For five years, the specter of Unocal Corp. loomed large in China-U.S. relations. Seeking to expand its global resource base in 2005, China's CNOOC Ltd. made an $18.5-billion play for the California-based integrated major. However, the proposed merger with the Chinese national oil company, 70% owned by the Communist government, set off some members of Congress.

Fellow California-based supermajor Chevron Corp. stepped up, offering an all-stock bid for Unocal that was less than CNOOC's all-cash offer on its face, but assured Unocal shareholders that the sale wouldn't become a forced taxable event in their portfolios. The Chevron bid won.

Since then, China's four national oil companies have ravenously spent $45 billion amassing assets around the world, according to Mergermarket, but ostensibly steered wide of the States. That is, until Chesapeake Energy Corp. announced in October 2010 that it would partner with CNOOC on a portion of its Eagle Ford shale project in South Texas. This time, CNOOC's onboarding the U.S. caused nary a stir publicly from Washington, and the Chinese were assigned a 33.3% interest in 600,000 net acres of Chesapeake's South Texas Eagle Ford leasehold position.

Chesapeake Energy Corp. chief executive Aubrey McClendon sees the company’s Eagle Ford shale joint venture with CNOOC Ltd. as a recycling of American trade deficits back into the U.S., putting Americans to work and creating new flows of domestic oil and gas. Here, he accepts Investor’s M&A Deal of the Year Award from Leslie Haines, editor-in-chief.

"The deal was significant because it marked the entry of a Chinese state-affiliated company into the U.S.," says Aubrey McClendon, Chesapeake chairman and chief executive officer. That entry could burst open a flood of Chinese capital into the U.S.

China already owns $2 trillion of U.S. debt, he notes. "I see this as recycling American trade deficits back into the U.S., putting Americans back to work, creating new flows of American oil and gas, and reducing oil imports. It's a big winner all around and on multiple levels. I'm thrilled about it."

Over time, considering CNOOC's working-interest carry over the life of the project, McClendon estimates its Chinese partner will invest upward of $20 billion of capital into the Eagle Ford alone. "That's $20 billion of American capital that might not ever have been repatriated and what industry but ours can bring back American capital in those quantities?"

Add to that, he says, "I think we're going to find an additional half-million barrels of oil and natural gas liquids flowing in the U.S. a day as a result of the Chinese capital infusion. We're going to create high-paying jobs for tens of thousands of Americans, and we're broadening the tax base. This deal does some wonderful things for America."

Ralph Eads, chairman, energy investment banking for Jefferies & Co. Inc., which advised Chesapeake in the Eagle Ford deal, says a Chinese investment in the U.S. is a meaningful sea change. "The Chinese are the biggest holders of financial capital in the world today, and have become the largest buyer and financier of oil and gas properties all over the world. The energy industry in the U.S. is in a position in which it needs capital. Now, the largest buyer of assets has decided to participate in the U.S. market. That's big."

Journeys to China

The suddenness and seeming ease of the unexpected partnership caused a stir in the industry in October, but, in fact, its genesis began a year and a half prior. Early on, McClendon recognized the vast source of capital in Asia available for energy investments and made it his mission to tap it. "I wanted to develop alternative sources of capital for our company," he says, "and there is a lot of money over there."

Following a series of joint ventures by Chesapeake involving international partners and a $2.2-billion Chesapeake preferred-stock raise in April 2010, led by Hopu Capital's Richard Ong, formerly with Goldman Sachs in Asia, McClendon engaged Eads in a conversation regarding a partner in its Eagle Ford shale position. The two had a relationship going back to their days at Duke University, where they were fraternity brothers. Jefferies had already represented the Oklahoma City-based company in all of its previous joint-venture deals. The Houston-based advisory firm also had a team on the ground in China, and had represented CNOOC in several international deals. McClendon posed the question to both Ong and Eads: "What about the Chinese?"

Eads replied, "Let's go to work on them." Ong concurred: "Come on. Let's go."

Chesapeake's preferred-stock offering, which included such Asian investment luminaries as Singapore-based Temasek, joined by sovereign wealth funds China Investment Corp., Abu Dhabi Investment Corp. and Korean Investment Corp., as well as other private Asian investors led by Ong and Hopu, had put the "Good Housekeeping" seal of approval on Chesapeake and made it much easier to call on the Chinese national oil companies (NOCs).

