Published: May 5, 2008

China Petroleum & Chemical (NYSE: SNP, $112.56) is a Chinese oil firm involved in every step of crude's journey, from the ground to the gas tank.

The company's flourishing exploration and production segment (which accounts for the bulk of its profits) extracts more than 900,000 barrels of oil daily from a proven reserve of 3.3 billion barrels. The firm is also the largest refiner in all of Asia, with two dozen refineries capable of processing more than 3.6 million barrels per day. Finally, "Sinopec," as it is commonly known as, operates approximately 30,000 gas stations throughout China and has locked up a strategic retail alliance with McDonald's (NYSE: MCD).

As you might expect, the firm's oil drilling or "upstream" production business has enjoyed the unprecedented run-up in oil prices -- which recently hit a new record high of $119.93 per barrel. However, those same high prices have plagued the refining segment, as refiners must first buy crude oil before they can turn it into products later sold to consumers. Sinopec's cost per barrel climbed from $56 to $68 last year, and that figure has headed even higher in recent months.

Unfortunately, the company can't pass along those rising costs, because the Chinese government (in an effort to clamp down on rising inflation) has set strict price ceilings for refined products like gasoline and jet fuel. Pinched between rising input costs and fixed retail prices, Sinopec and rival PetroChina (NYSE: PTR) have suffered heavy losses from their refining operations.

Basically, the government has enacted price controls to ward off inflation, but the strategy has only exacerbated the situation by boosting consumer demand and triggering widespread fuel shortages. Meanwhile, supplies were already low because refiners had cut back on their output to slow the bleeding.

Fortunately, government officials aren't blind to the predicament. Several months ago, they lifted fuel prices by +10%; the first hike in over a year. And recently, they decided to offer Sinopec a tax rebate for imported products -- on top of a 12.3 billion yuan ($1.76 billion) subsidy granted in March.

For now, the combination of direct subsidies and elevated fuel prices should help alleviate some of the pressure. Meanwhile, the firm's other operations have been able to easily absorb the losses. For example, sales of ethylene and other petrochemicals bounced +12% in 2007, while higher sales volume at the gas pumps pushed profits in the marketing unit up an impressive +18%. Overall, net income rose +6% for the year to around $8 billion on more than $150 billion in revenues.

Last October, SNP touched on a peak just below $180. However, like many other Chinese stocks, it has retreated sharply since then and can now be bought for a trailing P/E multiple of 12 -- very low for a company expected to deliver robust earnings growth of +25% annually over the next five years.

While margins in the firm's refining segment could remain under pressure for the foreseeable future, investors that have abandoned Sinopec are missing the bigger picture. Demand for gasoline and energy is unwavering, particularly in fuel-hungry China where millions of consumers are purchasing cars and burning natural gas with their newfound disposable income. And Sinopec's home territory is sitting squarely in the heart of the nation's most affluent and fastest-growing region.

More importantly, Sinopec's booming exploration and production business is chronically overlooked and will continue to thrive on high oil prices. The state-owned firm has close ties to the Chinese government, which has arranged for the company to seek out new oil reserves in fields throughout Africa, the Middle East and elsewhere. Furthermore, major discoveries like the recent Puguang natural gas field (the largest ever found in China) could be key growth drivers going forward.

The current challenges facing Sinopec's refining business are real, but they have also wiped out roughly -40% of the firm's market cap and left this global powerhouse trading at a bargain price.

Nathan Slaughter
Editor
Half-Priced Stocks

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