Description

CNOOC Ltd - Best of Breed APAC O&G company trading at steep discount at only 4.3x FY21 P/E and 2.1x FY22E P/E, with powerful catalysts to realize value ~200% upside. One of the biggest beneficiaries of rising oil prices due to favorable product mix and high-volume growth. Strong profitability at 16% ROE against industry at 10%, and 30% NPM against industry at 5-8%. Globally, it is one of the best-in-class in efficiency, execution and deep technological expertise.

Conclusion

CNOOC is the leading offshore E&P company in China and in Asia, with 100% profit elasticity to rising oil prices. It isn’t a new name to global investors; it had a NYSE listing until ex-US president Donald Trump signed an executive order to delist CNOOC, amongst other companies, in his final months in office in Nov-2020 (CNOOC isn’t in the US trade blacklist). US investors know this is a high quality and transparent business, unlike its state-run Chinese peers; CNOOC was run with a market-oriented approach with strong focus on operating efficiency, technological expertise and capital discipline. Therefore, CNOOC H share was valued historically at 11-12x P/E, at a significant premium to local peers’ H shares at 6-7x P/E; and it was on par with best-of-breeds like CoconoPhillips (COP), the world’s largest independent E&P. Since the NYSE delisting, CNOOC saw its valuation plunge to 4.3x FY21E P/E, whereas COP has rerated to 15x P/E and national oil majors like BP, Royal Dutch Shell and Exxon Mobil have rerated to 11-13x P/E. Even its biggest local peer, PetroChina H share, has rerated to 7-8x P/E, while PetroChina A share is at 12x P/E. Management mentioned their investor base used to be 70% US investors and 30% HK investors, this has changed drastically to a new investor base comprising of an equal split between Mainland China, HK and SEA investors.

At HKD 8.50, market has missed out: (1) CNOOC has just received the CSRC’s issuance committee approval for Mainland A share listing (Red Chip listing), being one of the few companies that’s able to get approval. Mainland institutional investors who are familiar with such a large company tend to rerate A shares in-line with global peers (eg. PetroChina A share), and arbitrage opportunity exists in Southbound flow towards cheaper H share, when volatile markets favor value stocks. (2) CNOOC has one of the lowest all-in costs at $26-28 per oil barrel, on par with the global best-of-breed COP. (3) It is also one of the only few companies globally that’s able to grow volume at 10% YoY in 3Q21, a feat that’s unmatched when most global peers are at negative to flat growth. This is achieved because it’s the exclusive E&P company in China offshore due to high barriers to entry; it has been able to invest continuously since the last oil bear market in 2014 due to its cost efficiency and strong balance sheet, and it doesn’t face investor pressure unlike Western peers to divert capex towards dividends/share buybacks. (4) China is the largest oil importer at 10m barrels per day or 10% of global demand; hence it places energy security as its top priority. CNOOC has high strategic importance to China as offshore production, which CNOOC dominates, contributed 80% of total national oil output growth in 2020, and 2020 was the third consecutive year that offshore accounted for more than 50% of national oil output growth. It’s a significant achievement when its much larger peer PetroChina, mainly onshore-based, makes up 2/3 of China’s oil and gas output. (5) CNOOC’s technological breakthroughs in deep sea, heavy oil, innovations to improve cost/manpower/data efficiency, and its upcoming wind power floating platforms further cement its leadership in Asia.

My TP for CNOOC is at HK$25. The key valuation thesis is that CNOOC has very limited downside risks with high 200% upside, by rerating back to 11-12 FY21 P/E (from 4x FY21 P/E) or 6-7x FY22E P/E after its A share listing, based on a very conservative LT oil price at $65. Oil price above $65 will create significant upside potential above TP HK$25, due to high profit elasticity to oil price. CNOOC is also planning to pay a special 20^th anniversary dividend on top of its annual generous dividend payout of 60-70% (PetroChina is 40-45% payout), its DPS will not be lower than HK$0.70 in subsequent years to its A share listing, and it will be doing share buyback from FY23.

