The Truth Behind CNOOC
Email this article
Print this article
The press' reaction to the offer of CNOOC Ltd. for Unocal was predictable. The Wall Street Journal headline trumpets: "Meet China Inc.: Topping Japan Inc. Of the 1980s, Corporate China Shows Muscle." Really? The New York Times opines "China's Strength, U.S. Weakness." These headlines provoke images of a robust young economy in competition with an ancient spent force. The opposite is true.
But the offer by CNOOC Ltd. is not an example of the triumph of Chinese capitalism. Far from it. China does not have a market economy. The allocation of capital, interest rates, commodity prices, technology and the structure of the legal system are subject to the requirements of state owned companies. Chinese private companies and foreign owned companies run a distant second. The Communist government of the People's Republic of China has made it clear that it has no desire to give up the economic control it gains from this system. The problem is that the system, like command economies everywhere, doesn't work.
It is important to understand just what CNOOC Ltd. is. It is a Hong Kong incorporated company, whose shares are listed on the Hong Kong stock exchange. Some of its shares are also traded as ADRs (American Depository Receipts) on the New York Stock Exchange. It was created in February of 2001 by its parent, Chinese National Offshore Oil Corporation (CNOOC).
CNOOC was itself created in 1982 by the Chinese government. It has the exclusive right to enter into production sharing contracts with international oil and gas companies for petroleum exploration and production offshore China. Although CNOOC transferred its rights and obligations under these contracts to CNOOC Ltd., CNOOC Ltd. cannot enter into any contract with a foreign enterprise without their parent, CNOOC's, consent.
According to its web site, CNOOC is a state owned company. The problem is that we do not know exactly what the state is. State owned companies can mean many things in China. A state owned company can be owned by a city, a province, a ministry or the central government. This is enormously important, because the precise government organization, who owns the company, gets the power over the company, the patronage and all the benefits. With a large powerful company like CNOOC, this could be enormous. It is not unusual for the government to set up competing companies to redistribute a share of the spoils or the power.
CNOOC has whatever assets the state decides to give it or take from it. Contracts are not protected under the constitution and the courts are not an independent coequal branch of government. If tomorrow, the central committee decided to revoke all of CNOOC's contracts and rights, it could do so.
In theory CNOOC is governed by Chinese corporate law. This law is rather an interesting document, because it gives a lot of protection to shareholders. It is designed that way because of an attempt at reform in the early 1990s. The idea was to divorce government from management. So although the state owned company was still 100% owned by the state, it was supposed to have an independent management. The Chinese were faced with the same problem that owners face everywhere. Managers tend to cheat. Like Bernie Ebbers, they tend to represent their own interests, rather than the interests of their shareholders. In China, the shareholder was and is the state. So the state, to protect its interests, drafted a corporate law that was very shareholder friendly. What the state creates, the state can take away when it suits.
CNOOC has shareholders, directors, by laws, a board, by laws etc. but there is no reporting requirement, so we do not know exactly, who or what they are. They also can be changed at any time.
The state did give CNOOC its assets and CNOOC gave some of those assets to CNOOC Ltd. This was a solution to a problem for state owned companies. Most lose money, so they are always desperate for more capital. In order to get it, they hit on the idea of raising it on international equity markets. Their favorite way to do this is to create a subsidiary, usually incorporated in Hong Kong and subject to Hong Kong law. The subsidiary then does an IPO and sells a minority stake to shareholders from many countries. Sometimes these shares are traded in the US as ADRs, which makes the subsidiary subject to US jurisdiction.
Any protection that shareholders of CNOOC Ltd. may derive from Hong Kong or US jurisdiction is an illusion. CNOOC Ltd. has almost no US assets and CNOOC has none at all. Hong Kong may have a separate legal system, but it is still part of China. In order to enforce an award for securities fraud or breach of contract against CNOOC Ltd. or CNOOC the action would have to brought in China with no chance of success.
Also CNOOC Ltd. is a subsidiary of CNOOC, who owns 70% of CNOOC Ltd. If the merger goes through as proposed, CNOOC Ltd. will own 100% of Unocal. So Unocal would be wholly owned subsidiaries of CNOOC Ltd. Parents merge their subsidiaries into the parents all the time. The only protection minority shareholders have is the law of the local jurisdiction. China's record of protecting any property rights including the rights of minority shareholders has been dreadful.
This contrasts sharply with Unocal, which is an American corporation, incorporated in the US with US assets. Its books are subject to SEC scrutiny. Its assets can be seized. Its American employees arrested. If Unocal was purchased by CNOOC Ltd. much of that could change overnight, because CNOOC Ltd. could do anything it wished with Unocal. It could merge Unocal into CNOOC Ltd., so Unocal would no longer exist or it could reincorporate it in Hong Kong or even China. In either case, Unocal would no longer be subject to US jurisdiction. Any US assets, of course, still would be.
