Upstream beats downstream when the government sets quotas and prices.
China's oil and gas companies--
We favor CNOOC, Ltd. as the best positioned of the three, based on the high weighting (80%) of oil in its production mix, lack of downstream activities, and favorable market price versus our fair value estimate. We think it offers the best combination of return expectations and margin of safety. We think the shares are undervalued by about 30%. In contrast, PetroChina, which is similarly undervalued, has a production mix of 70% oil but also has significant refining operations that we believe will curtail profitability.
How They Got Here
Before 2002, the People's Republic of China wholly owned all domestic oil and gas assets. Throughout the 1980s and 1990s, China's oil and gas sector underwent numerous iterations of organizational structure, ultimately resulting in the formation of three state-owned corporations: China National Petroleum Corporation, which primarily focused on onshore upstream exploration and production, China National Offshore Oil Corporation, which was devoted to offshore E&P, and Sinopec Group, which was mostly composed of the country's downstream assets.
In 2000-01, all three companies performed reorganizations to carve out profitable segments, and then listed those segments as PetroChina (87% of shares still owned by CNPC), CNOOC, Ltd., (64% held by CNOOC), and Sinopec (76% held by Sinopec Group). With the parent corporations fully owned by the PRC, all three companies are effectively government-controlled entities and subject to China's central planning mandates. However, the profitability and strategic importance of the energy sector provide the firms a reasonable degree of operational autonomy.
The distribution of assets among the three firms makes sense from an administrative perspective. Northern China contains substantially greater hydrocarbon resources, while the concentration of refineries coincides with China's denser population in the southern and eastern portions of the country. Offshore regions have no population and therefore require no refining capabilities. The firms' mix of upstream and downstream assets has drifted, but for the most part these historical allocations still define operations.
On the world stage, PetroChina and Sinopec are in the same league as the international supermajor petroleum firms--ExxonMobil XOM, Chevron CVX, Royal Dutch Shell RDS.A, BP BP, and Total TOT--in terms of production, reserves, and refining capacity. CNOOC, Ltd. is smaller in terms of production and reserves and has no downstream activities, a factor that we believe benefits the company.
The Chinese companies have near exclusive access to both the domestic reservoirs and end consumers of their product in the fastest-growing economy in the world. This exclusivity is the primary (and sometimes sole) source of these firms' narrow economic moat.
Upstream: It's All About Offshore and Natural
China's onshore hydrocarbon production is characterized by a substantial weighting toward crude oil from mature fields, using dated technology and enhanced recovery techniques that merely maintain volumes. Many oil fields have been in production for decades and have realized years of plateau production levels. As a result, the lifting cost of oil production is rising, while reserve replacement is tapering off.