PetroChina

Shale Gas, China’s Very Buried Treasure — Nikkei Asian Review

1 Comment / December 17, 2015

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Water, water not a drop to drink. While that may not precisely sum up China’s dilemma, it is clear that the country with the world’s largest shale gas reserves, and urgent need to extract it,  will have problems achieving its ambitious long-term goals. The newly-finalized Five Year Plan calls for an enormous increases in natural gas output in China. The carbon emission reduction agreement signed by President Obama and Chinese leader Xi Jinping also requires China to diversify away from coal. Shale gas is the obvious replacement.

As of now, virtually all that gas remains trapped in the ground. The two companies given the plum rights to develop the gas, China’s oil giants Sinopec and PetroChina, may not have the technical competence to fully develop the resource. The companies that have the skills, mainly a group of small entrepreneurial US drillers, has so far shown zero inclination to either come to China or come to the aid of the two SOE giants by providing equipment and know-how.

To attract them to China will likely require a significant shift in the way China’s energy resources are owned and allocated. It will mean creating terms in China every bit as favorable, if not more so, than skilled shale gas drilling companies enjoy in the US and elsewhere.

 

shaleMap

This is why for China’s senior leaders and economic planners, this map is as much a curse as blessing. Knowing that vast quantities of much-needed clean energy is in the ground but not having the domestic infrastructure and technology to get it to market efficiently is about as tough and frustrating as any economic problem China now confronts.

The Chinese policy goal and the on-and-in-the-ground situation in China are on opposite sides of the spectrum. China has said it must quickly increase the share of natural gas as part of total energy consumption to around 8% by the end of 2015 and 10% by 2020 to alleviate high pollution resulting from the country’s heavy coal use.  The original target announced with great fanfare was for shale gas production to increase almost 200-fold between 2012 and the end of the decade. But, this goal was quietly slashed by 30% last year. More slashes may be on the way.

What’s most needed and in shortest supply in China: more commercial competition, more players, more market signals.

Based on the US experience, drilling for shale gas isn’t the kind of thing that big oil companies are good at. Unfortunately for China, all it has are giants. Rather inefficient ones at that. Sinopec, PetroChina are, based on metrics like output-per-employee, perhaps only one-tenth as efficient as the majors like Royal Dutch Shell, Exxon and BP. Note, these big Western companies all pretty much missed the boat with shale gas. In other words, the bigger the oil company the worse it’s been so far at exploiting shale gas. Yes, it’s these big global giants who now seem the most interested to work with Sinopec and PetroChina to develop shale gas China. In fact, Shell is already partnered up with Sinopec. How’s this likely to work out? Think of a pack of elephants ice fishing.

China’s dilemma comes down to this: it’s probably the most entrepreneurially-endowed country on the planet, but entrepreneurs are basically not allowed in the oil and gas extraction businesses. It’s a legacy of old-style Leninism, that the state must hold control over the pillars of the economy. It works okay when the problem is pumping petroleum or natural gas from giant onshore or offshore fields. But, shale gas is another world, with many and smaller wells. A typical one in the Barnett Shale gas region of Texas costs $2mn – $5mn, barely a rounding error for large oil and gas companies. These smaller wells, depending on prevailing price and drilling direction, can achieve a return within one year or less.

Profits are usually much higher for shale wells with horizontal drilling capability. But, it’s also much trickier to do. Production drops off dramatically in most shale gas wells, falling by about 90% during the first two years. So, you need to know how to make money efficiently, quickly, then move on to another opportunity.

The one place where Sinopec is now producing a decent amount of shale gas, at field in Sichuan province, the cost of getting the gas out of the ground is running at least twice the US level. Partly its geography and partly it’s the fact giant state-owned companies operating in a competition-free environment usually need three dollars to do what an entrepreneurial company can do for one.

