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Chinese Big Oil under threat amid corruption scandal

China's major state-owned producers have been dogged by a spate of corruption scandals, with senior officials accused of abusing their positions and encouraging anti-competitive practices. Will new president Xi Jinping curb the might of the country's big three?

China National Petroleum Corporation (CNPC), one of the world's largest oil companies, is feeling the heat. In late August, the Communist Party's top disciplinary body put out a terse press release saying four executives at CNPC and its publicly-listed arm PetroChina were under investigation for "serious disciplinary violations", a Party euphemism for corruption.

A week later, the government ratcheted up the pressure, announcing that former PetroChina chairman Jiang Jiemin was also being investigated for "serious disciplinary violations".

The investigations, coming on the heels of former Chongqing governor Bo Xilai's high-profile trial for corruption and abuse of power, have been seen as part of new president Xi Jinping's anti-corruption drive. Before taking over the top job, Xi pointed to growing public outrage over China's endemic corruption as the biggest threat to Communist Party rule. He vowed to crackdown on both "flies" and "tigers" - low level and senior officials, who have widely been perceived to act above the law. Jiang is a tiger.

But some analysts see the investigations heralding something potentially more far-reaching than the downfall of a few senior oil industry officials. Some see it as paving the way for Xi to try to break the oligopoly China's big three state-owned oil companies have held over China's oil and gas sector.

China's big oil

The big three - CNPC, Sinopec and China National Offshore Oil Corporation (Cnooc) - were spun off from various government ministries during the 1980s as part of the post-Mao government's efforts to modernise the economy. Since then, they have grown into major international companies with a combined market value of around $400 billion.

In China, they own the most promising fields, produce most of the country's domestic oil and gas, refine most of its fuel products and control the key logistical networks. They have also been at the forefront of China's "going out" strategy, buying up oilfields and refineries around the world in a bid to secure China's growing energy needs for decades to come. There have been high-profile stumbles and embarrassments, such as Cnooc's failed $18.5bn bid for Unocal in 2005, but the oil companies have arguably been some of China's most successful abroad.

This success has earned the companies, and CNPC more than any other, enormous amounts of wealth and political power at home. Senior industry officials have for years worked their way up the state-owned oil companies and moved on to top central and provincial government positions. Unlike officials from many of China's inward focused industries, oil industry personnel gain deep international experience through their work with Western oil companies and governments around the world. That has given them a leg-up in the fierce competition for top party jobs as China's government has sought to internationalise itself. And as officials have moved between the industry and government, they have laid down informal but influential patronage networks, amplifying the industry's political clout.

Jiang was a prime example. He was seen as part of a loose network of industry officials who cut their teeth working at the Shengli oilfield, one of China's largest, in the 1980s and have worked their way up the party's ranks. Zhou Yongkang is seen as the leader of this faction. He was party secretary and director general of the CNPC subsidiary that developed Shengli in the late 1980s, and subsequently rose to head PetroChina before entering China's political elite. From 2007 to 2012, he was on the Politburo Standing Committee, China's highest decision-making body, where he was in charge of China's internal security.

Zhou, analysts say, used his position at the apex of Chinese politics to promote officials from the oil industry. After Jiang left PetroChina, he moved to the State-owned Asset Supervision and Administration Commission (SASAC), a party watchdog tasked with overseeing more than 100 of China's largest state-owned companies. And before being brought down by the corruption scandal, Jiang had been tapped by some as a potential candidate for a spot in the Politburo, with Zhou's backing.

The big three have used their wealth and power to dominate the oil industry. They have also successfully resisted economic and environmental reform efforts that would hurt their bottom lines and introduce more competition into the sector. "PetroChina enjoys government powers but has the flexibility of a corporation. In the economic realm it can do what it wants, and it can pin down government departments such that they can only protect its interests and are powerless to regulate it. It rides atop the government and runs free in the markets, feasting on market profits and government privileges," says Qiu Feng, head of research at the Unirule Institute of Economics, an independent Beijing-based think tank.

