Foot off the gas

“And he reached his hand into the pouch and took from there a stone and slung it and struck the Philistine in his forehead.”

That’s the rather succinct biblical description of how the shepherd David toppled the man-mountain Goliath. For the Chinese equivalent of an underdog triumphing against an apparently more powerful adversary, flaming ships (not slingshots) were the weapon of choice. These were unleashed by Sun Quan and Liu Bei to destroy the numerically superior forces of warlord Cao Cao almost two millennia ago.

Both stories lead to the conclusion that size does not always lead to victory, which might also be a topic for discussion at Sinopec this month, after the failure of its bid for China Gas Holdings, an operator of gas pipelines in 160 Chinese cities. The oil major had partnered with gas distributor ENN Energy Holdings for a $2.2 billion takeover offer. But after failing to convince China Gas shareholders of the merits of the deal for almost a year, the bidders pulled out earlier this month.

The M&A attempt has generated widespread media interest, in part because Sinopec’s move is seen as the first hostile takeover in Chinese corporate history, albeit for a target listed on the Hong Kong stock exchange.

But the deal’s failure is also being presented as evidence that the largest state-owned firms don’t always win through in the battle of wills with smaller, private sector targets. And there’s a final caveat to the story: that Sinopec’s setback will be welcomed by some Chinese policymakers, who are increasingly concerned by how state monoliths are dominating so many sectors of the domestic economy.

First, the gas industry backdrop…

A key reason for the takeover attempt: prospects for growth in China’s natural gas sector look promising. Last year, natural gas counted for about a quarter of the energy mix in developed countries like the United States but it makes up only 5% of China’s power portfolio. Correspondingly, the current five year plan (the 12th) is already targeting a doubling of the gas contribution from 4% in 2010 to 8% by 2015.

Currently, most gas usage is industrial, although a substantial share is also used in homes for cooking and heating. Meanwhile for cities choking with air pollution, natural gas is an enticing alternative to coal-fired power stations – after all, gas-generated power produces almost no sulphur dioxide emissions and about half as much carbon dioxide as coal. Also an advantage: it uses only 40% of the water needed by coal-fired plants and is a cheaper source of fuel, costing about half.

Beijing looks set to be the first Chinese city to consign coal-generated power to the history books, according to China Energy News, with its four remaining coal-burning plants due to switch over to natural gas by the winter of 2014. This transition started with the completion of the first phase of the Shaanxi-Beijing gas pipeline – China’s capital has built no new coal-fired power plants since 1998.

There are also plans to get more of the vehicles on Chinese roads running on natural gas, which seems like a good fit for Sinopec and its pre-existing petrol station network (see WiC58). Research out this month from HSBC estimates that about a million vehicles run on natural gas at the moment, mostly trucks and taxis. But there is a shortage of refuelling stations across the country, with 80% of outlets concentrated in Xinjiang, where gas supply is abundant but very few vehicles are capable of fuelling up with it.

But the new opportunity has hastened a battle for control…

All three oil majors are readying themselves for further growth in gas demand. Currently, PetroChina dominates domestic gas production, controls a greater share of the national pipelines and has a strong foothold in provincial and city-based distribution networks through its subsidiary Kunlun Energy. Sinopec also trails the third of the oil troika, CNOOC, in terms of contract volumes signed with the major suppliers of natural gas from overseas. So the risk is that it will be relegated to the margins of the gas market by its rivals. An embedded presence at various points in the supply chain – securing gas supply, delivering it into the Chinese provinces, and then distributing it via metropolitan pipelines in the cities – is seen as a way of preventing this. As such, a play for a company like China Gas, which delivers gas to 7 million residential users and 40,000 industrial and commercial customers, makes strategic sense. Back in March, analysts were suggesting that up to 80% of the gas pumped into homes by China Gas was being sourced from PetroChina, so completing the deal would have put Sinopec in a better position to become the main supplier.

