Chinese Energy Sector ADRs

The first sector I am going to break-out is the Chinese energy sector, primarily because this sector has the highest market cap of all the sectors I outlined in my last piece. There are 5 Chinese and HK ADRs withing the energy sector: PetroChina (PTR), Sinopec (SNP), CNOOC (CEO), Yanzhou Coal Mining (YZC), and Gushan Environmental Energy (GU).

Chinese & HK Energy Sector ADRs

Source: Bloomberg, analyst targets are an average provided by Bberg &for reference only

The Companies:

PetroChina (PTR, Neutral): PetroChina Company Limited explores, develops, and produces crude oil and natural gas. The Company also refines, transports, and distributes crude oil and petroleum products, produces and sells chemicals, and transmits markets and sells natural gas. All of PTR’s oil and gas production and reserve facilities are located within China. (Bloomberg)

PTR’s outlook in a nutshell: China’s continued strong economic growth should support increased demand for natural gas and petroleum products. However, domestic production of crude oil and natural gas has not and will not be able to keep up with the demand for refined energy products. This means PTR and other energy companies will have to rely more heavily on imported energy products. Currently, China imports roughly 50% of its crude oil, and we anticipate this percentage will rise, as China is now a net importer of oil. One of the catalysts behind the pickup of energy imports is the government’s oil tax rebate which rebates 75% of the 17% VAT tax on crude imports, and a full discount on the importation of gas and diesel. Currently, it appears this discount will stay in place through 3Q08, but it will be important to watch. It is likely that without these imports China could face more significant domestic energy shortages. All in all we believe that PTR’s margins will continue to come under pressure, and the ADR has limited upside, especially verses other ADR plays. With this said however, we believe PTR is in the better position than SNP. The reason being PTR holds the majority in both domestic crude oil and natural gas production. (Expected Q208 Earnings Report 8/21/08)

Events which could improve outlook:

• Slowdown in global oil prices.
• Increase in domestic price caps in gas.
• New oil field discoveries.

Events which could deteriorate outlook:

• Sharp rise in global oil prices.
  
• End to energy import tax rebate.
  
• New or stronger government regulations which could increase PTR’s cost.

PTR vs. Hang Seng

Source: Bloomberg

Sinopec (SNP, Underperform): China Petroleum and Chemical Corporation (Sinopec) explores for and produces crude oil and natural gas in China. The Company also owns refineries that make petroleum and petrochemical products such as gasoline, diesel, jet fuel, kerosene, ethylene, synthetic fibers, synthetic rubber, synthetic resins, and chemical fertilizers. In addition, Sinopec trades petrochemical products. SNP is currently China’s largest oil refiner. (Bloomberg)

SNP’s outlook in a nutshell: Like PTR, Sinopec is expected to face difficultly due to high oil prices compressing margins. Unlike, PTR however, SNP is much more vulnerable to the current government tax reductions for crude importation; SNP currently imports roughly 80% of the crude oil it refines. Good news for SNP is that it appears the VAT reductions should remain in place through Q3, but any changes to that could significantly impact SNP’s bottom line. Even with the recent drop in WTI prices it has been reported by company officials by the Xinhua news agency that the company’s break-even point is a WTI price of around USD80, far below current levels. Given this pricing pressure I see limited upside for SNP. It is also hard to predict what type of government intervention may take place to support the local energy industry, given this unknown it is an area I would like to avoid. (Expected Q208 Earnings Report 8/25/08)

Events which could improve outlook:

• Slowdown in global oil prices.
• Increase in domestic price caps for refined products.
• Greater expansion at its Tahe oil-field.
• New oil-field discoveries bolstering E&P earnings

Events which could deteriorate outlook:

• Further drop in refining margins.
• Any changes to reduce the magnitude or length of the VAT subsidies.
• New or stronger government regulations which could increase PTR’s cost.

