CNOOC Ltd is emerging as a new force in the international oil and gas business. With cash to spend, it is pursuing a strategy of increasing production through domestic exploration and overseas acquisitions.
The last 12 months have been particularly active for CNOOC Ltd, both at home and abroad. In China, production from the largest single offshore oil discovery commenced and the company's inventory of oil and gas projects continued to grow as field development plans were sanctioned and new discoveries made. Overseas, CNOOC Ltd acquired interests in two LNG projects – Australia's North West Shelf and Indonesia's greenfield Tangguh project – plus an unsuccessful bid for a stake in the giant Kashagan field in Kazakhstan.
China National Offshore Oil Corporation (CNOOC) was established in February 1982 with responsibility for oil and gas exploration and production in China's offshore regions, including the administration of contracts with foreign oil companies. In September 1999 CNOOC transferred all of its upstream assets to a wholly-owned subsidiary, CNOOC Ltd, set up as a listing vehicle. A successful initial public offering of CNOOC Ltd shares was completed in early 2001, with CNOOC retaining a 70.6 per cent stake in the listed company. Since then, CNOOC Ltd has followed a strategy of increasing reserves and production through domestic exploration and development via overseas acquisitions.
At the time of the IPO in 2001, CNOOC Ltd inherited a portfolio of domestic projects that had been built up over the previous 20 years. In addition to the development of independent discoveries, CNOOC had grown its domestic equity production to around 250,000 barrels of oil equivalent (boe) per day through its right to back-in for up to a 51 per cent interest in any discovery made by foreign contractors under production- sharing deals. The funds raised by the IPO were, in part, to finance the further development of domestic discoveries. During the second half of 2002, production started from three new oil developments, including China's largest single offshore field, Peng Lai 19-3. Additional phases of development were also completed on the Qinhuangdao 32-6 oilfield.
The successful implementation of these and other development projects will result in strong near-term production growth. Wood Mackenzie estimates that CNOOC Ltd's annual equity oil production is set to increase by 50 per cent from 2002 levels over the next two-to-three years, equating to an average annual growth rate of around 12 per cent. This production increase will predominantly be from the Bohai Gulf.
Domestic gas production, historically a relatively minor portion of CNOOC Ltd's output, is also set for a period of strong growth. The completion of the Dongfang field and the development of East China Sea gas fields will increase net equity gas production by 100 per cent from 2002 levels in the next two-to-three years. Gas production as a proportion of total domestic output will increase from 13 per cent in 2002 to 16 per cent in 2005. However beyond then, domestic gas production growth will plateau without new discoveries or additional development of existing projects.
Therefore, the challenge for CNOOC Ltd will be to maintain oil and gas production growth in the medium- and longer-term. In order to maximise shareholder wealth and secure hydrocarbon production for China's growing energy requirement, new strategically located reserve additions will be required. The challenge is especially relevant to domestic gas in which CNOOC Ltd has been given a unique role by the Chinese government to procure gas for the country's economically prosperous coastal provinces.
Offshore exploration in China is conducted by CNOOC Ltd on an independent basis and by foreign oil companies via productionsharing contracts (PSCs). CNOOC Ltd funds 100 per cent of independent exploration but does not contribute to PSC exploration costs. However, it retains the right to back-in to the development of any commercial PSC discovery up to a 51 per cent participating interest. To date, CNOOC Ltd has generally exercised this back-in right, meaning that it bears the entire risk of independent operations, while leaving foreign contractors to bear the risk of PSC exploration.
There has been mixed exploration success in offshore China over the last decade, with typically only one or two commercial or technical discoveries made each year. Only the occasional discovery in excess of 100m barrels of oil equivalent (Qinhuangdao 32-6, Nanbaoi 32-5, Dongfang 1-1 and Peng Lai 19-3) has been made. However, there appears to have been little difference between CNOOC Ltd's performance and that of PSC operators over the last 10 years – both have resulted in commercial success rates of around 15-20 per cent.
Over the last 12 months, CNOOC Ltd has taken a new approach to independent domestic exploration. A cluster drilling approach was employed in 2002, enabling it to complete a record 43 exploration and appraisal wells during the year. Drilling locations focused on areas surrounding existing fields in the Bohai Gulf and South China Sea. The cost advantages of this approach are partially offset by the reduction in information gained during drilling and the remaining requirement for appraisal wells in the event of discovery. The early signs are that the campaign has had some success, increasing its commercial discovery rate without an exces- sive increase in unit finding costs.
CNOOC Ltd, in conjunction with its parent, has also taken steps to promote new PSC exploration during the last year. Although five formal licensing rounds had taken place prior to 2002, most offshore PSCs have been negotiated bilaterally. Between 1997 and 2002, there were on average three new licence awards a year. However, with licence relinquishments also running at this level, CNOOC failed to attract significant new licence interest during this period. With PSC exploration drilling falling to its lowest annual level since 1994, the deepwater licensing round of Q4 2002 is the most important offering of offshore Chinese acreage in the last decade.
