Chinese oil companies: giants on shaky foundations


Chinese national oil companies (NOCs) are not mere puppets of their political masters. Whilst adhering to the overall guidelines provided by the government they have their own commercially driven agendas.

They operate significant domestic oil production from mature onshore fields. This is their heartland and the area of their core technical expertise. Prospects for growth within China are limited and overseas investments are deemed more attractive.

Twenty years of overseas investments have seen a marked shift from a few operated ventures in conventional fields in high risk countries such as Sudan to many (often non operated) ventures in different asset classes (including deepwater and unconventional assets) spread across the globe. Overseas ventures now account for about 30% of their oil production.

By far the largest investments were made during 2009 to 2013. They have often overpaid for these acquisitions with takeover premiums significantly higher than the industry average. But the main issue for the financial performance of these acquisitions is their timing: they were made in a high oil price world with asset prices peaked.

Towards the government, the NOCs have stressed that their acquisitions contribute to China’s energy security and to their own technical expertise (helping them to achieve their long term goal to emulate the western majors). This seems doubtful. Oil from their overseas investments is traded on the global market like any other oil. As yet, the Chinese NOCs are not seen to be able to operate in different asset classes, across the globe, in the way that the majors do.

Chinese banks have been more than willing to fund the NOCs. Chinese people, with a high savings rate, have few alternatives for their money. As for other Chinese state owned enterprises: should the NOCs run into problems these problems are shifted towards China as a whole. With Chinese debt growing at three times the rate of the economy this situation is not sustainable.

The NOCs have been a key target of China’s recent anti-corruption drive. Corruption may have been no more than a welcome pretext (the government has to be seen as being tough on unpopular corruption); it can also be seen a power struggle within the party and an attempt to reign in the poorly performing NOCs (with the aim to increase their performance).


Some 15 years ago I worked for a small and well-hidden part of Shell in Central Africa. I have fond memories of living on the shores of Lake Yenzi in Gabon where my children grew up in a world of lagoons and tropical rainforest virtually untouched by mankind. To this day I miss the human warmth of Africa.

Towards the end of my spell in Gabon we would discuss among colleagues the arrival of a new competitor in country: Sinopec. We were puzzled. How could we reconcile the stories that the Chinese were taking over Africa (if not the world) with this hapless new venture, which had trouble getting to grips (both geology and country wise) with a completely new environment? What were we missing? I do not think we underestimated them; it was expected they would work hard and learn fast (and they had money to spend). But the general view was that they faced an uphill struggle.

These days the Chinese national oil companies (NOCs) have long shifted their focus from leftover assets in Africa to other parts of the world, including North America. The growth in their overseas oil production has been phenomenal. But it has come at a price. Earlier this year Moody’s estimated that the debt of Chinese state owned enterprises (SOEs), of which the NOCs form a major part, had risen to about 115 % of China’s GDP, higher than for any other country in the world.

There are a number of questions that I want to address in this paper. Where did the Chinese NOCs invest? Did they overpay? What were their objectives to go abroad and were they met? And perhaps most of all: have the Chinese NOCs now become global energy powerhouses or giants on shaky foundations?


Chinese NOCs: what kind of companies?

A heartland of mature onshore fields.  Unlike some of its neighbors (e.g., Japan or S. Korea) China has a large domestic oil production. The major fields were found in the 1950’s and 1960’s. The largest field, Daqing, has produced over 10 billion barrels and is still producing close to 700,000 barrels per day. In spite of frantic efforts, later exploration has enjoyed much more limited success. In 1993 consumption overtook domestic production and since then consumption has increased fourfold (whereas domestic production has only seen limited growth). The large dependence on oil imports (currently China imports about 62 % of its oil) is a key issue for China’s energy security.

Today, China is still the fourth largest oil producer in the world. But the bulk of its production comes from very mature fields such as Daqing, which by now experience high water cuts. It is only by intense (and costly) enhanced oil recovery methods that decline can be limited. As a result China’s onshore production is not low cost, of the order of 30 dollars per barrel on average (with a marginal cost that is much higher). Western publicity of Chinese oil companies tends to focus on their overseas acquisitions but the heartlands of these companies are mature conventional fields and their core technical expertise is maximizing recovery from these fields.

Chinese NOCs operate in a different way compared to the western majors. Their preference is to do as much as possible in house (including the use of in house service companies). If this is not possible they tend to use Chinese service companies and only as a last resort (if specialized knowledge is not available in house or in China) western service companies. Activities such as logistics and catering are done in house. Their workforces are much larger than those of western firms with similar production (e.g., CNPC employs about 550,000 people).

