A twice out of favor opportunity
A twice out of favor opportunity
Ticker CNOOC Limited Ticker 0883.HK Market cap RMB 412B / $53B Website https://www.cnoocltd.com/ Dividend yield 6.5% Price to Free Cash Flow 2.9 P/E 6
Disclaimer: I intend to purchase CNOOC shares, through a company I control, and I am likely to increase this position in the future. This article is for educational purposes only, please do your own diligence, as this does not constitute investment advice. Full disclaimer can be found HERE.
Executive Summary
This report is covering CNOOC, the Chinese national offshore oil company. The stock is still depressed from the 2020 crash and did not recover compared to other oil stocks, due to negativity on oil Chinese stocks.
The general risks for Chinese stocks is not of great concern for CNOOC compared to other sectors like real estate or tech. Geopolitical risks exists, but short of a US-China war, CNOOC assets should be safe. If China manage to share exploitation of the South China Sea with its neighbors, this will benefit CNOOC.
Production is expected to keep growing thanks to domestic and oversea (mostly Guyana) discovery and development. Profitability is high. Ratios from P/E to price to free cash flow reflect a severe undervaluation. Dividend is at a 6.5% yield and should climb higher in 2022 and stay high later on.
The beauty of offshore
Two months ago I gave with the RIG/Transocean report a detailed argument of why offshore oil is paused to be the big winner of 2022-2025. Essentially, oil has been discovered in too little quantity for too long, and more capex and exploration will be vital to avert a massive energy crisis.
It was very well resumed in the tweet below. Since 2015, we consumed 160 billion (With a "B") barrels of oil more than we found. Worst this was even the case during high oil prices, like in 2011-2013.
Do you understand this chart?
Do you understand that since 2015, the World has found 39 billion barrels of oil but consumed 208 billion?
Do you understand even with $100 oil in 2011-2013, world oil discoveries were only 28-40% of consumption?
Please tell me you understand this https://t.co/aseWuOurqD pic.twitter.com/L8If3tt6SR— SRSrocco Report (@SRSroccoReport) December 30, 2021
Most of the easiest-to-find and pump oil fields have been found and are in terminal decline. It is very unlikely that we ever find again oil fields like the Saoudian's.
For a temporary period, shale oil gave us some respite. But shale needs to be permanently drilled to maintain production and has struggled to ever be cash-flow positive. With Tier 1 shale deposits already drilled and depleting, shale costs are likely to keep rising and need $60-$80 just to break even.
But this is not true for offshore deposits. Guyana deposits discovered by Exxon (and shared with CNOOC) have a break-even cost of $35/barrel, or maybe as low as $25/barrel. Petrobras in Brazil is managing a similar $35/barrel, down from $48/barrel a few year ago.
In addition to being cheaper, offshore oil fields are also lasting years or decades. This provides its operator solid protection from inflation. All the exploration, licensing, drilling, and development costs are in the past, but the future income is likely to follow inflation.
What I like here is getting inflation protection AND being paid for it. It used to be possible with other, less risky assets, like inflation-linked bonds. But with bonds offering ridiculously low yields, we need to look for alternatives.
Is it too late to bet on oil?
Staying away from western producers
Oil producers have provided one of the best returns in the market in 2021, after the horrible Covid-induced crash of 2020. So is it too late to get on board? For the main international major, I would say so.
For example, Exxon stock has already doubled. How much potential to the upside is left? Probably some, but not as much as I would like.
Besides prices consideration, I am myself going to avoid all the Western energy producers. They are all, some slowly like Exxon, some quickly like Shell, taken over by green activists or bullied by their government to reduce production.
Activist group targets Exxon with shareholder climate resolution
Dutch court rules oil giant Shell must cut carbon emissions by 45% by 2030 in landmark case
The only reaction to exploding electricity price and risk of blackout in Europe is "it shows we need more solar and wind". I expect activist pressure, court rulings, and government bullying aiming to damage oil companies to intensify over the 2020s. Probably until something break in our energy infrastructure. Staying out of the way of this trend is matter of survival for investors.
This leaves us with non-Western national oil producers.
The possible targets
The ones that almost made it
As I said, I would like a focus on offshore, as onshore oil fields are now all old and in terminal decline. Fresh, recently started offshore has a lot more potential for extra discovery and longer than expected reserves. So this excludes all the Gulf oil companies.
One good option is Brazil's Petrobras. The company used to be horribly mismanaged and seems to have finally reformed enough to be a viable investment. This report almost covered Petrobras, but it happened that Sven from www.undervalued-shares.com just published an excellent (premium) report on that exact company. I feel like his report is a great complement to mine, so I recommend you to go to him and give it a look.
