Sunday, January 11, 2015

They'll be back

Chinese SOE activity may have cooled, but that likely won’t last

This article appears in the January, 2015 issue of Oilweek 

By Peter McKenzie-Brown
Consider the record.

In 2007, when oil prices were on a tear, buyers spent $18.9 billion on oil sands assets. In 2010, companies poured $16.6 billion into oil sands acquisitions. The largest of the acquisitions that year was Chinese state-owned enterprise (SOE) Sinopec’s purchase of ConocoPhillips’s for 9 per cent interest in Syncrude Canada for $4.75 billion. A year later, Sinopec bought Calgary oil producer Daylight Energy Ltd. in a $2.1-billion deal. Then another Chinese SOE, PetroChina, bought Athabasca Oil Sands’ MacKay River project for $1.18 billion.

And in 2012 CNOOC – a “mixed-enterprise” company, which means it was not entirely owned by the Chinese government – acquired Nexen for $15.1-billion. Professor Gordon Houlden, director of the University of Alberta’s China Institute, says that “was the largest acquisition that China, in its 5,000-year history, has ever made.” It was also the culmination of a 7-year buying spree, during which China invested $30 billion in Canada’s energy sector, as part of a $100 billion splurge on global energy and mining assets.

Getting Tough with China: At least in theory, these efforts brought a firm response from Ottawa. “When we say that Canada is open for business, we do not mean that Canada is for sale to foreign governments,” said Prime Minister Stephen Harper as the Foreign Investment Review Agency let the deals go ahead. “Going forward, the [industry] minister will find the acquisition of control of a Canadian oilsands business by a state-owned enterprise to be of net benefit only in an exceptional circumstance.”

Harper toughened the rules on foreign ownership in Canada. Legislation proclaimed in 2013 broadens the definition of a state-owned enterprise. It now refers to an entity directly or indirectly controlled by a foreign government. Substantial investments in the oilsands are eligible for review, and in the case of the oilsands they must provide an “exceptional net benefit” if the acquisition means an SOE will control an operation. Also, the Minister of Industry has the discretion to accept or deny a deal.

Have these rules had an impact on investment in the oilsands? On the surface, that seems to be the case. Since the regulations became law, the number of SOE acquisitions of oilsands companies has declined steeply. As interestingly, merger and acquisition activity tied the lowest levels of the century: so far this year, there have been none.

However, it is important to put the federal government’s rules into context. China has not been buying, but neither has anyone else. Last year, bids for oil sands property sank from a gusher to a trickle. Transactions with oilsands content added up to only $770 million in 2013 and they have yet to recover. This year oilsands acquisitions have been higher – $1.8 billion – but nowhere near the highs of several years ago. And most of this year’s investment took the form of two deals. The larger one was a $751 million Exxon/Imperial acquisition of leases from ConocoPhillips. The other was Osum’s $325 million purchase of a project from Shell. Taken as a sector, the shares of oil sands producers are lower today than they were two years ago.

Lethargy: “Except for 2008-9, in recent years there been many acquisitions of oilsands companies in Canada,” said Professor Eugene Beaulieu of the University of Calgary’s School of Public Policy, “but this is in rapid decline.” Why did the oilsands suddenly sink into such a stupor? In a report available online, Beaulieu and his colleague, Matthew Saunders, show that in 2013 only a single SOE deal took place in Canada. It was worth a modest $320 million, compared to $28 billion the previous year, and it didn’t involve the oil sands.

Yet, according to Beaulieu, the recent changes in foreign investment have had at most a modest impact on foreign investment. “Ottawa’s Minister of Industry has a great deal of latitude at the political level,” he says, and “Canada has not been obstructive. We have been really open to foreign investment.” Except for the proposed $40 billion sale of Saskatchewan Potash Corporation to Australia’s BHP Billiton – a deal the Saskatchewan government opposed – and a $520-million offer for part of a Manitoba telecom, “we have been open to foreign investment. These new rules are not restrictive.”

In Beaulieu’s view, takeovers dried up because the oilsands industry faced internal problems. “The large companies have not been negatively affected as much as the little guys,” he says. Smaller oilsands companies are being disproportionately affected by a number of factors. “These include high extraction costs; changing regulations; such alternatives as tight oil; and problems with infrastructure and lack of access to markets. Those are the big four. Some people even say that China is experiencing buyer’s remorse because of all the properties” their SOEs bought at 2012 valuations.

In their report, Beaulieu and Saunders show that the oil companies suffering most from the decline in foreign investment were the juniors. Since Harper made his 2012 announcement about tightening SOE investment in the oilsands, share prices for the larger oilsands companies have risen slightly. By contrast, oil sands juniors had seen their prices decline by 40%. Calculated last May, these metrics did not reflect the steep declines in global oil prices since last summer’s highs.

