PetroChina: Western Canada’s Select Opportunity
The Rise and Fall of a Supermajor
PetroChina was established in 1999 under the Chinese National Petroleum Company (CNPC) umbrella alongside state-owned Sinopec and Chinese National Offshore Oil Company (CNOOC). During the height of the oil price booms in 2008 and 2014, PetroChina was among the most profitable companies in Asia, reaching the trilliondollar valuation mark while supported by its duopoly structure with Sinopec in mainland China. However, the unanticipated 2015 oil price collapse abruptly ended a decade of unreserved capital expenditure. In response, the industry adopted a new paradigm by prioritizing cash flow and cutting back capital investments, choosing instead to gradually grow production through existing assets. While effective in the short term, PetroChina’s adherence to this trend now threatens its status as an oil supermajor. It is recommended that PetroChina employ a turnaround plan and expand inorganically through asset acquisition in the familiar yet forgotten region of Canada’s oil sands.
A Crude Recovery
As a supermajor, PetroChina’s key value driver has been its ability to secure future income generating capabilities by steadily expanding production and reserves. However, the company remained congruent to the market trend of systemic underinvestment in development assets to its own peril. While comparable oil supermajors like Sinopec, CNOOC, ExxonMobil, Shell, Total, and BP have successfully driven returns through existing core asset production growth, PetroChina has lagged with its focus on legacy assets, which has compromised value creation and continues to weigh on the company.
As a result, other supermajors have recovered to pre-crisis valuations while PetroChina has remained at levels seen in the oil trough of early 2016. While its peers have maintained flat reserves and raised production by eight per cent, PetroChina’s proven oil reserves and production have declined by 12 per cent and nine per cent, respectively, from 2015 to 2018. Overall reserve life has fallen to 14 years from 18 years at the start of the decade. This is largely attributable to the company’s mismanaged portfolio allocation. PetroChina’s operations are heavily concentrated in Northern China’s maturing Daqing asset, comprising 31 per cent of its total productive wells. Since achieving peak output in 1999, operators are now realizing large production declines year-over-year at Daqing. While PetroChina’s exploratory oil well count in the Daqing has increased 45 per cent from 2016 to 2017, there have been no accompanying production increases. The company’s remaining reserves have a life of just six years and are in low-permeability, deeper reservoirs that have substantially driven up production costs. To make matters worse, CNPC has indicated an additional $22-billion investment— equal to three quarters of PetroChina’s total 2017 capital expenditure—in China’s Western Xinjiang region to recoup production losses from Daqing. This, however, is not a lasting solution; PetroChina’s existing Xinjiang operations have suffered a four-per-cent production decline since 2015. Additionally, the region is embroiled in rising ethnic conflict that could jeopardize the success of spending plans.
Given its asset base and current oil prices, PetroChina will be unable to generate sustainable excess returns in the next 10 years. Despite these troubles, the company is well-equipped to deploy a turnaround plan. As of Q3 2018, PetroChina sits on a healthy balance sheet with $24.1 billion in cash, a rare amount for even a supermajor, and significant capacity to take on debt. An attractive opportunity exists in the Canadian oil sands for PetroChina to deploy a turnaround strategy. PetroChina is one of the few supermajors equipped with both the financial capacity to engage in M&A without external financing and prior experience in developing an oil sands project from scratch.
Canada’s Oil Sands Climate
Located in Alberta, the oil sands are Canada’s national starlight for oil production. Since 2015, however, the region has been one of the most distressed oil production areas globally due to issues with extraction cost efficiency, environmental regulation, and ongoing limitations in downstream outlets for produced oil and gas. As a result, the West Texas Intermediate to Western Canadian Select spread (WTI-WCS), a measure of the relative discount of Alberta oil to global prices, has widened substantially. For large producers, investment opportunities in the region are priced attractively relative to global markets.
While small-scale producers have suffered from limits on takeaway capacity (including pipelines and refineries), those with midstream and downstream access and ownership have remained defensive against the WTI-WCS spread by capturing its intrinsic value. Furthermore, pipeline capacity is expected to grow by 45 per cent through the early 2020s, meaning that investor pullback may well be short-sighted.
In the recent wave of oil and gas M&A, assets are selling especially cheaply in North America. Acquisitions have been punished by the market as investors reward capital discipline. Thus, companies wishing to expand inorganically are pressured to offer limited acquisition premiums, causing further downward pressure on asset prices in the region. In addition, the equity markets have not been generous to oil and gas producers looking to raise financing. In 2017, exploratory companies’ equity offerings fell to less than half of their total value in 2012.
