Capital Markets

”Do More, Say Less”

PetroChina's transparency has won admiration -- and investment dollars -- from Warren Buffett. But can the state-owned giant really deliver?
Cesar BacaniDecember 29, 2003

Wang Guoliang seems an unlikely exponent of transparency in Chinese companies. For a start, 51-year-old Wang spent all of his working life at state-owned China National Petroleum Corp (CNPC) and its listed subsidiary PetroChina, the world’s sixth-largest listed oil company, becoming its CFO in 1999. Then there’s his education: he earned his master’s in international economics from a school in Hebei province, not from a prestigious American university. And like many now-successful Chinese executives, he had his hungry years. At 17 years old, during the chaotic height of the Cultural Revolution, authorities sent him from his Shanghai home to the countryside to till the soil and learn from the people.

And yet this child of communist China is now counted among the country’s most progressive CFOs. “Mr. Wang has been the primary interface with the investment community,” says Paul Bernard, energy analyst at Goldman Sachs. “I have been pleased with the job he and his staff have done, and the feedback I hear from investors is similar. PetroChina’s financial reports are detailed and timely, and are released around the same time as those of other major Chinese and Hong Kong companies.” Wang certainly talks the talk. When told that this reporter’s pension fund probably owns PetroChina shares, he replied: “Then you’re my boss. I should report to you.”

The ultimate validation came in April this year when Warren Buffett, the world’s most conservative yet most successful investor, bought 2.3 billion shares of PetroChina stock listed in Hong Kong. Buffett-controlled Berkshire Hathaway is now the Chinese company’s third-largest shareholder after CNPC and British oil giant BP.

Mao Zefeng, assistant secretary to the board and head of investor relations, briefed Buffett at his Omaha headquarters in October. “He was very lively and asked a lot of questions,” says Mao. “He said he invested in PetroChina after studying our financial reports, which he said were much better than those of many American companies.” What’s more, the PetroChina stake represents the first high profile foray of the formidable Nebraskan into a company that is majority owned by a government. The fact that the government happens to be that of volatile China where the market, economists predict, is headed toward overheating, suggests that Wang’s numbers must have presented a convincing tale indeed.

In fact, Buffett told Mao that he regrets not buying more shares. Certainly, the stock has already rocketed. Berkshire’s April purchases average out at around HK$1.65 per share. On October 15, PetroChina closed at HK$2.85, valuing Berkshire’s stake at HK$6.7 billion (about US$863 million). In less than six months, Berkshire is looking at capital gains of more than US$363 million. That is on top of the interim dividend of around US$30 million due to Berkshire after PetroChina reported record first-half profits of Rmb38.6 billion, up 102 percent over the same period in 2002. The consensus 2003 earnings-per-share forecast of 21 analysts polled by Multex Global Estimates is HK$0.36 (for a price-earnings multiple of 7.9 times), with forecast dividend at HK$0.163 per share (for a dividend yield of 5.7 percent).

Glass Ceiling

What else can the market possibly want? A lot more, it seems, and the most basic demand is something that Wang—or any other Chinese CFO—cannot do much about. Unlisted and opaque state-owned enterprises still own big chunks of China’s leading public companies. CNPC, for one, holds 90 percent of PetroChina stock (these shares are not traded). “With this dominant shareholding, which is the government basically, there is not much visibility or transparency,” says veteran Hong Kong investment advisor Marc Faber. “Production at their main oil fields at Daqing is declining and they have to move overseas. To what extent this to move overseas. To what extent this or to what extent it is on a commercial basis would be interesting to see.”

This is the glass ceiling that China’s CFOs find themselves bumping against even as they transform their enterprises into models of modern financial management. Faber concedes that he has yet to detect state interference in PetroChina’s business dealings, but the government’s huge stake makes him wary anyway. Any hint of politically motivated moves and investors could scamper away. Buffett’s purchase could be a two-edged sword in this regard. While he is known to buy and hold for the long term, he could dump PetroChina if he gets uncomfortable with the political and social risks in China. If Buffett were to sell for any reason, PetroChina’s stock would almost certainly tank—and the company’s reputation would sink along with it.

