Why We Sold China's No. 1 Oil Play

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gas pump.By Tim Hanson,The Motley Fool

If you've read The BP Statistical Review of World Energy, then you know that investing in oil in China looks like a virtual no-brainer. China's oil consumption has almost doubled since 1999 and now represents more than 10% of all global oil consumption. And yet, the country's per capita consumption is still less than one-fourth that of the United States. As more cars get on the road -- and China is now the world's largest auto market with more than 10 million new vehicles sold each year -- China's oil consumption can only continue to rise. This demand scenario is one of the reasons why oil is now selling for more than $100 per barrel.

And yet, despite this favorable backdrop, I recommended our Motley Fool Global Gains members sell their shares of Chinese E&P giant CNOOC (CEO) at a little more than $270 per ADR last week. The stock had been kind to us -- up 56% and 260% since our two 2008 recommendations -- but the risk/reward profile was no longer in our favor.

But if we're long-term investors (which we are) and believe in rising oil demand in China (which we do), why would we sell? It's a good question.

More Reasons I'm Stupid
CNOOC isn't just a beneficiary of pricing tailwinds. The company is also aggressively exploring and acquiring additional resources -- efforts that were rewarded by better than 44% production growth in 2010. Combine that activity with the recent rise in oil prices and you have the reason why CNOOC's earnings last year were up almost 85%. That's incredible growth for such a large company, which in turn drove rapid growth in the stock price.

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Furthermore, with a reserve replacement ratio that checked in above 200% and more than $6 billion of net cash available to keep investing in expansion, the good times for CNOOC may not be coming to an end anytime soon. Should investors really be cutting ties here or looking elsewhere for energy exposure?

Two Reasons the Answer is "Yes"
Based on our estimates for production capacity, cost of production, and capital requirements at CNOOC (and demanding a 12% rate of return), the recent ADR price north of $270 suggests that the market is pricing in better than $120 oil for the next decade -- just a few percentage points higher than the current price. While that's not outlandish given rising demand and political turmoil in several oil-rich and/or oil-producing nations, it does strike me as optimistic. Remember that oil is a commodity and that energy is a cyclical industry. As oil prices rise, production will naturally come on-line and alternative forms of energy will be adapted. Commodity prices, by virtue of the fact that they are prices for commodities, cannot rise to the sky. And I'm not alone in this view. Goldman Sachs, for example, recently advised its clients to start closing their bets on oil.

Not only will falling oil prices mean that CNOOC won't be able to justify its current valuation, but the company's recent investments and acquisitions mean that among the world's large E&P companies, it stands to suffer some of the worst consequences. Reserves in places such as Uganda and in the very deep water are neither cheap nor easy to extract. Furthermore, the partnership with Chesapeake (CHK) in U.S. shale deposits and investments in coal-seam gas in Australia both rely on higher oil prices in order to be economical. Should those prices not come to pass, the CNOOC risks sitting on potentially unprofitable production capacity.

And that brings us to the second reason why CNOOC was a sell at $270. The company -- like any in a "strategic" industry in China -- is majority owned and controlled by the Chinese government. Given that country's growing energy needs and the need to keep gasoline cheap for the large, generally poor population in order to maintain stability, it's not clear that CNOOC would slow production even in the face of falling oil prices. That matters to investors because it could mean CNOOC would use its cash to subsidize losses rather than reward investors. Put simply, the company answers to a higher power than U.S.-based investors. Yet even if prices were to remain high, there's a risk that China would slap the company with a windfall profits tax (which it would likely use to further subsidize the cost of gasoline -- a product that is already subject to price controls in the Middle Kingdom) rather than let the company's profits accrue to foreigners.

All told, if you're an owner or buyer of CNOOC at $270, you need to be able to answer "yes" to the following two questions:
  1. Will oil stay above $120 per barrel for an extended period of time?
  2. Do I trust the Chinese government to continue to let CNOOC's profitability accrue to foreign investors or shield them from less profitable production?
The Global View
Personally, I'm not sure I'd bet on either one of scenarios let alone the two of them happening together -- and that's why I recommended Global Gains member sell their shares. The other reality worth noting is that if you do believe in higher-priced oil, then there are companies with similar exposure that look like relative bargains. They include Total (TOT) , which has been investing aggressively in reserves in Africa, or names such as Canadian Natural Resources (CNQ) and Suncor (SU) , which will profit from increased production out of the oil sands.

Each one of these companies and their shareholders is relying on higher prices to make money going forward, but at least they don't have to worry about the influence or interference of the Chinese government. That is uniquely CNOOC's problem -- and investors should never underestimate the magnitude of that problem.

Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Total A. is a Motley Fool Income Investor pick. Motley Fool Alpha LLC owns shares of Chesapeake Energy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.





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