Oil Sands Process: Traditional vs. Synthetic
Source: Oil Sands Magazine
The Canadian oil sands present a lucrative opportunity for PetroChina, given the company’s ability to deploy substantial capital without external financing. Its size enables it to achieve integration through favourable shipping contracts and transportation ownership that would offset takeaway capacity issues burdening other producers.
PetroChina furthermore has previous experience in Canada, having acquired the complex and undeveloped steam-assisted gravity drainage (SAGD) oil sands assets of MacKay River and Dover. This history offers the company lessons in forming its future corporate strategy. PetroChina’s joint venture to develop MacKay River quickly turned into a wholly-owned project after its partner exited the project one year after PetroChina entered in 2011, causing development costs to balloon by 120 per cent more than expected. The experience significantly increased PetroChina’s skill in the oil sands and underlines the crucial importance of entering into joint ventures with trusted long-term partners.
Given PetroChina’s main issues of declining production, difficulty replacing reserves, and past experience with Canadian oil sands, the company should undertake an oil sands asset acquisition program through both joint ventures with domestic companies in underutilized assets, and wholly owning fully productive assets. An oil sands investment would serve as a natural hedge in PetroChina’s high decline portfolio. While less profitable, the long cycle timeline and low decline rate guarantees PetroChina future oil supply at low long-term capital costs while the company discovers greenfield projects. For the time being, an immediate fix is required as oil production is falling rapidly each year, forcing the company to miss out on the positive portion of the boom-bust cycle. Thus, PetroChina requires already productive assets to add to its portfolio, complemented by future production potential to aid its long-term position.
Imperial Oil’s Kearl and Syncrude assets stand out as promising asset acquisitions for PetroChina. Both have been plagued with reliability issues; Imperial appears to have employed a short-sighted capital strategy focused on shareholders and its more valuable downstream division. Moreover, Imperial has shifted its upstream focus to in-situ development. Unlike Imperial, PetroChina is able to focus on long-term capital appreciation as a state- owned enterprise, presenting potential for more effective operation of the assets.
The Kearl oil sands asset is a shallow open-pit mining operation separated into two stakes: 29 per cent owned by ExxonMobil and 71 per cent by its Canadian subsidiary, Imperial. The asset has averaged 202,000 barrels per day (bbl/d) of production in 2018 with steady state production expected to reach 240,000 bbl/d in 2020 after investment to improve operations. This production would account for 10 per cent of PetroChina’s total oil production, with Kearl’s expected 2019 production enough to offset PetroChina’s production declines since 2015. Limited additional capital expenditure is required to reach targeted production, as the incremental barrel costs 25 to 30 per cent of ramp-up production cost.
Furthermore, PetroChina would benefit from acquiring Imperial’s Edmonton crude-by-rail terminal, which would act as a defence against price differentials and as an insurance policy in the case of transportation constraints persisting post-2020. The rail access would enable the company to move its oil for less than $11/bbl and sell near WTI prices, increasing revenues by approximately $40/bbl given the current differential. In addition, PetroChina could improve spot price realizations that have currently been put under pressure by Imperial’s willingness to process low-priced production through ExxonMobil’s and its own refineries to boost downstream profitability. By ridding the asset of both this relationship and downstream prioritization, PetroChina can realize an estimated 28-percent greater price per barrel from the same oil.
ExxonMobil has been vocal about its desire to sell its Canadian business and Kearl could likely be purchased at an attractive price. In addition, there are few buyers with the financial capacity required to maximize the benefit from such a large-scale asset. With strong execution and longterm commitment to the asset, PetroChina could feasibly increase production by 26 per cent and raise operating margin per barrel by 48 per cent through cost cuts, rail utilization and upstream focus. The company should make a strategically timed entry by initially acquiring ExxonMobil’s 29-per-cent stake to build expertise in the asset as a joint venture operator, with the ultimate goal of becoming sole owner and operator of the asset.
A Sweet Premium Blend
Imperial’s 25-per-cent stake in Syncrude, a synthetic oil sands mining operation and the largest single source asset in Canada, is a complementary acquisition to PetroChina’s Canadian portfolio. The asset is majority owned and operated by Suncor Energy with additional stakes held by Imperial and China’s CNOOC/Sinopec. The acquisition would further align CNPC’s Canadian oil strategy and operations, with all three subsidiaries part of the same consortium. Syncrude is currently operating at 59-per-cent utilization, with potential to raise production through improved operational management in the near future. Imperial’s stake generates 45,000 bbl/d, with possible output of 87,500 bbl/d at full utilization. Based on current differentials, PetroChina would benefit from an approximate 40-per-cent higher oil price realization from Syncrude relative to other oil sands due to the quality premium placed on synthetic crude. While prices have been dragged down alongside WCS since October 2018, the forward curve in steep contango signifies a recovery to synthetic crude’s historical premium.
