China North East Petroleum (NEP)

Been quiet for a while on this one, and for a reason. There is news, however…
We’ve been quiet because there wasn’t much, if anything, to report and we’ve gone distinctly cool over those little Chinese smallcaps. Too many rotten apples and smoke and mirrors, and it’s near impossible for a couple of bloggers from another country to cut through the smoke and mirrors (if any) and we’re no forensic accountants either.

On the other hand, we do believe that the whole group is now tainted, and there are people taking advantage of that, creating even more confusion with their easy short and distort campaigns. The good companies (probably still the majority) trade at a significant discount as a result. NEP seems one of them, as they had their tires kicked pretty seriously last year when they had to restate their accounts, but we give you this proviso, we have no way to ascertain whether all their figures are 100% correct.

The funny thing is, if their accounts are correct, the result of the previous errors is higher profits in the future, not lower. So, although we won’t go overboard with this one, the situation still looks quite promising though.

The bull case is best set out here:

China North East Petroleum’s Shengyuan Acquisition: Significant Upside Potential
8 comments  |  by: Atticvs Research February 16, 2011  | about: NEP

China North East Petroleum (NEP) is a low-cost, high-margin, cash-generative oil producer and driller in Northeast China.

On February 7, 2011 NEP announced preliminary Q4 2010 production numbers showing an improvement on the previous quarter, but which were still anemic and below market expectations. The reason offered is the ongoing lack of regional road and related infrastructure following the well-documented severe floods and landslides of 2010. All perfectly valid, of course, but the market remains deeply untrusting and NEP stock sold off.

Still, whilst Q4 production numbers did disappoint, the fact remains that NEP’s future, an unusually bright future, rests very much with its pending acquisition in Inner Mongolia and not with NEP’s existing Jilin oilfield. It will be second half 2012 before that acquisition starts to bear fruit and 2013 onwards before the big acceleration in profits comes online.

In the meantime, NEP’s earnings should largely flat line at about $0.90 per share for both 2011 and 2012, which would generate $33 million cash flow each year. This, together with NEP’s cash balance of $60 million at December 2010, will facilitate acquiring Shengyuan and aggressive development of the Inner Mongolia oilfield.

It is clear that investors are heavily focused on the anemic results from NEP’s Jilin oilfield with almost no attention being paid to NEP’s prospects via the Shengyuan acquisition. This is understandable given that the acquisition will not be concluded for a few more weeks and that little information has as yet been published about it. However, while we await more definitive news, a compelling investment case is on offer; investors who quietly accumulate cheap NEP shares during the coming weeks and months stand to make very large gains over the longer term.

On January 20, 2011 NEP announced that it had signed a binding agreement to acquire Sunite Right Banner Shengyuan Oil & Gas Co. Ltd (“Shengyuan”), an independent oil company with exclusive exploration and drilling rights to the Durimu oilfield in Inner Mongolia. Durimu has estimated total reserves of 573 million barrels of which NEP’s share of recoverable reserves are estimated to be about 143 million barrels.

To comprehend the opportunity facing NEP via this acquisition, it is necessary to understand NEP’s existing business model and then apply it to the new acquisition. NEP has two business segments: oil production and, commencing in 2009, a well drilling business. NEP’s low cost structure means the company generates high gross margins in both business units. It also has a high net income % which translates into strong recurring cash flows.

The following numbers are actual extracts from NEP’s SEC filings with the 2010 numbers containing an estimate for Q4 2010. Gains/losses on warrant revaluations and tax thereon have been eliminated.

Year 2007 2008 2009 2010
Average Oil price $72.5 $94.3 $56.0 $75.7

Oil Production:

Sales ‘000,000 $19.5 $58.6 $51.1 $54.8
Gross Margin 54% 60% 66% 63%

Drilling:

Sales ‘000,000 n/a n/a $13.6 $43.5
Gross Margin n/a n/a 60% 60%

NEP’s overall net income:

Net Income ‘000,000 $5.1 $7.4 $19.6 $36.6
Net Income % 26% 13% 30% 37%

Note in particular the high gross margins for oil production – currently running at over 60% and this is despite the negative effects of a major flood disruption in 2010. These GM calculations have been arrived at after including the government oil surcharge in the costs of sales i.e. production costs are fully loaded.

When NEP’s existing business model is applied to the Shengyuan acquisition, what transpires is that NEP’s gross margins for Shengyaun should be noticeably higher than at present. Largely this arises because the oil output per well at Shengyuan is thought to be about 4 times that of NEP’s existing Jilin oilfield and thus NEP’s oil extraction costs per barrel going forward will be substantially less than today’s.

We already have sufficient information to allow us to get a ballpark view of NEP’s prospects over the next 10 years.

