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Shenhua Begins Selling its Own Petrol

The Hong Kong based China Shenhua Energy Co. (OTCBB:$CSUAY), the world’s largest coal producer, revealed on Friday that it is planning to open its first petrol station in the country. By entering into the retail oil market, Shenhua, which is also state-owned, is aiming to become part of the oligopoly of the other three national companies in this sector, PetroChina (NYSE:$PTR) Sinopec and CNOOC (NYSE:$CEO).  Shenhua is a major part of the Market Vectors Coal ETF (AMEX:$KOL) at 9.6% of AUM.

Unlike the Big 3, Shenhua will focus on selling oil produced from coal. Due to the relatively low cost of coal mining in China, Shenhua will be able to produce oil competitively to other leading coal producers. It is profitable from coal liquefaction, producing the equivalent of just 8000 barrels per day from their Erdos plant.  Planned output is just below 20,000 barrels per day.  But is backed by the Chinese government, is already a dominant coal producer and is also a regional pioneer in terms of coal liquefaction techniques.

China’s oil demands are rising rapidly and it is already the world’s largest energy and second largest oil consumer. This translates into an increasing oil import bill and foreign dependency. Shenhua’s move to produce oil locally from coal is therefore in line with the government’s national strategy to reduce the nation’s dependency on foreign oil.  

CNOOC just bought Canadian giant Nexen to gain access to oil and gas reserves there.  One of the fascinating things about Shenhua’s technology, if it can be scaled up, is the effect it will have on the search for replacement oil reserves.  This is something that the struggling Chinese majors have to come to terms with.  Oil from coal alleviates some of the pressure to secure reserves west of the Himalayas and Bay of Bengal for China. 

The coal market in China is being pulled down along with the sluggishness of the economy which has dropped prices and reduced the profits in the first half of 2012 for 15 of the 21 listed companies in China. While a few have not released their results yet they are all expected to record declining margins. For example, China Coal Energy, Shenhua’s nearest competitor, witnessed an 8.2% drop in net profits.  The whole industry is now facing a bust after the unsustainable boom as electricity demand is flattening overall and dropping with respect to GDP growth as China’s economy shifts away from energy-intensive manufacturing.   But, the demand for ground transport is going to increase as the interior of the country is opened up to economic growth, so converting coal reserves into oil produced locally or even from the vast strikes in Mongolia could turn into a cost-effective means to grow organically.

Under those circumstances, it came as a surprise when Shenhua posted a 17% increase in net profits to $4.2 billion, effectively beating all estimates. The revenues have increased by 20.1% to $19.2 billion. The increasing profits have primarily come from increasing sales volume but were also partly due to its railway business and some tax subsidies. It is planning to invest more in railways for coal transportation which, if run profitably, can offset coal production costs. 

China’s oil sector is completely dominated by the three big firms. PetroChina and Sinopec have more than 80% of the country’s market. Shenhua is not going to get a significant market share in the short term but with a business model designed to control costs from the mine to the end-user it will allow them the time they need to further refine their liquefaction infrastructure and increase volumes.  The price of oil is not going to drop in an inflationary monetary environment coupled with a billion people moving into the middle class over the next 30 years.

In a world of global, coordinated QE, food energy and monetary metals will all outperform the rest of the markets, coal prices will stabilize in the face of that for as oil and gas prices rise that will improve the profitability of fuels extracted from coal.   Since this technology is a 4 to 1 conversion process, 4 tons of coal produces 1 ton of oil equivalent, this will be supportive of thermal coal prices. 

Most of the Chinese companies in the industry are expecting further declines in the future. Mining costs are rising, the economy is slowing down and the coal prices do not seem to be increasing due to oversupply.  Shenhua on the other hand, is looking to not only reach its year end targets but potentially surpass them. Although China’s slowing economy will hurt the demand side of the equation, declining coal inventories going forward will bring prices back into balance. Since the beginning of July, coal inventories in the country’s ports have fallen from 24 million to 18.5 million tons while those at power stations have decreased from 97 million to 85 million tons.

Shenhua will also continue to benefit from its high-margin railways business unit, even if the coal prices continue to fall.   Globally, investment in coal remains risky because of macro-economic headwinds caused by the massive de-leveraging happening in the West necessitating mass QE.  But with Brent Crude (AMEX:$BNO) prices back over $116 per barrel and looking to head back above the February peak at $125, it’s a good bet that coal liquefaction will be very profitable at the margin.  

Shenhua Energy is trading at a P/E of 10.2 with a 3.5% yield and 6.1% return on assets.  And it looks like the worst of the coal oversupply for them is over since they now have a relatively inexpensive way to convert excess supply into something with higher demand if not higher margins.  This is a situation that investors should monitor with each earnings statement to assess carefully the stated production costs of Shenhua’s oil from coal versus their actual results.   It is too early at this point to know if the numbers being quoted currently are accurate.

For the coal industry in general, the major economies of Southeast Asia, namely Malaysia, Thailand and Indonesia are all moving in the short-term to adding significant electricity production from coal-fired plants.  The world is not awash in energy by any means so at these prices KOL is looking attractive from a value perspective. 

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Peter Pham is an author, international fund manager, and a registered financial director by the Cayman Monetary Authority (CIMA). In 2013 he published his first book entitled, The Big Trade: Simple Strategies for Maximum Market Returns. He currently manages the portfolio of a global hedge fund and runs an asset management company, Phoenix Capital.  (read more)

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