China's oil and gas companies--PetroChina, China Petroleum & Chemical Corporation (commonly known as Sinopec), and CNOOC, Ltd--play an important part in fueling the country's economic growth ambitions, controlling the majority of exploration, production, and refining activities. While they are in the same league with Western supermajors, we think the Chinese firms' function will remain more compartmentalised rather than integrated. Upstream growth will be realised through offshore oil exploration in the near term, with increasing efforts to increase natural gas production over the long term. Refining activities will continue to suffer losses over time, as governmental authorities balance price increases of refined products with the desire to suppress inflationary pressures. The disparity of assets among firms and the resulting roles they play in China's overall development plans will lead to very different returns for each firm, though acquisition activity could equalise these factors over time.
We favour CNOOC, Ltd. as the best positioned of the three, based on the high weighting (80%) of oil in its production mix, lack of downstream activities, and favorable market price versus our fair value estimate. We think it offers the best combination of return expectations and margin of safety. We think the shares are undervalued by about 30%. In contrast, PetroChina, which is similarly undervalued, has a production mix of 70% oil but also has significant refining operations that we believe will curtail profitability.
How They Got Here
Before 2002, the People's Republic of China wholly owned all domestic oil and gas assets. Throughout the 1980s and 1990s, China's oil and gas sector underwent numerous iterations of organisational structure, ultimately resulting in the formation of three state-owned corporations: China National Petroleum Corporation, which primarily focused on onshore upstream exploration and production, China National Offshore Oil Corporation, which was devoted to offshore E&P, and Sinopec Group, which was mostly composed of the country's downstream assets.
In 2000-01, all three companies performed reorganisations to carve out profitable segments, and then listed those segments as PetroChina (87% of shares still owned by CNPC), CNOOC, Ltd., (64% held by CNOOC), and Sinopec (76% held by Sinopec Group). With the parent corporations fully owned by the PRC, all three companies are effectively government-controlled entities and subject to China's central planning mandates. However, the profitability and strategic importance of the energy sector provide the firms a reasonable degree of operational autonomy.
The distribution of assets among the three firms makes sense from an administrative perspective. Northern China contains substantially greater hydrocarbon resources, while the concentration of refineries coincides with China's denser population in the southern and eastern portions of the country. Offshore regions have no population and therefore require no refining capabilities. The firms' mix of upstream and downstream assets has drifted, but for the most part these historical allocations still define operations.
On the world stage, PetroChina and Sinopec are in the same league as the international supermajor petroleum firms--ExxonMobil (XOM), Chevron (CVX), Royal Dutch Shell (RDSB), BP (BP.), and Total (FP)--in terms of production, reserves, and refining capacity. CNOOC, Ltd. is smaller in terms of production and reserves and has no downstream activities, a factor that we believe benefits the company.
The Chinese companies have near exclusive access to both the domestic reservoirs and end consumers of their product in the fastest-growing economy in the world. This exclusivity is the primary (and sometimes sole) source of these firms' narrow economic moat.
Upstream: It's All About Offshore and Natural Gas
China's onshore hydrocarbon production is characterised by a substantial weighting toward crude oil from mature fields, using dated technology and enhanced recovery techniques that merely maintain volumes. Many oil fields have been in production for decades and have realised years of plateau production levels. As a result, the lifting cost of oil production is rising, while reserve replacement is tapering off.
From the perspective of oil exploration, however, we believe China still has room to grow through offshore drilling. CNOOC, Ltd. enjoys exclusive rights to offshore exploration and production, as well as the ability to negotiate production-sharing contracts with foreign firms. These contracts provide Western firms the opportunity to gain a foothold in the Chinese energy market and should continue to boost exploration and development efforts. The company is gradually building capability in deep-water exploration and production, but the greatest share of CNOOC, Ltd.'s production stems from the shallower waters of China's Bohai Bay. In the near term, we believe CNOOC, Ltd. will be able to deliver returns on invested capital around 20%, thanks to its concentration in oil production and lack of downstream exposure.
China's transition to an energy importer presents the challenge of acquiring sufficient supply to meet its economic growth objectives. With limited domestic oil production growth and the emergence of concerns about pollution, planning authorities have begun to explore alternative energy sources. The country's 12th five-year plan outlines growth in nuclear and solar power, for example. We believe a shift to substantially increase natural gas production is inevitable, given the lower cost, better transportation, power generation efficiency, and fewer environmental concerns.
Exploitation of China's natural gas reserves is in its early stages. The country has substantial reserves of conventional and coal seam gas, at 99.2 trillion cubic feet, or just under 30 years of production at current rates. What's more, a 2009 assessment of technically recoverable shale gas resource released by the Energy Information Administration estimates China contains 1,275 Tcf--higher than that of the United States and Canada combined. Technical capability is the primary constraint, which could push out development for 5-10 years. The industry is seeking to acquire improved capability through joint-development partnerships and acquisitions in North America, which could accelerate China's progression up the shale gas learning curve. An alternative would be to enter into domestic partnerships to develop shale gas, which could be a tremendous windfall for the Western majors. Whether this will take place remains to be seen, as thus far shale gas partnerships have been very limited.
In anticipation of higher production, PetroChina has built an extensive network of natural gas pipelines spanning more than 36,000 kilometers and has been adding 3,000-4,000 km per year. PetroChina's proved reserves of natural gas dwarf those of the other two companies, and it hold positions in the most prospective basins for shale gas development in the northwest region of the country. Thanks to better assets and control of midstream, we believe PetroChina is best positioned for a shift in policy toward pursuing natural gas. Furthermore, we suspect that PetroChina's (and CNPC's) size, profitability, and significance to domestic energy needs will provide the company greater sway with the National Development and Reform Commission to direct policy more toward the company's favor. We think PetroChina possesses a favorable competitive position, based on reserves booked and control of midstream, but refining is a headwind.
