China creates a common carrier [NGW Magazine]

The biggest shake-up of China’s oil and gas industry in two decades is underway after Beijing finally kickstarted its long-awaited pipeline reform with the multi-billion-dollar transfer of major energy infrastructure assets to the country’s national pipeline company.

Two national oil companies, PetroChina and Sinopec, agreed in July to swap various assets – including pipelines, storage and import terminals – worth a combined Rmb 391bn (US$56bn) for cash and shares in the operator, known as PipeChina. Those deals, plus cash injections from other investors, will value PipeChina at Rmb 500bn once they close by the end of September – making the state-owned firm one of the largest pipeline companies in the world.

The asset transfers will end PetroChina and Sinopec’s near-duopolistic control of China’s midstream sector and could usher in a domestic upstream boom in the coming years. No longer incentivised to keep out gas produced by other companies, the two NOCs will have to sharpen their upstream focus while paving the way for more players in order to foster competition.

The reform represents the most significant overhaul of China’s energy industry since the domestic NOCs started listing on domestic and foreign stock exchanges in the early 2000s.

PetroChina stands to net Rmb 268.7bn in the form of Rmb 119bn in cash and a 29.9% stake in PipeChina, making it the largest individual stakeholder. Sinopec will receive RMB 122.7bn in the form of RMB 52.7bn in cash and the second-highest shareholding of 14%.

The remaining shareholders in PipeChina will be a mix of state-owned holding companies, the state pension fund as well as the country’s insurance investment fund, sovereign wealth funds, the regulatory watchdog for China’s biggest state-owned enterprises, and offshore oil and gas explorer China National Offshore Oil Corp. Their stakes will range from 2% to 12.87%.

PetroChina to bear the brunt

The impact of the transfer will be bigger for PetroChina than Sinopec, as the former owns and operates the biggest pipeline network in the country. The length of PetroChina’s domestic oil and gas pipelines measured 87,144 km, comprising 53,291 km of gas pipelines, 20,091 km of crude, and 13,762 km of oil products, according to its 2019 annual results.

The infrastructure assets to be spun off from PetroChina account for 8.9% of the total assets held by its parent, China National Petroleum Corp, according to an estimate from S&P Global Ratings. By comparison, Sinopec will be shedding 3.4-3.6% of its total assets.

Among the pipelines that PetroChina is divesting are the three West-East pipelines, which have a combined capacity of 73bn m³ and form the backbone of China’s gas transport network. The cross-country trunklines, originating in Turkmenistan and carrying gas from other Central Asian former Soviet republics, have transported more than 540bn m³ to date. Sinopec’s list of assets includes its Sichuan-East China pipeline that links gas fields in southwestern China to the thriving Yangtze River Delta on the eastern seaboard.

The newest project that PetroChina is involved in is the Power of Siberia, which is now ramping up; but more pipelines from Russia to China are planned. PipeChina has already taken over work on the domestic cross-country pipeline that distributes gas from Power of Siberia around China – it said in late July that it had started building the southern segment of the China-Russia East pipeline that will run from Yongqing in China’s northern province of Hebei to the financial hub of Shanghai in the Yangtze River delta.

PetroChina post-reform

The pipeline reform raises question marks over the future of PetroChina as its dominance of the distribution network is coming to an end. A short-term concern is how PetroChina will continue to weather losses incurred on the domestic resale of imported gas. The company lost Rmb 30.7bn on such sales last year, up from a loss of Rmb 24.9bn in 2018.

PetroChina’s pipeline business has generated steady returns that cushioned the impact of the import losses, but the burden will be magnified once its pipeline assets have been transferred. PetroChina’s management indicated in July that it was in talks with regulators on a solution between both parties, in which the company might be able to offload some of the losses in future.

At the same time, PetroChina will be relieved from the heavy spending on building long-distance pipelines as this responsibility will soon fall to PipeChina. In the longer run though, pipeline reform could be a prelude to an eventual restructuring of PetroChina given Beijing’s desire to nurture a more competitive upstream sector.

Pipeline reform effectively represents an assault on PetroChina’s oil and gas distribution monopoly, so Beijing may take a similarly hardline stance on the company’s upstream dominance since it accounts for 70% of domestic gas production. The idea – which so far remains no more than speculation among industry insiders – would be to break up PetroChina to create a fragmented but more dynamic industry of risk-taking upstream firms.