Another option would be the Russian national energy companies. The arctic deposits are probably full of undiscovered resources even if at slightly high production costs. However, the recent escalation between NATO and Russia over Ukraine and Kazakstan is worrying me.
The tone from Russian officials has changed from serious to outright threatening and insulting. I am not sure that it has ever been that bad since the Cuban missile crisis... In any case, probably enough to hurt Gazprom stock price despite record profits.
Russia slams US statements as ‘baby babble’
This is why I have taken all my gain from my Gazprom shares and am looking to have a more geographically diverse energy exposure. Part of it will be with Petrobras. Part of it will be the company covered in this report, CNOOC.
My pick, CNOOC
CNOOC is the acronym for China National Offshore Oil Corporation. This is the state company focused on developing offshore oil production, distinguishing it from the other giant Chinese oil company, Sinopec and Petrochina, respectively focused on onshore production and downstream activities. CNOOC has also way better margins than the other two.
Do you remember the Exxon stock chart, showing that a lot of the price recovery had already occurred? Well, this is far from true for CNOOC. In the last oil bull market, CNOOC was at a share price of 250, roughly twice what it is today. It is still in the same price range as it was at the end of May 2020.
Beyond the stock chart, the company ratios are all screaming cheap, and the dividend yields seem pretty decent. Despite brutal energy shortages and the perspective of fast depleting reserves worldwide, CNOOC is still valued as if oil price would never go stay at the current $70-$80 range. Any possible oil field discovery is also not priced in ... yet.
At the crossroad of 2 trends
Last year, the whole energy sector was dramatically undervalued and most producers rebounded accordingly.
What stopped CNOOC to perform as well as its peer was that China stocks have had an ... interesting year. For example, the tech-focused ETF PGJ is now half what it was a year ago. The leading name in Chinese techs like Alibaba and Tencent have suffered similar or even worse crashes.
As you know, my core strategy is to find the point where multiple trends are intersecting. Here, we have lingering worries about the energy sector + panic about China's "investability". Together, it provides us with a quality company at a discount.
At the heart of investors' disaffection for Chinese stocks was the threat by the Chinese government to dismantle its tech monopolies to preserve the power of the central government and the Politburo. For some companies like Didi, China's equivalent of Uber, this meant a disastrous IPO and incoming delisting from American stock exchanges.
China issues new anti-monopoly rules targeting its tech giants
If that was not enough, Evergrande, the country largest real estate developer, collapsed. And it brought down with it multiple other large developers and potentially the whole Chinese real estate bubble. This put into question the viability of Chinese economic growth. And of the world economic recovery with it.
Other news were not much more cheerful, with Covid outbreaks, geopolitical tensions and threats of Olympic boycotts for example.
CNOOC the company
In these reports, I normally spend a lot of time studying the company business and financials. With CNOOC being mostly Chinese, and in only one business, offshore oil, I will be able to keep that part short and mostly focus on the less known gorwht opportunity lying ahead.
Once this is done, I will discuss China's country risks, and if CNOOC's discount is worth exposing yourself to them. So this report will be a quick-ish analysis of the business itself, followed by a deep-dive into China-specific risks, and how they might affect CNOOC.
But first, let's look at CNOOC itself.
The business
CNOOC is producing 1.4 mboe (million barrel or equivalents) per day (this include both gas and oil), or 526 mboe / year. This put its reserves at 10y, not bad, but not really stellar either.
Most of the oil is produced domestically, with a few projects oversea.
One key asset is Bohai, in the gulf east of Beijing and next to Korea. Bohai represents roughly 1/3 of the company's production and a bit more than 1/4 of its reserves. The region does seems to still have potential for long term production, with a new discovery announced in September equivalent to 714 mboe (oil measuring units can be confusing, to convert tons of oil mentioned in the article to boe, go here).
To have a better understanding of China's oil resources, I recommend this report by Carnegie. Before I started that report I assume that most Chinese oil resources were offshore. Little did I know about multiple tight oil fields onshore.
This has some potential for Sinopec, not CNOOC, and I am skeptical of tight oil in general. So good for China, but one more reason to stay away from Sinopec if they are forced to develop unprofitable tight oil for strategic reasons. CNOOC is marginally involved in some onshore projects in the Erdos Basin and the Quinshin Basin, but most shale deposits seems to be the domain of Sinopec.
