CNOOC’s Nexen Bid Doesn’t Pass the ‘Net Benefit’ Smell Test

China National Offshore Oil Company bid 15.1 Billion dollars last week for Canada’s eight largest oil producer Nexen. The friendly bid offers a 60% premium on Nexen’s pre-offer stock price and was further sweetened with assurances of a new head office for the Chinese company’s North and Central American divisions in Toronto as well as an eventual listing of the company on the Toronto Stock Exchange.

Much of the talk surrounding the deal has had to do with the possibility that the deal may be blocked under the Canada Investment Act, which states that all foreign investment over 300 million must pass a ‘net benefit’ test before being approved. Such discretionary government powers have only been used twice to block deals in the past. MacDonal Dettwiler and Associates, a Canadian satellite-imaging firm, was the first firm to be saved from takeover based on national security concerns. BHP Billiton’s hostile takeover bid for Potash Corp of Saskatchewan was blocked by what can only be described as economic nationalism.

After an initial outcry from both Potash Corp’s management and the public in Saskatchewan BHP sweetened it’s then 39 Billion dollar offer by promising to continue any pre-existing community investments and reneging any potential tax breaks it would be eligible for following the takeover. That wasn’t enough to convince the political establishment in Regina.  For some reason the public outcry against the CNOOC bid is much more tame this time around.

Maybe the facts that Nexen is only the eight largest Canadian oil producer and that half its producing assets are foreign makes the pill easier to swallow for corporate nationalists. Also, assurances of heightened employment levels thanks to the new head office might endear CNOOC to Canada’s corporate and political elite. This time however Canadian corporate cheerleaders may actually have something tangible to worry about.

BHP Billiton is a commercially focused enterprise bent on squeezing out profit from all its assets. With BHP already building the world’s largest potash mine in Saskatchewan, any corporate or engineering synergies the company could have squeezed out of the takeover would simply have led to more labour productivity gains in the short run and more corporate profits to tax in the long run. The profit motive and BHP’s long track record in commercial ventures assured Canada both the those benefits. CNOOC’s bid for Nexen insures neither.

CNOOC has no efficiencies or productivity gains to offer, as it has never operated a steam assisted gravity drainage mine in the oil sands before. As a matter of fact we have no assurances that the company is a commercially minded institution as the Chinese have a longer track record of promoting its political interests than its commercial interests. A small example for the record is China’s financing of a new National Stadium in Costa Rica for no other reason but to make buddy buddy with the political class there. No one in Canada really understands what motivates the Politburo in Beijing, and since CNOOC is controlled by that same Politburo, why should Canada trust such sensitive and strategic assets such as the oil sands to them? As another example of the shadiness of China’s intentions, it is reported by Canadian security services that there may be as many as a thousand Chinese corporate spies passing on industrial secrets from Canada to China. China’s aggressive self-centeredness doesn’t stop there.

China has long had a policy of trying to secure energy assets to help feed its industrial base back home. In almost every commodity market China is one of the largest players, ever attempting to ratchet up the best deal so that its manufacturing base can wipe out the international competition. As far as we are concerned China may yet be willing to operate natural resource companies at a loss in order to bump up its local industries profitability. This has long been the case of the Chinese steel sector operating at a loss to bolster Chinese manufacturing competitiveness.

With such a history and the potential for direct trade in oil between China and the oil sands should Enbridge’s Northern Gateway get approval, it isn’t far fetched to imagine Chinese energy traders attempting to manipulate prices so as to reduce profits from their Canadian divisions, thus contributing less taxes to Canada and more profits to China. While this scenario is speculative many industry insiders wouldn’t be surprised to hear it.

There also remains the issue of environmental record. Chinese companies aren’t especially well known for green track records. Canada’s environment is prized by its citizens, and it is doubtful that Canadians would really trust a government backed company from the worst polluting country in the world.

Whether it be for national security reasons, environmental concerns, Canada’s commercial and economic interests, it would seem that everything points towards the necessity of prohibiting foreign government backed companies from buying up our strategic national assets. Canada did a great disservice to itself when it refused BHP Billiton’s bid for Potash Corp. We let our petty corporate nationalism get in the way of a deal that would have attracted financial and human capital to our country. We smudged our image as a trading nation open for business. Today for the sake of protecting that image we have spoiled, we are readying ourselves to accept a bid that is short on benefits and long on potential risks.

