Invisible Hand Revealed: Why Own When You Can Rent
Sinopec failed to acquire China Gas Holdings, yet it might be better off that way. Here’s why.
Sinopec’s recent failure to acquire China Gas Holdings has attracted much attention as the first hostile takeover attempt in Chinese history–even more so because the much smaller China Gas thwarted the efforts of the much larger Sinopec. The failure also has symbolic value as a rare exception to the trend toward increased control of China’s economy by state-run enterprises with privately-owned China Gas prevailing over state-owned Sinopec. However, the most important business lesson of this “failure”–that contracts are often a good substitute for ownership–has not attracted much attention. To understand the importance of this we first need some background.
Sinopec, an oil and gas refiner ranked number five in Fortune’s Global 500, along with gas distributor ENN Energy Holdings had made a $2.2 billion bid to buy China Gas, an operator of gas pipelines in 150 Chinese cities. Sinopec was said to be interested in China Gas’ extensive access to urban customers of natural gas. Lurking behind this is the expectation that use of natural gas will boom in China over the next decade. This attempted merger is what economists call a “vertical merger”–combining firms at different levels of the supply chain. This differs from a “horizontal merger” which would join firms at the same production stage such as two automobile manufacturers. (There is a third type of merger–between firms in unrelated businesses. This is known as unrelated diversification, a topic I discussed in Pork Barrel Politics).
China Gas rejected Sinopec’s overtures and prevailed in fending off the takeover but the story does not end there. The companies did not go their separate ways. Instead they reached a contractual agreement for long-term cooperation. Among other things, the contract specifies that China Gas will distribute Sinopec’s gas through its network. Where does that leave things? Sinopec got what it wanted but instead of buying access, they rented it.
This is likely a better outcome for Sinopec’s shareholders. Mergers often appeal to CEOs because they control something that is bigger but it usually involves all kinds of hidden costs for shareholders. The costs of integrating different operations and cultures are usually great and even once accomplished, can result in clumsy coordination because different teams are unaccustomed to working together. A contract avoids these costs and often accomplishes the same goal.
Vertical mergers also often lead to a loss of focus and blunting of incentives. Refining gas is completely different operationally than distributing the gas to residences. It is unclear how joining these two operations would have helped them work more efficiently. Moreover, judging China Gas’ performance and holding its management’s feet to the fire is tricky once it is not a standalone firm. Once the assets of Sinopec and China Gas are co-mingled, it becomes extremely difficult to judge how well the distribution piece of the business is performing. Doing so would require allocating all kinds of joint costs and figuring out the internal transfer prices the two divisions charge each other. With an arms-length contract this task is trivial–is Sinopec willing to pay more for access to China Gas’ customers than all other bidders?
The other nice thing about contracts is their flexibility. If conditions change–for example Sinopec finds a better distributor or China Gas a more effective supplier–undoing the contract is as simple as canceling or renegotiating it. In contrast, pulling apart a mistaken merger can be a costly affair as other firms have discovered. Time Warner merged with America Online (AOL) in 2000 for reasons remarkably similar to those given by Sinopec. Time Warner, a content producer, thought of AOL, a dominant Internet portal, as an attractive conduit for distributing its content to America’s households. Internet usage was growing fast just like natural gas usage in China. What transpired after the merger was not pretty. Within two years, the combined company had written off $54 billion. Difficulties in combining the operations and culture clashes were cited as main contributors to the write-offs and unrealized potential of the merger. After years of difficulties, AOL was spun off as a separate company again in 2009.
Of course, some of AOL-Time Warner’s losses can be attributed to the dotcom bust which occurred shortly after the merger. But that is exactly the point. If Time Warner and AOL had used a contract to distribute Time Warner’s content on AOL’s Internet properties, then this could have easily been adjusted as circumstances changed.
If history is any guide, Sinopec’s “failure” may be a blessing in disguise.
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