But maybe that is one of the reason, NEP is not
> able to achieve the valuation you feel it should. Also what I fail
> to understand is, what is the inherent competitive advantage the
> company has? Is there something that this company does that other's
> cannot do, or is it something that pretty much anyone can come in
> and do. Do they really have a moat in the business they are in. Also
> what happens after the 20 year agreement is up? Hopefully by then
> they will be big and doing something different. But what is the disaster
> scenario in that case?
>
> Thanks for your help in advance.
> Vish

Jul 01 08:31 AM

[User 3842:]

Thanks Nawar for your response. I think I see the underlying value better after your clarification.

Thanks


On Jul 01 08:31 AM Nawar Alsaadi wrote:

> Vish, this customer is tied by the royalty agreement to purchase
> all the produced oil, and PetroChina is not just any customer, this
> is one of the world largest oil companies and was the largest in
> 2008, the quality of the customer is not an issue in my opinion,
> and even if they stopped buying, selling their crude to someone else
> should not be an issue.
>
> In regards to their competitive advantage, the oil business is a
> commodity business, thus the competitive advantage of players in
> this industry is cost, and NEP has one of the lowest cost structures
> in the industry as evident by their ROE/ROA and ROC, as well as their
> gross and net profits margins.
>
> As for what happen in 2022 after the current lease expires, the company
> is looking to expand its production through the signature of new
> leases, the acquisition of a competitor or the move into a related
> business such as oil drilling, I believe the company has enough resources
> to expand beyond current leases way before 2022 and probably starting
> this year.
>
> The biggest risk to the company is the price of oil, if oil price
> dip under $30 and remain under $30 for an extended period of time,
> the company may not be able to fund its operations without additional
> debt or heavy dilution.
>
> Regards,
> Nawar

Jul 01 09:29 AM

[treit:]

Nawar,

Thanks for your considerable and clear research.

Assuming NEP secures additional new leases (announcement this year??):

1) do you assume the same terms 20% and 40% royalty, and

2 do you foresee a renegotiation of current leases with PTR.

That is, NEP would have every incentive to drill in the new leases (20% royalty) rather than the old, where PTR would have the obvious preference (40%). Are there any provisions that NEP must satisfy drilling the first leases to conclusion first (600+ wells). If not, would you expect Nep to negotiate some arrangement whereby new drillling could be split in some proportion between the old and new leases.

TIA


On Jun 18 01:36 PM Nawar Alsaadi wrote:

> Rich, if we assume that the business will remain as is in 2012, the
effect
> of the change in the royalty will mean lower production growth
or
> stagnant production growth, margins should not be effected much
(more
> on this later), it is worth noting that NEP reports its numbers
net
> of the PTR royalty, meaning the company actual production numbers
are
> actually higher then what is reported, since NEP pays the royalty
in
> crude and not in cash.
>
> Based
on
> the company business plan of having 675 wells on the fields, a
target
> that should be achieved by the end of 2012, the company
production
> will be much higher then where it stands today by 2012,
after
> that date expansion drilling is likely going to stop in those
fields,
> with drilling kept at a rate just enough to maintain production
as
> long as physically possible, the effect of stopping expansion
drilling
> will counter the increase in the PTR royalty as the company
biggest
> expense is drilling the new wells, the current fields after
2012
> will probably be used as a cash cow to finance new leases or
expand
> into related oil extraction fields such as drilling.
>
> Regards,
> Nawar

Jul 08 05:27 PM

[406597:]

So now we know that production for this quarter is up 65%. Also drilling is behind schedule due to the rainy season but the company believes they can catch up. Good news in a bad macro environment for oil and oil related companies.

Jul 09 10:01 AM

[Kung:]

The stock grew 22% yesterday~ I think what you are prediciting is happpening Nawar

Aug 03 10:25 PM