Credit FAQ:

Standard & Poor's Perspective On

Gazprom's Gas Contract With CNPC
And Its Implications For Russia And
China
Primary Credit Analysts:
Elena Anankina, CFA, Moscow (7) 495-783-4130; elena.anankina@standardandpoors.com
Gloria Lu, CFA, FRM, Hong Kong (852) 2533-3596; gloria.lu@standardandpoors.com
Secondary Contacts:
Trevor Cullinan, Dubai (971) 4372-7113; trevor.cullinan@standardandpoors.com
Boris Kopeykin, Moscow (7) 495-783-4062; boris.kopeykin@standardandpoors.com
Jian Cheng, CFA, Hong Kong (852) 2533-3576; jian.cheng@standardandpoors.com
Table Of Contents
Frequently Asked Questions
Related Criteria And Research
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Credit FAQ:
Standard & Poor's Perspective On Gazprom's Gas
Contract With CNPC And Its Implications For
Russia And China
On May 21, 2014, following a decade of negotiations, Russia-based vertically integrated gas company Gazprom OAO
and the largest Chinese government-owned integrated oil and gas company China National Petroleum Corp. (CNPC)
signed an agreement to export Russian natural gas to China. Under this contract Gazprom will supply up to 38 billion
cubic meters (bcm) of gas per year for 30 years, using a new pipeline--the Power of Siberia--that the company plans to
build between its east Siberian gas fields (Chayanda and Kovykta) and north-east China. Gazprom estimates its
investments in the project at about $55 billion over four to six years, and CNPC expects to invest about $20 billion
over the same period.
In this FAQ, Standard & Poor's Ratings Services addresses investor questions on the effects of the Chinese gas
contract on Gazprom's and CNPC's creditworthiness, the likely effect of the transaction on the Russian economy, and
the wider implications of the deal for the European gas market. It also examines the likely effects of the transaction on
China's energy structure and gas price reform.
Frequently Asked Questions
Will this agreement derail the demand/supply balance for gas in Europe, and is China going to
become the core export market for Russia anytime soon?
No, on both counts. The European gas market remains critically important for Russia, at least for the next several
years. We believe the new agreement will have no immediate impact on the European market for piped gas, for the
following reasons:
1. Exports to China will not reduce the volume of gas available for export to Europe. Gazprom's supplies to China will
only commence in four to six years' time. The company has a vast reserve base and large underutilized capacity,
particularly after the huge Bovanenkovskoye field was developed.
Gazprom's production is currently constrained by demand. It plans to supply China from new fields in eastern Siberia
and not from existing fields that are used to supply Europe. East Siberian fields are too far away from European
markets, from Gazprom's producing fields in west Siberia, and from its pipelines that supply Europe. What's more, the
population of eastern Siberia and the Russian Far East is not big enough to consume that much gas. In our view, it
would make sense to develop these stranded reserves for export to the Asia-Pacific region.
2. The gas market, unlike oil, is essentially regional, not global. The characteristics and price levels of the European
gas market are quite different from the U.S. or Asia-Pacific, mainly because gas is more difficult to transport. In
Europe, for example, a significant proportion of gas is supplied under long-term contracts where prices are linked to oil
products. In the U.S., natural gas prices have been much lower than in Europe or in Asia-Pacific following the shale gas
revolution.
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3. Gazprom's exports to Europe are under long-term contracts. The contracts feature ship-or-pay and take-or-pay
provisions, with a relatively predictable formula-based pricing. Although this could result in contract prices being
above the spot level, it provides predictable prices and volumes for European customers.
4. The European market will remain the key source of profits for Gazprom. In our opinion, when gas supplies to China
start, their share in Gazprom's revenues will be below that of Europe, and in profit terms even lower. The amount of
contracted sales to China is 38.0 bcm per year at peak supply, compared with 174.3 bcm Gazprom sold in Europe in
2013 and 243.3 it sold domestically. Currently, most of Gazprom's profits on its gas business come from Europe
because regulated domestic prices are low and provide only limited profitability. The selling price of Russian gas to
China has not been disclosed, but based on the public data available it should be broadly comparable with the price of
Gazprom's exports to Europe. Meanwhile, operating costs for the new east Siberian gas fields are likely to be higher
than for Gazprom's existing fields.
In the longer term, however, export diversification could strengthen Gazprom's bargaining power vis--vis European
customers. In recent years, European customers have pressured Gazprom to lower its contract prices, and in some
cases the company has had to make retroactive payments. It remains to be seen whether the pressure on Gazprom's
prices will ease as a result of the China contract. Also, Gazprom's contract with China may reduce the latter's need for
future liquefied natural gas (LNG) purchases, which may be positive for European LNG buyers. But we believe these
are long-term consequences. Therefore, all the parties involved should have time to manage any related risks.
