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How Chinese national companies will balance oil and gas industry declines

14 May 2020 Erik Darner Kunfeng Zhu Nick Sharma Yin Yuan

On the latest episode of Upstream in Perspective, our Asia-Pacific upstream research team explores the future of Chinese national oil companies. Balancing energy security priorities with the oil and gas declines during this downturn could mean different strategies and priorities for China's NOCs compared to the previous oil market crash. Listen to the full podcast online.

Nick Sharma:
Firstly, how will the national oil companies (NOCs) balance the current industry decline and how would that be balanced in terms of the long-term energy security and the policy reform ambitions. To the second point, some of the challenges the Chinese national companies will face with the domestic production stabilization targets. And lastly, how will they really look internationally in terms of the changes in the E&P industry, the mature domestic resource base, and how will they really respond to the opportunities based on the domestic and international front.

And so with that kind of setting the frame of what we would like to talk, I'd like to bring Kunfeng into the discussion to really give his views on how the Chinese NOCs respond to the low oil prices, and more important, the domestic oil demand decline, as you've seen globally. So, some of your quick thoughts here, Kunfeng, how do you see that play out?

Kunfeng Zhu:
When we say that Chinese industries are facing unprecedented challenges, and if we look at what is different from this time compared with last time, that is the adjusted demand decline caused by COVID-19. If we look at China's economy, it has contacted about a 6.8% decline in Q1, which is the lowest number ever since China has a record of a GDP number. And, if we look at oil demand, it is worse compared with the economy decline because our forecast of China's annual GDP gross can still be about 2%, which is a positive number, but oil demand is about a five or 10% decline compared to last year. Of course, the oil price crash and demand declined. We have a big impact on both upstream and downstream for the NOCs. Another challenge for the NOC is the extra burden of their responsibilities—that is China's national energy security.

We all know that China's economy grows; that there is oil import dependency starting to rise and has reached about 70% in last year. So, energy security has become the center of China's upstream policy when the oil price reached more than $100USD per barrel a few years ago. We know the three NOCs have just kicked off their seven-year action plans last year - setting very ambitious domestic production and reserve edition targets, such as growth in unconventionals. With all the new realities of low oil prices and the long-term energy security agenda, the strategic resilience of all those NOCs are under the test and the NOCs are under pressure to revisit their plans.

Nick Sharma:
I guess for context, you know, the old demand obviously had a direct correlation to the economic growth of the country. But oil production, if we think about the year 2000 to where we are today, domestically has grown a bit, but the exponential growth has really come from the import side. So, like a number of peer countries in the region, China's importing nearly 70 to 80% of the oil; and the gas is probably more in the 50-50 range. That's a pretty significant challenge. And then that obviously leads me to the important point, and then Kunfeng, if the policy, has to be two-faced? One- there's a domestic focus because the government wants them to secure and grow domestic reserves and resources. But, how do you balance that with the energy security? How do the national companies really tackle this when that's the government mandate?

Kunfeng Zhu:
If you look at China's upstream policy, and its history, the policy has always been centered around national energy security, but the focus of that has been shifted or has experienced several phases. If we look back on a few years ago, when the oil price was still very high, $100USD per barrel, the focus was more on international M&A, basically to buy assets outside of China, and try to explore domestic unconventionals, like shale gas or tight gas or CBM. But, starting from 2017, the focus of all the policy has been shifted back to domestic China. So, that's where we are right now. If we look at current upstream policy reform, it aims to diversify participants in China's upstream. To achieve that it needs to remove barriers for foreign and domestic private companies to invest in China's oil and gas upstream. That implies policy changes in areas like acreage awarding, acreage exit, and finally, the policy aims to create a competitive landscape that is still dominated by NOCs, but with very diversified participants.

We expect China's upstream policy reform to continue this pace despite the challenges of low oil prices. But, if we look at the new policies, the new policy from the Ministry of Resources, on further opening China's upstream, which was effective on 1st of May. However, it is unlikely to have attracted an influx of other non-NOCs because everyone is in their survival mode under the low oil prices and has been very constrained on capital and has changed their discipline of spending. But that may not always be in that bad thing. It means less direct impact to the NOCs in the short term. And, that buys time for the government to continue the reform when there's less friction, as it won't create big impact in the short term.

