The Global Bull Bets on a Chinese Hidden Gem

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

This week’s Global Bull Market Alert recommendation, China North East Petroleum Holdings Ltd (NEP), an ultra-low cost oil producer and driller in North East China, does just that.

A private company, China North operates 247 producing wells located in four oilfields in Northern China. And like many small Chinese companies, it is growing by leaps and bounds, doubling its proven reserves in 2009 alone. China North also recently completed its acquisition of Song Yuan Tiancheng Drilling Engineering, an oilfield services specialist, the largest private driller working for Chinese oil giant PetroChina (PTR). This acquisition alone will boost China North’s revenue estimates for 2010 by a whopping 50%. It also makes China North PetroChina’s partner of choice to develop new oil fields in the lucrative Jilin oil field, and elsewhere in China.

Nor is China North’s management about to rest on its laurels. Management has announced that it plans to consolidate some of the 36 private oil companies operating in the Jilin oil field. Many of these companies are smaller and have limited access to capital. By initiating an “industrial roll-up,” China North aspires to become a much larger and more significant oil player. With little debt and over $30 million on its balance sheet, it has the means to do so.

China North has some additional, built-in advantages. Operating costs in China are low. At the same time, China North sells oil at international prices. The result? The company’s net margin of 28% compares with 8.9% for Chevron, 6.5% for Exxon Mobil, 4.3% for Royal Dutch Shell, and 4.1% for ConocoPhillips. That makes China North one of the most efficient oil companies in the world. And like a good athlete, China North keeps getting better and better. In Q3 of 2009, its gross margin widened from 52% to 81%, and its operating margin rose from 47% to 54%.

Yet, as an “undiscovered gem,” China North remains extremely undervalued versus its peers. The company trades at roughly half the average industry price earnings ratio (12 vs. 21). It’s equally cheap, based on measures like price to sales, price to cash flow, and enterprise value to EBITDA.

And here’s why I think now is a good time, in particular, to get into the stock. The company announces Q4 earnings on March 29. Consensus estimates for Q4 2009 are based on an average oil price of $65 per barrel. But with the average oil prices above $65 in Q4, China North is almost certain to beat market expectations. And with oil prices rising above $80 a barrel overnight, China North’s prospects are only getting stronger by the day. The stock has been also very strong technically, never trading below its 50-day moving average, even during the recent sell-off.

So, buy China North East Petroleum Holdings Ltd (NEP) at market today, and place your stop at $7.50. If you want to play the options, I recommend the July $10 call options (NEP100717C00010000).

With a beta of 2.66, like all Chinese small caps, this is an extremely volatile pick. So, you might want to take a smaller position in the stock than normal.

Portfolio Update

UltraShort Euro ProShares (EUO) rose slightly this past week. With the structural flaws in the euro becoming more apparent, your bet against the European currency remains a BUY.

Mechel (MTL) jumped another 4.76% this past week, cementing its position as one of the best-performing global stocks over the past few weeks. I am keeping this volatile pick as a speculative BUY. Raise your stop to $20.20.

iPath DJ AIG Sugar TR Sub-Idx ETN (SGG) dropped back slightly this past week. With world sugar production forecast to trail demand by 9.4 million tons in 2009-10, compared with a previous estimate of 7.3 million tons, the fundamentals of sugar remain strong. But with some of the technicals looking weak, I am temporarily moving SGG to a HOLD.

P.S. If you want to keep up with my latest insights on developments in fast-paced global markets, you can now follow me on Twitter on @NickVardy.

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