Ancient Chinese oil well

China was the first country to drill successfully for oil, over 1500 years ago.   It could use more of that native ingenuity to unlock the country’s buried wealth. The shale gas industry is largely the product of one brilliant and stubborn Greek-American entrepreneur, George Mitchell, who began experimenting with horizontal drilling in Texas about 30 years ago. He had his big breakthrough in 1998. Everyone knew the gas was down there, as they do now in China. The trick Mitchell solved was getting it out of the ground at a low-cost. The company he started Mitchell Energy & Development, now part of Devon Energy, remains at the forefront of shale gas exploration and production.

China needs Mitchell Energy as well its own George Mitchells, who can use their pluck and tolerance for risk to make the gas pay. Not only shale gas, but China is also blessed with equally abundant deposits of coalbed methane. Pretty much all this methane is in the hands of big state-owned coal companies. Talk about a wasting asset. The coal miners have zero expertise, and for now it seems zero incentive to go after this fuel in a big way. Just about everything about the oil and gas business in China is state-owned and price-controlled.

The applause was nearly deafening, especially in the US and Europe, when the leaders of the US and China announced the big agreement to reduce carbon emissions. No one can argue with the sentiments, with the policy goal of creating a cleaner world. But, absent from the discussion are specifics on how China will meet its promises. It’s only going to happen if and when natural gas becomes a major part of the energy mix.

China has of course built pipelines to bring gas from Russia and more are on the way. But, even this huge flow of Russian gas, an expected 98 billion cubic meters per year by 2020,  will provide at most 17% of China’s projected gas needs by that year. Clearly then, the most meaningful thing that could happen is for the shale fields in China to be thrown open to all-comers, but especially the mainly-US companies that are experts at doing this. That isn’t happening.

I’ve been in the room with Chinese government officials when the topic was discussed about how to make it enticing for US specialist shale companies to drill in China. There’s a growing understanding this is the right way to go, but still the policy environment remains inhospitable. While China has the most shale gas, there is a lot of it in countries including stalwart US allies like Poland and Australia where the US companies are far more welcome and don’t have to deal with a market rigged in favor of state-owned goliaths. Everyone who wants to see a cleaner China and so a cleaner world should wish above all else that China’s shale and methane fields become a stomping ground rather than a no-go area for great entrepreneurs.

An edited version was published in the Nikkei Asia Review. 

Click here to download article. 

 

 

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China SOE Buyouts — Case Study Part 2

Leave a Comment / December 15, 2013

Jin finial

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When you can find them, State-Owned Enterprise (“SEO”)  buyouts are among the better investments in China. The reasons: the companies are cheap, professionally-managed and free of accounting fraud. The not-trivial challenge: finding good SOEs that can be bought.

For such an important part of the world’s second-largest economy, Chinese SOEs are widely misunderstood. They account for at least 20% of China’s GPD. Some estimates put SOEs’ contribution to GPD at 60% or higher. But, SOEs are often characterized, to quote from a World Bank analysis, as “dying dinosaurs that continuously absorb resources from the economy but produce little economic value.”

To be sure, there are many SOEs that fit this description. But, equally, there are plenty of good businesses among China’s more than 150,000 SOEs. The good ones, quite often, can be made substantially better by bringing in outside capital and chopping away at the heavy bureaucratic crust.

Buyouts make money when a new owner buys an business for less than it’s worth, then reinvigorates it. Generally that’s done by buying lazily-run subsidiaries inside larger conglomerates.

No conglomerate anywhere, at any time,  has been more laid-back about managing its assets than SASAC, the huge government organization that is the legal owner of most Chinese SOEs.

SOEs operate in, but are not entirely of, the market economy. They benefit from cheap and plentiful capital via loans from state-owned banks. But, SASAC is generally far more concerned with increasing revenues and investment than profits. SASAC generally doesn’t demand SOEs pay it dividends. Instead, it asks for an audit every year that shows an SOE’s revenues and assets are growing, and no money is actually being lost or assets pilfered. SASAC doesn’t act like an owner so much as a custodian.

SASAC’s casual attitude to profit-making filters down to all levels within an SOE.  Given the choice to maximize or minimize profits, most SOEs will choose the latter.  The goal is to make a little more than last year, but not so much that SASAC, or more senior levels in government, begin to ask questions. With few exceptions (mainly larger centrally-administered SOEs quoted in the US like China Mobile and PetroChina) the corporate equivalent of a “gentleman’s C“, a net margin of around 2.5%, is considered satisfactory.