Twelve deepwater blocks located in the Pearl River Mouth and Qiongdongnan basins in the South China Sea are on offer. CNOOC Ltd has offered to participate as a paying partner in deepwater PSC exploration and signature bonuses are contingent on a commercial discovery being made. However, 11 months after the launch of the round, only one PSC has been awarded (Block 04/30 to Husky Energy). Concerns over the prospectivity of the acreage on offer and high potential exploration drilling costs are likely to be at the root of the lack of interest. For CNOOC Ltd, foreign partnership in deepwater exploration, an area in which the company has very limited experience, is almost a pre-requisite. Negotiations with other interested partners, in particular ConocoPhillips, are understood to be ongoing. However, no significant new foreign partnerships have yet materialised.
Despite the seeming lack of interest in deepwater blocks, CNOOC has offered further acreage in the South China and East China seas in Q2 2003. It remains to be seen whether the blocks on offer, some of which have been explored previously, will attract significant new investment from abroad.
The success of the two licensing rounds will shape CNOOC Ltd's future approach to domestic exploration. The lack of foreign interest in deepwater acreage will leave it in the difficult position of being an inexperienced operator tasked with frontier exploration. A disappointing response to the 2003 round will also leave it facing the prospect of continued sole risk exploration in the South China Sea. With significant areas of the East and South China seas remaining relatively unexplored, CNOOC may be faced with a stark choice: continue CNOOC Ltd's sole exploration efforts or attract foreign interest through a reduction in its back-in rights.
Alongside its domestic counterparts CNPC and Sinopec, CNOOC has historically concentrated on domestic development in order to provide for China's energy needs. With domestic energy demand growing strongly over the last decade, China has faced a growing reliance on imported fuel, particularly Middle East oil. Against this background, Chinese companies are being encouraged to look overseas in order to secure alternative and new sources of energy.
Since its IPO in early 2001, CNOOC Ltd has followed a strategy of 'opportunistic' overseas expansion. In January 2002, the company completed the US$585m acquisition of Repsol-YPF's Indonesian upstream assets. Since then, interests in two LNG supply projects have been acquired and an unsuccessful bid made for a stake in the giant Kashagan oilfield development. Had this deal been successful, CNOOC Ltd's total overseas acquisitions would have exceeded US$1.2bn during the nine months to June 2003. This compares with Wood Mackenzie's US$10bn valuation of its upstream assets prior to the deals.
Landmark agreements were signed in 2002 for the first LNG imports to China. In August 2002, Australia's
North West Shelf project was chosen by CNOOC to supply China's first LNG-receiving terminal in Guangdong province. The project will supply 3m tonnesa- year of LNG to Guangdong over 25 years, commencing 2005. Concurrently, Indonesia's Tangguh development was selected as the supplier of 2.6m tonnes-a-year of LNG to China's second LNG terminal to be located in Fujian province. North West Shelf The award of the LNG supply contracts was followed by the announcement that CNOOC Ltd had been offered a 25 per cent stake in the upstream development of the North West Shelf project. It completed the purchase agreement in May 2003. Under the terms of the contract, CNOOC Ltd acquired a 5.3 per cent interest in the production licences, retention leases and an exploration permit of the project, and a right to participate in future exploration undertaken over and above the proven reserves. It is understood that CNOOC Ltd will be a carried partner in any future exploration efforts. Furthermore, should the final quantity of gas committed under the LNG supply agreement to Guangdong province be increased, CNOOC Ltd has the option to increase its equity participation in the project. It paid a US$348m consideration for the acquisition of its interest in the North West Shelf project.
The North West Shelf deal represents CNOOC Ltd's first move into the upstream LNG business and a significant new expansion of its business. It has gained this position through the strong negotiating position of its parent company. In what is a buyer's market, CNOOC has successfully secured a competitively priced source of LNG from a brownfield project and established its subsidiary as a 25 per cent equity player in the upstream supply element.
Tangguh CNOOC Ltd has also acquired an upstream stake in Indonesia's greenfield Tangguh development following the award of the Fujian LNG supply contract by CNOOC. In February 2003, CNOOC Ltd completed the acquisition from BP of an equivalent 12.5 per cent stake in the Tangguh LNG project for US$275m.
However, three significant uncertainties regarding the Tangguh project remain:
The Fujian contract is the Tangguh project's only slated LNG contract. Additional contracts will be required before the project will be sanctioned. In an increasingly competitive Asia-Pacific LNG market, securing additional contracts will be challenging.
The Fujian contract itself is conditional. Although details of the contract are confidential, Wood Mackenzie believes the slated 2007 start-up is optimistic. Further delays could result if the development of the Chinese gas market does not progress according to the aspirations of the Chinese government.