PetroChina already had a foretaste of this in August when its stock price fell 2.1 percent in one day. Buffett disclosed to US regulators that he had sold US$5 million worth of PetroChina’s American Depositary Shares in the second quarter of 2003. Flustered investors rushed to the exits. Was Buffett’s confidence in PetroChina wavering? The markets were reassured when it was revealed that Buffett’s ADS sales were made before he accumulated the 2.3 billion in H-shares he bought in Hong Kong.

There are company-specific risks as well. Production is diminishing at the Daqing oil fields, which have been worked over for nearly 50 years, yet PetroChina has been slow to expand abroad. Unlike fellow Chinese oil company CNOOC, which has gone on an overseas buying spree, PetroChina made its first and only foreign purchase in 2002. (Sinopec, China’s third oil company, concentrates on petrochemicals, not oil and gas exploration.) PetroChina paid US$262 million for stakes in six oil blocks in Indonesia. Those fields contribute less than 1 percent to the company’s total oil production of 103 to 104 million tons a year. Daqing currently accounts for around 48 percent of that total.

PetroChina is in talks with Russian partners to build an oil pipeline from Siberia to Daqing, but the project is now up in the air after Japan made a rival bid. The pipeline would have supplied PetroChina with 25 million tons of crude a year in the first five years, and then 30 million tons annually afterwards. But the company is going ahead with a US$5 billion natural gas pipeline even as final contracts with foreign partners have not been signed. The West-East Pipeline will connect gas fields in remote Xinjiang province to factories and homes in Shanghai and other affluent eastern cities. Analysts worry that the project could prove uneconomic if the government sets too low a price for the piped gas and demand is not as strong as projected.

Wang’s conservative financial management has also attracted some flak. Most CFOs would be happy to generate US$11.9 billion a year in net cash from operating activities while keeping gearing at just 17.5 percent. But some industry analysts wish to see PetroChina pile on more debt. “The company is under leveraged,” says Goldman’s Bernard. “We expect it to have net-over-equity of only 11 percent as of the end of 2003. That’s a very low ratio, particularly for a company with the size and stability of PetroChina and one that could borrow as cheaply as it can.” The subtext is that the company should be more aggressive in spending money on new projects at home and abroad.

Witness to Change

In his hotel room in Hong Kong, Wang ponders the vagaries of the capital markets. He is on a stopover for yet another business meeting in London. “My English is not so good, so please speak slowly,” he says. In fact, his English is more than adequate and surprisingly grows more fluent when he gets passionate about something. This is one of those moments. “I can tell you that the government does not interfere with our business,” Wang says forcefully. “I think people should look at PetroChina’s performance. We are truly an independent company.”

He understands the misgivings. But the CFO predicts that the overhang of government-owned shares will eventually disappear. “I don’t think the government selling more shares is a problem,” he says. “This is the trend. It is a matter of timing. We have no internal target as to how much will be sold. But I believe that in the future the government will dispose of its stake in our company.” There are advantages, however, in the strong CNPC connection. PetroChina does not have the right to enter into production-sharing agreements with foreign companies, a privilege that CNPC enjoys under Chinese law. Subject to approval by the Ministry of Commerce, CNPC has been assigning most of its production sharing contracts to PetroChina.

If the state does, indeed, give up full control, it would be the culmination of a process that Wang has personally witnessed. He started working for the Ministry of Petroleum Industry in the 1980s, when the agency was being reorganized along corporate lines. The ministry spun off China National Offshore Oil Corp (the forerunner of CNOOC) in 1982 and China Petrochemical Corp (now known as Sinopec) the next year. It then transformed itself into CNPC in 1988. “In the initial stages, we still had some government functions, such as the right to issue exploration rights,” recalls Wang. “Nowadays, CNPC is purely a commercial entity.” Oversight and regulatory functions have been transferred to the Ministry of Land and Resources.

Wang was seconded to a subsidiary, CNPC Finance, in 1995. Three years later he moved to another CNPC company, China National Oil & Gas Exploration and Development, where he served as deputy general manager and general accountant. When CNPC formed PetroChina in 1999, Wang was drafted as the new company’s CFO. CNPC wanted to list PetroChina abroad to gain access to foreign capital and expertise. Wang’s brief was to help value the assets to be injected into the new enterprise, create financial management and reporting systems consistent with international standards, and interact with foreign securities regulators and the global investment community. It was a stressful time.

