China introduces new gas pricing mechanism
Thursday, Jun 29, 2017
Investors and credit rating agencies were united this week in their belief that a new pricing mechanism for urban gas distribution would be good news for Chinese city gas distributors – or at least better than many had feared.

The National Development and Reform Commission (NDRC) issued a new regulatory directive on June 22, saying that it would link the price of independent gas distribution to the costs such companies carry while still allowing them enough space to make a profit.

The mechanism will be designed to cap the return for downstream gas transmission assets at 7%, it said – higher than the 6% that many analysts had expected and also better than the returns cap (excluding connection fees) that gas distributors are currently subject to.

Shares in distribution companies – many of whose financial health was already pretty good – jumped on the news. ENN Energy, for example, saw its stock climb by 6%, while China Gas Holdings’ shares lifted 5% to a three-year high and CIMC Enric rose more than 4%.

Moody’s said the new distribution tariff mechanism was credit positive for city gas distributors. It would increase transparency and help improve the stability and predictability of investment returns for distributors, the ratings agency explained.

On the up

Because under the new mechanism the distribution tariff will focus only on the companies’ gas distribution business – rather than factoring in connection fees or customer retail service fees – city gas companies might decide to spin off their gas distribution businesses, analysts said. Gas distributors might also work to cut costs, including sourcing cheaper gas and bypassing oil majors to earn additional returns.

The distribution tariff will benefit ENN Energy, which already has a plan to import its own lower-cost LNG, according to Daiwa analyst Dennis Ip. The company may enjoy an addition 10% to 15% margin on its 1.5 million tpy LNG contract once its parent’s Zhoushan LNG terminal is commissioned in the second half of 2018.

China Gas – whose shares have already rallied more than 40% this year and show no signs of running out of steam – was already in a strong position to benefit from Beijing’s push to promote gas over coal, noted Jefferies analysts Howard Lau and Laban Yu.

The company has this year signed framework deals with nine major cities to develop coal-to-gas (CTG) projects and has won contracts to convert 670,000 households in rural areas.

China Gas remains Jefferies’ top pick in the gas sector, with a buy rating plus a price target of HK$15.40 (US$1.97) per share.

Deutsche Bank analyst Hanyu Zhang – who also has a buy rating on China Gas – has raised his earnings estimates for the company by 10% for fiscal 2018 and by 8% for fiscal 2019, to reflect anticipated stronger volume growth and new connections. He has also increased his target price to HK$15.80 (US$2.02) per China Gas share.

Ratings agency Fitch had already said in an April note that it expects big city gas distributors to see sales volumes grow at a “low- to mid-teen” percentage rate in the medium term. This would see them maintain a track record of sales growth outpacing the national average.

Wiggle room

While the NDRC has set 7% as a nationwide limit for city gas distributors, local authorities will have some wiggle room, the economic planner said, adding that they should take into account the relative development of the local natural gas market when setting their own maximum return requirement.

The new mechanism will encourage gas companies to reduce costs and improve efficiency and should in the short term lower inflated gas distribution costs in some cities, it said. In the longer term, the mechanism will lead to more reasonable prices right along the natural gas supply chain, supporting the healthy development of the industry, the NDRC added.

The changes come at a time when China’s gas consumption continues to grow fast – and this will also support distribution companies’ sales.

In the first four months of this year, Chinese gas consumption expanded by 12% – up from a rate of 6.6% for the whole of 2016 – on the back of accelerated industrial activity and local authorities’ continued push to replace coal with gas.

A new report by the Chinese Academy of Social Sciences predicted earlier this month that China’s natural gas demand could grow by more than 3% per year until 2030.

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