PetroChina To Benefit From High Oil Prices (OTCMKTS:PCCYF)

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I believe PetroChina (OTCPK:PCCYF) (HKG:0857) is significantly undervalued considering its large oil and gas reserves, attractive valuations, and the recent announcements made by the Chinese government to ease some of the regulations for its oil and gas industry. PetroChina, hit by corruption in 2013 and subject to regulations, did not fully benefit from the 2021-22 increase in international crude oil prices, which is why the stock is trading well below its book value today. By the end of 2022, PetroChina had a book value of $119 and a low price-to-book value of 0.39, which makes it compelling for long-term value and growth investors to buy and hold the stock until it reaches its full potential.

In China, the state controls and heavily regulates the oil and gas industry using price ceilings to set lower prices and put limitations on higher profit margins. They realized an average price of US$95.19 per barrel for crude oil, of which the domestic realized price was US$95.58 per barrel, which represents an increase of 52.6% as compared to 2021. The domestic average realized price for natural gas was US$7.78 per thousand cubic feet, up by 31.2% compared with 2021.

Despite these high prices in international markets, the company was under restrictions to adjust these prices for its profit margin calculation because of government regulations in China that put a ceiling on oil and gas prices for producers and consumers to keep the economy running smoothly. Therefore, in my opinion, the revenue and the profits announced by the company in their annual reports are not really reflective of the true worth of the company.

Company Background

PetroChina is a subsidiary of China National Petroleum Corp. (SHA:601857), which owns and controls 80% of the company. It’s China’s largest oil and gas producer and contributes 50%-60% of domestic volumes. It focuses on scientific research, exploration, development and distribution of oil and gas globally.

PetroChina used to trade on the NYSE in the U.S. as American depositary shares (ADS) under ticker PTR at a price of $47, which represented 100 H shares. In August 2022, the company decided to delist itself from the NYSE. The ticker PCCYF is traded on over the counter markets (OTCMKTS) at a price of $0.47 per share (47/100=$0.47). The H shares of PetroChina are also listed on the Hong Kong Stock Exchange (HKSE) under ticker 0857 and are trading at HK$3.75 per share.

Note: The amounts in this article are converted from RMB to U.S. dollars (1 U.S. dollar = 6.84 Chinese yuan).

Competitors

PetroChina is at the top of its peer group in terms of its revenue. As per the 2022 Interim Report, the company generated revenue of $486 billion, representing an increase of 30.6% vs. $317 billion in Q3 2021. The net profit was US$20.9 billion, an increase of 60.1% compared to Q3 2021.

PetroChina’s revenue of $486.4 billion is higher than its competitor Exxon Mobil (XOM), which is also one of the largest oil and gas companies in the U.S. Exxon had revenue of $403.2 billion by the end of 2022. However, despite achieving higher revenue, PetroChina lagged in its net profits, which were lower than Exxon. Its net income of $20.9 billion was lower compared to $51.9 billion for Exxon because of the lower or normalized net profit margin of 4.31% for PetroChina vs. 13.41% for Exxon, mainly due to regulations in China.

According to PetroChina’s Q3 2022 quarterly report, the increase in operating profit and net income is due to the surge in crude oil and natural gas prices that boosted its sale of chemical products. However, it could be argued that PetroChina has not reached its full potential because the oil and gas prices used for the calculation of its revenue and profit margins are not market based. As such, their profit does not reflect the true value. The gradual increase in revenue and operating profits is because of effective controls on operational costs.

At the end of 2021, PetroChina had total assets of about $394.18 billion as compared to $338 billion for Exxon for the same period. PetroChina, trading at $47 (which represents 100 H shares), had a market cap of $86.6 billion ($47×1,843,000,000) as compared to Exxon, which was trading at $110 a share (translating into a market cap of $454 billion). PetroChina is also more attractive because of its market value, which is 33% below its total oil and gas assets of $128.65 billion for the same period. It had retained earnings of $121.2 billion by the end of 2021, which is 29% more than its market cap.

At the end of September 2022, the total assets of PetroChina stood at $405 billion as compared to $370 billion for Exxon. Therefore, PetroChina achieved an attractive return of 3.69% on its assets (ROA-net) despite its large asset base as compared to 6.86% for Exxon. This makes a compelling case for PetroChina as compared to Exxon for value- and growth-seeking investors looking to gain exposure to the oil and gas industry.

