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How Do You Invest in Fast-Growing Chinese Oil Companies? Carefully.

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Each Chinese oil major has its own problems, but they all share extraordinary growth potential.

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China's economy may be knocking and pinging a bit as an engine for global growth, but its three big state-owned oil companies are just hitting their stride. Consider these headlines from just the past week or two:

China National Offshore Oil Corporation, or CNOOC (NYSE:CEO), closed its $15.1 billion acquisition of Canada's Nexen (TSE:NXY), the biggest foreign corporate purchase in Chinese history. China National Petroleum Corporation, better known as PetroChina (NYSE:PTR), was reported in talks to acquire a big slice of a $50 billion elephant oil field in Iraq called West Qurna-1. PetroChina is predicted to either supplant or partner with Exxon Mobil (NYSE:XOM), which has run afoul of Baghdad authorities because it is dealing simultaneously with the autonomous government of Iraqi Kurdistan.

Meanwhile China Petroleum & Chemical Corp., aka Sinopec (NYSE:SNP), made a path-breaking move into US shale gas, paying Chesapeake Energy (NYSE:CHK) $1 billion for a share in an Oklahoma field that overextended Chesapeake cannot afford to develop on its own.

There should be plenty more acquisitions to come. China's three sisters are sitting on $40 billion in cash and presumably unlimited soft financing from state banks back home. Each has made clear that its global ambitions are far from slaked. The market has been treating them like rising stars lately. PetroChina and Sinopec shares have easily outpaced even a red-hot S&P 500 (INDEXSP:.INX) over the past six months, and all three have left the oil industry gold standard, Exxon, in the dust.

Yet investors should think carefully before piling on. Foreign rivals and politicians like to squeal about the unfair balance sheet advantage the Chinese Big Three enjoy thanks to their majority shareholder, the government. But being state property also exacts tremendous costs: Communist planners force the oil companies to sell fuel and natural gas at a loss so consumers can drive and keep warm more cheaply. And the management skills nurtured in these demi-bureaucracies may not be up to the challenge of playing on the world stage.

At least it will help to understand the background of each company and where it fits into Beijing's grand economic scheme. PetroChina is the original national champion. Its daily production of about 3.7 million barrels of oil equivalent is second only to Exxon among the world's listed companies. That output has risen by a quarter since 2006 while Western supermajors struggle to stay in place. Not surprisingly, PetroChina is priced like a growth stock with a trailing p/e of 12.9, compared to Exxon's 11.3 and 8.0 for Royal Dutch Shell (NYSE:RDS.A).

But PetroChina has two heavily bleeding wounds in its domestic refining division and growing gas import business, both of which are mandated to lose money. Management at the company seems a bit slipshod as well. PetroChina reported losing 23 billion renminbi ($3.68 billion) on refining in the first half of 2012. Sinopec, which processes more oil, lost a mere 18.5 billion, indicating much greater efficiency.

Sinopec was born to lose, as it were, being set up as China's dominant refining company. To make matters worse (financially), the government is forcing it to raise sulfur emissions standards to European standards to combat Chinese cities' pestilential smog. That will cost Sinopec an estimated $4.5 billion over the next few years.

But the company has fought back since 2011 under dynamic CEO Fu Chengyu, piling up profitable foreign assets to offset its forced domestic franchise. Sinopec's shares are the best performers in Chinese oil over the past three years, doubling the gains of PetroChina and outpacing Exxon as well.

CNOOC was created by the Chinese state in the 1980s as an offshore drilling specialist. It is blessed, in Chinese terms, to have few downstream assets, but diminishing reserves on its native shelf have led it abroad in search of growth. CNOOC's bid to acquire American oil company Unocal in 2005 was famously undone by political fury within the US.

The Chinese company made a new overseas breakthrough with the Nexen deal in Canada, but paid a fat price – a 60% premium over the target's market value. CNOOC's management also tacitly admitted it was not up to running a Western subsidiary as it quietly ceded operational autonomy to Nexen just before the transaction closed on Feb. 25. Perhaps all of that is provoking buyer's remorse in the market: CNOOC's shares have sunk by 16% this year.

So each Chinese oil major has its own problems, but they all share extraordinary growth potential. The Nexen and Chesapeake deals have broken a barrier to expansion in North America. They already have a leg up in much of the rest of the world, arriving without the political or environmental baggage of Western competitors. Production growth is not necessarily destiny in the oil business. But it will always make a company worth a look.
No positions in stocks mentioned.

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