Backed by some $2 trillion in capital, the NOCs have a mandate by the Chinese government to buy natural resources. "If they want to spend 15% of that on North American resource assets, for example, that's $300 billion," notes Eads. "That's more than (the price for) a Chevron."

CNOOC, the third-largest oil and gas company in China, is tasked with building an E&P portfolio abroad and has the most experience in doing deals with international partners. In the 18 months preceding the Eagle Ford JV with Chesapeake, it had spent some $10 billion outside the U.S. The company paid close attention to the Chesapeake preferred-stock offering.

"One of the motivations for doing the financing, other than to raise money, was to establish greater credibility among Asian investors," says Eads. "When we eventually went to CNOOC, Chesapeake's name was known. CNOOC had seen these sophisticated Asian institutions already invested in the company."

Meanwhile, CNOOC was alert to sensitivities within the U.S. about Chinese ownership of domestic natural resources, and knew it would need a partner to gain access onshore. Earlier, the company had dipped its toe into the Gulf of Mexico through a small nonoperated interest with Statoil without fanfare. Now it wanted to move onshore.

One of the most important aspects to CNOOC was to find the right partner, says Eads, not only from an operational and technical point of view, but also in navigating through issues with the government. "They were motivated to have a strong partner. We thought Chesapeake would be the best partner for them because of its scale."

CNOOC's motivation

The Chinese E&P made a high-level decision to evaluate the deal but, with no shale experience, needed more technical expertise. In June, CNOOC chose Tudor, Pickering, Holt & Co. Securities Inc. as its advisor. The Houston-based investment-banking firm had represented Temasek in the earlier stock offering, so its name had become known in Asian energy-capital circles. Ward Polzin, managing director and head of A&D for TPH, and his team, including Lance Gilliland and Danny Rathan, led the technical and financial evaluation of the Eagle Ford joint venture for CNOOC.

Foremost, CNOOC was seeking knowledge of how to extract unconventional oil and gas resources—that is, oil and gas trapped in low-permeability and low-porosity rock, such as shale. In 2009, the country's energy consumption grew to tie that of the U.S. at 19.5% of all global daily supply; adding in demand in Hong Kong, its total exceeded that of the U.S. at 19.7%, according to BP Plc's annual global energy review. And, like the U.S., it is a net importer of crude oil.

Yet it holds vast unconventional resources—some 1,000 trillion cubic feet of coalbed-methane gas in place and a possible 1,200 Tcf from 25 known shale formations, according to Hart Energy's Global Shale Gas Study. To reduce pollution from coal-fueled power generation, the Chinese government is pushing to switch more plants to natural gas. Simply, CNOOC aims to take U.S. shale-gas players' rock-fracturing practices back home.

"They're no different than other foreign players wanting to do shale deals," says Polzin. "Not just for the technology, but economies of scale too—running 10 to 20 rigs in a single play. They want to live it. They have a massive country."

And to McClendon, that is good for the U.S. and the world. "If we can show the Chinese how to find shale gas, then that is less coal they're going to burn. If they can take what they're going to learn from us and go find more oil in China, then that's less competition for increasingly scarce conventional oil resources."

What about any concerns about exporting American technology? At the end of the day, it's not the technology or knowledge that's proprietary—it's the acreage, says McClendon.

"If I teach you how to find oil in the Eagle Ford, that's great, and so now you know how to do it. But if you don't have any acreage, you can't do it. Technology gets spread throughout the industry quickly anyhow, and that's good—best practices get followed that way. But what is proprietary is the acreage that you own. We're never fearful about a negative impact on us from bringing in a JV partner."

American oil- and gas-finding technology remains the envy of the rest of the world, he says. "Combine that with a resource base that, from an accessibility perspective, may be the best in the world. These international JV deals just drive home the point that America leads the world in energy technology and, perhaps, also in potential energy resource upside."

Another motivation is what McClendon dubs China's $2-trillion problem. "They have all of these American dollars and bonds that could possibly decline in value and what are they going to do with them? I think they would like to invest them in American resources. It provides a good way for them to reinvest their foreign currency holdings back into the U.S. into something more productive than buying a government bond."

