Drilling into China North East Petroleum (NEP)
China North East Petroleum (AMEX: NEP) is a small crude oil exploration and production company that operates in Northern China's Jilin Field. The company operates 292 wells as of the end of September in 4 fields, with a total of about 6.1 million barrels of proved reserves. NEP's largest field (by far) is Qian'an 112, which holds about 5.8 million barrels of reserves, and which NEP holds a 20-year exclusive lease with PetroChina (NYSE: PTR). All of the company's oil is sold to PetroChina's Jilin Refinery at the average daily rate for what Platts terms "sour, heavy Indonesian" crude. This price is lower than the more commonly stated West Texas and London Brent varieties.
In 2009, NEP purchased Tiancheng, which provides oil drilling services. Tiancheng has 8 drilling teams utilizing 8 rigs, and drills on contract from PetroChina and other private oil companies. This unit gets payed based on the depth of each well drilled. This has been a nice addition for NEP. In the 3rd quarter, Tiancheng actually contributed more revenue than oil sales ($10.1mm vs. $9.9mm, respectively), although it is a lower margin business.
Clearly there are a lot of things to like about the company. Higher oil prices seem here to stay. Aside from the recessionary period of late 2008 and early 2009, crude oil has consistently sold at above $60 a barrel since 2005. Increasing demand, more expensive extraction, and inflationary concerns all are conspiring to maintain high prices for the foreseeable future. In China the situation is even more favorable, as oil demand is increasing by nearly 7.5% a year and the country is desperate to limit imports by finding more sources domestically.
Revenue is set to grow almost 70% in 2010 due to crude prices about 15% higher, combined with the new drilling operations. Management has outlined its strategy to stockpile cash for major new field acquisitions in the near future. Tiancheng has additional drilling contracts under negotiation which should add to the top line. Certainly, there are no shortage of growth avenues.
At the same time, NEP is quite profitable. Operating margins (outside of asset impairments) consistently exceed 50%. Less taxation, more lax regulatory limitations, and the lack of exploratory well activity compared to most U.S.-based drilling firms all appear to make NEP a cash producing machine.
While NEP is an intriguing growth story, leveraging the secular growth trends of higher oil prices and Chinese economic expansion, there is a long list of risks involved as well. The firm was de-listed for several months this year due to delays in SEC filings. Accounting mistakes led to several quarters being re-stated back in September. As a result, NEP has shuffled through CFO's before finally settling on Steven Chen as "Acting Chief Financial Officer" in October. I'm still not sure exactly what the title entails. In any case, NEP is not free of the common accounting uncertainties that surround so many of these small-cap China firms. MagicDiligence does not recommend investing in any firms where the numbers are not air-tight. Hopefully, the recent obtainment of Ernst & Young to provide assistance will help repair the company's reputation.
Another common Chinese small-cap risk that NEP exhibits is the tendency to dilute current shareholders. Last December the company raised $13.5 million off about a 2 million share offering, diluting shareholders by over 30%. The 10-K makes no bones about management's willingness to raise capital in this manner in the future. I wish these firms would consider going to the bank for capital instead of diluting shareholders.
This dilution risk is compounded by the fact that NEP is in a tight spot with regards to finding new fields. For one, their 6.1 million barrels in reserves is not particularly large, only about 6-8 years at current production rates. But a bigger concern is that the agreement with PetroChina stipulates that that company pay for 80% of shipped oil through 2012, at which point it drops to just 60%. This makes it imperative that management find new fields to drill, lest they lose 20% of their crude sales.
NEP is a difficult firm to model, considering much of future worth is going to depend on the new fields they can acquire. Assuming a moderate 10% rate of growth and a high discount rate of 13%, the stock looks to be worth somewhere around $10 a share, a 55% premium to current trading prices. That is a fair amount of upside, but the considerable uncertainties and risks make me want to pass this one for other opportunities in Magic Formula Investing.
Steve owns no position in any stocks discussed in this article.