For years, China's oil companies PetroChina (NYSE:PTR), Sinopec (NYSE:SNP), and CNOOC (NYSE:CEO) have had a major advantage over their integrated major peers, which flummoxed competing oil companies. This advantage has allowed them to gobble up oil and gas assets around the world at premiums well above market price. Unfortunately for these Chinese companies, it looks like this advantage is ending, and they will need to compete with the rest of the world's oil and gas producers for assets. Let's look at what this advantage was, why it may no longer be there, and what this could mean for the energy markets.
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All three of these publicly traded companies -- and just about every Chinese company dealing with natural resources, for that matter -- are beholden to two opposing masters. Not only are they accountable to their shareholders, but they also have ties to the national government that "encourage" them to act in the best interest of the state. This dual identity gives these companies some very distinct advantages in the global markets, but some disadvantages when it comes to investment.
These three Chinese energy companies have access to cheap capital through loans with extremely low interest rates. For perspective, ExxonMobil (NYSE: XOM) is one of only four companies in the world to hold a AAA credit rating from Standard & Poor's. That credit rating is even better than both the United States and Chinese governments. All three Chinese companies enjoy considerably lower interest rates on their senior notes.
|Company||Average Interest Rate on Senior Notes|
I will admit, this is a pretty crude estimate because it doesn't take into account the duration of the bonds, which affects interest rates. Still, the wide difference in interest rates is rather remarkable.
This isn't the only reason that these companies have a leg up on the competition, though. Since the central government has a large say in what these companies do, they are not under as much pressure from shareholders to generate returns.
|Company||Return on Capital (LTM)|
|Chevron (NYSE: CVX)||10.6%|
|Total (NYSE: TOT)||11.1%|
Keep in mind, this comes at a time when Big Oil players such as Exxon and Total are generating historically low returns on capital. When you combine access to cheap capital and a disregard for shareholder returns, these Chinese oil companies can outspend the competition to secure oil and gas. Just look at the record over the past few years:
- 2011: Sinopec buys Canadian producer Daylight Energy for $2.1 billion, a 44% premium to market cost.
- 2012: CNOOC buys Canadian producer Nexen for $15.1 billion, a 61% premium.
- 2013: Sinopec buys 40% working interest in Permian basin with Pioneer Natural Resources for $1.7 billion, a 40% premium.
Not only is this detrimental to shareholders, it hurts the entire oil and gas market. Wildly overpaying for acquisitions drives up the price for other potential buyers, making it that much more difficult for a company such as ExxonMobil to make acquisitions. Perhaps stealing isn't the most accurate term for what China is doing, so instead we'll call it sabotaging the performance of your own company by overspending to ensure a source of oil at all costs.
The bill has finally come due
Chinese President Xi Jinping has made it a priority to tackle corruption, and one way he is going about it is to reform these near-monopolistic industries in China. The goal is to make the nation a more attractive investment for private money to fund some of the massive development projects planned for coming years. This means that these companies will be more exposed to market forces and will therefore need to generate free cash flow to help fund development.
This has led to a reverse course in capital spending at each business, and even the divestment of major components. Both PetroChina and Sinopec have indicated that this year they will reduce capital expenditures by 5%-10% from 2013, and Sinopec is even looking to sell its $20 billion retail unit. Perhaps there hasn't been much media attention to this move, but it will have a significant impact on both the performance of these companies and the entire global market.
Who wins, who loses?
China's overspending in recent years did a couple things: 1) It helped pad the pockets of many companies that did deals with the nation, such as Pioneer Natural Resources and a number of oil-services companies, and 2) It hurt other exploration and production players due to increasing prices for services contracts to increase, or the Chinese companies placing artificially low bids on production-sharing contracts in places such as the Middle East.
As the trinity of Chinese oil companies start to act more like Big Oil players in pursuit of returns, we will likely see them become more cost conscious when it comes to contracting work, which will likely lead to a decrease in profitability for oil services and rig companies. At the same time, exploration and production companies will benefit from the more cost-competitive service contracts; it wouldn't be too surprising if they are able to generate stronger returns down the road as well.
What a Fool believes
With China mandating that its state-owned enterprises become more reactionary to market forces, many may struggle to become more market-driven than they are today. Overall, though, this will be better for the overall market by creating more competition among global oil producers. When all companies are competing on a more even playing field, everybody wins.