A Little Known Chinese Oil Play

Ryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

CNOOC (NYSE: CEO) isn't usually the first company that comes to mind when discussing the Chinese oil and gas sector. The acronym CNOOC stands for the China National Offshore Oil Corporation, and is an upstream oil and gas company.

In the context of the oil and gas sector, upstream companies are the ones that engage in exploration in order to discover locations of reserves. Upstream companies are also the ones that extract reserves once they are found. Midstream companies transport the oil and natural gas to refineries. Downstream are responsible for refining, marketing, and distribution.

A triad of dominance

The oil and gas sector in China is dominated by three huge companies, all of which are at least partially owned by the government. In addition to the aforementioned CNOOC, the other two big players are PetroChina (NYSE: PTR) and Sinopec (NYSE: SHI).

PetroChina is the biggest oil producer in China. Upstream, midstream, downstream, when it comes to oil and natural gas, PetroChina does it all. It conducts the vast majority of its operations on land.

Sinopec is China's largest petroleum refiner. It processes crude oil into a variety of products. Around 40% of its net sales come from petroleum products, things like diesel, gasoline, and jet fuel. But it also processes crude oil into plastics, resins, and intermediate petrochemicals (paraxylene for example).

China's dominant offshore driller

Finally there is CNOOC, China's premier offshore drilling company. According to its latest annual report, CNOOC is the only company in China permitted to engage in oil and gas production in offshore China with foreign parties under production sharing contracts. 

While approximately 69% of the company's reserves are located in offshore China, it also holds interests in oil and gas blocks in the United States and Canada, among various other countries.

It has significantly expanded overseas reserves in recent years. Such reserves now comprise nearly one-third of CNOOC's total, and still only account for 14.7% of revenues.

What are some of the biggest risks for CEO shareholders?

First and foremost among the risks facing CNOOC has to be that it is completely at the mercy of the Chinese government. All of China's petroleum resources are owned by the state. While government policies have for the most part served to benefit CNOOC, there are no guarantees this will always continue to be the case.

Additionally, I was a little bit disturbed by the fact that between 2010 and 2012 CNOOC increased the percentage of its reserves that it independently evaluated from 11% to 36%. Personally, I think the odds of malfeasance are a lot lower if a third-party company evaluates reserves.

Many metrics make CNOOC look cheap

As most investors know, the price-to-earnings ratio isn't a flawless measure by any stretch of the imagination. However, it can be a good starting point in trying to determine whether a company is a bargain or not. A ratio below 10 can be a sign that a company is trading cheaply. 

CNOOC's current P/E ratio stands at 7.24. Utilizing a three-year average for the EPS portion of the formula gives you a ratio of 7.42, which is still pretty low. Using a three-year EPS average to calculate the P/E ratio of Sinopec yields a ratio of 21.4 (which would be much lower were it not for a large net loss in 2012). For PetroChina, the ratio is 10.33.

When I was a little kid I used to scream for ice cream. Now I scream for dividends with low payout ratios. Oh how the times have changed.

CNOOC currently yields 3.3% with a payout ratio of 22%. PetroChina has a slightly higher 3.6% yield coupled with a much higher payout ratio of 45%. Finally Sinopec, whose net loss in 2012 means its payout ratio is negative, yields 2.1%. 

A look at the balance sheet

One of the first things that struck me as soon as I looked at the balance sheets for these three companies is that both PetroChina and Sinopec have working capital deficits. In the case of PetroChina, working capital is negative by nearly $8 billion. CNOOC, on the other hand, has a working capital surplus of over $14 billion.

All three companies have done well in regards to not allowing shares to become diluted. PetroChina and Sinopec had the same amount of shares outstanding at the end of 2012 as they did in 2009. CNOOC lowered the amount of shares it had outstanding during that period, but by an amount so small as to be negligible. 

In terms of growing shareholder equity, these companies all performed on different levels. Sinopec has grown shareholder equity at a compound annual growth rate of approximately 4% over the past four years. The figure for PetroChina was approximately 8.3%. For CNOOC, it was a scorching 19.8%.

Final Foolish thoughts

The oil and gas industry in China is dominated by three giants. PetroChina is by far the largest producer of oil and natural gas in China, and is involved in nearly every aspect of the oil and gas industry. Sinopec is the largest refiner in China and, while not as massive as PetroChina, also has upstream, midstream, and downstream operations.

And then there is the China National Offshore Oil Corporation, or CNOOC for short. With exclusive rights to engage in offshore drilling in Chinese waters with foreign companies, CNOOC occupies an enviable position.

While CNOOC is far from a sure thing, by many measures it could make for a far better investment than either of the other two members of the triad that dominate China's oil and gas industry.

CNOOC has grown shareholders' equity at a much faster rate in recent years than either PetroChina or Sinopec. It also currently has the lowest price-to-earnings ratio. While it's dividend comes in second place to PetroChina (by only 0.3 percentage points) the payout ratio for CNOOC is much, much lower.

Investing in China is fraught with risk, but risk is present in any investment. As an investor, you need to take calculated risks, ones where the odds are in your favor. And in my eyes, at current price levels, that seems to be the case with the China National Offshore Oil Corporation. 

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Fool blogger Ryan Palmer has no positions in any of the stocks mentioned in this article. The Motley Fool does not recommend or have a position in any of the stocks mentioned in this article. Try any of our Foolish newsletter services free for 30 days. 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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