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China Oil & Gas
China refining - Assessing the
effect of market-based pricing
J Clarke
Research Analyst
(852) 2203 6371
j.clarke@db.com
Tony Lee
Research Analyst
(852) 2203 6239
tony.lee@db.com
Fundamental, Industry, Thematic, Thought Leading
The recent correction in prices and softer near-term macro environment for oil
could be a catalyst for China to move to a market-based pricing regime for refined
products. In this report, we assess the effect of moving to market-based pricing
on PetroChina and Sinopec. Access to such a pricing regime should enable both
companies to realise a higher sustainable refining margin, which would in turn
result in materially increased operating cash flows and valuations (relative to the
current pricing regime), while substantially reducing regulatory risk to cash flows.
Deutsche Bank AG/Hong Kong
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
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Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm
may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision. Independent, third-party research (IR) on certain companies covered by DBSI's research
is available to customers of DBSI in the United States at no cost. Customers can access IR at http://gm.db.com or by calling 1-877-
208-6300. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
FITT Research
Top picks
PetroChina (0857.HK),HKD5.62 Hold
Sinopec-H (0386.HK),HKD5.04 Buy
Companies featured
PetroChina (0857.HK),HKD5.62 Hold
2007A 2008E 2009E
P/E (x) 14.1 7.4 12.7
EV/EBITDA (x) 7.7 3.8 5.5
Price/book (x) 3.4 1.1 1.1
Sinopec-H (0386.HK),HKD5.04 Buy
2007A 2008E 2009E
P/E (x) 12.0 5.2 5.0
EV/EBITDA (x) 6.8 4.2 3.3
Price/book (x) 3.2 1.1 0.9
Fundamental: Cash flow and valuation uplift from market-based pricing
Access to a market-based pricing regime – even in part – should enable both
PetroChina (PTR) and Sinopec (SNP) to realize a higher sustainable refiner margin
throughout the oil price cycle. We believe this adds c.US$46bn and US$52bn,
respectively, to PTR and SNP’s cumulative EBITDA from 2009-2015 over our
current estimates. We estimate the valuation uplift for PTR and SNP to be 35%
and 45%, respectively. We expect a larger benefit for SNP’s group EBITDA and
valuation (relative to PTR) given its larger, more complex refinery operations.
Industry: Chinese refining sector and refiner margins – a detailed overview
We analyse the refining sector in China detailing key market players, product price
regulation and product demand and supply. We also review current trends in Asian
refiner margins and provide a medium-term outlook.
Thematic: A weak oil environment could be the catalyst for pricing change
China has been assessing (for some time now) the merits of refined product
pricing reform, seeking to align domestic prices more closely to international
prices. The current oil price correction has resulted in China’s domestic prices for
gasoline, diesel and kerosene being significantly above international market prices
– suggesting that a price cut is imminent. We believe that China could use this as
an opportunity to move to a market-based pricing regime.
Thought Leading: Modelling product pricing scenarios
We model the cracking margins for PTR and SNP under market-based pricing
conditions to assess the effect on EBITDA and valuation. We rely on data from
Wood Mackenzie, our energy sector research partners, and their detailed global
refinery database to determine the per bbl margin uplift for PTR and SNP’s largest
refineries. We also rely on Wood Mac’s crack spread projections for refined
products in the Asia-Pacific region.
Thematic stock ideas: Sinopec to realise the greatest benefit
We would be positive on both PTR and SNP if China moves to a market-based
pricing regime – we prefer SNP, since it realises a greater uplift to EBITDA and
valuation. We currently rate Sinopec a Buy (PT=HK$6.1/share) and PetroChina a
Hold (PT=HK$6.40/share). In our sum-of-the parts valuations, we use DCF for E&P
and refining and earnings-based multiples for other business segments (see
company-specific sections for details). Industry risks: oil price volatility, a material
slowdown in global GDP growth, and regulatory uncertainty.
Table of Contents
Investment thesis .............................................................................. 3
Could a move to market-based pricing be imminent?...............................................................3
Sector valuation ........................................................................................................................3
Key sector risks.........................................................................................................................3
A move to market-based prices ....................................................... 4
Key points ................................................................................................................................4
Assessing the impact of free market pricing in 2006................................................................4
Looking into the future – running product pricing scenarios .....................................................6
China’s price setting regime .....................................................................................................9
Regional refiner margin outlook .................................................... 11
Key points ...............................................................................................................................11
Capacity expansion = weaker margins in the near term .........................................................11
Short supply could lead to higher longer-term cracking spreads ............................................12
China refining in detail .................................................................... 13
Market demand for refined products ......................................................................................13
The supply side.......................................................................................................................14
China’s refinery infrastructure .................................................................................................15
China product yields................................................................................................................17
Refined product trade .............................................................................................................17
Government subsidies ............................................................................................................18
Risks.................................................................................................. 19
Regulatory changes ................................................................................................................19
Oil price volatility.....................................................................................................................19
Upstream risks ........................................................................................................................19
Company sections ........................................................................... 21
PetroChina........................................................................................ 22
Sinopec-H......................................................................................... 28
Investment thesis
Could a move to market-based pricing be imminent?
