Energy security is a lingering headache for China, as the world's largest natural gas importer braces for extended turbulence in the LNG market. S&P Global Ratings believes the country should be able meet demand through its efforts to secure supply and reduce reliance on expensive spot purchases. Dollar margins are likely to improve for gas distributors thanks to their ability to control gas procurement costs, the likelihood of fuel costs coming down next year, and continued passthroughs.

With natural gas key to the country's decarbonization commitments, demand will rise by a total of 175 billion-180 billion cubic meters (bcm) between 2021 and 2030 and peak around 2040, according to oil major China National Petroleum Corp. (CNPC). The pace of growth, however, is slowing, with an expected increase of 65% by 2030 from 2020 levels, compared with a rise of about 212% between 2010 and 2020. The slowdown reflects decelerating growth in consumption in the industrial sector amid waning economic growth and spluttering coal-to-gas conversion for industrial and residential users. The power sector could soon take over as the primary growth driver, looking to support increasing peak-shaving needs to complement China's shift to renewables.

Imported gas should continue to meet 45%-50% of demand through 2030, with an increasing contribution from pipeline imports and long-term liquified natural gas (LNG) contracts, in our estimation. Pipeline gas will account for 40%-45% of total imports by 2030, compared with 35% in 2021, backed by increased deliveries from Russia and Turkmenistan on new and existing pipelines. China also signed sizable long-term LNG contracts in 2021 and 2022, to be executed mainly through 2025. This will reduce the contribution from spot and short-term LNG contracts to the country's overall gas supply mix to 5%-10% over the period, down from 14% in 2021.

S&P Global Ratings forecasts the average dollar margin for rated listed gas distributors will improve by RMB 0.02 in 2023. Our assumption includes lower costs of pipeline and long-term LNG imports because of declining crude oil prices. We also expect local governments to increasingly pass on costs, maintaining retail prices at historically high levels. We believe local governments may be wary of substantially compressing distributors' margins, as non-state-owned participants account for a sizable chunk of the sector.

Supply Keeping Up With Stabilizing Demand

Demand growth has slowed because of a decline in gas usage under stringent COVID restrictions and the economic slowdown. In turn, this has helped alleviate supply-side pressure. In our view, gas consumption growth is likely to drop below 1% in 2022, translating to about 4 bcm of increment demand. This can be met fully by domestic production growth of about 10 bcm and a likely 5 bcm increase in imported pipeline gas (PNG) from Russia, both of which are considerably cheaper than LNG.

Chart 1

Ramping up PNG and securing long-term LNG contracts can position China to meet domestic demand. If gas demand in China grows by 7% (about 26 bcm) in 2023, domestic production and pipeline delivery will cover about 70%-75% of the country's needs, while long-term LNG will account for another 15%-20%, assuming 85% contract fulfillment. This leaves spot and short-term cargo demand of 35 bcm-40 bcm (25-29 million tons), lower than the 51 bcm (37 mt) in 2021 as reported by the International Group of Liquefied Natural Gas Importers. This will help reduce the country's exposure to expensive spot LNG prices, which we expect to remain high through 2023.

China's gas source mix will remain relatively diverse, mitigating potential supply disruptions caused by geopolitical risks or force majeure events. In 2021, Turkmenistan PNG and Australian LNG were the only two external sources that accounted for more than 5% of China's gas supply, at 9% and 12%, respectively. Cooperation on energy between China and Russia is deepening as Moscow seeks to divert gas away from Europe, with existing pipeline delivery set to increase to 38 bcm by 2025, with another 10 bcm to arrive through a new Far East pipeline by 2026.

Still, Russia's increased PNG deliveries to China will cover less than half of the drop in exports to Europe by 2030, according to the International Energy Agency. China's LNG sources are also diversifying away from its largest supplier Australia--new contracts signed in 2021 and 2022 for 50 bcm focused on the U.S., Qatar, and Russia.

Construction and expansion of regassification terminals is on track to meet rising LNG import needs. As of June 2022, the nominal capacity of China's operating LNG terminal is 132.9 bcm per year (96 mt per year), with another 117.7 bcm per year (85 mt per year) under construction, based on Global Energy Monitor's database. In comparison, China's LNG imports in 2021 were 108.7 bcm. The country's fourteenth five-year plan also laid out ambitious targets to increase storage capacity to 55 bcm-60 bcm by 2025. Underground storage capacity as of 2021 is around 26 bcm, according to domestic research reports.

