Beijing’s long-awaited amendments on regulating the cost of transporting natural gas through pipelines, unveiled in August, is just one part of the broader reforms that China’s state-dominated oil and gas industry needs to become globally competitive. The reforms are also crucial, given that the industry could see a glut in supplies, low demand and technological advancements that keep prices and profits depressed over the longer term. “Lower domestic energy demand growth and persistent low energy prices have forced state-backed oil and gas majors to improve their operating efficiency,” Lin Boqiang, director of the China Centre for Energy Economics Research at Xiamen University, said in an interview with the South China Morning Post . “Beijing wants them to improve their operating efficiency so that they can compete and expand more effectively in the international market.” PetroChina gas distribution unit Kunlun Energy will sell oil and gas fields to sharpen focus Though China is well aware of the need for oil-sector reforms, the government has been deliberating on various proposals for more than two years, including offering exploration rights to new players and taking back development rights in cases where the state giants fail to meet their exploration investment obligations, besides forcing them to share exploration data with new entrants. Hu Zucai, the deputy director of the National Development and Reform Commission, China’s top economic planner, told an industry briefing last month that Beijing would consider further opening up the oil and gas exploration sector to private-sector investment, without giving details. Other reforms in the pipeline include those on revamping pipeline transmission tariffs and carving out the state oil majors’ pipeline assets and injecting them into a new independent national pipeline firm that can provide non-discriminatory pipeline access to all oil and gas producers, irrespective of their background. The move is aimed at facilitating new entrants to invest in oil and gas exploration and production as they need to be assured of a fair market in which they can sell their products. Consolidation of the state companies and divestment of assets or business segments through private stake sales or public share offerings are also being considered to increase industry competitiveness. However, the biggest progress has been made in the so-called “mixed ownership” of businesses or assets, which is aimed at enhancing corporate governance with greater scrutiny from external directors who are not related to the oil giants. Sinopec has sold 30 per cent of its fuel market operations to business partners and financial investors, while PetroChina has also sold stakes in its pipelines to various entities, mostly state-backed business partners or asset management firms. Little headway has been made elsewhere, except on gas pricing, which has been partially liberalised in the past few years. China’s oil and gas reforms are likely to be more incremental, than the ‘big bang’ [we had hoped for] Neil Beveridge, senior analyst, Sanford Bernstein Late last year, China set a goal to create a “fully open and transparent” market for non-residential gas trading in two to three years, with prices determined by buyers and sellers and reported to the Shanghai Petroleum and Natural Gas Exchange. Actual transactions had been paltry since the state giants’ market dominance has not been broken. For gas transmission, Beijing last month issued a draft policy circular for industry consultation, which sought to revamp the existing system where transmission tariffs are set on a case-by-case and non-transparent basis by the pipeline’s investors and regulators. Under the proposed system, tariffs on cross-regional pipelines will be calculated based on a clear principle of “allowed cost plus reasonable return”. Return on permitted assets will be capped at 8 per cent, lower than existing going rates that go as high as 19 per cent. Pipeline owners that also have upstream and downstream operations will be required to separately report the financial performance data on the pipeline operations. While this seems a good first step for tearing down deterrents for private investments, the lack of progress in making pipeline operations independent and non-discriminatory in customer demand fulfilment has been disappointing. “China’s oil and gas reforms are likely to be more incremental rather than the Big Bang [we had been hoping for],” said Sanford Bernstein’s senior analyst Neil Beveridge in a recent report. “[This year] was meant to be the year of reform,” Beveridge said. “Many had expected the separation of upstream assets from midstream assets to happen as a key step in the opening up of the upstream [oil and gas exploration and production] industry to private capital and liberalisation of the gas market. “However, separate financial reporting for pipeline assets should provide transparency and make it easier for the government to enforce separation of pipeline assets from upstream [production] assets if it seeks to do so.” Still, analysts expect further reform to be something that will happen sooner or later, in a similar fashion to the electricity industry, where the state-owned power distributors’ retail monopoly was broken last year after they were forced to adopt a transparent “cost plus reasonable return” model in transmission tariffs setting. Quicker pace of oil reform urged “The separation of natural gas transmission operation from that of gas production is a must-go step in the industry,” said Lin. “Whether it should require that PetroChina and Sinopec’s pipeline assets be spun off to form an independent firm with no ownership by the two giants, or whether they can internally ring-fence the assets and run them separately, is subject to debate. “While complete independence is the most ideal, as long as the pipeline operators are regulated to provide non-discriminatory access to their pipelines, the ownership of the pipelines is not the most important issue.” Robert Blohm, a Toronto-based energy industry consultant who has advised PetroChina and power distribution monopoly State Grid Corp of China on energy market design and transmission network reliability, said pipeline operators’ independence was important because they had access to a lot of market information that could be used by one gas supplier against another. “If the pipeline operator has privileged market information and is also a gas producer and supplier, there will be no real competition,” he said. “Hence you need a neutral vehicle that separates the supplier and the customers.” Sinopec looks to natural gas as oil prices fall Resistance from the incumbents, especially PetroChina, which owns the majority of the country’s gas pipelines, remains a stumbling block. “Nervousness around what has happened in other resource sectors following partial privatisation [in terms of] environmental degradation, dubious industrial practices and corruption” had also been cited by officials of the state giants for a slow approach to reform, Beveridge wrote. “We think this is a mistake,” he added. “What China needs is a complete revolution in upstream oil and gas that introduces new methods, new technology and new capital.” According to the US Department of Energy’s Energy Information Administration, although US oil output from “tight” sandstone formations – accounting for half the country’s oil output – is projected to fall 14 per cent between 2015 and 2017, output will rebound on cost reductions and drilling techniques improvements. “The use of more efficient hydraulic fracturing techniques and the application of multiwell-pad drilling, as well as changes in well completion designs, will allow producers to recover greater volumes from a single well,” the agency said in a recent report. Such improvements will force higher cost producers, including PetroChina and Sinopec, which have big portions of their output from mature fields, to raise their game or face long-term output reductions. PetroChina and Sinopec were forced to cut their oil output target – already lower than last year’s production – by a further 3 to 9 per cent this year. Though both firms managed to cut first-half production costs by 10 per cent year on year, it was insufficient to offset steeper falls in oil prices, which pushed their oil production operations further into the red. Jefferies head of Asia oil and gas research Laban Yu estimated in a note last week that China’s oil output could “collapse” by 400,000 barrels a day, or 10 per cent, during the next six months. “No other large oil-producing country in the world is experiencing this level of production decline,” Beveridge said. PetroChina president Wang Dongjin told reporters in August that the company would cope with prolonged low oil prices by slashing expenditure and stepping up technological innovation. According to Beveridge, PetroChina and Sinopec lag their Western peers in their returns on capital, returning just under 6 per cent, compared with 7 to nearly 14 per cent at ExxonMobil, Chevron, Total, Royal Dutch/Shell and BP. The two Chinese companies have almost 900,000 people on staff, according to their annual reports. With the bloated workforce – harder to push for redundancies during the industry’s tough – low productivity becomes inevitable. Output per person is only a third to one-sixth that of their Western competitors. “PetroChina and Sinopec are not set up to be particularly competitive,” Beveridge wrote. “Although they benefit from [a] virtual [duopoly] of China’s onshore business, performance-related pay is limited and management remuneration is well below what is needed to attract talent.” He noted their capital allocation decisions are negatively impacted by government polices, resulting in their overpaying for overseas oil and gas assets and locking into long-term gas import contracts at elevated prices during the boom years. State ownership also bred excessive focus on growth over returns.