SNP vs. Hang Seng

Source: Bloomberg

CNOOC (CEO, Outperform): CNOOC Limited, through its subsidiaries, explores, develops, produces, and sells crude oil and natural gas. (Bloomberg)

CEO’s outlook in a nutshell: Unlike PTR & SNP, CEO has significant exposure to E&P, which in a period of high oil prices should add considerably to the bottom line. At the same time, CEO has recently started production at its Xijuan 23-1 oil field and has numerous more scheduled to go online during the remainder of 2008. This should help CEO reach their roughly 15% production increase from last year. All in all, in the current oil piece environment, and with numerous projects already or nearly ready to go online we believe CEO is a good play in the Chinese energy sector. (Expected Q208 Earnings Report 8/27/08)

Events which could improve outlook:

• Higher international oil prices.
• New oil and/or gas discoveries could improve CEO’s long-term outlook
• Better than expected production especially at newly operational Xijian 23-1 oil field or others scheduled to come on line this year.

Events which could deteriorate outlook:

• A significant drop in global oil prices
• Not reaching 2008’s target production growth.
• Increased costs which could impact the bottom line.

CEO vs. Hang Seng

Source: Bloomberg

Yanzhou Coal Mining (YZC, Outperform): Yanzhou Coal Mining Company Limited operates underground mining and coal preparation and operation businesses. Its products are sold in domestic and international markets. The Company also provides railway transportation services. (Bloomberg)

YCZ’s outlook in a nutshell: Like its oil and gas counter parts YZC is susceptible to Chinese government price control policies. Despite this coal prices have remained elevated and this should benefit YCZ’s bottom line. Looking at YZC’s 1Q08’s earning release it would appear that YCZ has begun to shift its focus to producing coking coal vs. thermal coal, which has helped company margins. WE believe this trend will continue for the following reasons: According to a Wall Street Journal article coking coal, unlike thermal coal, isn’t effected by recent government price caps. At the same time the article quotes UOB Kayhian analyst Karen Li as saying, "We are bullish on China's coking-coal sector because of the current tight-market-supply situation.” YZC saw profits from coking coal exceed that of thermal coal for the first time in 2007. Addtionally, YZC owns a majority stake in a new methanol project, which is scheduled to begin production this year. The operation will use thermal coal to produce ethanol, with the first deliveries being made in 2H08. All in all, factoring out any potential government intervention further regulating coals prices or impacting YZC’s cost, we believe YZC is a good play in the Chinese energy market. (Expected Q208 Earnings Report 8/15/08)

Events which could improve outlook:

• Continued strength in coal prices.
• Further shift into higher margin coking coal.
• Success of methanol project and increased coal production at plants in operation.

Events which could deteriorate outlook:

• Weakening in coal prices.
• New Government policies restricting coal prices or export quotas.
• Transportation issues regarding coal delivery.

YZC vs Hang Seng

Source: Bloomberg

Gushan (GU, Outperform): Gushan Environmental Energy Limited produces biofuel. The Company produces biodiesel and by-products of biodiesel production, including glycerin, plant asphalt, erucic acid and erucic amide. (Bloomberg)

GU’s outlook in a nutshell: GU essentially turns waste oil into bio-diesel, and they do this rather successfully. In fact 1Q08 saw impressive increases in net income and revenue. This was primarily due to higher sales volume and prices. For the remainder of 2008 June’s diesel fuel price increase, and any future increase, should help benefit GU's margins. Additionally, GU has started selling its bio-diesel product to the chemical industry, which according to the company sells at an average RMB800 premium over sales to the diesel industry. In 1Q08 this accounted for 10% of total sales volume; the company expects this could reach 30% by the end of 2008. GU also has numerous ongoing projects to increase bio-diesel production, which is expected to total 400tons by the end of 2008 vs. 240tons in 2007. GU’s Shanghai plant began operations in June while Beijing’s plant became operational in January and is expected to double capacity in 4Q08. Moreover, two new plants are expected to become operational during that time period. It is anticipated that GU will announce 2009’s expansion plans during 2Q08’s conference call on August 11th. According to company officials all expansion is being paid for through cash on hand and cash flows without the use of leverage. Costs increased somewhat significantly for GU in 1Q08 due to higher than expected inflation caused by the Sichuan earthquake, but more recently costs have begun to moderate as Chinese inflation growth has slowed. Moreover, GU’s proprietary technology allows them to use lower quality waste oils than their competitors giving them a cost advantage in the sector. On average GU expects input costs to increase roughly in-line with the Chinese inflation rate. All in all given the current demand and potential shortages for diesel combined with GU’s entrance into the chemical market; we are optimistic about the company’s future, and believe the company could have significant upside. This is my favorite play in the Chinese ADR energy sector. (Expected Q208 Earnings Report 8/11/08)

Events which could improve outlook:

• Increases in the governments diesel fuel price cap
• Larger volumes being sold into the higher margin chemical industry.
• Meeting production targets and bringing new plants online within the targeted time frame.

