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The Wall Street Journal: Drilling Needs Yield Boon for Chinese Firm

China Oilfield Services’ Revenue, Profit Surge Amid Expanding Offshore Energy Production

September 24, 2007

BEIJING — The combination of rapid economic development and rising energy prices is accelerating demand for oil exploration in China — particularly off of its coast.

Analysts say few companies are in a better position to benefit than China Oilfield Services Ltd., known as COSL, which provides parent Cnooc and other oil companies with services needed to drill offshore.

While some analysts see the Hong Kong-listed stock as expensive, many call the company a “buy,” thanks to its better-than-expected earnings in the first half of 2007 and its position as Asia’s only integrated provider of oilfield services. Its main customer is Cnooc, China’s largest offshore oil producer.

COSL’s shares closed Friday at 16.10 Hong Kong dollars (US$2.07), or almost four times their closing price a year ago. The coming domestic stock offering has been sparking some of the rise.

Yesterday, the company said it was pricing an offer of 500 million Class A shares, which will make a debut in Shanghai on Friday at 13.48 yuan (US$1.80) each, or about a 16% discount to the last closing for the Hong Kong Class H shares. The domestic issue aims to raise 6.74 billion yuan ($898.3 million).
With international oil prices setting records, China is aiming to raise its offshore exploration. Cnooc has increased capital spending more than 18% this year to US$4.18 billion. Other national oil companies also are expanding their business offshore, which potentially increases demand for COSL’s services.

In the first half of 2007, COSL’s revenue reached 4.25 billion yuan, up 49% from a year earlier, while net income surged 63% to 1.1 billion yuan.

Analysts attribute the growth to the company’s competitive pricing for drilling rigs. Although it has increased its average day rate for drilling rigs 34% in the first half of this year, those rates remain about 45% less than those of international operators, according to Howard Pang, a Hong Kong-based analyst with Citi Investment Research.

That leaves the company room to increase prices further, he says. “We expect this gap to narrow to 20% in year 2009,” he says. Last month, Mr. Pang raised his target price for COSL to HK$18.30 from HK$11.50.

Gordon Kwan, head of China energy research at CLSA Ltd. in Hong Kong, regards COSL’s large supply of equipment for offshore work — it has 15 drilling rigs and 70 working vessels — as attractive to potential new customers.

“There is a global shortage of drilling rigs, and COSL’s customers are desperate to secure these drilling rigs and associated oil-field services to boost production in order to take advantage of higher oil prices ahead,” says Mr. Kwan, who is reviewing his firm’s target price for potential upgrades in the next 12 months. He rates the company a “buy.”

Some analysts consider COSL’s services, ranging from drilling and well services to marine support such as ships and vessels, an attractive model for state-controlled oil companies in Asia and Africa, which are likely to prefer one-stop services.

Some analysts express concern that international oil companies, such as Royal Dutch Shell, want service operators to be more specialized with more advanced technologies. COSL’s success is largely rooted in its contained costs; for example, the parts in its drilling equipment are mostly made in China, and it benefits from China’s low labor costs.

A challenge for COSL is to develop its deepwater-drilling capabilities. Later this year, it will test artificial-seabed technology called ASDD that would allow semisubmersible rigs to drill as deep as 1,500 meters (4,950 feet), rather than just 500 meters.

“If the experiment succeeds, it could transform an ordinary semisubmersible into a deepwater drilling device, which could boost COSL’s day rates substantially,” Mr. Kwan says.

Another risk for investors is the stock’s heady valuation. David Hurd, a Deutsche Bank analyst based in Beijing, warned in a report last month that the stock, which some analysts say is trading at about 40 times 2007 earnings, “still looks expensive relative to international peers.” He also wrote that the domestic share offering might dilute earnings-per-share growth in the first quarter of 2008.

Although Mr. Hurd raised the price target for COSL from HK$9.95 on Aug. 16 to HK$14.59 on Aug. 31, he rated the company “hold.”

Others say oil’s soaring price, together with offshore discoveries in Chinese territory, including Bohai Bay, will mean rising demand for COSL’s services. Mr. Kwan says he expects the boom to last as long as prices stay above US$50 a barrel. Another reason for analysts’ optimism is COSL’s effort to diversify revenue sources. When the company went public in 2002, more than 70% of revenue came from Cnooc. That has fallen to 60% to 65%.

One benefit of getting more business from overseas clients is that COSL can charge higher day rates, said Grace Liu, an analyst based in Shenzhen for brokerage Guotai Junan. She estimates that overseas clients might generate 20% of COSL’s revenue this year and as much as 30% in 2009, after recent contracts in Mexico, the Philippines and Papua New Guinea.

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