On A Fast Boat To China?

Why Unocal -- and its rich reserves -- may be snapped up

At first glance, Unocal Corp. (UCL ) doesn't seem much of a prize. The El Segundo (Calif.) energy company -- the nation's eighth-largest -- has seen its oil and natural gas production fall steadily during the past decade. Its stock price has badly trailed its peers. Yet on Jan. 6, Unocal shares jumped 10% when rumors began circulating that the company might be acquired by China National Offshore Oil Corp. (CNOOC), one of the three largest energy companies in China and, like most other big outfits there, controlled by the government.

Unocal and CNOOC wouldn't comment on the reports. And there is considerable skepticism among analysts about whether CNOOC has the financial heft or management depth to pull off such an ambitious deal, which at some $13 billion would be the largest acquisition yet of a U.S. company by the Chinese. But the news highlights a central dilemma of the oil business: Investors want to see growth in oil and gas production. Yet companies often get penalized when they try to develop risky new fields rather than just acquiring existing ones. That's why Unocal's market value trails that of other big oil companies -- and explains why it may get snapped up. The company, with large reserves of oil and gas in Indonesia and Thailand, could prove valuable to China, whose thirst for energy is outracing its domestic output. Or, Unocal could become the target of a cash-rich integrated giant like BP PLC.

How could Unocal go from ugly duckling to sought-after swan? The company has lagged its rivals in producing oil and gas. According to investment bank John S. Herold Inc., it is also below average in generating net income per barrel and replacing reserves, and has higher exploration expenses. However, Unocal still possesses tremendous assets -- nearly 1.8 billion barrels of oil and natural gas reserves, half of them in the Far East. Now, some of its long-term bets are beginning to pay off: After years of decline, the company's oil and gas production may begin climbing this year. And thanks to surging prices, Unocal remains solidly profitable. Analysts expect it to earn $1 billion for 2004 -- up 55% from a year earlier. Sales should reach $7 billion.

Founded in 1890 as Union Oil Co. of California, Unocal repelled a takeover attempt in 1985 from corporate raider T. Boone Pickens, but was left staggering under a load of debt. In the mid-1990s, Unocal went through a strategic shift. While many rivals were merging or acquiring existing oil and gas fields, Unocal began selling many of its less profitable U.S. assets to focus on big new fields overseas and in the deepwater Gulf of Mexico.

Fortunately for Unocal, its Asia operations were largely untouched by the recent tsunami. Those fields can take years to develop, however, and often face disappointments along the way. Take Unocal's giant West Seno field off the coast of Indonesia's East Kalimantan. Upon its discovery in 1998, a Unocal exec boasted that it would be the first of a "string of jewels" in the region. It turned out to be more like a millstone. Located under 3,200 feet of water, West Seno was the country's first deepwater project. Unocal had to build two floating platforms with 28-inch steel pipes snaking 50 miles to shore, costing more than $400 million.


Once it got drilling, Unocal found the flow of oil disappointing. The company used horizontal drilling techniques to cut across the shallower parts of the reservoir. That helped boost production to 40,000 barrels a day by the end of last year, but it may cause production to peak sooner than planned. In September the company announced that construction bids had come in too high and that it would not pursue a second phase.

In part because of the challenges of bringing on new fields like West Seno, Unocal last summer changed its method of forecasting production growth. Unocal now gives out only estimates that it has a 90% certainty of meeting, compared with a 50% certainty before. And it forecasts no more than one year in advance. For 2004, Unocal's output is expected to decline by 10%, to 406,000 barrels per day -- worst among the 11 largest U.S. and British oil producers, says brokerage firm A.G. Edwards Inc. (AGE ) "Our history has not been all that stellar in terms of meeting production targets," Unocal Chairman and CEO Charles R. Williamson told investors in August. He declined to speak with BusinessWeek for this article.

Unocal may yet turn things around. It has several big projects just now ramping up, including a 10% interest in a 4 billion-barrel field in the Caspian Sea. "This is a company that has disappointed in the past," says Steve Enger, an analyst at Petrie Parkman & Co. "But it could see production growth of 7% this year and 10% a year beyond that." That's exactly what may attract the suitors.

By Christopher Palmeri in Los Angeles

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