You don’t need to be a Buffett, Bonderman, Kravis, or Rubenstein to make money buying the right Chinese SOE. You generally don’t need to get your hands too dirty, launch a hostile takeover, borrow a ton of money, or make yourself unpopular by firing surplus workers. It’s going to be enough in most cases just to retain and incentivize current managers, and inform them that their goal now is to deliver net margins as good as, if not better, than private sector competitors.

Not in all cases but many, the current management of an SOE is quite good, professional, dedicated. The managers operate within a system that downplays the importance of maximizing profit. So, they behave correspondingly. But, that doesn’t mean they don’t know how to do so, especially when they have their salary or share options tied to profitability.

In a previous post I mentioned our two new SOE clients. We are working now to privatize them by selling majority ownership to a private sector investor. Both are 100%-owned by one state-owned holding company which, in turn, is fully-owned by another, even larger SOE holding group. Above them, is the local SASAC in the city where the holding companies are both headquartered. No sooner did we start asking the managers how to improve profits, then they began to share information on how much additional profit was being left unclaimed — unnecessary commission payments, tax rebates not filed for, revenues booked through unrelated group companies.

In the case of these two companies, the current CEOs have been running the businesses since they were started more than five years ago. They are about as far from a stereotyped paper-pushing “SOE Manager” as one could imagine. They are in their mid-40s, and take evident pride in running their businesses as efficiently as any Western manager would. The difference is, a lot of the profit they earn is siphoned off through lots of internal layers within the holding group. At the moment, that’s of little concern to them. They are ordinary salaried workers giving SASAC precisely what it wants. Giving more would do nothing to advance their careers, or fatten their pay packets.

These two CEOs are excited and ambitious to run independent private sector companies that will be free to make and keep as much money as the market and tax laws allow. I have confidence that in both cases, net income would more than double within two years, and triple within five.

What’s needed isn’t restructuring. It’s gardening. You weed out all the unnecessary fees, commissions and chop back the overheads. This reveals the companies’ genuine – and impressive – bottom line.

We are still doing our internal work with the companies, but will soon start the search for new majority owners for each company. All the layers above, up to and including the local SASAC, seem to support these transactions. Why? The holding company already has one very successful publicly-traded company. Once spun off, these two subsidiaries should follow a similar path and one day go public. That is the surest way to assure the companies have sufficient access to low-cost capital and so finance continued growth. Both companies, with revenues of over $100mn, are growing quickly.

Everyone is currently in agreement that the best way for these two subsidiaries to become not just the largest but the most profitable companies in their industry in China is by bringing in majority private shareholders, both to invest in the business and provide more focused, profit-oriented ownership. They sought our investment banking and advisory help to do so.

This isn’t to say these deals, or any SOE takeover, is as effortless as body-surfing. The privatization process in China is still evolving. Any transaction like this will likely generate some opposition. From whom? And from what level? Both are impossible to say.

A separate concern of mine: there are far too few capable and experience takeover firms active in China. Among those that are around, the level of experience and comfort with buying control of an SOE is not uniformly high. Done right, the new owners would be able to profit from a large gap between the current asset value as calculated using SASAC rules and each company’s level of underlying and future profitability. In other words, you buy using NAV but sell later on a p/e multiple.

Making money on that swap, from NAV-to-p/e, is the simple idea at the heart of many of the world’s most successful takeovers. Opportunities to do this are now quite rare in the US and Europe, which is one reason the returns for big buyout firms like KKR, Blackstone and Carlyle has generally been trending down over the last 25 years, and why it’s harder for Warren Buffett to find the kind of underpriced gems he treasures most.

The best days of takeovers have passed, right? Or should Buffett, Rubenstein, Bonderman and Kravis be booking flights to China?

