China North East Petroleum: Growth Confirmed, Stock Re-rating Anticipated

The following is an update to my previous article on China North East Petroleum (CNEH.OB).

click to enlarge images

Basis for Re-rating

• China North East Petroleum is a low-cost oil producer in North East China. In March 2008 the company activated a multi-year drilling program to expand well numbers from 157 to 675. The financial results for Q2’08, publication expected by mid-August, offer the first opportunity to verify the positive financial effects of the multi-year drilling program.
• On July 24, CNEH released preliminary production data for Q2; oil output up 119% compared to Q2’07, confirming a strong business up-trend has been established. Q2 evidenced 27 new wells brought into production, this achieved without using much of $15m funding package. CNEH is set to accelerate well drilling in the second half of 2008. During Q3 we should expect at least 30 new wells with an additional 35 in Q4.
• The shares are currently quoted on the OB market. On August 6 the company outlined measures to facilitate a full market quote by year-end 2008. October is a likely date for the promotion to Amex or Nasdaq i.e. approx 2 months from now.
• The stock closed August 6 at $4.28, equating to a 2008 p/e of 4.8 and a 2009 p/e of 3.2 based on $100 oil.
• The triple combination of markedly higher profits throughout the remainder of 2008 and 2009 as CNEH accelerates its drilling program, an ultra-low p/e ratio and a full market quote should lead to a significant re-rating of the stock over the coming months.

Synopsis of Business Model

To understand why CNEH is assured of continued strong earnings growth one need only comprehend the main aspects of its business model:

• Located in regional China, as opposed to a relatively more expensive Chinese city location, CNEH has an extremely low operating cost structure. Wages and salaries are 1/20th of those of the USA.
• CNEH delivers all its oil locally to PetroChina, gets paid full international price for the oil and incurs no selling costs.
• CNEH’s cost of drilling each new well is $330k, a small fraction of the $2.5 million a similar well costs in the USA. Based on $100 oil, each oil well is cash-flow positive within 21 months on a fully costed and fully taxed basis. These are unrivalled metrics in the oil industry where the valuable life of an oil well is typically 30/40 years. CNEH has agreed payment terms of 24 months with its well driller. Hence each new well becomes cash-flow positive before it is due to be paid off. Subject to available acreage and access to drilling rigs, CNEH is in a position to repeatedly double its total number of oil wells in less than 2 years whilst remaining cash-flow positive.
• CNEH has 4 oilfields with total estimated reserves of 75.1m bbls of which they expect to extract about 35% before the expiry of the lease in 2021. These fields can accommodate a total of 675 wells, an increase of 518 or 330% over the 157 wells in production at December 2007.
• Healthy liquidity is required in the initial stages of all large drilling programs and the Feb’08 $15 million funding deal satisfied this need for CNEH as well as providing funds for other, yet to be announced, business development purposes.

At this point, CNEH simply needs to keep drilling and that is what the company is doing.