What are the implications of the China contract for the Russian economy, in Standard & Poor's view?
The current geopolitical environment suggests that some European economies have an increased appetite to diversify
away from gas supplied by Russia. In this context, signing the contract with China could be seen as an additional effort
by Russia to pre-empt such events by diversifying its export markets outside of Europe.
Assuming that Gazprom's projected $55 billion investment were spread over 2014-2019, it would amount to an
average 0.4% of GDP per year in additional investment. This in and of itself would unlikely be sufficient to change our
view on the Russian economy. However, the investment will provide modest support to economic growth and will
likely result in a higher level of gas exports and related government revenues over the medium term.
In the short term, we contend that the transaction will do little to offset the negative sentiment around the potential for
tighter sanctions to be imposed on Russia by the EU and U.S. in relation to the ongoing political turmoil in eastern
Ukraine.
Although we believe the regions where most project activities will take place will benefit from additional economic
activity, we do not expect the effects to materially increase budget revenues for rated Irkutsk Oblast and the Republic
of Sakha, or unrated Amur Oblast. Positive effects will include higher employment, resulting in additional personal
income tax (PIT) revenues; and the creation of new assets that will generate property tax proceeds and additional
profits, and consequently profit tax paid by Gazprom's construction contractors and later by the project itself.
The details remain to be seen, but should all announced investments translate into a property tax base that we
estimate at $25 billion (excluding pipelines that currently enjoy property tax privileges), in our view it might result in a
maximum Russian ruble (RUB) 17 billion of property tax per year. This would be equivalent to 3%-4% of estimated
operating revenues for the three regions involved by the project's completion date of 2017. However, we expect that
project activities might benefit from additional property tax privileges provided by the respective regions and thus the
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Credit FAQ: Standard & Poor's Perspective On Gazprom's Gas Contract With CNPC And Its Implications For
Russia And China
overall effect on budget revenue will be less. Additional PIT and corporate profit tax revenues are more difficult to
assess, but at this stage we do not expect major effects exceeding those on property tax. At the same time, any
additional burden on the regional budgets related to road construction, health care, and other areas will likely
somewhat offset the positive effects for budget revenues.
Is the contract with China positive or negative for Gazprom's credit quality?
The China contract is broadly neutral for Gazprom's credit quality, in our view. We believe that Gazprom's stand-alone
credit profile is sufficiently robust at 'bbb-', despite the higher capital expenditure (capex) triggered by the transaction
with China.
In our view, Gazprom's contract with China is important for the company's long-term future. It will help diversify
Gazprom's exports markets, enable the company to monetize stranded gas reserves in eastern Russia, and obtain
offtake commitments before making large investments in a very costly project. In addition, the contract will secure
Gazprom's position in China's rapidly developing and increasingly competitive fuel market, where it will compete with
local coal producers, other pipeline gas suppliers from Central Asia and Myanmar, LNG supplies from other regions,
and potential shale gas production in China itself.
Actual gas sales to China will only start in four to six years, which is beyond our usual rating horizon. Although the
contract implies an increase in Gazprom's capex for the next several years, we believe that the related deterioration in
Gazprom's credit metrics should be manageable, for the following reasons:
The company's current credit metrics are solid. At year-end 2013, Gazprom's funds from operations (FFO) to debt
was 117%, debt to EBITDA was 0.75x, and free operating cash flow (FOCF) was a high $11.8 billion, which is better
than many similarly rated peers. This is because in our base case, we have already projected that Gazprom's credit
metrics will deteriorate due to high investments that are now materializing.
The actual increase in capex as a result of the China contract may be less than $9 billion per year (the company
estimates $55 billion over six years). Furthermore, in our view, Gazprom may cut other investments to focus on the
Chinese contract. Although we believe that FOCF could turn negative in our base-case scenario, we don't see FFO
to debt falling below 50% in the next three years.
To finance upcoming investments, we understand that Gazprom plans to raise up to $25 billion from China as a
long-term prepayment for future gas supplies. For our analysis, we would treat the prepayment as debt-like because
we believe it is essentially a form of borrowing. The long-term nature and flexibility of such funding should help
support Gazprom's liquidity. In recent months, Russian companies' access to international funding has become
more difficult as a result of geopolitical tensions. In this context, access to non-traditional long-term funding such as
a long-term customer prepayment is particularly valuable.
In addition, we understand that the Russian government may consider an equity injection to Gazprom. If this occurs, it
would offset any negative impact on Gazprom's credit metrics. However, it's not clear how the government would
finance such an injection. Also, Gazprom has a large free float, so an injection would dilute the share of profits
available to minority shareholders.
