Winners and losers from Chinese pricing reform [Gas in Transition]

Government reforms to how China prices gas earlier this year helped PetroChina – the country’s biggest upstream supplier – rake in record net profit over the summer, but downstream gas companies are concerned that lagging implementation of some of the reforms could squeeze their bottom lines again this winter.

PetroChina reported bumper earnings growth for the July-September quarter, leading smaller domestic peers Sinopec and CNOOC as it reported a 21% year/year jump in net profit to a record 46.4bn ($6.5bn). PetroChina’s net profit compared favourably with 17.9bn yuan at Sinopec, the second-largest onshore gas producer in China, and 33.9bn yuan at offshore-focused CNOOC for the same period.

The bonanza came despite a 4.6% yr/yr drop in PetroChina’s revenue to 802bn yuan. The NOC expanded domestic gas production by 5% to 1,096bn ft³, which was faster than a 3% increase in domestic and foreign oil output. Total oil and gas production for the quarter rose by 4% to 422mn barrels of oil equivalent, lifting output for the first three quarters to 1,315mn boe and putting PetroChina on track to meet a full-year production target of 1,728mn boe.

Rewarding reforms

Company executives attributed the impressive profits to recent gas pricing reforms by the National Development and Reform Commission (NDRC), China’s top economic planner, just weeks before the start of Q3.

“China has been actively promoting the market-based reforms of gas pricing, allowing end-user prices to better reflect market dynamics,” PetroChina president and executive director Huang Yongzhang said on a Q3 earnings call at the end of October.

In mid-June the NDRC loosened gas pricing controls by allowing local governments and gas distributors in China to adjust retail tariffs for residential and non-residential users more frequently than in the past. This has allowed tariffs to better reflect changes in upstream gas costs – a reform long sought by gas distributors that have often bought high from upstream suppliers like PetroChina and then sold low to consumers.

Household retail tariffs can now be readjusted up to twice a year in line with procurement costs for city gas distributors, while tariffs for commercial and industrial customers are allowed to change as often as every month. Residential tariff hikes are capped at RMB 0.5/m³ for every six months, but there is no such cap on adjusting tariffs for non-residential users, nor any limit on downward revisions for either category.

The frequency will bring gas pricing in China closer to how the country prices petrol and diesel, which the NDRC adjusts every two weeks based on a basket of global crude prices. The reforms mean PetroChina has been able to better pass through volatile changes in the cost of its gas imports, improving its “gas sales profit volatility”, according to credit ratings agency Fitch.

The NOC’s total gas sales inched up by 1.9% yr/yr to 193.13bn m³ in the first three quarters, while domestic gas sales grew by 5.5% to 155.36bn m³, which Huang said allowed the company to maintain a home market share of above 60%. China’s apparent gas consumption in the first nine months grew by 7% yr/yr to 288.75bn m³, according to official figures from the NDRC.

PetroChina still lost 10bn yuan on the 67.4bn m³ of gas it imported and then resold in China in the first three quarters, finance department general manager Mu Xiuping said on the earnings call. This compares with a loss of 7.21bn yuan on 80bn m³ in 2021. Mu said that to minimise losses on reselling imported gas, PetroChina has taken measures on both the procurement side and the sales side, to reduce the cost of imported gas as well as raising its sales prices.

PetroChina bullish on gas

PetroChina anticipates China’s gas demand will expand by an average of 7-9%/yr over 2021-2025 to reach 440-500bn m³ by 2025. This roughly lines up with the latest projections from the International Energy Agency, which believes China will consume 449bn m³ in 2025 and 496bn m³ in 2026.

Oil, gas and new energy comprising solar, wind, hydrogen and geothermal will each make up one-third of the company’s energy mix by 2035, and by 2050 new energy will take about half of the company’s total production capacity.

Gas remains the core focus of PetroChina’s energy plan as it expects to add 600bn m³/yr of gas reserves through 2025 and produce 150-160bn m³/yr by 2025, representing annual growth of 5%. As such the share of PetroChina’s production mix will grow from 45% currently to 50% by 2025. New energy meanwhile will account for 7% of production capacity by then and rise to 50% by 2050. Longer term, PetroChina aspires to be net-zero emissions by mid-century.

