Thursday, June 7, 2007


China National Offshore Corporation (CNOOC, ticker CEO) is responsible for the current and future development of China's offshore oil and natural gas reserves. With a market capitalization of approximately $50Bn as of 6/07, CNOOC is undervalued.

Chinese Majors Valuation Comparison Chart:

Ticker: PTR
PetroChina [E&P: 100% 05 income, Marketing: minimal inc Refining: loss]
Proven Reserves: 19.56 BBoE (41% gas, 59% oil)
Reserves/Production: 18.4 years
Market Capitalization: $236Bn
Standardized Measure: $175.2Bn (YE Chinese Prices)
Standardized Measure/Enterprise Value: 0.74x

Ticker: CEO
China Ntnl Offshr Oil Co [E&P 100% 05 Income]
Proven Reserves: 2.36 BBoE (68% oil)
R/P: 5.6 years
Market Capitalization: $50.0Bn
Standardized Measure: $25.2Bn (YE Chinese Prices)
Standardized Measure/Enterprise Value: 0.504x

Ticker: SNP
Sinopec (China) [E&P: 70% 05 income, Marketing 15%, Chem: Refin: 15% loss]
Proven Reserves: 3.362 BBoE (14.7% gas, 85.3% oil)
R/P: 10.6 years
Market Capitalization: $95Bn
Standardized Measure: $44.1Bn (YE Chinese Prices)
Standardized Measure/Enterprise Value: 0.46x

Notes: Market Capitalization values are from 6/07, but annual reserve and standardized measures are from 12/31/05, due to the fact that the year end 06 annual reports for the Chinese Majors are not available as of early 6/07.

Standardized measure is defined by FASB 69 as future expected cash flows from proven oil and gas properties, discounted by 10%. M0re information on the Standardized Measure can be found here:

Brief Overview of the Chinese Oil Industry:

The Chinese oil industry is comprised of three firms: PetroChina, CNOOC and Sinopec. CNOOC, Petrochina and Sinopec were created in the early 1980's when the Chinese government split its emergent oil industry into three pieces based on geography: Petrochina in the Northeast, Sinopec in the South and CNOOC for offshore operations. This move by the Chinese government has been explained by Chinese analysts as an effort to foster internal competition based on a American model of the oil industry.

China fully intends for each of its three oil firms to become "Supermajors" in order to compete successfully internationally. China sees its domestic oil industry mainly responsible for securing oil and natural gas supplies, which is a top concern given China's ravenous appetite for energy. Note that this assertion concerning China and the Big 3 is based on comments from Chinese officials and also based on the latest presentations from the Baker Institute of Energy Studies, found here: PetroChina can be considered already nearly a Supermajor (at 6/07) with a market capitalization of approximately $US240Bn and proven oil and gas reserves of over 17 billion BOE, in a large part due to PetroChina's ownership of the Daquing oil field in Northern China, which is one of the four largest oil fields in the world. CNOOC is the smallest in terms of market capitalization of the Big 3 at approximately $US50Bn (at 6/07).

The question comes to mind: Does CNOOC's relatively low market capitalization mean that the firm has the most room to grow in becoming a Supermajor compared to Sinopec and PetroChina? The answer to this question is a qualified "yes," in that, with the lowest reserve base of the Big 3, and with very favorable prospects domestically and internationally (as explored in this post), it is possible that CNOOC's reserve base could increase at the highest rate. Note also that it has been the case in the past that the Chinese government -- which owns the majority of all Big 3 Chinese oil firms -- has given assistance to one of the Big 3 in order to help the firm become a more vigorous competitor to the largest firm, PetroChina. That is to say, based on its intended industry model, China will likely prefer to have three very competitive international supermajors and not just one (PetroChina) in the future.

Two examples come to mind in support of a multi-firm model for the Chinese oil industry: first, the Chinese government is directly paying Sinopec funds in order to offset losses in Sinopec's refining division, as the price of gasoline in China is at low levels, in order to support Sinopec's financial competitiveness. This transfer of funds to Sinopec can be viewed as support of Sinopec's competitive position vis-a-vis PetroChina.

Second, typically only one oil company in China will bid for oversees projects, in order for one Chinese Big 3 firm to not "outbid" another and make the project more expensive than it could be with multiple Chinese firms bidding -- sort of an understood cooperation between the firms -- because the base owner of all firms is the Chinese government. As an example of this understanding, Sinopec was given favor over PetroChina in bidding for the development of Iranian oil fields in 2005 through 2007.

In summary, it is the author's opinion that it is unlikely that PetroChina will win a significant majority of all oversees Chinese projects in the future, as China will most likely want to spread around future oversees projects in order to maintain meaningful competition between its Big 3.