Also, says investment banker Mike Jackson of Scotia Capital, not everyone sees Canada as a low-risk country. For example, there is “the regulatory process we have around pipelines, and Aboriginal issues,” he says. “People outside Canada scratch their heads when they consider how lengthy and convoluted it can be for us to get anything done.”

“Government-owned entities make Canadian acquisitions not only to acquire resource properties, but also for intellectual property and experienced staff,” said an executive – he requested anonymity – with a senior bitumen producer. “In at least one case, the Chinese acquirer used corporate acquisition in Canada as a means of training its own staff to the detriment of the business.” He shook his head. “With proper structuring, all the benefits they want could be obtained through a joint venture arrangement. For example, a Canadian entity could transfer an asset to a partnership or corporation. The foreign entity could acquire a non-controlling interest in that entity in return for funding all or part of the subsequent development costs.”

Another Bite: Chinese SOEs “will be back for another bite, “says the U of A’s Houlden. “They have powerful incentives to continue to buy Canadian oil assets. One of them is that they are sitting on $6 trillion worth of cash reserves, and they would rather have assets than paper. They can only put so much into T-bills.” As importantly, he says, “The bulk of the oil they import comes from unstable parts of the world, where they have been burned many times in the past. Many of those countries are remarkably unstable. They have had bad experiences in Libya, Sudan, and Iraq, for example. Canada is rock-solid.”

“I think their absence is temporary,” he says; China is out of the Canadian market because they binged at the beginning of the decade and now they are digesting what they bought. “They were attracted to the price of our assets, but now they need to develop the software, the skill sets needed to run a large corporation in a North American environment. They are used to operating in developing world environments, but in North America the rules are different. The labour regulations are different, and the transparency requirements are far different. It is in their strategic interests to learn some of that. Also, we have attractive technology – shale gas, for example. That will be a good fit over time.”

According to Houlden, three things are behind China’s absence, although “you can’t put an exact weight on each of those factors.” For one, Chinese investors “aren’t happy with the adjustments to the Canada investment act regulations, which made it difficult though not impossible for SOEs to invest in the oilsands,” he says. Another is that the acquisition doesn’t look as good as it did a couple of years ago, either. “Valuations are declining. In the long run, though, I think CNOOC’s acquisition will be just fine. Nexen had attractive assets.”

Finally, he says, “We’re in the second year of an anticorruption campaign in China, and the kingpin in that campaign is Zhou Yongkang.” Formerly a senior party official, Zhou became quite wealthy through his involvement with SOEs. There has been a great deal of examination of his business dealings, and this is affecting the operations of Chinese SOEs abroad, according to Houlden. In addition to the corruption issue, he says, “the consequences of making a really bad investment are much more serious in China than they are in Canada.”

It is because China is out of the market, that the asset buying spree makes sense. However, says Houlden, “The Chinese will be back. They have the deepest pockets of anybody, and they are the biggest importers of petroleum.”

Shortly after the interview with Houlden, a senior Chinese diplomat, Calgary based consul general Wang Xinping, told a newspaper that China’s state-controlled energy firms were struggling to turn a profit in Canada – in part because of Ottawa’s immigration laws. Mr. Wang said China’s SOEs want to bring in their own employees to reduce costs. Ottawa has been unwilling to issue the work permits the companies asked for; this made it harder for Chinese companies to develop their projects profitably.[

Bottom Line: Although M&A investment in the oilsands is down, investment in just about every other hydrocarbon asset in the WCSB is at historically remarkable levels. To a large degree, that is because Canadian oil and gas plays are more profitable than their American counterparts – especially given the recent decline in the loonie compared to the greenback. More importantly, petroleum properties in Western Canada are stable and offer better value. Of 31 North American plays that pay out in 2.5 years or less, 25 are Canadian. In addition, the Western provinces often provide royalty holidays as incentives to drill.

Also, of course, the WCSB is a huge geological basin with the most diverse resource base on the planet. This makes it a particularly attractive place to invest in oil and gas, and this year investors have placed large sums in the sector. The shares of Canada’s public oil companies are barely higher than they were two years ago. Fanned by the winds of historically low interest rates, they are using debt to acquire and develop attractive conventional assets. Not everyone is so optimistic, however. Citing lower oil prices and uncertainty around pipeline construction, the Canadian Association of Oilwell Drilling Contractors (CAODC) expects drilling in the basin to drop 10% next year.

Private investors are even more enthusiastic. If you prorate the numbers in the Annapolis report to the end of 2014, private interests are almost certain to invest more in the basin than the $3.8 billion they did during the 2008 economic crisis. Stories are still circulating about private investors who made killings by putting money into energy assets in those grim days. Will today’s private investors do the same? If so, it will be another enticement for China’s SOEs to come back to the table.

“You can’t ignore them,” Houlden says. “China will be back.”

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