China North East Petroleum Poised to Grow

I have been an investor and a follower of China North East Petroleum (NEP) since mid-2008, and during this time, I have seen the business grow and evolve. The management team has been systematic in its efforts to transform the company from a small oil extractor in the Jilin oil field to a sizable oil player in the nascent Chinese private oil industry. (You may refer to: Tremendous Value Found in China North East Petroleum – January 19^th).

The company has crossed a number of milestones in its efforts to achieve its goals. Most notable was its ability to raise $15m dollars in debt (in addition to $13m in warrants) in March 2008 to quicken the pace of its drilling on its existing leases. This acceleration has lead to the expansion of its production capacity from 370,000 barrels yearly run rate at the time of the financing to 900,000 barrels yearly run rate today, and well on its way of hitting the million barrel a year run rate by the forth quarter of this year.

In June of this year, the company crossed a new milestone by listing its shares on the NYSE Amex (You may refer to: China North East Petroleum Catapults to the Next Level – June 18th). The listing has tremendously enhanced the visibility of the company and significantly increased the liquidity of its shares.

The increase in production, revenues, cash flow and reserves during the last few years is only one component of NEP's growth plans. NEP management has big ambitions for the company, and the true extent of their ambitions will only be revealed when one of the following takes place:

- The signature of a new lease with PetroChina (NYSE: PTR), thus greatly expanding the company reserve base and future production potential.

- The acquisition of a competitor in the Jilin oilfield, among the 36 private operators that operate in that field.

- The acquisition of a driller or an oil field services company in order to vertically expand the business.

Recent action by the management indicates that such an event is imminent. The company is perhaps weeks away from undertaking the biggest transformative step in its history. The reasons for my expecting this are as follows:

On November 14^th 2008, the CEO Mr.Wang declared the following:

“We are encouraged with our opportunity in the market and continue to focus on expanding our position in China's oil market by adding more wells to our production capacity and seeking additional oil fields to lease and operate.”

On March 30^th 2009, Mr. Wang had this to say:

“We have a solidly profitable business and a growing cash position which provides us with a unique opportunity to expand our presence in the northern China region. With oil prices at much lower levels compared to the prior year period, we will continue to evaluate obtaining additional oilfield leases and consider potential acquisition opportunities. We believe our ongoing growth initiatives will expand our market presence and further establish CNEH as an important player in the North China region. We are very excited by our future opportunities and look forward to sharing more of our plans with our shareholders as we progress through the year,' concluded Wang.”

On May 15^th 2009, the CEO had this to say:

“We remain highly focused on exploring all possibilities to further expand our business presence and market position in the domestic private oil industry in China. We will do so by continuing to increase our production levels, seeking to acquire new oilfield leases and expanding our business into directly related areas of petroleum operations.”

On August 14^th 2009, Mr.Wang reiterated the company commitment to expand:

“Furthermore, the Company's strong cash position provides us with a heavily favored position when applying for new oilfield leases in order to further expand our business presence and market position in the domestic private oil industry in China. The application has been submitted to PetroChina headquarters, and we will update the shareholders on our progress”

NEP was maintaining a strong cash position of $22 million dollars on its balance sheet as of June 30^th. This cash position is more than what the company needs to fund its operations, and historically the company has deployed excess cash toward the drilling of additional wells. Furthermore, within two weeks of listing on the NYSE Amex, the company filed a shelf offering for $40m. It is clear that the company is readying its financial capability for a corporate event.

The multiple reiterations by the CEO in addition to the growing cash position along with the filed shelf offering suggest that a transaction is in the works. It is probable that the sharp decline in oil prices in late 2008 and early 2009 delayed the execution of such a transaction; however the conditions today seems to be ripe for the company to go ahead with its expansion plans, the company’s cash position is strong, oil prices are elevated and the company enjoys easy access to the capital markets due to its listing on the NYSE Amex.

Supportive Policy Change

Management indicated in its latest investor presentation during the NYSE Foreign company investment forum on August 5^th that PetroChina (PTR) is planning to focus more on overseas expansion while leaving the domestic oil fields to be developed by the domestic private oil players:

“A right fit to the shift of investment objectives of PTR, which plans acquiring oil reserves from overseas, and let private firms to assist domestic oil production”

This assertion by the company has been confirmed by the Sinopec (SNP) announcement on August 24^th that it would expand its overseas presence, driven by a government directive to do so, from Bloomberg:

“Sinopec will invest in oil and gas fields overseas and expand refining ventures with foreign partners, while focusing on cost reduction as it expects oil prices to rise in the second half”, Chairman Su Shulin said in the statement.

“Sinopec’s main business is refining and it needs to increase its oil reserves and reduce its reliance on other oil producers,” said Larry Grace, an independent oil analyst based in Hong Kong. “There’s a government directive to increase overseas oil and gas assets.”

