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2 Key Risks That May Cause Pain for China Aviation Oil

China Aviation Oil (Singapore) Corp Ltd (SGX: G92), or CAO, is the largest physical jet fuel trader in the Asia Pacific region and also the key supplier of imported jet fuel to the civil aviation industry of China.

CAO’s business hinges on China’s aviation passenger traffic, as this determines its jet fuel supply volume growth. Demand for certain categories of jet fuel products may be volatile, as evidenced by CAO’s Q1 2019 earnings report. The decline in fuel oil volumes caused revenue from this segment to plunge 33%, which could not be compensated for by the increase in volume from middle distillates. In addition to this volatility, there are two other key risks for CAO that investors need to be aware of.

Poor gross margins

As CAO is essentially a fuel trader, it suffers from extremely low gross profit margins. This is evidenced by the Q1 2019 results: Gross margin was just 0.3% on revenue of US$3.7 billion. Q1 2018 was not much better, with a similar level of gross margin. The group is just a middleman that buys jet fuel from its supplier and then re-sells it to final customers. Hence, there is a very high likelihood that the company may get squeezed in the middle.

Having such a dismally low gross margin also puts the group at risk of incurring an operating loss should expenses and fixed costs suddenly spike. There is very little wiggle room for the group as there is hardly any margin to speak of. With little prospect of its gross margin improving anytime soon, this is a key risk investors should note.

Opening up fuel trading to other companies

A second major risk is that the Chinese government will open up the aviation fuel supply market. Currently, CAO is the only player within this market, and it has an established track record. However, the government may wish to reduce reliance on just one player (in case of financial stress), and there is a possibility it may liberalise the market. Doing so would be detrimental to CAO’s business as jet fuel volumes would plunge and may never recover to current levels.

The story sounds good but the risks loom large

The CAO story has been touted time and again by financial media and sell-side brokers, and they always put a positive spin on it by mentioning the group’s monopoly status and how it dominates this niche industry. However, I would caution investors to watch out for the two risks above, as they may completely invalidate the investment thesis.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Royston Yang does not own shares in any of the companies mentioned.