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CNOOC seeks fortune in the west with Nexen takeover

China’s bid to buy Canadian producer Nexen has met with a cautious reponse

China National Offshore Oil Corporation (CNOOC) is involved in the country’s richest foreign takeover attempt yet – a deal that encapsulates the company’s ambitions, but also the challenges it faces in its headlong global expansion.

Seven years after it failed to buy US producer Unocal, on 23 July CNOOC announced plans to take over Canadian producer Nexen Energy. CNOOC Ltd has agreed with Nexen management to acquire the company for approximately $15.1 billion.

Some pundits expressed surprise that CNOOC is willing to put its reputation on the line so soon after its high-profile, embarrassing failure to acquire Unocal. The Unocal deal was scuppered in 2005 in a rare example of Congressional bipartisan support during the Bush era. The deal foundered on concerns about national security and the lack of reciprocity for US firms wanting to enter China. Yet other analysts point out that the Chinese have learnt from this and are much better prepared for the battle ahead.

First off, there’s a juicy premium to the deal’s price, meaning there’s less likely to be a counter-offer from a western company. ChevronTexaco ultimately snared Unocal with an improved offer a month after CNOOC’s. This time around, CNOOC is offering $27.50 per share, a 61% premium to the closing price of Nexen’s common shares on the New York Stock Exchange on 20 July.

Realising a hostile takeover would have been unpalatable, the Chinese also correctly foresaw that a hefty premium would help bring on board Nexen’s management, who have unanimously backed the deal. Likewise, the Chinese have already secured the backing of major shareholders, according to analysts and media reports. The company has called a special meeting of shareholders for 20 September in Calgary.

Furthermore, CNOOC laid the groundwork for the deal over the past seven years by partnering Nexen and other Canadian outfits in a variety of projects. Through its $2.1bn purchase of Opti Canada, CNOOC now works closely with Nexen at the Long Lake oil sands property, where CNOOC has a 35% working interest.

And, unlike the situation seven years ago, western governments are less fearful of Chinese investment. Indeed, given the economic slowdown, many are in need of China’s cash.

“Attitudes to Chinese investment have since changed to some extent in North America as evidenced by CNOOC successfully acquiring a 33% interest in two large shale projects in the US last year in partnership with Chesapeake Energy, as well as stakes in four deep-water Gulf of Mexico wells and other exploration blocks in Alaska,” notes IHS Global Insight.

Government approval

Even so, as well as shareholder approval, the takeover also needs to be sanctioned by the governments of the various countries where Nexen has operations (it has assets in Latin America, Africa, Europe and the Middle East). The Americans may require the divestment of some of Nexen’s assets, most probably those in the US Gulf of Mexico. The deal could also face resistance from British regulators concerned about CNOOC acquiring the Buzzard field, which is influential in pricing the Brent benchmark.

Most pertinently, the Canadian government is required under law to establish whether any proposed foreign takeover is of “net benefit” to Canada. Gerry Angevine of the Fraser Institute’s Global Resource Centre, an independent Canadian public policy research organisation, points out that while CNOOC Ltd is a listed firm, its parent CNOOC is owned by the Chinese government. CNOOC’s top executives are members of China’s ruling Communist Party. “In effect, Nexen would become a crown corporation, but one controlled by the government of China instead of Canada,” Angevine says. “Takeovers by state-owned companies are simply not in the best interest of Canadians, given the long, sorry record of such companies.”

It doesn’t help that the announcement of the deal was marred by accusations of insider trading by a brokerage controlled by the chairman of China Rongsheng Heavy Industries Group Holdings, a shipbuilder which counts CNOOC as a customer. CNOOC executives are assisting the US Securities and Exchange Commission in the investigation.

CNOOC has offered the Canadian government some sweeteners, such as a pledge to retain employees and establish a head office for its North American and Central American operations in Calgary, both important considerations at a time of rising unemployment. CNOOC has attempted to highlight the benefits of the deal to Canada by “implementing and enhancing Nexen’s current planned capital expenditure programme”, which involves planned spending of up to $3.2bn.

