November 14, 2012 7:30 pm

Cnooc – gutsy call

The state-controlled energy company risks turning into China’s Gazprom
Wang Yilin, CNOOC chairman©Bloomberg

Wang Yilin, chairman: Sees no clash between investor and state interests

There is just one more vote to be cast. Cnooc, the state-controlled Chinese oil and gas producer, will buy Nexen, a Canadian energy group, if – and only if – the government in Ottawa gives the nod.

Cnooc’s commitment to the deal is demonstrated by its aggressive $15bn all-cash offer, which would be China’s biggest overseas acquisition. Cnooc has ambitions for growth but limited oil and gas reserves, so acquisitions are essential. Nexen looks a good option. The Canadian company’s shareholders have accepted the deal by a 99 per cent margin. They understand that a buyer with the means and motivation of Cnooc is unlikely to appear again. Regulators have until December 10 to decide but they must not use the Investment Canada Act to keep the would-be buyer and hopeful seller apart. There is no good political or economic reason for vetoing Cnooc’s purchase of Nexen.

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There is a final set of stakeholders who will not get a direct say on the deal, but who matter all the same. Private and institutional shareholders own 35 per cent of Cnooc through its listings in Hong Kong and New York. They can, of course, vote with their feet at any time, by selling. Those who have stayed put have decided that Cnooc’s earnings potential is so great that it justifies taking a back seat to a controlling shareholder whose interests may not always align with their own. Buying Nexen is clearly a good move for Cnooc. But buying Cnooc is a gutsy call for investors.

A breed apart

Cnooc’s history has given it a different profile from the other big, state-controlled Chinese oil companies. When China disbanded its ministry of petroleum in the 1980s, China National Offshore Oil Corp was created alongside Sinopec and PetroChina. But the last two were lumbered with old-style technology and infrastructure to exploit oil onshore. They were also left with old refining arms and sell fuel in China at government-controlled prices. By contrast, China’s lack of offshore technology and expertise meant that Cnooc had little choice but to start from scratch and team up with foreign exploration and production companies to develop offshore resources.

As a result, Cnooc is already more international than its peers. The Nexen deal would sharpen that edge, giving the company a big stake in North America to go along with its assets in Nigeria, Uganda, Argentina, Iraq and Indonesia, as well as large Chinese oil and gasfields offshore. It is also the leanest of the three. PetroChina produces just over 4,000 barrels of oil equivalent (boe) each year for every employee in its exploration and production arm, compared with more than 60,000 at Cnooc. Because of its high percentage of oil production versus gas, the high elasticity of oil prices, and its relatively low costs and tax exposure, Cnooc has among the highest net income per barrel ratios and returns on equity in the global oil and gas sector – more than a tenth above Chevron, for example.

Finally, Cnooc has a 35 per cent free float in Hong Kong, compared to just under 25 per cent for Sinopec and only 15 per cent for PetroChina, which should encourage liquidity. And minority holders have done well. Cnooc has returned more than 1,000 per cent over the past decade, almost five times more than ExxonMobil.

Cnooc is, in sum, the most attractive of China’s energy companies for international investors. It faces challenges, however. Its proven reserve life of nine years is decidedly below the industry average. The closure of its Penglai oilfield in Bohai Bay following last year’s oil spill has dented production growth and exposed its dependence on offshore China. Oil and gas production growth will slow to 6 per cent to 10 per cent annually over the next five years from an average 20 per cent over the past five years. Mergers and acquisitions are rarely the best way to create value in the oil and gas industry – returns are normally half the level of exploration investments. But as Wood Mackenzie notes, it takes 10 to 15 years for offshore oil and gas discoveries to reach peak production. Cnooc’s reserve life at current production levels does not give it that luxury. Cue its bid for Nexen.

O Canada!

Cnooc is targeting Nexen because, to put it bluntly, Canada is where the oil is, and it is supposed to be more open to foreign investment than, for example, its southern neighbour. Yes, Canada has so far blocked a $5.3bn bid for Progress Energy from Malaysia’s Petronas. The offer for Nexen is very different, however. Cnooc has showered Ottawa with love-bombs to ensure that the deal is a “net benefit” to Canada. It has suggested it could list its shares in Toronto, has made a guarantee to Nexen’s employees and will make Calgary its North America hub. And Canada is hardly selling off its geological inheritance; Nexen represents less than 1 per cent of its proven and probable reserves. The decisive point, though, should be that Canada’s oil sands require substantial investment, much of which will have to come from abroad, as US investors pull out to focus on shale gas at home. The US is, after all, on a path to energy independence.

