Sinopec: Expecting Continued Production Growth, Capacity Expansion

| About: China Petroleum (SNP)

Sinopec (NYSE:SNP) recently reported strong operational results for 2006. While a number of uncertainties remain, we believe that the near- to medium-term environment supports its continued upstream production growth and downstream capacity expansion.

Moreover, Sinopec's integrated petrochemical and refining businesses are expected to benefit from possible price reform for refined products in China. Therefore, we are maintaining our Buy recommendation on Sinopec.

China Petroleum and Chemical Corporation or Sinopec, with its head office in Beijing, China, is one of the largest petroleum and petrochemical companies in Asia. The company is the second largest crude oil and natural gas producer in China, and the largest refiner and marketer of refined petroleum products.

The company is also the largest producer and distributor of petrochemicals in the nation. China Petrochemical Corporation (or the Sinopec Group), a state-owned enterprise, owns a 71.2% stake in Sinopec. Sinopec is an integrated oil and gas company engaged in the exploration and production of oil and natural gas, the refining and marketing of petroleum products, and the manufacture and sale of petrochemicals.

While it has upstream, midstream, and downstream operations, its asset base and operations are geared more toward downstream activities. Sinopec operates in four business segments: exploration and production, refining, marketing and distribution and chemicals. The company's exploration and production activities are primarily located in mainland China.

At year-end 2006, the company had a proved reserve base of approximately 3.8 billion oil-equivalent barrels [BOE]. The company operates 25 oil refineries, with a combined throughput of approximately 2.93 million barrels per day.

Sinopec's installed refining capacity accounts for roughly half of China s entire refining capacity. As of year-end 2006, the company operated 28,001 company-owned and 800 franchised service stations. Most of the stations are located in the Eastern and Southern China, which are the more developed parts of the country.

Sinopec's recent results have been fairly strong. In the upstream business, oil and gas production increased year-over-year as well as sequentially. The company also posted gains in refined-product volumes. In the retail marketing business, retail volumes increased approximately 14% year-over-year, driven by continued robust refined-product demand in China.

The company's chemicals business continues to benefit from China s strong economic growth, with ethylene and synthetic resin volumes increasing by approximately 15% from the year-earlier level. We expect the company's recent performance momentum to be sustainable over the near to medium term. While there are uncertainties including government price controls that may squeeze downstream margins, volatility in crude oil prices, and rising domestic competition, we believe that the near to medium-term environment remains supportive to its upstream production growth and downstream capacity expansion.

Moreover, Sinopec has the most integrated petrochemical and refining businesses in China and possible refined-product price reforms will benefit it. Therefore, we are maintaining our Buy recommendation for Sinopec.

Our outlook for the Chinese oil and gas industry is positive. Strong oil price supports the high profit margin of oil companies. Rising oil demand and imports have made China a significant factor in world oil markets. The country s burgeoning energy needs are expected to provide significant growth opportunities to companies with exposure to China. Crude oil price are expected to remain fairly strong in 2007, given the continued tight supply-demand balance in the global energy complex. Sudden accidents such as terrorism, disaster and war will easily push up the oil price.

China is the world's second largest petroleum consumer (the U.S. is the largest), with total crude oil demand of roughly 7 million barrels per day, of which approximately 4.2 million barrels per day were produced domestically. The country imported 145 million tons of crude oil in 2006, representing a 14.4% growth rate.

It is estimated that Chinese demand will increase roughly 7% in 2007. Historically, natural gas has not been a major fuel in China. But given the country's substantial natural gas reserves of roughly 53.3 trillion cubic feet at the beginning of 2003 and the environmental benefits of using natural gas, China has embarked on a major expansion of its natural gas infrastructure. Until the early 1990s, natural gas was mainly used as a feedstock for fertilizer plants, with little use for electricity generation.

Natural gas currently accounts for only 3% of total energy consumption in the country, but that is expected to more than double in the next few years. This will involve increases in domestic production and imports, by pipeline and in the form of liquefied natural gas [LNG]. Given growth projections for the Chinese economy and more cars owned by Chinese people, the country's needs for oil and gas will continue to grow. This provides attractive growth opportunities to companies engaged in every aspect of the Chinese oil and gas value chain compared to most other markets in the world.

Moreover, the energy industry in China is highly regulated to protect CNOOC, Sinopec, and PetroChina from serious competition. What's more, energy is related to the safety of the country. It's unlikely that the government will enact policies that would hurt the state-owned companies in a major way.


Sinopec is one of the largest petroleum and petrochemical companies in Asia. In China, the company is the second largest crude oil and natural gas producer. Sinopec is the largest refiner and marketer of refined petroleum products in China. Sinopec has about half of the refining capacity in China. It also has a share of 64.6% in the retail market of refined petroleum products in 2006 and has more than 80% market share in coastal provinces.

The company is also the largest producer and distributor of petrochemicals in the nation. For some chemical products, Sinopec has more than 50% of the productions in China. Sinopec's downstream operations are primarily located in China's prosperous and fast-growing coastal provinces, which it has further strengthened by lowering costs, increasing refining capacity, and converting coastal refineries to handle imported sources of crude varieties. This has positioned the company to benefit from the continued growth in Chinese refined-product consumption levels.

On April 10, 2007, Sinopec announced its annual results for the twelve months ended December 31, 2006. Under International Financial Reporting Standards [IFRS], the Company's turnover with other operating revenues and income, was RMB 1,076.40 billion (US$135.21 billion) in 2006, an increase of 29.27% compared to 2005.

Profit attributable to shareholders was RMB 53.91 billion (US$6.77 billion), an increase of 30.05% compared to last year. The Board of Directors proposed a dividend of RMB 0.15 per share for the full year of 2006, which is equivalent to RMB 15 (US$1.88) per American Depositary Share [ADR]. After deducting the interim dividend of RMB0.04 that has been paid, the final dividend for 2006 is RMB 0.11 per share.

Currently, SNP ADRs are trading at 11.8x our 2007 earnings estimate, similar to its global and Chinese peers. Given the company's good position to leverage China's strong economic growth, we see upside potential from current levels. Our $100.00 price objective reflects a P/E multiple of 13.0x our 2007 earnings estimate.


  • Competition from major global integrated petroleum and petrochemical companies is increasing in China's market.
  • Sales have been sensitive to the availability and prices of feedstock and general economic conditions since most of Sinopec's revenue is attributable to prices of crude oil, refined petroleum products and petrochemical products.
  • More than 70% of the crude oil required by its refinery business was sourced from outside suppliers.
  • The Chinese government s regulations have influenced and will continue to influence the company's activities through determining retail guidance prices of refined products, rights to explore and produce crude oil and natural gas, and import and export quotas and procedures.
  • The special oil income levy will adversely affect the company's earnings when crude oil price exceeds US$40 per barrel.

  • Sinopec remains well positioned to benefit from China's strong economic growth.
  • Sinopec has the most balanced petrochemical business in China. The company's reported stable growth in 2006.

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