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1) Oil price outlook for 2021 is favourable
2) Oil Majors: Which has the optimal production mix and lowest production cost?
3) CNOOC earnings expected to recover to pre-Covid levels by 2023
4) CNOOC is very cheap: 8% dividend yield & 2.6x EV/EBITDA
5) Analysts ratings and target prices
6) Implication of the US blacklist
The InvestQuest View
On a sector level, Energy stocks performed worst in 2020, as oil demand fell dramatically due to lockdowns.
We expect a reversal in the fortunes for some of the laggard Energy stocks in 2021, with the progressive roll out of Covid-19 vaccines and global coordination in controlling oil production volumes.
We have a favourable view on CNOOC (883 HK), a China oil major. Operationally, the company is one of the most exposed to upstream oil production, with one of the lowest production breakeven costs among global oil majors, which makes it an appropriate investment for oil bulls. Valuations are currently very cheap, reflecting elevated geopolitical risk. We believe that the risk-reward is favourable for long-term investors, who can stomach price volatility in the short-term.
Disclaimer: We had bought into CNOOC Ltd (883 HK) on 11 January 2021 and took profit on 22 January 2021 for a 13% gain. We bought in again on 28/29 January 2021 and took profit on 19 February 2021 for a 23% gain. This article is meant for our personal investment research and should not be construed as investment advice.
1) Oil price outlook for 2021 is favourable
It is a consensus view that oil prices will be resilient in 2021. As Covid-19 vaccines get rolled out progressively, we should see an uplift in oil demand due to a resurgence in air and land transport. On the supply side, OPEC+ has also been supportive of oil production cuts – agreeing to production cuts of over 8 million bpd for February and March 2021.
Oil inventory levels should start to normalize by end-2021, and that should be supportive for oil prices. According to Credit Suisse research, oil product inventory levels have already seen a meaningful decline since August 2020 (see light blue line in the charts below). Inventory destocking is expected to continue in 2021 (dark blue line below), reaching 2015-2019 average inventory levels by end-2021 (red dotted line below).
In our view, the macro backdrop is ideal for positioning into energy related stocks, which has been the worst-performing sector across global stocks since 2020 (see chart below).
2) Oil Majors: Which has the optimal production mix and lowest production cost?
Not all oil majors are created equal. Oil majors have varying exposures to oil/gas/renewables segments, and varying exposures to the different segments of the supply chain.
- Upstream: oil & gas production
- Midstream: transport, storage & processing
- Downstream: oil refining to various petrochemicals, market & distribution
Oil bulls will prefer exposure to the oil major that focuses on upstream oil production, with the lowest production cost. The chart below shows the oil production mix across some of they largest oil & gas companies (black line, right-axis), as well as the oil-equivalent production cost per barrel (bar chart, left-axis).
Operationally, Saudi Aramco (ARAMCO AB) and CNOOC (883 HK) appear to be the most geared towards an upside in oil prices, given their high oil production mix (>80%) and low all-in cost of production (<US$30 per barrel).
We have also compiled the correlations of the largest oil stocks against Brent crude prices, which shows a similar result. Aramco, ConocoPhillips, CNOOC and Exxon’s share price movements are the most highly correlated with Brent price movements.
Oil majors have declined by an average of 23% since 2020. The below chart shows the total returns of the various oil majors since the start of 2020. As international retail investors are prohibited from investing in Saudi stocks (and by extension Saudi Aramco), we have excluded it.
CNOOC’s share performance has lagged sector peers. Despite having the desired operational exposure mentioned earlier, CNOOC has lagged due to elevated political risk, underperforming the peer average by 9%.
3) CNOOC earnings expected to recover to pre-Covid levels by 2023
CNOOC Limited (883 HK) is one of the three oil majors in China, the other two being PetroChina and Sinopec. From an investment standpoint, here’s how I would differentiate them in terms of their focus areas:
- CNOOC (883 HK): Upstream oil exploration & production
- PetroChina (857 HK): Diversified upstream oil + gas exploration & production
- Sinopec (386 HK): Mid to downstream refining, distribution and trading
Earlier on, we mentioned that we were generally optimistic that oil price would remain resilient heading into 2021. However, it is also important to look at how production volumes will trend over the coming years, to evaluate the growth profile of CNOOC.
CNOOC production volumes expected to grow by 3.7% p.a. between 2019 to 2022. The below chart shows the actual production volumes per day for CNOOC since 2006, and analyst estimates for 2020-2022. These estimates are on the conservative side, as we note that 9M20 production volumes for CNOOC is already ~1.42mn barrels per day (vs 1.38mn indicated in the chart below).
CNOOC revenue and net profit expected to surpass pre-Covid levels by 2023, according to forecasts by sell-side analysts. The earnings recovery is expected to be long-drawn, as it will take time for the oil demand-supply imbalance to normalize. The chart below shows the revenue (represented by the bars), and net profit (represented by the red line), from 2011 to 2023F.
CNOOC is predicted to be the biggest beneficiary among the China oil majors if oil prices trend up. According to J.P. Morgan estimates, every $5 increase in oil prices would lead to a 32% increase in CNOOC’s net profit for 2021 (vs +28% for PetroChina and +12% for Sinopec).
4) CNOOC Valuations
EV/EBITDA and P/B near historical trough
CNOOC is cheap from a EV/EBITDA perspective, trading at just 2.6x. Historically, the stock has typically traded at trough multiples of 2.5x, so the current entry level is inexpensive in our view.