Main Challenges

A short-term challenge for PetroChina was its negative working capital in 2021 because of a decline in its current assets. However, that situation improved in 2022 because of some serious efforts made by the company to reduce liabilities. The company had about $113.5 billion of total current assets in Q3 2022 with total current liabilities of $111.1 billion, which suggests that it will be able to meet its short-term obligations. However, since PetroChina is well supported by its parent China National Petroleum Corp. and controlled by the state, it’s fair to assume that it will steer around any short-term challenges and will not have any difficulty in raising funds to honor its obligations.

Another positive move made by PetroChina in terms of dealing with its challenges is that it has reduced its current liabilities and operational costs by restructuring its pipeline assets. According to a report by Reuters, PetroChina is selling some of its natural gas projects in Australia and oil sands in Canada to shift its focus toward more profitable sites in Africa, the Middle East, and Central Asia. Another reason for this change in strategy is the fear that there might be sanctions from Western countries in the wake of Russia’s invasion of Ukraine.

PetroChina is also under immense pressure from the government in China to raise private investments. That’s why it partnered with Sinopec Corp. (OTCPK:SHIIY)(SHA:600028), the second-largest oil and gas producer, to enter into joint venture agreements for certain projects.

Projected Revenues

PetroChina has very large proven reserves of crude oil and natural gas in China and overseas that provides an excellent opportunity for revenue growth. In FY2021, the company had a total of $128.65 billion in oil and gas assets. This includes 6,064 million barrels of total proven reserves of crude oil, out of which 5,375 million barrels are developed and 689 million barrels are undeveloped. It also had 74,916 billion cubic feet of total proven reserves of natural gas, comprising 42,576 billion cubic feet of developed and 32,340.3 billion cubic feet of undeveloped reserves for the same period.

If we are to project the future revenues for PetroChina by applying one-half ($45) of the average price of $90 for its total reserves of 11,439 million barrels of crude oil (developed and undeveloped), it will produce an estimated $514.7 billion. There’s also its equally large reserves of natural gas and 263.4 million acres of valuable land, according to its 2021 annual report. According to Bloomberg, the analysts at Bernstein have estimated its reserves at $208.7 billion. Therefore, the market value of PetroChina today is far below its value of reserves and future growth potential.

A catalyst for PetroChina is the recent reforms announced by the government of China to ease some of the regulations, like removing the price ceilings for oil and gas domestically. PetroChina was restricted from making high profit margins even if there was an increase in international prices for oil and gas. When the crude oil prices internationally rose to $80 per barrel, the refined oil prices in China were calculated at minimum or at normal processing profit margins.

When the price for crude oil rose to $130 per barrel or above internationally, the prices of gasoline and diesel were unadjusted or adjusted slightly upward in the interests of producers and consumers so that the national economy of China remained unaffected. The refined oil retailers were allowed to set prices, but they could not exceed the ceiling prices set and published by the government.

Furthermore, the Chinese government also reduced the ceiling of national average retail price for domestic refined oil production and marketing enterprises when gasoline and diesel were supplied to special customers like railway, transportation, and other business operators. The supply prices of gasoline and diesel supplied to the country’s strategic petroleum reserve and the Xinjiang Production and Construction Corps by domestic enterprises were also determined by deducting the circulation markup from the ceiling national average retail price.

The government regulated natural gas pricing using the city gate benchmark price by adjusting the base by no more than 20% upward, and without any limits on the downward for suppliers and purchasers. This undermined the growth potential for PetroChina.

Estimated Free Cash Flows and Fair Value

In 2022, PetroChina had about $31.6 billion in cash and cash equivalents. The net cash flow from operating activities for the same period increased to $45.85 billion, representing an increase of 38.3% as compared to 2021. The company also had strengthened its capital management by reducing its capital expenditure by 32%, leading to a substantial free cash flow growth of $11.67 billion in 2022. This represents 13.8% year-on-year growth and a per share cash flow of 1.43.

PetroChina has an estimated fair value of $96.86 based on its average free cash flows for the last 10 years. Assuming that the government in China accelerates these reforms and removes its restrictions, such as controlling profit margins, PetroChina’s free cash flow could be expected to grow at a rate much higher than 4%-5%. If we apply a discount rate of 6% (considering that the short-term U.S. treasury rates are close to 5% today) to the last 10 years of free cash flows to know the present value (PV), interestingly enough, we find out that the company is still trading at a huge discount of more than 106%.

Therefore, the company has a margin of safety of 49%, which tells us the investment risk is far lower than its upside potential in the short to medium term. As a result of its growing free cash flows, the company has increased its dividends to HK$0.35 per share, which represents an annual yield of 9.3%.

