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How to profit from China's oil hunt
The awakened giant wants to guarantee itself a steady oil supply, which might mean buying an oil company or two. Here are some takeover candidates.
By Michael Brush
When talk of a possible takeover of Unocal (UCL, news, msgs) by China's main energy company set a fire under Unocal shares in early January, many energy analysts around the world sat up and had the same thought. Where else might CNOOC (CEO, news, msgs), China's state-run energy company, or another Chinese energy company strike? After all, China has a powerful thirst for energy to help fuel its growth, and that's not going away soon.
The second-largest energy importer behind the United States, China takes in about 6 million barrels a day. The figure is expected to double in the next 15 years, says Amir Arif, an energy analyst with Friedman Billings Ramsey. "Given that current global supply is about 83 million barrels per day, that is a very big number," says Arif. "So the Chinese have been scouring the globe to secure supply."
Put another way, on average the Chinese use about 1.8 barrels per person a year, compared to average consumption in the United States of about 25 barrels, says Charlie Maxwell, an energy analyst with Weeden & Co. Rapid economic growth will only move China towards Western consumption levels. "Will the Chinese ever use five or seven barrels per year? That would be a huge increase," says Maxwell.
One more factor: China uses a lot of coal, and there's grumbling around the world from environmentalists about this because the pollutants don't stay in China. The country will likely come under more pressure to convert its coal-fired power plants to natural gas.
All these factors suggest China will continue to be on the hunt for foreign energy reserves for years to come, which will have the following investment consequences under three possible scenarios.
Sticking nearby
Scenario no. 1: China wants energy supplies close to home, so it'll go after companies that have plenty of reserves in the region.
This scenario makes some sense because it comes straight from the playbook behind the discussed CNOOC takeover of Unocal. According to the reports, CNOOC wanted to strip out Unocal's non-Asian reserves and keep its energy reserves in Asia, which could be more easily transported to China.
If this really is a big part of the Chinese thinking, that makes companies like Talisman Energy (TLM, news, msgs) and Murphy Oil (MUR, news, msgs) potential takeover targets or partners, since they have extensive energy holdings in the region. Neither company returned a phone call seeking a comment. The major oil companies with reserves near China, like Royal Dutch Petroleum (RD, news, msgs), are too big to be takeover targets.
Broken off from BP (BP, news, msgs) in 1993, Talisman was one of the first energy companies to recognize the limits on North American production and branch out abroad, says Morningstar analyst Mark Uptigrove. This helps explain why it now has assets in Southeast Asia that might be attractive to China. The company also has reserves in the North Sea, Africa and western Canada.
Murphy Oil picked up some of the richest reserves in the world a few years back, in the Sabah Trough off the coast of Malaysia. Those reserves make it attractive to China if the country really wants reserves in its part of the globe. Fadel Gheit, an energy analyst with Oppenheimer, however, doubts that Murphy is for sale, citing family control at the company.
Critics of this "close to home" scenario protest that it's really not hard to ship crude oil and liquid natural gas around the globe. So there isn't really a need for China to shop nearby for reserves. They favor the next scenario.
Taking the long view
Scenario no. 2: Chinese oil companies are controlled by the government, and the government thinks in a long-term, strategic manner. So it'll go after long-lived reserves that aren't going to run dry in a few years.
This immediately rules out most U.S.-oriented energy companies as targets, since U.S. reserves are largely in decline. "Any potential target would have to be a big resource play, something that is going to be there for a long time," says Shawn Reynolds, an analyst with the Van Eck Global Hard Assets Fund (GHAAX).
Canada, for example, has massive reserves of crude oil locked up in the form of "tar sands," vast areas in Alberta where a tar-like substance is mixed in with sand. Oil companies mine the sands and put it in hot-water tanks to separate the sand from the oil, which then gets refined.
Canadian tar sands are extremely attractive to the Chinese. The reserves are huge. Friedman Billings' Arif says Canada oil sands contain about 175 billion barrels of oil, second only to Saudi Arabia's estimated 250 billion barrel reserve base. The "decline rate" is minimal, too. The oil sands reserves will last for at least 50 years, says Arif. Then there's less political risk in Canada than in places like the Middle East, Russia or Venezuela.
What's more, small companies with Canadian oil sand reserves like Deer Creek Energy (DCRKF, news, msgs) and UTS Energy (UEYCF, news, msgs) need capital to develop them, says Arif. So a link with Chinese energy companies would be natural, says Arif. He doesn't rule out a Chinese joint venture with the larger Canadian Natural Resources (CNQ, news, msgs). Arif also expects that China may invest in a pipeline company like Enbridge (ENB, news, msgs) to help fund a pipe to Canada's west coast. From there, crude could be more easily transported to China. (The three companies also are listed on the Toronto Stock Exchange.)
"I can understand why we have been mentioned, because we are one of the few independent companies in the area of Canadian oil sands. But we are not in any type of discussions with the Chinese," says John Kowal, Deer Creek's finance chief. UTS, Canadian Natural Resources and Enbridge didn't return calls seeking comment.
"Canada needs the markets and China can provide the money to help develop the oil sands," says Arif. "So to me it is a win-win situation, and you are bound to see some deals in 2005."
Nexen (NXY, news, msgs) is another potential target or joint-venture partner because it has long-lived assets including Canadian oil sands holdings, says Darren Peers, an energy sector analyst with Nuveen NWQ Multi-Cap Value Fund (NQVAX), which is up 12.5% annually since it was launched in late 1997. It also has long-lived reserves in West Africa and the Gulf of Mexico. A Nexen spokesman says, "A number of the Chinese companies have been through Calgary talking very broadly with the Canadian oil sands producers." But he declines to comment specifically about his company.
Apache (APA, news, msgs) could also fit the bill as a partner for a Chinese oil company looking for long-lived reserves, because of Apache's big energy reserves in Egypt. Apache declined to comment.
A profitable upgrade
Scenario no. 3: Chinese refineries can only handle light grades of crude coming out of places like West Africa and Russia, and not the heavier forms like those from South America. This suggests China either has to focus on companies producing this kind of crude or upgrade its refineries.
Many analysts, including Oppenheimer's Gheit, think China will go for the second option. If so, it would provide a boost for companies that help build refineries, like Fluor (FLR, news, msgs), Halliburton (HAL, news, msgs), Jacobs Engineering Group (JEC, news, msgs) and Foster Wheeler (FWHLF, news, msgs).
Will outright purchases of foreign oil companies really be the best way to secure energy? Perhaps not. Many veteran oil sector analysts, for example, immediately wrote off the talk of a Chinese bid for Unocal, which sent the stock to over $46 from $41 in a matter of days. The skeptics point out that pundits have speculated Unocal is a takeover target for over a decade. "There are only rumors and who knows exactly where that came from," says John Segner, manager of the AIM Energy Fund (IENAX). "It could just be a rumor floated by some investment banker that wants to sell a company."
Besides, outright takeovers would mean Chinese state energy companies would have to shell out high premiums. And they'd likely drive out current managers and their expertise, which Chinese energy companies need because they've been focused on China for so many years. "They need the management expertise, and if they did a full takeover they would lose a lot of the top managers," says Charlie Ober, who manages the T. Rowe Price New Era Fund (PRNEX).
That's why joint ventures might be more common. "I don't think they necessarily have to buy companies, because they would have to pay a premium and they can get the same benefits with joint ventures," says Larry Goldstein, president of Petroleum Industry Research Foundation.
But even joint ventures with a major energy buyer like China will likely boost the shares of companies going into such agreements, if the deals provide a cheap source of capital and guaranteed demand for years to come.
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