CNOOC Producing Areas:

CNOOC mainly operates in offshore exploration and production (upstream operations). CNOOC currently derives approximately 94% of its oil and gas production from domestic (Chinese) offshore production. Going forward, Bohai Bay and oversees areas, mainly Africa and the Middle East (Iran) offer very high potential for reserve increases. The major producing areas are listed as follows:

Field Name 2006 Production (0il KBpd/gas mmcf/d) Reserves (oil MBoE/gas bcf) Notes
Bohai Bay 200.9 /64.5 933.4/765 Largest overall producing area, competes with PetroChina for development in Bohai, future prospects positive
Western South China Sea 40.4/251.8 190.5/2,648 Largest natural gas area, mainly develops reserves with oversees partners
Eastern South China Sea 105.9/23.1 200.2/792.0
East China Sea 1.5/21.2 20.4/390.0 Smallest area and reserves have not been increasing y/y
Oversees 24.0/130.3 145.3/1,636.5 Oversees represents mainly Indonesia and Australia, as Africa and Middle East deals are not counted in reserves as of 6/07

Bohai Bay:

Bohai Bay in Northern China is CNOOC's largest production area currently, and, over the near term, is the Company's highest priority development area. The area has significant potential, as in March, 2007, PetroChina discovered 7.3 Billion Barrels of Oil equivalent in Bohai Bay, the largest discovery in China over the last 30 years. (Development costs for the exploratary wells totaled $780M for PetroChina)(Note also PetroChina's stock moved up 12% with the announcement of the discovery). CNOOC has stated that it has several prospects for Bohai Bay going forward.

Near Term Production:

CNOOC has forecasted low production growth in 2007, of between 0% and 5%, as it brings new projects online. 5 projects are forecasted to come online in 2007 and are projected to reach full potential in 2008, 75% of these projects offshore China. CNOOC has forecasted investment expenses of $US512M development expenses.


CNOOC's two most substantial oversees projects are offshore Nigeria and offshore Iran. These two projects are discussed below.

Offshore Nigeria:

CNOOC in 2006 purchased 45% of Nigeria's offshore Alcpo Field for $US2.7Bn from the majority owner Nigeria National Oil Corporation (the national oil company of Nigeria). The field is classified as a "giant" field, with 620M barrels of oil proven total and 3.75 tcfe of natural gas (approximately 600MBOE), and oil numbers represent light, sweet oil. The reserve numbers are not consolidated in CNOOC's reserve numbers as the deal was completed in late 2006. The purchase price based on existing reserves represents $4.60 per barrel of equivalent. CNOOC's share of oil is expected to be 79,000 bpd of oil and liquids and 96,000 BOE per day of natural gas, according to PFC Energy. Further, the field has been lightly explored to date so further increases in reserves and production are possible going forward -- CNOOC has expressed the opinion that it is hopeful that oil only reserves will increase higher than 1 billion barrels.

CNOOC can consolidate more 45% of the purchase onto its books which means approximately a 20%-25% increase in overall reserves at the end of 2008 from this deal alone from CNOOC's current reserves base.

Offshore Iran:

The project with the most reserve upside for CNOOC is the development of the Pars natural gas field off offshore Iran, which was announced in late 06, amid opposition from the United States (due to sanctions, discussed below). The Pars gas field is the largest single, known natural gas field in the world, with Iranian reserves of an estimated 280 trillion cubic feet of natural gas, and an additional 17 billion barrel of natural gas liquids. The natural gas portion of the field is equivalent to an incredible 46 billion barrels of oil equivalent., which in turn, represents 17.7x total reserves of CNOOC at year end 05 (!).

Production is slated to start in 8 years (2014-2015), initially producing 20M tons of LNG a year -- equivalent to approximately 433,000 barrels per day. The numbers would presumably (although the author has not seen anything confirming this, the author's opinion only) move higher to the 1 million BOE range, as the field is of supergiant size.

Details of the joint development plan between Iranian National Oil Corporation and CNOOC -- including reserve recognition and income agreements -- have not been fully disclosed at as the date of this writing (6/07), although there have been contradictory reports out of China concerning the details of the agreement -- in late May 07, CNOOC reported that a final agreement was due in August 07, while a few days later, CNOOC denied that the Pars field agreement would be signed then. Most likely, CNOOC is trying to keep a low profile on this project due to the opposition from the US government, which has economic sanctions initiated against Iran. The US, for its part, is holding hearings in the US Congress and Senate to determine if CNOOC should face sanctions for this deal with Iran.

The question that is most important to investors is, will the agreement between Iran and CNOOC move forward? China, with its ravenous appetite for energy, is unlikely to drop the deal with anything less than extreme pressure from the US -- and even with extreme pressure, it is not clear that China will drop this deal. Iran is also not likely to drop the deal with China as it views cooperation with American, and to a lessor extent, European firms as unattractive, given its geopolitical situation. The question therefore becomes, will and can the US bring extraordinary pressure on CNOOC?

Typical pressure includes high level meetings and economic sanctions. It is beyond the scope of this analysis to completely judge if the deal will go forward. At this point, with the limited information available, the odds of the deal are placed at an even 50/50%.

Note however, even if the deal does not go through, more and more Islamic states are looking to cooperate with China verses the West on energy development due to geopolitical concerns, which is a positive for CNOOC and the Chinese Big 3.


CNOOC represents a significant portion of future Chinese offshore oil production. CNOOC will see increasing competition from the other two Chinese Majors, Sinopec and PetroChina, as these firms move offshore, but CNOOC is forecasted to obtain its fair share of offshore reserves going forward. As such, CNOOC represents a compelling buy at its current market capitalization at 6/07 of $US50Bn.

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