KEY CONCLUSIONS Equity Research Asia Pacific / China Oil & Gas Exploration & Production / Gas Utilities (Utilities CN (Asia)) 25 November 2014

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CS base-case China gas supply vs. demand

Misconception 1: The market believes gas consumption will be slower in the next two years. City gas names have corrected ~20% over the past three months, with the market concerned about possible demand weakness in the next two years. We learned that the Chinese oil companies, mainly PetroChina, have secured 73 bcm in new gas supply (38% of 2014 consumption) in 2015-16E. More supply should drive more consumption, but at lower gas prices. Instead of a slowdown, we expect gas demand to grow 13% and 19% in 2015E and 2016E, respectively (versus 7% in 9M14). Misconception 2: The market believes gas prices might not come down in 2015. As most of the new supplies have been signed on a take-or-pay format, Chinese oil companies have no option but to find buyers by cutting prices. We expect incremental city-gate gas prices to be cut by 15% within 2015. Misconception 3: The market believes new connections are at risk. Improving property data recently (new residential housing starts improving from a 20% YoY decline in 1H14 to a 13% YoY decline in 9M14) should help ease concerns about the earnings risks of new connections. We also found that not all companies have fully incorporated the urbanisation factor and China Gas Holdings has probably overstated the penetration rate, making the new connection outlook stronger than for peers. Stock calls. Our top picks are: China Gas and China Resources Gas (upgrade to OUTPERFORM). We also upgraded ENN Energy on better earnings and downgraded HKCG on valuation. We cut PetroChina FY15-16E EPS by 10-18% with lower gas prices hitting investment.

300

25%

260

20%

220

15%

180

10%

140

5%

100

0% 2010

2011

2012

2013E

2014E

2015E

Consumption (bcm)

Supply (bcm)

Consumption YoY growth (RHS)

Supply YoY growth (RHS)

2016E

Source: NDRC, Credit Suisse estimates

Price comparison of alternative fuel (current) (US$/mmbtu) 16.0

14.2

13.6

14.0

12.8

11.2

12.0

10.7

10.8

10.0 8.0 6.0 4.0

5.8

3.9

2.0 0.0 Coal

Brent

Fuel Oil

LPG

Existing Gas Incremental Gas Incremental Gas Incremental Gas (CS Base case) (after competitiveness restored)

Source: Bloomberg, Credit Suisse estimates

RESEARCH ANALYSTS Dave Dai, CFA 852 2101 7358 [email protected]

Thomas Wong 852 2101 6738 [email protected]

Horace Tse 852 2101 7379 [email protected]

Kelly Chen 852 2101 7079 [email protected]

Ran Ma 852 2101 6653 [email protected]

DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-U.S ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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Focus charts and table Figure 1: CS base-case China gas supply vs. demand

Figure 2: Gas price sensitivity to Brent Oil price

300

25%

260

20%

220

15%

180

10%

140

5%

100

Brent oil forecast (US$/bbl)

111.5 106.5 101.5 96.5 91.5 86.5 81.5 76.5

5% 3.58 3.39 3.19 2.99 2.80 2.60 2.41 2.21

Discount to substituting energy 10% 15% 20% 25% 3.39 3.20 3.02 2.83 3.21 3.03 2.85 2.67 3.02 2.85 2.69 2.52 2.84 2.68 2.52 2.36 2.65 2.50 2.36 2.21 2.47 2.33 2.19 2.05 2.28 2.15 2.03 1.90 2.09 1.98 1.86 1.75

2011

2012

2013E

2014E

2015E

Consumption (bcm)

Supply (bcm)

Consumption YoY growth (RHS)

Supply YoY growth (RHS)

(US$/mmbtu)

30% 2.64 2.49 2.35 2.21 2.06 1.92 1.77 1.63

16.0

14.2

13.6

14.0

12.8

11.2

12.0

10.7

10.8

10.0 8.0 6.0 4.0

5.8

3.9

2.0 0.0

0% 2010

Figure 3: Price comparison of alternative fuel (current)

