Uncle Sam's CNOOC dilemma

Chinese oil company makes trump bid for Unocal. But will the US block it as it did with Hutch bid for Global Crossing?

If at first you don't succeed, bid again. That seems to be the motto of CNOOC, the Chinese oil major that has just launched a fresh bid for Unocal of the US. Indeed, it did so yesterday after weeks of speculation much of which centred on divisions within CNOOC's board of directors as to whether the bid made sense.

After commissioning an independent assessment from NM Rothschild, the CNOOC board voted to up its bid even in spite of the fact that the Chevron offer for Unocal had reached such an advanced stage CNOOC would be forced to pay a $500 million indemnity to Chevron if it succeeded in breaking up the deal.

From the outset it was felt that the Chinese government, which controls 70% of CNOOC, was encouraging a fresh bid in order to fulfill China's energy goals. This fact alone makes the deal a fascinating one - mirroring some of the 'Great Game' politics of the late 19th century. Indeed, it is just this sort of geopolitical thinking that lies at the heart of US congressmen's desire to thwart the takeover of a major US energy company by a Chinese one.

First the facts. CNOOC has made an all-cash bid for Unocal that values the company at $67 a share, or $18.5 billion in total. That values Unocal at $1.5 billion more than Chevron's part-cash-part-stock offer, based on Chevron's closing price on June 21.

CNOOC will assume $1.1 billion of Unocal's debt and will pay for the deal with cash, debt and what amounts to quasi-equity (more on that later, as it is of direct concern to the rating agencies). CNOOC's total funding amounts to $19 billion and will be underwritten by its advisors Goldman Sachs and JPMorgan, as well as Chinese bank, ICBC and via soft loans from its state-owned parent, China National Offshore Oil Company.

If successful in acquiring Unocal, CNOOC will emerge as the world's biggest E&P company.

CNOOC has been very clever in the language it has chosen to spin its offer with. It has emphasized that its offer is friendly and consensual and that it is superior for Unocal shareholders. Moreover, no employees will be fired at Unocal, and to address US energy concerns, all of the existing oil and gas production that Unocal sells in the US will continue to be sold there (ie not be diverted to China). In a press release, CNOOC points out that this is hardly a make or break situation for US energy policy since Unocal's oil and gas production currently accounts for only 1% of total US oil and gas consumption.

In terms of synergies, CNOOC points out that it is keen to consolidate its own Asian oil and gas acquisitions. The bulk of Unocal's assets (about 56%) are in Asia. It is estimated that 85% of CNOOC/Unocal's combined assets would be in Asia and would lead to a more balanced portfolio with 53% of reserves comprising oil and 47% natural gas. The deal would double CNOOC's production levels and increase its reserves by nearly 80%. CNOOC's management says it will be cashflow and EPS accretive in the first year.

That all sounds great, so where is the snag?

There are not one, but two major snags. The first is the afore-mentioned political dimension: will the US government allow a Chinese company to buy Unocal from under the nose of a fellow US company?

The second is purely financial: the highly-leveraged nature of the transaction is clearly damaging to CNOOC's historically clean balance sheet (It has debt of around $2 billion, according to Deutsche Bank).

Moody's quickly responded to the announcement by stating that it was putting CNOOC's A2 rating on review for a possible downgrade. Moody's noted: "The ratings action reflects the cash component of the transaction and the significant debt that will be raised to fund the acquisition. Such incremental debt will elevate CNOOC's financial leverage to a level that is not consistent with its present A2 rating. In addition, the review for downgrade reflects the considerable integration challenges that CNOOC is expected to face in bedding down such a large acquisition, given its lack of track record in this area."

This brings us to how CNOOC's bid will be financed. Around $3 billion will come from the company's cash resources. A further $3 billion will come from bridge financing by Goldman and JPMorgan (which will later be taken out via bond issues).

ICBC will arrange loans worth $6 billion. Meanwhile, CNOOC's parent will offer it subordinated loans worth $7 billion, although $2.5 billion will have to be refinanced within two years.

The latter is being described by CNOOC as debt which should be interpreted as having significant equity credit due to its highly subordinated nature. Moody's has responded to this by stating: "We recognize that the parent's acquisition funding is of a very long term nature, carry low effective interest rates, and are subordinated to other external debt. Such enhancements will be incorporated in Moody's assessment."

That is to say, Moody's has not yet decided whether this parent lending constitutes the quasi-equity that CNOOC would like to portray it as.

What is clear is that CNOOC's debt spreads have widened in the markets. Investors are clearly stating their view on the impact of a deal on the company's financials.