Background of China’s O&G industry and CNOOC Ltd

China’s O&G sector is dominated by three listed SOEs namely, PetroChina (Parent: CNPC), Sinopec (Parent: China Petrochemical Group) and CNOOC Ltd (Parent: CNOOC Group). The three parent companies are owned by the umbrella body, State-owned Assets Supervision and Administration Commission of the State Council (SASAC). Of the three companies, only CNOOC Ltd is 100% upstream EPC, PetroChina derives 60-70% revenue from upstream and the remaining from downstream refining, marketing and trading etc, while Sinopec focuses on downstream activities mainly in the refining and trading businesses with <10% from upstream. In addition, CNOOC Ltd is designated to focus on domestic offshore, while PetroChina and Sinopec are mainly involved in domestic onshore. These create significant differences in their business models, as well as their profit growth trajectories in this oil super cycle.

The downstream activities are adversely impacted by rising oil prices, because prices are not fully passed through in retail gasoline or diesel prices, and retail gas prices are regulated at city-gate pricing. On the other hand, Chinese upstream crude oil prices are based on international Brent Crude oil or WTI crude oil prices and cannot be subject to domestic price regulations. In terms of product mix, CNOOC derives 80% of production from crude oil and 20% from natural gas, which gives it a much higher margin profile than global players like COP, Exxon Mobil etc which typically derive only 50% of upstream production from crude oil; generally crude oil operating margin is c.1.5-2x of natural gas margin at $65 per oil barrel. Management has also affirmed it’s impossible for China to regulate crude oil prices, because China’s oil production at 4-5% global share makes it a relatively small player and the country imports 10m barrels of oil per day, or 10% of global production. Even the US, the largest global crude oil producer at 16% share, is very hesitant to consider banning exports to tame oil prices, as international oil prices will consequently skyrocket and hurt future US oil imports in the medium term. For CNOOC, we are looking at mainly Brent Crude price rather than WTI price, since Brent price is the benchmark for offshore.

Investors who are familiar with the O&G sector understand that offshore EPC is significantly more difficult than onshore. Offshore requires high level of expertise in technology and engineering, decades of seismic data acquisition, high safety and compliance capabilities, high capex, experienced management. Offshore is a niche area where mistakes amplify and derail IRR. This creates high barriers to entry for CNOOC in China’s offshore; PetroChina and Sinopec are in domestic onshore, while foreign companies are only able to participate in domestic offshore through a JV with CNOOC.

Onshore projects in China are mainly high-cost mature assets, with stagnant to declining volume and high cost of production; whereas offshore production is still nascent and contributed 80% of China’s oil production growth in 2020. Upon its inception in 1982, CNOOC was designated to form JVs in domestic offshore projects with Western companies like COP and ExxonMobil, leading to decades of transfer of technology and management expertise, which explains its market-oriented culture. Today, CNOOC no longer shares profits in its highly profitable domestic projects, as it has acquired the expertise to exploit deep sea and heavy oil such as the Deep-sea No. 1 project in South China Sea with a maximum depth of 1,500 meters. Only the largest O&G companies in the US, UK and Norway have the capability to do so, and China was only able to drill up to a depth of 200-300 meters in offshore a decade ago. CNOOC participates in foreign JVs very selectively, such as the Guyana oilfield with ExxonMobil, which at peak production has the potential to achieve an operating margin even better than its lowest-cost Bohai Bay oilfields, due to its high quality of oil produced.

CNOOC’s workforce of 16,000 employees is only 3% of PetroChina but revenue is 10% of the latter. It punches above its weight through the efficient use of technology and organizational effectiveness.

Business model

In FY20, China made up 67% of its production but contributed 75% of revenue and >100% of production NPAT. In the past three years, China’s production has been leading volume growth in high single-digit due to discoveries of large oil wells, such as Bozhong 19-6 in Bohai Bay in FY18 which was one of the most successful discoveries made in recent years, with proven reserves of 100bcm natural gas and 100mcm condensate. The significance of this discovery has opened up a deep under-seabed reserve layer in Bohai Bay whereas previous discoveries were in shallow to mid-under-seabed layers.

