China North East Petroleum: Strong Growth, Clear Visibility 9 comments
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Having recently secured $15 million debenture financing, plus an additional $13 million equity warrants attached thereto, China North East Petroleum (CNEH.OB) has embarked on a path of demonstrably strong growth set to last a number of years.
Stable Business Model
CNEH possesses oil acreage with total reserves of 75m barrels of which they anticipate extracting about 35%, being approx. 26m bbls, over its useful life. As of December 31, 2007 the company had 157 oil wells and has instigated a multi-year program to boost this to 675. Substantial growth in sales and profits will come directly from this increase in well numbers. This will be complimented by CNEH using more up-to-date technologies in oil extraction, thus improving output and accelerating profitability.
Sustainable Strength
The recent $15m debenture financing, plus warrants, provides the company with sufficient cash to allow it to complete its entire drilling program by 2010 whilst maintaining strong cash balances at all times. After the drilling program is complete CNEH will generate large cash surpluses year after year.
Stable Business Model + Sustainable Strength = Strong Growth, Clear Visibility
Having already engaged the services of a well driller and commenced drilling, the combined effect of CNEH’s generous financing package plus the multi-year drilling program sets it on a path of exponential growth in sales and EPS for years 2008, 2009 and 2010 with good visibility.
Stock Price Target
Assuming an oil price of $90 for all of 2008, and using reasonably conservative forecast assumptions, CNEH’s estimated sales this year are $47.8 million with EPS of $0.70. Using an average oil price of $95 for 2009, forecast sales are $84.5 million and fully diluted EPS $1.10.
Using a p/e of 10, these EPS estimates should support a share price of $10 by late 2008 or early 2009, especially with the company committed, via pledges given under the $15 million financing package, to obtaining a Nasdaq or AMEX listing before the end of February, 2009.
Longer-term investors may take comfort in the view that a year later (end 2009/early 2010) the share price should approach $20 whilst still being moderately valued relative to 2010 EPS.
Keys to P&L and B/Sheet summaries
- Wells Drilled versus Wells in Production: In order to get an understanding of the volumes of oil being produced by CNEH at each oil well - and thereby better understand oil production forecast volumes going forward - it is necessary to exclude the non-producing wells from the overall well numbers. Such a numeric split is not disclosed in the SEC filings and we must rely on best assumptions. This model conservatively assumes that half of all wells drilled in a given reporting quarter will be brought into production that quarter, with the remainder brought into production the following quarter. There will be exceptions to this rule, for example during Q1’08 it is assumed that CNEH drilled only about 10 new wells, all after completing the financing deal, and none of these come into production until Q2’08. As announced by CNEH, a total of 100 new wells are scheduled for drilling in 2008.
- Oil output per well
per quarter has recently been trending up, driven by a combination of;
- new wells being more efficient than older wells;
- a refracture program being applied to some old wells, and;
- the company having introduced water injection technology during the last months of 2007.
Oil output per (producing) well per qtr during Q3 ‘07 was about 660 bbls and rose to just over 700 bbls in Q4 ’07. The estimated output for Q1’08, based on preliminary production figures announced April 28, is 787 bbls. For the sake of conservatism, these P&L estimates assume output per (producing) well per qtr will be 700 bbls for the remainder of 2008 and for 2009 and 2010.
- Average oil price: $90 assumed for all of 2008, $95 for 2009 and $100 for 2010. CNEH, under agreement, sells all its oil to PetroChina, the price per bbl for each calendar month being the price quoted on Singapore spot market on the first day of the month. Traditionally, the sales price is similar to Brent Crude i.e. $2.00 to $3.00 below WTI.