The Chinese, like almost ever other country on the planet, are concerned about their access to energy and other resources. Like the US, it needs to import oil to meet its energy needs. The difference is that China's leaders tend to view the world through a mercantilist perspective. Although rather common in Asia, the Chinese have used it to promote the strength of the party to the detriment of the rest of China's people.
Like other Asian nations they have suppressed domestic demand and manipulated their currency to encourage export growth. What is different is that they have deliberately favored small foreign owned enterprises over domestic private companies to achieve export growth. The advantage is that small foreign owned enterprises are expendable and will not be interested in local political power. The policy may have increased the power of the party, but it starved the most dynamic sector of the economy of funds and kept millions of farmers mired in poverty.
China's mercantilist strategy to gain oil might fail as well. From a strategic stand point, Unocal's reserves will not protect China's energy needs for two reasons. First, although Unocal's reserves are in Asia, to deliver them, they must be shipped by water across sea lanes patrolled by the US Navy. Second, these reserves are in someone else's country.
Most of Unocal's Asian reserves are in Indonesia. In addition, they have projects in Thailand, Bangladesh, Myanmar, Vietnam and Azerbaijan. The Indonesian gas project has long term contracts with Japan, South Korea, and Thailand that last for another five years. Many companies and countries have found to their dismay that long term contracts are not respected in China. So Unocal's customers may find themselves with a problem unless CNOOC decides to let Unocal remain an entity and keep it subject to US jurisdiction. If it does then the customers can find protection in the US courts. Unfortunately, they may not find any US assets to enforce their claims.
The Indonesians have expressed optimism that the Chinese will help in their exploration efforts. Other countries are not so sure. In Thailand, Unocal has contracted to supply the Thai state controlled national power company PTT. PTT is part of a government plan to rehabilitate the Thai Petrochemical Industry or TPI, which has been bankrupt since the Asian crises in 1997. TPI is the owner of Asia's largest petrochemical complex. TPI was subject to a recent bid by the Chinese conglomerate CITIC. CITIC backed off after a protest by the Thai government.
The Vietnamese are understandably wary about giving access to a valuable resource to a historical rival. Exports from Bangladesh were stopped after local objections. China is not the only country in Asia whose need for energy is growing. With the possible exception of Iraq, countries do not have to export their oil and gas.
Even though Unocal's reserves are not exactly available, China is still willing to buy them at the top of the market. This type of behavior is not an indication of strength. It is more a sign of strategic weakness and desperation. China has spent tens of billions of dollars to acquire oil and gas in Sudan, Kazakhstan, Venezuela and Peru. They have also attempted to purchase supplies or interests Yemen, Oman, Iran and Australia.
They are especially interested in supplies that can travel overland through expensive pipelines directly to China or oil that does not pass through American or European companies. China's President Hu Jintao has gone on diplomatic oil missions to Latin America, Africa and South East Asia. He will soon be on his third trip to Russia in an attempt to out flank Japan, so far unsuccessfully, for a large piece of Siberian oil.
One of the reasons for such desperation is that China guzzles energy at a rate that makes Hummer owners look positively green. Since China's state owned industries have no need to make a profit, they see no need to conserve expensive energy. China subsidizes petroleum prices to insure that its new car owners waste as much as possible on its new American inspired super highways. China consumes twice as much energy as India per dollar output, and between three and five times the energy per dollar output than the world average. They consume a staggering fifteen times more than the Japanese, who have been investing in energy efficient technology since the first oil shock in the 70's. If China could increase her energy efficiency just to the level of India, it could halve its demand.
The Chinese have belatedly woken up to the benefits of energy conservation. Unfortunately their command methods are about as wasteful as their energy use. This would be obvious to anyone who has used a public toilet in China. Instead of flushing when used, a constant stream of water wastes and pollutes thousands of gallons a day in a country that is desperately short. Shanghai has just announced that it is building a 100,000 kw offshore wind-power station, which will cost twice as much as an onshore station.
Decrees from the center also may not work as well as they once did when Mao ruled by terror. This summer Premier Wen Jiabao has dictated that air conditioners in government offices must be set no lower 78 degrees. The Premier's efforts may not have much success. Ten year old energy conservation guidelines have only a 10% compliance rate. Even market driven reforms like a proposed increase in the fuel tax run into political conflicts. Fuel taxes would replace road taxes collected by local governments, who are unhappy about ceding an important source of revenue to chronically deficit ridden Beijing.
The financial press, commentators and some politicians have been especially active in painting the recent spate of proposed purchases of US companies by Chinese companies as the triumph of 'Chinese capitalism'. The power of Chinese companies is either praised or feared, but never questioned. It should be.