There is a longstanding view among some experts in Beijing’s policymaking circle that gas output has underwhelmed because of an inefficient and risk-averse three-way monopoly in the Chinese energy industry.

One official from the state central planning department (the national development and reform commission) has previously told NGW that Beijing had erred in building up PetroChina as an upstream national champion, as such a company was never the correct structure for a country that does not export oil or gas. The official pointed to how the US, with its highly fragmented and competitive industry, has become a net exporter of both oil and gas – and is on the verge of energy self-sufficiency.

The official said parts of PetroChina’s assets – particularly those in gas – should be spun out to create a “critical mass” of independent players and wildcat well drillers that could absorb private capital and in theory increase output more efficiently.

Premium valuations

PetroChina and Sinopec both received premium valuations for their assets, easing shareholder fears that they would not be compensated fairly for the divestment forced upon them by Beijing. For instance, PipeChina agreed to pay a 43% premium above the book value of Sinopec Kanton’s 944-km Yulin-Jinan gas pipeline, resulting in a final cost of Rmb 3.2bn.

This was far above estimates among analysts that ranged from a 20% premium to none at all. Overall, PetroChina will get 1.2 times book value for its assets while Sinopec will get 1.4 times in the deals.

The consolidation of China’s transportation and storage infrastructure under PipeChina sits at the centre of reform efforts by the president-for-life Xi Jinping. His government wants to boost domestic energy production and distribution in the world’s largest energy market. The move to create a unified pipeline network is fundamentally about boosting the share of gas within China’s energy mix to a targeted 15% by 2030.

To that end, the Chinese government wants to see lower gas prices and considers greater upstream competition. By forcing its NOCs to divest their midstream operations, Beijing hopes to remove a major barrier for other firms to invest in upstream. Whereas PetroChina and Sinopec monopolised the distributed network to convey their own oil and gas supplies, PipeChina is expected to act independently and treat all producers fairly on capacity access.

This will make it easier for new E&P entrants to monetise any oil and gas resources that they discover and effectively end a decades-long monopoly over the upstream sector by China’s three NOCs.

There are implications for the downstream segment too, as improving third-party access to supply infrastructure will make it easier for companies to supply and offtake oil and gas from China’s network. This will help liberalise China’s LNG import market, as emerging LNG importers will be able to import inexpensive spot volumes and receive them at the regasification terminals to be divested by the NOCs.

There is still significant work to be done for PipeChina as it will need to manage conflicting interests among the companies contributing assets to become an efficiently operating entity. Some say it could take two years, others as long as five years, to overcome these rivalries and get things running smoothly.

Spending boost for E&P

PetroChina and Sinopec will earmark the bulk of the proceeds from their sales for a special dividend, but a considerable portion is likely to go towards upstream. Assuming that one-third of the cash is allocated for reinvestment, this would be an additional Rmb 39.6bn – or equivalent to a fifth of the Rmb 200bn that PetroChina has budgeted for capital expenditure in 2020. PetroChina spent Rmb 230bn on exploration and production alone in 2019.

The additional cash to plough into the upstream business is important as energy security has moved up the political agenda in Beijing over the past two years. Most recently, Chinese vice premier Han Zheng said during a tour of PipeChina in August that China should continue to deepen the reform of its oil and gas system to ensure a stable oil and gas market and national energy security.

Han’s comments came after the NDRC and the national energy administration issued a joint statement in June that re-emphasised energy security across a number of industries.

The statement said that within oil and gas, the focus will remain on increasing domestic exploration and development efforts, particularly in shale gas. Pipeline infrastructure buildout was also highlighted, to increase pipeline reach and ensure supply protection.

China’s quest for domestic energy security led to a record investment of Rmb 82.13bn in oil and gas exploration last year, up by 29% from 2018, while investment in hydrocarbon production surged by 24.4% to Rmb 252.71bn, according to the ministry of natural resources in late July.

According to the ministry, China booked an additional 1.12bn metric tons (7.868bn barrels) of oil in place in 2019, up by 17.2% year on year, while new gas in place reserves booked last year dropped by 2.7% over the same period to 809.1bn m³.