By staff reporter Yang Yue

PetroChina Co. has ended years of discussion by agreeing to take full control of a key Chinese overseas oil and gas concern in a more than US$ 10 billion swap with its parent, China National Petroleum Corp. (CNPC).

According to an unnamed CNPC source, PetroChina plans to buy CNPC’s 50 percent stake in CNPC Exploration & Development Co. (CNPC E&D), which currently operates 71 oil and gas projects in 26 countries.

PetroChina, CNPC’s listed subsidiary as well as China’s largest domestic oil and gas producer, already owns the half of CNPC E&D not controlled by CNPC.

Analysts said the move makes sense for PetroChina, which has been pinched this year by soaring global crude prices and the Chinese government’s domestic price controls.

“As international oil prices continue to rise, buying an upstream company will definitely benefit PetroChina,” said Hua Kailing, an analyst for Industrial and Commercial East Asia Finance Holding Ltd.

At the same time, the deal poses financial challenges and other hurdles for PetroChina.

Evolutionary Process

CNPC had intended to shift its overseas assets to PetroChina eight years ago, while the subsidiary was preparing for public listings in Hong Kong and New York. But later the plan was dropped due to weak performance for overseas businesses and because some projects were in Sudan and Venezuela, which are diplomatic flash points for tension with the United States.

CNPC E&D also owns exploration and drilling rights in diplomatically sensitive Syria, Chad and Libya.

Significantly, a CNPC source told Caijing that projects in disputed regions such as Sudan and Nigeria would not be included in the pending sale of CNPC E&D assets to PetroChina.

After its stock listing, PetroChina started looking overseas on its own and set up a subsidiary -- PetroChina International Co. Ltd. -- to explore the market. Soon, PetroChina International became a major rival for CNPC E&D for overseas business, sparking disputes between PetroChina and its parent.

To smooth the wrinkles, PetroChina in 2005 bought 50 percent of CNPC E&D for 20.2 billion yuan. It then merged PetroChina International and CNPC E&D in a deal worth 579 million yuan, although CNPC maintained joint control of CNPC E&D.

CNPC handed over to CNPC E&D all its overseas business. CNPC E&D then bought Kazakhstan’s largest oil producer PetroKazakhstan Inc. for US$ 4.9 billion, and won a bid for the Adrar Oil project in Algeria.

Eventually, CNPC E&D built a network covering Africa, Central Asia, Russia, the Middle East, South America and the Asia Pacific region.

At the end of 2007, CNPC E&D reported an overseas oil production capacity of 62 million tons per year and a processing capacity of 11.6 million tons. The company also reported an annual production capacity of 6 billion cubic meters of natural gas.

Financing Difficulties

PetroChina had considered a complete takeover of CNPC E&D ever since the 2005 agreement with CNPC, a source close to CNPC told Caijing. The plan finally started taking shape last May when Jiang Jiemin, chairman of PetroChina and general manager of CNPC, announced that a team had been assigned to work out a deal.

But the deal’s slow evolution raised costs for PetroChina. The price for 50 percent of CNPC E&D soared in recent years as international oil prices have climbed to more than US$ 100 barrel from about US$ 70 in 2005.

The Reuters news agency predicted the proposed deal for CNPC E&D would cost PetroChina US$ 11.8 billion. A CNPC source confirmed the transaction would break the US$ 10 billion level, above market expectations.

Qiu Xiaofeng, an industry analyst at Merchant Securities, said PetroChina will definitely pay a “higher cost” for the rest of CNPC E&D but argued “it won’t be a big problem for PetroChina.”

A CNPC insider said a CNPC E&D takeover should boost PetroChina’s oil production, reserves and business profits, particularly since CNPC E&D has nearly finished exploratory operations and is entering the production stage at project sites.

PetroChina’s 2007 annual report said CNPC E&D had registered assets worth 100 million yuan and a 12.4 billion yuan net profit.

PetroChina is also getting tax advantages out of the deal, since the Chinese government exempts overseas oil businesses from a windfall oil levy.

Nevertheless, PetroChina is being pressured by rising oil prices and government price controls.

To ease the capital squeeze, PetroChina issued 60 billion yuan in corporate bonds in July. Qiu said the company is likely to seek more cash by issuing additional shares, but thinks current market conditions could work against the strategy.

Qiu said PetroChina may have to issue 6 billion new shares. It currently trades 4 billion A shares on the Chinese stock market. “Such a large issue will have negative impacts,” he said.

“It would be positive for PetroChina to take over an upstream company such as CNPC E&D,” Qiu said. “But if the deal is funded by issuing additional A shares, it will be negative news to the market.”

Some analysts, including Industrial and Commercial East Asia’s Hua, think issuing new shares would be a better financing option than bank loans for PetroChina, considering the company’s liability ratio and high borrowing costs.

But because financing issues have yet to be settled, Qiu expects the transaction to close no earlier than the end of the year.

Tax Waiver?

Preferential government policies, such as subsidies or tax breaks, could prove an ace up the sleeve for PetroChina.

Indeed, one company source said a government decision on tax exemptions could determine whether or not the transaction succeeds.

CNPC is now lobbying the Ministry of Finance to waive a hefty capital gains tax levy that could pose a challenge for PetroChina. Without an exemption, the source said, the CNPC E&D transfer would include a 23 percent tax bill.

Still, a CNPC E&D buyout apparently offers a one-time opportunity for PetroChina, since the overseas driller might be the last valuable CNPC unit it can get.

1 yuan = 14 U.S. cents