Nick Sharma:
That's a really interesting point. In 2015, when the oil price downturn happened on a year-on-year basis, the domestic production was about 4.3 million barrels a day. And, as we exited 2019, we were down to about 3.8. Now some of that was maturity, obviously things were declining, some of the subsidy reliefs and the high EOR, we're also kind of taken off. So that was a gradual decline, but what's obviously quite startling is the demand or the import increase when we were in 2015, the number year-end was about eight, and year-end 2019 we were just under 11. So a domestic production decrease in the range of 400,000 but then our rapid import increase of three. So the challenge is really there, and that would obviously put a lot of strain on the finances. And so, Kunfeng, laid out some of the challenges, how's the financial health of the NOCs from 2014, and it'd be good to get a perspective of, you know, what happened pre-2014 and then what's happened from 2014 to 2019/2020. Yin, can you share some of your thoughts there?

Yin Yuan:
Yeah, sure Nick. So the Chinese, I know have been quite responsive during last round of market downturn in 2015. They quite rapidly reduced the high cost production especially in the domestic market. And, they also drastically cut the capital expenditure. I think all these measures are quite effective. The free cashflow rebounded in 2015, and they have been really strong in cashflow generation in the following years. More importantly, is that they have also directed a significant portion of the cashflow generated from the operations to debt reduction. So by the end of 2019, [00:09:30] the three companies have, you know, rather abandoned cash reserves compared with their international peers. So just to give you a quick stat that the cash balance that the group level for the Chinese NOCs is quite sufficient to count their short-term borrowings before the price crash in March.

So, and I mean, so the debt problem that's really prevailing for the US E&Ps is not the most significant challenge for them. And they also have easy access to financing from the domestic institutions that could provide another layer of protection for them. But the low price would put pressure on their financials as well. If you look at their financial reporting for the Q1 of 2020, Sinopec Corp and PetroChina already booked negative operating cash flow, and they also have hinted bigger capex cut than they originally planned. So this definitely shows the financial challenge for them. And I think what's different this time compared with the 2014 market crash is that they have to strike a really delicate balance between the long-term development goals and short-term cashflow goals. As Kunfeng mentioned, if the NOCs were to stabilize near-term production and also deliver on their savvier action plan, which is due in five years' time, they will definitely have to press ahead with current development projects. And they will also have to continue to exploration to replenish their reserve base at their reserve replacement ratio has dropped to a rather alarming level in the past few years. And I mean, it's in this situation, this could mean directing capital only to priority areas and projects.

Nick Sharma:
Yeah. And I think the numbers show the need for investment. If you look at US/North America independents, the peer group itself, very few have capex cuts less than 50%. The larger independents are in the 30 to 50%, the IOCs are around 30% and then the national companies are in a much smaller range of 10 to 20%. So, that's an interesting kind of a situation, in terms of, they need to continue to invest given the security. Eric, what does that really mean for them? Would you think this would be the right time for a counter cyclical M&A move given the prices are going to be quite depressed? What would be some of the opportunities they would think about here? And, then I like to come back to you, Yin, in terms of where their portfolios are currently and what kind of play types they may consider. So, Eric some initial thoughts?

Erik Darner:
I mean, I think we're in a very different place in this downturn when it comes to their appetite for international M&A than we were in the last downturn. I think you've got to remember that, you know, at the beginning of the last downturn in oil prices, they had just come out of the largest spending spree in history from 2009 to 2013 - spending about 15 to $30 billion a year on international oil and gas assets when world prices and asset prices were peaking. So, once the oil price crash of 2014 happened, there was a lot of hesitance in going back into M&A markets. And, you know, really their focus was on reorganization, portfolio optimization, change of management, cost control. And, and also to a greater extent, more and more in the first few years, active divestment, however times are very different.

Now they've gone through that whole process. It's very clear that energy security is at the forefront of their strategy. It's very clear that they need to continue to grow. You can't compare a Chinese NOC to an IOC, they're not measured in the same level of success. You know, many IOCs are no longer measured on their growth, whereas Chinese NOCs have to continue to grow. And so, you know, arguably they're in a much better position in this downturn to tap international M&A, not withstanding the fact like what Yin and Kunfeng has just said is, they are in a relatively healthy cashflow position and they have relatively low debt policy reform remains in place, energy security remains at the forefront of their agenda. And, there are a lot of opportunities out there with relatively cheap asset prices.

Listen to more in-depth insights on the China NOCs strategy in our podcast, Upstream in Perspective.

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Erik Darner is a Managing Director for Upstream Oil and Gas Consulting at IHS Markit.
Kunfeng Zhu is an Associate Director in the Upstream Insight team at IHS Markit.
Nick Sharma is a Director for the Global Upstream Oil & Gas team at IHS Markit.
Yin Yuan is a Senior Analyst at IHS Markit.

Posted 14 May 2020

This article includes information from an audio conversation and has been professionally transcribed as accurately as possible. Some words or phrases may have been unintentionally excluded.

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