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Chinese pipeline reform set to spur E&P

The transfer of major infrastructure assets away from the country’s NOCs to the newly created PipeChina should reinvigorate the upstream sector

China’s pipeline reform will be a boon for domestic E&P in coming years as it will allow the country’s NOCs to sharpen their upstream focus while paving the way for the entry of more players to ­foster competition.

The reform, initiated last month, saw PetroChina and Sinopec agree to swap various assets—including pipelines, storage sites and import terminals worth a combined RMB391bn ($56bn)—for cash and shares in a new midstream operator, known as PipeChina. Those deals, plus cash injections from other investors, will see PipeChina valued at RMB500bn once the transactions 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 control of China’s midstream sector. It represents the most significant overhaul of the Chinese oil and gas industry since the NOCs started listing on domestic and foreign stock exchanges two decades ago.

PetroChina stands to net RMB268.7bn, comprising RMB119bn in cash and a 29.9pc share in PipeChina, making it the largest individual stakeholder in the new company. Sinopec will receive RMB122.7bn in the form of RMB52.7bn in cash and the second-biggest shareholding of 14pc.

The long-awaited pipeline reform raises question marks over the future of PetroChina

As China’s top oil and gas supplier, PetroChina owns the biggest pipeline network in the country. Its domestic oil and gas pipelines stretch 87,144km, comprising 53,291km of gas pipelines, 20,091km of crude, and 13,762km of oil products, according to its 2019 annual results.

Among the connections PetroChina is divesting are the three West-East pipelines, which have a combined capacity of 73bn m³/yr and form the backbone of China’s gas transport network. The cross-country trunklines have transported more than 540bn m³ to date.

Sinopec’s list of assets includes its Sichuan-East China pipeline, which links gas fields in southwestern China to the economically vibrant Yangtze River Delta on the eastern seaboard.

Premium valuations

Both companies received premium valuations for their assets, easing shareholder fears that they would not receive fair-market value. For instance, PipeChina agreed to pay a 43pc premium above the book value of Sinopec Kanton’s 944km Yulin-Jinan gas pipeline, resulting in a final cost of RMB3.2bn.

This was far above analyst estimates, which ranged from a 20pc premium to none at all. Overall, PetroChina will receive 1.2 times book value of its assets, while for Sinopec the figure will be 1.4.

The consolidation of China’s transport and storage infrastructure under PipeChina sits at the centre of reform efforts by President Xi Jinping’s government 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 15pc by 2030.

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

RMB500bn – Value of PipeChina

This will make it easier for new E&P entrants to monetise any oil and gas they discover and effectively end the Chinese NOCs’ decades-long domination of the upstream sector.

There are implications for downstream too, as improving third-party access to pipelines will make it easier for companies to supply oil and gas to, and offtake it from, China’s distribution network. This will help liberalise the country’s LNG import market, as emerging LNG importers will be able to bring in inexpensive spot volumes and receive them at the terminals being 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 operate efficiently. Some say it could take two years, others as long as five years, to overcome these rivalries and make things running smoothly.

E&P spending

PetroChina and Sinopec will earmark the bulk of their sales’ cash proceeds for a special dividend, but a considerable portion is likely to go towards E&P. Assuming that one-third of the cash proceeds are allocated for reinvestment, this would be an additional RMB39.6bn—or equivalent to 20pc of the RMB200bn PetroChina has budgeted for capex in 2020. PetroChina spent RMB230bn on E&P 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. In June, the National Development and Reform Commission—China’s powerful economic planning agency—and the National Energy Administration issued a joint statement that reemphasised energy security across a number of industries.

By forcing its NOCs to divest their midstream operations, Beijing hopes to remove a major barrier for other firms to invest in E&P

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 ensure supply security.

China’s quest for domestic energy security led to a record investment of RMB82.13bn in oil and gas exploration last year, up by 29pc from 2018, while investment in hydrocarbon production surged by 24.4pc, to RMB252.71bn, according to the Ministry of Natural ­Resources.

China booked an additional 1.12bn t (7.87bn bl) of oil in place in 2019, the Ministry says, up by 17.2pc year-on-year, while new gas in place reserves booked last year dropped by 2.7pc over the same period, to 809.1bn m³.

Pipeline reform

The long-awaited pipeline reform raises question marks over the future of PetroChina. A short-term concern is how it will continue to weather losses incurred on the domestic resale of imported gas. The company lost RMB30.7bn on reselling imported gas last year, up from a loss of RMB24.9bn in 2018.

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

At the same time, PetroChina will be relieved of the heavy spending needed to build long-distance pipelines as this responsibility will soon fall to ­PipeChina. In the longer run, though, pipeline reform may potentially presage the eventual break-up of PetroChina given Beijing’s desire to ­nurture a more competitive upstream sector.

Pipeline reform represents an assault on PetroChina’s control of oil and gas distribution, and Beijing may take a similarly hardline stance on the company’s upstream dominance given it accounts for 70pc of domestic gas production. The idea—which remains just talk among industry insiders for now—would be to break up PetroChina to create a fragmented but more dynamic industry of risk-taking E&P firms.

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