China Oil & Gas:Mega contracts and acceleration of SOE reform

The structure of China’s gas supply chain will be reshaped by two massive gas import contracts signed recently, (1) a 30-year Sino-Russian contract signed on 21 May to import 38b cubic meters of piped gas a year from Russia starting from 2018, and (2) a 20-year Sino-British contract signed on 17 June to import 1.5m tonnes of LNG a year from the UK starting from 2019. These two mega contracts will reshape China’s natural gas supply mix (China imported 27.3b cubic meters of piped gas from Turkmenistan and 15m tonnes of LNG from Qatar in 2013). The new contracts will require accelerated construction and liberalization of China’s gas distribution and storage system.

More gas distribution and storage facilities. China’s rapidly growing gas imports will not only require new gas distribution and storage facilities, but also greater liberalization of the current distribution system to allow more private sector participation to achieve higher operating efficiency. We believe this will have the ancillary effect of accelerating the process of SOE reform. China’s State Council decided to open 80 demonstration projects to social capital in late April this year, of which over two-thirds (54 projects) are energy related, including gas pipelines and storage facilities.

Who will benefit? Beneficiaries of liberalization of China’s gas distribution system in conjunction with the country’s growing gas requirements are likely to be (1) steel pipe suppliers (e.g. Chu Kong Pipe (1938 HK, Not Rated) and Shengli Pipe (1080 HK, Not Rated)), and (2) oil & gas logistics service providers (e.g. Sinopec Kantons (934 HK, Outperform)). We consider Sinopec Kantons a good proxy for rising demand for gas distribution in China as the firm recently acquired the Yulin-Jinan gas pipeline from its parent. Though our channel checks indicated the acquisition may take longer to complete than the market expects due to the complexity of the deal, we nevertheless expect the injection to be completed in 2014F and begin making a full-year contribution in 2015F. The company is trading at 17.9x 2014F P/E, below the 19x historical average P/E in the last five years, thus providing a good opportunity for accumulation. Should more progress on the asset injection be announced in 3Q14, the stock may be re-rated.

Jingcheng Machinery another possible beneficiary. As a part of SOE reform, the parent of Jingcheng Machinery (187 HK, Not Rated) completed a material asset reorganization on 11 April 2014. This entailed injecting an 88.5% equity interest in Tianhai Industrial (engaged in the CNG/LNG cylinder business) worth RMB1,514m. Jingcheng Machinery’s CNG/LNG cylinder production capacity is roughly on par with CIMC Enric (3899 HK, Not Rated), though it is trading at only 1.5x P/B compared with CIMC Enric’s 3.0x P/B.