NEP has 8 drilling rigs; 2 x 4,000 meter rigs, 3 x 3,000 meter rigs and 3 x 2,000 meter rigs. During the first 9 months of 2010, the company drilled 156 wells amounting to 243,730 meters in total depth. This generated $34.7m in revenue and cost $13.86m. Extract sales revenue per meter $142, drilling costs per meter $57, gross margin per meter $85, and the average well-depth was ~1,500 meters.

In addition to drilling 243,730 meters in the first 9 months of 2010 (equivalent to 325,000 meters annually), NEP indicated that it was actively seeking further contracts in order to more fully utilize its rigs. On September 28, 2010 NEP announced that it had won a contract to drill 100 wells in Inner Mongolia and that it would fulfill this contract within 12 months and with just 2 drilling rigs i.e. 50 wells per rig per year. At an estimated average depth of 1,500 meters per well, this equates to a further total of 150,000 meters.

Furthermore, whist making this September 28 announcement, the company confirmed that even more contracts when under negotiation. All told NEP is capable of drilling total depth of over 500,000 meters in a full year with its existing rig count.

The expected depth of oil wells in the Shengyuan field has not been made known. However, because NEP is dedicating 2-3 rigs to this project the Shengyuan wells must be less than 4,000 meters deep. Also, there are known oil producers in Inner Mongolia who are producing from oil wells of less than 2,000 meters and NEP’s customers in this region also have oil wells of less than 2,000 meters in depth. While awaiting confirmation of the expected well depth from NEP, this exercise will assume that Shengyuan’s oil wells are 3,000 meters deep.

By eliminating NEP’s 3 x 2,000 meter rigs from the equation, this limits the company to using just its 2 x 4,000 and 3 x 3,000 meter rigs. Working off NEP’s estimated maximum of 500,000 meter total drilling capacity, NEP can currently drill about 125 wells per year of 3,000m in depth. In order to drill more aggressively , and bearing in mind that more delays occur when drilling deeper wells than shallow wells, NEP would need to make a further investment in rigs. For this purpose, this exercise assumes that NEP will invest a further $20 million in rigs during 2012. This is a high-side estimate and the addition of new rigs should ensure that NEP can drill about 250 x 3,000 meter wells per year.

NEP has a stated objective of undertaking “an aggressive drilling program” for Shengyuan and has confirmed that (a) the optimum number of producing wells in this field is 2,000 and that (b) the existing lease expires in 2035. In order to maximize its investment return and long term growth, NEP should realistically complete the majority of its drilling within about 10 years of the acquisition date i.e. by the end of 2020. Certainly, it would be neither efficient nor aggressive to leave substantial amounts of well drilling to be done in the latter stages of the life of the lease.

In order to assess whether it is feasible to drill aggressively there are a number of estimates to be established, as follows.

  • Cost of Drilling Per Well: At an average depth of 3,000 meters, the in-house drilling cost per well @ $57 per meter is $171k in total. Add 15% to this $171k base by way of provision for some dry wells, say $200k rounded-up. In addition to drilling, casing and cementing costs, NEP would also incur external costs for pumps, piping, collection tanks, etc. Allowing $100k for these extras the all-in estimated cost per well becomes $300k. (Note, for reference only: this in-house cost of $300k for drilling each well is comparable to an externally contracted cost per well of over $600k. Given the huge input cost differentials between inner-China and the USA this $600k figure would typically equate to a cost per well in the USA of $3 million or more. Essentially this enormous disparity in input costs explains how and why NEP has been capable of producing such high profits and cash flows, and why it will continue to do so.)
  • Oil Price: During the 2008-2009 global economic crisis, oil fell to $35 per barrel but as soon as August 2009 the price returned to the mid $70s. It is very telling that global oil prices reverted to the mid $70s level so quickly against a backdrop of the worst economic crisis since the Great Depression. With this in mind, and trying to use reasonably conservative assumptions, these estimates will use $75/oil for all years 2012-2020.
  • Annual Sales Per Well: The 3 existing Shengyuan test wells have a production rate of 30 barrels per day, net of 25% royalty payable to the Chinese state owned enterprise (SOE) that owns the lease. This exercise will assume a lower production rate of 25 barrels per day, equivalent to 9,000 barrels annually. At $75 per barrel, this equates to annual sales per well of $675k.
  • Annual Gross Profit Per Well: NEP currently incurs total production costs per barrel at its Jilin oil field of 19% of sales. The Jilin wells were drilled by an outside contractor and cost an average of $300k per well. The Shengyuan wells will be done in-house by NEP and will cost about the same amount, about $300k (as above). However, oil output per well at Shengyuan of 25-30 barrels per day is far greater than the current oil output at NEP’s Jilin oilfield of about 6-7 barrels per day. Ultimately, production costs per barrel at Shengyuan will be much lower than those at Jilin – probably below 10% of sales. This exercise will use 15% production costs during 2012 & 2013 and 11% thereafter when improved efficiency kicks-in. One additional cost of sales is the Government oil surcharge – with oil at $75, the surcharge is $11.50 a barrel.

