PetroChina: A Look Back

Warren Buffett first began purchasing shares of PetroChina (PTR) sometime in 2002 (because it was on a foreign exchange, we don't know the exact date), and filed his first 13G on April 30, 2003. The following is a short case study of Berkshire Hathaway's investment—from when the first purchase was made five years ago to when the entire stake was sold over the past month. For disclosure, oil companies like PetroChina are not in my circle of competence, so in this study I'll stick to the very basic themes of the investment and simplified calculations of intrinsic value.

By the time Buffett finished buying in 2003, Berkshire's total cost for the 2.3 billion shares was $488 million. This gives the investment an average cost per share of about $21 for the ADSS (for the rest of the post, all figures will be in US$ and refer to the PTR shares traded on the NYSE). On October 18, Buffett sat down with Liz Clayman for an interview on the Fox Business Network where she asked him about his investment in PetroChina. In addition to confirming they had sold the entire stake, Buffett mentioned that at the time of purchase he read through the annual report and pegged PetroChina's intrinsic value at around $100 billion.

PetroChina was established in 1999 as the publicly traded arm of China National Petroleum Corporation (CNPC), the largest producer of oil in China. PetroChina is vertically integrated where it explores, refines, and sells oil and natural gas. Because of the company's duopoly in China with Sinopec, PetroChina is the most profitable company in Asia.

Using the $100 billion estimated value at the time of purchase, Buffett valued PetroChina's enterprise value at about 12x operating income. Assuming Buffett can't predict oil prices or precise currency fluctuations, this seems like a fairly reasonable multiple for the largest oil company in one of the world's fastest growing economies.

Not being an expert on the business, I used the 12x multiple for all the value calculations below. With not much changing in the actual business (not oil prices), I think this is reasonable over the 5 year period. The table below shows a comparison between the price of oil, intrinsic value and market price since the investment was made ((Notes: Price's are end of year, except 2007 which is Buffett's estimated sale price. Oil barrel prices are average prices over the years through the end of September in 2007. "Sale" intrinsic value is based off of June 30, 2007 numbers.)).

Date Oil barrel Intrinsic value Price Margin of safety 2002 $22.81 $56 $15.87 72% 2003 $27.69 $80 $48.53 39% 2004 $37.66 $119 $47.09 60% 2005 $50.04 $160 $75.78 53% 2006 $58.30 $171 $135.76 21% 2007(S) $58.05 $173 $165 5% Annual +22% +27% +64%

Looking at the rise in average cost of oil per year (Column 2 above), it's obvious oil played a large part in the increase in earnings and subsequently intrinsic value. Currency fluctuations between the Yuan and US Dollar added about 2% to the annualized increase in intrinsic value. For reference, output of Oil & Gas Equivalents at PetroChina grew 5% a year from 2002 to 2006. Column 5 above shows the year-end margin of safety, and as you can see it narrows from 72% to just 5% with Buffett's recent sale.

The Sale

Given Buffett's amended 13G filing for September 30 (where 2/3 of shares had been sold), the comments he made in the FBN interview, and other observations made by analysts—Buffett most likely sold all PetroChina shares during September and the first part of October. Average sale price was probably around $160-170 per share. Using the average purchase price of $21, annualized return for the 4¾ year period was 54% (not including any dividends).

Like always, a large margin of safety played an important role in the outcome of this investment. What actually happened with the investment was one of many possible scenarios (it happened to be one of the good scenarios). Had oil prices remained flat over the years, intrinsic value may have increased by only 2-3% instead of 27%. In that outcome, if shares traded inline with value after the 4¾ year period, annualized return would still be a very respectable 27%.

In a more worst-case scenario (some unforeseen event), PetroChina's value could have decreased up to 72% over the years, and assuming there was no price/value gap Buffett would have no permanent loss of capital. This would be an extremely rare Black-Swan-type event—and even then, there would be little to no loss. This is the value of a huge margin of safety in a world where we can't predict the future (hence the name of this blog). Rule number one: don't lose money. Rule number two: don't forget rule number one.

Related articles: Quality Without Compromise / Buffett's investment in See's Candy Warren Buffett and the Washington Post