THE EXPLORER
CNOOC embarks on a global mission in a struggle to keep its oil burning.
By Abe De Ramos

When Shenzhou 5 blasted off into space on a cloudless day in mid-October, China etched another milestone in its history. It also sent a powerful signal to the world that it is no trading outpost but a country more than capable of taming new territories. No one embodies this spirit more than Mark Qiu, CFO of CNOOC, the state-owned oil giant that has become China's showcase of opportunistic, cross-border expansion.

CNOOC's exploits overseas, such as its latest announced deal Down Under, are a departure from the old paradigm. Foreign multinationals, hoping to tap a market of a billion people, would knock on the doors of state-owned enterprises with investment proposals and find willing ears. Lately, however, the reverse has been happening. Last year, TCL Group, an appliance manufacturer, bought bankrupt German TV maker Schneider; soon after, China Netcom, a telecommunications player, acquired the Asian assets of US-based Global Crossing. CNOOC has been the most expansive of the lot, and inadvertently, it has become the poster child of outward-looking Chinese enterprise. As CNOOC goes from deal to deal, it offers lessons for Chinese companies on international deal-making.

It's easy to understand why CNOOC, which has the exclusive mandate for oil and gas exploration and production in offshore China, is on a shopping binge. Although it is now running at full capacity, CNOOC still has about US$2 billion in cash that drags its returns. And even if it increases its production target next year, Qiu says its projected strong cash flow can still cover the extra cost he would need, or he could also increase his current low gearing ratio of 15 percent, a move that could actually decrease his cost of capital and thus increase returns. In short, Qiu has to find other ways to reinvest his money.

In less than two years since its initial public offering (IPO) in February 2001, CNOOC has spent US$1.6 billion acquiring assets in Australia and Indonesia. Last March, it bid for an 8 percent stake, valued at US$615 million, in a consortium of oil majors that were to develop a massive oil find in Kazakhstan. When that failed, it announced last September a commitment with ChevronTexaco to take an equity stake, believed to be 12.5 percent and estimated at US$350 million, in the Gorgon gas project in Australia, which the American oil major leads. The deal became all the more likely when Chinese President Hu Jintao announced in late October that China would buy gas from the project over 25 years, in a deal valued as much as US$21 billion.

Although CNOOC has shown a good rate of success, Qiu is first to acknowledge that the task of a Chinese SOE going overseas is fraught with difficulties. "The challenges are significant for Chinese companies investing overseas, simply and primarily because we're not experienced in dealing with complexities like sorting out different accounting systems, fiscal regimes, operating environments, politics, laws and regulations," he says.

But these are just the logistical challenges that can be overcome with the help of, say, lawyers and consultants. For the CFO of this generation of Chinese companies, one of the most daunting prospects is meeting the expectations of a skeptical new breed of shareholders, and finding a balance between near-term returns with long-term value creation. In CNOOC's case, it's the foreign, private investors who own 30 percent of the company - one of the largest public floats among Chinese SOEs, and listed in Hong Kong and New York - and the buyers of its bond issues, which have so far amounted to US$1 billion.

Then there is the implicit pressure to shake the baggage of perceptions involved with being a state-controlled entity. "Historically, investors have had unpleasant experiences with state-owned companies, whose transformation from planned-economy entities into market-based companies exposed a mismatch in culture, expectations, and performance," says Qiu. "So naturally, a great deal of investors have a suspicious attitude about everything a state-controlled company does."

CNOOC itself is battling this. Why, some ask, would CNOOC focus on the gas business (overseas at that) in the next 12 to 18 months, when oil prices are holding up, returns from oil investments are higher than those from gas, and only 39 percent of CNOOC's proved reserves have been developed? Is it a coincidence that the Chinese government wants to reduce reliance on coal, and is looking to cleaner energy sources, like gas? How many of CNOOC's decisions are based on business sense, and how many on the central government's whims? As Qiu is finding out, being able to address these concerns will make it easier for Chinese enterprises to face their ultimate challenge when acquiring or bidding for overseas assets: competing with major, international players. "It's tough enough for existing players to take advantage of a special situation," says Qiu. "It's even tougher for a newcomer, first, to identify a special situation suited to its goals, and second, to be able to execute the deal."

Under A Microscope

An MBA-toting, Western-educated former investment banker, Qiu is cut out for the job. In 2001, he was brought in as CFO to oversee CNOOC's post-IPO finance strategy, and quickly became one of its chief negotiators in its overseas forays. Qiu had previously spent five years with what was then the American oil company Atlantic Richfield (ARCO, now a part of the British behemoth BP). Of that, two years were spent as its lobbyist in Washington, DC.