Events which could deteriorate outlook:

• Significant rise in input prices effecting margins.
• Drop off in business to the chemical industry.
• Supply chain issues on sourcing waste oils.

GU vs. Hang Seng

Source: Bloomberg

A Look at Chinese and Hong Kong ADR’s

In this piece I highlight 66 Chinese and Hong Kong ADRs by sector, broken out by market cap, average 30 day volume, and a series of performance metrics. This piece will eventually be followed-up with specific analysis on Chinese sectors and companies. Before getting to the nitty gritty lets formulate a quick outlook on the global and Chinese economies.

As everyone by now has realized decoupling of the financial markets holds less credibility than the Loch Ness monster. This notwithstanding, I anticipate growth in developing emerging market economies, especially China, will continue to outpace their industrialized counter parts in the years to come, albeit it not at the pace we have grown accustomed to seeing. It is also very likely we will see domestic demand take over as the new engines of growth in these economies. The cause is simple, industrial nations, particularly the US, will experience slowdowns in consumption, hence overall growth over the next several years as wealth continues to deteriorate. The effect, less demand for foreign goods will likely cause trade balances to become a drag on growth for many EM export oriented economies On the other hand, this should be at least partially off-set by what I expect to be continued strong growth in the domestic sector. Domestic Consumption and investment should remain robust for many EM countries after experiencing high growth and a developing domestic economies.

With that said lets look at China, where the global slow-down coupled with an appreciating currency is a double whammy for exports. But how has the Chinese domestic market performing? In a nutshell the answer is good. According to China’s 2Q08 GDP figures domestic investment and consumption continue to experience significant growth. In fact, the June retail sales figure demonstrated 23%yoy growth. So why have Chinese equities faced such a bad year? Well I don’t believe there is any one specific reason for this, but a combination of factors including fears of monetary tightening, investors’ flight to quality, and liquidity issues in the global financial sector stemming from the housing crisis. I anticipate that as fears ease and liquidity returns to the market we could see a significant buy-back of Chinese equities. Additionally, as the Chinese export sector continues to deteriorate there is a growing possibility we could see a pull-back of domestic macro-policies aimed at preventing the over-heating of the domestic economy. This could include anything from increasing loans quotas to reducing reserve requirements. With this said, in the long-run I am bullish on the Chinese domestic sector, while slightly bearish on export oriented industries. There are of course risks, and I advise you to read some of my previous posts and other research. I will go into further detail on sectors and companies in future posts. Now let’s look at the ADRs:

Year to date the 66 Chinese and Hong Kong ADRs I tracked lost 24.0% of their value in market weighted terms, significantly outperforming the domestic Shanghai SE Composite Index which returned -45.6% during the same period, but underperforming Hong Kong’s Hang Seng Index which returned -18.4%. The best performing company was China’s VisionChina Media (VISN) which returned 167.1%ytd, while the worst performer was Hong Kong’s Corgi International (CRGI) which lost 73.0% during the same time period. Interesting to note is that in 2007 nearly 70% of Corgi’s revenues were derived from the US. The best performing GICS sectors for the ADRs were consumer discretionary, health care and IT which all lost 15%ytd in market weighted terms. The worst performing sector has been industrials, which lost 54%ytd. Please look at tables below for further details:

ADR’s sorted by Sector & Market Cap*

*Sector Performance is Market Cap Weighted

Source: Bloomberg

To be continued...