Canada already looks like the scared kid unwilling to dip more than a toe in the swimming pool of big business, and we may look it more so after blocking CNOOC. If the reasons for such a use of the ‘net benefits’ test are properly articulated and China is called out for its only half hearted adoption of capitalism, everyone outside of Beijing will understand and accept such a decision.

Of Planes, Ships and Misleading

F-35 Joint Strike Fighter

Canada’s order with the Joint Strike Fighter program for 65 Lockheed Martin F-35 Lightning II fifth generation fighter jet will be the country’s second largest procurement of goods ever. The decision to explore replacement of Canada’s aging fleet of 79 CF-18 Hornets (of the original 138 purchased) was taken in 1997. Agreement to fund development of  a plane to serve NATO fleets was taken in 2001. In 2007 the participating countries agreed on Lockheed Martin’s design. While Canada has participated on the financial funding of the F-35 development and has signed memoranda of understanding on the purchase of the planes, the government hasn’t actually penned any deals as of yet. The official governmental decision to purchase the planes was taken in 2010. The Auditor General praisedthe Department of National Defence and Industry Canada for their cooperation on obtaining partial commitments for economic spinoffs (local procurement and parts supply). The praise was tantamount to a proud clap on the back for not having brought back Mulroney-esque graft to Canadian national procurement (hrum…hrum Airbus…Shreiber…hrumph). The AG’s report than proceeded to admonish those very same departments for having done a lax job of informing their overseers about the potential costs of the planes. The subplot: bureaucrats at DND and Industry Canada got a little over excited about the F-35s and jump the gun on the costing and decision of the purchase.

Michael Ferguson Auditor General of Canada

With this update readers might be made to believe that the furor and outrage afoot in Ottawa has to do with bureaucrats lying to duly elected officials and ministers. So how his it that Peter Mackay, minister of defence is public enemy number one? According to Ferguson at some point before the campaign the minister was made aware that the numbers he had previously been given were probably low-ball estimates. The minister chose to stick to the script and reiterate the one number he was sure of and for which written documentation was available. “A purchase tag price of 9 Billion dollars”. Now that number is not being disputed (the number was re-confirmed at a congressional hearing this past week in D.C.), what is being disputed however, is whether it was misleading. The purchase price does not include operating, maintenance cost, nor the estimated 15 or so planes that may be purchased for purposes of replacement. The full purchase and maintenance costs as estimated by DND in 2010,  up to 14-16 Billion, depending on the value of the Canadian currency. The life cycle costs estimated by the Parliamentary Budget Officer Kevin Page including purchase, maintenance and operating ran the 14-16 Billion tab up to approximately 25 Billion.

Kevin Page Parliamentary Budget Officer

Now these numbers are all more or less irrelevant. A plethora of external factors out of the governments control or the PBO’s capacity to predict will raise or even drop the final costing of the entire program. The facts are that there are two kinds of variables here (as always in economics) exogenous and endogenous, that is in and out of the hands of the government respectively. What should be obvious to any assiduous political commentator is that the Conservatives are getting pounded politically and in the media for their reporting or non-reporting of the factors which are out of their hands and for which no estimates can be reasonably assumed to be correct. But what of those factors who’s outcome can be – if not guaranteed – at least affected?

Leaving aside the actual question of the necessity of the jets’ purchase (this is a blog on economics not international relations/war), there remains some important questions concerning the JSF program. Often military contracts provide the political and nationalist cover military industrial lobbyists use to wash politicians memories of the basic laws of economics. For example, the AG report celebrates DND and Industry Canada’s efforts to wrestle F-35 parts supply contracts towards Canada. South of the 49th Congressmen exert pressure on Pentagon and industry officials to manufacture jets, tanks and ships in this or that Congressional district. Much ink is spilled over the astronomical costs of the F-35 in Canada but what of the largest procurement contract in Canadian history? Little or no attention is given to the 33 Billion dollars or so being spent on ship building in Nova Scotia and British Colombia. As almost all know, the geographies to which the contracts are allocated are for the most part chosen politically.

