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.
At the same time, China North East Petroleum is quite profitable. Operating margins (outside of asset impairments) consistently exceed 50%. Less taxation, a more lax regulatory environment and the lack of exploratory well activity compared with most U.S.-based drilling firms all appear to make NEP a cash-producing machine. Although NEP is an intriguing growth story, leveraging the secular growth trends of higher oil prices and Chinese economic expansion, there is a long list of risks involved as well. The firm was delisted for several months this year due to delays in Securities and Exchange Commission filings. Accounting mistakes led to several quarters being restated back in September. As a result, NEP has shuffled through CFOs before settling on Steven Chen as "Acting Chief Financial Officer" in October. I'm still not sure exactly what the title entails. In any case, NEP is not free of the common accounting uncertainties that surround so many of these small-cap China firms. MagicDiligence does not recommend investing in any firms where the numbers are not airtight. We hope that the recent retention of Ernst & Young to provide assistance will help repair the company's reputation. Another common Chinese small-cap risk that NEP exhibits is the tendency to dilute current shareholders. Last December the company raised $13.5 million off an offering of about 2 million shares, diluting shareholders by more than 30%. The 10-K makes no bones about management's willingness to raise capital in this manner in the future. I wish these firms would consider going to the bank for capital instead of diluting shareholders. What's more, NEP is in a tight spot with regard to finding new fields. It has 6.1 million barrels in reserve -- not a particularly large amount, and is about six to eight years at current production rates. A bigger concern, however, is that the agreement with PetroChina stipulates that the company pay for 80% of shipped oil through 2012, at which point the percentage drops to just 60%. This makes it imperative that management find new fields to drill, lest they lose 20% of their crude sales.
NEP is a difficult firm to model, considering much of its future worth is going to depend on the new fields it can acquire. Assuming a moderate 10% rate of growth and a high discount rate of 13%, the stock looks to be worth somewhere around $10 a share, a 55% premium to current trading prices. That is a fair amount of upside, but the considerable uncertainties and risks make me want to pass on this name for other opportunities in Magic Formula Investing. At the time of publication, Alexander had no positions in any stocks mentioned. Please note that due to factors including low market capitalization and/or insufficient public float, we consider NEP to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.