China Natural Gas--Showing Investors the "Green."

A recent sentiment survey of commodity traders found only 17.0% were bullish on natural gas. This suggests to us that a bottom is forming. Welcome to our Common Stock idea of the day:

China Natural Gas, Inc. (CHNG-$3.15) is the first People’s Republic of China (PRC) based natural gas firm publicly traded in the United States. The Company is principally involved in the end user delivery of natural gas services to homes and businesses (2.6% of sales); the sale of compressed natural gas (CNG) as a hybrid vehicular fuel (natural gas/gasoline) at company-owned filling stations (62.5% of sales) and to third party natural gas filling station operators (2.2% of sales); and, the construction of pipelines that supply end users with natural gas (32.7% of sales).

End User Delivery of Natural Gas

China Natural Gas is the only private company to own and operate a (120 kilometer long) high-pressure natural gas pipeline in China's Shaanxi Province (home to China's second largest natural gas reserve). The Company is the sole authorized provider of natural gas to residential customers in certain parts of the Xi’An area, including Lantian County and the Baqiao District. Additionally, the Company has proprietary access to more than 63,000 Xi'An households through its network of pipeline.

The city of Xi'An is centrally located in China. Xi'An, supported by a population of 8 million, is the fastest growing city in China's western regions, and is considered to be the "gateway" to China's developing western regions, for it is within easy access to China's more developed regions in the East and South.

Management is seeking to expand supply services to the Shangluo and Ankang areas of Shaanxi province. Upon approval from the government, the Company would have the exclusive right to provide natural gas to residential and commercial end users in those areas, too. In order to obtain such approval, the Company was required to submit a project proposal for the feasibility of supplying gas to each area. The approval process takes approximately four to six months and is pending.

Wholesale to Filling Stations

China Natural Gas sells CNG to filling stations on a wholesale basis. The stations, in turn, sell natural gas to taxis and buses in Xi’An that operate on compressed natural gas (CNG) technology. Government statistics indicate that there are currently 5,000 buses and 20,000 taxis using natural gas in Xi’An. Each bus uses an average of 70 cubic meters of CNG per day and taxis use an average of 30 cubic meters of CNG per day. The municipal government estimates that by 2010 the city will have over 46,000 CNG vehicles.

In July 2005, China Natural Gas purchased a Compressor Station that is operated in proximity to its pipeline and which allows the Company to compress and transport natural gas via truck to retail gas stations.

Retail Filling Stations

In our opinion, growing demand for CNG as a vehicular fuel offers the Company the greatest opportunity for profit and growth.

China's "Eleventh Five-Year Plan" (2006 - 2010) promotes alternative energy sources including compressed natural gas (CNG) fueled vehicles. The Chinese government is supporting the use of natural gas due to its environmental friendliness and its cost effectiveness.

Hybrid fueled vehicles emit 87% less nitrogen oxide, 70% less carbon monoxide, and 25% less carbon dioxide than gasoline. It is estimated, too, that the hybrid CNG fuel saves about 60% on a price per mile basis compared to regular gasoline.

The Company is rapidly expanding its network of compressed natural gas filling stations to satisfy the tremendous demand for CNG. As of September 25, 2006, China Natural Gas operated eleven company-owned retail filling stations. By the end of 2006, the Company’s targeted goal is to be operating approximately twenty-one company-owned natural gas filling stations. [Ed. note. This might be a reach, for the construction time for each filling station is 45-60 days at a cost of approximately US$600,000.]

We do agree with management, however, that China Natural Gas’ vertically integrated operation should allow the Company to be able to surpass the average sales volume of competing stations, estimated at 12,000 cubic meters per day, based on its proprietary supply of CNG from its own pipeline.

Financials

For the second quarter ended June 30, 2006, China Natural Gas recorded net income of $927,269 (share-net of $0.04) on revenues of $3,724,183, compared to net income of $388,442 (share-net of $0.02) on revenues of $1,078,712 for the three months ended June 30, 2005. The increase in revenues was primarily due to substantially increased sales of natural gas revenues, which grew 488% (to $2.5 million) from the same period last year.

China Natural Gas began operating an additional 4 new natural gas retail filling stations during the three months ended June 30, 2006, bringing to a total of 7 CNG filling stations in operation at the end of the second quarter.

The balance sheet is healthy. As of June 30, 2006, the Company owed no long-term debt, had $6.6 million in working capital (net advances to suppliers and other prepaid expenses), and was worth $0.84 in book value per share.