Peter Mackay Minister of Defence

A case can always be made for the necessity to protect national security and guarantee the reliability of military hardware. Everyone would recognize the stupidity of building NATO’s next fighter jets or tanks in China or Russia. However, when Canada awarded the shipbuilding contracts, one key requirement in the bidding was for Canadian content and jobs to be maximized. When South Korea, a NATO dependent ally, has some of the most cost efficient shipyards in the World why does the government not try to maximize the military bang for the taxpayers buck? How can the government accept to participate in the developing of the F-35 when it is de-facto an American controlled program. Why is it that the purchasing of military hardware must be operated through the Pentagon and not directly with the manufacturer? America’s NATO allies should demand an end to the discriminatory practices of the American industrial-military-complex. When it comes to that sticky number that is the cost of maintenance of the F-35’s, why is the government promising to do all the work in Canada. If the Canadian dollar is high the government should be sending the planes to the cheapest maintenance operations throughout NATO and inversely the debt plagued nations of NATO should send their repair work to the lowest bidder.

If the point of purchasing military equipment is to protect a nations sovereignty and citizens , why is it that countries are willing to trade more military capability for a few more jobs? Or in the case of the US get a lot more jobs but disproportionally more deficit and debt. If Italy is good at manufacturing and Australia is good at producing commodities both countries are poorer for trying to muscle in on the others specialty. At the end of the day military procurement is a game of intra-alliance attrition which makes us all that much poorer and less safe. Enough with the petty demagoguery of military jobs. If we really need strong armed forces to protect us let’s make sure servicemen are equipped with the best hardware and make sure our economies are competitive and strong enough to support those armed forces.

Sunshine Oilsands Chinese IPO Plans

Hong Kong Chinese trade gateway

Sunshine Oilsands Ltd. a canadian based oil sands venture with chinese backing is preparing an IPO launch in Hong-Kong. The Financial Times reports that the Calgary based early development stage company is readying its IPO with backing from chinese institutional investor backing.

The float is estimated to reach as much as $600 Million representing 25% stake in the company. Last March Sunshine raised $230-million from investors including China Life Insurance and Bank of China Group Investment.

Traditionally primary ressource Canadian based companies float their stocks on the Toronto Stock Exchange TSX and Toronto Venture Exchange where a deep pool of ressource analysts and investors exists. Most of the Worlds Material stocks are concentrated in the TSX, London Stock Exchange and Australian Stock Exchange. The Hong-Kong stock exchange is not recognized as a particularly ressource oriented stock market. The reasons for a chinese based issuance have not been divulged by the company. The Financial Times in its article suggests the decision was influenced by Chinese government backed companies.

For those having read my previous posts know I take issue with Canada’s regulatory stance onforeign takeovers and investments. I had previously raised the issue of foreign entities not seeking profit should not be permitted to acquire companies in Canada. I would like to expand that statement to include purchases or investments at large in undeveloped ressources. The logical business decision here would have been to issue stock where it can be most precisely valued by experienced professionals to obtain the best price. Here in what can only be described as a nationalistic move to develop its internal financial markets, China has pressured its semi-private subsidiaries into picking Hong-Kong over Toronto.

Is the company going to be free from future interference? Will the destination and price of the oil produced by Sunshine going to be determined by profit seeking incentives and the Market place or by chinese polit-bureaucrats?

zài jiàn

Potash vs. Oil Sands, a policy dichotomy

With news of PetroChina International Investment Co. readying itself to be the sole owner of the undeveloped Mackay River in-situ project ~40 km Ouest of Fort McMurray, the question of Canada’s foreign takeover review scheme merits further attention than it’s been getting of late. The deal triggered by Athabasca Oil Sands Corp. owner of the remaining 40% stake not owned by PetoChina will lead to the latter buying the stake for an estimated $680 M Canadian dollars.

Now for those not aware, the Mackay river flows into the Athabasca river which itself flows into Athabasca Lake which outflows through Slave river and through a few national parks until the water system reaches its final destination in the North Arctic Sea. All that to say that the in-situ development finds itself in quite the environmentally sensitive region. Now, a foreign state owned company will be an environmental guarantor of the region. Why am I kicking up a fuss about this exemple of foreign Oil Sands ownership and not say, Statoil’s not far off operations. Is it maybe because Norwegians are something of green nuts while China is competing with Russia for most pollutated country in the World, maybe. Is it because Statoil is known for trying to maximize the return on Norwegian taxpayer dollar while PetroChina and other chinese primary ressource companies are known for attempting to distort markets for the gain of the motherland, probably.