- Total production cost is comprised of extraction costs plus amortisation of wells and well equipment & fittings and water injection system. As oil output volumes increase the total production cost per barrel will fall. This trend applies particularly to the water injection system, which typically reaches optimum efficiency when each water well services about 9 oil wells (depending upon geological structures etc). It will be a couple of years before this point of maximum efficiency is reached. In the meantime the company should enjoy a period of decreasing costs per bbl as the drilling program continues. CNEH’s total production costs per bbl were $25.9 in Q3’07 and fell to $23.2 in Q4’07. Again for the sake of conservatism, these P&L estimates use a slightly higher figure; $24.0 for all of 2008, 2009 and 2010. These higher estimates include a provision that 5% of all new wells drilled will be dry. As at December 31, 2007, CNEH had drilled 157 wells of which none were dry.
- Gov’t Oil Levy: Charged on oil sales above $40 per bbl on rising scale; $40-$45 @ 20%, $45-$50 @ 25%, $50-$55 @ 30%, $55-$60 @ 35% and above $60 @ 40%.
- SGA, Fees/Consulting, Depreciation: The P&L estimates assume these costs will trend up fairly sharply in 2008 and 2009.
- Income Tax: Effective January 1, 2008 CNEH benefits from the applicable Income Tax rate falling from 33% to 25%.
- EPS share count and equity: The terms of the February 2008 financing deal included 1.32 million warrants @ $0.01 per share, 1.65 million warrants @ $3.20 per share and 2.31 million warrants @ $3.45 per share. These P&L and Balance Sheet estimates assume that all the 1.32m warrants will be exercised in Q2 2008 and that both the 1.65 million and the 2.31 million warrants will be exercised in Q1 2009. Whilst this ups the share count somewhat it also boosts Equity by $13.249 million in Q1 2009. Accordingly, 2009 and 2010 EPS figures are on a fully diluted basis without requiring any adjustment.
- Debenture: Repayable over 4-year period from February 2008. The 6.5% cash fee ($975k) relating to the funding transaction is amortized over the life of the debenture and included within Interest Exp in the P&L.
- The temporary existence of 10m additional shares during part of 2007 has been ignored so as to give a clean picture of true EPS growth (refer Jan ‘08 Seeking Alpha article).
- Drilling Payables: Each well costs $320k to drill and CNEH has standard agreed payment terms with the driller; $93k payable in cash with the balance, $227k, payable over 24 months.
click to enlarge
* estimated in all cases.
General comment on the P&L and Balance Sheet estimates
These forecasts incorporate a number of items designed to preserve a conservative viewpoint so that the projections are ultimately more useful and reliable for investors. These include: (a) moderate oil price assumptions, particularly in the near-term, (b) oil output per well is forecast to be 700 bbls per well per qtr when in fact it is currently running higher and ought to remain above the 700 bbls level for the time being as additional new wells come on stream, (c) no account is taken of increased oil production in future periods due to water injection technology becoming more efficient, (d) production costs do not take account of water injection costs diminishing over time in line with increased well numbers, (e) production costs incorporate a provision against the company drilling some dry wells which may or may not occur, and (f) SG&A, Fees/Consulting and Depreciation costs have all been pencilled-in sharply higher for 2008 and 2009. Most likely not all these items will occur but for the moment the projections are left as-is because the investment thesis is highly attractive without maxing out all aspects. An additional observation is that CNEH may be in a position during 2008 to drill more wells than the 100 they announced. Certainly the cash-rich balance sheet supports this view. Later in 2008, as the CNEH picture develops further, these P&L and Balance Sheet forecasts will be updated in accordance with more recent global oil prices and the company’s production data. Based on recent trends the main upside may come from higher oil prices. By way of example only, if oil prices were $10 higher than projected for each year in this note the EPS and year-end cash balances would become:
Risks
Given that the company possesses under-exploited oil acreage with substantial reserves, has a multi-year drilling plan laid out, has secured the services of a drilling company and has adequate funding to complete its entire plan with cash to spare, then it appears that the major areas of risk have been buttoned down. One aspect that may deserve investor attention is the Government Oil Levy. Currently this is capped at 40% of oil revenues above $60 per bbl. There is a risk that this will be increased at some point. However, considering that (a) China has an imperative need to generate more oil internally via exploration rather than relying upon imports from the Middle East, Russia, Sudan and Venezuela, thereby an upward adjustment to the Govt. levy is unlikely to pass the 50% threshold, and (b) these forecasts incorporate relatively low oil price assumptions, then, in the instance that a 50% levy were to apply to oil sales above say $100 / bbl, the net adjustment to CNEH’s business and to the numbers used in this note is positive and therefore a moot point.
