China National Offshore Oil Corporation's (NYSE:CEO) acquisition of Nexen (NXY) has had a number of positive developments as of late, substantially increasing the probability of the deal being approved.
Firstly, and most importantly, CEO agreed to have 50% Canadian representation on its board and in management if the deal were to be approved. This is in the midst of Canada and China finalizing a Foreign Investment Promotion and Protection Agreement (FIPA), which puts binding obligations on both countries as to how they treat investors from each other's country.
As was pointed out by Michael Den Tandt in the Vancouver Sun (my local paper), this concession by CEO was noteworthy:
Article 7 of the Canada-China FIPA says that "a contracting party may not require that an enterprise of that Party . . . appoint individuals of any particular nationality to senior management positions." The agreement allows that a majority of a board of directors be "of a particular nationality or resident of the territory of the Contracting Party," but only if that does not "materially impair the ability of the investor to exercise control over its investment."
For CNOOC to accept a 50-50 board and executive-suite split, therefore, would denote appreciable flexibility in the interpretation of the FIPA, to Canada's benefit - perhaps driven by knowledge on both sides that the deal has become a hot potato.
Secondly, the presumed future leader of the Liberal Party Justin Trudeau, a once dominate political party in Canada which slipped to 3rd place in the last national election, wrote an OpEd in favor of the deal titled "CNOOC-Nexen deal is good for Canada," which was printed in newspapers across Canada on November 19th.
Given the nationalist inclinations of politicians, especially when it comes to the Chinese (which many forget still only enjoy a fraction of our living standard on a per capita basis), this was an impressive move by the young Trudeau. He demonstrated sound logic in his article including rightly noting that:
We deceive ourselves by thinking that trade with Asia can be squeezed into the 20th-century mould. China, for one, sets its own rules and will continue to do so because it can. China has a game plan. There is nothing inherently sinister about that.
In addition, Trudeau has the intellectual capacity to realize what is important, rising living standards, a phrase I didn't hear in any of the US Presidential debates:
Why is the CNOOC-Nexen deal good for Canada? Because Chinese and other foreign investors will create middle-class Canadian jobs. Foreign investment raises productivity, and hence the living standards of Canadian families.
Trudeau happens to be the son of one of our legendary Prime Ministers, Pierre Trudeau. With this OpEd, he is demonstrating the intellectual capacity, vision and political guts to fill those shoes.
In the polls, the Liberals are making strong gains with the buzz around Justin Trudeau, although still in third place.
- Conservatives (34%)
- NDP (30%)
- Liberals (26%)
Thirdly, as per Seeking Alpha's Market Currents, several hedge funds are wagering Canada will approve the takeover bid. John Paulson is especially notable of this bunch, as mergers and acquisitions was his specialization at Bear Sterns and how he built his fund prior to the subprime mortgage trade:
Several hedge funds, including the one run by John Paulson, and mutual fund firm Franklin Resources (NYSE:BEN) are among foreign investors betting Canada will approve Cnooc's takeover bid from Nexen after all bought shares in NXY during Q3. The growing consensus: ''The Canadian government wants to be seen as open to deals and business. It is not in their interest to say no.''
The Options Market's Response
Since I first wrote about the NXY merger, the March expiry call options with a strike of 24 I recommended buying have gone from $2.50 to $2.75, a 10% gain.
Concurrently, the probability that the deal will go through implied by the option prices has risen from 60% to 74%. The first probability analysis graph is from my last article, the second from today. Look at the matrix in the bottom left corner of each graph to see the change in the implied probability of the options touching $27.50 (the takeover price):
With the call options trading at $2.75, there is still plenty of upside if you were to purchase options at this price. Below are the updated calculations from my last article:
For these options to turn a profit, they have to be above the strike price plus the cost:
Strike = 24
Cost = 2.75
Breakeven price = 26.75
For simplicity's sake, I'll use the hypothetical situation of 1 contract to demonstrate the profit potential of the trade.
If the merger goes through at $27.50, the holder of 1 contract will receive 100 shares at $26.75, selling those 100 shares at $27.50:
Value of options bought = $2,675
Value of options sold = $2,750
Profit per contract = $75.
Cost per contract = $2.75 * 100 (each option contract is made up of 100 shares) = $275
Rate of return = 75/275 = 27% per contract
This is down from 40% per contract when I first published the recommendation, but is still a fantastic opportunity. I'm sticking with the March expiry, as the deal may be delayed further, but if it does go through, I believe it will be prior to March.
If you wanted to be more aggressive, you could purchase the December expiry options, as the Conservative Government plans to make an announcement December 10th, although this was delayed from November 10th last month. They are selling for $2.45, returning above 40% on deal approval.
The Bottom Line
There is a chance this deal will be rejected, but with recent developments, it is difficult to imagine how doing so could be rationally defended. The Conservative Government would have to make the case that the 1985 Investment Canada Act conditions weren't met. This would include making the arguments that:
- At least a 50% Canadian management team wasn't a high enough degree of participation by Canadians in the business in question.
- At least a 50% Canadian board wasn't a high enough degree of participation by Canadians in the business in question.
- At least 5 years of the same staffing level wasn't a high enough degree of participation by Canadians in the business in question.
- A 3% ownership of the Canadian Oil Sands was detrimental to competition.
- Rejecting this deal would positively contribute to Canada's ability to compete globally by hurting trade relations with the second largest economy in the world.
- A company with 70% of its current production outside of Canada was vital to Canada's national interests.
On top of all this, they'd be to the left of the Liberal Party economically.
Everything in life is a matter of probabilities, but with the established facts and recent developments in the NXY acquisition, the probability of this deal being rejected is exceedingly small. With the Conservative Government planning to announce its ruling December 10th, I continue to recommend buying the March expiry call options with a strike of 24 to participate in the 27% gain if this transaction is approved.
Additional disclosure: I continue to be long NXY call options with a strike of 24 and a March expiry.