China North East Petroleum Forecasts 2013 As Year For Big Production And Profits

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 |  About: China North East Petroleum Holdings Ltd. (CNEP)
by: Atticvs Research

China North East Petroleum Holding's (NYSE:NEP) Q4 2010 earnings conference call on March 16 provided valuable insights into Shengyuan, the pending acquisition located in Inner Mongolia, as well as the company’s existing business.

  • NEP plans to drill 20-30 test wells in 2011 in the Durimu oilfield after completion of the Shengyuan acquisition and bring these into production as soon as practicable.
  • The cost of drilling each well in the existing Jilin oilfield is about $340k (Yuan 2.0 to 2.5 million) and drilling costs at Durimu will be higher, although the company won’t be able to give accurate guidance on costs or the overall drilling plan until its engineering team completes further work.
  • The well-documented severe floods and landslides in China during Q2 and Q3 2010 hurt both oil production and drilling services, and escalated costs thereof during Q4. But now in Q1 2011, NEP is already back performing at fully normalized levels for oil production and drilling. Oil output is running at 2,200 barrels per day, equivalent to over 190k barrels per quarter.
  • During 2011, NEP will drill 10-20 wells at its existing Jilin oilfield in order to maintain oil output at current levels.
  • The company continues to work with Ernst & Young to improve its internal controls.

On February 16, I issued an outline multi-year view of NEP incorporating the Durimu oilfield acquisition. Two of the major assumptions used in that exercise were that (1) each new well drilled would cost $300k, and (2) oil would command a price of $75 per barrel.

Following the Q4 2010 conference call, NEP’s analyst has been quoted as citing that NEP’s total capex for 2011 may be $30 million. This would be made up as follows: $600k x 25 (ave 20-30) wells at Durimu = $15 million, plus $5 million for 15 (ave 10-20) wells at Jilin, plus $10 million initial oilfield capex to cover seismic work, land usage rights, local taxes and licenses, trucking fleet and oil storage units etc., total $30 million.

This $600k cost per well may possibly be overstated because drilling wells with its own in-house drilling subsidiary – which NEP will do at Durimu - is considerably cheaper than using external contractors - which NEP did at Jilin wells. However, until we receive further clarity directly from NEP, it is best to simply adopt the higher, more conservative $600k estimate. Accordingly, I have rerun NEP’s multi-year forecasts with the cost of new wells at Durimu being $600k and using an oil price assumption of $85 per barrel.

Before looking at the revised multi-year financial summaries here are the main assumptions used:

Durimu oilfield: Total reserves 573 million barrels of which NEP expects to recover 143 million barrels.

2011 wells: 25 new wells in Durimu and 15 wells at Jilin.

2012 wells: 70 new wells in Durimu and 15 wells at Jilin.

2013+ wells: 160 new wells at Durimu in 2013, 200 wells in 2014, 200 wells in 2014, and 300 wells annually 2015 to 2019. No further new wells at Jilin.

Oil price: $85 per barrel, all years.

Oil production: Durimu to commence July 1, 2012. This is again conservative and ignores the intention to bring test wells into production as soon as practicable.

Oil output: 10,000 barrels per well in first year of production, declining by 7.5% each year thereafter. The 10,000 output level is 10% below the flow rates encountered at the first 3 existing test wells drilled in Durimu.

Income tax: 30%.

Year

2012

2013

2014

2015

2016

Click to enlarge

NEP P&L - including Shengyuan/Durimu:

Sales ‘000,000

$114.8

$233.1

$361.6

$542.3

$748.5

Gross Margin

68%

70%

72%

72%

72%

Click to enlarge

Net Income ‘000,000

$36.2

$95.0

$162.0

$251.8

$352.9

Net Income %

32%

41%

45%

46%

47%

EPS, 37.5m shares

$0.97

$2.53

$4.32

$6.72

$9.41

Click to enlarge

NEP Cash Flow, including Shengyuan/Durimu ‘000,000:

Year

2011

2012

2013

2014

2015

Opening Cash

$60.0

$59.2

$53.3

$40.3

$50.3

Acquisition

$(10.0)

$0.0

$0.0

$0.0

$0.0

Capex

$(30.0)

$(47.0)

$(96.0)

$(120.0)

$(195.0)

Net Income

$35.2

$36.2

$95.0

$162.0

$251.8

Depreciation

$4.0

$11.6

$24.2

$38.6

$62.0

Working Capital

$(0.0)

$(6.7)

$(36.3)

$(70.5)

$(116.8)

Closing Cash

$59.2

$53.3

$40.3

$50.3

$52.4

Click to enlarge

Cash balances in subsequent years become; $136 million in 2016, $278 million in 2017, $472 million in 2018, $716 million in 2019 and $1.0 billion in 2020.

The Durimu oilfield, via the Shengyuan acquisition, will give NEP a stream strongly increasing profits over several years. Note the tremendous growth in profits and EPS during years 2013 through 2016. Such a degree of earnings visibility is important to larger investors and this will give the stock price strong support over time.

Today, however, that strong visibility does not exist. First, the acquisition must close. Then, NEP will have to drill several test wells to confirm whether the 30 barrels per day flow rate from the 3 existing test wells applies across the Durimu oil field.

Assuming the acquisition does close at the end of Q1, it will likely be May 2011 before NEP can start drilling. Plans to drill 20-30 test wells in 2011 suggest an average of 3 new wells per month for the remainder of the year. Hence, by summer this year, at which time NEP will have about 13 test wells including the 3 existing test wells, we can expect the company to already have a reasonable understanding of its profits potential over the life of the Durimu oilfield.

Ultimately, investors will look to 2013 as the year the big oil volumes and profits arrive with estimated EPS for that year being in the region of $2.50. The question becomes; for a company with excellent visibility and total estimated recoverable oil reserves of 155 million barrels (currently valued at just over $1.00 per barrel), what forward p/e ratio should we apply in mid 2012 to the stock price? A mid-year 2012 forward p/e ratio of 6 would equate to a stock price of $15, a forward p/e of 7 equates to a stock price of $17.50 and a forward p/e of 8 implies a $20 stock.

I fully expect that NEP’s thesis as an outstanding investment will be proved in the months to come as the flow rates from the 3 existing test wells are confirmed across the oil field. Accordingly, and with the help of increasingly certain and strong profits growth visibility over years to come, the stock will surely feature on many investors top pick lists for 2012 towards year-end 2011. For this reason, NEP’s stock will already have registered strong appreciation by Q4 2011 and, by implication, buying NEP stock in Q4 2011, though still good, will be too late for those seeking to maximize gains.

The best way to profit from NEP’s exceptional potential is to acquire shares gradually during the next few months. The shares are already cheap on an existing business basis, the balance sheet is strong and the downside risk is minimal because the new business has not yet been priced in. The current sub-$5 stock price is supported by a net $2 in cash plus a p/e of less than 5 based on its existing business excluding the acquisition. Current analyst pre-acquisition estimates for 2011 are for EPS of $1.01.

First things first, let’s wait to get confirmation that the Shengyuan/Durimu oilfield acquisition deal gets concluded at the end of this month.

Disclosure: I am long NEP.