Yet regulators weren’t keen on the bid?

That was one interpretation, with regulatory reasons being given as an explanation for the withdrawal of the offer.

The details here have not been made fully public, although it has been suggested that the takeover may have struggled to pass the central government’s anti-monopoly check. Then again, the distribution business at city level looks fairly fragmented, so another conclusion being drawn is that the political opposition to the deal may have been less specific in scope, and based more on blocking Sinopec from establishing a wider presence in the supply chain.

Why the reluctance to see Sinopec gobbling up a much smaller operator? One theory is that the proposed acquisition ran counter to talk from the State Council this year on how more competition needs to be introduced to reduce the sway of the state giants. The banks have come in for particular criticism, including sharp words from Wen Jiabao (see WiC163). But China’s outgoing premier also indicated that the policy is wider in its aims, warning that the central government would “promote the non-state economy, break monopolies and lower industry thresholds for new entrants” in other industries too, including the railway and power sectors. “A new atmosphere of ‘smashing the glass door’ must be created for the private sector firms,” Wen insisted during a tour of Sichuan province in July.

Of course, that advice doesn’t go down well with bosses at these leading state behemoths, many of which are still keen to bolster their positions, either through vertical integration (in the way that Sinopec seems to have intended with China Gas) or by bulking up in scale.

Recently, WiC has written about similar ambitions from Shenhua in the coal sector (WiC167), although the company we’ve featured most frequently for its expansive instincts is State Grid, the operator of China’s electricity transmission network (see issues 54 and 108 for two examples).

This trend has been termed guojinmintui (it translates as ‘the state advances as the private sector retreats’). It’s something we first discussed in WiC30. In short it has seen large SOEs use their access to cheap bank funding to muscle out or buy firms built by entrepreneurs. Always latent, it accelerated after the launch of the stimulus package in 2008, when SOEs were the main beneficiaries of lucrative infrastructure contracts. In more recent times there has been a backlash against guojinmintui. The country’s more market-oriented reformers are concerned it stifles competition as well as innovation (there is also a fear that the major SOEs have become illicit tools for politically-connected princeling families to enrich themselves and create powerbases.)

So another possibility behind the breakdown of Sinopec’s takeover this month is that it became too high profile. If successful, it would have been taken as further evidence of the state giants pushing back on the new policy winds, and gorging on private sector prey in disregard of Beijing’s directives. Realising this, and not wanting to queer its pitch for potentially more important M&A in other areas, Sinopec thus reluctantly bailed out of the bid.

Or was it more a case of the bidders botching their offer?

That’s the view of those who say that too much is being read into the politics of the takeover’s collapse, which they blame more on poor execution from the bidders.

Firstly, the initial price offered is widely seen as being too low, at HK$3.50 per share. This looked like an opportunistic move, triggered by the share price slump that followed the detention of China Gas founder Liu Minghui on allegations of embezzlement.

China Gas argued throughout the period that – although the Sinopec offer was 25% above the company’s share price at the time of the bid – it provided no premium to the stock’s average price over previous years.

Nor was the mood improved by the participation of ENN, a smaller distribution rival, allied with Sinopec. “ENN controlling China Gas is not acceptable because it can be understood as a small fish eating a large one,” China Gas executives told reporters, testily.

With their sense of the natural order so rudely disturbed, China Gas executives responded by refusing to even meet with the bidders to discuss the offer. This reduced the potential buyers to appealing to China Gas employees over their management’s head, promising in an open letter that they had nothing to fear.

In the meantime, outsiders stepped in to profit from the impasse. Those buying the stock included Liu (the former boss, then under house arrest), South Korea’s SK Holdings, London-listed Fortune Oil and Beijing Enterprises Group. This helped push shares in China Gas well past HK$4, far beyond the initial Sinopec offer.

Little of this seems to have been foreseen by Sinopec or its fellow bidder, which made no attempt at a friendly takeover or to increase their stakes by buying in the open market.

