The Canadian Conservative Government has taken a tough line on Foreign Direct Investment (FDI), especially from the Asian region. This is odd given that they have aggressively pursued free trade agreements, which increase FDI, signing free trade deals with nine countries including Panama, Jordan, Colombia, Peru, Iceland, Liechtenstein, Norway, Switzerland and Honduras. This is compared to 3 free trade agreements under the previous liberal government and 3 free trade deals completed by President Obama (although all 3 began under the Bush administration in 2007). In fact, Canada has blocked only three foreign takeovers in 27 years.
With China, there have been major steps forward in trade relations. This includes Canada being appointed as an Approved Destination Status, increasing Chinese tourism to Canada by 22.9% this year, and the recent Foreign-investment Protection Agreement (FIPA), which establishes legal recourse if a company's assets are expropriated without compensation in either country. Because of these initiatives and others, China has emerged as Canada's second largest trading partner, passing Britain and Japan and accounting for 6% of Canada's total world trade.
This is a government that understands the benefits of free trade, which is to be expected as Prime Minister Harper has a Masters Degree in Economics from the University of Calgary. The question is why is there such hostility to FDI as of late?
The 1985 Investment Canada Act
Foreign Investment in Canada is subject to what is known as the Net Benefit Test. This test came into place with the 1985 Investment Canada Act, which deemed foreign investments reviewable by the Federal Government if they met certain conditions. The condition that the China National Offshore Oil Corporation (CEO) and Nexen (NXY) merger meet was:
"non-cultural Canadian business that has assets over $1 billion and is being taken over by a World Trade Organization member country"
Under the Investment Canada Act, there are 6 factors to consider when determine whether the FDI would result in a net benefit to Canada:
- The effect of the investment on economic activity in Canada;
- The degree of participation by Canadians in the business in question;
- The effect of the investment on productivity, efficiency, technological development, product innovation and product variety in Canada;
- The effect of the investment on competition;
- The compatibility of the investment with national industrial, economic and cultural policies; and
- The contribution to Canada's ability to compete globally.
Historically Canada has been a friendly place for FDI. Since the 1985 enactment of the Investment Canada Act, there has been billions in acquisitions:
The Nexen Takeover
CNOOC made a bid of $27.50 for NXY on July 23rd of this year, a 61% premium to the closing price that day. Since the Petronas takeover of Progress Energy was disapproved (although Petronas has since renewed its bid), the price of NXY has slipped to $23.40.
This is when I take notice of the deal, and decided to investigate whether the probability implied in the stock price of NXY reflected the probability of the deal being approved. If there is a discrepancy, there is an opportunity to achieve an abnormal rate of return.
Using the 6 guidelines provided by the Investment Canada Act, one can assess the likelihood of the Nexen deal receiving approval:
1. What is the effect of the investment on economic activity in Canada?
This is a particularly interesting question, as there are internal and external effects to consider. The scenario is textbook game theory, with the approval or rejection of this acquisition sending a signal to the rest of the world. If the signal chosen is to reject the deal on net benefit grounds, it is likely the next move for China would be to retaliate against Canadian companies.
With these external effects in mind, the Canadian Government is using the NXY deal as a bargaining chip. Canada's banks and insurance companies are seeking to build businesses in China. According to a recent Bloomberg article, they are facing headwinds from Chinese Government policy. For instance, insurance companies have to apply for a permit for every single location they open, making expansion difficult and putting them at a disadvantage to their Chinese competition.
Although Jim Flaherty has stated he's not aware of talks with China with regards to a trade off in regulation, Prime Minister Harper is on record as saying:
Canada has had a situation with the People's Republic of China for some years where their investment has been virtually unrestricted here and we have had more difficulty with our investment there.
China's leaders are smart enough to read between the lines.
With the rejection of the BHP deal in 2010 and the Petronas deal in 2012, Canada is at risk of being perceived as a protectionist country. There has been a tremendous amount of rhetoric from Ottawa denying this assertion, and there is pressure to back this talk up with action.
2. To what degree to Canadian participate in the business in question?
This is a differentiating factor of the NXY acquisition. CEO has made a number of concessions to the Canadian Government to ensure this deal goes through:
- Guaranteeing Canadian Jobs.
- Boosting capital spending creating more Canadian jobs.
- Designating Calgary as its North American headquarters.
- Listing 35% of its post-merger shares on New York and Toronto Stock Exchanges, whose listing requirements will ensure transparency at CEO.
With these guarantees in place, there will be a high degree of Canadian participation in the business in question.
3. What will the effect be on investment in productivity, efficiency, technological development, product innovation and product variety in Canada?
As per the points above, CEO has agreed to make investments in Canada. In terms of productivity, Canada requires $220 billion in infrastructure investment to develop just proposed projects utilizing the countries resources. With FDI required to meet this number, and CEO committed to making investments in capital in Canada, the Nexen deal will have a positive effect on productivity in Canada.
4. What is the effect of the investment on competition?
Approximately 70% of NXY's current production is outside of Canada. The actual Canadian production average for Nexen is 60,000 barrels of oil per day, which doesn't even rank it among the 20 largest producers in Canada. There is no detrimental effect on competition due to this acquisition.
Below is a table of NXY's production by region from their Q2 report:
5. What is the compatibility of the investment with national industrial, economic and cultural policies?
With Nexen accounting for just 3% of current oil sands production, and in terms of reserves, only 1% of Canada's total, in the scheme of national industrial and economic policies Nexen is a non-starter.
