OVERVIEW

Sinopec recorded better than expected third quarter results in terms of both revenue and profitability. For the nine months ending September 30, 2010, operating income and net profit attributable to equity shareholders reached RMB1427 billion and RMB 56.4 billion, up by 59.79% and 11.6% yoy respectively. For the third quarter along, net profit was RMB19.6 billion, up by 14.8% yoy.

Although weighted average roe decreased 0.38 percentage points yoy on a nine-month basis, improvement has already been seen in the third quarter as it improved slightly from 3Q09.

Significantly improved E&P profitability. Due to the increase in production volume and better realized oil prices, the E&P segment in the first 9-month period recorded a 137% jump in profit yoy, and more impressively, profit margin was 32.4% compared to 21.6% same period last year.

Gross refining margin (GRM) was again being squeezed narrower in the 3Q10 compared to 1H10. Refinery, contributed 39% of the total revenue in the first 9-months, posted a decrease of 60.9% in its profit. Although refinery throughput increased 14.41% yoy, profit margin came worse than expected, namely 1.21%. NDRC indicates that a more flexible pricing mechanism is being discussed, but the improvement in GRM will not be materialistically significant (discussed in later section -- `potentially more flexible fuel pricing mechanism`).

VALUATION

We recommend `TRADING BUY` for Sinopec with a target price of HK$8.26. Sinopec posted solid 3Q10 results with increased production, but operating margin is on a downward trend compared to 1H10 and 2009. Sinopec is currently trading at the lowest forward p/e compared to its domestic peers, so we believe its price is not as inflated as others, resulting in room to increase in the near term. Given the brighter near-term economic outlook, we believe that Sinopec will enjoy this round of rally.

In a longer span, 12-months, We maintain our `NEUTRAL` view of Sinopec with target price of HK$7.49 based on a 2011 forward p/e of 7.46x. Sinopec is growing faster than PetroChina, with compatible cost controls, but declining margin due to the upward pressure from the crude oil price while PetroChina is enjoying the hike. So within the sector, we like PetroChina more in a 12-months time range.

OPERATING RESULTS

Profit form the E&P segment increased 137% yoy, with the 50.08% yoy increase of the profit margin. The significant improvement in this segment was mainly due to the higher than expected realized oil price and volume. Demand from domestic oil and chemical products increased steadily in the first 9 months of 2010. Crude oil production increased slightly to 34930kt, or 1.93% yoy, while production of natural gas increased 45% yoy.

However, we do notice that refinery, contributing 39% of the total revenue, posted a decrease of 60.9% in its profit, recording RMB8.46 billion in the first nine months. Although refinery throughput increased 14.41% yoy, profit margin came worse than expected, namely 1.21%. This is mainly due to the high oil price. Sinopec's break-even point is around US$80/bbl. Commodity prices have been fairly strong in the recent months, partially due to the softening of the US dollar. Crude oil spent much of its time trading above US$80/bbl in the past quarter. With another US$600 billion stimulus in the following eight months, US dollar is bound to weaken, and the inevitable soar of commodity will hurt Sinopec's GRM even more if NDRC's pricing mechanism doesn`t put more weight on the `refining profit` part (details are given in the `potentially more flexible fuel pricing mechanism` section).

Benefited from the pricing reform, marketing also posted better than expected profit, reaching RMB22974 million, up by 2.33% yoy.

PRODUCTION VS. RESERVES

Crude oil's production volume has been increasing at a steady rate since 2004, with a CAGR of 1.6%, which is more promising than its major competitor, PetroChina, whose production volumes remained pretty much flat over the years. But the tricky part is that PetroChina focuses more on the natural gas side now.

On the other hand, proved reserves declined from 3264 mmbbls from 2004 to 2820 mmbbls in 2009 while PetroChina's reserves were more stable, with some improvements in 2009. If we decompose the reserves by regions, reserves from the Shengli Oil Field, Sinopec's largest oil field and China's second largest oil field, declined at an annualized rate of 1.38%, actually better than the 2.5% across the Company. Yet, all other major oil fields had seen reserves declines in the past 6 years, while reserves from most of PetroChina's oil fields, besides Daqing - the biggest contributor for PetroChina, have seen improvements over the past years.

Although Sinopec is growing faster than PetroChina, in terms of oil's production, its replacement ratio does concern us.

COSTS

Revenues in all segments have seen more than 50% increase compared to 1H09; yet, operating margins (besides E&P which improved more than 100% compared to 1H09) decreased significantly compared to 1H09, or even full 2009 financial year. The potential appreciation of RMB will also impose an upward pressure to Sinopec's cost structure.

The hike of crude oil serves as a double-sword. While E&P posted a 27% margin, (11.9% in 1H09), margin in the refining segment is left with barely any room to breathe (although still better than 2007 and 2008 negative margins). With another US$600 billion stimulus in the following eight months, the US dollar is bound to weaken, and the inevitable soar of commodities will hurt Sinopec's GRM even more if NDRC's pricing mechanism doesn`t put more weight on the `refining profit` part (details are given in the next section).

Movement of the crude oil price is in a total opposite direction with both GRM and Sinopec's total profit margin as the benefit earned from E&P is more than offset by the loss in the refining segment, after all it's the biggest cash generator for the Company. As oil price is expected to be trading in a range between US$70/bbl to US$90/bbl at least till 1H11, profitability is not expected to see improvement.

POTENTIALLY MORE FLEXIBLE FUEL PRICING MECHANISM

Currently, domestic refined oil prices are under the `22-days 4%` mechanism, which means the prices will be adjusted accordingly if the international oil benchmarks change more than 4% within a 22-days period. NDRC has shown willingness to shorten the period so to reflect more transparency and supply-demand trend, and the market speculates that it could be shortened to 10 days.

The principal of this pricing mechanism is based on a balance of international oil prices, domestic processing costs, tax, capacities and reasonable profit. NDRC has a high discretion in interpreting the word `profit`. The bloom of refiners has set China in an over-supply zone, and NDRC takes the capacities into consideration when setting the price; thus, we believe, the 5.36% yoy GRM drop is greatly due to the over capacity problem but not the `22 days` price setting period.

Shortening the pricing period to a potential 10 days will make the market more supply-demand driven. But if the mechanism remains the same and over-capacity is not resolved, we keep a question mark on the improvement ability of Sinopec's GRM.

VALUATION

PEER COMPARISON

Risk

Upside:

Improved refining margin

Unexpected decrease of crude oil (but to no lower than US$68/bbl)

Downside:

Demand for oil products remain weakResource tax implements throughout the country thus squeezing the profit margin even lower

Financial Statement

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