So far, the Conservative government of Prime Minister Stephen Harper has only made ambivalent comments about the deal. Yet analysts like Daiwa Capital Market’s Adrian Loh reckon the government is unlikely to block the deal, given that it wants to sell more oil and liquefied natural gas to China, and it recently approved a Glencore-led deal that the market regarded as more strategic. “Reciprocity” appears to be a key word for ministers.

“In any case, Nexen is not entirely Canadian, as it has assets in the US, Nigeria and the UK,” says Loh. “However, the approval process is likely to take a few months.”

If the deal is not approved, it would be a big loss for CNOOC. Despite the premium, CNOOC is willing to pay for Nexen, Loh says the positives of the deal outweigh the negatives.

Above all else, Nexen gives CNOOC Ltd reserves. Via the acquisition, CNOOC Ltd will get proved (1P) reserves of 900m barrels of oil equivalent (boe), which would provide a significant boost to the company’s 1P reserves of 3.19bn boe held at the end of 2011. CNOOC has only nine years worth of reserves based on its current production rate, believed to be one of the lowest among international oil companies.

Those reserves also come at a reasonable price. The implied acquisition multiple of 1P enterprise value per boe (EV/boe) of $19.89 is less than CNOOC’s current $22.55/boe, while at 2P EV/boe the Nexen deal looks even cheaper, at $8.85/boe, compared with Daiwa’s estimate of $18.04/boe for CNOOC. For the first half of 2012, CNOOC said its average realised oil price reached $116.91 per barrel, representing an increase of 8.1% year on year.

Nexen’s production in the second quarter was around 207,000 boe a day (boe/d), which is 22.7% of CNOOC Ltd’s average production of 909,041 boe/d during 2011. In its first-half results, released on 21 August, the company kept its production target of between 330m-340m boe for 2012 as it launches four new projects offshore China. If the Nexen transaction goes through on schedule in the fourth quarter, CNOOC Ltd will see significant increases in output by the end of the year.

However, that 2012 production target highlights the problem that CNOOC faces: the struggle to grow at a time when tighter reserves mean further moves into more costly development projects.

The 2012 production target is lower than the target of 331m-341m boe for 2011. In the first half of the year, CNOOC saw its production fall by 4.6% year on year to 160.9m boe, less than half the full-year target.

CNOOC Ltd said net profits for the first half of the year were RMB31.869bn ($5.01bn) compared with RMB39.343bn in the first half of 2011. The decline was caused by a RMB5.805bn drop in sales revenues for the first six months of the year caused by the state-mandated shut-in of the leaking Penglai 19-3 oilfield in the Bohai Bay from September 2011.

Rising costs

Higher exploration costs also pulled down CNOOC Ltd’s net profit by RMB3.046bn, caused in part by higher industry costs, but also the launch of deep-water drilling in the Pearl River Mouth basin and drilling in high-pressure, high-temperature reservoirs in the Yinggehai basin, says IHS Global Insight.

For all that, analysts and rating agencies say CNOOC is well placed to weather the challenges ahead.

In August, Reuters quoted CNOOC Ltd as saying it has a cash pile of more than RMB100bn, although it still plans to raise more capital to fund the $15.1bn acquisition of Nexen in order to maintain its credit rating.

Moody’s Investors Service, which rates the company "Aa3", said the proposed acquisition would weaken CNOOC Ltd’s standalone credit profile, but its rating won’t change because of strong support from the parent. And while the weak first-half performance is credit negative, “CNOOC’s current strong financial profile is resilient to any temporary drop in earnings and cash flow… [and] the shortfall in production was mainly due to some one-off incidents, such as the suspension of Penglai 19-3, scheduled maintenance, and some asset sales.”

Even before the Nexen acquisition was announced, CNOOC Ltd management were talking about 2013 seeing a spurt in production growth, adding this would ramp up further into 2014 and 2015. With Nexen’s technology and operating experience at its disposal, CNOOC could play a key role in opening up China’s potentially huge bitumen, heavy oil and shale oil resources, as well as its coal-bed methane and shale-gas deposits.

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