There is a cultural component to consider, as a recent poll found that 64% of Albertans are opposed to Chinese ownership of assets. This is surprising as Alberta is Canada's Texas; the conservative party wins every election, it's full of cute blond girls in cowboy hats, they drive big trucks and there is a 0% provincial tax rate. Like their Texan brethren, Albertans are fans of capitalism.
Prime Minister Harper is from Alberta, therefore perhaps his posturing is to placate one of his strongest political bases in the country. In any event, I see it as just that, posturing, and not an issue that will lose him any support in Calgary. I'd be nonsensical, as CEO already owns a piece of the oil sands.
6. What will be the contribution to Canada's ability to compete globally?
As per point 1, the lines have been drawn on this deal. If the Canadian government rejects another friendly acquisition, there will likely be retaliation on Canadian companies operating in China. Rejecting this deal will hurt Canada's ability to compete globally, as well as upset trade relations between itself and its second largest trading partner.
After examining this deal through the lens of the 1985 Investment Canada Act, it is highly probable that this deal will receive federal government approval. Earlier this week, I was at a presentation by Patrick Meneley, the Head of Global Investment Banking at TD Securities, who foresaw this deal being completed as well. TD Securities provides advisory services to the government of Canada; therefore they know the players involved and have a unique perspective. The fact is Canada requires FDI to fully develop its natural resources. Leaders of government and industry recognize this.
With the investment thesis developed, how best to express this view in the marketplace?
Using Options to Profit From the Takeover
The review by the federal government is a binary event. With NXY trading at $17.00 prior to the $27.50 buyout offer, there is a large downside if the deal isn't approved. If you were to buy equity, a stop loss wouldn't be effective in containing your downside risk, as if NXY's stock price dropped to $17.00, your order wouldn't be filled. This is also known as slippage.
Therefore, options are the best way to participate in the upside in the completion of this deal while fully quantifying your risk. If you want to enhance your returns, options also provide a means of utilizing leverage.
During a buyout, options on that security are adjusted to require the delivery upon exercise of a fixed amount of cash, with trading of the options ceasing when the merger becomes effective. Said another way, option values are re-priced once a merger is announced, and once completed, options in the money are paid out and options out of the money expire worthless. NXY's option grid is below:
Options with a strike of $28.00 are almost worthless, as that price is above the bid of $27.50. The only way the 28 strikes would be worth anything is if a bidding war were to ensue, raising the buyout price. There aren't a lot of buyers in the $15 billion price range, making this an improbable scenario.
The option market is anticipating completion of this acquisition. As of today, the ratio of calls to puts was 6,994/1,256 out of the 8,250 contracts traded. Of the total open interest, the calls to puts ratio was 229,339/98,862 out of 328,201 open contracts.
Different call option contracts with expiries in November, December and March are below:
I've elected to go with a call option at a strike of 24 expiring in March (NXY 3/13 C24). The reason for the March expiry is that just today Reuters reported that the government review of the acquisition will unlikely be done by next week's deadline. With the bureaucratic machine that government is, this could happen a number of times.
A March expiry allows you to stay in the game if the deal is initially rejected, which would cause the price of the stock to drop, at which point CNOOC could renew its bid with more concessions for the Canadian Government, putting us back at square 1. This could all happen prior to March, so it is well worth the extra $0.50 of premium.
In addition, this option has the largest open interest, and therefore is the most liquid, enabling an early exit of the position if so desired.
The NXY 3/13 C24 is trading at $2.50, and in the interest of full disclosure, I purchased options at that strike and price about 30min before writing this, therefore that may be my trade on the books.
The Profit Potential
For these options to turn a profit, they have to be above the strike price plus the cost:
Strike = 24
Cost = 2.50
Breakeven price = 26.50
For simplicities 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 $26.50, selling those 100 shares at $27.50:
Value of options bought = $2,650
Value of options sold = $2,750
Profit per contract = $100.
Cost per contract = $2.50 * 100 (each option contract is made up of 100 shares) = $250
Rate of return = 100/250 = 40% per contract
Risk Management and Conclusion
Everything in life is a matter of probabilities. Although I'm confident the acquisition will be approved by the Canadian Federal Government, it is entirely possible that it won't. According to option prices, there is a 60% chance that this deal will go through by March. Below is the probability analysis chart:
Conversely, there is a 32% chance that the NXY acquisition will be rejected and NXY will trade below $17.00 by March. The question is what you believe the risk of the Canadian Government rejecting this deal is, and is a 40% return enough to compensate you for taking on this risk?
If you were to buy equity today at $24, you'd receive a profit of $3.50 per share or a 14.6% return if the acquisition was successful. If the acquisition were to be rejected, you'd likely have a sell order filled at $17, a loss of 30%, and potentially lower, with the 52 week low at $13.63, a loss of 43%.
If you were considering speculating on this deal with equity, I'd suggest going with options instead, buying enough options that would equate to the same return you were targeting with your equity purchase. This ties up less capital, which could be put to other uses generating a larger return for your portfolio, and fully quantifies your risk, as the most you can lose is the option premium of $250 per contract.
Of course, every portfolio is different and you should consult with an investment professional familiar with your financial goals before enacting this trade.
In 27 years, there has been 3 rejected mergers in Canada. Leaders of industry and government want to develop Canada's natural resources, which requires FDI. At this juncture, it would be foolish for the Canadian Government to reject this acquisition and undermine the work they have done to promote free trade. Our Prime Minister, with a Masters in Economics and roots in capitalist Alberta, knows this.
Additional disclosure: I am long NXY call options with a strike of 24 and a March expiry.