Government owned, not government run.  Initially oil production, processing and distribution were controlled by the Ministry of Petroleum Industry (the forerunner of CNPC) and the Ministry of Chemical Industry (the forerunner of Sinopec). In the 1980’s these ministries were converted into state owned enterprises (SOEs) and they both became integrated oil companies (be it that CNPC still has a bigger focus on the upstream and Sinopec has a bigger focus on the downstream). A third major SOE was added (CNOOC, China National Offshore Oil Company) and to date these companies (generally referred to in China as “the big three”) dominate China’s oil industry. Each of them comprises a wholly state-owned holding company and a listed subsidiary for which domestic and overseas shareholders own a minority stake (e.g., PetroChina in the case of CNPC).

To date, the heads of CNPC and Sinopec are of ministerial rank in China’s hierarchy (a higher rank than the much smaller government agencies that oversee them). To date there is no formal Ministry of Energy in China. The result has been described as “ineffective institutions and powerful firms”. The NOCs are owned by the state but not run by the state. According to an IEA report, “the top executives of the NOCs are deeply connected to the top leadership of the government and the CCP (Chinese Communist Party); they must wear two hats, as leaders of major commercial enterprises and as top Party operatives. It is in the interests of both the government and the Party that the NOCs are commercially successful, and that they secure adequate oil and gas supplies. Leaders have a great deal of freedom in how they achieve these aims, and those who fulfill them have leverage in bargaining for future promotions.” An extensive overview of the structure of the Chinese oil industry can be found in a recent OIES report.

Whilst NOCs will never omit a reference to China’s national energy security it seems that their own commercial interests are as strong a driver (if not the dominant one). There is no well coordinated master plan for China’s energy policy and overseas investments. Instead there are vague overall guidelines in an opaque environment.

The limited oversight and the opaque way in which overseas assets are acquired or work is contracted out create an environment where widespread corruption is possible.


The early days of going out: Sudan

The early 1990’s saw a number of developments that were of key importance to the Chinese oil industry and enabled them to go abroad. At the 1992 14th congress the CCP announced it would institute a “socialist market economy with Chinese characteristics”. Deng Xiaoping, retired from his official functions and yet at the height of his influence, believed the economic benefits of capitalism could be combined with the CCP guidance of a centralized and technically knowledgeable political system. Part of this economic reform policy involved the concept of “going out” (zou chuqu), investing surplus Chinese capital abroad to gain access to foreign markets, natural resources and advanced technology.

In 1993-1994 the Chinese government relaxed domestic oil prices, improving the financial situation of the NOCs and enabling them to invest abroad.

For the oil industry going out arrived at an opportune moment. In the early 1990’s it had become clear that domestic production could no longer keep up with consumption. The absence of exploration success and the increasing maturity of China’s producing fields implied that better opportunities for investment existed abroad. The go ahead to go abroad presented a huge opportunity to Chinese companies but also – given their complete lack of experience in operating or investing outside China – a huge challenge. But their long term aim was clear: to become competitive global businesses and to emulate the western IOCs.

Initially they started out as operators in a limited amount of countries (e.g., Sudan and Kazakhstan) with a relatively high political risk. At this time Chinese NOCs still lacked the financial muscle that they enjoyed later on and they had little choice but to go for these risky areas.

The largest of these ventures is the CNPC development of the Southern Sudan oil fields. It is also the one that has received by far the most attention in the western media. It has become the defining story for China’s investments in Africa, generating considerable reputational damage. Luke Patey’s “The new kings of crude” gives a well documented and balanced overview of CNPC’s Sudan venture (the remainder of this section is mostly based on it). It also paints a fascinating story of the pain of Chevron’s geologists (after years of hard work and exploration success having to leave the country for political reasons), the substantial achievements in development of the Chinese (establishing oil production and export in record time) and the difficult choices that the Chinese subsequently faced (with Sudanese leaders interested in power rather than their people’s wellbeing).

Throughout the late 1970’s and early 1980’s Chevron ran a major exploration campaign in Southern Sudan. It was Chevron that found the Heglig field and started the work on an export pipeline. Then things started to fall apart. An attack by Southern Sudanese rebels on Chevron’s base camp (with three fatalities) was followed by a worsening of the political environment, forcing Chevron to put things on hold. By the late 1980’s the National Islamic Front came to power and the new central government threatened Chevron to resume operations or face expulsion. A new Chevron board turned out to be less committed to the project. Making a major additional investment in a country torn by civil war was just too risky for them (also given the low oil prices after the 1986 crash). They sold their assets to a local company for a mere pittance and walked away from a 1 billion dollar investment.