 

 

China Investment Banking Case Study: An SOE Privatization

4 Comments / December 15, 2013


China First Capital Signing ceremony

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Anyone who’s dipped into this blog will know that I rarely, if ever, discuss directly what me and my company China First Capital do, our client work. Partly it’s because the work is usually by necessity confidential (clients, investors, deal terms) and partly because I don’t blog as a marketing tool.

But, I plan over coming months to share significant details about a “live deal” we are now working on, a buyout transaction involving a Chinese state-owned enterprise (SOE). The reasons: its size and structure make it an unusual transaction in China, and one that might also bust some myths about the way business in China, especially involving SOEs, actually works.

While I can’t reveal the name of the company, I can disclose why I think it’s such a compelling deal.  Our client is one of China’s largest, most well-known and most successful SOEs. The group’s overall annual profit of over Rmb12 bn (about USD$2bn) also make it one of the richest. Unlike a lot of SOEs, this one operates in highly-competitive markets, and has nothing like a monopoly in China.

The deal we’re working on is to restructure then “privatize” two profitable subsidiary companies of this SOE. Both of these subsidiaries are the largest businesses in China in their industry. Their combined revenues are about $220mn.

Privatization has two slightly different meanings in Chinese finance. First, is the type of deal, very common a decade ago, where big SOEs like China Mobile, Sinopec, PetroChina, ICBC, Air China, are converted into joint stock companies and then a minority share is listed through an IPO on stock markets in China, US or Hong Kong. The companies’ majority owner remains the Chinese state, with the shares usually held and managed by a powerful arm of the government known in Chinese as 国资委, in English known as the State-owned Assets Supervision and Administration Commission, or more commonly SASAC. In theory, SASAC probably holds the world’s largest and most valuable share portfolio, far bigger than Fidelity,  Vanguard, or the world’s sovereign wealth funds.

The other, rarer,  type of privatization is where a company’s majority ownership changes hands, from state to private ownership. This is the type of control deal we are working on. The plan is to spin out the two subsidiaries by selling a majority stake to either a strategic or financial acquirer. In all likelihood, each company will one day go public either in China or Hong Kong, at which time, I’d expect their market caps to each be well over US$1bn.

In essence, the deals are structured as a recapitalization, where a new private-sector majority owner will contribute capital in excess of the company’s current assessed value. That valuation is determined by an independent accounting firm,  based on current asset value.

The privatization process is heavily regulated and tightly controlled by SASAC. It involves multiple levels of review, outside valuation, and then an open-market auction process. The system has changed out of all recognition from the first generation of government asset sales done in the 1990s. These deals involved little to no public disclosure or transparency and generated quite a lot of criticism and resentment that Chinese state assets were being sold to insiders, or the well-connected, for a fraction of their true value.

For an investment bank, working with an SOE, especially a large and famous one, has a process, logic and rhythm all its own. There are many more layers of management than at a typical Chinese private company, and many more voices involved in decision-making. In this case, we’re rather fortunate that the chairman of the holding company is also the founder of the two subsidiaries we’re now seeking to spin out. He started the companies from zero less than ten years ago, and has built them into proud, successful, fast-growing businesses.

This chairman has far more sway over the strategy and direction of the SOE than is usual in China. I first met him over a year ago. I was called to visit the company to explain the process through which an SOE like his could raise outside capital. Though curious, the chairman said at the time it seemed like more trouble than it would be worth. He had a comfortable life, and was nearing mandatory retirement age.

In fact, as I now understand, that first meeting was really just a way to kickstart a long, complicated and confidential discussion process involving the chairman, his senior management team, as well as even more senior officials at the SOE.  Over the course of a year, the chairman was able to persuade himself, as well as the many others with a potential veto, that a spin-out of the two companies was worth considering in greater detail.

The privatization offers the promise of long-term access to capital and also, most likely, a greater degree of management autonomy.  Though the two subsidiaries do not sell to, rely on or otherwise have related party transactions with the parent, they are ultimately subject to some rather heavy and often-stifling bureaucratic controls. Contrary to the reputation of many Chinese SOE, the two companies sell high-end products to large fastidious global customers. They operate in highly kinetic markets but with a corporate structure above them that is as slow, ponderous and impenetrable as a five-hour Peking Opera performance.

