Sinopec 2007 Results

Sinopec (SNP) announced 2007 year end results on April 6, 2008 with overall earnings up 5.5% to RMB 58.7Bn. In terms of segment results, most notable was the fact that SNP's Exploration & Production division's operating profits were lower by 22.8% to RMB 48.7Bn, even though oil output was up 2.3% y/y and natural gas output was up 10.2% y/y. This result is assessed to be mainly due to one time charges and events -- mainly due to a lower than market realized price for oil and higher depreciation charges -- that are not expected to negatively impact higher expected E&P segment earnings going forward with the realization of higher oil prices.

Chart 1: Sinopec Key 2007 Financial and Operating Results

	2007	% Change
Sinopec Earnings RMB Bn	58.7	5.50%
Segment Operating Income: (RMB Bn)
Exploration & Production	48.6	-22.80%
Refining	-13.66	n/a
Marketing	33.6	18.20%
Chemical	13.4	-8.00%
Operating Statistics:
Oil Produced mm bbl	291.7	2.30%
Gas Produced bcm	8.06	10.20%
Exploration Expense RMB Bn	11.1	39.10%
Crude Processed mn/d day	3.13	6.30%

Brief Commentary on SNP's Refining and Marketing Divisions:

Sinopec Marketing boasted higher profits, driven by expansion in the Marketing division's number of outlets and volumes of product sold, and in the case of the Refining segment, lower losses due to the higher average prices of gasoline in China for most of 2007 verses the world oil price. Sinopec's Marketing division is expected to have a record year in 2008 even as Sinopec's refining segment is expected to post pre-subsidy losses (Sinopec's forecasted refining losses are the subject of this previous article).

E&P Division: Received a Lower than Market Price for Oil in 2007

Sinopec did not receive a significantly higher oil price during the fourth quarter -- Sinopec's E&P division's overall realized oil price during the full year was approximately 3.1% lower in 2007 than in 2006. The rise in the oil price during 2007 mainly occurred in the 4th quarter of 2007, as shown in chart 2 below:

Chart 2: Increase in World Oil Price in 2007:

The rapid rise in the oil price during the 4th quarter of 2007 meant that Sinopec's short term contracts for oil sale resulted in a significantly lower realized oil price for the year.
Note that going forward, Sinopec should expect to realize higher oil prices as long as oil prices continue to remain elevated as contracts reprice based on market levels, which should more than offset the higher costs associated with extracting oil and gas as E&P divisions generally receive higher revenue proportionally with higher oil prices verses costs.

Sinopec's E&P's Division: 2007 Deprecation Charges:

Sinopec recorded one-time non-cash depreciation charges of RMB5.3Bn in the 2007 in Sinopec's E&P division, which would have comprised an estimated 37% of the drop in Sinopec 2007 E&P income (reference: see page 28 of Sinopec's 2007 Annual Report (large pdf warning).

Why was there a large increase in deprecation charges during the 4Q07 at Sinopec? Under successful efforts accounting rules for oil and gas properties, future costs of extracting oil and natural gas over the life of a company's existing oil and gas fields are estimated based on current costs, and a charge is taken if the extraction costs during the current year have risen (reference, see Section 3 under the Full Cost Method of this University of Cincinnati accounting guide)(Note that Sinopec uses Successful efforts accounting vs Full Cost, but the amortization charges for higher future costs is similar under both accounting methods). As extraction costs rose for Sinopec during 2007, due to high inflation in drilling, materials, labor, etc, an increase in deprecation as defined as for extraction costs for all future years was recorded in 2007. Note that Exxon and BP and most oil firms, for example, took higher oil and gas extraction deprecation charges in 2007 -- Exxon and BP took higher deprecation charges of approximately $US800M and $US1.2Bn in 2007, respectively. As Sinopec currently produces a higher percentage of its reserve base each year -- ie Sinopec's reserve life is lower than Exxon and BP's reserve lives -- Sinopec's depreciation charge impacted its earnings to a higher degree. Note however that Exxon and BP's E&P segments did not perform extremely well in 2007 due to the same drivers that drove (temporary) lower operating profit performance in Sinopec's results, which will be explored below.

How Did Other Integrated Major's E&P Segments Perform in 2007?

Overall, the Integrated Major E&P divisions did not perform strongly as a group in 2007 in terms of operating income and production, mainly due to higher depreciation charges due to higher lifting costs, and lack of realization of higher oil prices as shown in the chart below. It is also noted that oil production (excluding natural gas production) was not strong for the Integrated Oil major universe in 2007 as a whole -- Sinopec's results of +2.3% for oil production growth actually placed it in the higher half of production growth for integrated majors. However, note as the realized price continues to stabilize at a higher level in 2008, reported earnings should be stronger in 2008 verses 2007 for the Integrated major's E&P divisions as a whole.

Chart 3: Selected Integrated Majors' 2007 E&P Segment Key Operating Metrics

in $US Bn	2007	% Change
Exxon Mobil
E&P Operating Income	26.497	1.01%
E&P Depreciation	12.25	7.30%
Oil Liquids Production*	2.6 mbpd	-1.90%
BP plc
E&P Operating Income	26.938	-10.10%
E&P Depreciation	7.72	18.20%
Oil Liquids Production*	2.5 mbpd	-2.10%
Royal Dutch Shell
E&P Operating Income	14.686	1.00%
E&P Depreciation	9.338	7.70%
Oil Liquids Production*	1.8 mbpd	-6.70%
Conoco Philips
E&P Operating Income**	4.615	-53.40%
E&P Depreciation	8.298	13.90%
Oil Liquids Production*	0.854 mbpd	-12.10%
Chevron
E&P Operating Income	14.816	12.70%
E&P Depreciation	8.708	16.01%
Oil Liquids Production*	1.7 mbpd	0.08%
Total
E&P Operating Income	29.26	-3.89%
E&P Depreciation	8.14	7.30%
Oil Liquids Production*	1.2 mbpd	2.30%
Sinopec
E&P Operating Income	6.59	-22.80%
E&P Deprecation:	2.45	40.60%
Oil Liquids Production*	0.8 mbpd	2.30%

* "Oil Liquids Production" is defined as oil and natural gas liquids production, and excludes natural gas production
** Conoco Philips recorded a write down of their Venezuelian assets in 2007, which was the main driver of COP's lower E&P Operating Income

Note: Other SNP E&P Division Costs: Dry Hole Costs and Special Taxes Are Not Expected to Significantly Impact Sinopec's Earnings Going Forward:

Higher exploration expenses, in particular, dry hole expenses -- defined as drilling that did not result in economic quantities of oil and gas) of RMB 3.1Bn, higher general costs in the E&P division of RMB3.6Bn y/y and higher special oil taxes of RMB 2.5Bn y/y also accounted for the change in 2007 E&P earnings (note that the special oil tax are mainly enacted by the Chinese central government to gain revenue to repay subsidies to Sinopec's refining division, so can be viewed as a realignment of revenue). Dry hole expenses -- costs associated with unsuccessful drilling -- are not high for a large integrated oil major, as for example, Chevron announced dry hole expenses of $US507M in 2007 (equivalent to approximately RMB 3.8Bn). Note that Sinopec still has not reported its massive Puguang Gas field in its reserves statement, so drilling and exploration costs associated with this field can be capitalized in 2008 -- the dry hole expense indicates that outside of Puguang, several wells drilled in 2007 were unsuccessful. Note that Sinopec's dry hole expenses a Drilling in 2008 with the Puguang field will be reported as more successful. But overall, in assessing the cost and revenue drivers of lower income, the largest contributor of the lower E&P division's operating performance is assessed to be the lower realized oil price.