Quick Description from Bloomberg of top 10 ADRs by Market Cap

1. PetroChina (PTR): PetroChina Company Limited explores, develops, and produces crude oil and natural gas. The Company also refines, transports, and distributes crude oil and petroleum products, produces and sells chemicals, and transmits markets and sells natural gas.
2. China Mobile (CHL): China Mobile Limited, through its subsidiaries, provides cellular telecommunications and related services in the People's Republic of China and Hong Kong SAR.
3. China Petroleum & Chemical (SNP): China Petroleum and Chemical Corporation (Sinopec) explores for and produces crude oil and natural gas in China. The Company also owns refineries that make petroleum and petrochemical products such as gasoline, diesel, jet fuel, kerosene, ethylene, synthetic fibers, synthetic rubber, synthetic resins, and chemical fertilizers. In addition, Sinopec trades petrochemical products.
4. China Life Insurance Company (LFC): China Life Insurance Co., Limited offers a wide range of life, accident, and health insurance products and services.
5. CNOONC (CEO): CNOOC Limited, through its subsidiaries, explores, develops, produces, and sells crude oil and natural gas.
6. China Telecom (CHA): China Telecom Corporation Limited, through its subsidiaries, provides wire line telephone, data, and Internet, as well as leased line services in China.
7. China Unicom (CHU): China Unicom Limited, through its subsidiaries, provides telecommunications services in the People's Republic of China. The Company's services include cellular, paging, long distance, data, and Internet services.
8. Aluminum Corporation of China (ACH): Aluminum Corporation of China Limited is a producer of alumina and primary aluminum in China. The Company refines bauxite into alumina and smelts alumina to produce primary aluminum.
9. China Netcom (CN): China Netcom Group Corporation (Hong Kong) Limited is a fixed-line telecommunications operator in China and an international data communications operator in the Asia-Pacific region. The Company provides broadband and other Internet-related services, including DSL and LAN services, business and data communications.
10. Yanzhou Coal Mining (YZC): Yanzhou Coal Mining Company Limited operates underground mining and coal preparation and operation businesses. Its products are sold in domestic and international markets. The Company also provides railway transportation services.

**Disclaimer: Author holds long positions in China Mobile(CHL) & EHouse (EJ)

Impending Chinese Financial Crisis…

Sitting here in Hong Kong, I know few people who aren’t transferring money into China to take advantage of the appreciating RMB and attractive domestic rates. In fact a study conducted by the Chinese Academy of Social Sciences estimates there could be over USD1.0trn of such money within China, with USD150bn coming during the first five months of 2008. The good news for these investors is that the RMB is still expected to appreciate over the next 1 to 2 years as the Chinese government continues to correct economic imbalances. However, there is bad news. Eventually, the RMB appreciation will peak, and those investors’ solely within the country to take advantage of the appreciating currency will begin to pull-back. This will likely cause liquidity problems within the Chinese economy, and will lead to further depreciation as more investors attempt to withdraw their funds. This potential crisis has not gone unnoticed. *The branch head of the Jiangsu province China Banking Regulatory Commission released in a paper this week the following comments;

“The initial judgment is that China's financial crisis will kick off between 2009 and 2010, though it may be a year or two later, and will be triggered by a turning point in yuan appreciation…”

“By that time, international capital will flow out instead of coming in and the yuan will face depreciation instead of appreciation pressure. China will face a liquidity shortage and financial crisis will therefore follow.”

In fact looking at the RMB NDF rates, we can see that the market is currently pricing in a slight RMB depreciation around the 3-year time horizon (chart below). In fact, back in May we even saw the 1-month contract briefly imply depreciation for the RMB, demonstrating the potential volatility of the market. This notwithstanding, we have begun to see the growth rate of Chinese exports slow, a trend we expect to continue. This coupled with an unwavering demand for imports, will place a stronger weight on the domestic sector to support China’s growth. To make matters worse for the export sector the Chinese government has initiated new capital controls to reduce the amount of 'hot money' that may be hidden within the sector (i.e. through over-invoicing). Some estimates have placed the amount of hot money hidden within the sector at around 2% of exports. The good news is that the increased importance of the domestic market within China could cause the government to reduce some restrictions on the sector, meant to reduce over-heating within the economy. Yet, a conundrum could arise if Chinese inflation rates once again begin to accelerate. However, at this point most analysts’ estimates are calling for inflation to slow.

