Production Woes Weigh On CNOOC

| About: CNOOC Limited (CEO)

China's largest oil and gas producer, CNOOC ltd. (NYSE:CEO), posted a 19% drop in net profits year-on-year for the first half of 2012; dropping from $6.19 billion to $5 billion. The company's revenue also fell by 5% to $18.6 billion in the same period. The drop is attributable to decreases in production due to both leaks and increasing costs. The costs per barrel produced also increased by 13.1% to $34.60 while the realized oil and gas price increased by 8.1% to $116.91 per barrel.

The Penglai 19-3 oil field, located in Bohai Bay, China, witnessed a 4.6% drop in production due to a massive leak. CNOOC is the co-owner of the oil field with ConocoPhillips (NYSE:COP) and is operated by their subsidiary ConocoPhillips China. The area accounted for 57% of CNOOC's total crude oil and liquid production in H1 2012. The spilling oil has polluted around 6,200 km(2) sparking lawsuits. So far, CNOOC has been required to pay $94 million in damages and compensation to fishermen and that number is likely to rise substantially.

The company proposed a 40% cut in its dividend to $0.02 per share due to the $15.1 billion acquisition of Canada-based oil and gas producer Nexen (NXY). This would be the biggest takeover by a Chinese company of a foreign energy firm ever. CNOOC has made a generous offer for $27.50 per share when the current share price for Nexen is $25.82. This is far bigger than the $5.3 billion that Malaysia's Petronas will pay for Canada's Progress Energy Resources.

The deal is expected to materialize by the fourth quarter. CNOOC has $15.7 billion cash in its pockets but it is planning to buy out Nexen through a combination of its own resources and external funding. These deals highlight just how important and vast the future needs for oil and LNG are for all of Southeast Asia and the Pacific Rim. Furthermore, the deal will give China access to the valuable oil reserves in U.K.'s North Sea, Canada, Nigera, and Gulf of Mexico.

Nexen has substantial operations and holdings in the Gulf of Mexico, which is being opened back up to drilling after the Deepwater Horizon's spill that continues to haunt British Petroleum (NYSE:BP). Since Nexen operates in U.S. territory the deal, therefore, requires approval from U.S. regulators.

CNOOC is following with its overseas expansion strategy that should give long-term benefits to its shareholders, at a cost of the present cut in dividend. Dividends from Asian stocks are both more common than they are for U.S. stocks and more volatile. U.S. companies only begin offering dividends when their growth profile is secure and it makes sense from a tax perspective.

This is part of the reason why Apple (NASDAQ:AAPL) resisted declaring a dividend for so long. But once an American firm begins paying dividends, that dividend will flow for as long as it is practicable as a means to keep investor's from panicking out of the stock. In Asia, on the other hand, paying out a percentage of profits as dividends begins much earlier in a company's life-cycle and as such, especially in frontier and emerging markets, is tied to a percentage of total profit and can be much more volatile.

In 2005, CNOOC had tried to acquire U.S.-based oil firm Unocal but the deal fell apart due to political pressure from U.S. If the CNOOC-Nexen deal goes as planned, then CNOOC will become the first Chinese oil producer to tap into U.S. deep water oil reserves. As was expected, some U.S. senators, such as New York Senator Charles Schumer, would like China to give the U.S. a more favorable trade policy in return. However, this time around, compared with 2005, there is no severe criticism of the Chinese takeover. Schumer likes to grandstand, especially in an election year, but since China holds the U.S.'s future in its foreign exchange reserves, those entreaties have amounted to nothing.

The management has warned that the current "volatile" environment will continue to exert pressure on oil prices. However, it was confident of reaching its 330-340 million barrels a year target by the end of 2012. It has produced 160.9 million barrels in the first half of 2012, down 4.8% year over year. It has made 10 new discoveries while its production in Long Lake Oil Sands, Canada, continues to improve, so the year-end target looks possible.

CNOOC is aiming for its long-term growth, although there aren't any major projects in pipeline due to Nexen's acquisition. The company is investing heavily in exploration, which is evident in the 198% increase in exploration expenses year-on-year basis in H1 2012. Capital expenditure also increased by 71.9% from $354 million in H1 2011. The current strategy is to build a strong foundation for a successful future and the management's execution, though not perfect, is still commendable. It is not going to shy away from making unpopular decisions for long-term survival.

Unlike most global energy giants, CNOOC was born just 13 years ago. From a global perspective, the Chinese oil and gas sector is still in its infancy. But the tremendous appetite for energy is fueling rapid expansion. The Chinese firms lag behind in technology and innovation compared with their Western peers. Gaining Nexen's expertise was part of the premium CNOOC is willing to pay for and it won't be sending its own engineers over to Canada.

The Nexen acquisition, if approved, will put CNOOC in a better long-term position than it was in before it, but it will be at the expense of short-term asset management. Integrating the two cultures will be challenging enough, without regard to the global economic picture. While we're bullish on the oil sector in general, in the short term until the Nexen acquisition is complete, there are other plays in the sector that are more attractive. Exxon-Mobil (NYSE:XOM) for example is trading at a comparable multiple with a comparable dividend and has far fewer questions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.