Coal

2016E

Brent

Fuel Oil

LPG

Existing Gas Incremental Gas Incremental Gas Incremental Gas (CS Base case) (after competitiveness restored)

Source: NDRC, Credit Suisse estimates

Source: Credit Suisse estimates

Source: Bloomberg, Credit Suisse estimates

Figure 4 Household penetration of listed companies

Figure 5 Share price fall from the peak

Figure 6: Gas sector: 12-month forward P/E history

Source: Company data, Credit Suisse estimates

Source: Bloomberg

Source: Bloomberg, Credit Suisse estimates

IDEAS ENGINE China Gas Sector

2

Investment case Misconception 1: The market sees slower gas consumption in the next two years City gas names have corrected ~20% over the past three months with the market concerned about possible demand weakness in the next two years. We learned that the Chinese oil companies, mainly PetroChina, have secured 73 bcm in new gas supply (38% of 2014 consumption) in 2015-16E. A large part of the supply increase comes from LNG imports as well as the new West-East III pipeline carrying imported gas from Central Asia. More supply should drive more consumption, but at lower gas prices. Instead of a slowdown, we expect gas demand to grow 13% and 19% in 2015 and 2016, respectively (vs. the 7% in 9M14). Listcos should continue to see expanding market share (35% in FY14 to 37% in FY16).

Misconception 2: The market believes gas prices might not come down in 2015 As most of the new supply has been signed on a take-or-pay format, the Chinese oils have no option but to find buyers at lower execution prices to stimulate demand, especially given lower oil prices—a 30% fall from its peak and undermining the economic advantage of gas. Also, we expect the government to implement the oil-linked formula to cut gas prices within 2015E. We expect city-gate gas prices to drop by 5% (the incremental price down 15%) within 2015. The price cut should help reduce market concerns about slowing demand recently.

Stock calls We upgrade city gas to OVERWEIGHT from Market Weight after the recent correction (valuations are now at a discount to the historical average) and our top picks are China Gas and China Resources Gas (the latter upgraded to OUTPERFORM). We have also upgraded ENN Energy on better earnings and downgraded HKCG due to its valuation. We cut PetroChina's FY15-16E EPS by 10-18%, with lower gas prices hitting investment. Other ratings are Beijing Enterprises (OUTPERFORM), Kunlun Energy (NEUTRAL), HK & China Gas (downgraded to an UNDERPERFORM from Neutral) and Shenzhen Gas (UNDERPERFORM). Figure 7: Stock calls Company

CGH CRG BJE ENN PetroChina

Ticker Rat.

0384.HK 1193.HK 0392.HK 2688.HK 0857.HK

O O O O N

TP

U/D

Mcap

17.5 31% 27.0 27% 84.0 33% 55.0 16% 7.5 -17%

bn US$ 8.7 6.1 10.5 6.6 230.8

P/E 14E 21.0 18.9 16.3 18.6 11.4

P/B 15E 16.8 15.3 13.5 17.5 11.7

14E 3.7 2.9 1.4 3.7 1.2

ROE 15E 3.2 2.5 1.3 3.2 1.2

14E 18.7 16.4 9.1 21.3 11.2

15E 20.2 17.8 10.3 19.8 10.3

EPS CAGR 14-16E 25.2 25.0 17.2 15.8 -1.3

Source: Company data, Credit Suisse estimates; China Gas on March year-end

Misconception 3: The market believes new connections are at risk A large part of city gas profits is derived from new connection revenue, which is linked with a 12-18-month lagging impact to the physical property market. Improving property data recently (new residential housing starts improving from a 20% YoY decline in 1H14 to a 13% YoY decline in 9M14) should help ease concerns about the earnings risks of new connections, a large part of city gas profits. We also found that not all companies have fully incorporated the urbanisation factor and China Gas Holdings has probably overstated its penetration rate, making the new connection outlook stronger than for peers.