The posting in the American capital gave Qiu the foundation for the skills he needs for what he is doing now. "That job made me aware of international politics, the political dynamics of business, and how a macro environment impacts a company's growth space," he says. At that time, from 1996 to 1997, he was lobbying the US Congress to give China the coveted most-favored-nation trading status. ARCO's ulterior motive was to win a US$500 million gas development deal in the South China Sea. Qiu ended up presiding over the completion of that project.

Now that he is on the other side of the fence, Qiu is finding a new set of problems. The pressure on CNOOC to spend its cash actually reflects the predicament it is in. The company has had a strong production run since its early days, with volumes expected to double between 2000 and 2005. The question is how long its reserves can sustain its stature as a growth company. In short, CNOOC wants to avoid what its larger siblings, PetroChina and Sinopec, are experiencing: a plateau in production growth, which, for any business enterprise, especially one engaged in resources, spells gloom. (See "Do More, Say Less", November 2003 issue)

When Qiu talks about his strategy, centered on cost reduction and volume growth, his words bubble out like just-uncorked champagne. But when the subject zeroes in on opportunities outside China, he begins to fumble, shifts in his seat and tensely re-straightens his necktie. "Our focus remains offshore China, but if there are opportunities outside China that meet our criteria," he starts, then gropes for words, "...strategically and economically, we will pursue them very aggressively."

That moment, when Qiu let his thoughts hang for a few awkward seconds, is a tell-tale sign that he is on the defensive. Managing close to US$2.8 billion in liquid assets, Qiu has been unable to deploy his funds without some investor casting a skeptical eye over his plans. Investors were initially impressed when CNOOC started to acquire overseas assets; but they began to have doubts last year when it made two huge acquisitions, fearing an impact on overall returns.

In a study of global oil industry trends since 2000, Goldman Sachs analyst Paul Bernard questions the path that CNOOC is taking. High asset growth and aggressive acquisitions, he argues, have led to significant falls in returns among oil companies globally. CNOOC, being the most aggressive of the three Chinese oil companies, has been and continues to be at risk of falling into this trap, more so than PetroChina and Sinopec. Its cash returns on capital invested (CROCI), Bernard estimates, is expected to drop from 32 percent in 2000 - before CNOOC's IPO and expansion binge - to 20 percent this year.

Some analysts think there is little pressure for CNOOC to acquire. And, for sure, CNOOC is hardly running dry of oil. Of its net proved reserves of more than 2 trillion barrels of oil equivalent (BOE), 61 percent have remained undeveloped, which means they have yet to be extracted from their wells, as of end 2002. Corrina Lim, oil and gas analyst at ABN Amro in Hong Kong, estimates that these reserves are enough to guarantee CNOOC that its production figure will continue to be on the rise until 2010. Assuming there are no more new discoveries or initiatives, the company will grow its production volume from 127 million BOE last year to a peak of about 250 million BOE by 2010.

"The only pressure on management is the cash sitting on its balance sheet, and the surplus cash generation from 2004 onwards," says an analyst at a European investment bank - and his opinion is echoed by many of his peers. (CNOOC partly addresses the former by rewarding its shareholders with generous dividends. In the first half of 2003, it surprised its investors with a US$190 million special dividend after announcing a net profit of US$760 million.) "The lack of pressure gives some comfort that management can afford to be selective." Translation: watch where you're going.

"CNOOC has very strong growth, be it oil and gas, and it doesn't need to make an acquisition," adds Mario Traviati, oil and gas analyst at Merrill Lynch in Singapore. Although he is in favor of the Gorgon acquisition, Traviati cautions CNOOC, in fact any oil and gas company, against looking to grow via acquisitions in the current high-cost energy environment, where there are more buyers than sellers. "It's a very dangerous strategy to pursue in enhancing shareholder value," he says. "The best way to grow in the oil and gas business is through exploratory and development success, rather than acquisitions."

Despite such concerns, and his guarded way of addressing them, Qiu declares unequivocally that the US$3.2 billion-a-year company will not relent. For one, Qiu can easily claim a track record of efficient, low-cost production that has enabled CNOOC to generate quick returns from its investments. The basket of oil fields it acquired from Repsol, for example, delivered US$160 million in operating cash flow last year, and made a strong contribution to its total production.

Also, CNOOC can always invoke the demand for gas in China as a leverage in valuing acquisitions. The reason? Oil and gas companies are more willing to share their projects with someone who can guarantee that their output would find a market. "The advantage of CNOOC's acquisition style is they know they have gas demand," says Gordon Kwan, energy analyst at HSBC Securities in Hong Kong, "so they can use that as a negotiating chip to get very good prices to take a stake in the upstream development (of Gorgon) with ChevronTexaco, which has been having difficulty finding customers."

Qiu can also always justify the deals he pursues by pointing to his low cost of capital. Kwan estimates that CNOOC currently has a 9 percent cost of capital, well below its CROCI of 20 percent, and returns from overseas investments. One European bank analyst estimates that CNOOC's internal rate of return from the Northwest Shelf project in Australia, acquired last year, would be 13 percent, while that from the Tangguh project in Indonesia, also bought last year, is just below 12 percent.