During the following years domestic and small western companies found themselves unable to make significant progress (to the frustration of the Sudanese government), lacking the financial and technical clout to develop a major new oil province at a large distance from shore.

By 1995 the Sudanese search for an operator able to unlock these major finds linked up with the Chinese search for overseas opportunities. It is easy to see why CNPC was interested: significant oil had been found and although field development required a large effort it was the kind of work (development wells, pipelines) that was well within their capabilities. Chinese banks were willing to finance with loans of (up to that moment) unprecedented magnitude. With the limited choices CNPC had it was an opportunity to good to walk away from.

Oil flowing from the Southern Sudan oil fields through a 1500 km pipeline to the Red Sea by 1999 was a major achievement for CNPC. In the preceding four years they threw everything at it that they had, sending out their best teams to their most important overseas venture. They built up an entire oil infrastructure, including a local refinery. The continuing political unrest and occasional hostage taking (or worse: killing) did not deter CNPC. In any case the grueling circumstances and low safety standards were a greater danger to Chinese workers than the Southern Sudanese rebels.

During the following years Sudan’s oil production soared (to a peak of 470,000 bpd in 2007) and the CNPC Sudan venture was by far the largest producer and profit maker of the Chinese NOCs’ overseas ventures.

But after 2005 things gradually started to become more difficult. The number of incidents started to rise and the fallout of the reputational damage of the Sudan venture started to become more clear. Sudan was becoming a major hindrance in the Chinese NOCs’ overseas investments and attempts to get access to western technology. Following the large initial investments the venture gradually went into cash cow mode. Investments in enhanced recovery, needed to crank up the recovery factors, were postponed. As a result recovery factors of these fields have remained low (e.g. 23 % for Heglig, which is considerably lower than the 30 – 50 % that has been achieved for similar high net to gross sandstone reservoirs in other parts of the world). The rapid severe water cut that these fields experienced in the 2005-2010 period suggest they have been producing too fast, maximizing profit in an unstable country that was now about to split up.

For CNPC Sudan was initially a major success story. The subsequent collapse of production after Southern Sudan’s secession in 2011 has been a major disappointment, however. To this day, Sudan and Southern Sudan are arguing about pipeline fees for the transport of Southern Sudan oil through the Sudanese pipeline. The Chinese are doing their best to keep both parties happy and remain unsuccessful in doing so (in the words of a Southern Sudan oil minister: “but Jesus said one cannot serve two masters”). Political risks (both within Sudan and the reputational damage in the western world) had been severely underestimated.


2009-2013: overseas investment explodes

Eventually, the overseas investments of the NOCs took off in earnest in 2009. The figure below (from a presentation by SIA energy) gives an overview of Chinese NOCs acquisitions in the 2005 – 2013 period. A total of US$ 123.5 bn was spent by the three Chinese NOCs during this period, primarily between 2009 and 2013.

China paper fig1

Apart from being of a much larger magnitude the nature of Chinese NOCs’ overseas investments in the 2009 – 2013 period is markedly different from the early investments in countries like Sudan, Kazakhstan and Venezuela. There is a shift from operated assets to non operated assets, from a limited set of high risk countries to investments well spread all over the world and from primarily onshore, conventional assets to a full range of asset classes (including unconventional, deepwater and oil sands).

Several reasons lie behind this shift: the scarcity of Sudan like opportunities (large amounts of relatively low-cost, onshore conventional oil), the wish to share risk (both technical and political), the wish to not make very large investments in a single high risk country like Sudan (were the total investment eventually amounted to some $ 20 bn) and the increased importance to get access to western technology (as remaining opportunities tend to be associated with unconventional, deepwater or oil sands deposits – none of which relate to the core technical strengths of Chinese NOCs).

Landmark acquisitions during this period were the $ 15 bn Nexen takeover by CNOOC in 2013 (following a 2005 failed attempt by CNOOC to take over Unocal, in spite of putting a bid on the table that was over 10 % higher than the eventually successful Chevron bid) and the Addax takeover by Sinopec.

The question whether the Chinese NOCs did systematically overpay has generated a lot of discussion. Several papers (e.g., by Derek Scissors) have maintained that this is the case, often within the context of increasing Chinese influence in general. Many reports on Chinese acquisitions contain statements that they “again overpaid wildly” but I have seen very few systematic studies. The few I have found (e.g. a very interesting paper by Anatole Pang, one of the few papers written by someone with Chinese industry experience) were academic studies that claim they found no evidence for systematic overpaying. As these studies are based on the cost of reserves I tend to doubt their conclusions. A deal where say 2 dollar per barrel of proved reserves is paid can be a deal that is worse than one where say 20 dollar per barrel of proved reserves is paid; it all depends on development costs, tax regime, etc.