Eads puts it this way: "Would you rather own Treasuries or Eagle Ford shale assets?"

Getting to know each other

Jefferies had maintained a regular dialogue with Chinese companies, with managing director and veteran asset advisor Bill Marko conducting regular road shows in the Far East, educating producers on shale-gas development. Once CNOOC decided to pursue the venture, Marko orchestrated the day-to-day logistics among the parties. "Bill ran the railroad," Eads says.

The relatively nascent development of the Eagle Ford shale-oil window, where most of the acreage is located, proved to be a major evaluation hurdle. "The oil sector of the Eagle Ford had few wells drilled at the time, which made it harder to do a transaction," Marko recalls. "When anyone buys this much acreage with relatively little historical results—that is, 'well control'—it's a risk."

But it's a good risk in the Eagle Ford, he adds, because once the acreage is proven it will produce, the value will double or even quadruple. "They're getting in early."

“It’s not like you’re selling an asset; it’s a marriage,” says Ralph Eads, chairman of energy investment banking, Jefferies & Co. Inc.

Ultimately, however, it was the relationship of CNOOC's chairman, Fu Chengyu, and McClendon that was the deal's catalyst. After the opportunity had been vetted by CNOOC's technical team, the two met for dinner in Beijing, along with Eads and two other CNOOC executives. It was McClendon and Fu's first meeting.

"The chemistry was really good," remembers Eads. "They hit it off. There was a clear recognition by CNOOC that Chesapeake would be a good partner. We walked away from the dinner with a strong consensus that we were going to get this done."

Fu, who received his master's in petroleum engineering from the University of Southern California and had led the scuttled Unocal deal, is also a senior official with the Chinese government. Like in the U.S., the deal had to pass muster with the Chinese state council. Fu saw that it did.

Chesapeake also invited two other Asian companies to make proposals, among which India's Reliance Industries Ltd. was one. But even though it had valued the assets at the same price as CNOOC, Reliance dragged its feet and the Chinese emerged victorious. Eads says, "Chesapeake wanted CNOOC as a partner." Nuptials were set.

Doug Jacobson, Chesapeake's executive vice president of business development, did the heavy lifting on negotiating the deal and creating the business structure. "He's in a league of his own," says Eads. "These joint ventures are complicated. It's not like you're selling an asset; it's a marriage."

On CNOOC's side, business-development officer Jianguang Zhang ran the process. Vinson & Elkins' Frost Cochran III led legal counsel for CNOOC, while Ray Lees of Oklahoma City-based Commercial Law Group PC led legal for Chesapeake.

Washington winds

In 2009, President Obama and Secretary of State Hillary Clinton met with China President Hu Jintao and unveiled the U.S.-China Shale Gas Initiative, part of a broader joint initiative on clean energy. The cooperative effort, according to the White House, "will allow the U.S. and China to use experience gained in the United States to assess China's shale-gas potential, promote environmentally sustainable development of shale-gas resources, conduct joint technical studies to accelerate development of shale-gas resources in China, and promote shale-gas investment in China through the U.S.-China Oil and Gas Industry Forum, study tours and workshops."

Chesapeake leveraged this endeavor to get CNOOC in the front door. "The U.S government is not discouraging Chinese investment," says Eads. "They just want it to happen in an appropriate way."

International transactions come under the purview of the Committee on Foreign Investment in the U.S., headed by Treasury Secretary Timothy Geithner. CFIUS, as it is known, has the power to block or unwind any such deal.

"The deal was crafted to respect U.S. sensitivities," Polzin says. "The Unocal experience—when they were trying to buy the entire company and operate—was still fresh in their minds." This time, "they purposefully chose to buy a minority interest and be a quiet partner."

Once the deal was set but not yet announced, Chesapeake and CNOOC floated the agreement through channels in Washington. Each hired D.C. lawyers expert on the process, who talked with each department represented on CFIUS. They were asked, "Could you preview the deal to see if there are any problems, and do you think CFIUS would like to review it?"

The State Department previewed the deal and liked it. From Clinton's perspective, McClendon says, "the hope was that we could attract some Chinese capital back to the U.S., but also help them to decarbonize their economy."