“We had only ten months to make everything work,” says Wang. “I took no vacation, no Saturday off, no Sunday off. I worked until the middle of the night.” He and his staff—the new company had 9,000 people in finance, taxation, budget and other financial functions—had to upgrade their skills. Advice came from various specialists, including listing underwriters China International Capital (partly owned by Morgan Stanley) and Goldman Sachs, external auditor PricewaterhouseCoopers and financial advisor NM Rothschild. “But PetroChina was such a huge company, so it was tough even for the investment bankers,” says Wang.

The most basic accounting exercises became something of a nightmare. Chinese accounting rules at the time did not distinguish between internal and external sales, which resulted in inflated revenue figures because of double counting. It took 60 people two months to track down and analyze documents, categorize transactions as internal or external revenue, and generate income statements. But most financial systems were in place by the time that PetroChina finally listed in Hong Kong and New York in April 2000. Then Wang’s education as CFO took another turn. Investors probably shrugged off headline-grabbing protests in the US against PetroChina, which activists painted as a surrogate of Beijing and its repressive policies in Tibet. But the internet mania was at its height and bricks-and-mortar companies like PetroChina fell by the wayside. At one point, its stock price fell below the initial offering price.

Wang saw what was happening from a computer terminal he asked to be installed on his desk. “As the CFO of a listed company, you must always focus on this issue [of stock price],” he says. “You must always be aware of the reactions of the capital markets.” Did he get discouraged when the stock price tanked? Wang pauses for a bit. “No, because we had confidence in PetroChina,” he answers. “I can understand the reaction of the capital markets at that time. Investors were not familiar with us. They needed time to communicate with us. Right now, the market reaction has been very good, very positive.”

Warren and Me

In part, PetroChina has Buffett to thank for that. Before news of his April purchases filtered to the market, the stock was just coasting along. It peaked at around HK$1.70 in Hong Kong—up a third from the listing price of HK$1.27. PetroChina jumped to the HK$2 level after Buffett’s vote of confidence. Strangely enough, Wang had never met Buffett. But then it is not the legendary investor’s practice to interview company executives. “Almost everything we learn is from public documents,” Buffett told his shareholders in May. “The numbers tell us a lot more than the managements.”

Wang is quietly chuffed at Buffett’s interest in PetroChina, especially since Buffett made the decision largely by perusing the financial reports that Wang and his staff prepared. “Our annual reports contain not just financial but also operating data,” he says. “We report production data every quarter and reserves as well, because they are an oil company’s most important asset.” He knows the importance of information. “I have read several books about Mr. Buffett,” says Wang. “He never makes a hasty decision on any investment. He does a lot of research first.” The CFO thinks PetroChina’s conservative, dividend-paying culture fits well with Buffett’s investment philosophy. “We focus on long-term returns. We never chase short-term results.”

But is the company too conservative? Wang gets irked by suggestions that PetroChina should take advantage of cheap rates and bulk up on loans. “We have a very strong cash flow,” he points out. “Based on our first-half financial statement, we have more than Rmb40 billion (US$4.8 billion) under free cash flow. Why do you have to raise money from the debt market? Even if the rates are low, you still have to pay interest.” He notes that CNOOC also has strong cash flows. “I don’t understand why they are still raising money from the capital markets,” says Wang.

CNOOC’s strategy seems to be to take advantage of cheap loans now to build up a war chest for its aggressive forays abroad. Since listing in 2001, CNOOC has spent US$1.7 billion on fields in Australia and Indonesia, eight times the amount PetroChina has invested abroad. At one point last year, PetroChina was looking at Canada’s Husky Oil, which is controlled by Hong Kong billionaire Li Ka-shing. But Husky’s stock price spiked up on the news and PetroChina eventually decided the oil company was not a good fit. “We don’t have the ability to run a Canadian-listed company,” says Wang. “Husky also has offshore assets and offshore is not our strength.”