I think that looking at takeover premiums for acquisitions of publicly listed companies is the best way to deduce whether Chinese NOCs did overpay. Based on this it seems likely that Chinese NOCs did indeed overpay – by an amount of the order of 20 – 50 %. Where publicly traded companies have been acquired the premiums paid by Chinese NOCs have been hefty. Premiums paid for the Addax and Nexen takeovers were 47 and 60 % respectively; significantly above the average premium in the energy sector of about 30 – 40 %.

In takeovers of assets that were not listed they have frequently outbid competitors by significant amounts (I am not aware of any examples of the reverse).

Several factors may contribute to overpaying. Chinese NOCs may feel overpaying is necessary to overcome political resistance and to preclude a long bidding competition that may generate adverse publicity. Government approval is required and, once obtained, may be an incentive to come to a successful bid. Failed takeovers may be seen as loss of face. Government policy for the NOCs was focused on volumes and growth rather than value until recently. And finally access to funding at relatively easy terms by Chinese banks may provide less of an incentive to bargain hard for a lower price.

Nevertheless, the financial performance of Chinese NOCs’ overseas acquisitions is not so much hampered by paying more than their competitors but rather by the unfortunate timing of their acquisitions. By far the greatest amount of takeover activity took place in the 2009-2013 high oil price world. A lot of money was spent on high production cost assets, such as (Canadian) oil sands or (North Sea) mature fields that were bought at the peak of the market. These assets have performed particularly poorly in the post 2014 low oil price world.

An example is the 2012 acquisition of a 49 % stake for $ 1.5 bn in Talisman’s UK assets by Sinopec. Relatively high field decline rates, a high downtime of ageing facilities and increasing estimates of future abandonment costs limited the attractiveness of these assets already in a high oil price world (many North Sea operators have been trying to divest these kind of assets for years, with few takers). With the 2014 oil price collapse this turned into a disastrous cocktail and the poor performance of its UK assets threatened to bring down Talisman as a whole (a company already weakened by low American shale gas prices). Efforts to further divest their North Sea assets were unsuccessful and in 2014 the company was taken over by Repsol. Repsol was interested in other parts of Talisman and saw little value in the North Sea assets, especially when oil prices turned out to be lower for longer. For Sinopec a $ 1.5 bn investment turned into an abandonment-related liability within 3 years. Sinopec’s subsequent legal demand for compensation from Repsol is seen as having a very low chance of success. It is a sign of their frustration, a way to put pressure on Repsol (which values good relations with Chinese NOCs with whom it cooperates elsewhere) and stakeholder management with respect to the Chinese government.

Another example is CNOOC’s $ 15 bn Nexen takeover. Nexen, a Canadian company, is heavily exposed to high cost Canadian oil sands. Apart from its high costs, these assets suffer from being landlocked. The US blocking the Keystone XL pipeline will now result in a lower price for Canadian oil for a longer time. Even among other oil sands assets Nexen’s assets are relatively high cost and have been recently plagued by operational issues.

Many Chinese and Chinese companies lack a profound understanding of the western world (in the same way as many in the western world lack an in depth understanding of China). China should perhaps be seen as a parallel universe instead of just another country. As a result they are not optimally equipped to fully analyze the technical, political and environmental risks associated with an overseas investment.

Off course many western companies have had their share of acquisitions turned sour. But I would argue that on average they have had a better track record (paying lower takeover premiums, being more reluctant to invest in high cost mature North Sea fields or Canadian oil sands, making a better assessment of political and technical risk).


Recent developments (2014 – present)

From 2014 onwards overseas investments have decreased dramatically. The current low oil price environment definitely plays a role here. Profits have dramatically decreased as a result of the low oil price and write offs of previous acquisitions. Internal funding of acquisitions has become more difficult. Funding is still possible, however, and the current low oil price environment is not the only reason for the overseas investments drop.

Management of the Chinese NOCs is currently under intense pressure due to the ongoing reforms of SOEs (triggered by their poor performance) and corruption probes. A high publicity audit of $ 10 bn Angola investments by Sinopec revealed the shady deals with Sonangol through obscure companies known informally as the Queensway group. Angolan assets put on the market by western oil companies landed up (upon Sonangol exercising its preemptive rights) with companies such as China Sonangol, owned jointly by Sonangol and Chinese middlemen (but funded by Sinopec). When these assets would eventually be transferred to Sinopec (more likely so for the poorly performing assets) it would be at a substantially higher price. The Financial Times reporting on the Queensway group is one of the few cases were investigative journalism has been able to unravel the dealings of Chinese NOCs and their middlemen in some detail.