Eads says it was important for CNOOC to be successful when coming back to the U.S. "They clearly wanted to prove they could come back," he says. "It's an important positive for CNOOC. They were ready to do it, and the joint venture was a good way for them to get comfortable with the U.S. and for the U.S. to get comfortable with the Chinese."

In the end, CFIUS quietly passed on the opportunity to review the deal, clearing the path. "The CFIUS process was not an issue," says Marko. "It was nicely handled by Chesapeake and its legal advisors."

The deal closed in November, merely a month after it was announced and conveniently two months before President Hu made a state visit to the U.S. "Had there been resistance," says Polzin, "they would have pulled back and tried to restructure."

Still, Polzin believes Washington's appetite for Chinese investment in U.S. assets has improved only marginally. "If we had Unocal sitting there today and a Chinese company wanted to buy it, I don't think they would get it approved today, either." The joint-venture structure was the right choice in the current political environment for getting the deal through.

McClendon says the deal drew so little attention from government regulators because it was clearly different than the Unocal deal. "This involved no control of assets. It was not an acquisition of a company. This is a passive investment in a nonoperated position. They took a look at this and realized it was in the best interest of the U.S."

First and second of its kind

When the dust settled, CNOOC took a one-third interest in an undivided 600,000 acres in five South Texas counties. It paid $1.1 billion upfront, with an agreement to fund 75% of Chesapeake's drilling expenses up to another $1.1 billion. The $11,000 net present value per acre was the highest metric paid at the time.

It's a good deal for both sides, asserts McClendon. While expensive in its entirety, the price by the acre is cheap, he argues, when considering the resource value underneath. "We think that, in the Eagle Ford, there are 5,000 barrels of oil equivalent recoverable under every acre. How much is it worth to have the right to find 5,000 barrels of oil for $10 per barrel to develop? CNOOC paid about $11,000 per acre, which is the equivalent of $2.20 per barrel.

"It's a great trade for us because we were in it for 40 cents per barrel per acre. And it's a great trade for them because they are still in at a very attractive price."

Once the terms were agreed, senior executives of both companies gathered to celebrate the ground-breaking arrangement.

McClendon calculates CNOOC revenues of $100 billion on $17 billion invested over the life of the project, but it will never be out of pocket more than $3 billion.

"Where else in the world can they find a billion and a half barrels of oil, spend $17 billion, have a return on investment of 6-to-1, do it in a country that will honor the rule of law, and then allow you to take profits elsewhere? There's no other place in the world where they can do that."

And, in fact, acreage metrics have now topped $25,000 in the region. "I believe they could sell today for twice what they paid," he says. "They are very happy with the investments they've made with us."

In an effort to quell domestic fears, CNOOC will not contractually have technical advisors imbedded in Chesapeake's operations like within its other international partnerships. It will be an active nonoperator, with plans to open an office in Houston. "I would expect their team to spend time in Oklahoma City for sure," says Polzin.

Once the terms were agreed, senior executives of both companies gathered at a grand, historic hotel in Beijing overlooking the Forbidden City to celebrate the ground-breaking arrangement. McClendon offered buckskin leather coats, cowboy boots and hats to the delighted CNOOC officials.

A few months later, Chesapeake announced CNOOC as its partner in a $1.2-billion deal in the Niobrara. "CNOOC got first shot at the Niobrara as part of the Eagle Ford package," confirms McClendon. "That was one thing they wanted. We had a handshake on the Niobrara while we were negotiating the Eagle Ford. They got a very good deal on both because of their ability to move quickly on the Niobrara."

Will there be an opportunity to do more deals with CNOOC? "I hope so," says McClendon, but one is not imminent. "I think they'll digest what they have. But I definitely think they will do more."

CNOOC's Fu has since moved to another Chinese national oil company, Sinopec, Asia's biggest refiner. "Fu is clearly an internationalist in his thinking," McClendon says. "I would suspect that Sinopec will be looking for deals to do, too."

Eads says, "The CNOOC deal was an important first step in the Chinese being able to participate in U.S. industry. Hopefully, there will be a series of deals between Chinese companies and American players."