Monday, December 30, 2013

The Big Chill

New foreign investment rules were supposed to provide clarity, but in fact are just pushing investment away from Canada
This article appears in the January, 2014 issue of Oilweek
By Peter McKenzie-Brown
China is an oil-producing superpower. Last year the country’s state-owned oil companies spent $35 billion buying foreign assets. One result: the country’s state-owned enterprises (SOEs) now produce almost as much oil outside the country as such OPEC kingpins as Kuwait and the United Arab Emirates. These overseas acquisitions are being operated as commercial investments, in the sense that oil from far-flung businesses is mostly being used to supply traditional markets. Add those volumes to China’s position as the world’s fifth largest producer from domestic fields and the quick result is a network of state-owned enterprises (SOEs) that are global in scope.

Since the start of 2009, Chinese national oil companies such as China National Offshore Oil Corporation and China Petroleum & Chemical Corporation (Sinopec) have spent more than $100 billion on overseas oil and gas – a sum which includes CNOOC’s contentious $15.1-billion takeover of Nexen Inc.

Canada’s response to that takeover was quite different from the US response to a Chinese “threat” in 2005. In that year, CNOOC made a hostile $18 billion bid for Unocal. Although CNOOC offered more for Unocal than Chevron, the Chinese firm had to back down after American lawmakers denounced the deal as a threat to national security.

When it made its big bid for Nexen, CNOOC had clearly learned from the Unocal debacle. The company announced that its head office for the Americas would be in Calgary, its shares would be listed in Toronto, its capital investment would increase and the new firm would continue its oil sands development. Also, the company offered a premium of more than 60% for the shares and got approval in advance from Nexen’s board. At about the same time, Malaysia’s Petronas acquired Calgary-based Progress Energy, paying a 77% premium.

An executive with a senior bitumen producer summed up the present situation thus: “From the government policy perspective you can now do property deals all you like, but SOEs aren’t allowed to buy companies. The problem from the industry’s perspective is that it put a ceiling or constraint over the equity value of all of the entities involved. That set an expectation that is no longer reflected in the shares of other companies. The government was concerned about this, and came in and said ‘We’re not going to allow this again.’”

The shareholders of Nexen and Progress did well, but did Canada? No, says the University of Calgary’s Jack Mintz – an economic thinker whose advice generally gets a sympathetic ear in Ottawa. “Right now you’re in a situation in these countries where they’re not interested in return on capital, but just buying assets around the world without real consideration of value.”

An associate dean at the University of Alberta, Edy Wong begs to differ. “The question didn’t arise when Statoil came into Canada,” he says. “The problem is that [Canadians] don’t understand [or trust] the Chinese regime. The government has five-year plans and they set goals. They might want to do more investment overseas to develop better energy security. They will then, for example, make preferable loans to SOEs to buy these assets.” However, he continues, “The Chinese are soon going to have the biggest economy in the world, and they are going to develop it their own way. We have to live with that. China has 1.3 billion people, a huge economy, and they are looking for energy security. It is the size of China that is creating the problem.”

Jack Mintz disagrees. He notes that in a free market, takeovers play an important and specific role in business development. “A takeover market should be an important way of replacing bad management with better management. It creates certain synergies that otherwise wouldn’t be available….In the normal state of affairs, companies do buy out companies, and the result is a more efficient sector. However in the case of a [high-premium] takeover by an SOE, that doesn’t happen.”

Mintz notes that in the last few decades Canada has privatized its government-owned petroleum companies. Indeed, “countries around the world have undertaken a whole spate of privatizations of publicly-owned companies to make them more efficient and create a more dynamic and productive business sector. Why should we let Chinese state-owned enterprises come in now and dominate our petroleum sector? When you look at the performance of these companies, they historically have not done very well. They are not efficient despite efforts by the Chinese government.”

Once again, Wong differs. “China has earned a lot of money by degrading their environment and now they have to convert that money into something which benefits them. When the Chinese buy resources to develop, it is so they can continue to produce goods which they sell to Europe and North America. This arrangement is in [Canada’s] interest.

Mintz acknowledges that the Chinese are learning to be technologically advanced and that the country has experienced remarkable growth in recent decades. However, “the Prime Minister was extremely concerned about keeping our [petroleum] industry competitive [and created a new policy regarding takeovers by SOEs]. The bigger question is why only the oil companies are governed by this policy.”

Wong again has a different take. “Let’s remember that our government went overseas to China and almost begged for new investments. We did that in China and we did that in India. We went to China and said ‘We want your investment.’ [Mr. Harper and his team] then came home and said the mission was very successful. But [Canadians] said ‘We don’t want the Chinese owning our resources,’ and they had to backtrack.”

