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Global Top Cat

China Outlook: Cautious, But Not Bearish

By Yiannis G. Mostrous, on Apr. 30, 2014

The Benefits of Reform

China’s government has also started to tackle the thorny issue of reforming the state-owned enterprises (SOE) that have been a staple of the economy for decades.

Almost 20 years ago, Beijing sought to reduce the size of SOEs operating in the industrial sector. From 1996 to 2005, this effort reduced the number of state-owned enterprises to about 27,000 from 87,000, a move that also dropped the number of people employed by these entities to 19 million from 42 million. This rationalization cut the number of loss-making industrial SOEs by half and improved operational efficiency.

But over the past eight years, many of the remaining SOEs have returned to their old ways, leading to a significant deterioration in profitability and efficiency–especially relative to the private sector.

Moves by some of China’s larger SOE’s to sell some of their assets to outside investors could drive significant upside for these names and Chinese equities in general.

Investment Strategy  

Investors should remain cautious when allocating funds to Chinese equities this year. At these levels, we wouldn’t sell the market short; a patch of good news could send Chinese stocks much higher in a hurry. 

Here are a handful of names for adventurous investors to consider.

China Petroleum & Chemical Corporation (NYSE: SNP)

China Petroleum & Chemical Corporation (Sinopec) explores for and produces crude oil and natural gas, and owns refineries that make petroleum and petrochemical products such as gasoline, diesel, jet fuel, kerosene, ethylene and chemical fertilizers.

Last year, China’s National Development and Reform Commission announced a new fuel-pricing mechanism, which would improve the quality of fuel available domestically and compensate refiners for the associated upgrades to their plants.

Sinopec stands to benefit the most from this reform; the company’s refining margins are expected to improve by an average of almost US$2.00 per barrel, which translates into a roughly 10 percent increase in annual earnings.

We also like the national oil company’s exposure to the Mainland’s growing demand for imported liquefied natural gas (LNG) via the construction of two import terminals that will receive and re-gasify LNG cargoes. Sinopec’s terminal in Shandong province will have a nameplate capacity of 3 million metric tons per annum (mmtpa), while the facility in Guangxi province will be capable of processing 5 mmtpa.

With three shale-gas blocks covering 6,500 square miles, Sinopec likewise offers exposure to growing domestic production from unconventional plays. Recently investors have been very interested in the company’s unconventional operations and especially in the shale gas project in Chongqing, where the indicators are that the geology of the shale formation is unique and among the best in China

Management has indicated that based on current well costs, gas prices, and data from the 21 wells drilled so far, the project returns could be higher than its conventional oil & gas projects. Success in these fields would be a big boost to the company’s upstream division, which generally lags those of its peers.

The company should also benefit from the boom in the coal gasification business, given Sinopec’s plan to invest in key coal-to-gas pipeline infrastructure.

But the biggest positive for the stock this year has been the February announcement of a plan to restructure the marketing unit and sell up to a 30 percent interest in this underperforming business, which includes a network of gas stations.

Not only would this strategic move comply with government-mandated restructuring, but this monetization would also make a great deal of sense from a business perspective.

Management has bet that the firm’s strategic partners will be able to improve returns from these assets by bringing operational expertise and knowledge of local markets to the table.

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