China Oil and Gas Sector
SECTOR REVIEW
Venus or Venus Fly Trap?
■ Big China oils have fallen sharply YTD, albeit largely with the market.
On P/Es, valuations are less onerous. Are they inexpensive or are they
value traps?
■ Oil prices border on US$50/bbl WTI and threaten to go lower, as global
growth slows. Operating leverage is high, with break-even points to
cover costs, capex and income taxes pushing US$46-66/bbl WTI.
■ Five-year development costs (reflecting high capex) are running
significantly ahead of DD&A per bbl. These are expected to rise sharply
in the next 12-18 months, we think, surprising consensus EPS and
ROE forecasts on the downside. Returns are set to fall structurally, in
our view. For SNP and PTR, there is the added risk of a petrochemical
downturn. New refining pricing formula should improve visibility, but
compress profitability.
■ The big oil stocks in China have not underperformed. Valuations are
low, but leaving 2006-07 excesses out, they are in line with the
historical average. Returns are set to be lower than that period,
suggesting room for a derating.
■ We are downgrading PetroChina and Sinopec to an UNDERPERFORM
and cutting target prices to HK$5.34 and HK$4.03 (from HK$9.31 and
HK$6.44). This implies a WTI US$70/bbl oil price in December 2009, and
a 25% discount (consistent with CNOOC’s history).

Venus or Venus Fly Trap?
US$50 is the new US$25?
As oil prices rose in the past five years, the underlying cost structures for the big-three oil
companies have deteriorated. At CS’s WTI forecast of US$60/bbl for 2009, upstream EBIT
per bbl for PetroChina and Sinopec is likely to be 5-30% lower than 2004, when oil was 30%
lower (US$40/bbl). For CNOOC, the numbers are only US$3/bbl higher than 2004, despite
oil being US$20/bbl higher. Taking it one step further, the break-even point for oil firms to
cover their costs, capex and income tax ranges from US$46/bbl for CNOOC to US$66/bbl
for Sinopec. In 2002, this was in the mid-US$20s. Operating leverage is higher.
With FCF yield for global oil stocks in excess of 8% for 2008, we believe that a minimum
5% should be par for the course for the big-three oil stocks in China. To offer investors a
5% yield, and cover costs and income taxes, and taking into account the FCF gains from
downstream businesses, CNOOC would need US$54/bbl, while PetroChina would need
US$58/bbl and Sinopec requires US$70/bbl. This, we believe has negative implications for
valuations, volume growth (if capex is cut) and could result in consensus disappointment.
Capex excesses still to hit the P&L
Stocks have struggled to generate FCF. Sinopec has generated an astonishing
HK$0.21/share in FCF (cumulative) since 2000. PetroChina and CNOOC have done
better, but trade above FCF multiples from history. The lack of FCF would hit the P&L
through DD&A – P/Es are therefore lagging indicators. DD&A is likely to burst upwards in
the coming 12-24 months (it has happened for PetroChina, something that we highlighted
in 2006). DD&A per bbl is 12-37% below the five-year average actual development cost.
Finding costs (about 30-40% is amortised through DD&A) have also risen 100-500%.
DD&A is the least forecast line item for consensus, and has the most potential to catch the
street out, especially in a lower oil price environment. If capex is cut back and wells are
shut, write-offs on impairment would rise, curtailing earnings. CNOOC is the most
vulnerable to a rise in DD&A, but a 15% plus CAGR in volume provides a cushion.
Sinopec, and to a smaller extent, PetroChina, are most vulnerable.
Chemicals a millstone; refining fair, not fat
Petrochemical margins, we believe, are headed to 2001 levels. With the currency 15%
stronger, and RMB overheads higher, there is greater room for operating leverage to kill
profitability. While petrochemicals is optically small (4-15% of total EBIT), zero is not the
floor, and as Sinopec’s 3Q08 highlights, big losses are possible at the bottom of the cycle.
Refining can help, as oil prices fall, and there is room for supernormal gains – if the
government is kind (deregulation is unlikely, we think). Earnings in excess of those due
are not likely on a sustainable basis, especially in an environment where China’s economy
is slowing.
Value or value trap?
While the extent of declines in stock price (down 55-58% YTD) and the P/E and P/B
multiples relative to history suggest that these stocks could be inexpensive, we note that
they could turn out to be value traps. On a P/FCF basis, stocks are still expensive, relative
to historical lows. Consensus earnings have downside surprise risks, as costs (especially
DD&A) continue to catch up with the P&L. That these stocks have fallen in line with the
China market makes them vulnerable to underperformance. We think CNOOC has the
best fundamentals, but a weak oil price would weigh on stock performance. Both
PetroChina and Sinopec are deceptively inexpensive – Sinopec has the worst
fundamentals, while PetroChina is slightly better off. We would avoid the sector, until
relative value emerges.