China North East Petroleum: An Opportunity for Short-Term Traders and Long-Term Investors

| About: China North (CNEP)

China North East Petroleum (NYSEMKT:NEP) is a low-cost, high-margin, cash generative oil producer in northeast China that experienced two very damaging events in 2010.

First, in early 2010 the company uncovered accounting errors that spanned 2008 and the first three quarters of 2009. The correction exercise lasted through to the end of August 2010, and the related lack of timely SEC filings led to a suspension of NEP’s stock quotation from May 26 to September 9, 2010.

NEP has taken appropriate steps to ensure that this issue remains a one-time event. On November 19, 2010 when the company released its Q3 earnings report Jingfu Li, NEP’s CEO commented:

… Management is actively working to improve the control environment and to implement procedures that will ensure the integrity, accuracy and timeliness of our financial statement preparation process going forward. We have utilized an outside consulting firm with specialized knowledge in financial accounting and specific knowledge of oil industry accounting …. We have also engaged Ernst & Young (China) Advisory Ltd. to assist us with SOX 404 compliance. Ernst & Young will also provide recommendations for instituting necessary additional controls to enhance the risk management capability of our internal controls over financial reporting …. We also implemented financial reporting training programs for specific staff members, particularly with respect to accounting for non-cash items. We are making the effort to support these endeavors to ensure that our previous reporting delays do not recur.

Against a media backdrop of considerable negativity towards all U.S.-quoted Chinese companies, this accounting issue proved to be very damaging to NEP’s share price. Ironically, NEP’s future operating profits are likely to be somewhat higher – not lower – than they would have been using the company's old methods. This arises because the company had to absorb large asset impairment costs during 2008 and 2009 by way of correction, and thus the related depreciation/amortization P&L charges going forward are actually reduced.

Second, spanning the months of May through August 2010, China suffered one of its worst floods of all time. Between floods and the associated landslides over 3,000 people lost their lives and 15 million people were evacuated from their homes. Total damage is estimated to be over $50 billion. Northeast China, including Jilin province where NEP operates, was one of the hardest hit regions. Floods and landslides washed away roads and caused major interruption to NEP’s oil operations, which rely upon trucks for collecting and delivering oil to PetroChina. The flood negatively impacted NEP’s oil output by about 15% during Q2 2010 and by about 40% during Q3 2010. The indications from the company are that production is returning to normalized levels during Q4 2010 and there is no real reason to expect any significant lingering impact into 2011.

On November 19, Jingfu Li, CEO advised: “We believe our fourth quarter production will operate at a more normalized rate."

The impact the two big 2010 events had on NEP’s stock price can clearly be seen on charts. NEP’s stock price was $9+ in early 2010 and at that time the company had total cash of $28 million, about $1 per share. During 2010 this cash balance has doubled to $2 per share, the company substantially grew its well-drilling business during the year, and NEP is now closer to boosting its future profitability via acquisitions. And yet the stock price currently sits at just $5.55.

Let’s look briefly at some appropriately conservative numbers.

Q4 2010: Assuming a legacy interruption effect of 15% from flood/landslide, on top of normal annual reservoir depletion of 10%, total oil output in Q4 would be 197,000 barrels. Using an average Q4 oil price of $80 per barrel, NEP would achieve basic EPS of 33 cents and fully diluted EPS of 31 cents. On December 31, 2010, NEP’s total cash was estimated at $57 million, just under $2 per share.

Full Year 2011: Assuming no significant lingering effect from flood/landslide, but incorporating a further 10% oil reservoir depletion, total oil output would be 850,000 barrels. Using average 2011 oil price of $80 per barrel, NEP would achieve basic EPS of $1.50 and fully diluted EPS of $1.42. On December 31, 2011, NEP’s total cash should be about $111 million, equivalent to $3.70 per share.

Note: In Q3 2010, NEP recommenced its drilling program once the effect of the floods waned and three new wells came into production in Q3. I assume eight new wells will come online Q4 2010 and a further 20 new wells in 2011. Oil output for new wells is higher than that of old wells because of natural reservoir depletion over time. Any positive effect of these new wells has been disregarded in the aforementioned Q4 2010 and 2011 numbers.

Short term trader or long term investor?

With NEP both approaches should be highly profitable. Currently the markets are displaying utter disbelief towards Chinese stocks, at least until these companies deliver proof of performance via strong earnings reports, at which time their stock prices are re-rated.

Many small companies, including NEP, are likely to report their Q4 2010 earnings in March or possibly early April.

However, NEP has a history of releasing its preliminary oil production data about a month following the end of each quarter – the exceptions being Q2 and Q3 2010 for reasons that are now clear. Around the end of January, NEP will likely publish its preliminary Q4 oil production data; if these numbers are in the region of 197,000 barrels, this will immediately validate the Q4 2010 and Full Year 2011 EPS numbers outlined above. Accordingly, NEP’s stock price should receive a nice boost in the next three weeks.

On January 7, NEP stock closed at $5.55, giving the company a market cap of $164 million. For a company about to deliver fully-diluted EPS in 2011 of $1.42, not to mention already having cash per share of $2.00, this is cheap, or more correctly, wonderfully cheap (the 2011 p/e is 3.9). Once the market has proof that the accounting and flood issues were indeed one-time events, we should see the stock price trade in the $8-10 range. An $8.50 share price is equivalent to six times 2011 EPS and leaves the $2 cash per share in for free, i.e. still cheap, leaving plenty on the table for other investors, and remain capable of moving significantly higher.

Long term investors can expect many catalysts to move the stock higher during 2011: (a) getting complete closure on the one-time flood and accounting issues of 2010; (b) winning new drilling contracts, which the company is known to be actively pursuing; (c) analysts updating their earnings estimates – currently published estimates have not been updated since about one year ago and are significantly understated; and (d) news of some accretive cash-acquisitions is also likely in the coming months. On this last topic, the words of the CEO on November 19 are instructive:

We continue to …. focus on potential acquisition opportunities. We have identified several potential targets and believe that if we are successful with our acquisition efforts, it could result in significant contributions to our overall operations.

By year-end 2011, NEP should be trading in the $12-$15 range. A $12 price is equivalent to a 2011 p/e of 8.5, and again this ignores the projected $3.70 cash per share at end 2011.


NEP’s stock price has been severely damaged by two very large one-time issues that came to light in 2010. The clear indication from the company is that these one-time events will be contained within 2010, and no spillover into 2011 is expected. Via the preliminary Q4 oil production report and the Q4 earnings report, the company will prove that this is the case. Once this occurs, the stock price will surely be much higher than at present.

Finding stocks that have been badly beaten down by genuine one-time events with no lasting damage to the underlying business on a forward looking basis is a highly profitable experience. I have been following and analyzing NEP since it was trading in the $2.00 range during late 2007 and early 2008, and have built up a reasonably thorough understanding of the company. I am confident that the current $5.55 stock price represents an excellent money making opportunity for both short-term traders and long-term investors.

Disclosure: I am long NEP.