China Aviation Oil - Phillip Securities 2016-03-28: Demand of jet fuel driven by the air traffic on the upswing

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CHINA AVIATION OIL(S) CORP LTD G92.SI 

China Aviation Oil (Singapore) - Demand of jet fuel driven by the air traffic on the upswing 

• Aims to become a global top-tier integrated transportation fuels provider. 
• Seeking long-term growth through M&A in synergetic and strategic oil-related businesses. 
• Burgeoning “One belt, One Road” initiative will benefit cross-border aviation transportation, whereby CAO sees potential lucrative opportunities lay on. 
• Initiate coverage with Accumulate rating and DCF valuation of S$0.92. 

Company Background 

• China Aviation Oil (Singapore) Corporation Ltd (CAO) is the largest physical jet fuel trader in Asia Pacific and the monopolistic imported jet fuel supplier to the civil aviation sector in People’s Republic of China (PRC). It engages in three segments of business, jet fuel supply and trading, trading of other oil related products (aviation gas, gasoil, fuel oil and petrochemicals), and investment in oil-related assets. The total trading volume has ramped up to 20.2mn tonnes in FY15, comparing that of 9.2mn tonnes in FY11, with CAGR of 21.7%.
• The Group, along with 4 wholly-owned subsidiaries, China Aviation Oil (Hong Kong) Company limited (CAOHK), North American Fuel Corporation (NAFCO), China Aviation Oil (Europe) limited (CAOE), and CAOT Pte Ltd (CAOT), is internalizing supply and trading business and expanding the network coverage across North America, Europe, and Middle East.
• The investment assets comprise 4 associates and 1 JV, Shanghai Pudong International Airport Aviation Fuel Supply Company Ltd (SPIA), China National Aviation Fuel TSN-PEK Pipeline Transportation Corporation ltd (TSN-PEKCL) China Aviation Oil Xinyuan Petrochemicals Co., ltd (Xinyuan), and Oilhub Korea Yeosu Co., ltd (OKYC), and CNAF Hong Kong Refuelling Limited (CNAF HKR). Over the past 5 years, these assets on average positively contributed over US$40mn to the Group annually, taking up approximately 70% of the net profit.

Investment Thesis 

Global aviation transportation remains solid, driving by robust traffic growth. 

• There are two dimensions to evaluate the global aviation transport activities, aircrafts supply, which can be measured by the new airplane deliveries in the duopoly market dominated by Airbus and Boeing, and air transport demand, which is mainly driven by the civil aviation activities such as passenger traffic and cargo freight. According to Airbus Global Market Forecast 2015 (GMF) and Boeing Current Market Outlook 2015 (CMO), expected new air aircraft deliveries are respective 32,585 and 38,050 from 2015 to 2034, along with 13,135 and 17,510 retirements from service. Therefore the net increments of aircrafts are 19,450 and 20,540. 
• Asia Pacific dominates the largest pie of the deliveries, followed by Europe and North America, and these are the biggest and highly populated economies. 

Steady growth on air traffic. 

• Given the distances between regions and countries are constant, as well as the explorations of new airline among spots are limited, the air traffic demand is driven by the frequencies of flights. Generally, revenue per passenger kilometre (RPK), measuring passenger traffic, and freight tonne kilometre (FTK), measuring cargo freight, are two main transport indicators. In the past decade (2006 to 2015), the average growth rates of RTK (5.63%) and FTK (2.98%) are above average global GDP growth (2.56%). Meanwhile, according to GMF and CMO, the CAGRs of air traffic during the period from 2015 to 2034 are projecting 4.6% and 4.9% annually, respectively. 

Aviation transport market is far from saturation. 

• Air traffic is seeing blooming perspective due to the fact that air travel is the most efficient way to complete journeys. Notwithstanding the expenditure per capita is still more costly than other transportation tools such as railways, vehicles, and vessels, the improving energy consumption efficiency, affordability to flight tickets, and convenience will lead to air travel more attractive. 