The Current RMB NDF Implied Rates show the RMB Depreciating Slightly in 3-Years

Source: Bberg

The bottom line is that China is facing a potential financial crisis that could occur sometime over the next 2 to 4 years. I will continue to look at the RMB NDF market and changes to the government’s foreign exchange policy as potential forward looking indicators to this crisis. In the meantime, the slow-down in Chinese exports will likely have 2 short term effects, 1) a decelerated RMB appreciation, & 2) the potential for authorities to lift some regulations put in place to prevent the domestic economy from over-heating. This could have positive effects on the local equity markets, after facing significant losses from their previous highs. In fact, last week we already began to see the local equity markets respond favorably to the possibilities of less stringent economic policies.

*http://www.quamnet.com/newscontent.action?articleId=889534

A Quick Look at the Asian CDS Market

Recently, I have been attempting to locate data on the Asian credit default swap (CDS) market, specifically on sovereign protection; I couldn’t find much. In response I decided to put together this posting, which tracks performance and allows for some basic relative value and correlation analysis verse equity markets. All CDS prices quoted in this entry are 5yr protection on each governments’ international bonds.

A credit default swap is an agreement between two parties, in which one party pays a premium to the other party, who in return provides protection against the default of an underlying bond. A CDS can be written or bought by anyone, even if they do not own the underlying bond. Since the price of the CDS is the amount a buyer is willing to pay for protection against a potential default it goes without saying that the price is a good measurement of market implied risk. This also means there should be some correlation between sovereign ratings and the sovereign CDS prices.

To start, let’s take a look at the three major rating agencies rating systems. The chart below breaks out each of the major rating companies systems, with the green area representing investment grade ratings and the red area representing non-investment grade ratings. I have also included the credit ratings of the Asian countries for each of the 3 agencies (see below).

Moodys, S&P, & Fitch Credit Ratings

Asian Countries Credit Rating

Next, I created a composite rating system for the countries being analyzed. To do this I assigned number values to the above rating system with the highest rating for each agency equaling 1, and the lowest rating equaling 21. In the case an agency had a positive outlook for any given country I subtracted 0.5 from their score (i.e. a S&P rating of AA would equal 3, but an AA rating with a positive outlook would equal 2.5). I then averaged these results together for each country and created the consolidated rating (see chart below).

Composite Asian Credit Ratings

You can see from the chart above that for each country, except Vietnam, current CDS prices correspond well to each countries composite credit rating. The next step is to look at each countries CDS performance to determine shifts in implied market risk, especially given the current credit crisis and large equity sell-offs.

Historical 5yr CDS Japan, Hong Kong, & China

Hong Kong - China 5yr CDS Spread

Source: Bberg

Over the past couple of months CDS prices in Hong Kong and China have seen a significant rise, this corresponds to the recent equity sell-off in both countries. Japanese CDS prices also rose, but remained somewhat contained compared to Hong Kong and China. It is important to highlight that year to date the Nikkei 225 is down 14.86% verse 23.70% & 46.5% for the Hang Seng and Shanghai indices, respectively. Recently, we have witnessed significant volatility between the Hong Kong and Chinese 5yr CDS spread; nevertheless the spread has begun to revert back to its historical average of around 12bps.

Historical 5yr CDS Korea, Malaysia, & Thailand

Source: Bberg

Similar performance can be seen for 5yr CDS in the Korean, Malaysian, and Thai markets. Generally speaking we have seen the spreads between Thailand, Malaysia and Korea moving tighter during the recent volatility.

Historical 5yr CDS Philippines, Indonesia, & Vietnam

Source: Bberg

Finally, and possibly most interesting we have seen 5y CDS move significantly higher in Vietnam. This comes despite the fact that over the past several years the spread between 5yr Vietnamese CDS and that of Indonesia and the Philippines has remained relatively constant. I believe the reason for this is due to growing concern over Vietnam’s economy and a growing conflict between the government plan to maintain economic growth and the central bank’s goal of controlling growing pricing pressures.

Finally, the following charts show each countries’ CDS movements verse the main domestic equity Index; CDS could be used as a hedge against regional equities. CDS prices tend to have a negative correlation with a country’s underlying equity index. This notwithstanding, hedging an individual equity via sovereign CDS will likely not hedge against intra-day or company specific price movements but will hedge against fundamental economic changes within the country. It is important to keep in mind that companies with traded debt may have its on CDS. However, at this point within Asia this market does not yet seem to be very robust.

Charts:

Source: Bberg

List of CDS traded in Asia

Source: Bberg (pricing from 7/7/08)