Subsequently, management was proven correct in the potential of adjacent deep-sea reserves with the discovery of Bozhong 29-6 and Bozhang 28-1 in Bohai Bay, these are large proven discoveries of up to 10m tons volume each. In overseas market, Guyana and Nigeria also saw large scale discoveries, and the quality of oil produced is very good which commands higher ASP. It should be noted that Bohai, which makes up 50% of China’s production in FY20, has the lowest cost structure & highest margin due to its massive platform scale, hence growth enabled by advanced technologies in deep water and heavy oil created cost-efficient discoveries and production. The Eastern South China Sea, which makes up 28% of China’s production in FY20, has also become one of its most important oil producing areas, where crude is mostly of light to medium gravity and command better ASP due to higher refining yield. Eastern South China Sea saw a production CAGR of 9% from FY17-20 due to significant deep-water discoveries, and production growth accelerated to 20% YoY in 1H21 when the Deep-sea No. 1 project reached full-capacity production in 1H21.

As a result, reserve life is lifted from 8.1 in FY16 to 10.3 years in FY17 with these new discoveries, and the booking of reserves from Liza Phase I and Libra (projects that received FID) as well as re-booking of reserves from the Long Lake oil sands project as costs had declined substantially (hence Canadian losses declined substantially in FY19 as seen in NPAT geographical breakdown). Reserves are expected to remain at 10 years till FY25-26 with current reserve replacement ratio at 120%. Management is confident that with the Shanghai listing IPO proceeds of RMB 35b, where 52% is for domestic projects and 48% for Guyana, should support their strong guidance of 6-7% production CAGR till FY25 to reach 2m boe per day. It has a good track record of beating guidance since FY18, and if this guidance is realized, it will be one of very few major O&G companies to achieve high single-digit volume growth for the medium term.

CNOOC has certainly come a long way since its listing in 2000. In the last two decades. As highlighted in its FY20 presentation, it has increased reserves by 3.1x, net production by 6.0x, revenue by 6.4x and total assets by 22.1x over the last two decades. Cumulative return was 1,599% and cumulative dividends reached HKD 345b, which is 90% of current market cap, due to its strong operating cashflow generation. Operating cashflow remained strong in FY20 even when average realized oil price was $41.

Based on FY21E realized average oil price of $67 per barrel, CNOOC is estimated to increase NPAT by 1.6% per $1 or 1.5% increase in oil price. This works out to 100% profit elasticity to oil price. Therefore, CNOOC is one of the biggest beneficiaries of rising oil prices. If we project FY22E average oil price at $120 in FY22E, CNOOC’s NPM at 38% (FY21: 31%) and ROE at 28.5% (FY21: 15.7%) should become world No. 1, far exceeding best-of-breed CoconoPhillips.

A key point is that CNOOC’s parent has shown good corporate governance in the last 20 years – it did not transfer the commoditized downstream business to the listco. It awards the listco contracts of 2-7 years to purchase natural gas from the listco with step-up price clauses – this helped CNOOC to stay profitable in 1H20 when oil price tanked to $38. Terms of trade with the listco are reasonable; trade receivable days maintained at 40 days and inventory days at 22 days while trade payable is 160 days, giving the listco high operating cashflows. With its parent’s support, CNOOC is able to pay a much higher dividend payout at 60-70% compared to PetroChina at 40-45%. Also unlike PetroChina which needs to do national service by importing expensive LNG and selling cheap due to its fully integrated operations, CNOOC’s parent fulfills most of this obligation as it owns the distribution. The listco does a small part – its crude oil and product purchase expense is only 9.8% of opex and 7.5% of revenue in FY20.

CNOOC’s undervaluation has reached absurd levels due to the delisting in Nov-20.  Back in the previous bull oil cycle from FY11-14, CNOOC was trading at HKD 14-16 based on average oil price at USD 96-110, at 10x P/E. With the consistent gains in scale economies and production growth, CNOOC attained the same level of profitability in FY18-19 as its previous peak in FY13-14, even though the average realized oil price in FY18-19 was only USD 63-67, and market once again valued CNOOC in FY18-19 at 10-11x P/E at a share price of HKD 14-15. But right after the delisting in Nov-20, share price completely decoupled from oil price movements as seen in the light blue line in the chart below (CoconoPhillips and CNOOC share price movements against Brent crude), as the new group of investors are not familiar with the company. Therefore, the upcoming A share listing is expected to become a major catalyst in the immediate horizon, through investor education and realignment with domestic institutions.

