Growth, but at what price? Industry estimates that China, in 2008, needs 221 tonnes of oil to produce US$1m of GDP, so that’s a good proxy. But as China powers on, it has been forced to look overseas for that precious resource while many of its top fields are feared to have peaked. When it comes to reworking such marginal oilfields, Sky China Petroleum Services (Sky China) is a specialist and one of the few stocks to provide exposure to China’s oil industry.

Three business units drive revenue at Sky China: technical extraction services, extraction and drilling, which contribute 47%, 41% and 12% respectively. Its technical services arm operates at the Dagang oilfield, Hebei, contracted till 2010. Likewise, its drilling services division also has a contract that lasts to 2011. Its extraction segment mines the oilfields in Song Yuan, Jilin, whose extraction rights were obtained when Song Yuan Tian Xi Harbour Oil Exploration was acquired.

Falling Margins
Since listing in November 2005, Sky China’s net profit has seen a CAGR of 34.6%. Fundamentally, the company remains sound, with a low debt-to-equity ratio. Cash position has also increased 69%, to $36.7m. For the half-year ended June 2008, net profit increased 14%, mainly from extraction and drilling; revenue was up 68%. Christopher Chong, one of the group’s independent directors, verified that while the stream of income from technical services is its most stable, charging a fixed annual fee of about Rmb102m, it has become too resource intensive to be the group’s main stay. Margins had dipped to 50.3% from 61% due to rising costs and the high depreciation rate on its assets. Chong said the plan, now, is to derive more of the group’s earnings from the extraction of crude oil, to about 60% - 70%, he estimated.

Currently, Sky China is remunerated on the amount of oil extracted at a price tied to the International WTI benchmark. Arguably more attractive, but mainland oil companies have a windfall tax to contend with. Calculated at 20%-35% on oil sold above US$40 a barrel and 40% when above US$60, earnings at one of Sky China’s main customers, China National Petroleum Corporation, were affected when taxes more than tripled on record oil prices. And Chong thinks the situation won’t be changing anytime soon. He stressed that the company’s move into oil-rig leasing is in the right direction as it commands a high margin due to tight supply and is a conscious move to diversify earnings away from the high tax regime.

Firmer Plans Needed
Chong updated that Sky China should be taking on a new project from Jilin, the details of which are still under wraps. The company also harbours hopes of acquiring exploration rights to an oilfield to drive long-term growth. China’s geographic disparity between its energy reserves and economic zones also offer an opportunity to supply the infrastructure necessary to distribute fuel, which are still relatively undeveloped, he said. The second half of the year should also be stronger.

But without firmer plans and amidst the recent selldown of S-shares, investors aren’t exactly biting. Analysts’ coverage is sparse and its IPO price of $0.28 has been diluted by two fund raising exercises last year. Its shares currently trade around $0.18 – below NTA and at a very low PE. While the company has provided for growth with some dividends and is involved in a lucrative industry, it isn’t exactly riding the crest of its wave. Chong openly admits that Song Yuan oilfield will see an estimated 7% - 13% drop in volume every year. A model heavy on fixed income also has little potential on the upside. The company’s shares is definitely in need of a catalyst to pull out of its slump, which at the present, a risk averse market is hard pressed to provide. Well, it’s that or firmer plans.