The F.O.B. pricing of the North West Shelf and Tangguh projects has set a new precedent in the Asia-Pacific LNG market. In order to gain a foothold in a new emerging market, and given the large volumes contracted, the project partners have been willing to offer significant discounts to prevailing Asia-Pacific LNG prices. This new pricing paradigm may now set the benchmark for future Tangguh contracts. Kashagan
In March 2003, CNOOC Ltd announced that it had entered into an agreement with BG to acquire half of BG's 16.67 per cent interest in the North Caspian Sea project for US$615m. This offer was accompanied by a bid from Sinopec for the other half of BG's interest. In May 2003, the existing project partners – ENI, ConocoPhillips, Shell, ExxonMobil, INPEX and Total – opted to exercise pre-emptive rights and acquire BG's stake.
The North Caspian project ranks as a world-class development and contains the giant Kashagan field and the Kalamkas discovery. Wood Mackenzie estimates that total proven plus probable reserves for the two fields exceeds 9.5bn barrels of oil and 10,000bn cubic feet of gas. The project area also contains three other potentially significant exploration prospects – Aktote, Kairan and Kashagan Southwest.
The acquisition would have gone some way to maintaining the company's expected medium-term production and diversifying its portfolio. In terms of upstream asset value, the deal would have elevated CNOOC Ltd to rank alongside the largest US independents, such as Anadarko or Occidental. Although the Kashagan project is a technically challenging one involving significant risk, the reserve and production potential of the project in a strategically important country would have been seen as sufficiently attractive for CNOOC Ltd.
The fact that CNOOC Ltd's US$615m bid was unsuccessful poses the question of just how much capital it has available to spend in the near-term on overseas acquisitions. Its domestic development schedule means that near-term capital cost commitments are significant. However, although Wood Mackenzie estimates that CNOOC Ltd will invest US$1.3bn in 2003 and US$1.1bn in 2004 in existing upstream developments, the company's upstream portfolio is likely to remain strongly cashflow positive during this period.
Successful bond offerings have seen CNOOC Ltd raise more than US$1bn in new debt finance since March 2002 while retaining a relatively low debt-to-equity gearing ratio. The company holds a significant cash and cash-equivalent balance of around US$2bn. These facts, combined with strong expected operating cashflow, mean CNOOC Ltd is well placed financially to make significant further acquisitions. Its budget for overseas acquisition is stated at US$1.25bn- 1.35bn in 2003, but there is potential for this figure to rise significantly in future years.
Future growth limitations
The events of the last 12 months have been of major significance to CNOOC Ltd and mark the emergence of a new international oil and gas player. However, a number of limiting factors can be identified in its potential future overseas expansion strategy.
The ability of CNOOC Ltd to meet political and strategic objectives will be a challenge in overseas expansion efforts. As a subsidiary of CNOOC, the company is ultimately controlled by the Chinese government. Its strategy reflects in part the requirement to secure energy supplies for the growing demands of the Chinese economy.
Although this can be used by CNOOC Ltd in order to leverage new upstream positions, political and strategic limitations may impact on its options for further acquisition. Certain opportunities may be foregone so as to meet parent and government objectives.
To date, CNOOC Ltd's overseas acquisitions have been in geographical areas that are strategically important to China. Acquisitions in Indonesia, Australia and Kazakhstan meet objectives of securing energy supplies in areas geographically close to China. The strategic importance of CNOOC Ltd's expansion efforts may preclude it from the acquisition of attractive assets in more distant or less welcoming countries.
Corporate resources Although CNOOC Ltd has been involved in upstream overseas activities since 1994, it remains a relatively inexperienced international player. Its technical experience is confined to offshore activities in which foreign players have often assumed operatorship. The company's limited exploration experience is also likely to restrict overseas expansion efforts. In the near term, it is likely to look for non-operated partnerships in established hydrocarbon basins with experienced operators.
CNOOC Ltd's limited international experience extends to its human resources. As its international business expands, management capabilities may become stretched. The ability of CNOOC Ltd's existing management structure to absorb new international business segments will be a particular challenge.
International competition The failed bid for Kashagan illustrates that CNOOC Ltd faces stiff foreign competition for assets. With international majors struggling to achieve production growth targets, it is unsurprising that the Kashagan bid was preempted. The ability of CNOOC Ltd to access projects that provide medium-term production additions will be challenged by existing international players and other emerging state oil companies. Petronas Carigali, PTTEP and, closer to home, Sinopec and CNPC/PetroChina, are all trying to expand internationally.
This increasing competition will not make overseas expansion into quality growth assets easily achievable without the outlay of premium considerations. Opportunities such as Kashagan will not present themselves frequently and CNOOC Ltd's lack of international experience will be felt in the judgement of challenging overseas acquisition efforts. In the domestic arena, its ability to leverage participation in additional LNG projects following Guangdong and Fujian may be limited by the ambitions of domestic competitors, in particular Sinopec.
A new international force
However, with cash to spend, it is likely that CNOOC Ltd will not find these barriers insurmountable. Its next move will be eagerly awaited, not only by shareholders but also by the wider upstream industry as it witnesses the emergence of a new international force. The possibility remains that some of these industry players may even fall direct victim to CNOOC Ltd's expansion ambitions – as targets of acquisition.
This article was written by Norman Valentine, senior Asia-Pacific analyst of global consultants Wood Mackenzie. Email: norman. firstname.lastname@example.org