Japan, South Korea, Taiwan and India have all used different methods of development. What is consistent among all three countries is that strong local private firms have been able to develop world class brands, international distribution, and new technologies without buying them from Western firms. When they are successful enough to purchase western firms, it is usually because they are augmenting their strengths, increasing their market share, or in the case of the Japanese during the '80s, to show off.
Toyota, Hyundai, Samsung, Wipro and Honda spent years perfecting their quality and building their brands. The result is a brand loyalty that translates into wider margins and more profits, not suicidal price wars.
In contrast, Chinese state owned 'national champions' buy from necessity. Lenovo bought the IBM brand because it could not develop one on its own. Worse, it is being beaten on its home turf by Dell and HP. At the end of last summer I could buy a Haier air conditioner for $99. This year the price has fallen to $74. Even with these heavily discounted prices, Haier still needs the Maytag and Hoover brands to penetrate the US market.
Chinese firms' failure to develop brands is in part a product of their failure to develop technologies. In a Foreign Affairs article published last year, George Gilboy, a senior manager based in Beijing, argued that the problem was the Communist Party. "With a few exceptions, Chinese firms focus on developing privileged relations with officials in the Chinese Communist Party (CCP) hierarchy, spurn horizontal association and broad networking with each other, and forgo investment in long-term technology development and diffusion."
Without a legal system, the only way that Chinese firms can protect themselves and their management is through connections with the people who make the decisions. The saying, who you know is far more important than what you know, has special meaning in China. Professor Huang in his book, Selling China, cites the example of Shanghai Automotive Industrial Corporation (SAIC) China's largest automobile manufacturer. SAIC used to buy its mufflers from Guizhou Honghu, because of their technological quality.
Rather than collaborate with Guizhou Honghu to develop a world class product, SAIC poured money into its developing its own muffler for political reasons. They were pressured by the Shanghai government, so it could create Shanghai jobs and increase Shanghai revenues at the expense of Guizhou, a Chinese province. Since it had the full support of Shanghai's mayor, later China's President, Jiang Zemin, profit and technology were secondary motivations.
Technology requires not only collaboration, but also communication. Communication requires free speech. Without free speech new ideas cannot be circulated and discussed. Without timely and accurate information, investors cannot determine and support the best research.
The absence of any intellectual property protection does not provide the incentive to develop cutting edge technology. In such an environment, it is hardly surprising that both export and domestic high-tech industries have become overwhelmingly dominated by foreign firms. If Chinese firms like CNOOC Ltd. need technology, like skills in deep water drilling, they have to buy it on the international markets for top dollar.
In attempting to buy an oil company rather than an oil asset, CNOOC Ltd. is heading into uncharted territory. Studies have shown that about two thirds of mergers fail to achieve the goals of the merger. This is true for Chinese companies as much as for their western counter parts. Like most Chinese companies, CNOOC Ltd. does not have a great deal of international management experience. Trying to buy it can cause problems.
Most mergers fail because of 'people' problems. The corporate cultures conflict. Power struggles emerge. Communications break down. The decision making process becomes paralyzed. Integrating two western companies with similar management styles can be very difficult. Integrating the corporate culture of an American private oil company with a Chinese state owned enterprise may be impossible.
CNOOC Ltd. has already had some experience with mergers. It purchased the Indonesian operations of the Spanish oil company, Repsol YPF, in 2002. The purchase has not exactly resulted in a merger. With the exception of three managers, the Chinese have basically left the operation alone. More indicative might be the joint venture between the French television manufacturer Thomson and the Chinese electronics company TCL in 2004. The new company, TCL Multimedia, became the world's largest TV manufacturer. Despite its size, manufacturing capabilities and domination of the Chinese market, TCL reported losses last quarter due to problems in Europe and North America.
If the risk of merger makes the acquisition of Unocal by CNOOC Ltd. look questionable, the price makes some investors question CNOOC Ltd.'s sobriety. CNOOC Ltd. is paying top dollar for a firm that is 70% of its own size based on Unocal's present market capitalization value, which has been bloated by the record price for oil. Worse, Unocal trades at almost thirteen times earnings compared with CNOOC Ltd.'s eight. This translates into a 60% premium for CNOOC Ltd.'s bid. The price of Unocal is also in US dollars. If the Renminbi really is undervalued, then the bid would reflect the distortion. For the price to make sense, you have to assume that the price of oil stays up and the value of the Renminbi stays down. If the price is questionable, so is the financing.
The first problem has to do with CNOOC Ltd.'s ability to consummate the deal at all. The directors of Unocal have very real concerns and are insisting on guarantees. As the Wall Street Journal pointed out, CNOOC Ltd. is listed in Hong Kong and has no US assets, few employees and virtually no US presences. Since the prospect of enforcing a contract in China against CNOOC Ltd. has basically no chance to succeed, Unocal is demanding that CNOOC Ltd. provide adequate assurances before it gives up the offer from Chevron.
