Wall Street Singes the Dragon PetroChina's Failed IPO

By Braden Penhoet

When the government of China put shares in its China National Petroleum Company (CNPC) for sale on the New York and Hong Kong stock exchanges, it hoped to lead a new wave of successful offerings by its state-owned companies on international stock markets. The government's optimism was shared by U.S.-based investment houses, consulting firms, accountants and lawyers prepping the offerings. But the troubled April 6 initial public offering (IPO) of CNPC's subsidiary PetroChina, Ltd. became a lesson in how uncertain the prospects are for easy access to western capital markets for China's core industries.

China is seeking western capital and western business advice to remake its state-owned companies into viable competitors when protective trade barriers fall under the country's hoped-for entry into the World Trade Organization. The stakes are high not only for China but for the dealmakers who hope to profit from bringing China's companies into western capital markets.

Early hopes were that the PetroChina IPO would raise $10 billion on the New York and Hong Kong stock exchanges. When PetroChina ultimately "went out," only $2.89 billion came back. A small number of Hong Kong investment companies accounted for over $1 billion of that total. A late commitment by BP Amoco PLC to make a strategic investment in PetroChina accounted for $576 million -- a purchase that could have taken place as a private corporate transaction without recourse to the New York Stock Exchange, but which was made through the IPO in order to secure other joint venture commitments. Lead underwriter Goldman Sachs set the IPO price at the low end of the projected range, and was widely believed to have intervened in early trading to prop up the price.

In addition to skepticism about PetroChina's competitiveness and the lack of meaningful shareholder leverage on management decisions, the IPO met considerable resistance from a coalition of labor, human rights and environmental groups, some of whom were already geared up to challenge the terms of the pending deal to grant China permanent normal trade relations (PNTR) with the United States and Chinese accession to the WTO. The activists pointed to CNPC's planned activities in Tibet and its 40 percent stake in the Khartoum-based Greater Nile oil developments, which has helped fuel the Sudan government's brutal civil war against Christian minorities, to build a broad coalition opposing the IPO.

Bracing for the Future

The PetroChina IPO was a watershed event in a multi-year effort by the People's Republic of China to streamline its oil and gas industries. The late 1990s saw significant efforts, funded initially with World Bank loans, to consolidate and reorganize China's major fossil fuel businesses.

The pressures to streamline China's energy operations come from two sources. First, China has increased its imports of oil and gas in recent years to meet the demands of an increasingly energy-hungry economy. Second, if China's bid to join the WTO is successful, it will bring dramatic short- to medium-term reductions in protective tariffs, import quotas and outright bans that have to date shielded state-owned industries from international competition. The immediacy of this second pressure is now apparent: On November 15, 1999, the US and China signed a trade agreement addressing China's entry into the WTO and the granting of PNTR. The U.S. Congress is planning an up or down vote on PNTR in late May.

The U.S. Financial Players

Major U.S. investment banks have been jockeying for position to become preferred partners in restructuring and privatizing China's state-owned industries. Goldman Sachs in particular has made China a priority, focusing on the largest companies and biggest deals, including PetroChina and China Telecom. But Beijing is spreading the work around.

Merrill Lynch was to have been the lead on an IPO last fall of the China National Offshore Oil Company (CNOOC). But a bad week on the stock market, concerns about the use of proceeds to provide retirement benefits to downsized workers and low interest in oil stocks killed the deal. Morgan Stanley Dean Witter holds the lead position for a tabled IPO of Sinopec, the dominant oil and gas player in southern and eastern China.

Together with other major banks such as Credit Suisse First Boston, the underwriters tow along secondary underwriters, consultants, accountants and law firms. Participants in the PetroChina restructuring and IPO included Goldman Sachs, PriceWaterhouseCoopers, consultants at McKinsey & Co., and lawyers from Shearman & Sterling and Sullivan & Cromwell.

These firms helped CNPC reorganize so that its most attractive, productive and potentially profitable assets were held separately by the IPO subsidiary PetroChina. The goal was to carve out a potential winner from the oversized and inefficient state-owned company. As part of the paring down, PetroChina took on roughly half a million of CNPC's more than 1.5 million employees. PetroChina incorporated the most attractive, productive and potentially profitable portions of the old state-owned behemoth, with businesses in oil refining, petrochemicals production, oil and natural gas production, sales, R&D and pipeline operations.