Putting these costs together on an annual basis total production costs in 2012 and 2013 becomes $205k and in years 2014+ $178k. With each well generating $675k in sales, the annual gross profit per well is $470k initially and $497k in years 2014+.

Q: Does it make financial sense for NEP to dedicate substantially all of its drilling rigs towards drilling its own wells in Shengyuan rather than trying to win drilling contracts with third parties?

A: Recalling that NEP makes a gross margin of $85 per meter drilled, the total margin NEP would earn on a 3,000 meter well drilled under contract would be $255k. Compare that to the gross margin of $497k derived from annual oil sales per well. Without any doubt, where the choice exists, NEP should dedicate all possible rigs towards drilling Shengyuan oil wells rather than seeking to win drilling contracts.

There are some other acquisition-related assumptions that need to be made prior to constructing NEP’s forecast P&L and cash flow for the next several years. These assumptions include:

  • 2011 Wells: NEP to drill a further 27 test wells bringing the total number of test wells up to 30.
  • 2012 Wells: A total of 70 wells drilled.
  • 2013+ Wells: A further 200 wells drilled in 2013 and then 250 each year until a total of 2,000 wells are completed by 2020.
  • Other Up-Front Capex: Approximately $20 million to be spent on other initial capex to cover seismic study, general infrastructure, government fees, land use rights, trucks etc. Note: Between well drilling and general capex, NEP will invest almost $700 million in Shengyuan by 2020.
  • Production: Commencement July 2012.
  • Oil Output: Assumed to be 25 barrels per well per day net for NEP, and incorporates a deterioration rate of about 5% per year.
  • Shengyuan SGA: $3 million annually from 2011 to 2013, then $5 million in 2014 rising to $10 million by 2020.
  • Income Tax: 30%.
  • Working Capital Cash Requirement: Equivalent to 3-months annual sales.
Year 2012 2013 2014 2015 2016
Average Oil price $75 $75 $75 $75 $75

P&L Extract – Shengyuan Only:

Sales ‘000,000 $21.9 $135.0 $286.9 $480.9 $659.1
Gross Margin 70% 70% 74% 74% 74%
Net Income ‘000,000 $8.6 $63.7 $144.4 $244.5 $335.0
Net Income % 39% 47% 50% 51% 51%

NEP’s Overall Net Income:

Net Inc ‘000,000 $33.3 $85.1 $164.1 $262.5 $352.9
EPS, 37m shares $0.90 $2.30 $4.44 $7.10 $9.50

NEP’s Overall Cash Flow, ‘000,000:

Year 2011 2012 2013 2014 2015
Opening Cash $60.0 $59.7 $56.9 $66.1 $109.9
Acquisition $(10.0) $0.0 $0.0 $0.0 $0.0
Capex $(28.1) $(41.0) $(60.0) $(75.0) $(75.0)
Net Income $33.8 $33.3 $85.2 $164.1 $262.5
Depreciation $4.0 $10.4 $17.8 $26.4 $33.7
Working Capital $(0.0) $(5.5) $(33.8) $(71.7) $(120.2)
Closing Cash $59.7 $56.9 $66.1 $109.9 $210.8

Cash balances in subsequent years become; $364 million in 2016, $556m in 2017 $794m in 2018, $1,062m in 2019 and $1,382m in 2020. These cash numbers demonstrate that NEP should be ideally positioned to make one or more acquisitions again in about 2016. That could entail an initial cash payout as large as $200m (about 4 times the Shengyuan acquisition cost) with the company also having the internal cash resources in the following 2-3 years to invest a further $400-$500m in capex to bring such acquisitions into production. Such an event would boost NEP’s overall sales and profitability by a factor of 2-3 times again. Certainly, the Shengyuan acquisition should not be the last major acquisition we will see from NEP.

The key to understanding how NEP can grow its business so aggressively comes back to the starting point of this note; the company is a very low-cost high-margin producer that, by its very nature, generates high volumes of profits and cash. There is little reason to suggest this will change over the next several years. In fact, with lower production costs, NEP’s profit margins and its ability to generate strong cash flows should only improve after production at Shengyuan has been ramped-up.

It is clear that NEP appears unusually cheap on a long-term prospective earnings basis, but what about valuing its oil reserves?

Shengyuan’s Durimu oilfield has an estimated 573.5 million total barrels of which, after delivering 25% to the lease owner, NEP expects to recover about 25% net i.e. 143.5 million barrels. In addition to the Durimu oilfield, NEP has continuing rights to the Jilin oilfield. This is a small field and, net of the 20%/40% royalty payable to PetroChina, the remaining recoverable reserves available to NEP may be about 12 million barrels. Total oil recoverable NEP reserves are therefore about 155 million barrels.

