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Growing pains
China’s oil companies are going through tough changes
When the smoke clears, China’s oil companies will have a considerably
larger gas presence composing their reserves and their EBITDA, and the
valuation premiums that they’ve held over international oils won’t likely
return. If the NDRC’s ‘cost plus’ margin system is implemented, natural gas
and refining will become stable utility-like businesses, opening up resources
which can then be deployed to growing reserves. For now, pump prices
have to be cut, and the growing pains involved in implementing reform must
occur. Also, operational performance will be under a microscope – cost
control and missing production targets will not be brushed off as in the past.
While a near-term re-rating may occur with promulgation of the new refining
policy, we continue to avoid energy stocks through 4Q08 and 1Q09.
Refining in China – demand outlook and policy
The NDRC is again promising a profitable refining system. We believe that
this will be intact to a limit – a return to high crude prices and inflation will
likely bring a return to refining losses. We expect 2.9% y-y growth in China’s
oil consumption and have adjusted our utilization accordingly (see page 8).
Oil’s big breakdown
Oil markets are showing worrying signs – all of 1Q09’s NYMEX gasoline is
priced under crude. Macroeconomic performance, rather than OPEC, will
determine how low oil goes, and we see further downside from here in 1Q09. A
weakened US consumer, weak petchem moving some naphtha to gasoline, and
Europe being structurally long in gasoline is damaging the key profit driver in
refiners. Asia’s simple refiners appear poised for bankruptcy.
Structural changes needed for value creation
Reserve growth and economic growth create value in oil assets. There are two
ways to create value in this environment: M&A activity, and operators
approach drillers to lock in 3-5-year contracts. The latter soaks up excess
rigs and nails down costs for operators. These are the best ways to grow
reserves in an environment where opex will be flat (or up) against low oil
prices and tight credit hurting small players. We see relative but not absolute
performance for energy in the near-term from refining reform. We’ll be buyers of
E&P and drillers at better pricing and when the industry adjusts to the times.
Contents
Proposing refining reform (again) .................................................................................. 3
How the new system will work 3
Why changes to Chinese oil companies are important 4
How will demand and utilization hold up in China? 6
Structural changes that need to occur........................................................................... 9
It will get better before it gets worse ............................................................................ 12
BNP Paribas’ Global Commodities team outlook 12
Company updates ....................................................................................................... 15
1. PetroChina 16
2. Sinopec 20
3. CNOOC Ltd...............................................................................................................................24
Proposing refining reform (again)
China’s integrated oils currently don’t operate like integrated companies – they more or
less monetize oil that they were endowed with via a communist government-controlled
refinery. Oil economics impact them on the cost front, but not necessarily on the
revenue front. There is a limited amount of room to out-manoeuvre this via small
changes to a refinery’s crude slate (changing the internal / externally-sourced crude
inputs).
Reform essentially means that they’ll behave somewhat closer to international oil
companies (IOCs) – or in our view, modified NOCs (national oil companies). Refining
may now be going from a loss-making subsidy function to a profitable business. We
warn that this will only last as long as inflation is not a threat. A return to inflation in the
next commodity cycle will likely mean a return to refining losses.
For now, the NDRC is proposing a cost plus fixed margin which, by our calculations,
comes to a USD6.30/b margin. This is better than Asian peers will likely fare, and with
virtual monopolies controlling imports and the full fuel value chain in China, they’ll likely
see some protection from imports. We’re told numerous times by international oil
companies of the concessions they have to make to get access to upstream plays in
China. We’re not too concerned with pressure from large players in the wholesale or
retail-fuel markets threatening what could be a decent margin for Sinopec and
PetroChina. Small players may compete, but this is likely to be confined to lessdesirable
geographies. We’re not proposing a stock price premium – the global refining
business will struggle. We believe that a re-rating to some degree is deserved as two
virtual refinery monopolies go from the red to the black.
How the new system will work
As we’re told by the NDRC and Sinopec: step one is to cut fuel prices down. Sinopec is
guiding that the government will cut July 08’s price hike and November 07’s price hike
(RMB1,000/tonne + RMB500/tonne), which would imply a breakeven of USD52.40/b.
On top of this cut, China will then insert a fuel tax (see below) which will offset the
cancellation of individual highway and toll taxes, and nationalize the highway system.
Part of the taxes collected will be redistributed to subsidize farmer’s use of diesel. Fuel
taxes curb consumption and can be adjusted higher or lower depending on economic
conditions. This is positive for China’s development.
From here, prices will be fully liberalized and a fixed margin system is going to be put in
place. We’re told that this will be a cost plus system, where the refiner makes a 4%
margin on top of transportation costs, conversion costs, and materials (chemical
catalysts) costs. We calculate this to be roughly USD6.30/b, but the draft law that has
been circulated does not have a specific formula. Having been largely disappointed with
China’s approach to energy policy, we will remain somewhat sceptical until something
more concrete on the cost plus system is released.
Why changes to Chinese oil companies are important
Basically, China’s oil majors are fairly competitive in terms of spending vs returns, even
with these subsidy functions. We model a liberalized PetroChina as: A long-term oil
price of USD80/b, a long-term natural gas price of USD6/mcf, and a USD6/b refining
margin. Under this scenario, the below ROE vs spending relationship to competitors is
maintained, and the company’s cash on the balance sheet doubles. We’ve stated
repeatedly that we don’t believe natural gas will be fully liberalized, nor will refining;
however, China’s companies are competitive even with these subsidies. Just decreasing
the negative affects of these subsidies puts a lot more cash in their coffers, which, if
they deploy at their historic returns / capex fashion, would bode well for shareholders.
The below metric highlights our key point – we plot spending relative to size (production)
and view this against ROE.
Exhibit 2: 2003-2008 Average Capex/Production
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