Greater Liberalisation In Sight?

BMI View : The punishment lashed out against officials from state-owned Sinopec for the company's culpability in a major pipeline accident in Qingdao has seen yet another national oil company fall from grace following corruption probes into PetroChina. While China's NOCs are likely to continue their dominance over the entire value chain of the country's oil and gas industry, the weakened political power of these firms could allow for greater liberalisation of the industry to the benefit of private players in the upstream, midstream and downstream. Although the upside risks from industry liberalisation to our production forecasts are high, we maintain our current outlook given that much uncertainty clouds the politics underpinning reform of China's oil and gas industry.

Another one of China's national oil companies (NOC) has fallen from grace. Sinopec became the latest firm to be indicted, with the State Council - China's equivalent of the cabinet - holding the country's largest refiner responsible for a major pipeline blast in Qingdao that killed 62 people and led to losses totally about US$123mn in November 2013. An official report opened by the State Council into the accident identified Sinopec's negligence in pipeline safety inspection, thereby allowing for pipeline corrosion and explosion risks to exist that led to the blast. In addition, it has also been held accountable for its 'weak emergency response' that failed to contain casualties from the fire.

In response to the report's findings released on January 10, 63 employees will be indicted. The official Xinhua News stated that 48 of them will 'receive punishment for violating Party and administrative disciplines' and 15 'transferred to judicial organs for their alleged crimes' - a veiled reference to the criminal trial that awaits them. Among the workers held responsible is Sinopec's Board Chairman Fu Chengyu, who received a 'demerit administrative sanction' - or another term for demotion. Following the reports, the NOC announced that it would compensate for losses, though the parties to whom it will compensate and the value of this compensation has yet to be established at the time of writing.

On The Rise, But Underwhelming Increase
China's Oil & Gas Production, 2000-2012

Greater Liberalisation In Sight?

BMI View : The punishment lashed out against officials from state-owned Sinopec for the company's culpability in a major pipeline accident in Qingdao has seen yet another national oil company fall from grace following corruption probes into PetroChina. While China's NOCs are likely to continue their dominance over the entire value chain of the country's oil and gas industry, the weakened political power of these firms could allow for greater liberalisation of the industry to the benefit of private players in the upstream, midstream and downstream. Although the upside risks from industry liberalisation to our production forecasts are high, we maintain our current outlook given that much uncertainty clouds the politics underpinning reform of China's oil and gas industry.

Another one of China's national oil companies (NOC) has fallen from grace. Sinopec became the latest firm to be indicted, with the State Council - China's equivalent of the cabinet - holding the country's largest refiner responsible for a major pipeline blast in Qingdao that killed 62 people and led to losses totally about US$123mn in November 2013. An official report opened by the State Council into the accident identified Sinopec's negligence in pipeline safety inspection, thereby allowing for pipeline corrosion and explosion risks to exist that led to the blast. In addition, it has also been held accountable for its 'weak emergency response' that failed to contain casualties from the fire.

In response to the report's findings released on January 10, 63 employees will be indicted. The official Xinhua News stated that 48 of them will 'receive punishment for violating Party and administrative disciplines' and 15 'transferred to judicial organs for their alleged crimes' - a veiled reference to the criminal trial that awaits them. Among the workers held responsible is Sinopec's Board Chairman Fu Chengyu, who received a 'demerit administrative sanction' - or another term for demotion. Following the reports, the NOC announced that it would compensate for losses, though the parties to whom it will compensate and the value of this compensation has yet to be established at the time of writing.

A Putsch Against China's Oil & Gas Elites?

The safety probe into China's oil and gas industry that transpired in the wake of the Qingdao accident and the heavy punishment against Sinopec seem to suggest greater openness - a rarity given the protected nature of the industry - dominated by three largest NOCs - by the state. A public announcement that China's petrochemical firms and oil storage sites contain at least '20,000 disaster risks' by the State Administration of Work Safety appears to show the willingness of the state to be more transparent about the dangers in China's midstream and downstream. This is in addition to an ongoing high-profile corruption graft into some of the highest-ranking officials in China's largest NOC PetroChina, indicating growing willingness of Beijing to reform and lift its protective shield over one of the most lucrative but opaque industries in the country.

Other considerations to reduce the extent of NOCs' control of the entire oil and gas value chain had also been periodically hinted at since the ascendance of Xi Jinping as China's president and most powerful party official in the Chinese Communist Party (CCP) in 2013. Although the strategic status of the oil and gas industry remains, thereby ensuring that the state continues to have a strong hand in it, there are ongoing debates that could erode the power of the NOCs in the Chinese market:

  • PetroChina could be forced to spin off its midstream arm. This would break the firm's near-monopoly in the gas pipeline transmission market and could help reduce gas transmission costs. Advocates of this state that this will promote an increase domestic upstream gas production, which will be needed to meet Beijing's gas consumption targets without dramatically increasing gas imports. A 2012 Energy White Paper aimed to increase the use of gas to 10% of the country's total energy mix by 2020, from 6% in 2012 - which would suggest an increase of at least 98.7bn cubic metres (bcm) (see 'A Pipeline Spin-Off For CNPC: Opportunities And Risks', October 2.

