CNOOC's well-oiled machine

CFO Mark Qiu, Salomon''s former oil and gas expert, talks strategy.

The CFO of China's premier oil exploration and production company rushes into the interview room at CNOOC Ltd's headquarters with the tense look of a man who has been "running with wolves", in this case the indefatigable and undeniably lupine Hong Kong press pack - eager to glean more information about the company's just-announced first-half results.

In CNOOC Ltd's case the press pack had little negative news to chew on, with the company increasing pre-tax profits by 11% to Rmb6.46 billion ($778 million) on the back of lower production costs and increased oil and gas production.

The company's share price reflects the company's improvement, and has risen around 21% to HK$7.30 since the company listed in Hong Kong and New York earlier this year, raising $1.4 billion from its IPO.

However, first half net profit fell 4.2% to Rmb4.62 billion as the company's tax bill doubled, in the wake of the termination of its previously beneficial tax status.

But this was no surprise as the company, proud of its corporate governance, had long made investors aware its tax status would change at the end of 2000.

It does, however, beg the question of whether any other special deals the company has arranged with the government are likely to end in the near future. For it is a well-known fact that investors in China prefer certain market-oriented reforms, although much lauded in principle, to stop short of a company in which they invest in.

CNOOC Ltd's ace up its sleeve is that it has exclusive exploration and production rights to the offshore market, and CNOOC Ltd does not expect that to end "in the foreseeable future". Qiu adds that this monopoly does not conflict with any international or World Trade Organization regulations, since any country has a sovereign right to protect, and benefit from, key industries.

Qiu explains how the process works.

"Foreign, as well as domestic companies such as Sinopec and PetroChina may carry out exploration and production activities identical to ours. But we have the privilege of æbacking into' a successful find, and taking a 51% stake in it," explains Qiu.

Qiu expresses his satisfaction with other figures just released for the first half of this year.

"Production growth is up 9% and the first half normalized return shows ROE (return on equity) is 30%. In particular, our production costs are low. The all-in expense per barrel is $8.15 per barrel (while international crude oil prices hit almost $36 per barrel last October and now hover around $28) and CNOOC Ltd achieved a price of $25.81 per barrel, the discount reflecting the quality of oil CNOOC Ltd produces," he says. The average price for a barrel of crude oil for the past five year is $22.30.

Qiu believes crude oil prices will continue to hover in the range of $22-$28, maintaining what has already been an unusually high-priced cycle, supported by OPEC's recent resolution to uphold oil prices and to stick to production quotas.

The inability of non-OPEC oil producing countries to put on capacity quickly should also support oil prices, says Qiu.

"We are enjoying 15% CAGR (compound annual growth rate) but we are talking about an industry which is targeting 5%, showing that it is becoming more and more difficult for non-OPEC countries to add capacity."

The healthy production cost figures are an extremely important indicator of the profitability for exploration and production companies, Qiu said, as that is the only area in which they compete with other companies, as the prices of crude oil is largely fixed - in both senses of the word - by OPEC.

CNOOC Ltd is eager to capitalize on the high price of oil by continuing to expand its crude oil production facilities, although it already has an inventory which can cover its sales for at least the next three years.

Qiu emphasized that for the next three years, CNOOC Ltd's profits did not depend on exploration success, since the company had sufficiently high inventory on the books to ensure production growth. This is an extremely low risk situation to be in, said Qiu.

Referring to future growth, Qiu says that China's potential oil exploration area (all along the coast of China, a distance of some 14,500km) is twice the size of the Gulf of Mexico and is full of potential. There are currently just 700 wells in operation, compared to over 20,000 in the Gulf of Mexico.

Chinese oilfields are sufficiently large to easily double CNOOC Ltd's current reserves of 1.8 billion barrels, estimates Qiu.

They are also relatively easy to access, since the oilfields CNOOC Ltd is exploring are in shallow waters, at a maximum depth of 200 metres, compared to up to 1,000 metres for oil fields in Brazil, for example.

Since China is a net oil importer - expected to import 100 million tons this year - the lion's share of CNOOC Ltd's production is sold domestically.

However, the company is free to set the price of crude oil it sells in line with the international price.

CNOOC Ltd is a pure exploration and production company and Qiu sees no interest in diversifying the company's operations.

"Downstream operations at the moment are not up to the returns being generated in upstream operations, so there is no point in entering those areas just for the sake of it," he says.

Additionally, downstream activities are a market-driven environment, while up-stream is a more predictable environment, where success rates can be averaged out and predicted based on technical exploration and engineering skills.

"Who knows how well we can compete (in the downstream market) with oil giant such as Exxon Mobil and Shell, who together control 80% of petrochemical's industry's research and development, and control the majority shares of patents and processing capacity?" asked Qiu.

However, CNOOC Ltd does have a presence in the downstream natural gas market via its parent, CNOOC, a state-owned company which owns 70% of CNOOC Ltd, and has established a petrochemicals joint venture with oil major Shell.

"The parent company is very healthy and not money hungry, it does not have heavy legacy costs, has no debt and is sitting on $1.6 billion of cash on the balance sheet as well as having profitable subsidiaries. It also has a very clear business strategy focusing on oil field services, and CNOOC Ltd's own substantial capital expenditure in the next several years provides them substantial growth and profit opportunities, as well as mid-stream and down stream natural gas projects," he said.

The parent received a dividend of $0.10 per share, translating into a yield of just 1%.

Qiu says that the listed company has the option to participate in any of the natural activities of the parent. This means CNOOC Ltd can share in the upside of natural gas finds and development but need not share in the risk.

As to whether he sees other Chinese oil majors or international companies as his prime competitors, Qiu says that from the point of view of accessing international capital markets CNOOC Ltd is competing with other oil companies' worldwide.

As to the impact of tariffs on CNOOC Ltd's business after WTO, Qiu is confident that the proximity of CNOOC Ltd to Chinese businesses will be a competitive advantage, whatever the tariff levels. Importers of crude oil in China currently have to pay Rmb16 per barrel of crude oil but this will fall to zero after China joins WTO, in all likelihood on January 1, 2001.

"But from the point of view of the (domestic) refiner, the net cost of our crude oil will be the most competitive, as it will be pumped over a much shorter distance than the oil of foreign companies," asserts Qiu.

As for raising capital, Qiu said he had an under-utilized balance sheet and did not need cash at the present moment.

Asked about the possibility of listing on the domestic equity markets, famous for their cheap capital, Qiu says that as a red chip (a Hong Kong registered company with primarily mainland business interests) the company may not at present list domestically, but that this could change in the future.

One threat to the share price of mainland companies, and which has spilt over into Hong Kong-listed mainland companies, is the government's decision to help finance its social security burden by selling down part of its majority stake in all the former state-owned enterprises that have launched IPOs.

During the CNOOC Ltd IPO earlier this year, for example, 10% of the old shares were sold down, raising $200 million for the government.

But Qiu says he is confident that this will have no bearing on the company's operations.