For that matter, China as a whole is producing almost 5 mboe/day, which makes it the 4th largest producer in the world. Ahead of Iran, Iraq of the UAE. Only Saudia, Russia, and the USA a producing more.
While the Chinese oil demand of 12.7 mboe/day clearly outstrips its production capacity, I never realized that China was that massive of a producer. So I guess some readers might be surprised by it as well.
The other CNOOC's main assets are the South China Sea offshore fields.
The Eastern fields (including the Pearl River Mouth Basin) represent 1/4 of reserve and 1/5 of production
The Western fields (Yingquiong Basin) are just 1/6 of reserves and 1/8 of production.
The rest is the little bit of onshore I mentioned, and overseas projects.
Oversea projects are making the last third of CNOOC production with minority participation in multiple projects over the world. The oversea segment will be a larger part of the company in the future (see below in the segment "going forward" and Guyana / Staboeck discovery) and will make a large part of the future growth in production and reserves.
It is also operating one offshore wind power project, with a planned installed capacity of 300MW.
Financials
The year 2021 was marked by record production and a recovery in oil & gas prices, boosting revenue compared to 2020. Capex stayed rather low, reflecting the prudent behavior toward recently very unstable oil prices. That capex will go up in 2022.
With oil prices even higher in Q4 2021, we can expect the 2021 revenues in the range of 210-2020 billion of RMB, similar to 2018 revenues. 2021 profitability will be high, with still low capex and increased revenues.
Going back to the company financial, low P/E ratio and high dividend yield are not the results of a one-time off windfall. Instead, it simply reflects the stagnating share prices compared to the company earnings improving with rebounding oil prices.
We can expect 140-150 billion RMG of free cash flow for 2021. With the company valued at 412 billion RMB, this put the price to free cash flow ratio at the extremely low of 2.9 Even assuming a rise in capex next year, the price / FCF is very attractive and below 6-8 in any case.
Dividends are standing at 6.5% right now but will be higher in 2022. CNOOC plans to boost production to 600 mboe and make the dividend payout at no less than 40%.
From 2022-2024, dividends should be at $HK0.70/share, plus a special dividend for the 20th anniversary of the company. Regardless of the stock price, some 7-10% dividend yield seems guaranteed for 2022 and more in later years with the company production growth (short a new collapse in oil prices of course).
Reserves & geology
With oil companies, it is important to see if the geology and costs structure is good enough. First, reserves are at the somewhat low of 10 years long, but it is worth noting that CNOOC managed to maintain the reserves at this level for the last 4 years. They actually increased, with 6% in 2020 (more got found than pumped out).
Whether is come form successful exploration or overly conservative reserve estimate, CNOOC is certainly not running out of oil in 10 years.
Costs are remarkably low, staying below $30/boe, when prices are currently in the $70-$80 range. Even when the company was a lot less efficient in 2013, costs were still low enough to be a dream for any shale oil company. Again, offhsore is so much better regarding margins and assets' lifespan.
Going Forward
Capex will increase next year by 25%, with a new focus on new development and overseas projects. This comes after the massive discovery in Guyana.
The Stabroek Block in Guyana is estimated to be a 10 billion boe field. The field is jointly exploited by Exxon (45%), Hess (30%) and CNOOC (25%). This mean that 2.5 billion boe are attributed to CNOOC, or as much as 50% of its current reserves.
Stabroek is Exxon new flagship project, but I am not willing to take the possibly future erratic governance of Exxon being taken over by climate activists. CNOOC seems to be a much better way to get exposure to the Guyana oil discoveries. We can trust the Chinese government toprefer keeping business running than destroy its energy supply for ideological reasons.
It is also worth noting that more and more discoveries are being done in the Stabroeck area (the latest in October), so potentially a lot of positive news from there.
Stabroeck comes after the other successful "Lisa" oil field (120,000 boe/day production), also in Guyana, in which CNOOC have also 25% interest.
I keep in mind as a small but not zero chance that activists at Exxon manage to force the company to (stupidly) divest its oil assets in Guyana. In such case, CNOOC would be in a prime spot to help Guyana keep its oil boom going by acquiring Exxon share in the project.
CNOOC is also developing its own technical capacity, after years of overreliance on western firms. Notably, it independently developed and produced the "first 100,000-ton deep water semi-submersible platform, Shenhai-1".
One last area of change for CNOOC will be the larger role of gas in its energy mix in the future. By 2025, CNOOC plans to have 30% of its boe production from gas. The recently started Lingshui17-2 field will play a large role to achieve it.
