Is Canada About to Approve the CNOOC-Nexen Deal?

Investors in the Canadian oil and gas industry continue to closely watch the government as it deliberates the fate of Chinese oil and gas producer CNOOC’s (NYSE:CEO,HKEX:0883) $15.1 billion purchase of Nexen (TSX:NXY,NYSE:NXY).

State-owned CNOOC made its friendly takeover offer on July 23, 2012. The bid amounts to US$27.50 per Nexen share — a hefty 61 percent premium on the stock’s closing price just before the deal was announced. Nexen shares jumped to $26.35 after the deal was announced, just below CNOOC’s offer.

Reading between the lines of the new China-Canada investment agreement

The federal government must now decide whether the takeover represents a “net benefit” to the country under the Investment Canada Act. Prime Minister Stephen Harper’s cabinet is reportedly divided on the issue, with at least two ministers opposed and one or two leaning toward approval. A decision isn’t expected until mid-November at the earliest.

Harper recently said that the government is giving the deal particular scrutiny because of its massive size and the fact that CNOOC is state-owned.

In perhaps a hint of which way the government is leaning, on September 8, Harper and Chinese President Hu Jintao signed the Foreign Investment Promotion and Protection Agreement, which is aimed at protecting foreign investors from discriminatory practices. “We want to see this economic relationship continue to expand, but we want to see it expand in a way where it’s a clear two-way flow and clear benefits for both sides,” said Harper.

Harper has previously said that allowing Canadian firms to make similar acquisitions in China is one of the “important questions” the government is taking into account in the Nexen sale. It’s currently very difficult, if not impossible, for Canadian companies to buy important energy infrastructure in China.

Chinese investments in Canada are getting bigger and more focused

If it goes ahead, the Nexen purchase will be China’s biggest overseas acquisition yet. To put that in context, Chinese companies have spent a total of $23 billion buying Canadian resource firms since 2005.

The move also marks a departure from Chinese firms’ current strategy of targeting investments in specific assets or minority stakes in Canadian resource companies. CNOOC, for example, already holds a 35 percent interest in Nexen’s Long Lake oil sands project, which produces up to 72,000 barrels of bitumen a day.

The reason behind China’s interest in Canada’s resource sector is obvious: the country needs to secure a steady supply of commodities to fuel its rapid growth. This year, China’s economy is forecast to expand at a rate of 7.7 percent, according to Deutsche Bank. That’s down from last year’s 9.2 percent rate, but it’s still very high by global standards.

The Chinese, too, are watching the Harper government’s moves closely. “It’s a litmus test,” said Howard Balloch, a former Canadian ambassador to the country, in a Businessweek article. The decision “will be seen in China as an indication of how open the Canadian economy is for major energy investments.”

In light of the wave of Chinese money flowing into Canadian resource assets, some in the mining industry feel it’s time for the government to clearly lay down some ground rules.

“What the government should do is sit down and either pick the sectors that are going to stay Canadian or pick the actual companies,” said Ian Telfer, chairman of Goldcorp (TSX:G,NYSE:GG). “Let everyone know what those rules are and then allow foreigners to make bids for other ones.”

Access to government cash a mixed blessing?

Another concern that is frequently raised about Chinese mining investment is that many of these companies are owned by the state and have access to the government’s deep pockets. Many feel that gives them an unfair advantage over private firms when competing for assets. But that’s not the case, writes Daniel Schwanen, associate vice president of international and trade policy at the C.D. Howe institute:

“It’s also incorrect to assume that being a state-owned enterprise confers only advantages in the marketplace. A number of such enterprises operate at arm’s length from governments, or, as in the case of CNOOC, in a semi-competitive domestic and global environment. The latter must also often compete with hands tied by government-imposed operational burdens in their home country—such as maintaining employment in low-productivity occupations — that private-sector enterprises do not face.”

Moreover, writes Schwanen, rejecting the bid based on the fact that CNOOC is state-owned equates to trying to solve a problem that doesn’t currently exist in Canada:

“If Canadian or other private bidders were lining up to acquire Nexen, and CNOOC was shown to have an unfair ability to overbid by virtue of its state ownership, a case could be made for some countervailing measure to offset the state-owned enterprise’s presumed unfair advantage. Yet, there is no such Canadian bidder claiming to be injured by unfair competition.”

CNOOC has learned from the mistakes of previous foreign acquirers

CNOOC, for its part, is doing everything it can to win the Canadian government’s approval. For example, it has offered to keep Calgary as the head of Nexen’s operations in North and Central America, retain the company’s current management, list CNOOC on the TSX and keep Nexen’s charity program going.

That may be because the company has learned from BHP Billiton’s (NYSE:BHP,ASX:BHP,LSE:BLT) failed hostile takeover of PotashCorp (TSX:POT,NYSE:POT) in 2010. In that case, BHP was accused of not taking the government review seriously. It’s also good public relations, writes business reporter Tim Kiladze of The Globe and Mail newspaper:

“Such a well laid out plan could also have something to do with CNOOC being a Chinese firm. Nexen’s acquirer isn’t Australian or British, which some people may consider to be friendlier buyers. There is a stigma around Chinese buyers, and the company is trying to show that the firm will more or less stay a Canadian one.”

A pivotal moment for the Canadian energy sector

Harper’s decision obviously has far-reaching implications for the Canadian energy sector. If the government upholds the deal, it opens the door for Chinese companies to snap up more Canadian firms. That would be a plus for investors who, like Nexen shareholders, stand to benefit as further takeover offers drive up share prices.

As for Nexen itself, previous evidence suggests the company’s shares could still hold on to their recent gains, even if the government rejects the deal. High-profile takeover bids, whether they are successful or not, often attract investors’ attention to the underlying value in the target company.

PotashCorp provides an example. When BHP announced its hostile takeover on August 17, 2010, the stock shot up 26 percent in response, from $39.08 to $49.11. However, it fell back just 3.3 percent, to $47.14 from $48.74, after the government blocked the deal on November 3, 2010. POT currently trades at $41.37.

Securities Disclosure: I, Chad Fraser, hold no positions in any of the companies mentioned in this article.