“The reaction from the China Gas board was not anticipated by us,” Wang Dongzhi, an executive director at ENN, admitted to Reuters. “Given the difficulty of obtaining the trade ministry’s approval and the challenge of integrating China Gas’ portfolios in a hostile deal, we chose to withdraw the offer.”

Until that point there was confusion, with the deadline for the offer extended several times. Both bidders were also rebuked by Hong Kong’s Takeovers and Mergers Panel in April for providing “ambiguous” commentary on whether the offer would be increased. But it never was. Instead, the bidders carried on regardless, acting almost as if the takeover was destined for success. ENN shareholders were also asked to approve the deal (at HK$3.50 a share), which they duly did.

It all made for a strangely disjointed approach, 21CN Business Herald has noted. Yes, the deal had the promise of China’s first hostile takeover but it was conducted in a manner lacking in the “put up or shut up” mentality of some of the bruising battles seen on Wall Street. Instead, this was an odd, non-confrontational affair in which attempts at direct resolution seem to have been postponed repeatedly during the period in which the offer was in play.

By August, the chances of success looked even more remote. Company founder Liu – whose departure had prompted the original slump in share price – had even reappeared on the scene, after his reinstatement at the firm. The facts related to Liu’s dismissal “were unclear, evidence was insufficient and the conditions for prosecution have not been met,” China Gas said in a statement to the stock exchange.

So it’s not just a case of David trouncing Goliath?

Three other factors cloud the picture of a symbolic victory for an underdog against a larger rival.

Firstly the ‘white knight’ involvement of Beijing Enterprises Group – a natural gas distributor in China’s capital, and also a state-controlled firm – makes it much harder to frame the confrontation merely as private sector versus state monolith (see WiC149). In this instance, David may have won through but he received some sling-and-arrow assistance from another Goliath, albeit a slightly less muscular operator than Sinopec.

Then there is the nature of the gas business itself, where the supply chains require huge sums of investment, with business models often relying on economies of scale to reach profitability. This means that larger firms are often better suited to delivering returns – and for larger firms in the Chinese context, read state-owned companies.

Policymakers will know this too, so there must also be limits to the sense of enthusiasm felt for smaller, private sector participants.

Nor is there much sign of a more fundamental change of direction on public ownership or a wider push to privatise the leading SOEs. As Reuters suggested last week, at most the objective is to split some of the largest state-owned firms into smaller units, as well as attract more private investment.

Despite this, the state’s dominance in industries like banking, resources and power is unlikely to waver and Reuters also reported on commentary from Qiushi magazine, the Party’s leading journal, arguing strongly in favour of the state monopolies as fulfilling an important economic role.

“Don’t fantasise that privatisation can resolve all the problems existing in industry monopolies,” the article urged, warning that attacks on the SOEs had roots in a Western conspiracy to undermine China’s economy and the competitive position of its companies overseas.

What happened once the bid was dropped?

Rather than a takeover, the deadlock ended with a tie-up – a new joint venture between China Gas and Sinopec. The plans now envisage China Gas sales channels distributing gas produced at Sinopec’s refineries; joint tendering for new pipeline concessions at city and provincial level; and a pairing up of China Gas’ city networks with some of Sinopec’s 30,000 petrol stations to provide natural gas fuel for vehicles.

Sinopec says that it will also “in principle” consider China Gas as a co-investor in inter-provincial pipelines in future.

So on the face of it, it seems like quite a rapprochement between the warring parties. Analysts are also impressed that China Gas seems to have come through its ordeal and now aligned with a powerful new partner. But the final outcome will probably be seen as acceptable by Sinopec’s chairman Fu Chengyu too. “Chairman Fu has ended up in a reasonable position,” briefed one insider to the Shanghai Daily. “He wanted access to downstream, and he has got it. He hasn’t lost face, he has ended up as a friend of China Gas.” For the moment, at least, hostile intent seems to have been forgotten.

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