P&L and Balance Sheet Estimates

• Oil price assumptions: The price for each month’s oil sales to PetroChina is fixed according to Singapore spot rates (typically approx $2 lower than WTI) on the first day of the month. The financial estimates incorporated into this note assume $100/bbl or all periods after Q3’08. For Q3 we already know the oil price on July 1 was $140 and was $122 on August 1. Therefore, working off a price of not less than $100 on September 1, we can assume CNEH’s average sales oil price for Q3 will be $118/bbl or higher. Hence $118/bbl has been assumed for Q3’08.
• Oil output per well continues to rise and this trend should continue as more wells are connected to the water injection system. In Q2’08 oil output per well was just under 800 barrels per quarter. For the sake of conservatism these estimates assume a slightly lower 780 bbls per quarter going forward.
• As the number of wells in production increases the average extraction cost per barrel falls. Again for the sake of conservatism these estimates use slightly higher extraction costs for the remainder of 2008 in order to cover unforeseen eventualities such as dry holes etc.
• The P&L estimated expenses include amortization of the debenture discount. This is a non-cash item and simply represents a reversal of the $7.8 million accounting item added to retained earnings in Q1’08 as per SFAS 157. No account has been taken of any temporary warranty related adjustments that may occur. On the balance sheet the debenture discount has been placed under the debenture for the sake of readability, in the SEC filings it is within shareholders equity .
• Balance Sheet: Because the company has such a low-cost basis and has favourable cash-flow metrics on each new well, the balance sheet at end Q2’08 is forecast to remain strong without using much of the $15 million cash from the debenture financing. Going forward the cash line becomes increasing healthy year after year. Forecast year-end cash: 2008 $11m, 2009 $27m, 2010 $38m – again based on $100 oil for all periods after Q3’08. Such a strong cash position affords the company scope to accelerate drilling as well as undertaking many other investments.
• Well drilling program: As stated by CNEH on July 24, Q2 is traditionally one of its slowest production quarters with business activity accelerating in the second half of the year. During Q2 CNEH engaged two drilling crews and brought 27 new wells into production. In H2 08 the company is expected to engage an additional one or more drilling crews and bring a minimum of 30 new wells into production in Q3 and a further 35 wells in Q4. Again these figures are viewed as conservative.
• From its 4 oilfields PetroChina receives the first 20% oil output up to 2011 and 40% thereafter. All data used in these estimates are net of the PetroChina 20%/40%.
• Fully diluted: For the sake of readability, P&L and Balance Sheet workings assume that the 1.32 million $0.01 warrants were exercised in Q2’08 and all remaining outstanding share warrants and options will be exercised by Q1’09. As such EPS estimates used for 2009 and thereafter are on a fully diluted basis.
• From the foregoing points the financial estimates used here incorporate a healthy degree of conservatism. It is hoped that such an approach may more useful and reliable for investors.

Share Liquidity Risk

CNEH, like many OB stocks, does not normally trade in heavy daily share volume. New investors are therefore encouraged to accumulate only gradually. After the company has achieved a major market listing later in 2008, it is expected that the daily share volume will increase significantly.

Forthcoming Events

• Q2’08 earnings release; mid August
• Graduate from OB to Amex/Nasdaq; October
•  Q3’08 production data; late October
•  Q3’08 earnings release; mid November

References:

• Company web site
• 10K December 2007

Disclosure: Long CNEH.OB

Comments

[rlwinvestor:]

Kudos Atticvs! Your article is thorough and very well organized. Having followed this company for about a year now, everything you've stated is spot on. Even if you knew little about oil or finance, it is plain to see that CNEH is a winner. Nothing in todays market is a sure bet, but CNEH is probably as close as they come as long as you are patient. It's just a matter of time before the institutions are all over this one.

2008 Aug 07 12:25 PM

[mo_scuba:]

Excellent job esp. in citing your assumptions. You tuck to financials and let the reader convert into share value; due to your good approach I'd like to see you do a share valuation model to end with.

2008 Aug 07 04:09 PM

[Aurelien:]

I actually like this one better without the share valuation. It allows the readers to come up with their own thoughts and lets the numbers speak for themselves. Narianu from the IV board has pointed out the the lowest TTM P/E CNEH has seen is 6.5, while more typical PE's are in the 9-13 range. Assuming a typical P/E at the end of 2010, CNEH should be in the $20-30 range by then.

I for one would be very happy to see those figures in 2 years.

2008 Aug 08 03:36 PM

[mo_scuba:]

Aurelien, I agree that CNEH is undervalued based on the production growth we asume is coming. However, I doubt CNEH will hit a PE over 10 due to China exposure and their need for new oil reserves as they are expediting their reserve consumption with their enhanced well development.

PE is not a good valuation tool as "G" needs to be quantified and not spread from company to company within a sector. In oil producers there are many small speculative companies that pull up the PE and "G" is a function of a commodity price.

2008 Aug 11 02:36 PM

[User 217652:]

Excellent work. However the well costs are increasing and the company had to pay several million dollars of the deferred drilling costs in order to increase the number of wells drilled.

2008 Aug 23 09:08 AM