China is faced with the difficult task of maintaining fuel affordability and managing economic
growth, while achieving long-term targets of reducing economic energy intensity and
incentivising future refining sector investment. Despite a 55% reduction in oil price since mid
July 2008, China’s regulated prices for gasoline and diesel remain unchanged (currently
priced at 45-85% above international prices). As a consequence, Chinese refiners should
realize significant refining margins in 4Q08/1Q09. We believe that the government will cut
regulated product prices within the next three months (our current estimates for PTR and
SNP factor in a 25% cut for diesel and gasoline prices at the start of 2009). A likely outcome
could be for China to implement some form of market-based pricing for gasoline, diesel and
kerosene (similar to the preceding regime which linked prices to a basket of international
prices) or to implement a free market pricing regime. In this report, we assess the impact of
a move to free market prices on EBITDA and valuation (relative to our current estimates) for
PetroChina and Sinopec.
We expect PTR and SNP to benefit significantly under a free market pricing regime. We
believe c.US$46bn and US$52bn could be added to PTR’s and SNP’s cumulative EBITDA
from 2009 to 2015. In addition, our current company valuations could increase by 35% and
45%, respectively. Although we have assessed the impact of a move to free market prices,
PTR and SNP would also benefit from a move (or partial move) to a market-based pricing
regime (which enables the realisation of prices which move with oil prices). We believe a
change in refined product pricing methodology could occur before the end of the current oil
down cycle (by mid-2010, based on DB’s view on the oil price).
Our FITT report assesses the effect of free market pricing for gasoline, diesel and kerosene
on PetroChina and Sinopec refiner margins as if such pricing had existed in 2006, using
Wood Mackenzie’s proprietary global refining database. We then assess the effect of free
market pricing if it were to be introduced in 2009, and its likely impact on cumulative EBITDA
(from 2009 to 2015) and PTR’s and SNP’s valuation relative to our existing numbers. In our
analysis, we incorporate Wood Mackenzie’s view of regional refining product crack spreads.
In the second part of our report, we provide an overview of Asia’s regional refiner margins
and a detailed look at China’s refining sector, focusing on product demand and supply, trade
balances, pricing and expected capacity additions.
Sector valuation
We adopt a SOTP valuation for both Petrochina and Sinopec. We value the E&P business on
DCF and only take into account the company’s proven (1P) reserve base and reserves that
we think will be booked over the next several years (from announced discoveries). We rely
heavily on Wood Mackenzie in arriving at an estimate for reserves. We also value the refining
segments using a DCF. The other segments are valued largely by reference to comparable
earnings multiples. Please refer to the company sections for further details on our valuation.
Key sector risks
In addition to oil price volatility and a larger-than-expected slowdown in global GDP growth,
other sector-specific risks include continuing market concerns over refining losses and the
lack of predictability in subsidies/price hikes from the government. A key upside risk to our
2009E and 2010E earnings are lower-than-expected refined product price cuts.
A move to market-based
prices
Key points
PetroChina and Sinopec would realize significantly higher maintainable refiner margins
under a market-based or free market pricing regime for gasoline, diesel and kerosene.
Refineries with heavier product slates will realize greater uplift to margins per barrel
relative to refineries with lighter product slates. As a result, PetroChina realises a larger
increase in margin per bbl relative to Sinopec.
Our current cumulative EBITDA estimates (2009-2015) for PTR and SNP will increase by
US$46m (+32%) and US$52m (+35%) under a market-based pricing regime.
Assessing the impact of free market pricing in 2006
We assess the impact to historical 2006 refiner margins for PTR and SNP had free market
prices been available in that year. Our energy research partners, Wood Mackenzie (Wood
Mac), have developed an extensive database of regional refineries and a methodology to
estimate the refining EBITDA/bbl of Chinese refineries if they operated under ‘mid-cycle’
conditions in 2006. Wood Mac defines a ‘mid-cycle’ operating environment as:
Refineries operate in an environment and to a level where a long term sustainable refiner
margin is achieved. Refinery operations are measured on the performance metrics
detailed in Figure 1.
Products are sold in free market pricing conditions (China refineries can sell their
products at international prices) with no sector subsidies or tariff concessions.
We assume 2006 refinery plant capacity and configuration.
Long-term sustainable refiner margins are determined by Wood Mac’s outlook for
maintainable long-term refined product and crude prices.
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