[In the battle for Unocal, state-backed CNOOC has Beijing's deep pockets behind it. Is that fair?]

(FORTUNE Magazine) – AS FIREWORKS were exploding in the skies across America on July 4, celebrating U.S. independence, a cadre of Chinese and American businesspeople were plotting their own revolution. In a virtual war room that stretched from New York City and Washington, D.C., to Beijing and Hong Kong, American bankers and lawyers joined CNOOC executives from Asia in a conference call to plan the next move in the Chinese company's battle to buy California-based Unocal. It was the second time that day the war room had convened, as it has regularly at 12-hour intervals for two months, holidays and weekends included. By offering $18.5 billion for Unocal, topping an already accepted bid from Chevron by $2 billion, CNOOC--China National Offshore Oil Corp., which is majority-owned by the Chinese government--has ignited a storm of controversy about China's potential threat to U.S. businesses. And that has required constant vigilance from CNOOC's war room. "Not a day goes by without a call," explains one CNOOC banker. "It's tactical, it's operational, and we're fighting it every day."

They're not the only ones. In Washington, politicians, pundits, and lobbyists are squaring off over the ramifications of a Chinese firm outbidding an American company for American assets. Prodded by an aggressive Chevron campaign, the capital is awash with assertions that keeping Unocal's energy reserves in U.S. hands is a matter of national security. Lurking just behind are xenophobic sentiments that have been brewing for years: American jobs moving abroad is bad enough; American dollars following, via the trade deficit, is worse. But now a whole U.S. company, the once proud owner of Union 76 filling stations across the heartland, may be snatched away from good ol' American Chevron.

Is it really that scandalous? After all, there was barely a peep when BP, a foreign company, bought both Amoco and Arco. CNOOC chairman and CEO Fu Chengyu contends he was caught off guard by the torrent of criticism. While he assumed there would be some U.S. political opposition to what is the biggest overseas takeover bid ever by a Chinese company, he says, "I did not expect so much heat." Fu, who earned a master's degree at the University of Southern California, laments, "I don't know why they reacted that way."

What's at stake here isn't simply American access to Unocal's crude. Despite the Sturm und Drang in D.C., Unocal's daily crude-oil output worldwide is less than what America consumes in the first 15 minutes of each day. CNOOC is after Unocal's Asian natural-gas reserves and its deepwater-drilling expertise. Fu is willing to divest Unocal assets in the U.S. to satisfy any national security concerns by the Committee on Foreign Investments in the U.S. (CFIUS), the government panel that would have to approve CNOOC's bid. "We are happy to cooperate," he says.

Instead, the fight for Unocal is about deeper anxieties over China's long-term oil ambitions and how they will impact the future of U.S. companies like Chevron and Exxon Mobil. These Goliaths--as well as European giants like BP and Royal Dutch/Shell--face an ever harsher landscape as government-backed companies like CNOOC elbow their way into the industry. Despite record profits thanks to $60-a-barrel crude (four of the top ten corporations in this year's FORTUNE Global 500 are oil companies; see following story), most big Western firms are having a hard time boosting production to meet demand; many, like Chevron, are in acquisition mode. Yet so are new, deep-pocketed rivals like CNOOC. Just as China's demand for energy is changing the market and driving up prices--only four years ago, the Department of Energy predicted China would consume 6.7 million barrels a day by 2010, yet Beijing will easily surpass that mark this year--so, too, are China's aggressive efforts to control its energy supply shifting the balance of power in the oil business.

This is why energy CEOs like BP's John Browne are watching the Unocal battle so closely. "The question is what happens to this industry," says Browne, as he paces his London office. "It's an upside-down world, because unlike in telecom, for example, more production and reserves are in the hands of state players. Private companies are dealing with the small part of the deck."

THE CHAOS AT THE DRILLING RIG IN the remote Libyan desert one day last year would have shocked any Western oil exec. Instead of standing tall, as rigs should, the big derrick lay in pieces on the sand. The Chinese project managers were prodding their Libyan workers to literally get the rig off the ground. But the Chinese didn't speak Arabic, and the Libyans couldn't fathom Chinese. Progress was slow. "This is something new for the Chinese," admits Abdulla Salem el-Badri, the chairman of Libya's National Oil Co. "But they are trying very, very hard."

Places like the middle of the Sahara used to be the exclusive preserve of Big Oil. But the surge in oil prices over the past few years has enabled new players to simply buy the technology they need for onshore drilling, dramatically leveling the playing field. Now, American and European giants find outfits they've barely heard of suddenly muscling in on their turf. When Libya auctioned off 15 new exploration licenses earlier this year, Oil India and Abu Dhabi's Liwa joined more familiar names like Chevron and Occidental in the winner's circle. Chinese companies in particular can now be found all over the world, led by CNOOC, Sinopec, and CNPC/PetroChina (see timeline below).

