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Sinopec - putting the house in order

The Chinese giant is shifting priorities to make the most of weaker crude prices

As the Austro-American economist Joseph Schumpeter famously argued, recessions are good for business because they force management to achieve more with less. "Creative destruction" was the term, and it applies neatly to China's state-owned Sinopec, the biggest refiner in Asia and the country's second-largest producer of oil and gas by volume.

At last equipped with a new president -- the post was left vacant for more than a year -- Sinopec has been spending heavily on its downstream business; a quest for higher-margin sales from its chemicals and other value-adding divisions. And, while not neglecting the upstream, China's petrochemical giant spent much of 2016 building up its retail businesses and customer relationships in ways that are clearly intended to help it navigate a prolonged period of low crude prices.

The job of guiding the company into an uncertain future has fallen to 52-year-old Dai Houliang, the long-serving chief financial officer who was appointed to the top position in August. Dai landed the presidency, which is effectively general manager, as Sinopec recovers from a leadership crisis following the arrest in 2015 of former president Wang Tianpu on bribery and corruption charges, part of Chinese President Xi Jinping's crackdown on graft. (In November Wang reportedly pleaded guilty to accepting 33m yuan, or about $4.7m.) The new manager is an engineer who rose steadily through the ranks. He held down several senior positions over the past 18 years, including that of chairman and president of Yangzi Petrochemical company, before moving to head office in Beijing where he started as deputy chief financial officer.

Faced with intense competition from independent refineries in a saturated market, Sinopec is focusing on higher-margin gasoline and kerosene

One looming question is whether Dai will be expected to push through a merger with PetroChina, the other state-run oil giant. It's thought that President Xi wants to fold the two groups together - part of a plan to wring some efficiencies in the face of low crude prices. Like Sinopec, PetroChina is slashing costs to achieve acceptable profits in a tough market.

Dai's hand can already be seen in tight financial management. In the first nine months of 2016, net cash flow from operating activities rose 13.3% (131.7bn yuan compared with last year's 116.2bn yuan). Without that, the 11.3% slump in operating income would have been worse. So would operating profit, which actually improved, rising by 4.2% to 51.4bn yuan. In another indication of how Sinopec managed to squeeze more from less, return on net assets rose by 4.4%.

But these figures flatter the group. Sinopec got a huge boost from a state-imposed floor put under the price of fuel and other consumer products that helped to account for the $10.72-per-barrel refining margin, 54% above the average in 2015, that was achieved by listed subsidiary China Petroleum and Chemical Corporation. Driven by a sharp jump in the consumption of gasoline and kerosene, this sector grew by nearly 4.4% while diesel consumption slipped.

Despite low oil prices, Sinopec continues to invest heavily in the upstream. Deploying a budget for exploration and production of 9.2bn yuan out of total capex of 25bn yuan in the first nine months of 2016, the company has focused on three fields: the ultra-deep and technically challenging Tahe, in Xinjiang region; Beibu Gulf, on the Vietnam border; and the Yin-E Basin, in Inner Mongolia.

Most of the exploration and production budget, however, was poured into the development of the second phase of a shale gas project in Fuling and into two liquefied natural gas terminals: one in Guangxi, in the south of the country, and the other in Tianjin, southeast of Beijing. The gas pipeline linking Jinan and Qingdao also received an unspecified part of the budget.

To cut costs, Sinopec stepped back from some of its more difficult fields, crimping its production by just over 8%, to 322m barrels of oil equivalent. Falling crude output, which dropped by 12.5%, accounted for most of this reduction, while natural gas production rose by just over 5%.

Refining reshuffle

Faced with intense competition from independent refineries in a saturated market, Sinopec is focusing on higher-margin gasoline and kerosene. While turning down the taps slightly - refinery throughput fell by 1.72% --the company managed to boost sales of higher-grade gasoline (up by just over 3%) and jet fuel (4.3%), which helped compensate for a 6% slump in diesel sales.

The virtue of targeting the top end of the market is reflected in revenues. Sinopec's refining business posted earnings before interest and tax (ebit) of 43.5bn yuan, a staggering rise of 183%. That more than justifies the 5bn yuan in capex pumped into the refineries, mainly to improve the quality of gasoline and diesel. In the retail race, Sinopec also splashed nearly 6bn yuan in the downstream, on projects including an upgrade of its chain of service stations.

Chasing higher returns in chemicals, Sinopec earmarked 4bn yuan for the division. Clearly excited about the potential for adding value, the group managed to lower the cost of feedstock for ethylene. Although production of ethylene fell by nearly 2% last year, to 8.1m tonnes, overall sales from the chemicals division jumped by over 11%, to 50.5m tonnes. Chemical sales posted pre-tax earnings of 19.1bn yuan, almost a 9% increase. Sinopec now believes it's reaping the rewards of investing heavily along the entire value chain including in the manufacturing plants.

Cash flow from operating activities rose 13.3% to 131.7bn yuan

"This has achieved great results," the group said. "We strengthened research and development, production and marketing capabilities of new high value-added products, with performance polymer ratio reaching 59.7% and the differential ratio of synthetic fibre reaching 84.8%."

In a flat upstream market, this is the right direction for Sinopec, according to Moody's, a ratings agency. It rated the group's latest issue of unsecured dollar notes, mainly to refinance debt, as Aa3,. "The strong profits generated by Sinopec Group's downstream business will offset the impact of low crude oil and natural gas prices on its upstream exploration and production businesses," the agency said in September.

But Sinopec is also expanding its global operations. Although it's early days, the collaboration with Argentina's state-owned YPF could be significant, particularly in the Vaca Muerta shale project located in the Neuquén Basin. With around 16bn barrels of oil and 308 trillion cubic feet of natural gas, the basin holds much promise for the partnership. Details of the collaboration are somewhat thin, but YPF says it could lead to other projects in Argentina.

As Sinopec heads into 2017, its not-so-secret weapon remains state ownership. Without the virtual guarantee that the government will do whatever is necessary to support its flagship petrochemicals group, Moody's would not have bestowed its Aa3 rating. Much, though, still depends on oil prices. As the agency warns, Sinopec could be downgraded if Brent prices fall below $45 a barrel in the next 12-18 months. Without a healthy price for its main product, there's only so much creative destruction that a company can achieve.

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