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The third of the three leading firms in the Chinese oil and gas industry, Asia's largest refiner, China Petroleum & Chemical Corporation, otherwise known as Sinopec (NYSE:SNP) posted a significant decline in first half yearly profits for the current year. The company recorded a drop in net income of 41%, which now stands at $3.9 billion, while its turnover also dropped by 6.2% to $7.3 billion. All of this beat analyst expectations, however.

China's other two leading oil and gas companies CNOOC ltd. (NYSE:CEO) and PetroChina (NYSE:PTR) also recorded drops in profits year over year in the second quarter. The market had priced most of this in as the stock fell just by 1.8% in Hong Kong on the news but rallied in New York slightly after the earnings announcement. Since the beginning of the current year, Sinopec's stock has fallen by 9.2% in New York and 17.9% in Hong Kong, while SPDR S&P 500 ETF (NYSEARCA:SPY) has risen by 12.8% and Hang Seng Index has been flat (0.61% up) for the year so far.

While Sinopec has made improvements in cost control, it continues to suffer due to the lack of fuel pricing reforms. In other words, due to price capping, the oil refineries in China cannot transfer the burden of the increase in crude oil prices to the final consumer. This is why Sinopec has been hit the hardest as it generates a much higher proportion of its revenue from refining.

Sinopec's core area of operation is downstream refining and since the Chinese government's fuel pricing policies are aimed at keeping a lid on inflation, all of the refiners have been doing so at a loss. Sinopec's parent, PetroChina, lost $3.65 billion that it recorded from refining 490 million barrels of oil in the first half of the current year. Sinopec, on the other hand, refined 811 million barrels of oil (65% more than PetroChina) in the same period with a lower refining loss of $2.9 billion. Some analysts have called into question the accounting in the discrepancy, but at face value, this implies that if and/or when the Chinese government revises the pricing system for downstream fuels that Sinopec's refining division will return to profitability faster.

Analysts have also predicted that while Sinopec continues to achieve operational efficiency, its fortunes are still tied to fuel pricing reforms. Management agrees, stating the losses are due to "the government's policy of capping retail-fuel prices." Unfortunately, China is struggling with rising food prices, threatening to release strategic reserves of corn and soybean products to quell issues there. This, along with now rising oil prices, are putting a significant dent in the PBoC's ability to respond to a real estate market that is in need of liquidity.

China's GDP growth in the second quarter of 2012 slipped to its lowest level in three years, while the EU debt crisis lingers on putting a strain on exports and the global economy struggles under too much debt and too much money. This is the main reason why the fuel pricing system has not been overhauled, but it will need to happen. In the meantime the whole oil sector in China is under pressure.

The Sinopec group is almost entirely owned by the Chinese government, therefore, they do not mind incurring refining losses, in fact, they seem quite satisfied to the their role in containing the domestic inflation levels. This may be true, but it does not bode well for investors. Like most multinational Chinese firms, Sinopec is also focused on an expansion strategy as it goes forward with acquisitions and takeovers of foreign firms. Oil refining at this point is being used as a loss-leader for the Chinese economic engine. How sustainable this scheme is depends entirely on their balance of trade. As long as they can afford to subsidize this situation, it looks like it will continue.

So far, Sinopec has invested more than $95 billion in different sectors in 55 countries and regions. By the end of 2011, its foreign assets accounted for more than one-third of the firm's total assets. Last month, Sinopec had purchased a 49% stake for $1.5 billion in the UK-based Talisman Energy (NYSE:TLM), which operates in the valuable UK-North Sea and which has been selling off unproductive North American assets to focus on the North Sea and Southeast Asia.

Cutting its dividend in half versus the second half of 2011, Sinopec is trading at a multiple of 8.3 carrying a 3.3% yield. If the Chinese alter the fuel pricing system, making it more reactive to the open market, moving from a 22 day moving average of oil prices, to a 10- or 7-day moving average, then Sinopec will begin to see margin expansion and with it earnings growth. The market is currently pricing the worst to be over, but the higher Brent Crude goes without a change in policy, the worse the arbitrage for Chinese refiners will be.

Source: Price Controls Limit Sinopec's Profits