China vs. The Rest: A New Era of Global Energy Dealmaking.

• Author: Wang, Qiangyu

1. INTRODUCTION

   China's energy policy is increasingly playing an pivotal role in shaping global energy markets as well as corporate merger and acquisition prices (Mu and Ye, 2011). Our findings suggest that China seems to have learned from their high profile failure to acquire U.S. company Unocal in 2005 (Wan and Wong, 2009) and is now reviving an interest in global deal-making. Chinese companies acquired more than ten percent of global reserves sold over the period 2006-2012, enjoying some deal pricing success in the process. In particular, prior studies of deal attributes suggest that China employs various approaches to command discounts in transactions; executing oil for loans at a country level in state deals, or cash for equity acquisitions in private deals, closing strategic acquisitions to their advantage (Zhang, 2012). The broader suggestion of Chinese 'Petronationalism', is that her acquisitions are driven not by commercial interests, but by a desire for energy security (Grifin, 2015). The dual commercial and security implications of China's energy dealmaking serve to make this an interesting policy research area. In this paper we, therefore, focus on Chinese merger and acquisition prices.

   We are interested in where China acquires reserves and whether it does so at competitive prices. Analytical insights from 726 deals over a seven year period from 2006-2012 signal a reshaping of global reserve ownership. We note that China (competing side by side with other companies) achieves a relative discount in most oil producing regions, by median, Chinese prices are closed a full 6.5 percent lower than comparable deals. This deal insight is relevant since it shows that while China's state investment arm has historically acquired reserves for security, they seem not to be overpaying (Sun et al., 2014). On the contrary, other sector players seem to be paying (relative) premium prices. We also find that China is becoming a global player in oil and gas reserve ownership, but with Chinese state companies exhibiting a distinctly greater country risk appetite than commercial competitors.

   The 'bid discount' metric we use focuses on the relative bid price of all buyers (Chinese and non-Chinese) compared to a simplified computed value for in-the-ground acquired reserves. We acknowledge that this may be viewed as an oversimplification since oil and gas valuation is a complex multivariate process. Reserve acquisitions are typically closed at a value less than the full reserve value on the market (by a statistically significant margin) due to many factors: the reserve production profile, time value of money, taxation, production sharing terms and development costs are but a few of these. Full valuation is also highly idiosyncratic by region, geological reservoir complexity and fiscal terms. Kretzschmar et al. (2008) model 292 oilfields across developed and emerging market producers, finding that these factors may generate a risk and return inversion. In addition, size of reservoir also plays a role in valuation, Kretzschmar and Moles (2006) specifically model oilfield real options and note that volatility--and therefore option value--depends on the field size idiosyncracies. Notwithstanding the above complexities of valuation, practitioners do use simplified in-the-ground reserve values. This approach while reasonably simple, enables a focus on the relative discount between value of reserves and purchase price. Useful insights are provided using this approach, particularly where a sample has sufficient regional transactions to enable us to compare cross sectional prices between buyer groups, an approach we adopt in this paper.

   Some authors have studied when deals were executed, noting that in the period post 2008, when Western credit lines were tight, China closed deals backed by low cost Chinese funding (Sun et al., 2014). Specifically, over this period The China Development Bank (CDB) extended lines of credit totalling around 65 billion to energy companies and governments in Brazil, Ecuador, Russia, Turkmenistan, and Venezuela. In turn, loans were repaid in physical oil (Meidan, 2016). By 2015, the lending had already made progress toward achieving China's primary goals: 1.4-1.6 million barrels per day in oil fowed to China, building their strategic reserves, investing heavily in new riskier production provinces. Other studies have suggested why deals were so important: firstly, they increase China's energy security (Grifin, 2015), but in addition, the effect is to reduce Chinese spot market exposure. An increased Chinese ability to produce 'of market' oil from new oil partnerships reduces China's spot market exposure and also enables China to sell into forward and option derivative markets (thereby hedging price risk on domestic oil purchases closer to home). This latter process serves the purpose of hedging Chinese exposure to volatile spot markets while limiting the feedback volatility of Chinese purchases on spot markets, an effect noted by Li and Leung (2011).

