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On Nov 15, 2013, we downgraded Chinese energy giant PetroChina Co. Ltd. (PTR - Analyst Report) to Neutral from Outperform. Our revised investment thesis is supported by a Zacks Rank #3 (Hold).

Why the Downgrade?

Despite PetroChina’s leverage to the fast-growing domestic market and the ever expanding market/resource base, we remain concerned by its sluggish oil production growth prospects and heavy exposure to significantly mature producing areas. Regulated prices, policy uncertainty and an ambitious investment program add to the downbeat sentiment.

Detailed Analysis

China’s impressive economic growth has significantly increased its demand for oil, natural gas and chemicals. This growth momentum presents attractive opportunities for industry players (like PetroChina) that can meet the country’s fast-growing energy needs. Additionally, we expect the company – the world's biggest listed oil producer by volume ahead of Exxon Mobil Corp. (XOM - Analyst Report) – to benefit from attractive growth prospects in the downstream and natural gas sectors.

We like PetroChina’s natural gas deals in Canada and Australia. The Chinese behemoth’s plans – to form a joint venture in Canada's Alberta to develop natural gas/condensates assets and to purchase interests in the proposed Western Australian Browse liquefied natural gas (LNG) project – will provide it with a global resource and market base, making the company a leading international energy player. Additionally, these ventures will also provide a hedge against the uncertain Chinese product pricing policies.

The recent decision by the Chinese government to allow PetroChina to raise gas prices – the first time in three years – is a long-term positive for the company. The move would not only boost the state-run energy major’s margins but also cut its import losses.

However, the major long-term concern for PetroChina continues to be its prospects for oil production growth. With about a third of its current crude oil volumes coming from the Daqing Oil region, the company is heavily exposed to this area. The Daqing Oil region is the largest crude oil producing area in China, but has significantly matured over the years and is currently well past its prime. As the degree of difficulty in extracting crude oil from the mature Daqing field increases over time, costs at these fields will continue to increase.

Other near-term headwinds include PetroChina’s limited international exposure and an ambitious investment program.

Stocks That Warrant a Look

While we expect PetroChina to perform in line with its peers and industry levels in the coming months and advice investors to wait for a better entry point before accumulating shares, one can look at Matador Resources Co. (MTDR - Snapshot Report) and SM Energy Co. (SM - Analyst Report) as good buying opportunities. These U.S. upstream energy operators – sporting a Zacks Rank #1 (Strong Buy) – have solid secular growth stories with the potential to rise significantly from the current levels.

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