Second, CNOOC Ltd. is getting $7 billion from its parent. $4.5 billion is in the form of a thirty-year loan and another $2.5 is in the form of a bridge loan to be repaid by an equity issue in two years. CNOOC Ltd.'s parent, China National Offshore Oil Corporation is an unlisted state owned enterprise. It is not required by anyone to reveal its finances. It would be interesting to know where CNOOC Ltd.'s parent came up with $7 billion. Was it just lying around? Invested in US treasuries? Or will it come from state treasury or worse from a state-owned bank. We will probably never know.
Of course, part of the money that CNOOC Ltd. is a bridge loan to be repaid in just two years. The loan is to be repaid with the proceeds of a $2.5 billion stock issuance. This assumes that oil prices remain high, the markets continue to want Chinese stocks and the world markets are not in a recession. Three large presumptions.
The third issue has to do with the $6 billion loan from Industrial and Commercial Bank of China (ICBC). This seems like a lot of money coming from a bank with a nonperforming loan ratio of 19 percent making it technically insolvent. ICBC has been able to lower its nonperforming loan ration to 19% by dumping on their dud loans onto their asset management company, Huarong (AMC). The problem is that the Huarong buys these questionable loans at face value using its own bonds. The AMC has to pay back the bond with money earned from the disposition of the assets, which is not happening. Besides bad loans, ICBC has some venal employees. The bank recently lost a mere $893 million through embezzlement.
Fourth, another $3 billion is coming from a bridge loan provided by CNOOC Ltd.'s investment bankers, Morgan Stanley and Goldman Sachs. Goldman Sachs recently revealed that it was considering a $1 billion equity stake in ICBC, no doubt to be secured by Unocal's oil assets. Goldman Sachs is also represented on CNOOC Ltd. board. Kenneth Courtis, vice-chairman of Goldman Sachs in Asia is one of its non executive and, theoretically, independent directors.
The real description of this deal is a world away from the present hype. The truth is something quite different. This bid is about CNOOC Ltd., a Hong Kong listed subsidiary of a Chinese state owned company, which has no assets and virtually no legal presence in the U.S. It is trying to buy a US oil company, Unocal, whose capitalization is 70% of CNOOC Ltd.'s. The bid is a 60% premium at a time when oil prices are at record levels and the Chinese currency is kept artificially low against the dollar. CNOOC Ltd. has limited experience with mergers, which fail two thirds of the time regardless of the parties. If the deal goes through, China will get oil and gas properties that are located in other countries, which might prohibit export. If they allow export, the oil and gas is contracted to other countries for the foreseeable future. To pay for the deal, CNOOC Ltd. is using money from an insolvent bank. The money loaned by its parent comes from an unknown source. Part of the loan is to be paid for from an equity float on a potentially moribund stock market. The rest of the money is to be provided by one of the advisors, an investment bank, with a seat on CNOOC Ltd. board, which is considering purchasing a stake in the insolvent bank. This is not muscle. This is a mess.
This is not a disaster for the United States. It is not even a strategic threat. On the contrary, the main beneficiaries are Unocal's shareholders. US investment bankers, who have advised and underwritten the deal, stand to make tens of millions. It is a disaster for CNOOC Ltd.'s minority shareholders. These minority shareholders include many small American investors, who own pieces of mutual funds that they assume are invested in safe assets or the prospect of an ever growing China. It is a disaster for CNOOC Ltd. bond holders, who will lose when S&P down grades their rating. However, the people who will be affect most will be the Chinese, ICBC's depositors, if the bank does not get paid back, and Chinese taxpayers, who ultimately will have to bear their leaders' folly.
It is likely to damage something else, China's reputation as an ever growing money machine. If this merger is consummated, it is highly unlikely to make money. A failed merger would make it more difficult for Chinese firms to raise capital on international markets, at least without a substantial premium. As capital dries up the people who will be harmed the most will be the Chinese and their Communist government.
Rather than feeling concern, then, the US authorities should look to the recent example of China Life for some idea of the perils such Chinese adventures may encounter. China Life, unlike many other Chinese state owned companies, did not bother with a Hong Kong IPO. They went directly to New York where the big money is. Their IPO was an enormous success, raising billions. The problem was that it exposed China Life to US laws. When it was later revealed that China Life had failed to disclose a 'slight' problem involving $658 million, China Life became liable. They were exposed to the most clever, cunning, ruthless, destructive force known to the marketplace, US plaintiff securities lawyers. Given the basics of CNOOC Ltd.'s bid, it will only be a matter of time before a feeding frenzy proves to the Chinese leadership the real power of the United States and her laws.
William B. Gamble, President of Emerging Market Strategies, appears regularly in the business media and is author of Investing in China: Legal, Financial and Regulatory Risk(Quorum Books, 2002).
| Related Links | |
 | |
 |
|