How risky is China?
If you follow too closely Western news, you could be forgiven for thinking that China's economy has already collapsed, the country is totally isolated and that its government is going to return to hardcore communism and nationalize everything.
I want to provide an alternative point of view to the 24/7 news cycle hysteria. Let's first look at China's trade balance on Macrotrend. Does 2020 make China look like an isolated country that no one trades with anymore? When putting to rest the US state department rhetoric about "containment", it is clear that the world is as dependent on Chinese imports as ever.
Real estate, growth and social order
Now let's discuss tech monopolies and the real estate bubble deflating. It is something westerners are intimately familiar with, so it is easy to draw parallels.
2008 was a prime example of how NOT to handle a real estate bubble bursting. The US (and European) government bailed out banks, mortgage providers and let the taxpayers foot the bill. How many billionaires got wiped out in the process? Virtually none.
Now how is China handling it? By making the oligarchs that got rich endangering the country's economy pay for it.
China Urges Evergrande’s Hui to Pay Debt With His Own Wealth
I know this is a populist move, putting the Party on the side of "the people" versus "the elite". Nevertheless, imagine how popular a government of ANY political color would have been for doing the same in a western country. Billionaire losing their money if their company fails? Unheard of. Trump election would probably have never happened to begin with...
China is undergoing a lot of changes. Tech monopoly crackdown, bankrupted billionaire, real estate bubble deflating are all symptoms of a greater change. It is heralding as a new era of "common prosperity".
Why Common Prosperity Is Alarming China’s Billionaires
A key part of this program is to at least slow down the real estate market, at best slowly reduce real estate prices and speculation. The wealthy usually own multiple properties and got richer speculating. The working poor and youth are locked out of the real estate market, with prices growing much quicker than their income ever will.
Sounds familiar? If you are a Millenial or a Gen Z, for sure it must be something you know all too well. The CCP have realize the brewing revolt of the new generation, and decided to act.
China Cracks Down On Real Estate Industry So That Families Can Afford Housing | The Daily Wire
Common prosperity is a societal overall
Let's review quickly some of the key new regulations and changes brought to achieve the common prosperity goal:
abolition of private tuitions
limitation of gaming for minor
organized deflating of the real estate bubble
authorizing up to 3-children per family
breaking down tech oligopoly
investigating excessive and risky lending (especially the Ant Group, branch of Alibaba, but also real estate loans and developers)
The thread linking all these elements is social discontent. From protests about corruption to extreme wealth inequality, video game addiction and the declining birth rate, China's social order is under increasing stress. This put the communist party in a bad light as well. Inequality, corruption, youth frustration, and demographic collapse is not what the Party wants to be associated with.
During its years of aggressive economic growth and industrialization, China has neglected the social consequence of the economic revolution that has hit Chinese society in barely 2 generations. Not anymore. Demography is the crucial part here.
Young people simply cannot afford a decent living. Crowded in small flats, overworked and lonely, they postponed or even gave starting a family. The 996 lifestyle (9am to 9pm, 6 days per week) promoted by Jack Ma and the Chinese tech moguls is also not compatible with children andhealthy families.
As a result, many young Chinese are simply quitting, or "lying flat". Something not dissimilar (even if less dramatic) to the opioid crisis in the US. If you cannot win in that system, stop participating.
So I hope by now, you understand that President Xi-led "common prosperity" is not "China turning back to Maoism" like so many lazy or dishonest commentators are pretending. It is a sincere (even if heavy-handed) tentative to solve social problems stemming from industrialization, urbanization, inter-generation conflicts and capitalism. Something far from unique to Chinese society.
Will it work? Maybe.
Is the method authoritarian by Western standards? Yes.
But at least I must give something to the CCP. It is trying, (even if this might be just out of survival instinct). I personally would love to see a western politician actually addressing social issues like excessive real estate prices, atomization of society and collapsing demography.
Let's not forget Geopolitics
Overall, I do not think that the CCP is intending to return to the pre-1970s era of isolationism and abandon its "capitalism with Chinese characteristics?". So I do not see the common prosperity mantra as a threat for CNOOC.
I also do not expect China to want to aggressively hurt all non-Chineses investors, as this would deal a death blow to its plans to internationalize the Yuan. So a sudden cancellation of the VIE structures is unlikely to happen.
I actually expect that once most Chinese companies are primarily trading in Hong-Kong and Beijing, ownership of Chinese companies will be authorized, and the VIE structures merged with the parent companies. I have explained my reasoning on this topic more in detail in this Twitter thread.
