Musings: The Chinese Are Coming! The Chinese Are Coming!
In a bold move on Monday, July 23, the China National Oil Company, CNOOC, announced an agreement to purchase Canadian-based explorer Nexen for $15.1 billion in cash. The C$27.50 per share purchase price represented a 61% premium to the closing share price of the prior Friday. The news of the transaction sent Nexen's share price soaring, but it failed to trade at a premium to the purchase price signaling that Wall Street and Bay Street investors believed there might be another buyer who would try to compete with CNOOC. Rather, investor speculation shifted to the question of which Canadian oil company might become the next acquisition target of either Chinese or other aggressive buyers. As expected, however, along with the speculation about foreign buyers of Canadian oil and gas companies was outspoken nationalistic protest against any deal involving important Canadian energy assets.
As the dust surrounding the deal's initial announcement settled, the focus shifted from surprise to concern over whether this was a proper transaction and in the best interests of Canada. Clearly the deal was in the best interests of shareholders who stood to walk away with a substantial profit that likely wouldn't have been realized by a rising share price anytime soon given weak natural gas prices, lower crude oil and natural gas liquids prices, and cash flow challenges. The debate of the day was whether foreign-controlled oil companies should be allowed to buy leading players in another country's energy business – an industry considered critical to the development of every economy. The corollary question is how does a transaction of this type fit into a capitalistic economy? Within hours of the CNOOC/Nexen deal's announcement, the politicians and mainstream media waded into the debate.
Some Canadians were outspoken that the federal government should not approve the deal because it would guarantee that the development of domestic resources would be controlled by a country that might have different goals and objectives than the private company's bosses. And certainly those objectives might differ from the goals of Canadian citizens and their leaders, although the current Prime Minister, Stephen Harper, has been an advocate that the country needs to develop other non-North American markets for its oil and gas output. Some citizens questioned whether the Nexen deal would be a long-term strategic positive for Canada or merely the latest version of the infamous Japanese global investment wave of the 1980s? People may not remember but during that decade of Japanese economic ascendancy its companies bought up many high-profile businesses and iconic assets, especially in North America, only to find to their regret that they grossly overpaid and couldn't turn around structurally flawed companies. It was a costly and disruptive experience.
On the other hand, some Canadians viewed the CNOOC/Nexen transaction as merely the logical extension of the flood of foreign money that has been coming into Canada's natural resources industries, with oil and gas being the most recent beneficiary. Shortly before the Nexen deal, Petronas, the Malaysian national oil and gas company agreed to purchase Canadian-based Progress Energy Resources Corp. at C$20.45 per share in a C$5.5 billion transaction. That deal rewarded investors with a 77% premium over the June 27th closing price on the Toronto Stock Exchange. The purchase will bring Petronas exposure to oil and gas assets in British Colombia and Alberta, with a particularly strong position in the Montney trend. The wave of foreign investment began a few years ago and was initially focused on mining companies with attractive assets but in need of capital to develop the mines and export infrastructure. That effort peaked with the high profile and controversial offer by Australian miner BHP Billiton to purchase Canada's Potash Corporation for C$39 billion in late 2010.
The Potash deal tested the resolve of political leaders in Canada as they wrestled with the economic implications of the transaction. Under the Canada Investment Act, the federal government must determine whether any proposed acquisition is in the best interests of Canada – its people and its economy. Potash had a major presence in Saskatchewan and the announcement of the offer set the province's premier off on a major lobbying effort to get the deal killed. Business columnist Eric Reguly of Toronto's Globe and Mail, wrote an article "The Real Story Behind Ottawa's Potash Rejection," in which he wrote, "Saskatchewan faced losing billions in revenue because of perfectly legal tax and royalty avoidance under the BHP ownership scenario, and possibly declining potash prices because of its vow to dismantle Canpotex, the international potash marketing and sales cartel that Potash Corp. sponsors." Given that Prime Minister Harper was leading a minority government, he wanted to avoid angering his western Canada supporters. For the second time ever under the investment law, a foreign transaction was rejected.