Chart 2

Lower Fuel Costs Ahead

An anticipated decline in gas costs from 2023 will run along the same trajectory as crude oil prices, as supply-demand balance in the oil market improves. Based on S&P Global Ratings assumptions, Brent crude will decline to around US$85/barrel (bbl) in 2023, compared with around US$100/bbl in 2022. This could push gas costs down by an average of 10% for rated gas distributors. The lagging six-month average of the Brent spot price can be used as an indicator for imported gas prices, and thus allows for prediction of total upstream gas costs. China's onshore gas production costs tend to be low, historically fluctuating below RMB1.50 per cubic meter based on mining difficulty, according to local media.

Chart 3

We expect local governments to adjust for a smaller decline in retail prices, since costs were not passed on sufficiently in the 2021/2022 winter. This would support the operating viability of gas distributors and prevent disruption to services. Retail prices in 2023 should therefore remain considerably higher than levels prior to 2022. Some end users can handle higher gas prices, such as peak-shaving gas power plants that have passthrough tariffs and commercial users for whom gas accounts for a minor portion of operating costs.

Gas distributors' dollar margin expansion in 2023 will also be supported by a likely higher portion of consumption from commercial and industrial users, which provide better margins. COVID-related lockdowns in 2022 hit their gas volumes but hiked up residential use as people stayed home. The trend should reverse in 2023, barring any major lockdowns. Retail volumes for rated city gas distributors are set to increase by an average of 9% annually over 2022-2024, still above the national average but decelerating from 14.2% in 2021. For the first half of 2022, their gas sales volume grew by 6%, compared with a 0.5% decline nationwide.

Surging costs and inadequate passthrough last winter will undoubtedly compress dollar margins in 2022, but not severely. Under our estimates, the average dollar margin for our rated gas distributors will decline slightly by around RMB 0.03 to RMB 0.46/ cubic meter, narrowing down from RMB 0.05 in 2021, despite similar levels of cost increase in both years. This is due to slightly better passthrough conditions for the non-heating season, whereby many regions allowed retail prices during the winter of 2021/2022 to be carried over.

For the distributors we rate, gas costs will likely surge by 15%-20% in 2022, following the 16% increase in 2021. In the first half of 2022, gas costs rose by about 32% year on year and 12% from the second half of 2021. Costs for winter 2022/2023 will likely exceed that of 2021/2022 based on current crude oil prices.

Chart 4

Regulatory Framework Reform To Create Better Operating Environment

China's overarching goal for gas reform is full market liberalization of upstream and downstream pricing (excluding residential users), while keeping midstream transmission and distribution under tight regulatory control. A liberalized market can allow for upstream and end users to adjust their gas supply and usage more quickly and efficiently.

The reform may gradually reduce inefficiency in the current pricing framework, whereby upstream gas prices, which are largely dictated by the big three national oil companies, are more reflective of market supply-demand balance, while end-user retail prices remain influenced by local governments.

Over the past two years, more provinces and cities have rolled out or amended policies on passthrough mechanisms with increasing transparency. They have started to include details on the thresholds to trigger adjustments (typically a 5%-10% cost increase from previous adjustment cycle) and a specified limit on price adjustments (see table 1). Also, a hearing process previously required for adjustment of residential gas prices is being phased out.

Table 1

Still, the quality of passthrough execution varies across the country. In addition to a time lag in price adjustment, the extent of passthrough is dependent on the user category and balancing of social-economic factors. In some areas, such as Shijiazhuang City and Fuzhou City, policies require price adjustments to account for end users' ability to shoulder cost burden, and to prevent large price swings.

The pace of reform will likely be disrupted by the current high gas cost environment, as full passthrough would mean higher volatility and a surge in end user costs. In a downside scenario where crude oil prices continue to rise and China's economy weakens sharply, local governments in certain areas may be less willing to pass on rising costs, as the priority shifts to protecting the industrial sector's operating profits.

Maintaining energy security remains a considerable challenge for China, but efforts to diversify on the supply side should cushion the landing as demand growth falls.

Table 2