Conclusion

The combination of the strong cash position, shelf offering, reiterations by the CEO and the policy directive confirm that a key corporate event is indeed likely imminent.

The official declaration of such an event being a signature of new leases with PetroChina or the undertaking of an accretive acquisition of a competitor or a driller will have a strong positive impact on NEP's shares. Investors would be wise to take a position in the stock ahead of such an announcement.

Disclosure: The author is long NEP shares.

References

- Bloomberg

- China North East Petroleum official website

- Company SEC filings

- Company Presentation

Comments

[Danny Furman:]

Thanks for the thorough analysis, Nawar. Higher oil prices vs Q2 and additional wells in production should result in a record Q3. There seems to be a lot of shorting going on since the NYSE listing, seemingly to accumulate at these levels while volume is minimal. FY09 results will likely be the catalyst if NEP ever attains fair valuation (12x current earnings?).

Aug 27 11:22 AM

[Nawar Alsaadi:]

Thank you for your comments, I believe Q3 will be strong and the best for the year so far, but it will not be a record for the company, it will be in the $15m revenue range and around 20 EPS, the record quarter is going to be Q4 due to increasing production and rising oil prices; a fair valuation indeed will take us to a low double digits P/E and stock price.

Regards,
Nawar


On Aug 27 11:22 AM Danny Furman wrote:

> Thanks for the thorough analysis, Nawar. Higher oil prices vs Q2
> and additional wells in production should result in a record Q3.
> There seems to be a lot of shorting going on since the NYSE listing,
> seemingly to accumulate at these levels while volume is minimal.
> FY09 results will likely be the catalyst if NEP ever attains fair
> valuation (12x current earnings?).

Aug 27 11:38 AM

[egarl:]

One thing that seriously harms NEP is the government's surcharge mentioned in the 2nd quarter report. The surchage is 20% on oil over $40 and 40% on oil over $60.

Aug 27 01:53 PM

[Nawar Alsaadi:]

There has been some talk (by the head of PTR and few analysts) about the surcharge threshold being upped to $60, however nothing came out of it as of yet; by all means despite the surcharge NEP gross and net margin is much higher then oil extractors in the US who pay no surcharge.

Regards,
Nawar


On Aug 27 01:53 PM egarl wrote:

> One thing that seriously harms NEP is the government's surcharge
> mentioned in the 2nd quarter report. The surchage is 20% on oil over
> $40 and 40% on oil over $60.

Aug 27 02:03 PM

[User 479026:]

There is currently a serious drought in north east China. What affects would this have on oil production?

Aug 29 12:31 PM

[User 479026:]

The most severe drought is in Jilin province, where NEP operates its oil fields.

Aug 29 12:36 PM

[Nawar Alsaadi:]

Actually the lesser the rain the better it is for NEP, one of the biggest problem for drilling is the rainy season, in May their drilling was delayed due to the heavy rains, if I am not mistaken current conditions are ideal for NEP drilling plans.

Regards,
Nawar


On Aug 29 12:36 PM User 479026 wrote:

> The most severe drought is in Jilin province, where NEP operates
> its oil fields.

Aug 29 01:50 PM

[milo Wolff:]

China has specialized some of its oil operations, for greater efficiency. NEP is mainly a driller. Other companies do the prospecting, refining and retailing. Accordingly NEP will grow rapidly.
- Milo

Sep 05 12:18 AM

[User490104:]

Thanks for your analysis. What is your take on the $18.4 million offering that NEP just closed? Another sign that another announcement is on the way?

Sep 23 12:33 AM

[Nawar Alsaadi:]

This offering was a much needed step for NEP to proceed with its expansion plans, at this point, all the pieces are in place for NEP to start its strategic growth plan, starting with a driller and ending with access to new oil leases or the acquisition of further reserves, the combination of strong organic growth along with a number of external growth initiatives will yield very strong revenue and EPS growth in the next few quarters.

Regards,
Nawar

Sep 23 08:11 PM

[User490104:]

Thanks for your reply. I look forward to your next article.

Sep 24 12:02 AM

[Ramesh:]

This is a general question about migration of stocks from pink sheets or other OTC to an exchange. What happens to the shares held? Do they get migrated? Do you have to sell them and purchase the exchange version?

for example, what happened to CNEH.OB holders when NEP was listed in amex?

thanks.

Oct 06 11:41 AM

[Nawar Alsaadi:]

Sorry, I just saw your message, you continue to hold the shares, your broker will switch them with the new shares.

Regards,
Nawar


On Oct 06 11:41 AM Ramesh wrote:

> This is a general question about migration of stocks from pink sheets
> or other OTC to an exchange. What happens to the shares held? Do
> they get migrated? Do you have to sell them and purchase the exchange
> version?
>
> for example, what happened to CNEH.OB holders when NEP was listed
> in amex?
>
> thanks.

Oct 22 11:36 PM