“In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at about $37 billion. Charlie and I then felt that the company was worth about $100 billion. By 2007, two factors had materially increased its value: the price of oil had climbed significantly, and PetroChina’s management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the company rose to $275 billion, about what we thought it was worth compared to other giant oil companies. So we sold our holdings for $4 billion.
A footnote: We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government – defense, social security; you name it – for about four hours.”
Since the divestment the company has grown profits to $21 billion (from about $20 billion in 2007), yet the market capitalization is down slightly to $237 billion. By Buffett’s standards the price is not cheap at a price to earnings of 11. When he first purchased the stock the ratio was closer to 6. But something else also changed in the process; margins fell, and they didn’t just fall — they collapsed.
This main culprit appears to be the cost of revenue which has increased from about 40% of revenues to 55% of revenues over the past nine years. Included in the category are such items as depreciation, exploration expenses (which have dropped over the past couple years) and taxes other than income taxes which nearly doubled from 2007 to 2009. If PetroChina is becoming a vehicle for taxation rather than oil production, investors should beware. China is unique in that the state controls the price of oil the oil companies are paid. The compensation price has generally lagged the market price as the state is naturally reluctant to put the burden on its citizens. This puts PetroChina at a disadvantage to companies like Exxon (XOM), as the cost for underlying oil equipment surely increases as the price of oil increases.
Exxon’s profit margins, though not as high as PetroChina’s, have still rebounded from 2009, while PetroChina’s continue a steady decline. A comparison of the two companies will also show that Exxon is much more productive with its assets. Exxon’s asset turnover was 1.26 while PetroChina’s was only .88 for the year 2010. This shows up in return on equity, as Exxon’s 20% bests PetroChina’s 14%; however, the two companies have similar debt profiles.
If China’s economy sours as Jim Chanos and other short sellers predict it will, would buying PetroChina at an eventual low price still be a good investment? The company quadrupled earnings from 2001 to 2011. That feat will certainly be much more difficult with a profit margin spliced in half. Buffet noted in the 2007 annual report the company had done an excellent job in building reserves. In 2007 the company had “proved developed and undeveloped reserves” of 11.7 billion barrels, but that was down to 11.2 billion in 2009. Further, “proved developed” reserves declined 1.2 billion to 7.8 billion in the same period. These are disconcerting figures, as the oil company will have to import more and more oil from abroad.
Of the 455 million tons of oil China consumed in 2010, 200 million tons were imported. As I mentioned earlier, China pays oil companies a price it finds agreeable. But in operations overseas PetroChina has to obtain equipment and personnel on an international price that will increase as oil prices rise. This puts the company in a bind, and pricing power does not seem to be one of its strengths.
Time will tell if the Chinese economy is as weak as it appears. Until then the current price for PetroChina does not offer a margin of safety sufficient for the risk.