Outlook for the Oil and Gas Industry

The main opportunity for PetroChina is the projected investment in the upstream sector of the oil and gas industry, which will also serve as a catalyst. This investment is estimated to be US$9.2 trillion between 2021 and 2045. It will surely benefit PetroChina, being one of the largest producers of oil and gas with very large reserves.

According to the World Oil Outlook, there will be an increase in global demand for oil over the medium term between 2020 and 2026. It is also estimated that 13.8 million barrels a day (mb/d) and 80% of this demand is expected to materialize within the first three years, between 2021 and 2023. The demand for oil and gas will continue to grow due to the growth in population, especially the middle class, which will increase economic activity and result in significant growth. Furthermore, the demand for oil especially in non-OECD regions is expected to increase by 25.5 mb/d between 2020 and 2045, reaching 74.1 mb/d in 2045.

The transportation sector is forecasted to be a major contributor to this incremental demand, which will add 13 mb/d between 2020 and 2045. In July 2022, PetroChina announced an expansion program to invest $4.5 billion to increase its total annual capacity to 2.76 million tons to meet and benefit from the demand, which is in line with the growth forecasted for the industry.

The Risks

PetroChina is extensively regulated and controlled by the Chinese government in terms of its issuance of exploration and production licenses. They also impose industry-specific taxes or product-specific taxes and levies for the implementation of environmental policies and safety standards.

PetroChina is also heavily dependent on its Daqing Oil region for its oil production. About a third of its current crude oil volumes comes from this region, which is one of the largest crude oil producing areas in China. Daqing seems to have matured over the years. In 2021, the crude oil output from this region fell 3.7% as compared to a year ago until recently, when it started to increase its capacity to 200,000 bpd.

PetroChina also acknowledges this risk in its 2022 annual report and highlighted that it is making efforts as part of its expansion and acquisitions offshore and abroad to reduce its exposure to mature domestic areas like Daqing. Therefore, despite the regulatory constraints locally and competitive pressures internationally, the company is making progress – gradually, but surely.

Another risk for PetroChina is the negative perception and sentiment among its investors and shareholders because of its senior management’s involvement in corruption. In 2013, some of the senior executives of PetroChina were investigated and jailed by the Chinese government for severe disciplinary violations and corruption. In 2019, Reuters reported that the vice chairman and non-executive director of PetroChina, Liao Yongyuan, who had served the company for 30 years, was sentenced to 15 years by the Chinese court. Liao abused his position for personal gains by taking bribes amounting to $1.95 million between 2003 and 2015.

Under new management and support from the government, PetroChina has gone through some major reforms and structural changes. It is making progress in changing its image locally and internationally, which will benefit the company and its shareholders in the long run.

Conclusion

PetroChina is shifting its focus from being a large domestic player to becoming a major player internationally. The company is trading below its fair value today due to things such as regulations and corruption. The state that controls PetroChina and its management has empowered the new management to work tirelessly to change the perception of the company in order to attract foreign investment and expansion.

The government also intends to align its national interest with that of the company’s investors and shareholders. It is important that PetroChina accelerates its efforts to regain trust and confidence to attract private investment. Without these reforms, the company might not be able to attract investments from large conglomerates from China and the U.S., like Berkshire Hathaway (BRK.A), whose billionaire owner, Warren Buffett, had invested in PetroChina in 2003 and made a killing from it. The company is shifting its focus from large volumes to large profits with the support from the government by easing some of the regulations will ensure that the shareholder value is increased.

PetroChina today is the fourth largest oil company after Exxon, Shell (SHEL), and Chevron (CVX). As noted above, it has a book value of $119 per share. Yet, the current share price using any valuation method is not justified considering that there has been a surge in crude oil prices of 19% over the last two to three years.

According to the Central Pricing Catalog issued by the National Development and Reform Commission in 2020, the good news is that the government is accelerating its efforts to remove some of the restrictions to liberalize the price ceilings for oil and gas to make it more market-based in due course. This will ensure that the company operates efficiently and profitably. Their capital investments are also directed toward low-cost new oil fields for production engaging in joint ventures, rather than wasting resources on high-cost old oil fields for the purpose of meeting the rising demand and consumption in China.

Lastly, if the government decides to restructure its pipeline resources, spin off some of the assets, and remove the price ceilings completely, this will further improve the overall operational efficiency and profitability for PetroChina in near future. It will attract foreign investment and unlock the true value of the company. As a result, it will improve the sentiment for investors and shareholders, who will benefit in the medium to long term.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.