Competitive strengths of CNOOC

1.      Most competitive all-in cost producer

All-in-cost refers to the production cost of oil and gas, it doesn’t include exploration expense, special oil gain levy, impairment cost, crude oil purchase cost. All-in-cost is one of the most definitive metrics to compare companies in the O&G industry, as the lowest cost producer survives the oil bear market, invests throughout the bear cycle, and emerges as the biggest beneficiary in a recovery driven by both volume and margin expansion. CNOOC has one of the lowest all-in-cost among major global players, even slightly lower than COP, and is far lower than its local onshore peers like PetroChina and Sinopec. Even Asean’s EPC leader Thai oil major PTTEP has an all-in cost of $46, way higher than CNOOC. Due to its highly optimized cost structure and high crude oil mix at 87% of revenue, CNOOC has the highest operating and net margin among the major players. Its ROE is lower than COP yet higher than the vast majority of its peers; but given that CNOOC has a high profit elasticity to oil price, assuming FY22 average realized oil price at USD 120, CNOOC’s ROE will almost double to 28.5% in FY22 and far exceed its peer group. CNOOC’s all-in cost has seen remarkable cost reduction since FY13 due to capital discipline such as zero budgeting every year since 2003, scale efficiency, organization efficiency/SOP workflows and technological gains. These reduce the unit lifting cost, depreciation, depletion & amortization (DD&A), and ancillary costs like dismantlement and taxes other than income tax.

CNOOC is the only company in the comparison that has a slight net cash position, attesting to its financial prudency, strong operating cashflow and consistent profitability. Management doesn’t rule out M&A in overseas offshore projects, but for now it will focus on utilizing the upcoming IPO proceeds of RMB 35b on domestic projects and the Guyana oilfield JV with ExxonMobil.

Management has guided to continue at high single-digit volume CAGR till FY25 at 2m boe per day. COP had 39% volume growth in FY21 due to the $9.5b acquisition of Shell’s Permian basin production. If we normalize COP’s organic volume growth from FY21-25 it will be 4.2% CAGR, below CNOOC but decently higher than its Western peers which are facing a decline in reserve life below 10 years. PetroChina’s reserve life of 11 years is largely skewed by low margin natural gas reserves at 18 years vs higher margin crude oil reserves at only 6 years. 

Leader in technology and engineering expertise

As mentioned earlier, CNOOC is one of the few global players from major oil markets like US, UK and Norway that has achieved breakthrough in deep sea drilling of up to 1500m. This has enabled the company to make large adjacent discoveries in Bohai and Eastern South China Sea. It has also achieved breakthrough in heavy oil thermal recovery technology. Its proven heavy oil reserves are c.600m tons, which is large compared with its total proven crude oil reserves at 3,649m bbl (16% of reserves). Previously due to technical limitations, the company only utilized 100m tons of heavy oil reserves with thermal production contributing less than 100k tons per year. In 1H19, the company's first offshore super-heavy oil overall heat injection development project, Luda 5-2 North Oil Field, uses superheated steam boilers to improve thermal recovery efficiency, thus providing a demonstration effect for large-scale utilization of offshore super-heavy oil reserves. The company expects its Bohai heavy oil thermal recovery production to gradually scale up to 1.6m tons or 11m boe in FY25, out of its total production of 528m boe in FY20.

Besides production breakthroughs, CNOOC is leading the industry to digitalize operations in an effort to lower its offshore operating costs. It has earmarked RMB 2.4b over the next five years to establish data centers around the world and modernize data communication through the use of microwaves, fibre-optic and Raman-scattering technology at offshore fields, with increased use of satellites. Already, the oil fields in northern Bohai Bay are 100% covered by microwave technology. The objective is to improve management, exploration, production and sales efficiency through three separate cloud computing systems. The shared information technology infrastructure will create a flexible, cost effective and on-demand information technology environment, which helps to standardize and simplify operations, as operations get increasingly complex with South China Sea’s development heading into deeper and more remote waters. The digital facilities enable the field complex to be remotely controlled for “single-key” gas distribution, boosting efficiency up to tenfold, according to the company. It can shorten the time taken to resume production after shutdown to 20 minutes, compared to two hours before the introduction of automated facilities.