Forthcoming events
- Q1’08 earnings release; mid May ‘08
- Investor presentations; mid ‘08
- Launch of new company web site; May ‘08
- Q2 production data; July ‘08
- Move from OTC to AMEX or Nasdaq before February 2009. Typically, this would be preceded by appointment of additional board of director members. Look for BOD appointments in H2 ’08 and expect move to main market about 3 months thereafter.
- Acquisition of additional oil acreage; open possibility, cash is available.
- Broker coverage; likely in H2 ‘08.
Disclosure: Long.
References:
10K December 2007 via Edgar online: http://access.edgar-online.com/
$15m Debenture: http://biz.yahoo.com/prnews/080303/cnm030.html?.v=12
Preliminary Q1’08 production:
http://biz.yahoo.com/prnews/080428/cnm012.html?.v=49
Company web site: http://www.cnepetroleum.com/
Original Seeking Alpha article:
http://seekingalpha.com/article/62400
China Unified Corporation Tax rate: http://www.worldwide-tax.com/china/chi_econonews.asp
China oil imports and reliance: http://www.iags.org/china.htm
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This article has 9 comments:
Excellent post! Thanks!
POS: LONG
P1 at December 2007 was 2.5m bbls.
P2 has not been published but would represent the estimated amount of recoverable oil in the four combined oil fields. This figure should be about 35% of the total oil reserves of 75m bbls, less the approx 40% output that belongs to PetroChina in the remaining years of the leases. Net-net this works out at about 16m bbls.
P3 is 75m bbls.
Over the next few years, as CNEH rolls out its drilling program, we can expect P1 to increase towards the P2 figure of about 16m bbls.
Should CNEH be successful at implementing CO2 technology, that would increase the recoverable percentage by about 20% to say 55% of total reserves, which in turn would boost Proven & Possible (P2) to about 25m bbls, and Proven reserves (P1) would then, in time, graduate towards this higher figure.
I will still be purchasing more even at the 4.00 it's at now and dips if they occur. I really appreciate these articles in seeking alpha on CNEH it was a big reason for me to purchase 6 months and I'm extremely happy with the results so far. I just don't see how a well managed company with a good balance sheet and high potential can do anything but well. The only thing I wish is that I had more money to invest now while it's sill under the radar.
Does anyone dare speculate when they will be on a major exchange?
Thanks for your help.
can someone answer this question. If everyone is saying 75mlb of reserves, then why does the report on CNEH website to SEC say only 2.5 mlb?
thats helpful
I have substantial investment in CNEH, which I have undertaken in the $4.5 range, I believe this company has the potential to cross the $10 mark within the next few months, strong oil prices and a strong growth profile will both undermine the move, while the float will probably amplify the upward move.
I believe the share price will significantly benefit should the company undertake an acquisition of further oil reserves, such an acquisition will greatly help the stock price for several reasons:
- Higher valuation due to bigger reserves.
- Higher future revenues as the new assets get drilled.
- The pricing of acquisition growth in the stock price, which will already add to a strong organic growth profile.
CNEH certainly has the potential to overshoot to the upside once the stock moves to the AMEX or NASDAQ, while the stock present a rare investment opportunity, traders and speculators are likely to push the limits of the reasonable in the next few months.
As for a specific comment on the article, you mention the risk of a higher windfall tax, as a matter of fact Petrochina president is expecting a lower tax (he mentioned that in AGM May 15th) Petrochina is expecting the government to up the windfall tax threshold to reflect current oil prices, as well as to stimulate production, which in effect means lower tax for the oil producers on current prices, thus I believe the tax issue will be a positive catalyst for the stock price in the near future.
Regards,
Nawar