Does Standard & Poor's see risks of a further increase in Gazprom's massive investment program?
That cannot be ruled out for large projects, and Gazprom's Eastern program is no exception. Also, if Gazprom starts
negotiating another gas contract to China using the western route (that is, across the Altai Mountains), it may further
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Credit FAQ: Standard & Poor's Perspective On Gazprom's Gas Contract With CNPC And Its Implications For
Russia And China
increase its capex commitments.
We believe these risks are largely captured in our current rating on Gazprom. Still, we will continue to monitor the
company's capex plans and financial policy priorities. The key question for us is whether or not Gazprom will be
willing and able to adjust its capex to maintain comfortable credit metrics, as it has done in the past.
Is the China contract value-accretive or value-destructing for Gazprom?
In our credit analysis of Gazprom, the crucial element is the effect of the China transaction on the risks for Gazprom's
creditors rather than the project's net present value. We note that the project's value for the company depends on a
number of factors that are as yet unknown or not yet public. They include the actual cost of construction and gas field
development (which may be different from the budget), the actual gas pricing formula adopted for the program, and
whether and how quickly Gazprom would be able to utilize the full capacity of the Power of Siberia pipeline (the
contract is for 38 bcm per year while the projected pipeline capacity is up to 60 bcm).
What is the main factor affecting Gazprom's credit quality?
The main factor influencing our rating on Gazprom is the sovereign credit rating on Russia rather than Gazprom's
stand-alone financials. At present, the sovereign rating constrains our foreign currency rating on Gazprom. This is
because we view Gazprom as a government-related entity with a critical role for the Russian economy and very strong
links to the government.
We believe that if the sovereign comes under stress, there is a risk of government interference in Gazprom's activities.
For instance, the government could force Gazprom to help other weaker entities, fulfil costly policy mandates, or
invest in large projects for strategic rather than economic reasons. Therefore, we don't believe that Gazprom would be
sufficiently resilient in a sovereign credit stress scenario.
What are the implications of the Gazprom transaction for China's evolving energy structure?
The Gazprom contract is positive for China's evolving energy structure, in our view. Demand for gas is strong due to
the country's continued economic growth, accelerated urbanization, and still-low natural gas penetration. Greater use
of gas also fits in with China's environment protection measures: The Chinese government supports using more natural
gas to reach its carbon emissions target and reduce the serious air pollution, particularly in northern China.
China has set an energy structure target that by 2017 natural gas shall account for more than 9.0% of its primary
energy mix, from about 5% at present. We estimate that natural gas consumption will more than double from its 167
bcm level in 2013 to about 400 bcm by 2020. We anticipate gas consumption growth (at a compound annual growth
rate of 10%-15%) will exceed the country's GDP growth.
We expect China's gas consumption to outpace production, leading to a higher dependence on imported gas unless
there is a breakthrough in the large-scale commercial production of nonconventional gas in the country. In the past
five years, China's domestic gas production growth has been low, at about 6.7%, compared with demand growth of
15.4% during the same period. In 2013, China imported 53 bcm of gas, representing 31.6% of total gas consumption,
rising sharply from the first ever net import in 2006. By 2020, China expects to import at least 100 bcm of piped gas
per year and a further 50 bcm of LNG. At the same time, It expects the total gas supply to reach 400 bcm-420 bcm,
satisfying gas demand.
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Credit FAQ: Standard & Poor's Perspective On Gazprom's Gas Contract With CNPC And Its Implications For
Russia And China
Will the transaction expose China to the risk of over-reliance on gas supplies from Russia?
In our opinion, the transaction with Russia is sizable but unlikely to expose China to the risk of over-reliance on Russia
for gas supply. Energy security and diversified energy sources have long headed the strategic considerations of
Chinese policymakers. Now the country will have four main sources of import: North-west piped gas from Central
Asia, mainly Turkmenistan (up to 30 bcm capacity per year, potentially increasing); the south-west pipelines from
Myanmar (up to 12 bcm); north-east piped gas from Russia (with capacity up to 38 bcm); and LNG shipments from the
Middle East, Australia, Malaysia, Indonesia, and others. By 2020, we estimate that Russian gas is likely to account for
about 30% of total imported gas to China. Piped gas is cheaper than LNG and may replace some LNG supplies if China
issues contracts for additional volumes of piped gas.