IDEAS ENGINE China Gas Sector

3

Figure 8: Valuation table Company

Ticker

Oil & gas producers PetroChina - H Sinopec - H CNOOC PetroChina - A Sinopec - A Simple average City gas (HK – listed) China Gas Holdings Beijing Enterprises Holdings China Resources Gas ENN Energy HK & China Gas Kunlun Towngas China China Tian Lun China Oil & Gas Binhai Investment Tianjin Jinran Simple average City gas (A-shares) Shenzhen Gas Shenergy Chongqing Gas Shaanxi Natural Gas Simple average

Rating

TP

Mkt cap

P/B (x)

P/E (x)

Dividend yield (%)

ROE (%)

(US$ mn)

14E

15E

16E

14E

15E

16E

14E

15E

16E

14E

15E

16E

EPS CAGR (%) 14-16E

857 HK 386 HK 883 HK 601857 CH 600028 CH

N O N N O

7.5 9.0 11.5 7.4 7.1

230,847 98,304 70,574 230,847 98,304

1.2 0.9 1.2 1.4 0.9 1.1

1.2 0.8 1.1 1.3 0.8 1.1

1.1 0.8 1.1 1.2 0.8 1.0

11.4 8.8 9.0 12.6 8.9 10.1

11.7 9.0 10.9 12.9 9.0 10.7

11.7 7.5 10.1 12.9 7.6 10.0

3.9 4.5 3.9 3.6 4.5 4.1

3.8 4.5 3.7 3.5 4.4 4.0

3.8 5.3 4.0 3.5 5.3 4.4

11.2 10.7 14.2 11.2 10.7 11.6

10.3 9.4 10.9 10.3 9.4 10.0

9.7 10.5 11.0 9.7 10.5 10.3

-1.3 8.1 -5.4 -1.3 8.1 1.7

384 HK 392 HK 1193 HK 2688 HK 3 HK 135 HK 1083 HK 1600 HK 603 HK 2886 HK 1265 HK

O O O O U N NR NR NR NR NR

17.5 84.0 27.0 55.0 15.2 8.0 NR NR NR NR NR

8,675 10,490 6,093 6,633 25,399 8,878 2,831 872 793 509 337

3.7 1.4 2.9 3.7 3.7 1.3 1.6 4.0 1.5 4.3 n.a. 2.8

3.2 1.3 2.5 3.2 3.5 1.2 1.5 3.2 1.3 3.2 n.a. 2.4

2.7 1.2 2.2 2.8 3.3 1.1 1.3 2.5 1.1 2.0 n.a. 2.0

21.0 16.3 18.9 18.6 26.7 11.9 18.1 24.0 12.2 23.3 23.4 19.5

16.8 13.5 15.3 17.5 25.9 11.5 15.3 17.7 9.9 15.6 19.7 16.3

13.4 11.9 12.1 13.8 24.6 10.8 13.1 13.5 8.7 8.9 18.8 13.6

1.1 1.8 1.1 1.8 1.9 2.4 1.1 n.a. 0.8 1.0 0.7 1.3

1.3 2.2 1.3 2.0 2.3 2.5 1.3 n.a. 0.9 1.2 n.a. 1.7

1.9 2.5 1.6 2.9 2.4 2.6 1.5 n.a. 0.9 2.1 1.8 2.0

18.7 9.1 16.4 21.3 14.3 11.0 9.2 20.2 11.1 21.1 5.6 14.4

20.2 10.3 17.8 19.8 13.8 10.6 10.0 20.1 12.7 24.5 5.1 15.0

21.6 10.8 19.3 21.9 13.7 10.5 10.7 21.1 12.7 29.7 6.4 16.2

25.2 17.2 25.0 15.8 4.1 5.0 17.5 33.3 18.3 61.6 11.8 21.4

601139 CH 600642 CH 600917 CH 002267 CH

U NR NR NR

6.8 NR NR NR

2,589 3,821 3,153 2,173

2.9 1.0 5.4 3.0 3.1

2.7 1.0 5.0 2.7 2.8

2.5 n.a. 4.6 2.4 3.1

21.5 8.8 56.5 28.5 28.8

19.1 8.2 49.3 21.2 24.5

17.2 n.a. 44.4 16.2 25.9

1.9 3.9 0.6 n.a. 2.1

2.1 3.5 0.6 n.a. 2.1

2.3 n.a. 0.7 n.a. 1.5

14.2 13.0 9.7 10.3 11.8

14.7 10.6 10.0 12.6 12.0

14.9 n.a. 10.0 14.7 13.2

11.9 n.a. 12.8 32.7 19.1

Source: Company data, Bloomberg, Credit Suisse estimates; China Gas on March year-end

