- Refined oil pricing mechanism reform is highly anticipated. In our opinion, the potential gain of the pricing power will bring PetroChina's refining segment back to profit.

- PetroChina recorded 3Q11 net profit of RMB40.7 billion, up by 8.2% yoy and 23% qoq (2Q11 had an unordinary weak quarter). The profit jump was mainly due to a lowered tax expense. Eps increased by RMB0.4/sh from 2Q11 to RMB0.20/sh in 3Q11 on the back of the strong E&P results.

- 3Q11 earnings in the E&P segment were inline with our expectations. With an average realized oil price at US$108/bbl, operating profit jumped 67% yoy and 16.1% qoq to RMB57.1 billion. Total 9M11 operating profit from E&P increased 40.4% yoy to RMB160.8 billion.

- The refining and chemicals segment backfired, posting another RMB17.4 billion loss. The 9M11 segment losses mounted to RMB38.4 billion.

- We lower our 2011 full year earning estimates by 8.3% due to the newly implemented resources tax effective from November 1, 2011 and the worse than expected refining losses in 3Q11.

- Until the official implementation of the new refined oil pricing mechanism, we keep our `HOLD` rating with lowered 12-month target price of HK$10.9/sh

Refined oil pricing mechanism reforms expected

According to China Securities Journal, the three SOEs, including PetroChina, may be given the flexibility to adjust prices for their refined oil products under the new pricing mechanism being considered by the NDRC. The new pricing mechanism is likely to shorten the pricing adjustment cycle to 10 days from the original 22 days. Also, the SOEs can adjust the prices if the international oil prices are within certain ranges, given that the NDRC may not issue further notices for price adjustment. According to the proposal, the three SOEs must lower the prices if premises are met; on the other hand, the SOEs can adjust prices upwards within or beyond the upper limit allowed by the NDRC when raising premises are met.

The transfer of pricing power from NDRC to the refiners will reward PetroChina with a small refining margin. While we believe that all three SOEs will be able to turn around and earn a reasonable return going into 2012, Sinopec is expected to benefit the most from this policy change.

Driver of profit – lower tax rate

3Q11 EBT was RMB44.65 billion, marginally lower than the RMB44.75 billion and RMB53.51 billion EBT in 2Q11 and 1Q11 respectively. However, the 3Q11's 23% increase in net profit compared to 2Q11 was purely due to the lowered income tax. While incomes were taxed at 25% and 24% in 2Q11 and 1Q11, profit was only taxed at 8.9% in 3Q11. 4Q11 is expected to continue enjoying the lowered tax rate to a certain extent due to the Western China's development tax credits

3Q11 E&P profit was inline with expectation, up by 40% yoy, but refinery losses widened

Operating profit from E&P in 9M11 and 3Q11 jumped by 40.4% yoy and 67% yoy to RMB160.8 billion and RMB57.1 billion respectively. On a quarterly basis, 3Q11 E&P earning results were slightly lower than that of 2Q11 by 1.23% due to a US$3/bbl lowered average realized oil price (2Q11 averaged at US$111/bbl and 3Q11 averaged at US$108/bbl). This is inline with the Brent prices, which averaged at US$115.6 in 2Q11 and US$111.1 in 3Q11 accordingly.

Refining and chemical segment posted another RMB17.4 billion loss, worse than our expectation. We expected the losses from refining to narrow in 3Q11 as crude oil prices subdued slightly from 2Q11. Based on PetroChina's 9M11 data, total crude oil output was 670mmbbl, while processed crude oil was 725mmbbl. This means that approximately 90% of the processed oil could be supported by internal production. Without having the refining products pricing power, the gain in E&P will ultimately be built on the pain of refinery.

No reasons to be bullish in 4Q11 – high oil prices continue to hurt refinery, resources tax suppresses E&P

Going in to the last quarter in 2011, we have no reasons to be bullish on PetroChina's earnings. First, we originally expected the refining losses to moderate in 2H11, but refining and chemical losses in 3Q11 widened to RMB17.4 billion. Going in to the forth quarter, the Brent oil prices averaged at US$108/bbl (Nov 29), already bounced back from the slump seen in Aug-Sept. At the main time, NDRC cut the fuel prices by RMB300/ton on October 8, representing a 3.5% and 3.9% price cut for gasoline and diesel respectively. We do not expect refining margin to improve significantly in 4Q11 at this point. We will, on the other hand, re-evaluate the GRM if the refined oil pricing mechanism reform becomes official.

E&P enjoyed the high oil prices so far in 2011, but the national wide implementation of the new resources tax (effective from Nov 1, 2011) will negatively impact E&P profitability. The losses will be partially offset by the rebate of value added tax, which was granted by the government in August this year for imports natural gas that cost more than the domestic wholesale prices, for the period from 2011 to 2020.

Trimming down 2011e and 2012e earnings down by 8.3% and 10.1% respectively

We adjust FY11e eps to RMB0.77/sh to incorporate the widened losses from the refinery and the implementation of the new resources tax. The new earnings target means an expected eps of RMB0.21/sh in 4Q11. We also lowered our 2012e eps by 10.1% to incorporate the resources tax. We will, however, adjust our eps target upon the official implementation of the new refined oil pricing mechanism.

Valuation

PetroChina is currently trading at 9.9x FY11e p/e, slightly above its 4-year mean value at 8.9x. Its H-share is trading at approximately 25% of a premium over its A-share. P/b is trading at 1.5x FY10, which is below its 4-year historical mean value. While the outlook of the global economy remains gloomy, and international oil market is volatile, we believe PetroChina's trading multiple is already higher than its domestic peers.

We maintain our NEUTRAL rating and slightly lower PetroChina's 12-month target price by 3% to HK$10.9. We use DCF to value the E&P segment, with the assumption of average oil prices of US$102/bbl in 2011 and US$100/bbl in 2012. The remaining segments are valued using average estimated p/e. The target price is based on an overall 2012e p/e of 11.2x.

Risks

We believe that PetroChina has an overall low risk profile. Key downside risks include: 1) PetroChina is exposed to foreign exchange rate risk, especially due to the wider RMB fluctuation range; 2) Unexpected movement of oil prices that further hurts refinery margin; 3) Cost control faces high pressure; 4) Adverse government policies, ie windfall taxes and price caps for refined products, would affect PetroChina's earning ability; 5) The potential slowdown of China's growth rate and oil demand. Upside risks include: 1) Better than expected oil prices accompanied with higher prices for refining and chemical products, especially gasoline and diesel; 2) Improved costs control; 3) Brighter global economic outlook, which will in turn drives up valuation; 4) Unexpected M&A and discoveries

Peer Comparison

Financial Statement

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