Sluggish economy in China. 

• Since 2014, China has entered the era of moderate growth of GDP. The driving powers from export and domestic investment are weathering, resulting in economic restructuring and transformation initiated by the new governors. 
• Moreover, the unfavourable external economic conditions such as low price level of commodities, currency devaluation in peripheral emerging countries, and low growth of world economy, challenge the business environment in China. Therefore, various sectors are undergoing tough period. 

Civil aviation traffic is seemed immune. 

• However, the civil aviation is one of the very few sectors stand out and enjoy substantial counter-cycle growth. In the past decade, RPK maintained at double digits annual growth, ranging from 11% to 20%, except the cliff jump to 3% during global financial crisis in 2008, whilst the FTK growth fluctuated significantly but stabilized at 10% in 2014 and 2015. 
• Over the next two decades, China’s domestic market is assumed to be the largest domestic air travel market worldwide. The 20-year forecast annual growth rates of RPK and FTK are 6.6% and 7%, respectively in China. 

Air traffic gap between US and China is narrowing, foreshadowing the potential room for China to develop. 

• The management from CAO suggested that US aviation market is the benchmark of China aviation development going forward. Nowadays, US’s aviation industry is the biggest globally in terms of traffic flows, not only because US is the most open market worldwide, but also it has the most well-established infrastructure nationwide. 
• According to Bureau of Transportation Statistics (BTS), as of 2014, total number of aircraft carrying passengers or cargo in US is approximately 7,000. By contrast, according to CAAC, the number is much less, recorded only 4,168 in China. Thus, there will be a long way for China to improve the facilities quantitatively. 
• China, surpassing US in population and country area, has been increasingly opening the market towards the world, so it is reasonable to foresee the traffic gap between the two giants is narrowing down. 

Oil supply glut continues, but the spread will narrow. 

• According to OPEC World Oil Outlook 2015 (WOO), the trigger of the rout in oil market in the second half of 2014 till now was due to the excessive supply of crude oil. The mid-term forecast showed the supply glut peaked in 2015 and would gradually diminish afterwards, but still it wouldn’t be balanced by 2020. Therefore, the price of middle distillates and other oil products remains low accordingly. 
• The EIA Short-term Energy Outlook (STEO) in March 2016 showed the Brent crude oil prices were forecast to be average US$34/bbl and US$40/bbl in 2016 and 2017, while the Forecast West Texas Intermediate (WTI) crude oil prices were expected to average the same as Brent in 2016 and 2017, amounted to US$35/bbl. Both the Brent and WTI crude oil price slumped from US$100/bbl over in Sep 2014 to bottom at below US$30/bbl in Jan 2016, and recently the prices started to recover. Correspondingly, the Bloomberg Singapore Jet Kerosene Price rebounded from below US$40/bbl in in Jan 2016 to above US$48/bbl recently.

Investment Merits 

Prosperous oil demand is trending up in aviation sector while China outperforms other regions. 

• WOO 2015 forecasts the oil demand level guradually grow from 5.5 mn barrels of oil equivalent per day (mboe/d) to 8.4 mboe/d, and the increment is mainly from developing countries (DCs). Further geographic breakdown by regions shows China stands out, followed by other Asia, OPEC, and OECD Europe. Thus CAO is benefiting of strong demand of jet fuel in the next 25 years.

Absolute strength of sole jet fuel importer to China and “cost plus” model. 

• CAO exclusively imports jet fuel to domestic airlines and airports in China. Currently, the group’s jet fuel supply network extends to 15 international airports within the border, including the major gateways such as Beijing Capital International Airport, Shanghai Pudong International Airport, and Guangzhou Baiyun International Airport. 
• CAO’s parent company, China National Aviation Fuel Group Corporation (CNAF), is a state-owned largest aviation transportation logistics services provider in China, and its services include aviation fuel distribution, storage, and refuelling services. Since CNAF and CAO operate and manage the whole aviation fuel supply chain with exclusivity on it, CAO will continue to enjoy monopoly and capture the opportunity of substantial demand of jet fuel in domestic market.

