Will the Caspian purchase abate China's hunger for oil?

CNOOC and Sinopec try to stem the flow of oil imports with a $1.23 billion purchase in the Caspian sea.

China's increasing focus on obtaining reliable oil supplies, led CNOOC and China Petrochemicals, the parent company of Hong Kong-listed Sinopec, to spend $1.23 billion last week to each acquire half of a 16.33% stake British Gas (BG) held in the North Caspian Sea Project.

The project, said to be the largest discovery in the past 30 years, lies within the territorial waters of Kazakhstan and the Kashagan field alone has estimated reserves of 13 billion barrels of oil equivalent, although evolving extraction technology could push the figure higher.

The existing consortium which operates the field still has first right of refusal to buy the BG stake, although observers argue that it is highly unlikely they would wish to antagonize two out of China's three leading oil majors, given the Mainland's rising importance as an energy market. Indeed, some believe one of the reasons BG was so keen to sell the stake in the first place was to extract favours on the Mainland in return. Currently, Exxon Mobil, Shell, TotalFinaElf and ENI-Agip (the project operator) each have 16.7% and ConocoPhillips and Inpex Corp a further 8.3% each.

CNOOC (China's premier offshore exploration company) and Sinopec (its largest refiner) paid the same price for the equally sized stakes within a couple of days of each other.

CNOOC's share price drifted lower last week following news of the announcement, as did Sinopec's.

"We believe the decline is due to general market volatility ahead of the possible war in the Middle East," comments CNOOC CFO Mark Qiu. Backing him up, the Hang Seng Index closed at 8787.45 points on Friday, down from its 8857.30 open.

"The new fields will be generating some very strong cashflow for the company once production goes fully on stream," he adds.

Analysts say Sinopec's parent bought the asset to insulate the shareholders of the listed entity from risk, since Sinopec is not primarily an exploration and production company. CNOOC, on the other hand, is.

"If you're confident about the project buy CNOOC, if you want to wait and see, buy Sinopec," one concludes. "It's likely the parent company will eventually inject the assets into the listed vehicle if they perform well, although shareholders might have to pay a premium."

The project is far from full production and it is estimated it will take another $20 billion and three years before it becomes operational, reaching peak production around 2014. The oil could then be transported via pipeline back to China, with which Kazakhstan shares a border, or it could be sold to more proximate markets in Europe via a pipeline to the Mediterranean on a swap basis, with China importing the equivalent amount from Malaysia.

According to Goldman Sachs MD, Jin Yong Cai, who worked closely on the deal representing BG, the price was calculated on the basis of extraction costs, taking into account a 'normalized' or average oil price rather than the current high figure of almost $40 a barrel.

"BG will get over one billion dollars on its balance sheet, a nice chunk of cash," he says.

Excluding exploration costs, BG has so far paid $183 million developing its stake.

HSBC oil analyst Gordon Kwan arrived at a discounted cash flow valuation of $1 billion for each of CNOOC and Sinopec's stakes and consequently believes the two have achieved a good price.

Goldman's Cai says that BG divested its stake in order to focus on its core gas competency and was also not keen to wait until the 2006 production start date.

Kwan estimates the deal will boost Sinopec's net assets per share by HK$0.08 and CNOOC's by HK$0.88.

A second analyst adds that the deal should be additionally beneficial for Sinopec since it will enable the company to lessen its reliance on increasingly expensive imported oil for its refining operations.

One interesting aspect of the deal is the extent to which it is politically motivated. Both companies are majority state-owned. With the recent turmoil in the Middle East, China has been looking to diversify away from its reliance on Middle Eastern oil and set up strategic oil reserves.

China's reliance on imported oil is growing. In 1992, the country was a net exporter, but became a net importer the following year and currently imports one-third of oil needs. By 2010 experts believe it will need to import around 50%.

"Domestic oil production growth will continue by 1% to 2% per year in China," Kwan states, "so oil is certainly not running out. But what's changing is demand, which is estimated to grow 4% to 5% over the same period."

In fact, contrary to the aftermath of the 1992 Gulf War, when the Middle East rewarded the Allies with lower oil prices, Kwan believes prices will remain on the high side this time round.

Added to this, he says, China's growing demand will continue to push up oil prices and estimates long-term prices of around $25 rather than $20.

HSBC also estimates that the combined Chinese stakes of the Caspian oil fields will only represent 3.5% of China's daily energy consumption even at full production.

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