TORONTO/KUALA LUMPUR (Reuters) - Canada has blocked Malaysian state oil firm Petronas’ C$5.17 billion ($5.2 billion) bid for gas producer Progress Energy Resources in a surprise move that could signal problems for a much larger Chinese deal in the country’s energy sector.

Motorists pump natural gas at a Petronas station in Kuala Lumpur July 1, 2010. REUTERS/Bazuki Muhammad

Canada’s announcement late on Friday, minutes before a deadline, was a blow to Petronas, whose domestic oil supplies are shrinking and which has been seeking to boost its resources beyond Malaysia and volatile areas such as Sudan.

It also raises doubts over Chinese oil group CNOOC’s C$15.1 billion offer for oil producer Nexen and could weigh on other Canadian firms hoping for foreign investment to tap their vast energy reserves.

A rejection of the CNOOC bid would likely damage trade ties Canada has been trying to build with China, underlining political sensitivity to Chinese corporate expansion in North America.

“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,” Industry Minister Christian Paradis said in a statement.

The government, which has said C$630 billion investment is needed in Canada’s energy sector over the next decade, has been trying to balance concerns over the deals with that requirement for capital.

The companies have 30 days to make the offer more palatable.

Progress Chief Executive Michael Culbert said he was disappointed with the ruling and his company would take the next month to try to determine what concerns led to the rejection and what potential remedies might assuage them. Petronas had no comment on Saturday.

The bid had not been expected to run into hurdles in a review process that asks whether a deal is of “net benefit” to Canada. But in a sign that it was attracting greater scrutiny, Canada earlier this month lengthened its review period by two weeks.

Investment industry sources said Progress officials had initially told them that Investment Canada wanted the unusual two-week extension because it was experiencing staffing and workload issues due to numerous files it was juggling, and that no serious issues had arisen or new information requests made.

Then at the last minute, Ottawa came back to Petronas to ask for another extension, a request the Malaysian company, already irked by the delays, refused, forcing Paradis’ hand, the Canadian and U.S. sources said.

The sources suggested Prime Minister Stephen Harper wanted the extra time to allow his government to draw up a set of rules for takeovers by foreign state-owned enterprises, something he has said he would deliver with the Nexen decision.

Some investors heaped criticism on Ottawa, saying the move and other recent deal rejections smacked of protectionism. But the Conservative government insisted it was still open for business.

“Canada has a broad framework in place to promote trade and investment, while at the same time protecting Canadian interests. Our government welcomes foreign investment that benefits Canada,” said Margaux Stastny, spokeswoman for Paradis.

The Petronas deal attracted scrutiny after CNOOC made its bid for Nexen. Some Conservative Party members are wary of the CNOOC offer, in part because of what they say are unfair Chinese business practices.

Earlier this month, Harper said China’s “very different” political and economic systems were a concern.

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.

WARNING

Last month, China’s ambassador to Canada said the government should not allow domestic politics to affect its decision on whether to approve CNOOC’s bid.

However, some sources said the CNOOC deal need not necessarily be threatened.

“I don’t think that kills the CNOOC-Nexen (deal) but we do hear there is still a lot of local opposition to overcome,” one Hong Kong-based energy sector banker said.

“It allows Canada to send a signal without upsetting a large trading partner. Better to upset Malaysia than China in a way.”

Chinese firms have more usually had difficulty doing business south of Canada’s border, and this has come to the fore in recent weeks. The United States House of Representatives’ Intelligence Committee issued a report earlier this month saying companies should stop doing business with Chinese groups Huawei and ZTE over security concerns.

On Thursday, the chief executive of U.S. aircraft maker Hawker Beechcraft, whose $1.79 billion sale to a Chinese firm fell through, said China-bashing by U.S. presidential candidates may have contributed to failure of the talks.

The United States has long been the largest market for Canadian energy exports. But with growing U.S. oil output from unconventional sources and the rejection this year of an 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.

“The long-term health of the natural gas industry in Canada and the development of a new LNG export business are dependent on international investments such as Petronas,” Progress’ Culbert said in a statement.

CNOOC, which has won approval from Nexen shareholders, has said it will retain all Nexen employees and make Calgary the headquarters for its Americas operations.

Petronas had also attempted to highlight the benefit its deal offered to Canada, saying it would combine its Canadian business with that of Progress and retain all staff.

“Maybe Canada is using this to attach more conditions to the Nexen deal,” said Gordon Kwan, head of energy research at Mirae Asset Securities in Hong Kong. He thinks CNOOC will get the go-ahead.

Progress’ share price has doubled since talk of the possible Petronas bid emerged in April, closing at C$21.65 on Friday. Nexen stock has also surged since CNOOC announced its bid in July, rising 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 Potash Corp, the world’s largest fertilizer maker.

BHP also had a 30-day period to come back with additional undertakings but withdrew its offer, sensing the bid was unlikely to be approved in the face of political opposition.

BIG DEALS?

Canada is grappling with concerns that approval of the deals could spark a flurry of takeovers of energy companies - the country is home to the world’s third-largest proven oil reserves, most of them in the western province of Alberta.

Petronas, Malaysia’s only Fortune 500 company, 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 800,000 acres holdings in the Montney shale-gas region of northeastern British Columbia, reserves that could feed a planned liquefied natural gas facility on the Pacific coast.

It raised its initial offer of C$20.45 per share to C$22 in July after a rival bid from an unnamed suitor.

Petronas 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 all but shut its pipelines there.

On Thursday, Canada’s broadcast regulator blocked BCE’s C$3 billion bid for Astral Media, saying the deal would give too much power to BCE, Canada’s biggest telecoms company and the owner of numerous TV and radio assets.