Valuation Analysis

Aside from the (known) speculative risk of owning a small-cap company, China Natural Gas, with a market capitalization of only $74.1 million, is an inventive way to leverage a single investment into two sectors—the red-hot Chinese economy and the depressed natural gas market (the price of the Common Stock is down about 44.0 percent—from its $5.68 per share intra-day high hit in February 2006).

The Company is selling for only 7.9 times estimated 2007 share-net of $0.39 on revenue of about $43.6 million. The future looks “green” for China Natural Gas. The current distribution infrastructure in Xi’An supports less than 40% of the current estimated market need for more than one million cubic meters of vehicular CNG per day (which is expected to continue to increase with China’s “Clean Energy Policy.”

Leveraging its existing pipeline, China Natural Gas should easily be able to double its number of company-owned CNG filling stations, too.

Going forward, China Natural Gas is looking to expand its footprint to the neighboring province of Henan, which is the most populous province in China with a growing population of approximately 100 million people.

China Natural Gas just signed a natural gas supply contract with Zhengzhou Zhongyou Oil & Gas Co., Ltd., a subsidiary of Sinochem, China's largest chemical company to supply 350,000 cubic meters of compressed natural gas per day to the Company's planned new stations in China's Henan Province. The 5-year natural gas supply agreement should ensure an uninterrupted and reliable gas supply to the new stations in the Henan region.

Management also has plans to develop a liquefied form of natural gas (LNG) that can be transported over longer distances by gas tanker truck and which could expand the Company’s geographical sales. The Company is currently conducting a feasibility study with regard to LNG production.

Investment Risks and Considerations

#1. China Natural Gas depends on a single source for its supply of natural gas and an interruption to this service may harm its business.

Currently, China Natural Gas has only one natural gas supplier, the Shaanxi Natural Gas Co., Ltd., a government owned enterprise. In the past, contracts were renewed on an annual basis. However, as the volume of usage has increased, Shaanxi Natural Gas has revised their policies, and contract terms are now six months and subject to review prior to renewal. Management, however, reports that it does not expect any issues or difficulty in continuing to renew the supply contracts going forward. Price points for natural gas are strictly controlled by the government and have remained stable over the past 3 years.

#2. The revenue of China Natural Gas’ pipeline business is generated under contracts that must be renewed periodically. In particular, management’s ability to extend and replace contracts could be adversely affected by variable factors, including competition by state-owned natural gas pipeline companies; the proposed construction by other companies of additional pipeline capacity; or changes in state regulation of local distribution companies.

The three largest state-owned energy companies, CNPC (China National Petroleum Corp.)Group, SINOPEC, and CNOOC are principally engaged in the upstream supply of energy and are major players in exploration and transportation of oil and gas. They build much of the country's high-pressure pipeline infrastructure. Natural gas is distributed to smaller regional firms that redistribute the gas to the end user, either through lower pressure pipeline networks, or via tankers in the form of liquid natural gas.

China Natural Gas is aware of two privately owned companies in China which may be considered to be its direct competitors: Xinjiang Guanghui LNG Development Corporation Ltd and Xin'Ao Gas Field Ltd. Xinjiang Guanghui LNG Development Corporation Ltd is primarily involved in the transportation of LNG via tanker truck to storage facilities from natural gas wells. Xin'Ao Gas Field Ltd. is a publicly owned company traded on the Hong Kong Exchange, distributing natural gas via pipeline, doing business in 13 provinces and municipalities that have a combined population of 31 million. Neither Xinjiang Guanghui nor Xin'Ao is approved to supply natural gas to any area in which Xilan is currently operating.

Additionally, in order to meet the growth in natural gas demand, the PRC government has encouraged private companies to invest in and build the natural gas infrastructure. On December 27, 2002, the Ministry of Construction issued a memorandum stating that regulation of the public utility industry (including gas distribution) should be liberalized and foreign and private investment participation should be encouraged and welcomed. The memorandum encouraged private investment in the sector and provided a legal framework for private urban natural gas distribution.

#3. China Natural Gas may not be able to build and/or acquire, and successfully integrate identified retail CNG filling stations as planned, which would adversely affect corporate’s ability to grow its business.

Currently, there are approximately 31 filling stations in Xi’An City. Thirteen of these stations are state owned enterprises. The other 18 stations are privately owned with the majority of these being single station operators. Management believes that it can effectively compete with the stations based upon its organization, experience and financial resources.


Editor David J Phillips owns stock in China Natural Gas. The 10Q Detective has a full disclosure policy.