CNOOC’s bid for Nexen a sign of China’s future

CNOOC’s bid for Nexen is just the beginning of a Chinese invasion. The oil patch will never be the same–and that’s a good thing.

 
(Photo: Wu/AFP/ImageForum)

If you applied Murphy’s Law to the oilsands, the result would look a lot like Long Lake. The oilsands project was predicated on a novel Israeli-developed gasification process intended to reduce the project’s natural gas consumption. Now that natural gas has become dirt cheap, the benefits of this technically challenging approach hardly seem worth the effort. Long Lake’s startup in 2008 was delayed nearly six months, and it has lagged well behind schedule ever since. The anticipated flood of 72,000 barrels per day turned out to be more of a trickle. (During this year’s first quarter, it reached 34,500 barrels per day.) The cost overruns were horrendous even by Fort McMurray standards. Long Lake is, in short, the Florida swampland of Alberta’s oilsands region. All of which prompts the question: Who’d want to buy it?

On July 23, the China National Offshore Oil Corp. (CNOOC) revealed its offer to purchase all shares of Long Lake’s majority owner, Nexen. It’s prepared to pay dearly: at 61% above the share price, the premium is roughly double the average in Canadian acquisitions. That’s likely sufficient to dissuade others from bidding. (CNOOC is nothing if not determined: it already owns Nexen’s former partner at Long Lake, Opti Canada, having bought that insolvent company last year for $2.1 billion.) Fortunately for CNOOC, Long Lake is actually something of a sideshow: most of Nexen’s assets lie outside Canada—in the U.K., Yemen and the U.S.

China’s appetite for energy and raw materials is voracious. But this overture bears greater significance—as a trial run for possible future investment. If consummated, this would be China’s largest-ever overseas takeover by a considerable margin. It’s also outside China’s traditional hunting grounds in the developing world. The implications for Canada are equally momentous. This might be regarded as a second chance to build a meaningful economic relationship with what has become, by many measures, the world’s second-largest economy.

A few years ago, the federal government reversed what had been an antagonistic stance toward Beijing. This thawing process gained greater urgency following the U.S. government’s decision last year to delay approval of TransCanada Corp’s proposed Keystone XL pipeline, a conduit for oilsands product. Ottawa now worries Canada’s traditional partner is losing enthusiasm for buying and investing in our filthy crude. Canada’s energy sector has also suffered lately from a combination of oversupply and stagnant U.S. demand, resulting in discounted prices. Greg Priddy, an analyst with political-risk consultancy Eurasia Group, noted in a recent commentary that “the Alberta and federal governments, along with the oil and gas sector, broadly support the effort to diversify Canadian energy exports to high growth markets in Asia.”

Seven secrets to a happier relationship with China

One of the most devastating rebukes to any business person is to say she doesn’t “get” China. Here are a few pragmatic principles, expressed as translations of popular Chinese proverbs, that should guide us in building closer relations:

When the wind of change blows, some build walls while others build windmills.
If anyone understands the futility of wall-building, it’s the Chinese. Several thousand years of erecting barriers did little to prevent “barbarians” from Mongolia and elsewhere from invading. Rather than erecting barriers to Chinese investment, we should seek creative ways of capturing its energy.

Thatch your roof before rainy weather; dig your well before you become parched with thirst.
And forge investing partnerships before you desperately need them. Regardless of whether or not we can mend fences with the Americans over energy, our dependence on them for capital has always rested on dubious logic.

He who rides a tiger is afraid to dismount.
Much has changed since the 1960s, when the “Seven Sisters” controlled most of the world’s oil. Today’s “Big Five” possess less than 5% of global reserves—national oil companies control most of the rest. “If you want to play in this business, you cannot avoid working with them in a significant way,” says Yuen Pau Woo, president of the Asia Pacific Foundation of Canada. “It’s not as if you can say no to state-owned enterprises and expect the private sector to fill the gap.”

To know the road ahead, ask those coming back.
We can learn much about the traits of Chinese investment by looking to Australia. Glen Hodgson, chief economist at the Conference Board of Canada, says that adjusting for the size of its economy, Australia attracts six times as much investment from China as Canada—one reason its economy grew during the recession. “There are advantages to being tied to the other, emerging superpower,” he says.

I hear and I forget; I see and I remember; I do and I understand.
We’ll get better at managing our relations with Chinese businesses as we deal more with them— and vice versa. Having the North American headquarters of a major Chinese oil company might just be a good start.