PetroChina’s current new energy investments and projects include six hydrogen refuelling stations compared with two presently in Beijing, additional wind and solar power capacity of 850 MW compared with 31.5 MW in 2020, and 18 carbon capture, storage and utilisation projects totalling 600,000 tonnes/yr. The NOC is keen on synergistic opportunities within gas power generation, hydrogen, wind and solar and CCUS.

Winter pressure snowballs for distributors

But while PetroChina has profited from the gas pricing reforms over the summer, city gas distributors could be facing high procurement costs this winter as some local governments are dragging their feet in raising tariffs for residential users. As upstream companies like PetroChina have raised the cost of their gas but local governments have not hiked residential tariffs to reflect the higher procurement cost, distributors could find themselves squeezed this winter.

“Residential gas cost passthrough remains a downside risk this winter, as PetroChina has hiked residential gas costs by about 10% this year,” S&P Global Ratings analysts said in September. “While numerous tier-one cities have recently achieved breakthroughs in residential cost-passthrough following years of stable prices, many cities have yet to follow. We believe delayed passthrough is still likely in some regions due to socioeconomic considerations.”

While local governments are not keen to raise gas costs for households, the other problem is that the pricing reforms have enabled China’s upstream companies to aggressively charge downstream distributors higher prices for volumes.

At the start of every year city gas distributors and bulk gas users like power plants normally sign annual procurement contracts with PetroChina, Sinopec and CNOOC that have two parts – a base volume and a flexible volume. The base volume reflects total gas consumption in the previous year and covers the basic demand requirement, while the flexible volume reflects demand fluctuations due to seasonality or other factors.

The base volume is priced at a fixed rate regulated by the NDRC but flexible volumes can be priced up to 20% above this fixed rate. When negotiating annual contracts in recent years, the three NOCs have attempted to sell less gas as the fixed-rate base volumes and more as the higher-priced flexible volumes. This has led to standoffs between the NOCs and gas distributors, leading to insufficient procurement by the latter that has resulted in household gas shortages in the middle of winter.

One city gas distributor in Xingtai city of Hebei province had specified a base volume requirement of 250.4mn m³ to cover residential demand this winter, but upstream suppliers including PetroChina only approved 104.4mn m³ at a cost of 2.27 yuan/m³, according to a state media report in October on the industry topic that was later censored.

The remaining 146.02mn m³ would have needed to be bought as flexible volume under a price of 3.9 yuan/m³. The overall price for the total volume stood at 3.4 yuan/m³, amounting to a total cost of 851.4mn yuan, but the residential tariff that the distributor can sell at was fixed at 3.1 yuan/m³ or 776mn yuan.

The potential direct loss from buying and reselling the gas would have therefore reached 75.1mn yuan and when factoring in safety operations, personnel costs and pipe network equipment depreciation costs, climbed to 250mn yuan.

Another example involved an unnamed city gas operator in north China, which sells gas to households at a government-regulated price of 2.8 yuan/m³ in the summer and 3.3 yuan/m³ for the rest of the year.

Sinopec is charging the company 3.2 yuan/m³ for upstream supplies this winter. Including a distribution cost of 0.7 yuan/m³ that includes safety operations, labour and pipeline network equipment depreciation, the city gas company stands to lose about 0.6 yuan/m³ on reselling Sinopec’s gas to residential users.

“I was really looking forward to it when I saw that the NDRC had successively launched ‘forceful’ policies and measures at the beginning of the year to guide the signing of medium and long-term gas contracts and the reform of the gas price linkage mechanism,” said a representative of a Hebei gas enterprise quoted in the now-censored article. “But due to the lack of follow-up supervision, subsequent implementation has led to insufficient base volumes, high flexible gas prices, and lopsided gas sales. To put it simply, good policies have not been well-implemented.”