Keep CNOOC's Exclusivity
14 December 2005
(updated 18-Dec-05)
What is it about the holiday season that brings out the worst in companies? Investors in CNOOC Ltd (CNOOC, 0883, NYSE:CEO) must act fast to preserve value at a New Year's Eve shareholder meeting, as we shall explain. One of the attractions for investors in the IPO of CNOOC was its exclusivity - right up there in the first paragraph of the summary on page 1 of the 16-Feb-01 prospectus:
"We are... the only company permitted to conduct exploration and production activities with international oil and gas companies offshore China".
To ensure this, the state-owned parent of CNOOC, China National Offshore Oil Corporation (CNOOC Parent) gave a non-compete undertaking, shown on page 119 of the prospectus:
"[CNOOC] will enjoy the exclusive right to exercise all of [CNOOC Parent]'s commercial and operational rights under the PRC laws and regulations relating to the exploration, development, production and sales of the PRC offshore oil and natural gas..."
neither [CNOOC Parent] nor any of its associates1 will engage or be interested, directly or indirectly, in oil and natural gas exploration, development, production and sales in or outside the PRC."
The undertakings were unlimited in time, unless CNOOC ceased to be controlled by CNOOC Parent or any other PRC government entity. Now in an announcement dated 8-Dec-05 and a circular rushed out 2 days later, CNOOC is seeking minority shareholders' approval to amend the non-compete undertaking in a way which in our view is tantamount to scrapping it.
There's a lot of value in that exclusivity, and if shareholders approve this amendment, they will be giving it away. The key to this is the Production Sharing Contracts (PSCs) with foreign partners. The prospectus explains:
"Through CNOOC Parent, we have the exclusive right to enter into [PSCs] with international oil and gas companies to conduct exploration and production activities offshore China. Under the PSCs, we have the sole right to acquire, at no cost, up to a 51% participating interest in any successful discovery...the foreign partners can recover their exploration costs under the PSCs only if a commercially viable discovery is made." (emphasis added)
All the exploration costs under PSCs are paid for by foreign partners, and CNOOC gets up to 51% of the upside when discoveries are made. CNOOC can exercise the participation right after the foreign partners have made commercially viable discoveries, and then they share the development and production costs and split the profit, net of the taxes and royalties payable to Government.
What CNOOC Parent wants
What CNOOC Parent now wants is to amend the non-compete undertaking so that as long as CNOOC gives prior consent, CNOOC Parent can engage in the competing business. That consent may be given by the board of directors of CNOOC. But of course, the composition of the board, including the "independent" directors, is controlled by CNOOC Parent, which as the majority shareholder can elect or remove any of them.
In any case, the "independent" non-executive directors are a minority (currently 5 out of 12) so even if all the INEDs objected, the board could still give consent by majority. As a superficial token, CNOOC Parent has granted an indefinite option to CNOOC to acquire any competing business - but that option can only be exercised at a price to be negotiated - not at no cost as the prospectus said. Those PSCs are lucrative, and CNOOC Parent could charge for the privilege of participating. Of course, on any particular project, if the negotiations fail, then there is no deal. And again, the board of CNOOC is hardly likely to exercise the option unless its controlling shareholder wants it to.
The written consent and option are in our view just smoke and mirrors to disguise the fact that minority shareholders are being asked to give up exclusivity, and the right to participate in PSCs without payment to CNOOC Parent, in return for....nothing. Apart from PSCs, the proposal would also open the door to CNOOC Parent investing directly in competing projects or companies.
If CNOOC really wants to pass up its rights to exclusive participation in any particular PSC or investment, then it should seek minority shareholders' approval on a case-by-case basis. CNOOC Parent would then have to explain, to the satisfaction of minority shareholders, why it considers that a project or investment is good enough to pursue but not good enough for CNOOC to take.
The INEDs and IFA
The 5 INEDs, on whose election CNOOC Parent votes, have recommended in favour of this proposal. What were they thinking, if indeed they were thinking? Given that CNOOC Parent is not offering any payment for compromising this exclusivity, it should be a no-brainer that you don't give up something for nothing. But then three of the five last year also thought it was a good idea to lend money to the parent's finance company (the other two were appointed later).
Coincidentally, the board has just awarded the deep-thinking INEDs an increase in fees from HK$200,000 to HK$500,000 per annum net of Hong Kong tax. Sure, that's not a lot by US standards, and CNOOC does have a NYSE listing, and the INEDs have (hopefully) put a lot of time in during the aborted Chevron bid, but the timing is unfortunate to say the least.
On 5-Feb-04 (before the events of last Easter) the board also awarded each of the first three INEDs (and one who has since quit) options to subscribe 1.15m shares at $3.152 per share, vesting over 3 years.
The independent financial adviser on the current proposal, Dao Heng Securities Ltd, offers nothing to justify it, except to say that several recent listings have contained such a get-out from the non-compete undertaking. That's true, but CNOOC didn't, and if they had, then shareholders would have paid less for the shares they bought. The fact that some other companies don't have exclusivity is irrelevant to whether CNOOC should give it away.
The Chinese government has in the past often privatised slices of major industries such as telecoms or power, and then gradually injected provincial licenses or additional power stations into the listed vehicle. CNOOC was supposed to be different - investors were sold all the offshore business, present and future, in one go. You can't eat your rice twice.