  • More teapot refineries could be given crude oil import rights. The National Energy Administration (NEA) is mulling an increase in crude oil import quotas given to non-state crude oil importers and is currently seeking recommendations from the public for its implementation.

  • More freedom for private companies to invest. The NEA had stated that it is looking into this, which could result in freer conditions for companies to participate in China's Third Shale Gas Round.

These measures take place in a wider backdrop of a draft for industry reform by the State Council's Development Research Centre, which also included proposals to liberalise oil and gas prices. This was affirmed during the country's Third Plennum meeting - a key event for the CCP whereby the party hints at the direction that economic and social planning in China would take in the coming years.

If these measures are pushed through, China's NOCs and their officials stand to lose the most. Given that officials of the NOCs are also powerful party members, they could have significant sway in influencing the agenda of market reforms in China. The corruption probe against PetroChina and Sinopec's culpability in the Qingdao blast appears to have been opportunities to reduce the political power of leading individuals in these major state-owned enterprises. It could in turn ease the path towards the Xi government's goal at further opening up China's economy and, by association, the oil and gas industry.

Liberalisation Perks

China's upstream segment could stand to benefit most from liberalisation. Oil and gas production has been on an upward trajectory, but this trend is increasingly being supported by enhanced recovery measures in large and existing fields by the country's NOCs that are maturing fast. In recent years, it has had some success in producing from new offshore and tight oil and gas fields. Unconventional output has also picked up, with coal-bed methane (CBM) increasing to more than 3bcm in 2013 - a significant improvement from its struggle to even hit 1bcm a couple of years ago - and shale gas output coming in at 0.2bcm. Still, its offshore and unconventional exploration and production (E&P) can also be said to have been underwhelming.

On The Rise, But Underwhelming Increase
China's Oil & Gas Production, 2000-2012

State dominance has partly contributed to E&P, particularly offshore. Stringent terms that shift nearly all exploration risks to private firms but gives NOC China National Offshore Oil Corporation (CNC) with a majority stake (of at least 51%) in all contracts are not particularly appealing. For shale gas, stringent domestic partnership conditions and investment requirements have also seen exploration disappoint, for a country estimated by the US Energy Information Administration (EIA) to potentially possess the world's largest pool of recoverable shale gas resources. In particular, many licences awarded in the Second Licensing Round in October 2012 remain untouched, having been won by many large state-backed firms which lack the expertise to conduct operations. In contrast, it is notable that the US' shale gas revolution took off thanks to the efforts of more risk-prone independents.

Estimates For Resources In East China And South China Sea
East China Sea South China Sea
Oil (bn bbl) Gas (tcm) Oil (bn bbl) Gas (tcm)
US Geological Survey/Foreign Sources 100 - 28 -
Chinese Sources 70-160 4.9-5.88 213 56
Source: USCS

Opening up the upstream could see more investment pour into the country. This could be further supported by a liberalisation of the mid-stream as well, to provide attractive project economics. The effect could be less obvious in the downstream, as China already appears to be sufficiently supplied with refined oil products from the NOCs' relentless expansion of the segment. However, private participation could pay off in the longer run if price liberalisation takes place. With refined oil prices no longer set by the state as is the current practice, abundant supplies from both NOCs and other players could cap the increase in oil prices.

It's All About Politics

Nonetheless, we warn against early optimism that increasing regulatory openness about the oil and gas industry would necessarily put China on a firm path towards liberalisation. The probes into PetroChina and public punishment of Sinopec could merely be a process of political rationalisation by President Xi Jinping, as he continues to consolidate his control over the state and the party. Indeed, Sinopec's Board Chairman Fu Zhengyu, together with PetroChina's ex-head Jiang Jiemin, had been identified for a corruption probe by the previous government under Hu Jintao as early as in 2010.

While the more conservative stance on the economy might have pitted Fu and Jiang against the previous and existing government politically, China's political environment remains too opaque to ascertain that new personnel assigned to head these firms - most likely political allies - would necessarily see radical liberalisation if improved relations between the NOCs and Beijing lead to comfort in the status quo. As such, though the upside risks from liberalisation to our oil and gas production forecasts are high, we maintain our current outlook given that much uncertainty clouds the politics underpinning reform of China's oil and gas industry.

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