So I will prefer to buy share trading in HK to reduce the risk of US delisting. But I do not expect more financial threats from that angle.
What about South China Sea conflict?
Beyond the area in which CNOOC operate, there is the large South China Sea region, suffering from multiple and mutually exclusive claims from the regional powers. China's claims overlap with Vietnamese's, Phillipines' and Malaysia as well as Brunei.
The area is rich in natural resources including oil & gas (see map below), and obviously, if China succeeded at claiming the area for itself, this would be a positive for CNOOC. A tentative claim that then fail or turn into a regional war would alternatively be a disaster for CNOOC.
The situation is more than a little tense, with the broader US-China relations thrown in the mix. So this is a source of worry for investors, many of who probably do not realize that CNOOC reserves are not located in the contested areas.
There is reasonable chance that the ressources will be shared instead of fought over, but the risk is there. Let's hope cooler head prevail over nationalism and egos.
The tensions in the South China Sea are not just about fishing rights or oil either. Ultimately, this is a crucial strategic objective for China to be able to navigate toward the Indian Ocean without foreign interferences. And that maritime road is full of the small archipelago (that can turn into military bases) and chokepoints easy to control (circled down). Most notableS are
The archipelagos in the South China Sea, Paracel and Spratly islands
Singapore
The Malacca straight
The Andaman islands
Without this trade road, China is vulnerable to being cut off from its import in energy from the Middle East, and metal, food, and other commodities from Africa. Trade with Europe via the Suez canal would also be disrupted.
This is also why the "Belt and Road"-supported Panama-like canal is planned in Thailand, cutting possible Indonesian influence and offering another alternative passage (I marked it on the map too).
Or why pipelines crossing Central Asia and Burma are being built to bring in Iranian and Gulf oil. It is all wrapped together in the need for China to ensure it cannot be isolated from its suppliers in vital goods like food, metals and energy.
What does it mean for CNOOC shareholders?
First, it means that before investing in CNOOC, you need to know you will stay calm enough at every little scuffle around "freedom of navigation" and China expansionism in the news. Same for discussion about impending Chinese economy collapse or return to hardcore communism.
If you do not have such a temperament, you are guaranteed to sell at a low during a moment of pessimism like nowadays.
What comes in the long run, your guess is as good as mine.
If you think that the USA is determined enough about the South China Sea and Taiwan issues to engage in a war, you probably want to stay away from CNOOC stock. If you think the 2 world major powers will keep competing but stay in not-too-hostile terms, then you should take the risk.
Determining the scenario of the future USA-China relationship is in my view almost impossible. Like most long-term forecasts in geopolitics really. So I try to not overworry about it.
I will start considering things are getting serious if like with Russia recently, China accuses the American of being murderers and rapist, and say negotiations are useless. Until then, it is just a "normal" rivalry I can live with while collecting dividends.
Conclusion
What I expect is the following, and each is conducive to good returns from CNOOC stock.
That is obviously if WWIII does not start. Then I expect I will have other concerns that my yearly returns anyway. Of course, this is just my opinion, I highly encourage you to do your own analysis and draw your own conclusions.
So what I expect from CNOOC:
Constant high demand for oil in China for decades to come.
Need for higher production limiting political interference.
Growth in CNOOC production, including Guyana and other overseas windfalls.
Rising role of gas in the production mix, replacing some LNG imports.
Return of CNOOC multiples and ratios back to a more reasonable range.
Growing dividends with high yields compared to today's price.
High volatility of the stock according to the popularity of Chinese stocks in general.
All of them are conducive to good returns. High dividendd ensure money returning to shareholders, while also leaving enough money for investing in production growth. I expect long-term returns in the range of 10-15% yearly.
A key part of CNOOC returns will be in the short term the general sentiment about Chinese stocks. In the long run, the business free cash flow will matter a lot more.
The duration of the $70-$80/barrel oil price is also a key component. This would be negatively affected in case of a global recession triggered by rising interest rates and Quantitative Tightening. In reverse, high post-Covid demand would mean much higher oil prices.
I personally consider that long-term under-investment in the energy sector should provide a solid support for prices during the whole 2020s.
Short of a global depression, CNOOC's margins should stay strong. And even then the current margin of safety should allows for less dramatic losses than with overvalued sectors, like tech for example.
Disclaimer: I intend to purchase CNOOC shares, through a company I control, and I am likely to increase this position in the future. This article is for educational purposes only, please do your own diligence, as this does not constitute investment advice. Full disclaimer can be found HERE.