Description

Energy names in general are no longer so battered and neglected, but we think CNOOC (NC2B:FRA) offers a compelling entry point. While China is not known for its energy E&P, and Chinese SOEs are not known for their shareholder friendliness, CNOOC is a constructive surprise on both fronts

Unfortunately, this writeup was already basically complete when I saw the recent Reactivation. I’m still submitting: for one thing, this is a fairly succinct introduction to the name, and more importantly, emphasizes a different perspective. I’ll try to focus on the unique aspects of the setup that leave this de-risked relative to other Chinese names (where the marginal US investor hasn’t already been shaken out)

To say it plainly from the outset, we are not approaching this investment like a studied energy analyst, but are instead using a generalist’s framework. I would summarize the investment thesis as. The confluence of:

1. US investors have been shaken out by the CMC sanctions. And the reach of the US is incredibly broad

2. Elon Musk notwithstanding, ESG trends have removed many marginal longs from the equilibrium

3. Energy performance over the past decade (the implicit momentum from every energy allocator getting punished) has removed more of the marginal longs

4. For the international investors unaffected by (1), many are debating whether China is investable at all

translating to outsized returns for the rare investor that can survive all those filters

CNOOC is the third-largest Chinese domestic oil company, but is the preeminent operator, with near monopoly status in the development of offshore oil and gas as well as in cooperation with foreign partners. It’s that history of co-development that has cultivated efficiency and best practice at CNOOC in a way that Sinopec and Petrochina have not. In short, they operate in a moderately regulated monopoly, harvesting relatively low-extraction-cost assets. Here are there operating margins against Sinopec and PetroChina:

Or, to let CNOOC talk its own book:

The vast majority of their production occurs in shallow (that is, low cost) waters in Bohai and the South China Sea, blending to an average cost of about $25. They also have a wide variety of international ventures, the largest of which was formerly Nexen (including the Long Lake assets), and the most recently prominent of which is a 25% stake in the Guyana offshore development.

To touch briefly on the valuation standpoint, which we think is relevant, but not the most important lens: CNOOC is cheap. It’s not the cheapest E&P out there. And it’s not the cheapest Chinese SOE. But it’s cheap. In the neighborhood of 5.5x P/E on 2021 earnings, or < 3x on the current Brent curve. There are some obvious mitigants to the apparent bonanza from current crude prices: CNOOC has some hedges; and the state shares in the windfall (40% of the realized price above 85 USD is paid back to the government). We think reasonable minds can differ on translating this to a run-rate P/E, but we feel comfortable calling it 2.5x-5x. At which point, we convince ourselves that it is cheap, and focus instead on how we expect to realize value through this investment

Although overly punitive, we think a reasonable starting place is a dividend-floored valuation. Overly punitize in the sense that CNOOC is not your typical SOE, with a track record of international investor engagement and know-how. Still, we think this is appropriate when considering the very real risk that political and economic changes (e.g., Common Prosperity) mean ambiguity is generally not to the minority investor’s advantage. CNOOC has committed to an annual payout ratio of >= 40%, meaning a dividend yield of 8-16%. They’ve further committed to >= HKD 0.7 in annual dividends for at least the next 3 years. And on top of that, they will pay a special dividend in 2022, commemoration the 20th anniversary of their HK listing. We see very little precedent for these kinds of commitments going unmet. And we would emphasize that these expectations were set in a much cooler commodity climate (a not-so-distant past where long-dated Brent traded under $60). Even 2019 dividends exceeded HKD 0.70. Though we understand the hesitation at a false bond-equity equivalence, we can’t help but observe that most CNOOC bonds are yielding < 3%

That yield is potentially boosted further by planned buybacks for 2022. The scope of the buybacks has not been discussed. We think it is unlikely, but not impossible, that they attempt to neutralize the dilution from the upcoming A-share listing. This would be an extremely positive catalyst, as it would result in the H-share float effectively reducing by ~20%

In short, we find that CNOOC is priced like a Guyanese ice cube, but its business is anything but. Production is growing steadily at 6% / year. For whatever concerns there are about climate, no reasonable investor could expect China to risk its energy (and therefore national) security as part of a cooperative global effort. In this way, we actually think there is some asymmetry, as Chinese E&Ps are likelier to benefit from cross-national under-investment in oil and gas.

There are, of course, risks. As with all Chinese SOEs, there is the general risk of your interests being secondary to those of the state. This can take the form of poor capital allocation (though we are encouraged by the > 25% ROEs in the past commodities up-cycle). Or unfavorable transactions with the parent (again, we take some comfort from the investor-orientation of management, and more credibly, the lack of misalignment in past behavior). We see relatively little downside from a collapse in crude, and this minimal downside is part of what makes this investment so appealing. Short of crude dropping below $40 on a sustained basis, we don’t see risk of the dividend getting cut (though it would surely prevent it from rising further). In our view, the realistic downside here is something like: crude reverts and trades at 2019 prices; energy remains unpopular; sanctioned Chinese SOEs remain extremely unpopular. And in that state of the world you’re left clipping a 10% coupon. Not a home run, but a pretty attractive margin of safety. The imaginable, but very unlikely, downside is that China-Taiwan goes the way of Russia-Ukraine. Though even here, we think the risk is heavily mitigated by the significant ownership of CNOOC through the Southbound Connect program. That is by buying the H-share, you are investing alongside many PRC institutions

In terms of catalysts, some investors point to the China reopening post-Covid, but we are more focused on financial ones. Most notably the looming A-share listing. With urgency re-motivated by the CMC sanctions, many Chinese H-shares have been adding A-share listings, and CNOOC is next. Unlike most equity issuances, these tend to be very positive events for equity for a couple reasons: one, it catalyzes investor attention from the crucial, marginal long (who sits in Mainland China); two, it’s accretive, in that the raise will likely occur at a 70-100% premium to CNOOC’s H-share price. The A-share listing was just approved by the CSRC on Feb 24th, so we think the listing timeline is imminent. The other catalyst is just payout. We think the market is handicapping dividends in line with guidance, and underestimating the likelihood of positive revision in light of improved operating conditions. And we think this is aligned with state interests, as shareholder return has been flagged as an important component of SOE reform. Thai might sound like idle talk, but it’s at least nominally supported by the increased clarity the company has recently offered on its capital return. A relaxation of sanctions would be an obviously, hugely positive catalyst, but we consider it very unlikely. Although it’s one of the more dubious CMC names, there is very little political incentive in the US to unwind this.

Catalyst

• Mar/Apr A-share listing
• Payout
• (low likelihood) return of international investor base