IDEAS ENGINE China Gas Sector

4

Misconception 1: The market believes gas consumption will be slower in the next two years We upgrade the China city gas sector to OVERWEIGHT from Market Weight and cut earnings forecasts substantially for PetroChina. Given the collapse of crude oil prices and slowing gas demand, we expect China to cut gas prices to stimulate demand within 2015, especially ahead of the large supply coming in the next two years. These supplies are largely take-or-pay contracts so supply delays are less likely and China has limited storage capacity to pile up the large inventory. Our top picks are China Gas Holdings and China Resources Gas, which are expected to benefit from stronger volumes.

Figure 11: City gas share prices fall from their recent peaks

Figure 9: City gas—rating and target price changes Company China Gas Holdings (CGH) Beijing Enterprises (BJE) China Resources Gas (CRG) ENN Energy (ENN) Kunlun Energy HK&China Gas (HKCG) Shenzhen Gas (SZG)

Code

New rating

Old rating

Target price

384 HK

OUTPERFORM

Outperform

HK$17.5

392 HK 1193 HK

OUTPERFORM OUTPERFORM

Outperform Neutral

HK$84.0 HK$27.0

2688 HK 135 HK 384 HK 601139 CH

OUTPERFORM NEUTRAL UNDERPERFORM UNDERPERFORM

Neutral Neutral Neutral Underperform

HK$55.0 HK$8.0 HK$15.2 Rmb6.8

2014E

2015E

2016E

-2% 2% 0% 0% 0% 0% 0% -2%

3% -3% 3% -3% 0% 0% -4% -10%

13% 12% 12% -3% 0% 0% -3% -18%

0%

0%

9%

Source: Bloomberg

Figure 12: Gas sector—12-month forward P/E history

Source: Credit Suisse estimates

Figure 10: EPS estimate changes CRG ENN CGH HKCG BJE SZG Kunlun PetroChina Average of CRG, ENN, CGH and HKCG Source: Credit Suisse estimates Source: Bloomberg, Credit Suisse estimates

IDEAS ENGINE China Gas Sector

5

The market is missing the supply coming in Based on our current domestic gas production forecasts and import commitments signed for both piped gas and LNG, we see an incremental 73 bcm of gas supply adding to China's gas market over the next two years. These gases will need to find buyers. In our China natural gas supply model, we forecast total gas supply will reach 220 bcm in 2015 and 263 bcm in 2016; our 2020 gas supply forecast now stands at 385 bcm. Figure 13: CS China bottom-up natural gas supply model (bcm)

2013

2014E

2015E

2016E

2017E

2018E

2019E

2020E

104.6 10.0 3.2 3.0 0.2

112.4 11.0 6.0 4.0 2.0

121.0 11.0 11.5 5.0 6.5

128.3 11.0 18.2 8.0 10.2

136.0 11.0 24.9 11.0 13.9

144.1 11.0 31.6 14.0 17.6

152.8 11.0 38.3 17.0 21.3

161.9 11.0 45.0 20.0 25.0

117.8

129.4

143.5

157.5

171.9

186.7

202.1

217.9

9.9%

9.9%

10.9%

9.7%

9.1%

8.6%

8.2%

7.9%

25.0 1.0 2.5 -

29.0 3.0 3.0 -

29.0 4.0 5.0 5.0 -

29.0 4.0 10.0 10.0 10.0 -

29.0 4.0 10.0 15.0 10.0 -

29.0 4.0 10.0 25.0 10.0 1.0

29.0 4.0 10.0 35.0 10.0 10.0

29.0 4.0 10.0 35.0 10.0 20.0

Domestic gas production Conventional gas Coal gas & others Unconventional Gas - CBM - Shale gas Total domestic gas production YoY%

forecast gas production will show a 6% CAGR, which we believe is conservative. The growth is primarily driven by production ramp-up from PetroChina's Tarim and Changqing gas fields, and Sinopec's Yuanba gas field. 2)

