Financial Sense   Home  l  Broadcast  l  WrapUp  l  Storm Watch  l  About Us  l  Contact Us

The China Syndrome, Part 2
A Joe-Duarte.com Retrospective
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
January 25, 2005

Editor’s note:

The articles reprised below set forth evidence for irregularities in the way China does business, and how the world is looking the other way.

At some point, when large mistakes in policy, or the conduction of business, the bottom falls out of all Ponzi schemes.  Part 1

December 3, 2004

China Aviation Oil Scandal: Wider, Deeper, And Increasingly Political.

China’s business practices are under increases scrutiny as repercussions from a half billion dollar’s worth of losses in jet fuel trading begin to spread.

Singapore police has opened an investigation into a Chinese trading company’s huge losses in jet fuel trading, with Bloomberg reporting: “the Securities Investors Association of Singapore, a group representing retail investors in the city, said it was ``shocked'' by the losses, which it said raised concern about corporate governance at Chinese companies in Singapore. “ Meanwhile the company’s CEO Chen Jiulin has left Singapore for China as authorities call for his return and his aid in the investigation. According to the U.K. TimesOnline: “Beijing said he had been detained and would not resume his position until an investigation into the affair had been completed.”

What makes this story more bizarre is the fact that China Aviation Oil was voted the “most transparent” company listed in Singapore last year.

The China Aviation Oil Singapore story, broken by The Wall Street Journal, and reported here, with emphasis on 12-2, is gathering steam. According to Bloomberg: “China Aviation Oil (Singapore) Corp., which supplies a third of China's jet fuel, is being investigated by Singapore's white-collar crime unit after disclosing $550 million of losses on derivatives trades.” The situation exploded onto the scene on Tuesday, when the Wall Street Journal’s Hong Kong bureau broke the story. Bloomberg added: “China Aviation, a unit of Beijing-based China Aviation Oil Holding Co., said this week it will seek court protection from creditors after losing money on wrong-way bets on oil prices. The disclosure highlights a lack of transparency at many China- related companies.”

International concern, as we predicted here on 12-2 is starting to mount. Bloomberg, quoting S & P noted: [``Complex corporate structures and unreliable accounting practices make it difficult to perform substantive analysis on some China-related companies. On the accounting side, the problem of limited disclosure is compounded with problems of compliance.'']

Forbes reported: “The scandal is the latest in a series to hit the Chinese corporate world as companies with little experience in foreign markets expand their presence abroad. It is likely to prompt regulators to step up enforcement of laws banning Chinese-controlled companies from engaging in speculative trading, the China Daily newspaper reported, citing people in the industry.”

According to the magazine’s web site: “In another prominent case, mainland insurer China Life is facing a class-action lawsuit in the United States alleging ["massive financial fraud."] It was filed after the disclosure in February by China's National Audit Office of alleged accounting irregularities at its Chinese-based parent company, China Life Group.”

The Wall Street Journal reported: “Scandal has racked a unit of Bank of China that listed in Hong Kong in 2002. In February, Liu Jinbao, a former chief executive of BOC Hong Kong (Holdings) Ltd., was arrested in China on corruption charges. In August, BOC Hong Kong announced that two former deputy CEOs, Zhu Chi and Ding Yansheng, as well as former General Manager Zhang Debao, had been detained on allegations of embezzlement.”

Insider Trading Scandal Brewing

As we noted here on Tuesday, this situation has the potential for spreading. Not only are the losses significant, but the potential for cracking open the door into China’s other potential conflicts of interest and “insider” type way of doing business could be devastating.

According to Forbes: “Court documents obtained by The Associated Press in Singapore said the Chinese parent company of China Aviation Oil was aware of the financial problems when on Oct. 20 it sold a 15 percent stake in the troubled supplier for US$108 million. According to an affidavit signed by Chen Jiulin, China Aviation Oil's suspended chief executive, his company notified its parent group of its troubles on Oct. 10. Some analysts believe the Beijing company's failure to disclose that information before the sale could constitute insider trading.”

Forbes also reported: “According to traders at Shanghai's futures exchange, China Aviation Oil may have taken advantage of loopholes in regulations, which lag behind developments in financial markets.”

European Banks On The Hook

The first reports of collateral damage are starting to appear. According to business.timesonline.co.uk: “Western banks are waiting to see if the Chinese Government will act to limit their exposure to the financial scandal in Singapore in a which a company controlled by Beijing has lost $550 million on oil derivatives.

