BARRON’SOnline: Bid Puts New Focus on China's Oils: “Whatever happens, expect Cnooc and PetroChina to be more aggressive in their hunt for overseas assets. One possible candidate: Woodside Petroleum, the Australian company that's 34% owned by Shell.”: Monday 27 June 2005

By LESLIE P. NORTON

Emerging Markets

EVER SINCE ITS INITIAL public offering in 2001, China National Offshore Oil Corp., or Cnooc (ticker: CEO), has traded at a premium to the better- known PetroChina (PTR), notwithstanding billionaire Warren Buffett's stake in the latter.

Growth prospects for Cnooc, which explores offshore for oil and gas, were perceived as superior. PetroChina was saddled with mature fields and difficult-to-extract reserves, as well as thousands of gas stations subject to price controls. The other Chinese oil stock, downstream play Sinopec (SNP), historically has traded at a discount to both.

But in January came rumors that Cnooc was considering bidding for Unocal (UCL). The offer didn't come, and in April, Chevron (CVX) made a cash and stock bid for Unocal that late last week valued the company at $61.25 a share. Then Thursday, Cnooc bid $67 a share in cash, valuing Unocal at $18.4 billion. Throw in the net debt and the $500 million breakup fee that Unocal would owe Chevron if Cnooc triumphs, and the offer is $20 billion-plus.

Despite rising oil prices, Cnooc shares have lagged behind all year as investors fretted that a Unocal bid would mark an end to Cnooc's financial conservatism and chief Fu Chengyu's attention to shareholder interests; some also worried that oil prices were peaking. After we profiled Cnooc ("Feeding an Energy Hunger," Nov. 1, 2004), its American depositary receipts ran up to 59 from 52, and then fell back. Last week they traded around 55.

Fu said last week his all-cash bid is friendly and "superior" for Unocal shareholders. Cnooc also maintains that the deal would be accretive in the first full year and that the company, helped by low-cost government financing, would maintain an investment-grade rating. Fu in the past has said he refrained from making big acquisitions because they didn't add value. Now the company is stressing that the multiple being paid is "in line with the benchmark average" for both big-cap and Asian exploration and production companies.

Oil prices are high, yet the world economy is unquestionably slowing, and growth in the supply of petroleum is on the rise. 

Reasons abound as to why Cnooc's bid may fail, not least that Chevron could increase its offer or that regulators could disallow it. Citigroup Smith Barney, for example, said Chevron "could easily justify" matching Cnooc's bid.

What seems sure, however, is that perceptions of Cnooc's growth prospects have suddenly altered, perhaps permanently. Before the Unocal bid, Cnooc had missed production estimates, raising concern that finding and extracting energy in the China Sea is more challenging than once believed. The lifeblood of a resource company is replacement reserves. With finding and development costs soaring, buying reserves on Wall Street has lately seemed the cheapest route. Thus, to some, Unocal wasn't such a bad deal. The bid values Unocal's reserves at up to $9.50 a barrel of oil equivalent (BOE), says Lysle Brinker, senior vice president at John S. Herold, an energy specialist. Cnooc's finding and development costs soared to $9 per BOE last year, compared with a three-year average of $6. Brinker figures that Unocal's North American reserves, more highly valued in the merger market, are probably worth $13 to $14 per BOE, valuing the foreign reserves at $6-$7.

Cnooc last week traded at 11.5 times trailing earnings, about on a par with PetroChina; in November, it traded at 16 times. Unocal and Exxon Mobil (XOM) trade at 14 times. Even at those discounts, Brinker added, "the Chinese oils are fairly valued."

Hernan Ladeuix, head of oil and gas research for CLSA Asia Pacific Markets, said, "It's a really expensive acquisition and kind of a surprise." Cnooc is bidding 12.5 times Unocal's 2005 earnings, or 65% more than its own valuation. Debt will soar. Ladeuix believes that the deal could be dilutive, and will certainly be followed by a $2.5 billion share offering that will pay off one of the loans financing the bid.

Continues Ladeuix: "The whole point is that Cnooc was supposed to be a growth company. If they really needed to go abroad, it's because growth is more disappointing than we thought. We are coming from two years where the company missed production targets." As a result, Ladeiux thinks the historical premium to PetroChina is permanently eroded.

Much depends on a bullish outlook for oil prices. High finding and development costs matter less if higher prices linger. Nothing suggests that oil will fall below $40 in the near future. Merrill Lynch, which took Cnooc off its Buy list on news of the bid, recently upgraded its forecast for West Texas Intermediate to $50 for this year and $42 next year. That could make PetroChina, Sinopec and Cnooc look more attractive.

Yet the world economy is unquestionably slowing, and supply growth is accelerating. George Morgan, an oil-and-gas specialist at Franklin Templeton, has slashed his Chinese oil exposure in recent months in favor of European names like Repsol, with reserves at about $5 per BOE, and other integrateds like ENI (ENI), Shell and BP (BP), which have "decent yields."

"There's no doubt if you're using 40-something oil, you can make the Chinese oils work and an awful lot of names look attractive. But we're not there. We're roughly at the mid-30s, and that's already a fair leap up." The risk, says Morgan, is a global slowdown and investments in added supply. "Where do you go then when you're sitting on stocks priced like this?"

Whatever happens, expect Cnooc and PetroChina to be more aggressive in their hunt for overseas assets. One possible candidate: Woodside Petroleum, the Australian company that's 34% owned by Shell.

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