In terms of safety, it can monitor high-risk operations on site, track the mitigation of hidden dangers, monitor various mechanical equipment and implement fault diagnosis. When it comes to production, it can analyze and process production data, coordinate the production of multiple gas fields. And in the future, the application of digital technology can boost reservoir information through smart seismic data analytics, increase oil recovery and unlock reserves such as heavy oil deposits in Bohai and tight gas in Eastern China Sea and South China Sea. Even though CNOOC isn’t an IT company, it has the capability to build its own resources as an Infrastructure-as-a-service (IaaS) and Platform-as-a-Service (PaaS) and has expanded its computing capacity by 55%.

Prior to the digitalization drive to enhance data, the company has started on initiatives such as: (1) Smart platforms (2) Unmanned offshore platforms (3) Onshore power links. In Oct-21, CNOOC commissioned its latest smart oilfield in Bohai Bay, installing more than 400 digital cameras and 26k automatic data collection points, to oversee operations, monitor equipment and collate production data to control multiple oil fields in a coordinated manner. Technologies including Cloud computing, big data and AI, 5G wireless and Beidou navigation satellite system were installed to improve the field’s production efficiency by 30%, reduce maintenance cost by 5-10% and cut manpower by 20%. The sensors at the field are capable of collecting up to 100k messages per second, with data collection around 6 terabytes each year. Most importantly, the entire digitalization process is done in-house and isn’t easily replicable, due to the lack of vendors who have a deep understanding of offshore. CNOOC owns full proprietary rights to the field’s digitalization applications, with more than 1.3 million lines of codes and over 100 algorithm modules. CNOOC is able to achieve these even though its 16k workforce is only 3% of PetroChina, implying a much flatter organization structure and forward-looking management style. By 2022, all platforms will utilize onshore power which will result in cost savings.

Leverage offshore expertise to master emerging floating wind energy platform

Floating projects are a fast-emerging solution for wind energy transformation. They enable developers to install turbines in deeper waters further from shore where the wind is much stronger. CNOOC plans to use its 40 years of offshore operations to give them an advantage in using marine geological exploration, engineering and shipping experiences to develop clean energy. CNOOC will allocate 10% of capex towards developing clean energy. PetroChina aims for one-third of output to come from new energy sources by 2035, while Sinopec expects to spend $4.1b by 2025 to focus on hydrogen production. Between the Chinese players, CNOOC’s plan for clean energy transformation is the most synergistic. Management knows better than peers to set a production target for clean energy, knowing the focus should be on technology and operational development, rather than a top-down driven bureaucratic goal.

1.    Driving cleaner natural gas production 

CNOOC plans to increase exploration and production yields of its gas fields to increase production mix of natural gas from 20% to 35% after 2025. Natural gas has half the carbon footprint of coal. While there may be gradual impact to margins from a shift in mix towards lower margin natural gas, management believes the increased scale of natural gas production and persistent culture to drive cost savings will mitigate the margin impact. For now, CNOOC’s direction remains focused on realizing energy security goals for China, and crude output growth is the focus for the next few years in this current super oil cycle. 

Discussion on oil price trends

I cannot emphasize enough that the thesis for CNOOC is based on a very conservative LT oil price at $65, where it’s valued at FY21 4x P/E with TP at HKD 25, or 200% upside for a best-of-breed APAC E&P leader. The thesis is not based on oil price speculation. However, investors should have a rough idea of the demand and supply trends, and the catalysts or detractors of oil price appreciation.

Russia and Iran are the two wild cards for how oil prices may move in the next few months. Russia produces 10 million barrels of crude oil per day or 10% market share, of which 5 million barrels are exported mainly to Europe and a much smaller extent to the US. Although Russia’s energy sector isn’t yet sanctioned by the EU, the partial exclusion of certain Russian banks from the SWIFT system has made it highly risky and costly for traders and refiners to purchase crude oil from Russia. Purchasers’ banks are reluctant to issue letters of credit for oil trade with Russia. Lots of companies treat Russian oil as sanctioned and not touch it even if it is allowed. And while there are alternatives such as the internal systems of international banks having branches in Russia, Western bankers said it will be quite a mess. The US and the UK have just announced they have sanctioned imports of Russian oil today; while their imports aren’t as significant as Germany and France, we have seen pressure build up subsequently across the EU bloc to follow the unilateral sanctions by the US.

