A Cultural Business Divide

China North East Petroleum (CNEP) is a US company that was reborn through a reverse merger of Chinese assets in 2004.

The story of CNEP is a perfect example of the cultural business divide between China and, in this instance America.

CNEP was born in 2004 when Mr Wang Hongjun decided to move his Chinese oil producing assets into an already existing listed US company of which he then became the controlling shareholder.

By late 2009 it had become a glowing example of US investors being able to participate in the economic marvel of China from the comfort of downtown Shreveport.

US investors took the stock to $12.00 and a market cap of some $300m on the AMEX board of the New York Stock Exchange. But US investors are pampered souls who get upset if things are not quite as represented. And their interests are now protected by some very comprehensive legislation.

Today CNEP has a market value of just $7m some 3 years later. And, to boot, it has been delisted from the AMEX board and now trades on the Pink Sheets of the OTC.

Many US investors in CNEP are now asking “is the company real or was it all just a Chinese scam designed to rob us poor Americans investors”.

Well CNEP has real contracts, and has real oil production, and has real cash. Or rather its Chinese subsidiary companies do. Of this there is no doubt.

However to understand the issues of CNEP, some understanding of the Chinese regulatory environment and business culture is required.

Chinese law and business culture is not always BLACK and WHITE. Actual it rarely is. 70% plus of the time it is very GREY and very open to interpretation; and even on occasion negotiation. CNEP is right bang in the middle of this GREY area.

Business in China is also very much about relationships (guanxi). These relationships form the basis upon which most business deals are cemented in China. The problem with deals done based on guanxi is that those deals are between “people” and they not always documented in clearly worded form; and most often they are in the “grey area”; and reality is that “people” tend to get moved without notice (especially when such a person is a government or SOE official) and hence once a person moves they are no longer in a position to influence the sustainability of an outcome.

China, however, is a country of 2 billion people; and power in all facets of the country is disseminated down to provincial, city, county and village tiers of government. And businesses in China can often use “connections” at provincial level to avoid the need for getting central government blessings. And for Chinese nationals, the central government is typically happy to leave the provincial and other level of governments to administer and approve in most cases. It is clearly impossible for central government to exert administrative and approval control over the provinces at every level of activity; especially the more remote provinces.

So if you are a Chinese company owned by Chinese nationals then it is preferable to be in the grey area and most Chinese will be operating there. And it works. And central government turns a blind eye.

However when you mix petroleum assets held by a Chinese company into a foreign company, then the situation becomes a lot more fragile.

The Chinese petroleum industry is also very regulated. More especially when it comes to foreign participation. And whilst the the central government permits local Chinese owned companies to operate in the petroleum industry with provincial level approvals, the regulations clearly do not allow any foreign participation in the petroleum industry unless it is administered and approved by the central government in Beijing and its designated SOEs.

So herein lies the problem for CNEP.

CNEP is based in Heilongjiang Province, which is the most north easterly province of China. And that is the place of its nexus. The guy who put the whole thing together is Mr Wang Hongjun. He was probably ex CNPC or PetroChina, a senior provincial level employee; and definitely had good “guanxi” at Heilongjiang provincial level. Based on these relationships and his sphere of influence, he built a group of Chinese companies, owned by Chinese nationals with Chinese style production and drilling service contracts; and approvals from provincial level. All fine. No foreign participation. Everyone is happy! Everyone is making lots of money. Oil price is at international parity and the gravy train is rolling.

However some people are never satisfied. And hence the concept of putting this little cash flow generator into a US listed vehicle was born. Great idea……….except for a few cultural and regulatory issues.

Firstly hurdle was the reporting and transparency requirements for a US listed company are about 25 bridges too far across the business cultural divide for your average Chinese businessman to get his head around. Well lets be honest, often they are quite a few bridges too far for most people to get their head’s around. And clearly this was the case with Mr Wang. And this has been largely the reason for CNEP’s delisting from AMEX down to the Pink Sheets. Someone had forgotten to tell Mr Wang that he was no longer running a Chinese owned company where transparency was to be avoided at all costs. And that he could no longer use the company’s money to make some undocumentable but necessary payments. Or at least some one failed to tell him how to make then documentable!!

Second hurdle was that with the introduction of CNEP foreign ownership, the whole structure of the CNEP subsidiaries was potentially outside of Chinese regulations in terms of foreign involvement in the Chinese petroleum industry. Hence we see what appears on the face of it to be some very complex deals within deals, which no one really understands; and a corporate structure which is equally complex and again hard to understand and follow. This in reality is all “window dressing” to try to disguise the fact that there is foreign ownership and to make sure those that need to benefit can benefit without falling foul of the US FCPA; thus substantiating a legal basis for CNEP to own the assets they do. And clearly various lawyers (Chinese and international) have wrapped their vast intellects around the deals and the structure and blessed it all as “legal”. Well sure, its not BLACK (illegal); however neither is it WHITE (indisputably legal). Its bang slap in the middle of the GREY area! Well whats wrong with that. This is China we are dealing with!

The Chinese government is endlessly pragmatic and whilst they may not like something, until it becomes a public embarrassment, they are quite happy to turn a blind eye. Turning a blind eye of course doesn’t by any stretch of the imagination infer their blessing or approval. Just that they have more important fish to fry, than to start a potential provinical political battle in Heilongjiang; a fight which is probably neither nationally impacting nor important enough to warrant action. Well at least not today. Maybe next year or in 10 years. Maybe never.

The third hurdle, which it seems only time will bridge, but doesn’t seem to worry anyone, is how do RMB revenues get repatriate to shareholders outside of China. I am not sure at present that they can be; in a strictly legal way that is!

So when all is said an done CNEP is probably still a great potential cashflow generator. Might even still be generating lots of cash. However the cultural business divide is huge. And the likelihood of transparency to SEC requirements is realistically remote in the short term.

For now I would suspect that Mr Wang is working hard to find a solution to free himself and CNEP’s assets from entanglement with SEC regulations; and CNEP as an entity.

Now Americans are of course very litigatious, and not surprisingly CNEP finds itself in court defending its lack of transparency. If you believe the SEC findings, CNEP and its officers siphoned off some $59m. Unfortunately as one wit aptly pointed “is there someone who goes to China to serve a summons”. Of course a summons to a US court doesn’t have much impact or meaning in China. The SEC and the US courts can pass whatever judgements they choose, but they will be to basically zero impact to someone in China.

The reality is that all the assets, cash, production, companies and business of CNEP are all in China (somewhere over which the SEC and US courts have no juridiction) and held in subsidiary Chinese companies; and without Mr Wang Hongjun’s proactive support and goodwill, it would seem US shareholders in CNEP are unlikely to see a return on there investment unless they want to embrace the Chinese legal system; if there are indeed grounds for so doing. Mr Wang Hongjun may not be in breach of any Chinese laws, at least not breaches, based on which a CNEP shareholder could pursue him. CNEP as a company would perhaps have recourse should it be so predisposed!! But then who controls CNEP the company and its assets? Not the US shareholders nor the courts nor the SEC, thats for sure.

Forget analysing the business fundamentals or waiting for some miraculous intervention.

For now CNEP has morphed into 2 very separate beings

One is a penny stock “market play”. And with 10-20% daily variations there is real money to be made. Or you can choose to gamble that CNEP’s woes will only get worse and “short” the stock. However stock “shorting” and the mentality of people who seek to make money from the misfortune of others is a commentary for another day.

And the other a company with real assets, real cash and real production.

But sadly there is little tying thees 2 beings together for now.

At least not until the China/US cultural business divide has been bridged.