Before Investing in Chinese Energy, Read This

Putting "Chinese" before the name of any industry seems to garner loads of attention from investors. Companies like Baidu and Dangdang get labels like "the Google or Amazon of China." But what about Chinese energy? The country is expected to grow its total energy consumption by 71% between now and 2035. So energy companies like PetroChina (NYSE: PTR  ) and CNOOC (NYSE: CEO  ) should get the labels "the Chevon (NYSE: CVX  ) or Royal Dutch Shell (NYSE: RDS-A  ) of China," right? Not so fast. Let's take a look at some of the big players in the Chinese energy space and why they may not be slam-dunk investments. 

Who are we talking about, here?
Although several Chinese solar companies have garnered much attention from investors, they are still only a very small part of the entire energy equation for China. So for now let's focus on the big energy providers for China: Coal and Oil. Coal by far is the largest source; attributing for 70% of total energy produced in the country. Oil only eats up another 19%, , but it's still three times larger than the third largest source, hydroelectric. By contrast, the United States gets 54% of its total energy from these two sources

Unless you are big on picking up companies on the Hong Kong exchange, or from the Pink Sheets, there are really only four companies we can talk about for Chinese energy: PetroChina, Sinopec (NYSE: SNP  ) , and CNOOC are the three big oil players, and Yanzhou Coal Mining (NYSE: YZC  ) is the only Chinese coal company traded on the New York Exchange to date. 

Proceed with extreme caution

YZC Total Return Price Chart

YZC Total Return Price data by YCharts.

Over the past year or so, the market has not been kind to these companies, but over the past decade, only Yanzhou Coal Mining has underpoerformed the S&P 500 on a total return basis, and CNOOC has more than quadrupled the market. So, is this year a fluke for these companies, or is the market starting to get wise to these players? Based on the recent reports coming out of China, it may be the latter. Here are three of the major concerns for these companies that should make investors concerned:

  • Infrastructure is in shambles: 12,000 miles of oil and petroleum products pipeline in China may sound impressive, but it is actually quite small when you stack it up against the 190,000 miles of pipe we have in the U.S. Yet even though Chinese pipeline has such a small footprint, it is horribly out of date and there are many safety risks. A Sinopec owned pipeline that exploded back in November killed over 60 people and will likely result in penalties in the hundred-million-dollar range. This incident was a glaring example of a penergy infrastructure that is more than 40 years old and has suffered years of corrosion. Also, following the explosion, a Chinese government led safety inspection identified more than 20,000 major safety risks at petrochemical and oil storage facilities. Not only do these issues put companies like Sinopec and PetroChina at litigation risk, it also can severely interrupt operations. Furthermore, coal transportation networks between Shaanxi province, China's coal country, and many of the demand centers are wildly overwhelmed and coal consumers have needed to rely on imports instead of domestic production.
  • Overspending for production: Some of the biggest energy deals in North America recently have involved Chinese oil companies. Back in 2012, CNOOC bought out Canadian oil sands specialist Nexen for $15 billion, a 54% premium on shares at that time. These companies have also been throwing lots of money around in American shale gas because they want to learn how to tap their own domestic resources. Since PetroChina, Sinopec, and CNOOC are actually national oil companies, they put a much larger premium on production growth than generating returns for investors. So these players are much more willing to spend than the other big players, like Chevron or Royal Dutch Shell. 
  • China wants to cut coal consumption:

    Source: commons.wikimedia.org/Joowwww.

    Take a look at this picture. No, that is not low hanging clouds or an early morning fog, that is the air quality in Beijing. Recent air quality measures put total particulate matter at a high of 671 micrograms per cubic meter, that is 26 times higher than what the World Health Organization considers safe for humans. China isn't naive to this issue, and the country is looking to tackle the problem by slowing the growth of coal consumption. In certain parts of the country, regional directors are taking a much harsher look at how coal is consumed. Heibei province, the nations steel manufacturing hub, actually wants to cut steel production by 15 million tons per year. Not just because of poor steel economics right now, but because they are deeply concerned about carbon emissions from coal consumption. With such a focus to lower coal use, China will become an extremely competitive market for Yanzhou Coal Mining as well as any other company supplying China with coal.

What a Fool believes
Investors who want to profit from these companies will find it harder and harder over the next several years. CNOOC just admitted recently that its production growth numbers will probably once again be lower than hoped, and the company will need to grow production by over 20% in 2015 if it hopes to meet the production goals it set back in 2011.

That doesn't mean money cannot be made in Chinese energy, though. China wants to tap its worlds largest shale gas reservoirs, so they have signed on major joint ventures with both Chevron and Royal Dutch Shell to make it happen. Also, to get these projects off the ground, they will need to rely heavily on oil services companies. This could end up being a very large growth market for those that have large international footprints like Schlumberger (NYSE: SLB  ) and National Oilwell Varco (NYSE: NOV  ) . Overall, though, Chinese energy still has lots of inherent risks, and investors should be cautious when looking at this tempting market.

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