The reason I raise this issue is because I personally disagreed with the Canadian federal government’s decision to oppose the BHP Billiton bid for Potash Corp of Saskatchewan, while I opposed the federal governments regulatory decision to allow PetroChina’s majority ownership and operating of Canadian natural ressource exploitations. So who between the Conservative government of Canada and myself is wrong while both hold seemingly inconsistent and paradoxical opinions? I’ll let you answer that once I’ve finished exposing my case.

Let’s start by raising a point that would seem to show inconsistency on behalf of the Government. The regulatory approval of PetroChina’s deal with Athabasca raised the feds no problem because it could only increase competition for the supply of Canadian Oil and increase the competition for demand in Canadian labour, win-win right? The decision to oppose the purchasing of Potash Corp. was one of opposing increased supply of Canadian potash (one of the worlds most popular agricultural fertilizers). Sudden policy shift or backtrack? Not really, here is a situation of two weights, two measures. Both ressources are considered ‘Strategic Ressources’ in Canada. However one is treated as a free market good while the other one is considered as legitimate producer collusion product, a.k.a. a cartel worthy product. In light of the Governments recent abolition of the Canadian Wheat Board monopoly, their previous decision to protect the Saskatchewan potash cartel seems strange. Or maybe it doesn’t after all Alberta (where most of the Oil Sands are) is traditionally pro-market whereas Saskatchewan is traditionally left-leaning. Does lobbying by Provincial governments really explain a difference in policies. The real difference lies behind the fact that Oil production is extremely geographically atomized, thus it’s trade is quite competitive, potash on the other hand can only be found in a few regions of the World. One of the regions richest in potash is western Canada. Essentially the difference is that Canadians can get away with cartel-esque behaviour in potash but not in oil.

This demonstrates that if the conservatives in Canada are not consistent in their policies it is not for lack of reflection of pragmatic economic solutions, simply inconsistent and un-ideological ones. So we actually have two very different decisions made for pragmatic reasons. That just means I will have to raise two different objections!

Regarding the BHP Billiton takeover of Potash Corp. blocking. The main reason for blocking the takeover was because of the aforementioned cartel in potash. In Saskatchewan the export of potash outside of NAFTA is undertaken by a corporation called Canpotex (short for Canadian Potash Exporters), which effectively operates as a cartel controlling over 30% of the worlds potash production. BHP would have broken up the cartel in order to produce at capacity and sell freely. The Provincial governments belief was that it would have lost royalty revenue from the drop in per unit profit. Whether the government would have actually registered a drop in revenues following the decision is aside from the point. It represents a stark intervention into markets which should be unacceptable in a modern democracy. A short list of consequences include, higher fertilizer prices for such poor farmers as those found in India or Africa, damaged Aussie-Canadian relations, reduced attractiveness of Canada as an investment destination and countless other immeasurable and unimaginable damages to Canada and the World.

Unfortunately one bad decision tends to follow another in politics, let’s now turn our attention to the regulatory decision that paved the way for a foreign power’s state owned corporation buying up ressources in Canada. As a fervent classical-liberal and staunch internationalist, I am all in favour for increasing developing nations and less than democratic nations participation in Global trade. I think there is no better way to improve their economic and socio-political prospects, than permitting them to join the WTO and partake in international trade. Although these beliefs push me to reflexively accept international takeovers, I believe there are a few caveats needed to smooth things out. First problem is the lack of reciprocity. Chinese companies benefit from industrialized nations legal systems when investing in the West. Western multinationals do not benefit from such property protection when doing business in China. Let’s help China, let’s show them some tough love by telling them they can buy our ressources when our companies will get some respect in China. An important issue is that state owned corporations do not necessarily seek to maximize profits as much as maximize socio-economic and political priorities of their governments, whereas public companies always seek to maximize profit for their shareholders. From the economic literature I believe it is most evident to all that maximizing profit in a competitive environment is the key to increasing global welfare.

It is hence my view that the Government’s Foreign Takeover Review process should be aimed at differentiating between those companies who will seek to maximize profit through increased productivity, the real key to increased wealth, and those companies who may have alternate motives such as shifting wealth from one geography to another (like state owned corporations). Blocking foreign State’s proxies from buying our ressources and encouraging public companies to invest is good policy. Let’s hope that when the Canadian federal government finishes its review of the takeover process that will be the ensuing conclusion.