Dripping water pierces a stone; a saw made of rope cuts through wood.
We should persist in efforts to encourage China to liberalize its own foreign investment rules. In doing so, we should target specific areas where Canadian companies excel.

Don’t get in the way—let them overpay.
Actually that’s not a Chinese proverb. But they’ll grasp its meaning soon enough.

Although the federal government insists CNOOC’s offer will receive due scrutiny, most observers expect it will be approved. Nexen itself already backs the deal, and the company isn’t regarded as Canada’s top oilsands operator—quite the opposite, really. “We’ve had to work hard to build the relationship over the last two or three years,” says Glen Hodgson, chief economist at the Conference Board of Canada. Kiboshing this deal, he says, “clearly would not advance that.” Conversely, “if this deal goes well,” observes Yuen Pau Woo, president of the Asia Pacific Foundation of Canada, “it will feed into the comfort level that Chinese have with investment in Canada, and likely will inspire other bids.”

If so, the more important issue is what kind of relationship Canada wants with China going forward. The endless debate over the “hollowing out” of Canada’s business sector is but one symptom of anxieties surrounding our investment relationship with the Americans. But at least the U.S. is proximate to Canada politically, geographically and culturally. The same cannot be said for China. We’d be dealing with state-owned enterprises, beholden to a Communist government and bearing a distressing penchant for stealing intellectual property. The government’s human-rights practices also offend western sensibilities. Expanding our investment relationship with China invites a host of daunting, unfamiliar challenges. We should pursue it nonetheless.

Things didn’t pan out well the last time a Chinese company bid for a sizable western oil company. In late 2004, CNOOC made overtures to Unocal, which produced primarily in Asia but also the U.S. The Financial Times leaked word of the negotiations early the following year, well before CNOOC even issued a formal offer. American oil giant Chevron pounced, pointing out CNOOC’s Communist backing and China’s controversial human-rights record. Chevron swanned off with the prize.

The Unocal debacle is sometimes attributed to American xenophobia, but CNOOC’s own missteps inflicted worse damage. Repeated press leaks about its negotiations suggested it was less than discreet. Then CNOOC failed to provide serious offers in time to meet deadlines set by Unocal’s board. And it was caught entirely flat-footed by Chevron’s deft stoking of anti-Chinese sentiment. These errors effectively handed the opportunity to Chevron. This happened not because CNOOC’s executives were stupid, but rather because they were naive.

Such rebuffs made Chinese companies more cautious when approaching targets in developed countries. For years, they stuck to purchasing minority interests or “greenfield” investments. Then they graduated to small companies like Opti. The Nexen bid suggests confidence has returned. “The CNOOC-Nexen deal is a quantum leap that if approved, in a single swoop, will be as much as all the Chinese investment in Canada in the past two years,” observes Woo.

The Nexen bid reveals how much CNOOC executives have learned. CNOOC secured full support from Nexen’s board before taking everyone by surprise. It promised to keep current management and employees in their jobs, while pumping new money into Nexen’s capital spending programs. CNOOC vowed to locate its head office for the Americas in Calgary, list shares on the TSX and invest in tarsands research. It is, in short, a proposal the Harper government will find difficult to reject. Indeed, the greater threat may come from U.S. policy-makers, some of whom have already declared their opposition to Chinese involvement in deepwater drilling in the Gulf of Mexico.

This growing deal-making savvy is generally true of Chinese enterprises, and it’s just one reason one might expect them to be more active abroad in the years ahead. Until recently, China’s outbound foreign direct investment (FDI) was trivial. The country’s first quarter-century of liberalization was preoccupied with attracting investment; its corporations had little motive (and less capacity) to invest abroad. Although outgoing FDI has grown astronomically since the mid-2000s, that’s another way of saying it grew from nothing. Nevertheless, expectations run high China will in short order become one of the largest investors globally. “This is only the beginning of a very large wave of outward investment,” says Woo.

Partly, it’s because China has money to burn. Like Japan in the 1980s, China’s export-driven economic success and high savings rate needs a relief valve if it is to avoid rapid appreciation of its currency, the renminbi, the exchange rate of which is carefully managed. Until recently, the main valve had been buying foreign government debt, particularly U.S. Treasuries. China now has accumulated so much of that single asset class that its appetite appears to be waning—its holdings of U.S. Treasuries are actually expected to decline this year. Not only can China secure more natural resources through foreign acquisitions, but it can also diversify its investment risks and access new markets. “If China follows the typical pattern, the world will see hundreds of billions of dollars in Chinese overseas investment in the decade ahead, balanced between mature markets and natural resource hosts,” opined a recent report from the Rhodium Group, a private think-tank based in New York. Canada happens to be both.

