Chinese upstream, downstream players lock horns over gas pricing [Gas in Transition]

A dispute between state-owned upstream companies that dominate China’s gas supply, and independent downstream utilities that buy and resell volumes from them, has prompted calls for changes to gas pricing regulations. A number of provinces and cities have already made adjustments in recent weeks, which could be rolled out nationwide by China’s central government in coming months.

The disagreement that prompted adjustments to pricing regulations first spilled into the open in December and January, when severe gas shortages afflicted rural areas of Hebei province in northern China – despite a relatively balanced Chinese gas market at the time.

The outages that left residents unable to cook food or heat their homes in the middle of winter prompted angry complaints, and forced local bureaucrats to intervene to manage the supply. The government blamed China Gas Holdings, one of the country’s biggest downstream gas distributors, for failing to sign contracts with suppliers to secure enough gas to meet demand this year – resulting in difficulties in meeting residential demand. China Gas in turn lays the blame at the feet of the upstream providers.

Gas flows resumed to ease the shortages but the incident underlined the systemic weaknesses of China’s gas pricing mechanism, which remains half-baked despite reforms that started a decade ago.

Prices and volumes at play

China Gas and other distributors buy most of the fuel they sell every year from PetroChina, Sinopec and CNOOC. Towards the end of every March the three NOCs and utilities sign sales contracts that cover supply for the next 12 months – including the summer and winter peak demand seasons, when consumption spikes for cooling and heating purposes.

The NOCs typically sell the contracted gas to the distributors at close to the citygate tariff of each province. As these volumes are committed for residential demand, Chinese regulations strictly limit the price at which the distributors are allowed to sell them to households – typically not more than the provincial citygate tariff.

The distributors supplement these contractual volumes with higher-priced uncontracted volumes from the NOCs, or source their own gas via LNG imports, to ensure they have enough gas to meet anticipated overall demand.

But in a sign of tensions between the upstream producers and downstream distributors, the pace of contract signings this year has stalled due to a standoff over prices, volumes and other terms, according to recent local media reports. The NOCs – mainly PetroChina, which contributed nearly two-thirds of domestic gas supply last winter and this spring – have been reducing contractual volumes by 5-20% every year, compelling the utilities to purchase more uncontracted gas at high cost, Chinese media reported recently.

PetroChina has squeezed city gas distributors further by raising prices for contractual volumes. In this year’s contracts the NOC priced residential gas supplies 15% above citygate prices compared with a 5% premium last year, according to media reports. The utilities on the other hand want to buy greater volumes of contractual gas and pay as close to the citygate tariff as possible, so that they can sell any surplus to non-residential users at lucrative prices.

Messy pricing reform

The deadlock between the two sides speaks to the incomplete state of China’s gas pricing reforms, which have been a slow-moving work in progress since Beijing scrapped its cost-plus scheme nationwide in mid-2013 and moved to more market-based pricing.

Under China’s current convoluted pricing system, the citygate price of imported LNG, offshore gas, unconventional gas, and imported pipeline gas from projects launched since 2015 are not regulated but linked to a basket of international oil product prices with a time lag. The citygate price of onshore gas and imported pipeline gas under projects launched before the end of 2014 is still regulated.

But a longstanding problem is that central authorities have been slow to update the basket to reflect oil price trends. Caught between higher gas import costs and low regulated domestic gas prices, PetroChina has suffered multibillion-dollar losses from reselling imported gas domestically.

More recently, as European and Asian gas prices spiked due to supply disruptions caused by the Russia-Ukraine war, PetroChina opted to raise the price of contractual volumes while also reducing allocation to utilities. This move enabled PetroChina to sell more gas as a higher-priced uncontracted supply to alleviate pressure from mounting import losses that soared to 18.3bn yuan ($2.7bn) in the first nine months of 2022.

It also meant residential gas demand was not adequately covered by contracted gas volume, a mismatch that led to Hebei’s embarrassing gas shortages last winter. The shortfall prompted a request from the National Development and Reform Commission (NDRC), China’s top economic planning agency, for the NOCs and utilities to finalise their 2023-2024 supply contracts by the end of February – a goal that was not met.

Cup runneth over

The dispute can arguably be blamed on the past actions of some city gas distributors. Current residential tariffs are much lower than non-residential tariffs, which has allowed the distributors to arbitrage the difference when buying gas from PetroChina and upstream suppliers. This caused a number of disputes between distributors and suppliers when setting gas allocations for households, like the current spat.

In the past, some distribution firms have requested household gas allocations from PetroChina that were much higher than actual consumption, a source at the NOC tells NGW. The distributors then sold the surplus to industrial users at significantly higher prices. “PetroChina has been aware of this but didn’t have a good way to deter it. Local authorities didn’t have a solution either,” the source said.

 The present system is not ideal for the utilities either. Local governments can adjust residential and non-residential prices to pass through higher contractual prices paid by the utilities to the NOCs, but can be reluctant to do so due to the broad unpopularity of consumer price hikes.

At the same time the row could encourage utilities to source more of their gas volumes from cheaper alternative sources, including unconventional gas and LNG imports. There is some evidence that China’s appetite for spot LNG could be returning in time for the peak summer demand season, as the number of available LNG import slots at regasification terminals has dropped from May to December.

Testing the water

A number of provinces and cities have started to test different reforms of the gas pricing mechanism in a bid to alleviate problems. On May 13 the NDRC branch for Fuzhou city in Fujian province said that in principle, non-residential gas prices will be adjusted on a three-month cycle. When comprehensive gas purchasing prices fluctuate by 5% inside the cycle, terminal sales prices for non-residential gas and gas purchasing prices will be jointly adjusted.

This came after the government of Hunan in central China revised the gas cost pass-through mechanism for the province in early April, shortening the price adjustment cycle and eliminating the price adjustment cap for non-residential gas. Around the same time Inner Mongolia’s arm of the NDRC issued a document stating that sales prices of residential gas supplied through short-distance pipelines in the region and non-residential terminal sales prices would be uniformly adjusted.

China’s central government has taken notice of the problem. Chinese media reported in mid-May the NDRC was working on a mechanism to link upstream gas prices – which are more reflective of market supply-demand balance – with downstream prices that remain influenced by local governments. This would improve the effectiveness and timeliness of the pass-through mechanism, which has been a key factor in the volatility of gas distributors’ earnings over the past two years. A draft policy could be released in the first half of 2023 and cannot come soon enough.

The last major reform of China’s gas industry took place three years ago when the central government consolidated most of the midstream infrastructure assets owned by PetroChina, Sinopec and CNOOC into one aggregator known as China Oil & Gas Pipeline Network Corporation (PipeChina), in order to facilitate third-party access and spur greater competition in the Chinese gas market.

PipeChina operated eight out of China’s 24 LNG regasification terminals at the end of 2022, along with a number of major cross-country pipelines like the West-East Pipeline network.

But Beijing has not reformed its domestic gas pricing mechanism in a significant way since June 2018, when it unified wholesale gas prices for residential and non-residential consumers to better reflect rising demand and costs.

The idea behind the harmonisation was to lift residential gas prices in order to encourage upstream producers and suppliers to boost gas supply through imports and domestic production. Greater supply would lead to increased gas consumption – particularly in northern China, where there had been a large gap between residential and non-residential prices that favoured combustion of cheap coal for heating. The move was the first major change to China’s household gas pricing system for eight years.