Fuel price doesn’t matter, but “cost-plus” does. 

• CAO is not subject to the volatility of jet fuel price, which is positively related to international oil price, because it only earns the spread between the procurement cost and selling price. The profit model is a pass-through system, and CAO’s margin is based on dollars per barrel rather percentage of costs. However, the model is specifically applicable for domestic jet fuel supply in China, while it does not apply to the supply to overseas airports and other oil products trading, whereby CAO mainly earns profits by providing value-added logistics services. 
• In FY06 and FY07, jet fuel importing to China contributed the whole revenue, so we can roughly estimate the margin of “cost-plus”. The profit model enables CAO to generate positively resilient gross profit that depends on the trading volume, on the condition that the Group controls the trading risk appropriately.

Enhancement of diversification and internationalization. 

• CAO’s strategic goal is to achieve the global top-tier transport fuels provider. Since 2008, CAO has been internationalizing the jet fuel supply coverage beyond China. In 2009 CAO diversified the oil product mix by continuously introducing other oil products trading. 
• Though China is still the biggest market, the percentage of its contributions is trending down to nearly 50%, and meanwhile overseas exposure is growing. There is no doubt that apparently CAO kept improving the capability on supply chain management and marketing. The increasing penetration into overseas market favours the brand and reputation establishment and reduces the risk from demand side effectively. 
• Once CAO consolidates the global market position and maintains the supply channels on long-term basis, the reinforced bargaining power will come along accordingly.

CAO aims to achieve that the contribution from other oil product segment reaches one third of total revenue by 2020. 

• Since FY11 the trading volume of other oil related products has been ramping up, and even though amid the plunge of oil price in FY15, the volume maintained as that of previous year. 
• Going forward, CAO established gas oil trading book in FY12 and started to supply aviation gas in FY14. Nevertheless, CAO marked to market closely in order to reduce losses resulting from market turning around. 
• In 3Q14, it suspended petrochemicals trading, due to weak market demand and backwardation, and was ready to restart to trade once market improved. With the stringent risk management, CAO is building up more mature trading model on these fragmented oil products. Diversification of product mix benefits CAO in terms of inflating the turnover and the resistance upon market shortfall, as each distillate has its demand and driver, and outperformance of each single product can probably offset the underperformance of another and vice versa under the rise and fall of business cycle, but the portfolio as whole buffers the strike of oil price volatility and stabilizes the profitability. 

Key propellants: investment of oil-related assets. 

• CAO’s long-term strategy is the integration of transport fuel value chain, including procurement, delivery, storage, and fuelling. As of Dec 2015, the investments in oil-related fields are comprised of 4 associate companies and 1 joint venture, SPIA, TSN-PEKCL, Xinyuan, OKYC and CNAF HKR. CAO has been vertically integrating the downstream sectors such as transportation, storage, and even end customers. The complement of the downstream channels optimizes the synergies among the Group as a whole. 
• The share profits from associates and JVs sustained at more than US$40mn over the past 5 years, which is a major driver of net profit.

Investment Risks

Business risk 

• Unmatched supply and demand dynamics 
• Competition

Market risk 

• Oil price volatility 
• Market turns around

Credit risk 

• Counterparty defaults 

Investment Actions 

• CAO’s jet fuel supply business and oil related investments expose to the prospective of domestic and overseas air transportation, which the demand is estimated on an upward trending. 
• We initiate coverage CAO with Accumulate rating and DCF valuation of S$0.92.

Chen Guangzhi Phillip Securities | http://www.poems.com.sg/ 2016-03-28

Phillip Securities SGX Stock Analyst Report ACCUMULATE Initiate ACCUMULATE 0.92 Same 0.92