Yet cozying up to China carries particular challenges. The most obvious is that as an explicitly Communist country, it attracts opposition on ideological grounds. This could prove particularly daunting for the prime minister, many of whose supporters have long tented in this camp. A second (related) problem is the primacy of state-owned enterprises. They’re the primary conduits through which China invests abroad. (Its sovereign wealth fund, the China Investment Corp., constitutes another.) They’re heavily subsidized with state financing, below-cost land, energy and other inputs, and shielded by favourable regulations. And their activities are dictated in part by the Chinese Communist Party. How CNOOC’s North American division performs as a publicly listed company could prove a spectacle indeed.

By allowing any company to invest, Canada is effectively partnering to harvest its resources. “The overwhelming evidence from around the world is that privatized companies operate better than state-owned enterprises,” says Jack Mintz, chair of the University of Calgary’s School of Public Policy. This implies Alberta may earn less taxes and royalties from Long Lake under CNOOC’s stewardship. “This raises big issues for provinces like Alberta, Saskatchewan and B.C. about who ends up exploiting the resource and whether you’re going to get the kind of development that would lead to maximum rents earned,” Mintz says. For him, this should be enough to give us pause.

A third problem is that Chinese companies tend to regard intellectual property differently than western counterparts. There are few ideas they will not copy or steal, given the opportunity. Sell any Canadian company to China, and there’s a good chance its secrets will be widely disseminated. This is a bigger problem for countries like the U.S., where innovation contributes more to the economy—but a real one nonetheless.

But here’s the real rub—Nexen couldn’t go to China. We may allow China in to snap up our oil companies, but China won’t reciprocate. Derek Scissors, a researcher on Asian economic issues at the Heritage Foundation, testified a few weeks ago before the U.S. House of Representatives Committee on Foreign Relations. “The state must own all participating firms in oil and gas, petrochemicals, electric power, and telecommunications,” he said. “In aviation, coal and shipping, the state must control the sector as a whole. In autos, construction, machinery, metals, information technology, and environmental technology, the state is to expand until it controls the sector.” This naturally raises questions about why we shouldn’t tell CNOOC to fly a kite.

The answer is that we need all the capital we can get. Throughout its history, Canada has always imported capital to harvest its resources. Other than the Americans, it’s not as if we have a surplus of friends willing to provide it. And our traditional sources seem at considerable risk of drying up. According to the UN Conference on Trade and Development, global foreign direct investment flows recovered last year to US$1.5 trillion, higher than before the financial crisis. But it expects further growth will be slow. “Foreign investment from a lot of other jurisdictions is going to be really constrained over the next three to five years,” concurs Hodgson. “Because everybody in Europe is hunkering down. American companies are focusing on rebuilding their business strength in the U.S. and then trying to sell to the rest of the world. China has most of the cards right now.”

How might we best play ours? Ottawa should resist calls to reject the Nexen bid as pre-emptive punishment for China’s protectionist behaviour. It should be exploited as an invitation to China to forge a deeper relationship. We stand to learn a great deal from the exercise—and those insights could be crucial, since Canada’s handful of multinationals likely can’t avoid competing with Chinese businesses in the decades ahead. We should continue pressing China selectively for improved access to targeted areas of the Chinese marketplace where Canadian companies are poised to excel. We’ve already made modest progress: in February, Canada and China signed a Foreign Investment Promotion and Protection Agreement, which the federal government claims will make doing business in China safer and more predictable for Canadians.

Proper application of Canadian laws (governing environmental protection, labour, competition and much else besides) should go a long way in assuaging our fears. “All of the terrible things that one could imagine a state-owned enterprise doing after it acquired a Canadian firm can be addressed through regulations that apply to all companies,” suggests Woo. And whatever the shortcomings of our foreign-takeover review process, its vagueness grants considerable flexibility. Industry Canada can still—and should— reject future bids that compromise national security or our interests generally. We can even use it to punish China (later) if it stubbornly insists on a one-way relationship. And Canada should certainly rebuff a Chinese bid for any company whose intellectual property we would not want disseminated widely.

Despite the anxieties and problems our investment relationship with the U.S. created, few would claim it has not proven mutually beneficial. Properly managed, a deeper relationship with China should be fruitful as well.

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