China Oil Sector:Worst over, but further rebound could be slow

The oil price has already rebounded 25% since mid-January 2015after hitting the lowest point in six years. Although it may continue torecover in the near future, further rebound may be slow as anaverage big US shale oil producer is already profitable at the currentoil price level. On the other hand, the sharp fall in the oil price couldlead to a cut in the price for incremental volume gas. At current level,we do not think the shares of the major Chinese oil companies offermuch value although CNOOC Ltd could be the bet on oil pricestrength.

    Key Points

    The spot price of ICE Brent has rebounded 25% to US$57/bbl since mid-Janafter hitting a 6-year low of US$46/bbl. Several positive signs, such as oilcompanies’ cut in capex, the decline in the US rig count, stock-up by oilimporting nations and oil trading companies, have lent support to the oil price.

    While we believe the oil price will continue to recover, the pace of rebound islikely to slow as an average big US shale oil producer can already make profitat the current level. Further sharp rise in the oil price will jeopardise OPEC’sgame plan of squeezing out US shale oil producers. According to our analysis of3Q14 operating data, we estimate the production cost of an average big shaleoil producer (output ≥ 50,000 bbl/day) at US$49.4/bbl and that of a small shaleoil producer (output < 50,000 bbl/day) at US$59.8/bbl.

    The price of ICE Brent averaged US$99.7/bbl in 2014, lower than our forecastof US$102.4/bbl. In view of the previous sharp fall in the oil price, we lower ourforecasts for the average price of ICE Brent from US$90.4/bbl to US$63/bbl for2015 and from US$92.0/bbl to US$77.0/bbl for 2016. We also lower ourlong-term oil price forecast from US$93/bbl to US$80/bbl.。

    To support domestic oil producers amid a low oil price environment, theChinese government has raised the threshold of windfall tax from US$55/bbl toUS$65/bbl since the beginning of 2015. However, at our current oil priceforecasts, we do not think domestic oil companies can benefit from this in 2015anyway.

    Given the previous sharp fall in the oil price, the NDRC is likely to lower theprice of incremental volume gas for non-residential users in 2015. In our basecase, we now assume the NDRC will cut the price of incremental volume gas by10% and raise the price of base volume gas by 7% so that the weightedaverage price will remain the same. We previously assumed the base volumegas would increase by 19% to match the price of incremental volume gas.

    In view of the cuts in our forecasts for the oil price, natural gas price and crudeoil output for some companies, we cut our earnings forecasts by 5-25% for2014 for the big three Chinese oil companies. We expect PetroChina andSinopec to have to record huge amount of inventory loss for their downstreamoperations. For 2015 and 2016, we cut our forecasts by 53-70% and 15-48%respectively.

    Key Risks to Rating

    Stronger-than-expected surge in the oil price.

    Better-than-expected cost control by the oil companies.

    Top Picks/Sells

    CNOOC Ltd stands out among the big three as it is the most direct beneficiaryof any oil price recovery. PetroChina suffers from the uncertain outcome ofthe gas price reform. Huge inventory loss and relative high cost for upstreamoperations overshadows the earnings outlook of Sinopec.

    With CNOOC Ltd already slightly outperforming the market recently, werecommend investors to buy at HK$10.40 or below.