Low prices have put the squeeze on Canadian oil companies. But with the appetite from state-owned enterprises and private companies remaining strong, when will activity in the energy sector take off again?
They say if you want to know what someone’s thinking watch what they do, not what they say. US private-equity firms typically don’t say much, but they’re beating the bushes in the oil patch. To get a sense of just how hard, check the flights between Calgary and New York.
Some Wall Street private-equity firms are sending their teams in biweekly. They book about a dozen meetings in each two- or three-day trip, mainly with bankers and company executives. But you might be surprised to know who else they’re talking to.
“Given how keen they are to find quality assets and invest in them, private-equity firms are also actually reaching out to lawyers like me,” says Derek Flaman, an energy lawyer at Torys LLP.
“Calgary’s such a small town they realize the lawyers who do this type of work may have clients or know people – their kids may play hockey together – at a particular oil and gas company that needs investment. So they’ll actually reach out to people like us to say: ‘Hey, if you hear of anybody that’s going through some difficult times, they’re unable to get further extensions on their debt credit lines, just let us know.’”
Flaman says the frequency of calls and meetings is worth noting because it speaks volumes about the appetite US private-equity firms have for Canadian energy deals right now. “They know if they want to find good deals, the best way to do so is be on the ground as much as they can. From what I’ve seen in Calgary in the last 20 years, the level of interest right now might actually be unprecedented.”
How about the level of interest from the state-owned enterprises, or SOEs, that were splashing money around the Canadian energy sector just a few years ago?
Flaman pauses. “I do a fair bit of work for SOEs that have assets here already, and as a very general statement, I’d say they’re almost the inverse of the private-equity firms in terms of excitement and appetite for further acquisitions and further equity commitments in the industry right now.
“It’s not that the gold rush is over, but it’s happened. So whether it’s [China National Offshore Oil Corporation] or any of the others, many have been here for a while and they’ve been stung. If they’re looking at it today, they’re saying we bought in at this price and now the price is less.
“If you talk to a bunch of lawyers and bankers, I think most will tell you they’re not fielding nearly as many calls from SOEs as they are from other types of investors.”
Looking at prospects for foreign investment in Canada’s energy sector for the rest of this year, does the tactical retreat of state-owned companies matter? The answer is, it depends whom you speak to.
China’s state-owned enterprises burst on to the scene as power buyers in Canada’s energy sector in the economic slowdown that followed the financial crisis, when the price of crude fell to as low as US$35 a barrel.
CNOOC, PetroChina Co. Ltd., Sinopec Group, China Investment Corp. and other state-owned enterprises made a raft of big bets on western Canada’s vast untapped oil reserves — the third-largest in the world.
To law firms in the oil patch, some days it must have seemed like deals were flying in the door.
Energy is a cyclical business, so even if they bought high you wouldn’t think state-owned enterprises – some of the world’s most sophisticated buyers – would be put off from doubling down when commodity prices are low.
There may be another factor dampening their enthusiasm. You can’t talk about foreign investment in the energy sector very long without running up against CNOOC’s controversial $15-billion purchase of Nexen Inc.
When the Nexen deal was first announced in the summer of 2012, some members of Parliament had already expressed alarm at permitting a country many feel will become the world’s dominant superpower to gain control over Canada’s strategic energy assets. It was a concern that resonated with regular Canadians, with 73 per cent of those polled saying they opposed the sale.
When Prime Minister Stephen Harper announced his government would allow the transaction, along with the $5-billion sale of Progress Energy Resources to Malaysia’s state-owned Petronas, he said that in future, state-owned enterprises would no longer be permitted to buy Canadian oil sands companies except under certain exceptional circumstances.
In 2013, the Investment Canada Act was amended accordingly. The changes expanded the definition of SOEs to include any company subject to influence by a foreign government, and assigned any deal involving an SEO a review threshold of $344 million, in contrast to $1 billion for other types of foreign acquisitions. The timeline for national security reviews was also extended.