These rates are below earlier projections: CNOOC had told analysts that its target was 15 percent. But Qiu prefers to look at the long-term benefits of his acquisitions to his shareholders. Building a portfolio of long-dated assets, he argues, will not only extend CNOOC's peak production period, but also diminish its geographic risk, or over-reliance on one supply source. "This industry has one hidden risk that not many investors can identify, and that's geological risk. The number of yet-to-be-discovered oil and gas reserves declines over time," he says.

This Must be the Place

For that reason, when ChevronTexaco announced it was looking for a partner to develop Gorgon in Australia, CNOOC immediately jumped on board, signing a memorandum of understanding to take a stake in the giant gas project. This came as the company was still smarting from a failed attempt last May to take a stake in the consortium that develops the Kashagan oil project in Kazakhstan, which is deemed the world's largest oil find in 30 years. Most recently, there has been speculation about CNOOC being interested in an equity stake at another oil company in Kazakhstan, called Dragon.

Investing in Iraq is also a possibility that Qiu does not dismiss. "As an upstream company, certainly we are interested in any oil and gas rich basin, and Iraq would be a major reserve," he says. "But we don't see an independent effort in Iraq, because it calls for a large scale investment," he adds. "Unless we are in partnership with somebody else, CNOOC is just not large enough to afford exploration there. We're always open to partnership opportunities that offer attractive, risk-adjusted returns."

In the process, Qiu tries to turn a perceived liability into strength, specifically, the stigma involved in being largely state-owned. David Hurd, oil and gas analyst at Deutsche Bank in Hong Kong, says this may have been a factor in its - and Sinopec's - rejection by the Kashagan consortium, which consists of oil majors such as Royal Dutch/Shell, Total, and Exxon. "They tried to acquire oil in Kazakhstan, but they got thrown out," he says. "It was more difficult (for CNOOC) because it's a Chinese government company, so it comes along with that baggage."

Kwan of HSBC says another perceived liability lies in the bureaucracy of state enterprises. "You could argue that too much state ownership can make the decision-making very slow," he says, "so it could take forever for, say, PetroChina to make a bid for the Caspian Sea, while it could only take a phone call from the CFO to the CEO for any privately run company."

Aware of such perceptions, CNOOC has been working hard to debunk them, setting up a lean management structure, as well as creating a corporate governance system that distances itself from direct maneuvering by its ultimate owner, the central government. Bureaucracy-wise, its bid for the Kashagan deal was decided upon within weeks after British Gas (BG) announced that it was selling out. "We worked and negotiated over the Chinese New Year and the fact that we were able to do this deal (winning the bid) within a very short time shows the company's readiness and maturity in executing deals of this scale," says Qiu.

CNOOC has also embraced transparency and adopted a board structure that puts the listed company at an arm's length from its parent, China National Offshore Oil Corp, efforts that have won the trust of the financial community. "CNOOC has been given free rein by the Chinese government to go out and act as if it were an independent producer," says Hurd, "and the reason for that is image."

One of the ways the Chinese government can expropriate from a listed company is through related party transactions. When CNOOC's parent sold a portion of its finance arm to the listed entity in September, investors were immediately suspicious, and sold down the stock. CNOOC's share price upon announcement of the deal fell 3.4 percent. It recovered when investors realized the company paid a fair price. CNOOC's books, investors agree, are among the most open in Hong Kong. "Even if you conduct business at arm's length, the fact that they are related still gives the markets a reason to feel uneasy," says Qiu. "All the company has to do is to disclose to the full extent."

As a further evidence it is pulling away from the shadows of the state, Qiu brushes off suggestions that there was a political reason behind the rejection in the Kashagan deal. Analysts have warned members of that consortium against exercising their rights to pre-empt CNOOC and Sinopec from buying out the BG stake. China, analysts said, could bar them from doing deals in the country, which in turn are often executed by CNOOC, Sinopec and PetroChina. (Any foreign company interested in offshore China has to partner with CNOOC, which automatically gets at least a 51 percent ownership in the resulting project.)

Implicitly, the analysts meant that CNOOC is being coddled by the state, and being used as leverage for its energy security. Qiu will have none of that, and in fact defends the decision of the consortium. "Business is very different from politics," says Qiu. "The bottom line is, Kashagan was an attractive opportunity. Anyone would have made the same decision. Everyone exists for a profit." Hardly crestfallen, Qiu sees a valuable lesson in the experience. "In a relationship, if you are turned down by an attractive lady, being emotional about it doesn't get her attention back," says Qiu, himself a bachelor. "On the contrary, if you have a positive attitude, you can get on to the next target, and probably be more productive."

Abe De Ramos is managing editor of CFO Asia