Over the last 2 years former presidents of both CNPC and Sinopec have been convicted for corruption. Many other high ranking managers have been placed under investigation or convicted. The most prominent case was that of Zhou Yangkang, who after his spell as CNPC president eventually became a member of the CCP standing committee, China’s top decision making body. Corruption may have been but a welcome pretext (the CCP has to be seen as being tough on unpopular corruption); the underlying reasons are more likely to be a combination of a power struggle within the CCP and the removal of people opposed to the reform of poorly performing Chinese SPE’s (as well as the poor performance in itself).

Knowing that unsuccessful overseas acquisitions can eventually result in convictions (be it for corruption rather than the acquisitions themselves) has made the Chinese NOCs much more cautious. Future acquisitions should involve smarter investments in quality assets, focusing on value rather than volume.

Cost cutting is now starting to result in a significant drop in domestic oil production (which still accounts for over 70 % of the total production of Chinese NOCs). 2015 is likely to have been the year that Chinese domestic oil production has peaked. By July 2016, production had dropped by more than 8 % from its peak.



On the positive side, I would consider the Chinese NOCs to be able operators for their domestic (primarily onshore, conventional) production. Average cost of the order of 30 dollars per barrel imply that these assets generate substantial profits.

Twenty years of overseas investments have resulted in equity production that is about 30 % of their total production, amounting to over 2 million barrels per day. But what else? Surely, if this were to be a true success story, it should not be just about growth.

If it is about energy security it should be noted that oil from the NOCs overseas assets is sold on the open market – and is going to the refinery that is best suited for this quality of oil and is willing to pay the highest price (and not necessarily to China). Control over the strait of Malacca (through which about 80% of China’s oil imports is transported) seems a much bigger issue here.

If it is about profitability than I feel that their record of overseas acquisitions is a mixed bag – at best. What hampers them in this regard is their record of overpaying and the timing of the bulk of their acquisitions, which coincided with the 2009-2014 high oil price world.

If it is about technical capabilities I note that, whereas they have massively invested in deepwater, oil sand or unconventional, they have done so mostly as non-operators. The technical knowledge acquired by being a non operating partner (or by acquiring a company that is subsequently run at arm’s length) is not of the same order as the technical knowledge needed to operate and grow organically. I do not see the Chinese NOCs operating e.g., deepwater fields across the globe, in a way that the western majors do. Their operated production is still primarily domestic conventional production.

I do not think that emulating the western IOCs in operating different types of assets across the world or emulating the US tight oil industry in Chinese tight oil are successful business models for Chinese NOCs. For China as a country I think it would be more beneficial to put a greater emphasis on conventional oil and gas within the Asian continent (in particular, Kazakhstan, Russia, Iran/Iraq), thus aiming at a greater share of conventional assets (closer to the NOCs technical strengths) in locations close to China that at least in part export oil by pipeline to China rather than by tanker through the strait of Malacca. Kazakhstan has so far been one of their more successful overseas investments.

The strength of Chinese NOCs (apart from their domestic production) is financial rather than technical. A western company with a similar record of acquisitions would be in severe financial trouble. Not so the Chinese NOCs: the absence of public shareholders with a short time horizon and the funding by Chinese banks imply that for them the rules of the game are different. So far, “China Inc” has bailed them out.

Their rapid growth has been fueled by profits from domestic production (in particular in a high oil price world) and by debt. Chinese banks have been more than willing to fund. Chinese people, with their high savings rate (and limited ability to move funds abroad) have few alternatives for their savings. It is for them to ultimately pick up the bill.

Chinese SOEs in financial trouble have so far been bailed out. This does not solve the problem though in the long term – it just shifts the problem upwards to the next level (which is basically “China Inc”). When evaluating the strength of Chinese NOCs one cannot look at these companies in isolation; one has to look at them as “part of China”.

In the long term, the strength of China and Easternisation are they to stay. How could it be otherwise? As Lee Kuan Yew, the former prime minister of Singapore stated: “Theirs is a culture 4000 years old with 1.3 billion people, with a huge and very talented pool to draw from. How could they not aspire to be number one in Asia, and in time the world?”

But in the short term: when will Chinese debt and the ability of China to bail out all its poorly performing SOEs hit a ceiling? At some stage pumping more debt into increasingly unattractive projects has to stop. At this stage Chinese debt is growing at three times the rate of the Chinese economy. With an increasing share of problematic loans the question is not if, but when, there will be a Chinese debt crises. Chinese that have the means to do so have now started to take their money out of the country.

The Chinese NOCs are giants on shaky foundations for a simple reason: they are part of an even bigger giant – on even shakier foundations.

China paper fig2

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