SUMMARY:

- 1H11 recorded better than expected results, with net profits reaching RMB39.3 billion, up by 51.4% yoy. Eps was RMB0.88, 7% higher than our expectation. An interim dividend of HK$0.25 was declared.

- Net oil and gas production was up by 12.9%, reaching 168.7 mmboe, which is in line with our estimates.

- FY11 production target was lowered by 7% as expected. New production guidance is set at 331-341 mmboe.

- Cost control maintains a leading position among global competitors

- The incident at PL19-3 is 95% in control and the clean up is expected to be completed by the end of Aug.

- We keep our `BUY` rating with a lowered target price of HK$18.2

Net production surged 12.9% yoy, but 2Q11 saw a production drop

Total oil and gas productions increased 12.9% yoy, reaching 168.7 mmboe. Crude oil production was up by 10.7% yoy reaching 133.2 mmboe, while natural gas production was up by 24.9% yoy reaching 208.2 bcf. At the same time, productions from new fields and new acquisitions increased 11.3 mmboe and 7 mmboe, respectively. Although the surge of the first six months` total production was impressive, outputs for crude oil fell short in 2Q11 to 64.4mmboe, down by 6.5% qoq. Production from Bohai Bay fell 7.8% qoq to 36.5 mmboe, the most significant decrease in all areas. Overseas production also dropped 6.1% to 9.2 mmboe. Natural gas production was robust, showing a surge of 15.3% qoq and 24.9% yoy, respectively.

Production target adjusted downward by 7% to 331-341 mmboe

The decrease in oil production was mainly due to the incidents at PL19-3 Bohai Bay and the delayed closing to increase stakes in PAE. The oil spill at PL19-3 caused CNOOC a loss of 22kbbl/d oil production since mid July. Although the management was confident about completing the clean up by the end of August, they are not sure when production can be resumed. Secondly, the acquisition of the second phase of Bridas was originally expected to complete by 1Q11. While the regulatory approval from Argentina took longer then expected, the upcoming presidential election in October may further delay the deal. The production target set at the beginning of the year included approximately 20mmboe from PAE; however, the newly downward-adjusted production target doesn`t include any contribution from the PAE. While we expect the deal to complete earliest in 1Q12, management remains silent on the date.

Net profit up by 51.4% due to the high oil prices

Thanks to a 40.8% surge in the average realized oil price, net profit jumped 51.4% yoy. Average realized oil and gas prices were US$108.16/bbl and US$4.992/mcf, up by 40.8% yoy and 15.5% yoy respectively. Average realized oil price for 2Q11 reached US$116/bbl, considerably higher than our expectation. CNOOC achieved higher than WTI average oil prices for the first time since 2006. Chinese oil companies track Brent more closely than WTI, and the abnormally large spread between the two benchmarks works in CNOOC's favor. However, we expect the oil prices to revert to a more reasonable range in 2H11. Thus, we estimate that 2H11 will contribute approximately 45% of 2011's full year revenue.

Crude oil prices have already tamed down since the beginning of July, with WTI and Brent averaging at US$ 93/bbl and US$113/bbl up to date (Aug 16), significantly lower than that of the second quarter. We don`t expect the global oil prices to be crazy in the second half of 2011. First, outlook of the global economy remains uncertain. According to data released in Aug, the IEA adjusted the global 2011 oil demand downward by 0.1mmbbl/d. Secondly, oil prices faced downward pressure when rebels in Libya claimed victory since Aug 24. So far into this year, approximately 1.3 mmbbl of crude oil were held in Libya; however, as much as 180 kbbl/d oil production is expected to resume shortly as the rebels gain control. According to people with knowledge, total production could reach 500 kbbl/d by the end of 2011, but full recovery may not be achieved in as long as 3 years.

Cost control in place, profitability up

CNOOC's cost control remains competitive among its global peers. All-in cost increased slightly by 7% to US$26.14/boe, mainly due to the 7.4% increase in DD&A (from US$11.72/boe in 2010 to US$12.59/boe in 1H11). The 3.8% drop in opex was mainly due to seasonality factor, and management expects an increase in 2H11. Both EBITDA and net profit margin improved in 1H11 compared to FY10, and we expect the full year profit margin to achieve 32.4% (31.6% in 1H11)

Updates on Bohai Bay clean up

According to the press release by CNOOC on Aug 12, more oil-based drilling mud (OBM) was identified on the sea floor at Bohai Bay. OBM on the seabed amounted to 400m3, or 2500bbl, while oil released to the sea surface remained at 114m3, or 717bbl. So far, the total amount of oil and OBM reached 514m3, or 3217bbl, more than doubled the original 200m3 estimated by the operator, ConocoPhillips China (COPC). According to COPC, 269 m3, or 1700bbl, of OBM from the seabed and 70m3, or 440bbl of oil/water mix from the sea surface were recovered to date. The State Oceanic Administration required the cleanup be completed by the end of August. Management said the situation was 95% under control, but when to resume production remained uncertain.

We maintain our `BUY` rating with a lowered target price of HK$18.2, which is based on DCF with the assumption of an average realized oil price of US$92/bbl in 2011 and a CAGR of 9.0% in the following 5-years. Despite the recent volatility in crude oil prices, we are positive on CNOOC's ability to deliver robust earning in 2H11. We have already factored the lowered production target into our valuation model back in July; yet, the better than expected realized oil prices partially offsets the lower production volume. We keep our full year eps estimate at RMB1.63.

The stock is currently trading at an attractive valuation. Both p/b and p/e are more than 1std below their respective 5-year means. We expect the earning multiple to recover to 8.1x in 2011.

Given the uncertainty in both China and the global economic outlook and reluctant growth in demand, CNOOC could be hurt more than expected for its cyclical nature. Delays in new projects would also lower the expected growth rate. The incident at PL19-3 could increase CNOOC's operational risks. The higher than expected strengthening of RMB could negatively affect earnings. Volatility of oil prices could also negatively affect the Company.

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