Prices Of China-Russia Deal Are Positive For The Gas Sector

The author is Fitch Ratings Inc.

The 30-year gas deal signed last week between China and Russia, in which Russia’s OAO Gazprom will supply gas to China National Petroleum Corporation, underscores CNPC’s strategic role in the country’s gas pipeline infrastructure and helps China to secure adequate gas supply over the medium term, especially for the north-eastern part of the country.

Under the deal, Gazprom will supply 38 billion cubic meters (bcm) of gas a year starting around 2018 at a price that sets a new benchmark for what China is willing to pay for natural gas over longer term contracts.

The agreement also demonstrates China’s determination to switch to cleaner energy. China used around 168bcm of natural gas in 2013 and aims to use over 400bcm in 2020. The import agreement will meet close to 10% of China’s consumption of natural gas in the medium term.

Although China has substantial gas resources, exploiting the large unconventional reserves is technologically challenging.

In 2013, the country imported nearly 30% of its gas requirement. We expect imports to increase as a share of total consumption in the medium term.

The new deal helps diversify the sources of China’s natural gas imports, now mainly Turkmenistan and shipments of liquefied natural gas (LNG).

It follows an agreement by CNPC in 2013 to take an equity stake in a Russian LNG project and buy gas from the project, which is controlled by Russia’s OAO Novatek.

While pricing for the Gazprom deal has yet to be announced, it appears from numbers reported in the media that the price will likely be at or above US$350 per thousand cubic meters, which is about 60% cheaper than China’s current LNG imports and similar to the price for imports from central Asia.

Although we do not expect LNG imports to fall significantly because the use of natural gas in China is increasing, we do believe the Gazprom deal will help reduce upward pressure on import prices in the medium term.

China has been and will continue to increase domestic gas selling prices that are controlled by the state, which should ensure profitability for operators like CNPC.

For example, following gas price increases to-date, CNPC reported profits in its mid-stream gas operations in the fourth quarter last year after losses during which high import costs sapped profitability.

For domestic gas producers, the Gazprom deal will provide incentive to further invest in natural gas exploration and production because the deal’s expected price is higher than domestic production and as the authorities are expected to liberalize domestic natural gas pricing in the next couple of years.

The indicative Gazprom deal price is at least 40% more than the current spot price for domestic gas, which ranges from RMB1 to RMB1.6 per cubic meter.

We believe the Gazprom deal is positive for CNPC, which holds over 60% of China’s gas reserves and whose realized natural gas prices from its domestic productions in 2013 were around US$180 per thousand cubic meters.

CNPC will be responsible for building the pipelines and storage facilities in China under the deal. That the state has tasked CNPC to take on such important responsibility indicates that CNPC continues to play a strategic role in China’s gas infrastructure, even though its subsidiary PetroChina said in May 2014 that it would eventually sell all of its stake in the First and the Second West-East Gas Pipeline to private investors.

To domestic city gas operators, especially in the north-eastern region, the deal soothes the concerns about gas supplies over the medium term.

(The article has been edited for clarity)