The Chinese Challenge.

CNOOC's bid for the California oil and gas producer, made late on June 22, put the world on notice that China was ready to go head-to-head with oil-industry giants in a worldwide scramble for energy. According to Thomson Financial, the deal would be the third-largest cash-only offer in history, trailing only Cingular Wireless' $47.1 bn takeover of AT&T Wireless Services in 2004 and Unilever's $23.7 bn acquisition

of Bestfoods in 2000.

The move pit China National Offshore Oil Co. against the second largest US oil company, in a deal which Chevron had hoped to seal within the next several weeks. Bernard Picchi, analyst at Foresight Research Solutions in New York, was on June 24 quoted as saying: "We have the feeling that the CNOOC-Chevron competition is just Round One in the fight for strategic energy resources among the world's leading energy organizations, including those in developing countries". CNOOC, in a statement issued after the market closing on June 22, said it was willing to pay $67/share for Unocal. Using Unocal's $64.85 closing price of June 21, the offer topped Chevron's bid by about $1.5 bn. CNOOC Chairman and CEO Fu Chengyu said: "This friendly, all-cash proposal is a superior offer for Unocal shareholders. The deal is fully financed, subject to customary closing conditions, and priced in line with market values for comparable businesses. We hope to be able to enter into a dialogue with Unocal soon and reach agreement on a consensual transaction".

A CNOOC-Unocal merger requires paying Chevron a $500m breakup fee, on top of $18.5 bn offered to Unocal. If approved, a Unocal acquisition would more than double CNOOC's oil and gas output and boost its proven reserves by 80% to 4 bn boe. The news sent all three companies' share prices higher in afternoon action on June 23. But the moves were muted by the fact that CNOOC's bid fell short of the $70/share price many investors were hoping for.

For its part, Chevron fired back minutes after CNOOC's announcement, saying it stood by its original agreement. The San Ramon company, in the first round of the battle for Unocal shareholder support, pointed out that its deal already had the approval of both companies' boards and cleared several key regulatory hurdles. Unocal, in a separate statement, pledged to evaluate CNOOC's offer, but added: "In connection with entering into the Chevron merger agreement, the Unocal board of directors recommended the transaction to Unocal stockholders. That recommendation remains in effect".

CNOOC has been considering a bid for the El Segundo company for months, attracted by its vast Asian oil and gas holdings and China's fast-growing need to secure energy supplies for its booming economy. Speculation that CNOOC was poised to pounce had run rampant ahead of the company's June 22 board meeting in Beijing, creating a tug of war between industry analysts who saw the deal as a good fit or far too expensive for the growing company. At the end of the day, CNOOC's board of directors saw Unocal's assets too tempting to resist.

The Chinese offshore oil firm said: "CNOOC Ltd. believes that the combined company would have a leading position in the Asian energy market and an expanded role in the development of China's liquefied natural gas (LNG) market". According to The Wall Street Journal, bankers from Goldman Sachs and J.P Morgan advised CNOOC on the deal. CNOOC said oil and gas from Unocal's US fields would remain in the country, a move aimed at defusing any regulatory objections raised the specter of domestic oil flowing overseas, even though the bulk of Unocal's reserves are in Asia and the Caspian Sea region. Pitching the benefits of its offer over Chevron's, CNOOC pledged to keep as many of Unocal's employees on the payroll as possible rather than shed redundant jobs. And it offered Unocal executives positions on its own management team. Most energy industry analysts said they expect CNOOC, if given the chance, would sell off Unocal's US assets.

In addition to its effort to scoop up petroleum assets, CNOOC's bid for Unocal was seen throughout the energy and financial communities as another strong signal that China was willing and able to tackle acquisitions without foreign investment. And, increasingly, those coveted acquisitions are in the US. Moody's Investors Service on June 23 placed the A2 issuer rating of CNOOC and the long-term rating of its guaranteed subsidiaries on review for possible downgrade. Moody's also placed the issuer rating of CNOOC's parent, China National Offshore Oil Corp., on review for possible downgrade.

CNOOC said it planed to finance its proposed takeover of Unocal with its cash reserves of more than $3 bn as well as bridge loans of $3 bn from Goldman Sachs and J.P. Morgan and a bridge loan of $6 bn from the state-run Industrial and Commercial Bank of China (ICBC). It will also use a 30-year subordinated loan of $4.5 bn provided by its majority shareholder, China National Offshore Oil. The loan carries a 3.5% interest, portable after five years under "certain conditions", CNOOC chief financial officer Yang Hua said in a conference call with investors, according to AFX-Asia. This loan was expected to receive equity treatment for credit ratings purposes, the firm said in a statement. Another subordinated bridge loan of $2.5 bn will be provided by CNOOC's majority shareholder. The bridging security carries no interest and the firm expects this credit will be refinanced with equity within two years, Yang said, adding: "We are confident in getting significant equity credit for both [majority shareholder loans]". The company also said the Industrial and Commercial Bank of China loan will be replaced by permanent debt financing in the form of term loans at or shortly after completion of the proposed takeover. It said the Goldman Sachs bridge loan will be replaced by permanent debt financing in the form of bonds.

Moody's said its rating actions "reflect the cash component of the transaction and the significant debt that will be raised to fund the acquisition". The ratings agency said such incremental debt "will elevate CNOOC's financial leverage to a level that is not consistent with its present A2 rating. In addition, the review for downgrade reflects the considerable integration challenges that CNOOC Ltd. is expected to face in bedding down such a large acquisition, given its lack of track record in this area".

CNOOC chairman and CEO Fu said: "I am confident that with the US government heading the campaign for global free trade and freedom, and with US companies making acquisitions in China, the transaction will prevail in the US". Fu told reporters in a telephone news conference CNOOC's proposal did not carry any potentially negative effects for US national security. "That process has to do with national security", he said referring to a call by two Republican members of Congress for the Bush administration to review the CNOOC bid. He added: "We all know this company does not [have] any negative impact to the national security of the US. People need to understand this is a purely commercial transaction driven by market forces and consideration".

What Can OPEC Do? OPEC is already producing close to full capacity. OPEC's meeting on June 15 decided to raise its official ceiling by 500,000 b/d to 28m b/d from July 1 and authorised its current president, Kuwaiti Energy Minister Shaikh Ahmad Al-Fahd Al-Sabah, to raise it by another 500,000 b/d if prices remained high.

In reality, however, OPEC now is producing about 30.30m b/d and its sustainable capacity by end-2005 will be around 31m b/d. If OPEC raises its official ceiling to 28.5m b/d, this means the spare capacity will have declined by 500,000 b/d. In oil futures trading this will lead speculators to push prices higher by raising their investments on NYMEX and/or on the IPE in London. Speculators will keep pushing WTI up until they smell the early signs of a global economic recession.