This joint venture structure would assist the company in developing its competencies in producing synthetic crude. PetroChina has limited experience with this product, but synthetic crude is becoming increasingly important in the Canadian context. A crucial part of the Syncrude strategy would entail representing CNOOC and Sinopec’s stakes in the asset, as it would streamline operations and generate synergies. The asset has been afflicted by outages caused by a lack of urgency and calibration between co-operators, emphasizing the inefficiency of a crowded ownership structure. Consolidating the asset among just two operators, Suncor and PetroChina, would simplify governance, enabling seamless execution on logistical matters and rapid turnaround on future outages. In doing so, PetroChina could reduce operating costs at Syncrude from $42/bbl to $24/bbl by 2020 by eliminating inefficiencies in transportation, workforce accommodation, and equipment warehousing, as well as consolidating administrative operations and procurement.
A fully-owned Kearl and a 25-per-cent stake in Syncrude would provide immediate relief to PetroChina’s woes by adding over 327,000 bbl/d of estimated 2019 production and proven reserves of 773 million barrels. PetroChina’s daily oil production would effectively increase by 13 per cent, four-per-cent greater than 2015 levels. Proven oil reserves would rise 10 per cent, just three-per-cent shy of 2015 levels. The reserve count does not take into consideration 3.5 billion barrels written off in Kearl in 2016 due to lack of economic viability, which could potentially be reversed in the case of higher oil price realizations. A highly focused PetroChina committed to investing in project development, technology and timely upkeep to preserve long-term asset performance could realize operating profitability improvements of 46 per cent at full utilization. The appeal of these acquisitions lies not just in the immediate impact, but also in the long-term safety net provided by the near-zero decline rates and expected life past 2040 at Kearl and Syncrude. This effectively keeps PetroChina out of the precarious position of constantly cycling capital to grow production.
Source: CME Group, IBR Analysis
In addition to acquiring ownership in Imperial’s rail terminal alongside Kearl, PetroChina will realize synergies with the help of its CNPC partner to mitigate the risks of takeaway capacity constraints. In September 2018, Sinopec announced an investment in building a Canadian oil refinery to process 167,000 bbl/d of crude oil into fuel products. Becoming a feeder to a local refinery would aid the company in realizing oil prices closer to global levels. PetroChina’s existing Grand Rapids Pipeline would continue to aid the company in moving its oil sands production to market, and the potential completion of three export pipelines by the early 2020s would create 1.8 million bbl/d of additional takeaway capacity for oil sands producers.
It is recommended PetroChina offer $5.3 to $6.1 billion in aggregate sum for the package of upstream assets, warranting a 13-per-cent to 30-per-cent premium to the value of Imperial’s daily production due to the premium weighting of synthetic oil and the company’s ability to increase utilization at both Kearl and Syncrude. Including an additional $800-million consideration for Imperial’s rail terminal, the acquisitions would generate a projected internal rate of return of 17 to 21 per cent on a substantial portion of PetroChina’s $24.1-billion cash balance.
Addressing Political Risk
Although the political climate under the previous Canadian government was hostile to foreign Chinese investment, asset sales back to domestic producers and Sinopec’s investment into a Canadian refinery indicate such concerns are no longer an issue. The nature of the advised strategy, being focused on asset acquisitions instead of corporate acquisitions, should mitigate concerns of power transfer to China. Furthermore, PetroChina would be effectively acquiring Kearl and Syncrude from ExxonMobil, another foreign-owned entity, rather than stripping Canadian control in the oil sands.
Proved Plus Probable Success
Effective execution of such an acquisition strategy in Canada would demonstrate to investors a new PetroChina that is willing to see a future outside of its legacy Chinese assets. This strategy would create hope for a more capital-efficient and stable long-term outlook for the supermajor. The warning signs surrounding reserve replacement would be eased without requiring the significant M&A spend that would be necessary in other parts of the world. More importantly, the acquisitions would provide PetroChina with the most crucial commodity of all: time. The reserves and production addition would allow the company runway to gradually wean itself off its addiction to Chinese assets and ensure a healthy survival, with a fresh start in Canada.