The squeeze on PetroChina

Energy

by Dexter Roberts

PetroChina (PTR) has been the sweetest of China plays for global investors in recent years. Warren Buffett started investing in the mainland's biggest oil producer back in 2003, and the company's shares appreciated more than sevenfold from that point until last November. Last fall, when PetroChina listed in Shanghai, it enjoyed a surreal market capitalization of just over $1 trillion, a figure roughly equal to the economic output of India and $600 billion more than the value of ExxonMobil (XOM) shares.

These days the mood is likely far more subdued at PetroChina's Beijing headquarters. It's a primary target of a divestiture push by human rights groups. They are outraged by the investments of PetroChina parent China National Petroleum Corp. (CNPC) in Sudan, which has drawn international criticism over atrocities in the war-torn province of Darfur. And PetroChina's shares on the Shanghai and Hong Kong stock exchanges have fallen 40%-plus over the last four months, thanks in part to a slower earnings outlook. (Weep not for Buffett: He sold off his estimated 2.3 billion shares, or 1.3% stake, in the company last October and made a killing.)

Earnings pressure

PetroChina still boasts plenty of strengths: It has global scale and $105 billion in annual revenues, and it drills for crude and refines gasoline and other products in a hypergrowth, domestic economy. Yet it's now caught in a painful squeeze. It must pay around $100 per barrel in international oil markets for imports to offset its declining production at home.

At the same time, PetroChina is under government orders to subsidize domestic fuel prices for consumers. Gas and diesel "prices in China reflect $60 a barrel for oil, not $100 a barrel," says Hernan Ladeuix, head of oil and gas research for CLSA Asia- Pacific Markets in Singapore. (PetroChina executives declined to comment for this story.) Nor is Chinese President Hu Jintao's government likely to cut much slack for PetroChina. Consumer price inflation on the mainland hit an alarming 7.1% annual pace in January. Beijing officialdom fears social instability among lower-income Chinese above all and won't let domestic oil companies push through price increases.

True, PetroChina rakes in profits on the oil it produces abroad and then sells in global markets. But two years ago Beijing slapped on a windfall profit tax that generates $8 billion in government revenues used to subsidize energy-hungry Chinese industries. In March, China's legislative body, the National People's Congress, may hike other taxes related to oil production. Beijing "thinks it's good to take money from the very rich oil companies to help more vulnerable parts of the economy," says K.F. Yan, a Beijing-based analyst at Cambridge Energy Research Associates.

At the same time, PetroChina is coping with declining production at its aging domestic oil fields in the northeastern city of Daqing. Crude output grew only 0.9% in 2006, to 830.7 million barrels, while in the first half of last year it inched up 0.1% year-on-year. PetroChina did announce a major find along the tidal waters near the northern city of Tianjin that the company expects will eventually provide some 200,000 barrels a year. Still, Morgan Stanley (MS), which forecasts PetroChina's 2007 net profit to come in at about $22 billion, is predicting profit growth this year of only 4.5%. Back in 2006, earnings rose 6.6%.

The hunt for more oil has prompted PetroChina (and parent CNPC) to explore energy sources in Kazakhstan, Sudan, and Venezuela. But in Sudan's case, it also has put the company in hot water with human rights groups. "Absent China and PetroChina's involvement, it might be easier to bring sanctions against the Sudanese government," says Sophie Richardson, Asia advocacy director with New York-based Human Rights Watch.

Another risk: In a politically unstable country such as Sudan there is always the possibility of an abrupt change in government and the seizure of foreign oil assets. PetroChina, like other global oil companies, faces risks such as "nationalization, rising taxation, and changing contract structures," says Xu Xiaojie, director of the Institute of Overseas Investment at CNPC's Research Academy of Economics & Technology.

The outlook for PetroChina in the far more stable natural gas business appears bright. The company already operates the country's transnational gas pipeline from the western region of Xinjiang to power-hungry Shanghai. On Feb. 22, PetroChina began building a second extension that will run to Guangzhou. It also has teamed up with Chevron (CVX) to produce natural gas in Sichuan province.

Yet until PetroChina can close the gap between the high price of oil it buys abroad and the subsidized prices at which it must sell it at home, its earnings and stock price will remain under pressure. Savvy investor Buffett appears to have timed his departure last fall just about right.