Unconventional gas: We forecast 11.5 bcm of unconventional gas production in 2015 (shale gas + CBM), growing to 45 bcm in 2020E. The primary change to our unconventional gas supply forecast is for shale gas. We believe the 6.5 bcm shale gas production target in 2015E is achievable, while our 2020E target is lowered to 25 bcm (from 45 bcm) on the revised national target. In August the NDRC revised down its 2020E shale gas production target to 30 bcm (from 60-100 bcm). We are constructive on China's shale gas potential and believe that the success in Sinopec's Fuling shale gas development is positive; PetroChina is also seeing a success in its Weiyuan shale gas project, prompting it to raise its 2015E shale gas production target to 2.5 bcm. However, the certainty of China's 2020 production target, in our view, will have to depend on whether there is further evidence to prove that geological and technological expertise in Sichuan can be replicated in other shale gas basins in China.

Figure 14: CS domestic gas production forecast—conventional gas

(bcm) 180

Piped gas imports Turkmenistan Myanmar Kazakhstan Turkmenistan II Uzbekistan Russia Total piped gas imports YoY%

28.5 29.5%

35.0 22.8%

43.0 22.9%

63.0 46.5%

68.0 7.9%

79.0 16.2%

98.0 24.1%

108.0 10.2%

Total LNG imports YoY%

24.9 22.7%

26.2 5.3%

33.6 28.2%

42.8 27.5%

54.5 27.2%

54.5 0.0%

56.6 3.8%

58.7 3.7%

Total China gas supply YoY%

171.2 14.6%

190.6 11.4%

220.1 15.5%

263.3 19.6%

294.4 11.8%

320.2 8.8%

356.6 11.4%

384.6 7.8%

162

153

160 140

121 120

105

128

136

144

112

100 80

Source: China OGP, CEIC, company data, Credit Suisse estimates

Domestic gas production 1) Conventional gas: Our bottom-up supply forecast driven by the big three oils— PetroChina, Sinopec & CNOOC—suggests that domestic conventional gas production will grow by 7.5% p.a. for 2014-15E. Over the next five-year period (2016-20E) we

IDEAS ENGINE China Gas Sector

60 2013

2014E

2015E

2016E

2017E

2018E

2019E

2020E

Conventional gas Source: Industry data, company data, Credit Suisse estimates

6

Misconception 2: The market believes gas prices might not come down in 2015 We see a highly unsupportive case for any further price hikes in 2015E due to: (1) supply growth outpacing demand and (2) oil prices at lower sustained levels. In fact, we see gas prices potentially lowered for incremental gas volumes (增量气) and even possibly for existing gas volumes (存量气). Our base case for 2015E assumes existing gas volume prices will stay where they are (Rmb2.47/cm, VAT inclusive), but for incremental gas volume it will be revised down to match that of existing gas volumes. In short, we expect a 5% cut in the blended price.

Prices caught between oversupply and lower oil price: Cuts inevitable; CS base case: a 15% incremental price cut

How much lower should gas prices go? We assess how much gas prices should be lowered from two different angles based on: (1) the pricing competitiveness of gas relative to other fossil energy; and (2) the substituting energylinked formula guided by the NDRC. Our conclusion is that if price competitiveness is to be restored to 2011 levels, then gas prices (incremental city gate) may need to be cut by c. 50% to US$5.8/mmbtu. We admit the possibility of such a drastic correction is highly unlikely, but the analysis shows that any further hike is neither justified nor aligned with the government's goal to push for more gas consumption. In other words, our base-case price cut could have downside risks, and it could be significant. (1) Pricing competitiveness of gas relative to other fossil energy

Demand-supply dynamic losing balance As discussed above, we will be looking at an expected 73 bcm incremental gas supply in the next two years (an 18% CAGR), but gas demand growth is unlikely to match this, unless a lower price is adopted to push up demand, especially substitution demand (from oil to gas). Our base-case gas demand adds 63 bcm, leaving the domestic gas market 14 bcm oversupplied. This is already under the assumption that prices will be lowered some time in 2015, resulting in a demand rebound in 2016E. If prices stay where they are or go even higher as the market previously expected, we believe that demand growth would repeat the weak case in 2014E (10% YoY) or be even lower. Figure 15: CS base-case China gas supply vs. demand 300