The chairman invited me to return for another visit in June. What followed was a rather intensive process of me and my team submitting several different financing plans and options, including the privatization of either the whole holding company or various subsidiaries, either as standalones, or grouped into mini-conglomerates. These different plans got discussed very actively inside the SOE. In under a month, the company had decided how it wanted to proceed: that its two strongest and most successful subsidiaries should be separately spun off and majority control in each offered to a new investor.

It may not sound like it, but one month is a remarkably fast time for an SOE to consider, decide and then get necessary approvals to do just about anything. We also work with another even larger Beijing-headquartered SOE and it took them almost four months to get the eleven different people needed to approve, and apply the chop to, our template Non-Disclosure Agreement.

I was summoned with one day’s advance notice to return to the company in late July to sign a cooperation agreement to advise them on the proposed privatization/recapitalization of the two subsidiaries. Again, that’s rather typical of SOEs:  meetings are called suddenly, and one needs to drop whatever one’s doing and attend. For me, that meant a hastily-booked two hour flight, then a three-and-a-half hour drive to the company’s headquarters. A photo from the signing ceremony is at the top of this page. (I have to cover over the name of the company.)

The contract signing was followed by another in a series of very elaborate and extremely tasty meals. The chairman has converted a 13-acre plot of the company’s land into an organic farm, where he grows fruits and vegetables and raises free-range pigs, ducks, chickens. Everything I’ve eaten while visiting the company has come from this farm. Everything is remarkably good. And, yes, along with the food, a rather large amount of Chinese alcohol is poured.

In future posts, I’ll talk about different aspects of the transaction, including how to parse the balance sheet and P&L of an SOE, as well as the industrial and investment logic of doing a takeover of an SOE. In the current market environment in China, where so many PE minority investments are stranded with no means to exit, there has probably never been a better time to do buyout transactions, particularly of mature and successful industrial companies with scale, good profit margins and clean accounting. Good businesses like this are few. We are now working for two of them.

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China Needs Shale Gas as Much, If Not More, Than US

Leave a Comment / May 25, 2011

Shale gas is the most important major new source of energy on the planet, as well as the most important development in the petroleum economy since deep water drilling. Shale gas is reshaping the world’s energy market in a way that even a decade ago seemed unthinkable. This is especially true in the US, where most of the shale gas development is now taking place. Ten years ago, shale gas was just 1% of American natural-gas supplies. Today, it is about 25% and could rise to 50% within two decades. Estimates are that US has more than a 100-year supply of natural gas, thanks to the development of shale gas. Natural gas is used for everything from home heating and cooking to electric generation, industrial processes and petrochemical feedstocks.

Shale gas was first discovered over a century ago. But, it’s only become a commercially-viable source of natural gas with the invention, over the last twenty years, of new drilling technology to break layers of rock and release the gas trapped within. The technology is known as hydraulic fracturing (now widely known as “fracking” or “fracing”). The companies that have played the leading role in developing this technology are mainly all American. They are already making billions of dollars using their techniques to drill deep under the surface across the continental US and harvest the gas trapped there.  The US, which just a few years ago looked to be running out of natural gas, now may someday begin exporting, thanks to its large deposits of shale gas.

The US has long been the world’s largest user and importer of energy. Last year, it was announced that China has overtaken the US in overall energy consumption. Its energy imports are on track to overtake America’s. Although natural gas use is increasing in China, it only comprised 4 percent of the country’s total energy consumption in 2008.

Beneath China’s surface also lies shale gas, most likely quite a lot of it. According to information released by the US Energy Information Administration (EIA) in April, China has 1,275 tcf of technically recoverable shale gas resources, nearly 50% more than the US.  Those estimated recoverable reserves are more than one thousand times the amount of natural gas used in China in 2010.