Neither can China fully absorb the 5 million barrels of oil exports from Russia, should Europe agree on an oil import ban. This is because of pipeline capacity constraints. CNPC, PetroChina’s parent, has a deal to import 40 million mt of pipeline crude from Russia, comprising 10 million mt/year via Kazakhstan through the Atasu-Alashankou pipeline under a bilateral state agreement, and 30 million mt/year of ESPO Blend from Rosneft via the Skovorodino-Mohe pipelines to PetroChina. Both are near full capacity, according to refinery sources. The only room to increase imports is via Atasu-Alashankou pipeline; it is limited at around 100,000 b/d. Supplies from the seaborne market is more likely to increase if South Korea and Japan are not willing to compete. Feedstock managers at major South Korean, Japanese and Indian refiners said they could find purchasing Far East Russian crude rather troublesome due to the increase in legal, financial and administrative hurdles doing businesses with Russian oil entities. Freight rates have also skyrocketed, making it more troublesome and costly for China to mass import by freight. Should the 5 million barrels of crude oil exports or 5% of world production remain severely disrupted for weeks or months, it will exacerbate the current inventory drawdown rate and reinforce a multi-year oil super cycle.

The Iran nuclear deal may potentially restore 1.0-1.3 million barrels of crude oil exports per day, though the actual increment may be lesser as Chinese independent refiners have been purchasing them illegally. Regardless, the impact is much smaller than the potential Russian oil disruption, and sticky points remain for the deal, such as the unaccounted uranium deposits and the demand for the US to guarantee future administrations cannot back out of the deal.

Structural factors on oil price

Even before the Ukraine war, the tight demand and supply have been pushing up oil price steadily to $90+ per barrel. 

Historical global E&P spend

Supply trends

The central problem is that since the last oil bull cycle ended in 2014, global E&P spend has remained at a low level, which declined even further in 2020 and 2021 to $400-430b due to Covid-19 (not shown in chart). The push for green energy and carbon zero policy disincentived Western players from ramping up fossil fuel production. As a result, CNOOC is a key beneficiary to gain significant market share in the current super oil cycle, due to China’s focus on energy security rather than energy transition.

Of the c. 2.6 million b/d of spare capacity globally, 96% lies with Saudi Arabia and the UAE, with Saudi Arabia accounting for >2 million m/d. And Saudi Arabia has made a strong commitment it will not utilize the full spare capacity immediately, but instead follow through the gradual ramp-up under the OPEC+ agreement, where OPEC+ will implement a step-up of 400k b/d quota per month until the end of 2022 to restore the previous reduction of 5.8 million b/d due to Covid-19. Moreover, the majority of OPEC+ members including Russia have demonstrated their inability to ramp up production, due to years of underinvestment. For the first time in decades, Saudi Arabia is firmly in the driver seat to control the pace of global oil supply. US shale oil players have faced firm investor pressure not to increase capex spend even in the current oil price climate, instead paying out higher dividends and share buybacks from the oil prices. CoconoPhillips, the most cautious of the US shale companies, has warned about oversupply with shale output increasing by 800-900k b/d in 2022 with a similar magnitude increase in 2023. However, most of the US shale companies are increasing production by fracking and redeploying rigs to existing oil wells, this doesn’t allow for a sustained oil output increase without capex commitment. The current operational oil rig count at 500 is still half of the number at pre-Covid. With the 5 million b/d supply disruption from Russia, the US shale players could not meet demand even under the most optimistic scenario.