There was cry of a chill and warnings the government was harming the cash-hungry energy sector’s ability to attract capital from some of the best-financed foreign investors in the world.
China was clearly displeased. “Discriminating against SOEs from China is not very wise,” Chinese Consul General Wang Xinping told The Wall Street Journal.
And there hasn’t been much action since then — at least not the kind of control transactions that attract Investment Canada review and make newspaper headlines.
The Nexen effect “is certainly part of the reason we haven’t seen any serious M&A activity out of China since then,” says Donald Greenfield, who heads the energy practice group at Bennett Jones LLP's office in Calgary.
So were the naysayers right?
It may be too early to conclude that China has drawn a line in the sand post-Nexen. It too has fallen victim to a slowing economy. Acquisitions by China’s state-owned companies dropped 13 per cent to US$53 billion last year, says a report by the Rhodium Group, a New York-based advisory firm.
Spending on energy and materials acquisitions – a category that averaged US$30 billion a year between 2008 and 2013 – tumbled to US$19 billion, according to the analysis of China’s global outbound M&A activity in 2014.
Where China was doing deals, the report shows the US, Europe and Australia saw an uptick in interest. Canada? It all but fell off the map. “Chinese M&A in Canada collapsed due both to lower interest in extractive assets and greater political scrutiny for investment by state-owned enterprises,” Rhodium says in its analysis.
Two-and-a-half years later, the Nexen fallout is echoing in the oil patch.
Flaman of Torys says there’s no question it had an effect “and continues to be an effect on foreign investment. We have experts at our firm who specialize in Investment Canada work, and I’ve been in lots of those meetings. You can walk a client through a proposed deal and analyze it as best you can but, at the end of the day, there is some risk there you could spend a lot of money on transaction fees and this national security interest provision gets put in front of you, and you lose your deal. Nexen was not helpful.”
Alicia Quesnel, an M&A and energy practitioner at Burnet, Duckworth & Palmer LLP in Calgary, has seen the Nexen effect up close. “I’ve been involved in two or three transactions where SOEs were looking and they just decided for various reasons that they’re not prepared to make further investment, whether it’s oil sands or natural gas or light oil. So after Nexen, we did see deals that were being negotiated fall off the table. It’s not the only factor, but it would have been an important one.”
The retreat of state-owned companies like CNOOC and Sinopec – for whatever mix of reasons – is relevant, she says, because they had a significant impact on pricing in the oil patch in recent years.
“The one thing the SOEs did when they came in is they actually paid premium prices. They also brought in sweeteners at the time — they might have made an investment in the equity of the company or offered favourable financing, allowing the company to pay out its existing bondholders. So it wasn’t just the price they paid, it was what else they brought to the mix. Obviously, we’re not seeing that right now.”
Quesnel, for one, doesn’t expect to see it again in the foreseeable future, certainly not the rest of 2015. “I think companies wait to see what’s going to happen with the price [of oil]. Have we bottomed out, is it going to go up? When you look at it on a sector basis, obviously, in the oil sands you need a bit of a higher price in order to make new projects or expansions more profitable. So existing projects are going to continue but new projects will be delayed for a time.
“I don’t think we’re going to see a whole lot of foreign investment in the oil sands this year. That’s a big one.”
If you ask Greenfield at Bennett Jones LLP whether the Nexen effect is dampening foreign interest in Canada’s energy sector in general, he says it depends on whom you’re talking about. “It seems to me that in Nexen, there was a fair amount of antipathy towards Chinese SOE investment here because of where it was from — from China.”
That hasn’t transferred to non-SOE foreign investment, he says, pointing to Spanish energy giant Repsol SA’s friendly US$8.3-billion offer for Talisman Energy Inc. For those types of public-company acquisitions, he says, “I don’t see the investment review process any bigger a challenge now than it was five years ago. And I’d even differentiate in regard to SOEs. A Statoil, for example, would be viewed quite differently from a Chinese SOE. There’s a spectrum there, the government would view different political systems differently. Norway and China aren’t on the same place on that spectrum.”