For China in decades to come, as much as for America, shale gas could be the energy “game-changer”, increasing energy self-reliance and helping to shift the country away from its heavy reliance on coal for electricity generation. Domestic shale gas, if fully exploited, would have enormous impacts not only in China, but worldwide. It could moderate China’s skyrocketing demand for petroleum, one of the primary drivers of higher oil prices. It would mean less coal gets mined and burned, which would have widespread environmental benefits and also ease the strain on the nation’s transportation infrastructure, a large part of which is now devoted to moving coal from where its mined to where its burned for electricity.

China already has more cars and busses running on natural gas than the US. Quite a few cities, including some large ones like Chongqing and Urumqi in Xinjiang, have many of their taxis running on natural gas. There is already a large infrastructure of “natural gas stations” across China. In other words, China stands to benefit, proportionately, even more from the US from a large supply of cheap, domestic natural gas.

The key question is: will China be able to tap its shale gas efficiently? In fact, it may be one of the most important questions in world energy markets over the next five to ten years. The technology is new, complex and almost entirely American. The owners may not be interested to share it with Chinese companies. For one thing, most of the companies with core technology and experience in tapping shale gas are themselves producers, not just suppliers of drilling equipment. Under current rules, they might not find China a very attractive market, especially when the US has so much untapped natural gas, as does neighboring Canada.

China’s leaders clearly understand the importance of shale gas to its economy and the importance of US shale gas technology. China’s goal is to produce 30 billion cubic meters a year from shale, equivalent to almost half the country’s gas consumption in 2008.  In November 2009, US President Barack Obama agreed to share US gas-shale technology with China, and to promote US investment in Chinese shale-gas development.

That sounds more significant than it probably is. President Obama cannot do much to help China, since the US government has little shale gas technology of its own, nor can he provide any real economic incentive for US companies to share technology with China. If there is a good market reason for US companies to drill for shale gas in China, they will surely do it. That is not the case now, as far as I can tell. Energy production and pricing are both heavily controlled by the Chinese government. A US shale gas producer would probably not be able to fully-own a shale gas field in China, nor sell its output at world market prices.  So, my guess is the owners of the best shale gas technology will not likely share it with China.

PetroChina and China National Offshore Oil Corporation (CNOOC) bought stakes in North American shale drillers like Chesapeake Energy and EnCana with the intent of acquiring technology and ramping up production at home. But, it is not certain, to say the least, that this strategy will pay off — becoming a small shareholder is not the same as buying a right to that company’s technology and expertise.

That leaves China with two choices, neither of which is appetizing: first, rely on domestic technology; second, try to obtain US technology by other than legal means. It could take domestic producers a long time to master the technology, and even then, it may not be equal to the best of what the US now has. With the second route, the problem is that it’s not enough just to get hold of drilling equipment. Exploiting shale gas reserves requires a mix of special equipment and know-how, which is far harder to obtain. A lot of the most successful shale gas fields in the US, for example, use horizontal drilling, a method pioneered in US, that allows operators to “ drill down to a certain depth and then to drill at an angle or even sideways. This exposes more of the reservoir, permitting the recovery of a much greater amount of gas,” according to the noted energy researcher Daniel Yergin.

China needs its shale gas, now. It is of vital importance to China, as well as the rest of the developed world. Everyone is hurt if Chinese demand for petroleum continues to push prices higher and higher, especially when there is an attractive alternative, that China shifts more of its energy consumption to natural gas, produced at home.

It’s a troubling sign that China’s Ministry of Land and Resources continues to delay distribution of the country’s first official shale gas blocks. Its first announcements indicated that only Chinese state-owned energy companies could bid on rights to these shale gas deposits.

My preference would be for China’s government to make it as financially rewarding to exploit shale gas there as it is in the US. It can do this with a mix of tax incentives and various rebates available, for example, to US companies that develop shale gas fields in China. The US oil industry doesn’t bother much with politics. They go where there is money to be made.

China will likely spend over $180 billion this year on oil imports, enriching foreigners in places like Iran, Russia and Venezuela. Based on that uncomfortable fact, and that using more natural gas will cut the environmental damage caused by burning so much coal, the rational policy choice is to do about whatever it takes to get US shale gas producers to come to China and start drilling, fraccing and pumping.

My advice: let it be done, and let it be done soon.


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