The Opposition

After the IPO, CNPC was set to remain PetroChina's dominant shareholder, with at least 85 percent of its outstanding shares, effectively controlling all board and management decisions. But analysts were not impressed that PetroChina carried $15 billion of CNPC's debt on its books, while activists were alarmed about the initial inclusion of Sudan-related assets in the PetroChina portfolio, potential impacts on China's environment from new drilling and pipeline construction, the role that new exploration and extraction activities might play in further subjugating Tibet, and the effects of massive layoffs on workers' living standards in a global economy.

Concerns about Sudan led to the withdrawal of a draft offering prospectus from the SEC, and the creation of an accounting firewall to convince wary investors, members of Congress and activists that IPO funds would be kept apart from CNPC's Sudan-related investments and activities.

Opponents were not satisfied, however.

More than two dozen Members of Congress signed letters opposing the PetroChina issuance, focusing on concerns that any IPO for PetroChina would further CNPC activities in the Sudan.

Opposition to the PetroChina IPO continued unabated up to the date of the issuance.

"There is only one country today that is experiencing a true religious genocide. That country is Sudan," says Nina Shea, director of the Center for Religious Freedom at Freedom House. "Until oil came online last August, Khartoum was a bankrupt, pariah state. Now Talisman [a Canada-based oil company] and China National Petroleum Company are oil pipeline partners with Khartoum and are providing it with the financial means and international prestige to finish off its genocidal campaign" against Christian minority and animist groups in Sudan's southern regions.

John Ackerly, president of the International Campaign for Tibet, opposes funding natural resources extraction in Tibet "because there are no benefits for Tibetans, and these activities are often accompanied by very damaging consequences for Tibetan communities both environmentally and politically. Tibetans feel that these [resources] are being stolen, and that their rights are ignored."

The AFL-CIO weighed in heavily on PetroChina, calling on pension fund managers to pass on the offering and holding an "alternative road show" in March at New York's St. Regis Hotel, the same day that Goldman Sachs scheduled a sales pitch to investors. The labor federation put out a detailed position paper on the offering, raising "governance, market, political and human rights risks," noting particularly CNPC plans to lay off a million workers and allegations of forced labor activities in Sudan and Tibet.

Environmentalists, including Friends of the Earth and the Center for International Environmental Law, expressed concerns about effective environmental regulation in China and low disclosure standards imposed by the SEC in connection with companies' environmental, labor and human rights activities.  Access by foreign issuers to U.S. capital markets is encouraged under a streamlined and less demanding disclosure regime than that applicable to domestic companies. The Securities Exchange Commission lets foreign company directors and parent companies off of several disclosure hooks relating to their "integrity" as managers and fiduciaries. In addition, foreign companies need only report on their activities annually, rather than quarterly as U.S. companies do.

Goldman Sachs spokesperson Kathleen Baum expressed frustration at the firm's inability to answer critics during SEC-imposed "quiet periods" aimed at avoiding over-hyping stock issuances. She defended the PetroChina IPO, saying that bringing Chinese state-owned companies to market "makes sense if we in the U.S. are serious about privatization, free markets and democratic rule."

Goldman Sachs CEO Henry M.Paulson, Jr. wrote in the op-ed pages of the New York Times that "the case for [PNTR] with China is the story of PetroChina repeated a hundredfold or a thousandfold," and that engaging China through access to capital markets, like goods markets, would improve business opportunities in the U.S. and help promote progressive change in China.

BP Amoco, which ended up with a crucial stake in PetroChina, offers a more nuanced view.

Questioned about China's human rights record, Michael Townshend, director of international affairs for BP Amoco, says that BP Amoco stands by the UN Declaration of Human Rights, and applies "social, ethical and environmental" standards -- published on the company's web site in Mandarin -- to its business relationship to PetroChina. However, he acknowledges that "there are limits to our influence."

Townshend also says that BP Amoco has been assured by PetroChina and CNPC that IPO proceeds from BP Amoco will not facilitate investments in Sudan, or even Tibet. U.S.-based accountants will prepare financial statements on the separations of funds, he says, and BP Amoco hopes to make these statements public. "Most of the time [we] feel we do better by engaging a country than by isolating it, but Sudan is an exception," Townshend says, indicating that the company hopes to distance itself from atrocities committed there.