The TimesOnline article reported: “Although no-one concerned will comment formally, the oil futures trading scandal is thought to have left a number of Western investment banks nursing losses that are not covered by hedging. One source put these at $160 million, split between Société Générale and Banque National de Paris of France, Goldman Sachs, Standard Chartered and Morgan Stanley.”

Politics First Shareholders Second

The China Aviation Oil disaster is a clear indication of China’s major problem, the inability to even partially separate business and politics. According to the Wall Street Journal: “One of the big problems, analysts say, is that China's listed state companies still haven't managed to elevate shareholder interests above political considerations. That is because listed companies often maintain unclear ties to the parent company -- and to Beijing. Corporate chiefs one day can become provincial governors the next. Bosses at rival telecommunications companies might be asked to switch jobs, no matter what shareholders know or say. ["It's very hard to figure out what's going on in these companies. They are a complete black box, maybe a black hole,"] says Fraser Howie, co-author of ["Privatizing China: The Stock Markets and Their Role in Corporate Reform."]”

Conclusion

This story is beginning to get some legs. The way that China handles this, meaning, the extent to which the Chinese government makes good on China Aviation Oil’s trading losses, will likely set the tone as to what happens over the next few weeks.

A cynic might say that unless the Chinese government makes up most of the losses, they are likely to find themselves in an interesting situation, as foreign capital begins to slip and slide away from the Beijing miracle.

The bottom line seems to be that the word business seems to have more than one meaning in the Chinese government.

December 7, 2004

China Aviation Oil (Singapore): A Government Backed Pump And Dump Scheme?

CAO and Deutschebank sold 15% of a company that insiders knew was on the verge of a financial collapse to hedge funds, at a discount, who in turn flipped the shares onto the public in the open market.

The Wall Street Journal reported: “On Oct. 20, Deutsche Bank offered 145 million CAO Singapore shares at S$1.35 each, a hefty 14% discount to the market price. By industry measures, the deal was a success. The bank sold all the shares within two hours, almost exclusively to hedge funds that had signed waivers acknowledging the extra risk. And nearly all of the funds were able to flip their shares to unsophisticated investors on the open market at prices higher than what they had paid, according to the person familiar with the deal. But in subsequent weeks CAO Singapore's stock price fell steadily, losing 39% before trading was suspended on Nov. 26.”

Authorities in Singapore are starting to uncover the road to ruin in the China Aviation Oil debacle. According to the Wall Street Journal: “attention is likely to focus on two broad areas of possible wrongdoing: inconsistencies between management's upbeat public statements as losses were mounting and the sale of 15% of the company to investors by its Beijing-based parent, even though the parent knew about the losses.”

At the center of the situation, as this stage of the investigation, is the above referenced sale, which suggests the potential for a possible Chinese government backed “pump and dump” scheme. The Journal reported: “The block sale of shares by the company's state-owned parent is causing concern at a time when China's government-owned enterprises are attempting to present a more-polished front to investors. And that transaction's disastrous outcome for investors illuminates a corner of Asia's capital markets in which companies can jettison big chunks of shares in rapid and loosely regulated trades.”

Aside from the losses, and the poor judgment exhibited by the company‘s traders and executives, the large question, in our opinion is who knew what, and when did they know it?

If the trail leads back to the Chinese government, it could be disastrous.

How The Deal Was Done

According to The Wall Street Journal: “On Oct. 20, Deutsche Bank offered 145 million CAO Singapore shares at S$1.35 each, a hefty 14% discount to the market price. By industry measures, the deal was a success. The bank sold all the shares within two hours, almost exclusively to hedge funds that had signed waivers acknowledging the extra risk. And nearly all of the funds were able to flip their shares to unsophisticated investors on the open market at prices higher than what they had paid, according to the person familiar with the deal. But in subsequent weeks CAO Singapore's stock price fell steadily, losing 39% before trading was suspended on Nov. 26.

‘["It appears like insider trading to me,"] said David Gerald, president of the Securities Investors Association of Singapore (to the Wall Street Journal). ["If certain facts were known that are not known to the market, and [the parent company] acted on it to their own advantage, that's insider trading."]’

According to the Journal’s account of the story, the sale met the regulatory standard in Singapore , which seem to be very loose, and highlight the problem with emerging market investing. “CAO Holding, the parent, approached Deutsche Bank for help in selling the stake through a block trade. Typically in such a deal, an investment bank purchases a large block of shares from an issuer -- the company or a big shareholder -- and resells the shares at a discount to a small cadre of professional investors. Discounts tend to range between 5% and 10%.”