Demand trends

Currently in 4Q21, global demand remains at 1.4m b/d higher than supply. Two things to note: Firstly, the demand forecast from EIA is very conservative, it doesn’t seem to factor in any reopening impact on demand. For example, world consumption is projected flattish in 1Q22 vs 4Q21 at 99.7m b/d, and is projected to rise slowly to 100.04m in 2Q22, vs the historical increase we saw per quarter in 2021 at +2m b/d QoQ. EIA forecasts 2022’s average consumption at 100.61m b/d vs 97.07m b/d in 2021, and at the same level as 2019 at 100.4m b/d. So EIA is assuming in 2022, there will not be any major production, logistics and human transport demand growth across sectors to address the broad supply chain shortage and inflation.

Secondly, the inflection point for EIA and traders to reprice oil futures may come in 2Q22. This is an important quarter when EIA forecasts for the first time that inventory will increase by >1m b/d every quarter going forward. This is in contrast to the period since mid-2020 to 4Q21, when every quarter had an average inventory drawdown of 1.8m b/d. Should the market realize inventory continues to drawdown from 2Q22 onwards, or even worsen due to the reopening demand, these forecasts will reverse significantly and traders would have to reprice futures higher. EIA does acknowledge in the report that because of the current low global inventory level, any fluctuation in production and consumption estimates may induce a high volatility on oil price.

In conclusion, there is no easy way to resolve the oil supply shortage, nor is it likely to be resolved this year or next year. As the EIA data gets revised and shows a more persistent shortage situation, investors may pay more attention towards inflation bottlenecks. Globally, 86% of the world’s energy needs still come from fossil fuels. Under the net zero 2050 plan, it will be another 30 years of gradual transition before renewable energy can supply >70% of global needs. One of the key bottlenecks for renewable energy is battery storage, and battery storage capacity has been increasing gradually at 6-7% CAGR for the past decades, despite an influx of investments. Energy security may take precedence over energy transition if inflation proves sticky.

Energy is the mother of all inflation. This means that as the economy works towards resolving various inflationary issues in production, logistics and human mobility, it will create a vicious effect to increase oil prices which in turn worsen inflation across various sectors of the economy, and lead to another round of increase in oil prices. Therefore, inflation in the energy sector is likely to outlast most other inflation.

Sensitivity Analysis of FY22 P/E to average realized oil price and target price

The above table shows the maximum target price suitable for each level of average realized oil price in FY22. The purple highlighted values represent FY22 P/E ratios that are below 15x, which is a reasonable maximum valuation without being excessive. For example, if the average realized oil price reaches $160-170 and the market is also pricing in peers at this oil price level, a maximum TP for CNOOC, as indicated by the purple highlights, will be at HKD 80.

Risk factors

1.     Oil price fluctuations. As discussed in the above section, the thesis for CNOOC isn’t based on oil price speculation, it is already highly undervalued at LT oil price at $65. Additionally, this current super oil cycle is unlikely to abate this year or next year.

1.    Chinese regulatory pressure. As explained earlier, China cannot afford to impose a price ceiling on oil prices, it has never done so in the past and is unlikely to be able to do so in the medium term. On the other hand, the Chinese government imposes a special oil gain levy on the EPC companies. The formula is as below. Generally, the impact of the levy is very limited, unless the average realized oil price goes above $120. In fact, the Chinese government has been lowering this levy over the past decade to encourage more oil production to meet energy security needs. The threshold for the levy has been increased from $40 to $55 per barrel in 2012 to $65 per barrel in 2015 and onwards, thus lowering the levy. Note that the above sensitivity analysis table has included the impact of oil gain levy at different oil prices.

1.     Is Southbound flow going to happen after the Red Chip listing? Southbound flow has already begun for CNOOC, with mainland institutional funds gradually replacing smaller investors in HK and SEA, due to marketing roadshow presentations conducted by management in China. Below is the February 2022 Southbound flow to HKEx stocks. CNOOC had the 4^th largest Southbound inflow in February. Note that PetroChina isn’t in the list, which could indicate CNOOC is starting to replace PetroChina as the key oil proxy in China.

Catalyst

A-share listing on Shanghai Stock Exchange priced at double the valuation of the H-share stock price. Valuation gap from global peers to narrow as the IPO facilitates mainland China investor education and realignment with domestic fund institutions. Southbound flows from Mainland China to HKEX will also help to narrow the valuation gap.