To avoid over-reliance on gas imports, the Chinese government is keen to develop its own nonconventional gas
supplies such as shale gas, coal-bed methane, and coal-to-methane, of which shale gas probably has the most
potential. China Petrochemical Corp. (Sinopec) made a splash in 2013 with the news that its first major shale gas
project at Chongqing Fuling had delivered steady trial production totaling 265 million cubic meters so far, and was
ready to start commercial production. Fueled by its success in Fuling, Sinopec has accelerated its shale gas
exploration. At the same time, CNPC, Sinopec's major competitor, has reported a 2015 shale gas production target of
2.6 bcm per year.
In our view, there is a distinct possibility that the country's shale gas output will reach the government's 6.5 bcm target
in 2015. What's more, China has set its sights on producing 60 bcm to 100 bcm of shale gas per year by 2020.
What would the increase in gas imports imply for the looming natural gas price reform in China, in
Standard & Poor's opinion?
We believe it should prompt Chinese policymakers to maintain the scheduled natural gas price reform of becoming
more market-driven by the end of 2015. In recent years, domestic gas price regulation in China has centered on
affordability, resulting in a gap between domestic and international gas prices and fuelling further demand.
CNPC has suffered huge losses because it has had to sell imported gas at below cost (2013: about Chinese renminbi
[RMB] 20 billion, corresponding to a 10 U.S. cents loss per cubic meter of gas imported). The government has
provided a financial subsidy to cover part of CNPC's losses. Nevertheless, we contend that China's artificially low
pricing of natural gas is unsustainable over the long term while gas consumption and imports keep increasing.
We expect the price of natural gas in China to be largely driven by market forces when Russian gas arrives in four to
six years' time. China has experienced two nationwide natural gas price hikes since 2011. There has also been a pilot
reform launched in the Guangdong and Guangxi provinces since December 2011, with city-gate prices primarily based
on a formula that references a basket of imported liquid petroleum gas (LPG) and fuel oil prices in Shanghai.
It's likely that price hikes expected prior to the end of 2015, which may increase the natural gas price by another
20%-30%, and the softening Chinese economy will moderate the growth of gas consumption. Nevertheless, we believe
the price competitiveness of natural gas, coupled with the government's push for cleaner energy, will continue to
support natural gas use. In China, the prices of substitute energy products such as LPG, gasoline, and diesel have been
largely liberalized.
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Credit FAQ: Standard & Poor's Perspective On Gazprom's Gas Contract With CNPC And Its Implications For
Russia And China
Is the import of natural gas from Russia positive or negative for CNPC's credit quality?
We view the transaction as neutral to positive for CNPC's credit quality, provided the price of natural gas in China is
primarily market-driven. The beneficial effect will depend on the actual terms of the contract with Gazprom (yet to be
disclosed), the level of any government support for CNPC, and the terms under which CNPC can directly distribute gas
to large end-users (with a higher margin). In addition, we understand that there is a large prepayment to Gazprom of
about $25 billion. We believe this is likely to be financed by the Chinese policy banks.
Essentially, the role of CNPC in the transaction is to represent the government in executing the contract, constructing
the pipelines, and transmitting the gas to downstream city gas distributors. We believe that the contract will further
solidify CNPC's unchallenged position in the Chinese natural gas market. CNPC's pipeline construction and gas
transmission for Russian gas, along with other operational pipelines, is a long-term, stable, but low-margin business
regulated by the government. The transmission price is a function of pipeline investments, maintenance costs, and
transmission distance. CNPC has a dominant position in gas transmission, operating about 70% of national
high-pressure pipelines in China. In our view, CNPC could partly fund the substantial investments in the new pipelines
for Russian gas by introducing other shareholders, including the local governments that may benefit from a new supply
of gas. We note the company is already divesting its interests in certain other pipeline projects.
We believe the economic benefits of this transaction to CNPC will be determined by whether the company can recoup
its costs of sale of natural gas (from either its own exploration and production or imports) via the city-gate price
charged to downstream distributors when the Russian gas starts to flow through. To a large extent, this will hinge on
the natural gas price reform in China. If CNPC can benefit from the reform and start to break even on its natural gas
business from 2015, the company's financial metrics are likely to further improve. In 2013, CNPC's debt to EBITDA
was 1.2x, consistent with our assessment of its "modest" financial risk profile.
Related Criteria And Research
Related criteria:
Corporate Methodology, Nov. 19, 2013
Related research:
Gazprom OAO, May 30, 2014
China National Petroleum Corp., May 9, 2014
China's Shale Gas Industry May Be Booming, But It Still Provides Just A Fraction Of Needed Energy, April 21, 2014
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affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject
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Additional Contact:
Industrial Ratings Europe; Corporate_Admin_London@standardandpoors.com
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Credit FAQ: Standard & Poor's Perspective On Gazprom's Gas Contract With CNPC And Its Implications For
Russia And China
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