Unocal, a seemingly innocuous underperforming oil major, first caught my attention in January of this year. As I was reading the latest edition of Business Week, I stumbled across an interesting discussion of the prospects of a Chinese takeover of the struggling firm. Although I knew very little about the company until that point, what I read in the article immediately piqued my interest. The rumor on Wall Street, according to reporter Christopher Palmeri, was that dynamic Chinese oil player CNOOC was considering a bid to acquire Unocal and its lucrative assets. The report went on to discuss the nature of the American firm’s holdings, which I found to be especially interesting.
The company has lagged its rivals in producing oil and gas. According to investment bank John S. Herold Inc., it is also below average in generating net income per barrel and replacing reserves, and has higher exploration expenses. However, Unocal still possesses tremendous assets — nearly 1.8 billion barrels of oil and natural gas reserves, half of them in the Far East. Now, some of its long-term bets are beginning to pay off: After years of decline, the company’s oil and gas production may begin climbing this year. And thanks to surging prices, Unocal remains solidly profitable. Analysts expect it to earn $1 billion for 2004 — up 55% from a year earlier. Sales should reach $7 billion.
Thinking in terms of China’s hunger for resources, I immediately suspected that this could have broader implications beyond a simple corporate acquisition. Nevertheless, I shelved the issue in the back of my mind. Based on Mr. Palmeri’s reporting, it seemed as if CNOOC was only putting out the most basic of feelers. Since it appeared that nothing would likely come of the matter, I viewed it thereafter as just another small piece of the geopolitical energy puzzle. Once Chevron, an established Western oil firm, moved in and things quieted down, I considered the matter finished. Yet as CNOOC’s recent bold gambit shows, events have progressed further than I could’ve imagined. A minor oil acquisition deal has become a geopolitical focal point, and an important indicator of China’s rise on the world stage. As Japan leveraged its booming economy in the 1980s to invest outward and make a tremendous mark on the world stage, now China is doing the same.
Formally announced on June 23rd, CNOOC’s $20 billion bid has been the talk of Wall Street for several days now. Led by Goldman Sachs and JP Morgan, the Chinese firm has assembled a world-class team of lobbyists, bankers, and public relations experts and backed them with what seems to be the full resources of the Chinese government. They clearly take this bid very seriously, and are supporting it with dogged determination against a powerful array of Congressional skeptics and commercial opponents. This dispute threatens to spiral into an all-out corporate war, waged at the intersection of Washington intrigue, geopolitics, and international economics.
The reasons that CNOOC tendered this offer are both political and strategic. While it’s true that Unocal’s portfolio of assets and resource claims would be a boon to the Chinese firm, Wall Street analysts have pointed out that the financial burden associated with the deal would exceed any short-term profit CNOOC hopes to reap.
For a commercial deal, the cost is enormous. CNOOC is planning to spend all its US$3bn in cash on the deal. The rest will be financed by debt. […]
CNOOC’s net debt level will shoot up to 2.9 times ebitda immediately after the deal, a highly leveraged position when compared with other companies in the sector, which may result in a lower credit rating and increase the cost of refinancing.
Nevertheless, as the same article points out, there are compelling commercial-strategic motivations underlying the deal. CNOOC is one of China’s most dynamic and expansionary oil firms, so a breakthrough deal of this nature would not be out of sync with its general strategy. In fact, over the long term, the acquisition of Unocal could be a great financial success for the company. This is for several reasons.
First, the company is working from a position where it is almost guaranteed strong demand. As the Asian economies have explosively grown over the past few years (especially in China and India), the demand for energy resources has kept steady pace. This has put intense pressure on oil prices, helping to maintain them at a high level, and producing consistent returns for petroleum firms. This trend will not abate in the future, as demand will only intensify and supply will not be able to keep up. CNOOC is, wisely, betting that they’ll be able to exploit these prices to turn a very tidy profit from Unocal’s fields. In particular, the proximity of these deposits to the fast-growing economies of Asia (especially China) gives CNOOC a strategic advantage in shipping cost and access.