Then again, there are some who believe that CNOOC will mitigate the impact on its balance sheet (should its bid prove successful) by breaking Unocal up, and selling off the non-Asian assets.

And as ever in M&A transactions there are controversies surrounding asset valuations. Deutsche Bank recently released a research report that quoted Wood Mackenzie stating that Unocal's upstream assets were worth $12.1 billion. It stated: "Our conclusion is that CNOOC should not acquire Unocal.... CNOOC has painted itself into a corner. CNOOC's overwhelming success since IPO in acquiring cheap assets, managing costs and providing top-decile production growth is at risk."

On the other hand, UBS states: "Unocal shares are trading at 5.3 times 2006 estimated earnings, versus 5.8 times for peers." That is to say, UBS does not view the pricing of the bid as at all unrealistic.

Likewise CSFB upgraded CNOOC to an outperform, stating that the bid removed some of the uncertainty on the stock and adding that CNOOC has traditionally traded at an average PE premum of 41% to PetroChina, but is currently trading at a discount.

CNOOC's stock price rose slightly yesterday.

If those are some of the financial arguments levelled against the deal, it should be stated that they are not insurmountable. Analysts are sometimes right, sometimes wrong and company managements' sometimes ignore them.

Then there are the political arguments. These are far more of an issue. And they could be insurmountable.

Indeed, there are easily enough hypocritical conservatives in the US Congress to ensure such a deal as this one is stymied - even if it requires a new law to do so. Remember that the attempt (a couple of years ago) by Hutchison Whampoa to acquire Global Crossing was blocked because of national security concerns.

Meanwhile past US actions on steel and textiles have shown that America's elected representatives have a highly selective memory when it comes to the concept of free trade and globalization - ie bash the Germans when they complain about US private equity funds taking over German assets; but when a Chinese company tries to acquire an American energy company via the self-same capitalistic processes, attack it as a danger to the nation's security. That evidently plays well in Iowa, where the US is firmly viewed as Jedi to China's Sith.

What may escape the folks in Iowa is the plain, unabashed fact that the US needs inward M&A. It needs the money from such overseas deals to buy dollars to fund its alarming trade deficit.

According to Morgan Stanley's Stephen Roach, the US requires $2.9 billion of foreign capital inflows every day to plug the deficit. When a nation is living on a proverbial credit card - as the US is - it stands to reason you are going to have to eventually sell some real assets, be they buildings, companies, or foreign oil fields.

In view of the politics, it is equally interesting that two of the US's most prominent investment banks, Goldman and JPMorgan are advising CNOOC on its acquisition. Historically CNOOC has been closer to CSFB and Merrill Lynch (which did its IPO), but this latest deal confirms a shift in its investment banking relationships.

JPMorgan got close to the company by helping to arrange a $1 billion convertible bond used last November. Goldman was also involved on that deal (in a more junior role) and ranks as one of the premier M&A advisors in recent US history; and in that respect its inclusion is of little surprise. (Unocal is being advised by Morgan Stanley and Chevron by Lehman Brothers).

But Goldman's role in the deal has been complicated somewhat by the fact that one of CNOOC's independent directors works at the US firm. Kenneth Courtis, a vice-chairman of Goldman in Asia, is on the board and was known to be opposed to CNOOC making a renewed bid for Unocal. Sensing his own conflict of interest, he recused himself from voting when the board decided whether or not to bid.

Ironically enough, Goldman launched a global policy in 2003 that prevented any of its managing directors from sitting on the boards of publicly-listed companies. Courtis and others who currently sat on boards have been allowed to serve out existing terms before resigning. As such, the CNOOC transaction could prove the last time that Goldman faces such a quandary - where the investment bankers are advising one course of action and one of its own bankers is a director advising the opposite.

In spite of all these interesting dynamics, it still remains highly uncertain whether the CNOOC deal will go ahead. The company has evidently made Unocal shareholders a better offer.

But as UBS research point out the $67 bid puts Unocal in line with its peers and Chevron still has room to sweeten its bid. UBS believes a Chevron bid offers more regulatory certainty and speed of closure.

Indeed, the entire CNOOC bid has taken some by surprise. When FinanceAsia had coffee with one industry expert who had intimate knowledge of CNOOC just three weeks ago, he totally dismissed the idea of the Chinese firm making a renewed bid. He must currently be eating his hat.

The management of CNOOC has crafted a clever bid with good advice from its US investment bankers. But given the challenges it still faces from US legislators, as well as the potential for a raised bid from Chevron, this is far from a done deal. Indeed, CNOOC's management might well be advised to remember the line from 16th century English poet, Edmund Spenser: "Be bold, but be not too bold."