Yang Hua, now a director at Cnooc, is a veteran of its failed attempt in 2005 to buy Unocal in the US. He orchestrated Cnooc’s purchase of a stake in MEG Energy in Canada a few months before the Unocal bid. Cnooc has acquired more Canadian assets since, culminating in last year’s purchase of the bankrupt oil sands producer OPTI Canada. That company’s main asset is a 35 per cent stake in Long Lake oil sands in Alberta. The rest is owned by Nexen giving Cnooc an opportunity to have a good look at one of its main reserve assets.

If it acquires Nexen, Cnooc’s annual production will jump by a fifth. Its proven and probable reserves would rise by more than a third. Its reserve life would extend to more than 18 years at current production levels, according to Macquarie, the bank. In addition to Canada’s oil sands (70 per cent of Nexen’s proven and probable reserves), Cnooc would bag Nexen’s assets in the North Sea, the Gulf of Mexico and Nigeria. This would raise the company’s production outside China to a third, from a sixth in 2011.

Pricey, but not loonie

What is more, Cnooc is offering a good price for Nexen. Cnooc’s $27.50-a-share bid represents a 61 per cent premium to Nexen’s undisturbed share price. Nexen’s shares have stumbled in recent years in response to bumpy operating performance, most notably at its oil sands projects. However, since this deal is about extending Cnooc’s reserve life, it is taking a long view and measuring the deal in terms of dollars per barrel of oil equivalent. Viewed this way, the price is not outrageous. Including Nexen’s debt, the offer is worth $17.9bn. That equates to $19.90/boe for Nexen’s 900m boe in proven reserves – roughly in line with recent big oil and gas acquisitions. Including Nexen’s additional 1.1bn boe of probable reserves, Cnooc’s offer falls to $8.90/boe, close to the global average of $8/boe, notes Bernstein, the brokerage. But most value will be made if Cnooc can extract Nexen’s total 5.6bn boe in contingent reserves, when the price falls to $3.20/boe.

Cnooc’s exploratory costs have averaged $18.20/boe over the past three years; the cost of adding Nexen is not too far off the price it would pay to add production organically. And this is a long-term bet.

Falling to earth

Cnooc’s current return profile, as measured by return on capital or equity, is so high that any effort to raise production and reserves will dent these ratios. Buying Nexen would reduce Cnooc’s return on equity by 5 percentage points, to 15 per cent, Macquarie estimates. In other words, if Cnooc successfully pursues a policy of growth by international acquisitions, through the Nexen deal and other tie-ups that are likely to follow, it will come to resemble a global oil company – in ways both good and bad.

This leaves minority investors with several questions. Can Cnooc manage a full-scale international operation? Global oil companies must deal delicately with local regulators, governments and citizens; Cnooc has shown little talent for communication. It took a month to publicly report last year’s oil spill in Bohai Bay in northeastern China, which it owns in partnership with ConocoPhillips. It will need to do much better than that in Canada, especially given the environmental concerns which surround development of the oil sands. It is a bad communicator with investors, too, providing scant detail on its international operations.

Most importantly, Cnooc is a government-controlled company. Wang Yilin, its chairman, told the Financial Times that there was no clash between shareholders’ interests and Cnooc’s state masters. But the question is whether the majority owners will always have incentives to make economically-driven investment decisions and share returns with minority owners. One risk is that China’s new leadership will seek to create a version of Russia’s Gazprom – a pure extension of government power in the global energy market; or that it decides to weaken state-controlled enterprises, which were favoured under the outgoing leadership. For now, both scenarios seem unlikely. Economic growth in China may be decelerating but its energy needs will continue to grow.

As long as Cnooc remains state-controlled, its minority investors must insist on a discount price for their theoretical share of its future earnings. How big a discount will remain a matter of debate. But investors comfortable taking a subordinate position to the government have several factors working in their favour. Production setbacks now leave Cnooc’s shares trading near its historical lows but production at Penglai has resumed and is ramping up. Buying Nexen would raise output further, giving Cnooc a more balanced exploration and production portfolio and, most importantly, lengthen its reserve life. If Canada vetoes the deal, Cnooc can pursue other options – its cash flow after dividends is $2.5bn a year. Smaller targets or stakes in promising exploration options off Africa could be next. Despite the moderation in returns that will accompany Cnooc’s expansion, its cost structure advantage will persist. Global investors cannot afford to ignore Cnooc.

Additional reporting by Leslie Hook

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