Economic reform

That privileged status, though, could be coming to an end as Xi seeks to tackle vested interests seen to be opposing deeper reforms, such as increased competition in the oil sector and more stringent environmental standards. "The PetroChina case is clearly not limited to anti-corruption. Of course it is important to catch a few corrupt officials, but the deeper meaning lies in striking these monopoly enterprises, in clearing the way for systemic reforms," says Qiu.

In early September, just after the corruption investigations were announced, premier Li Keqiang, China's second-highest ranking official, said that greater efforts needed to be made to open monopolised sectors such as the oil industry to private investment. It was the highest-level indication yet that serious reforms for the sector could be on the way.

Prior to the corruption investigation, China's Ministry of Environmental Protection said they would temporarily withhold approval for billions of dollars in new refining projects from CNPC and Sinopec after the companies failed to meet key pollution targets in 2012. The companies had long resisted government efforts to mandate tighter environmental standards such as cleaner automotive fuels that would require significant new investment. Government ministries had long kowtowed to the oil companies on environmental issues, but the latest move appeared to mark a more forceful effort from Xi's new administration to bring the industry into line on environmental regulations. 

The most dramatic move the government could take would be the break up of one or more of the big three state oil and gas companies. It would echo in some ways the US government's dismantling of Standard Oil, the forebear of ExxonMobil, in 1911. CNPC and Sinopec, which has been plagued by corruption scandals in the past, are seen as the most likely candidates to be broken up. Cnooc, the smallest of the three, is generally seen as being better managed and a model for the others.

CNPC

The focus right now is clearly on CNPC. There are two ways forward for the company, argues Yu Laban, an analyst at Jeffries, an investment bank. The government could bring in new management to root out corruption. There is a precedent in the oil industry. After Sinopec's chairman Chen Tonghai was arrested for corruption in 2007, and later convicted for accepting nearly $30 million in bribes, he was replaced by Su Shulin, a CNPC executive who won praise for cleaning up the company.

The other option would be to break CNPC apart, potentially into separate operating units. There is also a recent precedent for this option, according to Yu. China's Ministry of Railways was dissolved into three separate functions amid a spectacular corruption scandal involving railway minister Liu Zhijin, who received a suspended death sentence after being convicted of large-scale corruption. "If China's leadership were to decide that the root of corruption can be traced to PetroChina's scale, the company could go the way of the Ministry of Railways," said Yu.  

Yu recently questioned PetroChina's financial reports in a research note, arguing that the company reported a $10bn revenue shortfall last year. PetroChina attributed the discrepancy to 'accounting differences', though Yu rejects this argument. He says either the company's disclosed realised oil and gas prices are wrong, refiners are in worse shape than previously thought, costs have been mis-reported or PetroChina is "plagued by graft".

In any case, Yu argues, PetroChina should emerge a stronger company, or companies. "We believe both a cleaner-scrubbed and a broken-up PetroChina could release value currently encumbered by the leakages and discrepancies we have found."

Not everyone, though, sees major changes for PetroChina afoot. "We don't believe PetroChina is losing its financial clout and privileged connections with the government, judging by the latest $5bn deal announced in July 2013 to buy an 8.4% stake in the Kashagan field... PetroChina's senior management and president Xi Jinping were together at the signing ceremony," Nomura analysts said in a recent report.

Increasing competition

Other analysts have argued that China has benefitted from having very large state-owned companies capable of going out and striking multi-billion dollar deals around the world.

Nevertheless, there are signs that the government is seriously considering ways to increase competition in the domestic oil industry in a way that would threaten the big three's privileged position.

The government may start reform at the pump, where consumers would most immediately see the results of the government's efforts. "As a good way to form fair market competition in the petroleum sector, we should make some adjustments in the oil retailing field by stripping away the oil station business from the three main state-owned oil enterprises and set up another state-owned enterprise specilaised in the operation of fuel stations," Xu Baoli, director of research at SASAC, was quoted as saying in state media.

China's roads are dotted with CNPC and Sinopec petrol stations, with the companies holding a combined 80% share of the market. That duopoly has distorted China's fuel market and put smaller station owners at a severe disadvantage in the market. Opening up the sector to greater competition, Xu, argued would lead to lower prices and improved service. He said he would particularly like to see foreign companies with a presence in China, such as Shell, be able to expand their networks.

