China Gas Utilities:Policy roll-out could be intensive in the next few months

Prefer China Gas and ENN; upgrading Kunlun to Hold

    Policy reform announcements over the next few months will aim to lower gas prices and simultaneously raise gas demand. Along with a possible cut in city-gate prices by oil majors in the low season, we expect a more favorable environment for a sustainable gas demand recovery over 2017-18. These reforms are not without risks for downstream, but uncertainties during this process may create good entry points for quality names. Looking into 2018, valuations are attractive, especially for China Gas (11x P/E) and ENN (10x P/E), both of which are key beneficiaries of China’s coal-to-gas switch momentum.

    We are confident of a sustainable volume growth recovery

    With both statistical and anecdotal evidence of improving gas demand in China, we have become more convinced that gas distributors will be able to meet or exceed their volume guidance for 2017 and maintain the momentum in 2018. Further volume upside could come from 1) a stronger push for coal-to-gas conversion in both the residential and industrial sectors by central/local governments, 2) continuous sector reform to introduce competition in the upstream sector and open up gas facilities to create more diversity in gas supply, 3) potential city-gate price cuts by oil majors in the low season, and 4) lower transmission/distribution tariffs.

    We are more conservative than managements about gas sales margins

    Although most of the gas distributors guide for a stable margin outlook, we factor into our model an Rmb5-8cents/cm (or 7-11%) C&I margin squeeze over 2017-19E to reflect potential price/return controls by local governments and price discounts by distributors to large users. At the current stage, we believe that our margin assumptions provide a sufficient buffer for regulatory risk.

    Policy roll-out could be intensive in the next few months

    In the next few months, we expect several policies to be issued or executed: 1) China’s Oil & Gas Reform Plan, 2) Opinions on Accelerating Promotion of Natural Gas, 3) execution of return regulation (8%) on inter-provincial pipelines issued in October 2016. Overall, we believe that these policies will be positive for the downstream sector as they introduce upstream competition, reduce transmission tariffs and encourage natural gas utilization. In the next step, regulatory guidance on downstream return/pricing at the central government level is possible. We calculate that returns from gas sales business (excluding connection fees) by gas distributors are not excessive at group level.

    Stock picks, valuation and risks

    We fine tune our 2017-18E earnings and introduce a 2019 forecast (see Figure 11 for details). We prefer China Gas (multi-faceted growth in LPG/natural gas volume/connections, less earnings sensitivity to margin risks, better 2HFY17E results) and ENN (a key coal-to-gas beneficiary, long-term cost-saving potential, strong free cash flow, undemanding valuation). We upgrade Kunlun from Sell to Hold as we expect an earnings improvement in its gas sales/LNG terminal segments, but it is still a less favored name in the China gas utilities space due to lower-than-peer volume growth momentum and high earnings sensitivity to SJ pipeline tariffs. We base our TPs on SOTP (BEHL, Kunlun, HKCG) and DCF (others). Key risks include higher/lower-than-expected gas sales volume/new connections and regulatory risks relating to return controls/connection policy.