25%

The dominating trend of China's gas consumption in the past decade–"supply creates its own demand"—has reversed in the past year on gas price hikes and oil/coal price declines. After two rounds of price hikes, the competitiveness of gas has been rapidly destroyed: incremental city gas is priced 14% above current fuel oil and 6% discount to LPG whereas in 2011 gas price was 50% - 60% discount to fuel oil and LPG. Of course, oil price (also dragging down the prices for fuel oil and LPG) drop made the situation even worse. To restore the price difference we observed in 2011, which we believe to be the key reason for gas consumption growth, we estimate gas price will have to be reduced by c. 50% to US$5.8/mmbtu (i.e., 50% - 60% discount to fuel oil and LPG). Figure 16: Pricing comparison—current (US$/mmbtu)

260

20%

16.0

14.2 11.2

12.0

220

15%

180

10%

13.6

14.0

6.0 4.0

5%

5.8

3.9

2.0 0.0 Coal

100

Brent

Fuel Oil

0% 2010

2011

2012

2013E

2014E

2015E

Consumption (bcm)

Supply (bcm)

Consumption YoY growth (RHS)

Supply YoY growth (RHS)

10.8

10.0 8.0

140

12.8 10.7

2016E

LPG

Existing Gas Incremental Gas Incremental Gas Incremental Gas (CS Base case) (after competitiveness restored)

Source: Bloomberg, Credit Suisse estimates

Source: Company data, Credit Suisse estimates

IDEAS ENGINE China Gas Sector

7

Misconception 3: The market believes new connections are at risk

Source: Company data

YoY

1H14

9M14

2015E

GFA sold GFA sold (residential) GFA started GFA started (residential)

-6% -8% -16% -20%

-9% -10% -9% -13%

stable

IDEAS ENGINE China Gas Sector

2013

Dec

Nov

Oct

Sep

2014

Source: CEIC

Figure 18: 2014 property sales and housing starts

Source: CEIC

2012

Aug

23% 42% 53%

Jul

CRG

17% 44% n.a.

Jun

ENN

15% 49% 51%

May

CGH (FY14)

Apr

Revenue Gross profit Operating profit

('000 Sq m) 200,000 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0

Mar

Figure 17: Connection contribution to revenue / gross profit / operating profit in 2013

Figure 19: Residential gross floor area (GFA) started

Jan-Feb

On the other hand, connection revenue still contributes a significant portion of city gas companies' earnings (>40% of gross profit and even more to the bottom line). We have been generally concerned about potential earnings risks in FY15-16E with the weak property numbers in 1H14 (see Appendix on analysis of the delayed impact of the housing market on connection revenue). However, new starts saw meaningful improvement during 3Q14 (a 13% YoY decline in 9M14 vs. a 20% decline in 1H14) despite contact sales' 10% decline. Credit Suisse China Real Estate analyst, Jinsong Du, believes that both housing starts and sales are unlikely to improve for the rest of the year and housing sales should be largely flat in 2015, making it a less worrying trend.

n.a.

The weakness in the housing market may have a negative impact on the residential connection fee revenues of city-gas companies, as a large proportion of it (50-90%) comes from gas connection services for new residential properties. Although connection fees only accounted for 15-23% of the listed city-gas companies' (ex. BJE) total revenue in 2013, it contributed 4249% of gross profits due to its higher margin compared with gas sales. Property developers usually sign gas connection contracts with city-gas distributions within one year after the start of housing construction. Therefore, theoretically speaking, housing starts/sales could be a leading indicator for city-gas companies' connection fee revenues.

8

Stock calls Share prices of gas operators have dropped by ~20% over the past three months. We perceive the correction has been driven by market concerns about rising future earnings risks coupled with only a 5% EPS cut, while forward P/E multiples have seen rapid contractions from 19x to about