PetroChina’s long-term target is to source 10 percent of annual production from foreign assets. It will increase production at smaller oil fields in the west while limiting the decline in Daqing in the northeast. In theory PetroChina can dig more wells in Daqing, but the new deposits are more difficult and expensive to access. So the goal is to keep total production of crude stable at around 2 million barrels a day while finding enough new reserves to keep the replacement ratio at 100 percent or higher. Even at these levels, PetroChina will remain China’s largest oil producer. CNOOC’s daily production is less than 300,000 barrels while Sinopec pumps about 700,000 barrels a day.

Wang says PetroChina’s current crude production is large enough to keep its refineries and chemical factories humming. The company’s lifting cost is US$4.32 per barrel-of-oil-equivalent, far lower than Sinopec’s US$6.26 but higher than CNOOC’s US$3.92 in China (overseas lifting cost is a very high US$9.06). Industry leader ExxonMobil places its lifting cost at US$3.58. Capping crude production should help limit the extreme volatility of PetroChina’s earnings. Nearly 58 percent of the operating profit of PetroChina’s exploration and production division in the first half of 2003 is accounted for by the rise in oil prices to US$28 from US$20.11 in the same period last year. Every US$1 increase translates into an additional Rmb5 billion in operating profit—or a fall by a similar amount if the price moves in the other direction.

What a Gas

The gas business is more predictable and the push is on to speed it up. “In Moscow, one city alone, 30 million people use piped gas,” says Wang. “We will be serving China’s most economically developed areas. So I never worry about marketing to the customer.” He does not fret about supply either. The gas fields at Xinjiang and Chongqing, the wellsprings of the West-East Pipeline, harbor reserves of 12.9 trillion cubic feet. In total, PetroChina’s proven gas reserves, both developed and undeveloped, topped 38 trillion cubic feet as of the end of 2002. CNOOC only had 3.5 trillion while Sinopec had 3.3 trillion.

PetroChina is no tyro at building and operating pipelines, having completed its first project in the 1950s. Last year, it sold 588.4 billion cubic fee of natural gas to utilities, fertilizer factories and chemical companies through regional pipe networks totaling 12,299 kilometers. The West-East project, at 3,800 kilometers, will be the company’s longest and most expensive line. It has attracted enormous interest from the world’s oil majors. ExxonMobil, Shell and Russia’s Gazprom are among the six members of an international consortium that has signed a framework joint-venture agreement. Sinopec is also on board.

Regulators recently set the price PetroChina can charge for its gas at Rmb1.27 per cubic meter. “Some customers wanted the lowest price, so they lobbied the government,” says Wang. “That’s natural.” At Rmb1.27, he estimates that the pipeline will break even when it sells 8 billion cubic meters of gas in one year. Wang says sales will reach full capacity by 2007, three years after the project is fully completed. The segment’s contribution to operating profit is still a puny 2.4 percent. Oil accounts for 91 percent.

Cost Cutter

As CFO, Wang is also focused on the unrelenting campaign to trim production and operating expenses. Lifting costs are probably as low as they can get given Daqing’s age, but Wang sees a lot of elbowroom in refined products. “We are shutting down small and inefficient facilities and concentrating [chemical] production in bigger plants,” he says. “We are looking at optimizing energy consumption, transportation, and other operating costs.” The chemicals segment swung to a profit of Rmb648 million in the first six months of this year partly because of cost savings estimated at Rmb330 million.

Since listing in 2000, PetroChina has cut 60,000 jobs and kept labor expenses at 8 to 9 percent of total costs. Wang concedes that PetroChina still employs more people than foreign firms. But salaries, bonuses and social security benefits are low in China, so expenses per employee are actually cheap by international standards. More layoffs are not on the cards. “Manpower is a sensitive issue, so we don’t want to cut too many jobs,” says Wang.

In March last year retrenched employees in Daqing staged protests after PetroChina offered to give them more cash in exchange for stopping their medical insurance and payment of heating bills. The unprecedented rallies drew international attention as other unemployed joined in. “It was a misunderstanding,” Wang says. “The new social security policy was actually beneficial, but this was not explained very clearly.” A show of force by the police and PetroChina’s promise to revisit the issue helped resolve the crisis.