The conclusion from the BHP/Potash rejection was that foreign takeover deals for Canadian companies would no longer be a slam dunk. Proving that a takeover will be a "net benefit" for Canada would now face a higher bar than before. But that lesson has not been lost on CNOOC and others who are investing in Canadian natural resource industries. Moreover, the wave of foreign capital flowing into the Canadian energy sector in the past couple of years has been welcomed by the industry along with local and federal governments and the Canadian mainstream because substantial investment capital needs is required to develop the country's oil sands deposits and its unconventional oil and gas resources. This is probably the primary difference between the Chinese and Asian investments and BHP's proposed deal. The latter's target was not really in need of capital infusion and Potash had a proven track record of successfully raising capital.
South of the 54th parallel there was a different reaction. New York's Senator Chuck Schumer (D-NY) and Massachusetts' Representative Edward Markey (D-Mass) auditioned for the roles of Paul Revere and William Dawes by racing to the microphones to proclaim: "The Chinese are coming! The Chinese are coming!" Here was an opportunity to use the deal struck north of our border to attack the Chinese government over its trade practices with the United States. Plus, the deal offered an opportunity to go after the missing royalties Nexen isn't paying on oil and gas production from leases acquired in 1998 and 1999 that omitted the requirement to pay royalties on production when crude oil prices exceeded $34 a barrel. This "oversight" involved about 1,000 leases approved by federal officials during the Clinton administration. These leases were signed by the successful bidders in the sale, and the Bush administration tried to convince them to pay the royalties but without any legal authority. These missing royalties have been used repeatedly by Democratic politicians to berate the oil and gas industry whenever possible with the aim of shaming the companies into voluntarily paying the royalty toll on moral grounds.
Let's not bother with the minor detail that the United States government signed a valid contract with the oil companies before they were allowed to start exploration and development activity. But the political party of which Messrs. Markey and Schumer are leaders, recently tried to prevent the Republican-controlled House of Representatives from correcting a bill where the modifier "un" was omitted from the final legislation about limiting federal spending that was tied to the "employment" rate, rather than the "unemployment" rate as originally conceived. Unlike Messrs. Revere and Dawes who were captured by the British before they completed their rides on the fateful April evening, no one has been able to stop Messrs. Markey and Schumer from threatening to derail the CNOOC/Nexen deal.
After CNOOC's unsuccessful attempt to acquire on an unfriendly basis America oil company Unocal in 2005, Chinese oil companies began aggressive investment in oil and gas assets around the globe, but primarily where the government could create a receptive environment. The Unocal deal was the reflection of the Chinese government's desire to gain a stepping stone for greater involvement in the U.S. oil and gas industry. The attempt created a huge backlash of American nationalism, which ultimately resulted in Chevron purchasing Unocal. In this Canadian deal, Nexen does have a U.S. subsidiary that has allowed it to acquire and operate oil and gas leases in the United States. What may ease the deal for the Canadians is that Nexen has oil sands and unconventional assets that require substantial investment. The rest of the company's assets are located outside of Canada, which offers the Chinese an interesting oil and gas investment portfolio.
The bigger problem, which Messrs. Markey and Schumer seem not to understand, is that by attacking CNOOC via its potential U.S. holdings through Nexen they may force the Chinese company to exit the U.S. properties. That outcome might embolden CNOOC to make sure that none of its Canadian and Nexen oil and gas production winds up in the United States. That would seem to satisfy an objective of the Harper government to see that export pipelines and ports are built to send Canadian oil sands output, along with other conventional and unconventional hydrocarbon production, to non-North American markets. Over time this move could mean that Canada, currently the U.S.'s largest oil supplier, might see its contribution shrink. It is already shrinking due to the robust increases in American crude oil and natural gas production coupled with weak demand. Today, many would say that is not a problem, but there is no assurance that the computer models showing the United States ultimately becoming self-sufficient in oil and gas will be right. If these models are wrong, or the production growth is not as robust as projected, this attack by Democratic politicians could ensure that the U.S. in the future will become hostage to oil and gas supplies from governments that have no love for us.
Paul Revere and his cohorts in their midnight ride thwarted the key objective the British government wanted to achieve in its march from Boston, which was the capture of military supplies stored in Concord. The secondary objective of the British of capturing John Hancock and Samuel Adams who were staying in Lexington was also thwarted. Without that midnight warning, the British might have changed the course of American and British history. Messrs. Markey and Schumer may have a similar impact, but the outcome of their warning may not be as favorable for the long-term future of America.
G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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