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I would like to discuss two very promising companies that will benefit from the opportunities in China's oil service industry, SinoTech (NASDAQ:CTE) and Recon (NASDAQ:RCON). CTE is an LHD provider and RCON is an oil field management solution provider.

SinoTech Background

SinoTech (CTE) provides EOR services in China. Its two key services are: lateral hydraulic drilling (LHD) and EOR solutions that utilise molecular deposition film (MDF) technology.

LHD services enhance the reach of existing vertical wells by drilling laterally from them into surrounding oil reservoirs. This allows oil to flow into the vertical wells. SinoTech will be a major beneficiary as it is the sole licensee of its US supplier’s third-generation LHD technology in China.

MDF is a chemical flooding EOR technology. The MDF solution is added to water to be injected into oil wells, where it forms an ultra-thin film around sand and stones. This allows the residual oil that adheres to sedimentary rock or sand to flow more freely.

Growth Strategy

SinoTech plans to increase the number of its LHD units to 20 by the end of March 2012. This will more than double its current servicing capacity and can accommodate about 1,000 wells a year.

The company also modified its contract with Jet Drill in October 2010, so that SinoTech has exclusivity in China subject to a 10-year contract, which can be renewed thereafter every three years perpetually. As Jet Drill has improved its production efficiency and cost controls (and given that SinoTech is its largest customer, and thus values its business), the price of each LHD unit has also been lowered from $8m to $6.8m.

SinoTech’s LHD business is its main focus and will account for more than 80% of the company’s revenue from FY11 onward. Management thinks its MDF business is likely to remain flat.

The company has contracted Hebei Daofu and Panjin Hanyu to provide MDF services. SinoTech will charge its contractors a fixed monthly fee instead of basing it on the amount of oil extracted. Even though revenue would be lower, this would allow SinoTech to achieve a higher profit margin and stable revenue.

Supply

According to its agreement with Jet Drill, SinoTech has exclusive rights to use LHD technology in China. Its 10-year exclusivity can be extended every three years thereafter into perpetuity.

Jet Drill has produced about 50 LHD units so far, which it sold to customers in markets such as Indonesia, Colombia and Kazakhstan. Its LHD technology is not widely used in the US as about 50% of the wells there only produce about 2bpd. According to Jet Drill, it does not make economic sense to apply LHD technology in the US.

MDF

MDF is a chemical flooding EOR technology. The MDF solution is added to water to be injected into oil wells, where it will form an ultra-thin film around sand and stones. This allows the residual oil that adheres to sedimentary rock and sand to flow more freely. SinoTech has been applying MDF technology at the Dagang and Liaohe oilfields, where production have risen 17%-36% on average. MDF costs $30,000-295,000 per area serviced. SinoTech has purchased all the patents related to MDF technology and has an exclusive agreement with a third-party supplier in Tianjin.

Financials

SinoTech paid down its $50m loan in November 2010 with the proceeds from its IPO, making it debt-free. With strong cash flow from its LHD business, I expect the company to accumulate a large cash position. This could provide SinoTech with the opportunity to acquire more LHD units.

According to the most recent quarterly report, CTE had superior growth in operating income but negative net income. This is caused by non-cash charge of warrants. Let’s take a closer look.

On January 2010, CTE’s China operating entity entered into an amended and restated facility agreement with a group of financial institutions (arranged by Deutsche Bank) for a loan of up to $65m. CTE utilised $50m of the loan to purchase LHD units and subsequently paid it down to zero in November 2010.

Premium Sino Finance, owned by CTE CEO Mr.Qingzen Liu, issued four series of warrants, in Tranches A, B, C and D, to the lenders, to entitle them to purchase a certain percentage of Superport’s fully diluted share capital from Premium Sino Finance. Premium Sino Finance is required to transfer its shares in Superport to the warrant holders upon the exercise of the warrants. (Superport is 100% owned by the SinoTech U.S. listed entity and owns 100% shares of CTE’s China operating entity).

Since the warrants issued by Premium Sino Finance were for the purpose of obtaining a bank loan for SinoTech, the fair value of the warrants has been recognised as warrant liabilities in SinoTech’s financial statements, with the corresponding amount recognised as a discount to the loan.

As the warrants were issued by Premium Sino Finance, which is solely owned by Chairman Qingzeng Liu, exercising them did not lead to a dilution of SinoTech’s shares. Since SinoTech’s IPO in November 2010, all the warrant holders have exercised their warrants.

I expect that the non-cash item will be decreasing within the fiscal year of 2011. In 2012, we will see a very healthy income statement and balance sheet of CTE.

Overall, I believe CTE will benefit from an oil price runup and huge demand in China. The share price dropped below $5 after the IPO and slowly and steadily climbed back to above $7. I think it is a good time to accumulate the stock. Within 4-6 months, I expect to see the share price above $10.

CTE is a recent IPO and its underwritters are Deutsche Bank (NYSE:DB), UBS (NYSE:UBS), and Citigroup (NYSE:C). Its Venture Capital investor is famous Sequoia Capital.

Recon Background

Recon (RCON) is another company I found interesting. Recon Technology has provided oilfield services and products to automate and enhance the extraction of petroleum in China, including well service, drilling service, production and field service. Recon's specialized proprietary software and hardware can manage the oil extraction process in real-time, thereby reducing extraction costs.

Recon Technology engages in the design, manufacture, and installation of oil field servomechanism systems engineering.

Recon Technology’s products and services include:

  1. RSCADA System, an industrial computerized process control system for monitoring, managing, and controlling oil field service extraction
  2. water system, a technology designed to find and block water content in oil field service
  3. multi-purpose fissure shapers, which helps in enhancing the extractors’ability to test for and extract petroleum.
  4. acoustic pipeline monitoring system widely used to prevent gas leakage in the transport pipeline.

The company did its IPO in October 2009. However, as a small company, it is basically forgotten by investors. Even oil has rallied from $50 to near $90, and this stock is still trading in a tight range.

China's oil and gas industry is dominated by three state-owned companies. Two of them and CNPC are Recon's primary customers. Recon has provided services to Sinopec since 1998, and CNPC since 2000. Recon conducted automation projects for about 80% of CNPC and Sinopec's oil and gas fields, covering three of China's four highest producing oil fields in Daqing, Shengli and Xinjiang.

RCON is a very small company. Its trailing 12 month net income was $3.0M, and the management is projecting minimum organic net income growth of 20% in 2011. If you check the Canadian and US Peers, they enjoy P/Es as high as 66x. A very conservative P/E of 10x gives RCON a $7-$8 stock price.

So overall, I like these two stocks. I think with positions in both of these two stocks, investors will have a great exposure to China’s fast growing oil service industry.

Disclosure: I am long CTE, RCON.

Source: How to Profit From China's Rising Oil Demand