Wang insists that PetroChina is in far better shape now than it has ever been. Remember the 60 employees who spent two months reconciling revenue figures? “Nowadays only one person in the finance department offsets revenue and it takes just two hours,” says Wang. “We do everything with computers now. And it is all very accurate because we have set up very sound financial information systems.” Profits are up, costs are down and the hemorrhaging chemicals division is finally in the black. PetroChina has also bulked up its distribution network with the acquisition last year of 2,994 gas stations and 478 storage facilities from CNPC.

The Future

Still, he is worried by the slew of foreign oil companies making a beeline to China after the country’s accession to the World Trade Organization. The upstream exploration and production segment is unlikely to be thrown open to them, but downstream wholesale and retail are likely to be. PetroChina needs to master the art of marketing to the consumer, something that foreign companies have vast experience with. As it is, the company is still lagging Sinopec, which claims an 80 percent share of the refined products market in the rich south and east, where most of its refineries operate. PetroChina incurs higher transport costs because its production is in the less prosperous north and west.

Wang is also focused on managing the heightened expectations of the capital markets in the wake of Buffett’s investment. Mao Zefeng’s pilgrimage to Omaha in October is indicative of PetroChina’s desire to keep communication lines open with a high-profile investor whose decisions can make or break the company’s stock. From here on, the investment community can expect even more comprehensive, transparent and timely financial reports and briefings from Wang and his team. But it will be the bottom line that will do most of the talking. Says Wang: “PetroChina is all about ‘Do more, say less.’”

And the concerns about government ownership? “Whether CNPC disposes of more shares or not, PetroChina will remain a government company at the end of the day,” says Yang Liu, China fund manager at Britain’s Atlantis Asset Management. “Energy is too important to be handed over to the private sector. Is this good or bad? To me, it’s a non-issue. You must simply look at PetroChina as a unique company, one of only three with access to China’s huge resources and exposure to its economic growth. It’s the biggest, most profitable, and a high dividend payer. What else can you ask for?”

Let the markets decide.

Cesar Bacani is a contributing editor at CFO Asia.

Wooing Warren

So you’re hoping to do a PetroChina and entice Warren Buffett to buy your company’s shares? Here’s what you need to know.

  • You must operate in a developed market or in an emerging economy with clear growth prospects. “We prefer slightly things in the US and avoid some countries altogether,” says Buffett. “We don’t make any great judgment about China. We simply look at investments around the world and buy things that make the most sense.” Most of Berkshire’s equity investments are in American companies, among them Coca-Cola, American Express, Gillette and The Washington Post. The portfolio currently has only five foreign stocks, including PetroChina. Buffett sank US$265 million in Irish beer maker Guinness in 1991, but sold at a loss three years later.
  • Your financial reports should be comprehensive and timely. Buffett depends almost exclusively on income statements, balance sheets and other information available to the public. He does not usually meet executives of any company that interests him. Buffett judges corporate transparency, governance and quality of management from the detail and candor of annual reports and other regulatory filings.
  • Your financial management must be consistently conservative. Buffett and partner Charlie Munger keep a lid on gearing at Berkshire. “In retrospect, it is clear that significantly higher, though still conventional leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8 percent we have actually averaged,” he wrote in one of his essays. “Even in 1965, perhaps we could have judged there to be a 99 percent probability that higher leverage would lead to nothing but good.” But there was a 1 percent chance that some shock factor would result in temporary anguish or default. Says Buffett: “We wouldn’t have liked those 99:1 odds—and never will.”
  • Your stock must offer great value. Buffett buys equity in a company only when he is convinced the price reflects its real worth. He calculates that “intrinsic value” by assigning the most probable earnings per share the company would produce annually over, say, ten years. He would add up those figures and then deduct what an investment in US Treasury bills would have earned for each of those ten years. The resulting figure would then be halved—this represents what Buffett calls his “margin of safety”. If the result equals or is lower than the current stock market price, he will buy. If not, he will wait. Buffett has endless patience. Berkshire has US$24 billion in cash waiting for opportunities.