   By contrast with the above studies, this paper focusses on the risk metric of where the Chinese reserves were acquired, and then whether the prices paid were 'good business'. Across 726 deals over the period, we find a positive relationship between reserve size and bid discount, meaning the larger the reserve, the lower the bid price (per barrel). For the whole sample, we find that political risk is directly and positively related to bid discount, supporting the intuition that the higher the political risk, the higher the discount, the lower the bid price. Despite the discounts enjoyed in risky production provinces, when comparing China to global deal trends, we find that an important dealmaking region for China was North America, comprising approximately 31 percent of deals (measured by reserve size).

   North American deals are closed at the lowest Chinese discount. This suggests that China is less able to achieve a relative discount in developed capital markets. At the other end of the country risk spectrum, for example Russian markets, China achieved the highest bid discounts. In fact, oil in-the-ground in Russia and Kazakhstan are shown to be worth significantly less than elsewhere, consistent with early work by Smith (1995). Despite achieving the lowest discounts in the U.S. and Canada, value-adding deals do still occur since targeted Western companies provide Chinese access to technology and new production assets. In particular technical oil sands expertise was an attribute noted as a central driver of the highly contentious Chinese acquisition of Nexen.

   There are numerous studies on the effect of risk and equity returns, however, no studies really seem to focus on buyer risk characteristics in reviewing deal value or discounts. Erb et al. (1996) utilize four measures from the International Country Risk Guide's political-, financial-, economic- and composite risk indexes and one metric from Institutional Investor's country credit ratings to demonstrate that country-risk measures are correlated with equity returns and, in turn, with equity valuation. Kretzschmar and Kirchner (2009) provide market evidence of the effects of reserve location on oil and gas company returns by adding a proxy--the proportion of oilfield assets subject to progressive tax terms--to the classic Fama-French framework. They find companies with oilfield assets owned under progressive production sharing contracts are unable to capture the benefts of oil price increases, and as a result, significantly under-perform companies with concession holdings, and that these returns vary by production region (Kretzschmar et al., 2008).

   Glick and Weiner (2007) come close to investigating the effect of risk on the value of crude oil reserves. Controlling for factors that affect reserve value, they demonstrate value-destruction from political risk, and estimate the asset discount across 37 countries, showing that the discount depends on market conditions. Specifically, the higher the expected future market prices of oil and gas, the larger the discount, regardless of a country's level of risk. This paper seeks to add to their work by answering the questions as to where reserves are acquired and whether they are 'good value'. We conclude that China has a high country risk appetite which helps achieve a higher deal discount in those risky regions.

2. METHODOLOGY

   2.1 Defining Bid Discount

   As noted earlier, valuation is a complex process, containing technical and market risk elements. Proven and probable reserves are usually analysed to ascertain annual production profiles, with the production multiplied by a forward 'price deck', in projecting revenue. From the gross revenue, lifting costs, taxation, operating expenses and development costs are deducted and then discounted for the time value of money (the oil market convention is to use 10 percent as the discount rate). To achieve an accurate value, detailed valuation models are constructed. However, to simplify the above, oilmen reference an 'oil in-the-ground' value, enabling a simplified estimation of value--it is this approach we use.

   Subsurface reserve acquisitions are typically closed at values less than the full reserve value on the market as bid price and the full reserve value as ask price, we term the spread between bid price and ask price as bid ask spread. It is, of course, noteworthy, that the operational synergies may be usually considered and realized in corporate takeovers, however such synergies are less attainable in oil and gas because of location specific factors. Thus, the more dependent firm cash fows are on production assets, the more they are able to realize synergy gains (if they acquire adjacent assets and benefit from joint development blocs). This possible rationale for paying a premium noted by Ng and Donker (2013) is not modeled in relation to the size of the discount.

   Kretzschmar et al. (2008) examine...