Competition in unexpected places is just one of the new challenges facing the oil giants. Spend time in the boardroom of any Western energy corporation and you'll hear a lot about something called the hurdle rate. That's what companies must earn per barrel to justify drilling a new well or building a new pipeline. Oil execs like BP's Browne remember just how painful it was for the industry when oil plunged to $11 a barrel in 1998. They now demand that new projects earn a decent return even if crude prices drop by half--or more. But the newcomers from China, India, and elsewhere are able to accept far lower hurdle rates, in part because they are government-backed. They have access to low-interest loans from government-controlled banks, allowing them to pay more for oil--or for companies (CNOOC is borrowing $7 billion for its Unocal bid at terms Chevron can only dream about). Over the past three years, CNOOC, Sinopec, and PetroChina have spent $1 billion buying up assets in Indonesia and Kazakhstan alone. Big Oil is painfully aware of--and increasingly vocal about--the uneven playing field it now faces. With competitors free to fork over larger sums, it gets hard for the likes of Chevron to find projects that meet their hurdle rates.

Meanwhile, governments in oil-producing countries are demanding a bigger share of the profit pie. Venezuelan national oil company PDVSA, for example, is raising taxes on foreign companies from 34% to 50%. One reason President Hugo Chavez can play this game, says Larry Goldstein of the Petroleum Industry Research Foundation, is that if a Western giant were to quit Venezuela in protest, Chinese competitors are ready to take its place. In Russia, the Kremlin has broken up privately held Yukos and anointed government-controlled Gazprom and Rosneft as the national champions in the energy sector. New restrictions on exploration by foreign companies are being imposed. "You've got private U.S. companies competing in a world dominated by governments," says analyst Paul Sankey of Deutsche Bank. "But the companies need these governments, because they control the oil. The companies just have to grin and bear it."

Or they can shift their focus to the biggest, most technologically complex projects in the world, like deepwater drilling in the Gulf of Mexico or shipping liquefied natural gas (LNG) halfway around the world at 260 degrees below zero. That's what Chevron, Exxon, BP, and Shell are increasingly doing. "The future of the oil industry is the ability to execute very large projects," says Jeroen van der Veer, Shell's CEO. These "elephants," as he calls them, "are where we have added value."

As for oilfields where the majors don't have a cost or technological advantage, van der Veer says, "other people can do that." Shell is pouring billions into LNG, which requires cutting-edge high technology that can't simply be bought from Schlumberger or Halliburton. It's also an area where the Chinese are still safely behind. "Right now we're an oil and gas company," says van der Veer, noting that crude accounts for 60% of Shell's energy production. "By 2015, we may be a gas and oil company."

Even here, though, the upstarts from Asia are gaining. One reason CNOOC is eager to buy Unocal, says CEO Fu: "We'd have enough capacity in terms of deep sea to really deliver." In this way, CNOOC's bid for Unocal is just the latest step in China's long race to catch up with the West.

CNOOC'S OFFER FOR UNOCAL MAY have triggered day-and-night conference calls spanning the globe, but the final decision to bid was reached with a minimum of fuss on the evening of June 22 in Beijing. Following a 90-minute presentation to CNOOC's board by J.P. Morgan, Goldman Sachs, and law firm Davis Polk, according to bankers who were present, the panel deliberated only a little over an hour before granting approval.

As it turned out, of course, that was just the beginning. Chevron responded with guns blazing, despite the fact that CNOOC and Chevron have long been partners in major projects in China and Australia. Eight months after calling his company's relationship with CNOOC "extremely successful" in a speech in Beijing, Chevron vice chairman Peter Robertson told FORTUNE that CNOOC "clearly isn't a commercial company. In my opinion, that's not right." Raising the temperature even further, Robertson added, "We think it's a national energy-security issue. We're clearly up against the Chinese government."

Chevron and its allies on Capitol Hill have been pushing the national-security argument hard--even though it might jeopardize CNOOC's cooperation on future projects. "Chevron needs this deal a lot," says veteran oil analyst Fred Leuffer of Bear Stearns, noting that Chevron's energy production is expected to drop in 2005 for the sixth year in a row. While CNOOC has intimated it could come up with even more money to sweeten its bid, Chevron knows that if the Committee on Foreign Investments blocks the deal, no amount of money will make it fly. Even a delay in CFIUS approval helps Chevron: Its bid has been cleared by regulators, putting the deal on the table for a Unocal shareholders vote on Aug. 10. If CNOOC's bid takes too long to finalize, those stockholders may decide that a few extra dollars down the road isn't worth the wait.

In any case, the competitive pressures facing the Western energy giants will not abate. Chinese, Indian, and other companies will continue to get state support, since their governments consider oil a strategic asset. Even if a Chinese acquisition of Unocal poses no national-security threat, the fact that state-sponsored foreign companies are aggressively trolling for assets across the globe certainly presents risks. The only answer, argues Shell's van der Veer, is to focus on mega-projects that competitors don't have the technology to undertake--and invest heavily in expanding that skill advantage. Yet it's only recently that some supermajors significantly upped their exploration and production budgets. Big Oil may need to open the spigot wider--or risk being bought by a Chinese company, rather than merely competing against one.

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