Vote NOW
We strongly urge all minority shareholders to vote against this value-destroying proposal. It will go to a poll vote (1-share-1-vote) so your votes WILL be counted. However, don't wait around, because custodians can be slow to process voting instructions during the Christmas holidays. If you snooze, you lose.
CNOOC is employing a familiar tactic; spread the meeting notice period over a public holiday (in this case, Christmas) which reduces effective reaction time, particularly if you are holding American Depository Receipts (ADRs) on the US register. They must have planned this announcement some time ago, because you can't produce and clear a circular through the stock exchange and get an independent financial adviser's opinion in 2 days flat. Several weeks would be more typical. And the EGM is on New Year's Eve, a Saturday!
The last time CNOOC did this was when it successfully sought minority shareholders' approval to lend money to its parent's finance company, with a notice timetable straddling Easter 2004. At the time, we claimed that CNOOC had been in breach of the Listing Rules for its previous loans, which the company denied. Eventually, CNOOC was censured by the Stock Exchange and we were proven right. Later that year, CNOOC's sister, China Oilfield Services Ltd (2883) sought similar approval and was vetoed after we campaigned against it.
Be careful when you vote to vote against the correct resolution in the correct meeting, because CNOOC is holding two EGMs half an hour apart. We offer no opinion on the other proposals - suffice to say that after the way they have behaved, anything this company now proposes deserves healthy scepticism from investors. The resolution on the non-compete is in the second EGM at 10:30 a.m., item 1 on the proxy form.
Update 18-Dec-05
In response to the above article and the ensuing media coverage, late on Friday night (16-Dec-05), CNOOC filed this press release2 with the SEHK. It clarifies that CNOOC Parent will be allowed under the terms of the proposal to engage in competing business "in or outside the PRC but not in respect of PRC offshore oil and natural gas." In fact, the shareholder circular simply stated that the competing business would be allowed "underground in and outside the PRC" (page 1, definition of Business).
To sort this out definitively, on Saturday morning we briefly suspended our Christmas shopping, avoided the WTO protests and trekked down to the offices of CNOOC's law firm Herbert Smith to look at the "documents available for inspection" listed on page 58 of the circular (not something most investors in CNOOC would have the proximity to do3). The 4-page "Supplemental Agreement" we inspected does indeed refer to:
"any opportunities falling within the scope of the Business which are within the onshore areas of the PRC or outside the PRC".
So this at least means that projects in PRC waters remain the exclusive domain of CNOOC. However, that doesn't remove the fundamental problem with the proposal, which is that for the rest of the world, onshore the PRC and outside the PRC, it is not sufficient for CNOOC Parent to seek the consent of a board the composition of which is controlled by CNOOC Parent. Nor is it realistic to expect the board of CNOOC to continually review and independently decide whether to exercise a call option to acquire competing businesses which in any case leaves a price down to negotiation. Minority shareholders should not delegate this to such a conflicted entity.
In the press release, CNOOC says that they are just protecting minority shareholders from "inter-governmental projects and projects involving high risks etc.,...to reduce the potential risks to [CNOOC]". Gee, thanks guys, but minority shareholders are quite capable of assessing risk for themselves. If CNOOC Parent wants to make a commercially unattractive investment outside of CNOOC, then you can always ask for minority shareholders' consent on that project, although if a Government-owned entity is pursuing uncommercial oil and gas projects then it begs the question of whether China's demands to be treated as a free-market economy really make any sense.
There's another reason why CNOOC minority shareholders should be nervous about its parent engaging in unattractive projects - remember that vote last year? CNOOC can now lend up to RMB6.8bn to CNOOC Parent's finance vehicle which in turn can make intra-group loans to finance such projects without your approval. So in fact CNOOC minority shareholders' money could be indirectly used to finance these "high-risk" projects without any economic upside for CNOOC.
CNOOC's 2004 annual report proudly states that it is currently the largest offshore oil producer in Indonesia - an area which we hopefully can all agree is outside the PRC. CNOOC also has an interest in the North West Shelf gas project in Australia. These are the kind of projects which CNOOC Parent in future might undertake on its own, without any further say so from minority shareholders, putting itself in competition with CNOOC for the sale of the resulting products in the PRC and elsewhere. So our recommendation is reiterated. Vote against this proposal, and retain your right to veto competing business.
1 The word "associates" is in the prospectus. In the circular, it has magically changed to "subsidiaries" - a much narrower definition which would exclude companies owned 50% or less by CNOOC Parent.
2 Although the press release was filed in the SEHK's corporate document system, it doesn't constitute a formal announcement under the Listing Rules because it didn't comply with the content requirements, including a list of the current directors and a disclaimer of SEHK's responsibility. Does this mean that the SEHK's filing system is now open to press releases? That could be good, if it encourages companies to file more than the regulatory-minimum disclosures.
3 The SEHK should amend the Listing Rules to put all "documents available for inspection" on the web, not in some downtown HK office, so that investors everywhere have an equal opportunity to read them. The SFC has recently amended the Takeover Code in this respect, so that starting on 1-Jan-06, documents put on display during takeovers will be available on the web. However, they allow the documents to be "removed" from display after the takeover offer period is over - which will put future investors at an informational disadvantage to those who grabbed the information while they could. In the interests of fair disclosure, we will remedy this by archiving the material on Webb-site.com.
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