CNOOC:Still meaningful upside,but multiple to remain suppressed near-term

We cut our one-year price target on CNOOC to HK$12.00 from HK$13.50, andremove the stock from Macquarie’s Marquee Buy list. Put simply, the oil priceoptionality has yet to play out and, in our opinion, the recent cut to productionguidance may serve as a near-term overhang on CNOOC’s arguably cheaptrading multiples. However with still 29% TSR upside to our price target and 40%upside to our residual income valuation, we firmly maintain an Outperformrecommendation.

Reflecting prudent guidance.

The combined impact of an average 7% cut to CNOOCs 2017-18 productionguidance and the top-end of CNOOCs capex range for 2017 is an average cut of7% to EBITDA, 13% to EPS and 9% to residual income valuation. For context a$5 move in the oil price makes a 10-25% impact on the same parameters.

Cheap multiple to remain suppressed near-term.

CNOOC trades on 3.5x 2018 EV-DACF, a 30% discount to EM comps (fig 7, 10).

The common deflection we get on this is ‘why should the shares trade on morethan 1x price-to-book if the company is going to run out of oil in 8 years andmore quickly offshore China?” CNOOCs production guidance cut will likely addweight to this bear argument and serve as a near-term overhang for the shares.

However, we would be buyers of the pullback and argue: (1) CNOOC’s currentproduction guidance reflects a low watermark as only economic barrels at$51/bbl Brent have been included in guidance; (2) reserve life (fig 9) on astandalone basis is largely meaningless and CNOOC’s 10-year average organicproven reserve replacement ratio of 115% (fig 11) is potentially a more usefulmetric to gauge future production potential; (3) return metrics will rise along withhigher oil prices and our forecast average 2017-20 ROE of 10% implies ajustified P/B of 1.2x (5-year trading range 0.9-2.2x, fig 8).

Fundamental buy case with meaningful upside remains.

While our confidence on the timing of a re-rating for CNOOC has waned, ourconviction on the free cash flow generation potential and the leverage to risingcrude prices has not changed.