Buying the US company will boost CNOOC’s own reserves by 79 per cent and double its annual production from 140 mmboe in 2004. This would make CNOOC bigger than Sinopec, currently China’s second-largest oil and gas company, as well as international rivals such as Occidental and Encana.
Aside from mere profitability, there are deeper strategic factors behind the deal. Diversification is particularly important. As the Financial Times notes, “CNOOC’s current reserves are 65 per cent oil and 35 per cent natural gas. On merging with Unocal, the proportion would become 53 per cent and 47 per cent respectively, which CNOOC said would suit its business better.” In the volatile and speculative energy market, diversification is a sagacious move, especially for a company that will be putting itself in a heavy indebted position. Balancing its reserves almost equally between natural gas and petroleum ensures that the firm is insulated from a sudden downturn in prices for either commodity, whatever the cause may be. Furthermore, as natural gas will eventually supersede oil as one of the world’s key fuels, gaining experience and credibility in that sector will prove beneficial as the company expands its gas reserves in the future. Also, and most importantly, CNOOC will gain access to advanced Western drilling and extraction technology which it currently lacks. This technology will prove essential if it hopes to efficiently develop more remote and inaccessible fields in the future.
Finally, acquiring Unocal would strengthen CNOOC’s position geographically. In addition to acquiring exploitable reserves in areas ranging from the Gulf of Mexico to Indonesia, it would give the firm a foothold in Central Asia’s emerging oil fields; prior to this, the company had been shut out of that lucrative opportunity, and so this places it in a much more advantageous situation for capitalizing on future discoveries. Not to mention, of course, that this massive deal gives CNOOC global credibility and international reach.
Nevertheless, ascribing the offer to corporate strategy alone would be misleading at best. Although many party officials in Beijing, conservative by nature, would counsel against CNOOC’s move, Chinese strategists cannot help but see the advantages that would arise from the acquisition. Most importantly, the acquisition of Unocal would give China control over several large deposits of gas and oil. In their race to secure energy resources in the face of competition from Japan, India, and others, the Chinese are looking more toward benefits than costs, and so would probably be willing to overpay modestly for the resources they need. After all, fossil fuels are a strategic resource, not just a simple commodity; for China to sustain its spectacular economic performance in the coming century, it’ll require a substantial supply of them. This also, as noted before, has to be looked at within the context of China as a burgeoning great power. The country has been receiving massive inflows of capital and investment, and has heretofore spent much of it on internal development and currency stabilization (buying American government securities). Overflowing with funds, it’s only natural that Chinese businesses have begun to look outside the country for acquisition opportunities. This is only one of a string of bold Chinese bids that have been tendered as of late, the most prominent being Lenovo’s deal with IBM.
So, the question becomes, will CNOOC succeed? Although several prominent analysts (most notably Stratfor) immediately declared the issue dead on arrival in Washington, I think that conclusion is far too premature. CNOOC has done everything possible to reassure American legislators that its intentions are benign and that the deal won’t compromise US energy security. The company has promised that any oil produced in the US would be sold in the US, and will probably end up selling off much of its US-based infrastructure and operations, should it prevail; the overseas resource rights are the true prize. Several Washington notables, including Alan Greenspan, have publicly warned Congress over challenging China, and I believe that the White House will be hesitant to embark on yet another trade battle; the passage of CAFTA and the resolution of the Airbus-Boeing dispute have already caused the administration enough vexation. The real fight will be in the halls of Capitol Hill. Both sides have powerful supporters and deep pockets, and it’ll probably be a matter of whether the opposition is strong enough to rally significant support in Congress. If opposition fizzles, then CNOOC has a straight shot to success. Judgement will have to wait for more information to emerge, however.
In any case, President Bush has bigger fish to fry. This is a minor issue compared to the passage of CAFTA, upon which Washington’s credibility in Latin American is fixed. Should that fail, the US would be essentially locked out of trade agreements with the region for a long time, any chance of a regional trade bloc would evaporate, and it would become much more difficult to push through an international agreement on agricultural subsidies or such. The White House, instead of wasting time on what is basically a non-issue for the US, should instead spend what precious political capital it has left on passing the trade deal.