CNOOC is also trading near its lowest P/B multiples in history, close to the trough of the 2015-16 oil crisis.
Brent Price implies a higher P/B
CNOOC has one of the highest correlations with oil prices among the oil majors. This is evident when we look at the stock’s historical P/B ratios against Brent prices (see chart below). However, there has been a divergence in recent months, where Brent (grey line) has rallied while CNOOC’s stock price (red line) has languished. In our view, this creates an opportunity for a convergence trade.
CNOOC screen wells on profitability-adjusted valuations
In the below chart, we compare how the various oil majors rank in terms of profitability (using forward ROE as a guide, see y-axis) and valuations (using P/B ratio as a guide, see x-axis). Stocks that are above the red dotted line would be more desirable.
In our view, CNOOC and BP are screening attractively based on these metrics, and we currently hold both of these stocks in our portfolio.
Dividend yield is healthy
CNOOC does not have a firm dividend policy but the payout ratio has been ~60% for 2018 and 2019. The below chart shows the dividend per share by calendar year since 2006 for the firm’s HK listing.
In 2020, CNOOC paid HKD 0.65 of dividends, implying a trailing dividend yield of 8%. This is relatively attractive compared to the firm’s historical average yield of 4.2% (see chart below).
Even if 2021 dividends decline to HKD 0.37 (similar to 2016 during the oil crisis), it would still imply a 4.6% dividend yield, based on the current stock price of HKD 8.09.
Share purchase by CNOOC’s parent company is a positive signal
As a show of confidence, CNOOC Ltd’s parent company purchased 253.88mn shares of CNOOC from the open market as at 23rd December 2020 (see HK Exchange announcement). This represents 0.57% of the total issued shares of the firm, or close to USD 300mn in value. CNOOC Ltd’s parent company China National Offshore Oil Corporation now holds a 65.01% stake in the firm after the acquisition.
5) Analysts ratings and target prices
The table below shows the latest analyst ratings and target prices for CNOOC (883 HK). We have only shown ratings that have been updated from November 2020 onwards.
Consensus is bullish with a median target price of HKD 9.79, implying 21% upside from the current stock price of HKD 8.09.
6) Implication of the US blacklist
CNOOC is well-positioned operationally with attractive valuations, however the stock has underperformed due to the elevated political risk.
- On 3 December 2020, the U.S. Department of Defense added CNOOC to a blacklist of alleged “Chinese military companies”, potentially due to its alleged link to military activities at the South China Sea (see HK Exchange announcement).
- On 8 January 2021, the Office of Foreign Assets Control (“OFAC”) of the Department of the Treasury of the United States of America added the Company to its list of Chinese companies with alleged ties to the Chinese military (see HK Exchange announcement).
- On 14 January 2021, the the Bureau of Industry and Security (BIS) in the Department of Commerce added Chinese National Offshore Oil Corporation (CNOOC) to the Entity List. (see announcement)
There is still a lot of uncertainty on the implications of these blacklists but we do want to highlight a few points that were mentioned by various research reports:
- Operational impact to CNOOC Ltd expected to be manageable.
- Having been put on the US Department of Commerce’s “Entity List”, which China semiconductor company SMIC is also on, the implication is that US companies cannot export, reexport, and transfer items to CNOOC. It remains to be seen how much this would impact the firm operationally.
- US operations accounted for 5% of CNOOC’s oil and gas revenues in 2019, so the impact looks significant but manageable.
- Restriction on US investors from investing into CNOOC. Having been put on the DoD and OFAC blacklist, US investors will have 1 year grace period to divest their holdings of blacklisted companies. According to J.P. Morgan, US shareholders accounted for 15% of CNOOC’s total shares as of September 2020.
- Index compilers such as MSCI, FTSE and Hang Seng indices may reconsider removing CNOOC Ltd from certain benchmarks, adding to the selling pressure. It’s hard to pinpoint what the price impact would be if this comes to pass but using China Mobile (941 HK) as a gauge, the news of its forced US ADR delisting and removal from MSCI and FTSE indices resulted in a peak-to-trough decline of 18% between 4th to 8th January 2021 (China Mobile has since recovered back near to its 4th January stock price).
For more information on the blacklist details and implications, I found this article to be very explanatory.
Given our own longer-term investment horizon, we are not as worried about the restriction of US investment into CNOOC (we are more cautious on the operational impact to CNOOC’s business). That said, we are ready for stock price volatility brought about by newsflow on this topic.
The InvestQuest View
On a sector level, Energy stocks performed worst in 2020, as oil demand fell dramatically due to lockdowns.
We expect a reversal in the fortunes for some of the laggard Energy stocks in 2021, with the progressive roll out of Covid-19 vaccines and global coordination in controlling oil production volumes.
We have a favourable view on CNOOC (883 HK), a China oil major. Operationally, the company is one of the most exposed to upstream oil production, with one of the lowest production breakeven costs among global oil majors, which makes it an appropriate investment for oil bulls. Valuations are currently very cheap, reflecting elevated geopolitical risk. We believe that the risk-reward is favourable for long-term investors, who can stomach price volatility in the short-term.
Disclaimer: We had bought into CNOOC Ltd (883 HK) on 11 January 2021 and took profit on 22 January 2021 for a 13% gain. We bought in again on 28/29 January 2021 and took profit on 19 February 2021 for a 23% gain. This article is meant for our personal investment research and should not be construed as investment advice.
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