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Potential foreign buyers of all stripes are aware of the Nexen brouhaha, Greenfield says, and he frequently gets questions about the political climate for inbound deals. “They all want to know about the foreign-investment review process for sure. We tell them that policy change was directed toward SOEs buying control of Canadian oil sands businesses. Otherwise, I’d say it’s business as usual. Investors from other countries who come here are sophisticated, I think they’d recognize that there were some China-specific factors.”
Craig Hoskins, a partner at Norton Rose Fulbright Canada LLP in Calgary, believes the importance of Nexen has become somewhat exaggerated. “I think it’s overblown in terms of people blaming the Investment Canada policy on the slowdown. It did occur, there was obviously a significant downturn in M&A activity shortly after the Nexen deal was completed, but I think there were other things at play, starting with the economy.”
There is foreign interest in the energy sector from all sorts of directions, says Hoskins. “We’ve actually had some tire-kicking type inquiries from international players. There are foreign-based pools of capital, private-equity and pension funds, insurance companies and the like who have had some interest in Canada for some time. We’ve had inquiries from the United States, Asia and Europe.
“In at least one case, the party looking at deploying capital into Canada already has investments in other jurisdictions like Nigeria and other African countries where the political risk becomes unpalatable. This counters the whole perception that Investment Canada has made Canada seem unattractive. At least one party we’ve been talking to says he still sees Canada as politically stable and a good place to be investing in.”
Michael Laffin, Chair of the Asia Region initiative at Blake, Cassels & Graydon LLP in Calgary, says when he hears people saying there is little or no Asian SOE interest in the oil patch, “I’m left scratching my head. The Asian appetite is still very strong, not only from SOEs but from private companies as well. We’ve seen acquisitions in the past two years into Canada, we’ve seen major SOEs taking stakes.
“What’s lost in all this discussion is that the Sinopecs and the CNOOCs still have companies to run, their capital expenditures are very high. But they’re still looking for major acquisitions. And they’re making significant investments in various LNG [liquefied natural gas] projects, which seems to be lost on Canadians when we talk about the interest of Asian companies seemingly dissipating.
“In fact it’s not dissipating. I just don’t think people are looking in the right places.” The right places, according to Laffin, are those LNG projects and on the west coast of Canada.
CNOOC is involved in building the Aurora LNG on Digby Island, for example, and there are several other projects, including LNG Canada and Pacific NorthWest LNG, in which SOEs are involved, he says. They involve investments of tens of billions of dollars but, as greenfield operations being built from scratch, they do not require Investment Canada review.
The same investors are also very interested in energy infrastructure from pipelines to hydroelectric projects, says Laffin, who has been lead counsel for Sinopec, CNOOC and others.
“In terms of SOEs, you also have Korean companies involved in LNG, you have Japanese private companies who receive a lot of their funding from state-owned enterprises. Everybody wants to get in that space. We’re getting serious queries on that, if not on a biweekly basis, on a monthly basis.”
As for control transactions that would require Investment Canada review, Laffin says it’s not so much that Asia’s massive SEO investors are steering clear of them, it’s more that no one wants to be the first to jump back into the fray. “I don’t think they’re concerned about reviewable, I think where there are any additional obstacles as in possibly oil sands, they’d like for precedent to be set there. They’d like someone else to take the leap.”
Will anyone try? The next few months may well tell the tale, with low oil prices putting the squeeze on Canadian oil companies — making an ever-increasing number ripe to make a deal.
Oil prices below US$60 a barrel cause many of Canada’s landlocked producers serious problems. The cost of shipping a barrel of heavier crude by rail can approach US$22 without factoring in exploration, extraction and production, as well as other costs of doing business.
The pressure is causing the country’s oil and gas companies to split into three groups — predators, prey and those in the middle, says Bruce Lawrence, National Chair of the Oil and Gas Focus Group at Borden Ladner Gervais LLP in Calgary.