Inclusive of the 5.8 million shares to be issued on completion of the Shengyuan acquisition, NEP will have total shares issued of 37million. The current share price of $5.21 (closing price, February 15) gives NEP a post-acquisition market cap of approx. $193 million. NEP’s total recoverable reserves of 155 barrels are therefore valued at approximately $1.25 per barrel. Recoverable oil at $1.25 a barrel will not remain this cheap for long.

What can go wrong? Things can always go wrong, technical hitches may occur and delays can and do happen. Still, with NEP having its own drilling rigs and sufficient cash flows to support an aggressive drilling program, the way is clear for NEP to exponentially grow its sales, net income, EPS and cash flows in years 2013 and thereafter.

The assumptions used in this note – oil at $75, well depth of 3,000 meters and production costs with room for improvement – all leave plenty of cover against setbacks. For example, whilst the repercussions of oil being above $75 are readily apparent, it is also very possible that the Shengyuan oil wells are less than 3,000 meters deep in which case the drilling process will be cheaper and faster, thereby enhancing profitability and cash flow.

Additionally, the working capital assumption of 90 days errs on the high side – a lower figure will make more cash available for other profitable uses such as drilling. Furthermore, if NEP should use water injection technology in the future at Shengyuan that would substantially boost oil output levels but such eventualities have also been omitted from these estimates.

All told there may be as much probability that EPS estimates in this note prove to be low-ball as they might be high side. Ballpark they are reasonable.

How to Profit From NEP

The question is not to buy or not to buy, the question is when to buy. With such big potential on offer, NEP’s stock price will jump from time to time in accordance with positive newsflow. Bearing this in mind here are some important calendar markers:

  • Q1 2011 – Shengyuan acquisition due to be closed. Expect to hear further details about the Durimu oilfield and its implication for NEP’s future. Deal closed possibly in February, more likely in March.
  • Summer 2011 – NEP will carry out seismic studies, drill test wells and issue progress reports. Given that NEP is dedicating 2-3 of its own rigs to Shengyuan, not to mention its stated commitment to undertaking an aggressive drilling program, the probability is that positive reports should commence this summer. Hence, once we get to summer 2011 we should have effective confirmation of Shengyuan’s true potential. Thus, it’s likely that NEP’s stock price will already have moved up by summer 2011 and between now and then represents the best buying window.
  • Year-End 2011 – By this time the financial community should already be aware of NEP’s long-term outlook and with Shengyuan production due to start in 2012 i.e. the new era for NEP, the stock should enjoy a strong year-end. To help get the story told NEP is likely to do some Investor Presentations.
  • H1 2012 – NEP will issue progress reports and confirm that Shengyuan production will go live in H2 2012. Such reports will support a higher stock price.
  • H2 2012 – Production will go live at Shengyuan. Once we’re into H2 2012 it will be widely known that strong sales and EPS estimates for NEP are about to be realized.
  • Other dates: Each regular quarterly earnings release is likely to contain updates concerning progress at Shengyuan.

It is a shoe-in that NEP’s stock price will be much higher in mid-2012 than it is now. At just 7 times 2013 EPS, the stock would be $16 (i.e. over 300% today’s price in about 15 months time). Much larger gains will be available for those who hold for longer periods. To get an idea of the magnitude of the longer term gains on offer, just take a look at the estimated EPS numbers (above) that are forecast to arrive in years 2014, 2015 and 2016.

Summary

There is an enormous amount of negativity in markets these days towards small Chinese stocks. Against this backdrop, NEP’s stock price is wallowing on the back of improved but still soft Q4 2010 production numbers from its Jilin oilfield.

Meanwhile, there is, for now, a lack of definitive information about the significance of the pending Shengyuan acquisition. With NEP’s existing oilfield being relegated to being a bit-part player investors can’t yet have the wherewithal to focus attention or money on NEP’s exciting prospects. This will change in tandem with the calendar-markers outlined above.

I believe the best way to profit from NEP’s exceptional potential is to acquire shares quietly and gradually between now and early summer 2011 and hold them at least until H2 2012. For self-protection, best not buy on days when the stock price spikes. Such events will surely occur periodically when the story appears in the media. Meanwhile, negative sentiment driven by Chinese inflation fear is likely to remain with us well into 2011. Accordingly, for the most part such spike-days should be short-lived and the buying opportunity should reassert itself at least during the near term.

Recommended reading from the U.S.A. Energy Information Agency on the Chinese oil industry can be found here. Also, here’s a link to an interview published by Barron’s on February 12, 2011 with long term oil analyst Charles T. Maxwell. Amongst other insights, he sees oil at $85 in 2011, $95 in 2012, $115 in 2013, $140 in 2014 and then rising sharply in subsequent years as the global demand/supply metrics worsen.

Disclosure: I am long NEP.