Unocal deal may be a bitter pill, but it's good medicine

PUBLISHED : Wednesday, 22 June, 2005, 12:00am
UPDATED : Wednesday, 22 June, 2005, 12:00am

If CNOOC goes ahead to mount an aggressive takeover bid for independent oil and gas company Unocal Corp of California, it will face formidable obstacles.

The mainland firm will have to overcome opposition from independent directors and minority shareholders, both of whom are likely to accuse it of heavily over-bidding.

It will also have to accept the probability of a downgrade from credit rating agencies, which will frown on a deal certain to drive its debt levels through the roof.

On top of that, CNOOC risks a nationalist backlash in the United States Congress, where representatives are already rumbling about threats to American jobs and energy security.

But even though CNOOC will have to pay richly for Unocal and is likely to see its share price fall in the medium term, the acquisition could still be a smart move.

In an era of US$60 barrels of oil and fast-growing East Asian energy demand, oil companies are going to have to get used to paying more for their reserves. In offering a high price for Unocal, CNOOC is merely front-running an emerging long-term trend.

That will not comfort CNOOC's minority shareholders. To be in with a chance of acquiring Unocal, CNOOC will not only have to offer a significant premium over the US$16.4 billion bid Chevron Corp agreed in April, it will also have to take on board US$1.6 billion of Unocal's debt and pay a further US$500 million penalty for busting the Chevron deal.

Altogether, that means CNOOC will be paying more than US$20 billion for the company.

Worse, with no appreciable operations in the US, CNOOC can expect none of the US$350 million annual cost savings that Chevron is expected to realise on the deal. That leaves any acquisition attempt looking expensive for the mainland company.

Shareholders clearly think so. CNOOC's stock slipped 1.18 per cent yesterday to close at $4.175. It has now fallen 9.23 per cent from its March high and badly lags the shares of industry peers such as PetroChina, which has risen 12.56 per cent over the same period due to higher oil prices.

CNOOC's non-executive directors may regard a bid as expensive, too. The company's independent directors are believed to have scuppered a proposed bid for being too pricey in April and they could well take the same line now.

If the board does give the all-clear, a bid will still face hurdles. With a market capitalisation of just US$22.5 billion, CNOOC's stock will not be an attractive currency for Unocal's investors. That will leave the mainland company little option but to supplement its meagre US$1.7 billion cash reserves with massive borrowing to make an all-cash offer if it is to stand any chance of success.

Although CNOOC will surely receive favourable terms from China's state banks, a credit rating downgrade looks inevitable if the bid proceeds. That will further hurt CNOOC's stock price and substantially raise its future borrowing costs.

Even then, the US authorities could block a takeover. Californian congressmen are already calling for any CNOOC bid to be referred to the Federal Trade Commission, a process in which the transaction could become mired for months and which would greatly add to cost and uncertainty, even if the deal ultimately succeeds.

However, a Unocal purchase would still have its benefits. The deal would almost double CNOOC's proven reserves to the equivalent of four billion barrels of oil.

Admittedly, the mainland firm would be paying a hefty premium and accepting a lower rate of return than its western rivals might be prepared to swallow. But with little in the way of overseas reserves, acquisitive mainland firms are going to have to pay big premiums from now on anyway, and future opportunities to double their reserves at a stroke are going to be rare.

In April, industry consultancy Wood Mackenzie concluded that US$18.4 billion would be an attractive price for Chevron to pay for Unocal, assuming a long-term oil price of US$30 a barrel.

Today, with oil nudging US$60 and showing few signs of dropping back below US$50, let alone US$40, US$20 billion is surely not too much for CNOOC to pay.