“The majority of companies fall into the middle category,” says Lawrence. “They’re the ones that have hunkered down and are content to ride out this storm. They’ve cut their dividends, they’ve cut their capital expenditures, they’ve laid people off.”
If oil prices remain low through the second half of the current year, Lawrence says, without access to financing some of them will likely become prey. “That will surface in outright receiverships, soft receiverships, or because they just see the writing on the wall and know in the long run they can’t make it because they’re on a slow but steady decline.”
If prices start to move up, however, a number of companies from the middle group will become predators. “They’re the ones saying, ‘Let’s just preserve capital, and if an opportunity comes in for a smaller bolt-on, a modest acquisition, we’ll be ready for that.’”
Where things get really interesting, says Lawrence, is if prices bounce around in a band between US$50 and US$60 a barrel. That could double the amount of M&A activity in the energy sector.
“A number of companies are still marginal at US$60 a barrel. For them, it just prolongs the agony, it doesn’t mean they survive, they need oil at US$80 or more. So you start to get greater spread between predator and prey.
“For companies in that middle category, their balance sheet is going to be better, they’re going to have more cash flow, they’re going to be able to borrow more money – their stock will have come back – so now they’ll be emboldened, empowered to go after some of the other companies that can’t make it out, that need US$70, US$80, US$90 a barrel just to break even.
“So I think there will be more polarization in the second and third quarter of this year. And it will have a definite impact on M&A.”
Even without SOEs for now, there are plenty of other cash-rich foreign investors ready to pounce once the price of oil stabilizes — many in the US.
Chip Johnston, a partner at Stikeman Elliott LLP in Calgary, says the interest is there, what’s been holding things back is “significant price dislocation. The changes in asset values are so significant right now it’s very difficult for people to have visibility on what a clearing price is. Every buyer is happy to buy for free and every seller is happy to sell for a huge premium, so when you get these kinds of price dislocations it can take a while for people to figure out what reasonable prices are.”
The telling thing is global liquidity, which remains extremely high, creating pent-up demand-side activity for M&A and financings. “With all the global liquidity, there’s a lot of money to invest. With the currency and with the commodity and Canada’s relative stability, probably there’s some kind of transportation upside in Canada at some point over the next 10 years, it’s not a terrible bet. And from the US you don’t get a currency kick, so we probably get some preference out of that.
“The difficulty is the assets they want to buy are the assets people want to keep, so you have to see more pressure on sellers in order to free some of those things up. It’s all great that you’re loaded up with money but you need something to buy and what you want to buy is what people don’t want to sell until things become even more adverse and people start to make decisions. So I think you have to fundamentally go through this Darwinian process.”
Ben Rogers, Co-Practice Group Leader of the national Energy ‒ Oil & Gas Group at Blakes in Calgary, says trouble agreeing on valuations is killing more deals than anything the government may or may not have done post-Nexen.
When and if prices settle in the second part of this year, he too is expecting an uptick in activity in the energy sector.
US private equity seems especially interested in Canada’s junior explorers and producers, he says. “In that segment you have these great management teams that have great assets that private equity would really probably like to preserve and would see as an opportunity to get involved.
“I also see increased activity from the majors and super-majors — they are long-term players. They too are going to be looking for opportunities to acquire assets in this pricing environment. So I think we should start to see more private-equity and major and super-major investment from the US into Canada.”
He agrees that prices hovering around US$50 a barrel at the start of this year bred a little disconnect between buyers and sellers in the energy market, but “nothing we haven’t seen before. Whenever there’s a change in commodity pricing, until people have a strong belief in where the price is going to stay it gets hard to align buyers and sellers.
“So there’s been a lot of tire kicking and deals in the embryonic stage or even one or two stages further but the parties just can’t get there. Most people I talk to believe that somewhere over the next 12‒18 months you’re going to see a recovery to the US$60 to US$80 level. When you see that, I think all of these deals that fell through in this strange environment will get more traction, and we’ll see lots of activity.”