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Drilling Into China North East Petroleum

Stocks in this article: NEP

NEW YORK ( TheStreet) -- China North East Petroleum (NEP), a small crude oil exploration and production company, appears to be undervalued, but the company's uncertainties and risks mean value investors may want to steer clear.

As of the end of September, the company operated 292 wells in four fields, with a total of about 6.1 million barrels of proven reserves. China North East Petroleum's largest field (by far) is Qian'an 112, which holds about 5.8 million barrels of reserves. NEP holds a 20-year exclusive lease for this field with PetroChina (PTR).

All of China North East Petroleum's oil is sold to PetroChina's Jilin Refinery at the average daily rate for what Platts terms "sour, heavy Indonesian" crude. This price is lower than the more commonly stated West Texas and London Brent varieties.

In 2009, NEP purchased Tiancheng, which provides oil drilling services. Tiancheng has eight drilling teams utilizing eight rigs and drills on contract from PetroChina and other private oil companies. This unit gets paid based on the depth of each well drilled. This has been a nice addition for NEP. In the third quarter, Tiancheng actually contributed more revenue than oil sales ($10.1 million vs. $9.9 million, respectively), although it is a lower-margin business.

Clearly there are a lot of things to like about the company. Higher oil prices seem here to stay. Aside from the recessionary period of late 2008 and early 2009, crude oil has consistently sold at above $60 a barrel since 2005. Increasing demand, more expensive extraction and inflationary concerns all are conspiring to maintain high prices for the foreseeable future. In China the situation is even more favorable, as oil demand is increasing by nearly 7.5% a year and the country is desperate to limit imports by finding more sources domestically.

Revenue is set to grow almost 70% in 2010 due to crude prices being about 15% higher and because of the new drilling operations. Management has outlined its strategy to stockpile cash for major new field acquisitions in the near future. Tiancheng has additional drilling contracts under negotiation which should add to the top line. Certainly, there is no shortage of growth avenues.

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