Simon Billenness, senior analyst with the Boston investment firm Trillium Asset Management, targets responsible investment opportunities. He passed on the PetroChina offering on "both financial and social grounds," noting that "CNPC has enormous problems in Tibet and Sudan" as well as problems associated with limited shareholder rights in a Chinese company. Buying PetroChina stock, he said, "would expose you to all of the financial and moral risks without any control or influence."

Trillium does own stock in BP Amoco. Billenness and others met with BP Amoco representatives on April 11 to get "a handle on" environmental and social issues raised by  BP Amoco's PetroChina investment, Billenness says, noting that there may be opportunities to "explore to what extent BP Amoco can influence CNPC to do business in Tibet responsibly, including but not limited to meeting codes of conduct like those put together by the [Tibetan] government in exile" in Dharamsala.

Activists lobbying against the IPO materially contributed to its failure, says Roger W. Robinson, Jr., of the William J. Casey Institute of the Center for Security Policy and former economics advisor in the Reagan administration. "Efforts to attribute exclusive -- or even primary -- responsibility for this draconian decline in U.S. investor interest to traditional market considerations are misplaced," he says. The PetroChina experience signals the rise of "potent, new 'non-financial' concerns, notably those involving national security and human rights" as significant factors in international financing, he says.

Option 2: Strategic Partnerships

Beijing may be reconsidering its strategy of pursuing listings on capital markets. PetroChina was to be the largest yet, but not the last, Chinese state-owned company to seek western capital on stock exchanges. Now Beijing seems interested in creating strategic partnerships with foreign companies, as embodied in the BP Amoco-Petro China partnership. Such partnerships may prove especially attractive in the petroleum sector.

BP Amoco's big investment in the PetroChina IPO served to anchor the offering and kept it from capsizing entirely. Amoco's investment was part of a larger commitment to China, according to company officials. Other key investments include a joint venture (51 percent PetroChina, 49 percent BP Amoco) set up to develop domestic natural gas capacity and to explore importing gas from Russia, Indonesia and possibly Alaska, all to displace coal as a primary energy source for China, and another joint venture to increase BP Amoco retail sites, primarily in eastern China.

"We've been operating in China for some 25 years," says BP Amoco's Townshend. "Lots of this activity has been in retail sites -- about 45 gas stations, airport refueling in 17 airports, as well as liquid propane gas and a chemicals plant. These have been fairly discreet activities, and with the [recent PetroChina stock purchase and joint venture relationships] we're looking for a way to enhance" these investments.

Townshend says the two joint ventures will require an additional $1 billion from BP Amoco and $1 billion from PetroChina over the next two years.

Like Goldman Sachs, BP Amoco has plenty of competitors looking to establish significant positions in China. Shell, through it Shell Exploration China Ltd., signed up to participate in a $3 billion CNPC natural gas development program focusing on Shaanxi and Inner Mongolia. Enron Oil & Gas Co. has entered a long-term contract with the China National Offshore Oil Company for natural gas and crude oil development in the Sichuan Basin, and the Houston-based energy giant announced in March that it would invest in a $200 million CNPC-led natural gas pipeline project stretching from Sichuan Province to Wuhan. Chevron Corp. and Atlantic Richfield Corp. (ARCO) have agreements in place to help CNOOC extract gas from the South China Sea. ExxonMobil and Unocal are among the other oil and gas companies with significant interests in China.

China and dealmakers like Goldman Sachs have to decide whether PetroChina stock float fared so badly because Western investors prefer new economy communications offerings to old economy oil reserves, or because Chinese corporate practices -- relating both to internal governance and social responsibility questions -- are unpalatable. After putting SinoPec into a holding pattern, China may test the waters by offering up shares of new economy technology and communications companies like Sohu.com and Sino.com. The change in tack would test whether concerns about investing in China are primarily political and ethical ones, or result rather from discomfort with the economics and behavior of old line and extractive industries.

Braden Penhoet is a journalist and attorney with the Center for International Environmental Law in Washington, D.C.