Canada has blocked Malaysian state oil firm Petronas' C$5.17 billion ($5.22 billion) bid for gas producer Progress Energy Resources Corp, a surprise move that could signal problems for a much bigger offer by China's CNOOC Ltd for oil producer Nexen Inc.
The announcement late on Friday in Canada is a blow to the expansion plans of Petronas as its domestic oil supplies shrink and it seeks to boost its resources beyond Malaysia and volatile areas such as Sudan.
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Its bid for Progress had not been expected to run into hurdles in a review process that asks the government to examine whether a deal is of "net benefit" to Canada. A rejection of both the CNOOC and Petronas bid could significantly damage the trade ties that Canada has been trying to build, especially with the Chinese.
Petronas, which said it was not ready to make any comment, has up to 30 days to make additional representations that could make its offer more palatable but it was not immediately clear what else it could put on the table.
"I can confirm that I have sent a notice letter to Petronas indicating that I am not satisfied that the proposed investment is likely to be of net benefit to Canada," Christian Paradis, Canada's minister of industry, said in a late-night statement.
"Due to the strict confidentiality provisions of the (Investment Canada) Act, I cannot comment further on this investment at this time," he said.
Paradis, whose statement on the Petronas-Progress deal came minutes before the official deadline on the review, said if required, the 30-day period could be extended with the consent of the government and Petronas.
"Subsequently, I will either confirm this initial decision or approve the acquisition," said Paradis, adding that Canada would maintain an open investment climate.
The deal attracted scrutiny after Chinese state oil firm CNOOC made a C$15.1 billion bid for Canada's Nexen Inc. Some members of Canada's governing Conservative Party are wary of the CNOOC offer, in part because of what they say are unfair Chinese business practices.
Earlier this month, Prime Minister Stephen Harper said China's "very different" political and economic systems were a concern. The Canadian government has extended its review of CNOOC's bid for Nexen by 30 days, to November 11.
A CNOOC spokeswoman in Beijing said she had no comment on the ruling against Petronas or whether it could mean the Chinese company's bid for Nexen was in trouble.
Last month, China's ambassador to Canada warned against letting domestic politics drive the Canadian government's decision on whether to approve CNOOC's bid for Nexen.
The United States has long been the largest market for Canadian energy exports, but with America's growing oil output from unconventional sources and its rejection this year of the initial application on the controversial Keystone XL pipeline project, Canada has been forced to try to build bridges with Asian markets that would welcome its energy supplies.
Gordon Kwan, head of energy research at Mirae Asset Securities in Hong Kong, said he believed CNOOC would get the go ahead because it had made a lot of promises to reassure the Canadian authorities.
CNOOC, which has won approval from Nexen shareholders for the acquisition, has promised to retain all Nexen employees and make Calgary the headquarters for its Americas operations. It will also pursue a secondary listing of its shares in Toronto.
But Petronas had also attempted to highlight some of the benefits the deal offers to Canada. It has said it plans to combine its Canadian business with that of Progress and retain all of the target company's staff.
"Maybe Canada is using this to attach more conditions to the Nexen deal," Kwan said.
The rejection could spark a sell-off in shares of both Nexen and Progress Energy on Monday, as investors temper their expectations on the deals being approved.
Progress' share price had doubled since talk of the possible Petronas bid emerged in April, closing at C$21.65 on Friday. Shares in Nexen have also surged since CNOOC announced its bid in July, rising about 48 percent to C$25.15.
Canada last blocked a foreign takeover in 2010, when it stunned markets by rejecting BHP Billiton's $39 billion bid for the world's largest fertilizer maker, Potash Corp.
At the time the government gave BHP a 30-day period to come back with additional undertakings, but BHP withdrew its offer, sensing the bid was unlikely to win approval in the face of strong political opposition from Potash Corp's home province of Saskatchewan.
Canada is grappling with concerns that approval of the deals could spark a flurry of mega-takeovers of Canadian energy companies. Canada is home to the world's third-largest proven oil reserves, most of them in the western province of Alberta.
The government is trying to balance concerns over the deals with a huge need for foreign investment in the energy sector. Ottawa says C$630 billion in investment is needed over the next decade alone, with much of it to come from overseas.
Petronas, Malaysia's only Fortune 500 company, had already made a big push into Canada's shale gas sector last year when it bought a $1.1 billion stake in a field from Progress.
Petronas first bid for Progress in June to gain control of its holdings in the massive Montney shale-gas region of northeastern British Columbia, reserves that could feed a planned liquefied natural gas facility on the province's Pacific coast. The company raised its initial offer of C$20.45 per share to C$22 in July after a rival bid from an unnamed suitor.
As its domestic supplies start to dwindle, Petronas has been expanding abroad, investing in Sudanese oil, South African petrol stations and European liquefied natural gas.
It had seen the Progress deal as a crucial step to increase its presence in a more stable country after clashes on the border between South Sudan and Sudan this year virtually shut down its pipelines there.
The rejection throws into doubt Petronas' plans to partner with Progress to build a liquefied natural gas plant in Prince Rupert, British Columbia. The plant is being designed to process up to 1.2 billion cubic feet of gas a day, with a proposed startup of 2018.
Progress produced 44,641 barrels of oil equivalent per day in the second quarter. However its most valuable asset is 800,000 acres of exploration lands in the Montney shale-gas region of northeastern British Columbia.
Friday's announcement was the second time in two days that Canadian authorities had intervened to prevent one company taking over another.
The broadcast regulator on Thursday blocked BCE Inc's C$3 billion ($3.05 billion) bid for Astral Media, declaring the deal would give too much power to BCE, already Canada's biggest telecoms company and owner of numerous TV and radio assets.
($1 = 0.9908 Canadian dollars)
(Additional reporting by Charlie Zhu in Hong Kong; Editing by Raju Gopalakrishnan)