Here is where it seems someone was very shrewd in working the deal, taking advantage of the loose regulations. “According to Singapore regulations, Deutsche Bank wasn't required to perform extensive due diligence on the company ahead of time, and it restricted itself to a short set of questions, says a person familiar with the deal. In the U.S., CAO's block trade would have been illegal without the due diligence of a secondary stock offering. The underwriter would have asked questions of the company, reviewed its financial records and submitted a regulatory filing. ["The diligence conducted by Deutsche Bank included questioning of the company's financial situation and whether there were any issues current or pending that could have a material adverse impact on the business or its financial condition,"] said Michael West, a Deutsche Bank spokesman. ["The answers provided gave us confidence to proceed with the placement."]’

Appearance Of A Cover Up

As would be expected, this situation, although the story just broke, has been ongoing for some time, giving the impression of a major cover up by the parties involved. “In an affidavit filed Nov. 29, former CAO Singapore Chief Executive Chen Jiulin detailed how the company began using risky derivatives a year ago to bet against rising oil prices -- and how modest initial profits quickly turned into losses that mounted throughout the year.“

But there was no mention of the worsening situation, by anyone at this time. According to the Journal: “Yet even as the company faced "a serious cash flow position," according to Mr. Chen's court filing, senior management gave no public indication that problems existed. By June, the company had racked up US $35.8 million in potential losses and was adding to its ill-conceived bets against the rising price of oil. The company's earnings release for the second quarter, issued Aug. 12, reported 16.7 million Singapore dollars (US $10.2 million) in net profit. It made no mention of trading losses or liabilities and boasted about its ["tight risk-management procedures."]”

In fact, as recently as August, the company was remarkably upbeat about its prospects: “In the text of an online chat with investors, posted on the CAO Singapore Web site Aug. 27, the company played down concerns about rising oil prices. One investor asked if the company would benefit from rising oil prices. ["Our profitability relates to the positions we take rather than the overall trend of prices. So we cannot say that we are beneficiaries of high oil prices (nor, for that matter, are we penalized by them),"] came the response, signed by ["the management team."] Arguing that the company's shares ["are a bargain at current levels,"] the company said it was ["very optimistic about our full-year numbers."]”

But even as the company chatted positively about its prospects, the truth is that they were sinking below the weight of massive bad bets in the oil derivatives market: “Yet CAO Singapore's losses were ballooning. And as it was unable to meet its banks' demands for more collateral, the banks began forcibly closing some of its positions -- turning potential losses into real ones.”

Eventually, the cat was out of the bag. “By Nov. 16, when the company briefed analysts on the third-quarter net profit of S$8.8 million it had released four days earlier, CAO Singapore had realized trading losses of US $302 million and huge additional liabilities from open positions. ["Trading didn't do as well as hoped,"] read the title of one slide shown at the analysts' presentation. The company released figures that indicated a loss from that activity of about S$10 million during the quarter.”

Conclusion

All the reported information, thus far, points to a very sophisticated game that was perpetrated on investors, and of an attempted cover up scheme.

Much too reminiscent of Enron, the China Aviation Oil situation is different in one key area. While Enron had some connections to the U.S. government perhaps at the advisory level with regards to energy policy, China Aviation Oil is essentially a Chinese government owned company.

If and when the allegations of fraud being leveled and investigated are followed through to their conclusion, the trail could lead to the highest levels of the Chinese government.

And while that is not guaranteed, it is both possible and plausible, that major repercussions to the markets, as well as the Chinese economy, could start being felt, as this situation continues to unfold.

© 2005 Joe Duarte, M.D.
Dr. Duarte's Bio and Archive

Joe Duarte, M.D.

Joe Duarte M.D. is founder and Editor in Chief of Joe-Duarte.com. Dr. Joe Duarte's Daily Market I.Q. is a premium service that provides daily intelligence, trading strategies, and technical analysis at www.joe-duarte.com. Duarte offers free analysis and news coverage at www.intelligentforecasts.com . Dr. Duarte is a board certified anesthesiologist, a registered investment advisor, and President of River Willow Capital Management. He is author of "Successful Energy Sector Investing" and "Successful Biotech Investing" (Prima/Random House). Duarte's analysis appears regularly in major outlets including CBS MarketWatch and Investor's Business Daily.