Media reports have also indicated that Chinese authorities want to see more competition in China's natural gas pipeline sector. Taiwan-based Want China Times reported in late September that the National Development and Reform Commission (NDRC), China's powerful economic planning body, is pressuring CNPC to spin off its natural gas pipeline business.

The natural gas pipeline sector is an area where monopolisation is now clearly an impediment to expanding China's gas sector, a key policy objective for the government. CNPC produces around 75% of China's natural gas and owns about 80% of the pipeline network, including major import links from Central Asia and Myanmar. Sinopec, another major gas producer, is the other major gas pipeline operator. But both companies have been criticised for managing their networks in conjunction with their own upstream operations, and to the detriment of third party producers.

Opening up equal access to the infrastructure and allowing more competition for the construction and management of pipeline networks would likely encourage significant new investment in the sector, which could potentially boom over the coming years. Chinese policymakers are keen to see gas consumption rise. It burns cleaner than coal, which dominates the energy mix, and would help China address its appalling air pollution and rapidly rising carbon emissions.

CNPC, though, is unlikely to easily give up its grip on the sector. It has already spent tens of billions of dollars on its natural gas infrastructure and it expects government-fixed domestic gas price increases to provide a major boost to its bottom line next year. Moreover, the complicated shareholding structure of the gas pipeline business could make any attempt to spin off an independent company very complicated.

CNPC, for instance, sold a major gas pipeline unit, the Shaanxi-Beijing line, to its Hong Kong-listed subsidiary Kunlun Energy in 2011 for $2.8bn. As a result, the government would have to convince investors in Hong Kong to go along with the plan.

The problem with shale development

China's halting efforts to develop shale gas is, analysts argue, another area where monopolisation has become a hindrance to achieving broader political and economic objectives. China is thought to hold vast shale oil and gas reserves, potentially more than the US, which has seen its energy industry transformed by new production from shale. The government is keen to tap into the resource to boost energy security and ease a growing oil and gas import burden.

But the big three are struggling to develop those resources. There are a number of reasons why: domestic gas prices remain too low to encourage exploration and production; water needed for hydraulic fracturing is limited in many areas; and China does not have the advanced drilling technologies needed to develop its complex shale formations.

The more entrenched problem, though, is the lack of competition in the shale sector. The US' shale patch has been a hotbed of competition and innovation, with dozens if not hundreds of small and medium sized upstream and service companies driving the industry forward. China, by contrast, initially relied on its big three to kickstart a shale revolution. It has not worked. Exploration has been more expensive than expected and results poorer than expected. As a result, the big three have soured on shale exploration and production and the sector has stalled.

The Chinese government appears to recognise the problem. The country's second shale round, held in January 2013, was opened to more than just the handful of major state-owned oil and gas companies allowed to take part in the first auction. And it was successful in attracting more companies into the sector, with more than 100 firms taking part.

The problem is that few of the companies that won blocks in the round, mostly coal companies, power utilities and local-government backed investment firms, had any previous oil and gas experience, let alone shale experience. In a recent report, the Ministry of Land and Resources said that many of those companies that won acreage in the second round had yet to start any exploration activity, and instead seemed more focused on using the shale-gas blocks to raise cash.

That has forced the government into a radical rethink about how it purses shale oil and gas and structures the industry as a whole, argued Farzam Kamalabadi, president of Future Trends International, an energy investment consultancy in China. "Exploiting shale gas is the trigger that will open up Chinese oil policy," said Kamalabadi.

He points to the absence of mid-sized companies in China's oil patch as a major problem for the development of shale and China's broader upstream sector. There is no Chinese equivalent to Chesapeake Energy or EOG Resources, two companies that were instrumental in developing the US shale industry. Those types of companies have the scale to carry out large-scale operations and pioneer new technologies but are small enough to remain nimble and have the freedom to take risks larger companies usually will not.

"There are very small companies and super large companies, nothing in between... I believe that the Chinese government is changing its policies. The very fact that the former chairman of CNPC is ousted is not random, it is not simply a corruption case. It should be seen as a sign that China is opening up the industry," argued Kamalabadi.

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