Chinese NOCs introduce market-based gas pricing in downstream contracts

China's national oil companies have introduced market-based gas pricing in downstream sales contracts this year, in what is likely to be the first move to reflect international imported LNG prices in at least a portion of domestic pipeline gas sales that have historically been fully regulated.

Global energy prices have surged on the back of the Russia-Ukraine war, and the reforms would allow NOCs to partially pass on higher procurement costs to customers. It would also help ease their trading losses in the natural gas business and signals some progress in China's gas market liberalization.

China has a complicated downstream gas pricing mechanism, under which wholesale prices for imported LNG, offshore natural gas, unconventional gas and imported pipeline gas under projects launched after 2015 have been liberalized. Wholesale prices for domestically produced onshore natural gas and imported pipeline gas for projects before 2014 are still regulated by the government.

The city-gate prices, which is the price at which gas is sold by upstream suppliers to local distributors via pipelines, are currently set by the Provincial Development Commissions, and still serve as benchmarks for most natural gas sold in the pipeline system.

Specifically, the price of pipeline gas sold to residential users by upstream suppliers, including state-owned and private LNG terminals and gas companies, do not exceed the provincial city-gate gas prices. For non-residential users, prices can be raised within a specific range above the benchmark city-gate prices. If this gas is from regulated sources like onshore conventional gas and pre-2015 pipeline projects, the range can only be as much as 20%.

China's city-gate gas prices are mainly set based on the production and transportation costs of domestic natural gas, however, nearly 45% of China's natural gas demand needs to be met through imports that are mostly not reflected in city-gate gas prices.

As a result, Chinese natural gas importers, mainly the big three national oil companies -- PetroChina, Sinopec and CNOOC -- have incurred annual losses in their imported natural gas business for a long time as most of their imported volumes are sold through pipelines. Trucked LNG sales are not regulated.

To ensure stable supply, city gas companies and major industrial users normally sign annual gas purchase contracts with the NOCs that have two parts -- a base volume and a flexible volume. The base volume reflects total gas consumption in the previous year and covers the basic demand requirement, while the flexible volume reflects demand fluctuations due to seasonality or other factors.

If suppliers are unable to meet the flexible volume demand, city gas companies have to buy this from the spot market but they can also cancel offtake from pipelines if they don't want the flexible volume.

The prices quoted in contracts for the flexible volume were previously settled at transaction prices of the Shanghai Petroleum and Natural Gas Exchange or other spot natural gas prices transacted by PetroChina and Sinopec. With the changes, they will now be linked to Platts JKM from this year, according to multiple market sources at the NOCs and downstream gas companies.

Platts JKM, the benchmark price for spot LNG assessed by S&P Global Commodity Insights, was at $24.781/MMBtu Nov. 17 for January 2023 deliveries to northeast Asia.

PetroChina, Sinopec downstream sales

Both PetroChina and Sinopec have introduced JKM assessments into their pricing formulas with downstream buyers this year, multiple sources close to the two companies said. Sinopec has also been selling all uncontracted natural gas at prices linked to JKM starting from November, a company source said.

PetroChina's 2022-23 downstream gas contracts have a base to flexible ratio of 90:10 while Sinopec has a ratio of 80:20, sources said. They said while the base volume remains regulated, the price of the flexible volume has already been shifting gradually to market-oriented pricing, having been raised by around 80% this year and by around 40% two years ago.

The JKM-linked pricing is expected to bring additional relief to NOCs despite the previous increases, and the relatively small share of flexible gas sales in China's total volumes.

The country's largest natural gas supplier PetroChina sold 194.59 Bcm gas in the domestic market in 2021, accounting for around 53% of total gas demand of 369 Bcm. Nearly 41% of its sales were imported, including both pipeline imports and LNG. Sinopec's natural gas sales volume reached 62.1 Bcm in 2021, accounting for 17% of China's gas demand. Of this, around 30 Bcm was imported LNG, data from the company showed.

PetroChina incurred a loss of around Yuan 7.21 billion ($1.01 billion) for imported natural gas in 2021, narrowing from Yuan 14.16 billion and Yuan 30.71 billion in 2020 and 2019, respectively, due to previous price increases, the company's CFO said earlier. Sinopec posted a loss of around Yuan 6 billion in the LNG business in 2021, according to company data.

Gas market reforms by China's top economic planner National Development and Reform Commission have included separating infrastructure assets like pipeline networks and LNG terminals into a separate company called PipeChina in 2019 that broke the control of NOCs over infrastructure access.

In May 2020, the NDRC removed natural gas city-gate prices from the central government's list of regulated entities and said other wholesale prices will be liberalized in future. In May 2021, NDRC issued guidelines for gas pricing reform in the 14th Five-Year Plan (2021-2025), including better linkage between sales prices and procurement costs.

In April 2020, Zhejiang province in eastern China launched trials for pipeline gas trade between upstream suppliers and downstream buyers at market prices. Shandong province in eastern China allowed city gas companies to pass on LNG purchase costs to non-residential users from October 2021.

Other regions and provinces, including Inner Mongolia, Xinjiang, Ningxia, Guangxi, Yunnan, Ganshu, Hunan, Guizhou and Guangdong, have all gradually implemented upstream and downstream price linkage mechanisms over 2020-21, although the specific measures vary.

China's new downstream city-gas pricing mechanism for 2022-23:

Notes:

* Actual pricing could vary in different regions

* Regulated gas sources are domestic onshore conventional natural gas and imported pipeline gas for projects before 2014

* Unregulated gas sources are imported LNG, offshore, unconventional and imported pipeline gas under projects after 2015

* PetroChina supplies domestic conventional onshore gas, imported pipeline gas and LNG. Sinopec supplies imported LNG and domestic unconventional gas

Sources: State-owned oil companies, buyers of PetroChina and Sinopec, and domestic market analysts