Downstream: Insufficient Reforms Leave Us Pessimistic
Sinopec is the dominant player in Chinese downstream with 1.6 billion barrels per year of refinery throughput, compared with 985 million barrels per year for PetroChina. We estimate the two firms make up roughly 65% of total domestic refining throughput, with the remainder of the country's capacity operated by both companies' respective parents and a few small independent refiners.
China's refining industry is an entanglement of government production quotas and price controls that lead to substantial earnings volatility. Crude oil is purchased at a market price (derived from the average Singapore market price in the prior month), but is subject to provincial volume requirements and sold amid a fixed pricing structure.
Conversely, the NDRC sets a maximum retail price for gasoline and diesel, and provincial authorities wield the ability to set maximum wholesale prices. These factors have historically led to large refining losses for Sinopec and PetroChina, especially when oil prices move up sharply, because the NDRC fails to adjust prices accordingly.
We are pessimistic about Chinese refining for several reasons.
China's pricing mechanism appears to be ineffective. Refined product prices are referenced to international crude oil, taxes and levies, production costs, and a reasonable profit, in principle. This mechanism was enacted to align prices with market conditions after refiners experienced huge losses in 2008. In actuality, however, adjustments to refined product prices have not been set at levels that consistently produce favourable economics. We suspect this is due to Beijing's efforts to tame price inflation.
Reference processing costs are based on the industry average. The production cost used in the NDRC pricing mechanism is based on the average domestic cost across the industry. As a result, more inefficient refineries can be forced to run at a loss.
New investment is set at a national level determined by national needs, not economics. Our perspective on downstream investment projects is that the focus is on building processing capacity, not increasing efficiencies to realise improved returns. This is exacerbated by the fact that investment is directed according to national decree, not by supply and demand.
Since China is a net importer of crude oil, consideration must also be given to how PetroChina and Sinopec secure sufficient oil to meet demand. In 2011, 35% of PetroChina's processed oil volumes were sourced externally, while 78% of Sinopec's processed oil was obtained from international third parties. A further 6% of Sinopec's oil was purchased from PetroChina and CNOOC, Ltd. As the preponderance of economic rent resides upstream, PetroChina's substantially larger upstream capacity gives the firm a decided advantage. Though we award a narrow economic moat to both firms (again, because of the mandated oligopolistic nature of the Chinese market), we think PetroChina's moat is much more secure.
Also, downstream activities are evolving into an implicit tax on upstream profits for Sinopec and PetroChina. In recent months, there have been calls to reform the NDRC's pricing mechanism to better track oil prices and provide a reasonable profit to refining. Downstream, however, has never enjoyed comparable levels of profitability to those of upstream activities. Therefore, we believe that even with reforms, Sinopec's heavy weighting toward refining will continue to act as an anchor on returns and is unlikely to be on equal footing with PetroChina in terms of domestic operations.
Expect International M&A to Continue
We believe international acquisitions will be critical to the Chinese oil and gas majors to offset rising oil imports and gain access to new technology. Flat domestic oil production and rising demand caused imports of crude to grow at an average annual rate of 11% over 2005-09 (the latest available official data from the National Bureau of Statistics of China) and has accelerated to 13.9% in 2008-11 (according to Platts). As world oil prices climb, these imports become increasingly expensive and have forced Chinese firms to seek production elsewhere to offset the economic imbalance of imports. When it comes to unlocking shale gas reserves, PetroChina and Sinopec are technically inferior to Western firms. Western service firms have thus far been hesitant to make technology for horizontal drilling and hydraulic fracturing available, probably for fear of intellectual property poaching. As a result, the Chinese firms have gone on an acquisition spree in recent years.
Of the three firms, we think Sinopec will be the most active in pursuing deals. The firm has the greatest need for upstream growth, given the level of externally sourced crude for refining operations. To that end, the company has the right man for the job. Chairman Fu Chengyu, who previously led CNOOC, Ltd., is by far the most deal-savvy of the three firm's current oil and gas executives, in our opinion. In his first year at Sinopec, Fu has already commenced 11 deals for $10.4 billion.
We think acquisitions will be more of a necessity than opportunity, and we would expect firms with the following attributes to be the most likely to draw bids.
Attractive valuation. In the past, Chinese firms' willingness to pay inflated prices was well known. This has changed, with recent deals falling within comparable levels. Additionally, the Chinese firms are becoming more opportunistic with the timing of their bids, as Sinopec was when it bought Daylight Energy after a 60% decline in share price over the prior six months.
Not too big, not too small. We think there is a balance between capital deployed and affordability. We think producers with market capitalisations in the $5 billion-$15 billion range are attractive acquisition targets.
Room to expand production. Acquisitions will be motivated by strategic interests, not financial. Firms with large undeveloped acreage positions are more attractive, especially in unconventional gas and oil sands reservoirs.
Potential for export. PetroChina, Sinopec and CNOOC Ltd. have all accepted shipping commitments on Enbridge's Northern Gateway pipeline from Edmonton, Alberta, to Kitimat, British Columbia, which would allow for export of oil volumes to China. Additionally, the Chinese are increasing investment in heavy oil refining capacity, which would point to additional acquisitions in the Canadian oil sands.
