Abaci's Common Sense Investing

This is the 1st part of an I-hope-not-too-long series on Sinopec, a business which is both huge and diverse. If this is not difficult enough, the rapid movement of oil price creates further headaches to those who try to analyze and properly value Sinopec. Nevertheless oil, like coal, is the mother of energy, but it's cleaner. Oil, like gold, serves as a hedge against war and instability of this world, but it has much greater industrial use. So my first impression is oil is a better investment than either coal or gold.

While there'll always be plenty of buyers for oil, the unanswerable question is price, which could be US$70 per barrel last year or only $25 per barrel 5 years ago post 911. And for this reason I'd prefer Sinopec over PetroChina and CNOOC for its downstream operations and stability, relatively speaking. Others though might prefer the other two when making a hedging bet in a portfolio.

Sinopec runs a fully vertically integrated operation from exploration to refinery to petrochemicals to distribution of oil products. Looking at the asset breakdown each division is roughly equally sized at $106-135 billion, which is a surprise as the exploration and production (E&P) unit is perceived to be biggest because of its earnings (contributing 3 quarters of total operating income). The refining unit made a loss and the rest made up the balance of the earnings.

E&P

Looking at the operational data from 2001-2005, I noted that both the production output and the proven reserves stayed pretty much the same, at about 270-280m barrels and 12 years of production. So far Sinopec has been able to replenish its reserves by finding new wells and squeezing extra mileages from existing wells using more advanced technologies, though it seems not much can be done to increase production level. This is consistent with my observation that for most oil producing countries production can't be rapidly raised to meet demand even under a higher oil price.

With oil prices hovering around high level it's said many old wells and untapped reserves previously deemed not commercially viable have become productive because oil companies can now afford using more expensive technologies in extraction. Explorations are probably getting more costly as well since new findings are few and far between. The case is probably similar for Sinopec so I expect to see increasing costs over time and I've tried to verify this in the following ways.

I extracted that the total operating cost of E&P per barrel of production output increased by 18%, 15%, and 12% over the last 3 years, an definite up-trend though the magnitude of increase was getting smaller.

5 years' average capex of $21b a year exceeded amortization (i.e. depreciation of fixed assets plus write-off of dry well cost) by 74%. This was against the background of no growth in either reserves nor production.

Indeed, the carrying value of E&P fixed assets kept growing by $10b a year for 3 out of past 4 years and has grown by 47% since end of 2001, but depreciation only grew by 35% over the same period. Maybe there's some giant infrastructure being built that's yet in operation, like say long distance pipes to bring oil/gas from Russia. But there's no figures or description in the annual report to give any useful insight.

Which way I choose look at it, it suggests reducing margin for E&P over time.

At the back of the report though, there's a supplemental disclosure prepared under US accounting standard which showed the discounted value of the oil and gas reserves at $360b (calculated based on 2005 year-end oil price of US$60 per barrel and a discount rate of 10%). Amortizing this over the reserve's production life of 12 years gives an annual expense of $30b a year, 3x of last year's depreciation. I then plugged in US$50 in the calculation, the amortization expense was a rough $22b a year still $12b more than last year's depreciation. All these are very imprecise estimate I must say. And I've not thought it through that whether it's necessary to take such amortization from an investor's point of view, in lieu of the company provided amortization.

Finally there's the new 'oil' tax put in place that weighs down earnings. But I'll wait until the release of the 2006 results for further analysis. I think what I have now is already complicated enough.

To sum up, costs are up, additional amortization might be needed, and taxes are higher, but all these won't matter if oil price is high enough. So it all comes down to oil price again, which no one can foretell. Here's a quick look at the E&P profits of the past 5 years and the average oil price.

2005; US$55; $46.9b
2004; US$38; $25.6b
2003; US$29; $19.2b
2002; US$25; $14.8b
2001; US$25; $23.4b

I'll come back to the valuation after I'm done with other parts of the Sinopec business.

DISCLOSURE: I hold 386 at time of writing.