A Different Kind of Beast
From Wong’s point of view, China has become “the kind of animal” that Canadians just don’t understand. “The Chinese are now creating a new way of doing business and we don’t know where it’s going. They call it state capitalism, and there is more competition in China then there is in Europe or North America. The Chinese economy is very market-oriented, but very often the competition is between different SOEs [like CNOOC and Sinopec]. For the Chinese, industries like aircraft manufacturing and energy are strategic. It’s just like in Canada: we won’t let someone come into this country and buy a bank. The new policy has more to do with political and cultural considerations than with real economics.”

Since the announcement of the new policy a year ago, the collapse in many Asian currencies has made Ottawa’s new policy more or less irrelevant. Japan because of its monetary policy, but also Australia, China, India and Pakistan are now in much weaker positions in terms of buying Canadian assets. As far as Mintz is concerned, that makes no difference. “It’s true that the exchange rate problems in Asia have made capital that we thought was available for the oilsands unavailable. But investment can come from anywhere – there is a world capital market. We don’t have to take it from SOEs. Europeans are a very significant investor in Canada, for example. It will be interesting to see what’s going to happen as a result of the free trade agreement between Canada and the European Union.”

An executive with a senior bitumen producer said anonymously that the business environment since the Nexen takeover is not good. “It certainly doesn’t help that Western Canada Select [the Canadian heavy oil benchmark] is once again trading at a discount of over $40 to West Texas Intermediate crude. Penn West has light-oil assets and EnCana has loaded up on natural gas, but the increasingly grim outlook for [bitumen sales] doesn’t help even their prospects much.” He doesn’t expect more Asian SOEs to buy Canadian companies. “First, the government might not let them; second, nobody wants to get into the process that the Chinese got into over Nexen, where you make an offer and you go through a lot of lobbying to get approval. They got approval, but only on the basis that they were the last one through the door.”

Geoff Hill of Deloitte agrees. A chartered accountant by background, in the interest of full disclosure he notes that his firm is auditor for both Nexen and CNOOC, and that he therefore can’t discuss issues related to the books. Because he provides business advice to clients, he is deeply concerned about the clarity of the government’s rules. They are “ambiguous,” he says, “and that has created angst among foreign investors. They are restrictive and that too has created angst among foreign investors. The real question when it comes down to the specifics of any deal is how the rules will play out.”

He wants clarity in the system. “Foreign investors still view Canada as a good place to invest, but they have a very short claw-back time in terms of getting their money out. They are now less certain about their investments in this country. What always makes investors nervous is uncertainty, and other elements of the Canadian landscape aren’t easy for foreign investors. Besides the federal and provincial policies, there are municipal and first Nations jurisdictions. Having so many overlapping jurisdictions can make foreign investors nervous about working in Canada.”

The federal government is aware of this concern. In a recent speech, the Prime Minister acknowledged the complaints about lack of clarity, but was unabashed. “I would put it this way,” he said. “There is margin for the government to exercise its judgment…. In my opinion, when you are dealing with large state investors, foreign governments as the investor, I think it would be foolish for the Canadian government to provide absolute clarity. It is absolutely necessary, when the investor is a foreign government, for the government of Canada to be able to exercise its discretion and have direct conversations with those foreign investors”

According to Hill, “As a Canadian you can see the logic of this. But as a foreign investor, you would be concerned. [For example], if your plans are to understand Canadian technology and the complex geology and geoscience of Canada’s landscape and to take some of that knowledge back to your country, you want clear rules.”

The Impact
A key element of the policy is that it does not impose limitations with respect to joint ventures. What SOEs can do is earn an interest in an oil sands property by investing in its development. Unfortunately for that strategy, the market has changed a lot in the last year – especially because of problems with market access – and foreign partners are increasingly hard to find.

Athabasca Oil Corp. has been looking for Chinese friends since before the new policy went into place. Though it came close last year, that was then and this is now. Like most bitumen producers, the company’s share price dropped in the post-Nexen environment – in Athabasca’s case, by two-thirds from an $18 high. One of the few analysts to tip it as a good buy is Eric Nuttall of Toronto-based Sprott Asset Management. In his view, the company may soon ink a deal by which it will receive $3.30/share in cash from PetroChina, for a joint venture in Canada. That “could lead investors back to the story after a few very frustrating years,” he says, adding that Athabasca’s asset value exceeds $10/share.

The big decline in the company’s share price reflects new market conditions, but more importantly it echoes the new policy environment. After all, other oil sands companies have not seen such precipitous price drops. “Why are SOEs so different?” Geoff Hill asks again. “At present, a lot of Canada’s resources are controlled and produced by foreign companies, but the reserves are still owned by Canada or the provinces. So what’s the fuss?  The Canadian government should provide the investment community and the Canadian public with an explanation of what the rules really are.”
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