China's gas distributors just about remain on track for a recovery in 2023. S&P Global Ratings believes that weak industrial consumption, a poor property market, and soft manufacturing growth will depress gas demand, but that rated distributors will still average 8% volume growth this year. This, along with a modest margin recovery, should keep entities within ratings buffers.

Dollar margins, an important piece of the retail-gas puzzle, will pick up from the historic low set in 2022. However, stagnant demand from high-margin industrial consumers and chronic issues in residential cost passthrough will limit the upside for gas distributors.

Retail gas earnings recovery should persist with higher visibility in 2024-2025, driven by sustained volume growth and improvements to the dollar margin.

Volume Growth Presents The Biggest Hurdle To Retail Gas Earnings

Our expectation that rated distributors will average 8% volume growth this year is below the 10% average growth that distributors projected at the start of the year. The weaker pace of industrial volume growth, which averaged a modest 7% in the first half of 2023, will also dilute the quality of this growth. Gas sales to residential households, certain commercial customers, and filling stations have lower margins.

This growth projection excludes the outlier performance of ENN Energy Holdings Ltd., whose industrial volume declined 12% in the first half of 2023, year on year. This followed a drop in demand captured by cheaper competitors.

Assuming these volumes are not fully recouped amid continued low prices for liquefied natural gas (LNG), volume growth could decline by about 5% in 2023. This may modestly raise the company's leverage over 2023-2025, though the level will likely stay well within the tolerance for the current rating on the entity.

Over 2024-2025, we project average growth of 9% for rated distributors. This assumes a moderate pace of industrial recovery, limiting prospects for the high double-digit growth that was seen prior to 2022. The projection references our forecast that China's GDP growth will slip to 4.7% in 2024 and 2025, from our projected rate of 5.2% in 2023.

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Dollar Margin Improvement Will Be Modest In 2023

We maintain our forecast of a Chinese renminbi (RMB) 0.02/cubic meter (cbm) increase in average dollar margin for rated distributors for the year. This modest increase encompasses the mixed assumptions of improved cost passthrough, customer optimization, and lower LNG costs. Rated distributors reported an average RMB0.02/cbm increase (year-on-year) in their dollar margin in the first half of 2023.

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Distributors with potential larger increases in dollar margin include ENN Energy (+RMB0.03/cbm) and China Resources Gas Group Ltd. (+RMB0.05/cbm). ENN Energy's significant decline in sales to power plants will benefit dollar margins as the company's volume mix shifts to industrial consumers with modestly higher margins. Meanwhile, China Resources Gas' dollar margin improvement rests on improved residential gas cost-passthrough, following passthrough delays and high upstream costs in the second half of 2022.

In addition, lower domestic and international spot prices mitigate against modestly rising contract gas prices from the three national oil majors, keeping overall gas costs stable. This particularly benefits ENN Energy, China Resources Gas, The Hong Kong and China Gas Co. Ltd., and Towngas Smart Energy Co. Ltd. The group procures around 10%-20% of their supply from domestic unconventional sources and through LNG imports.

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Residential gas cost passthrough remains a downside risk this winter, as PetroChina Co. Ltd. has hiked residential gas costs by about 10% this year. Risks will be elevated if regulated gas volumes from the oil majors remain tight in the winter and distributors turn to alternative supplies. While numerous tier-one cities have recently achieved breakthroughs in residential cost-passthrough following years of stable prices, many cities have yet to follow.

We believe delayed passthrough is still likely in some regions due to socioeconomic considerations. Gas projects in these areas may only see a margin pick-up in the first half of 2024. In the interim results briefings in August, China Resources Gas said that the government had approved about half its volumes for residential cost-passthrough. However, the ratio for ENN Energy was 34%.

We expect dollar margins for distributors to rise another RMB0.01/cbm to RMB0.02/cbm in 2024, and again in 2025. This assumes still high but declining upstream gas costs, as well as modestly rising volume mix from high-margin industrial customers as the economy continues to recover.

New Household Connections Will Keep Dropping Over 2023-2025

Connection services typically contribute the second-largest portion of earnings for distributors. Given the continued turmoil in the property sector--with particularly weak performance in lower-tier cities--the market for new residential connections over the next three years will drop, particularly for distributors with nationwide coverage.

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This is in line with our projection of an average 5%-10% decline in new household connections annually for rated distributors over 2023-2025. Kunlun Energy Co. Ltd. is the least affected company as it is less focused on developing its residential sector, and has low contribution from connection fees.

Expansion In Non-Gas Segments Provides Earnings Cushion

ENN Energy, China Resources Gas, and Towngas are developing their integrated energy and value-added businesses. The growth potential is high as the integrated energy market thrives on the increasing decarbonization needs of industrial customers and synergies with gas supply. Over 2023-2025, we project that these businesses would contribute about 30%-35% of gross profits for ENN Energy and Towngas, and 10%-15% for China Resources Gas.

Meanwhile, Kunlun maintains a strategic focus on its natural gas value chain. The company looks to expand its midstream assets by adding capacity of 3 million tons a year through investment in its LNG terminal in Fujian. This will complement its well-utilized LNG terminals in Jiangsu and Hebei, which generate steady earnings that account for one-third of Kunlun's EBITDA.

Rated Distributors Can Support Their Leverage Profiles

A continued recovery in the gas sector should help gradually repair balance sheet strength of distributors such as China Resources Gas, Hong Kong and China Gas, and Towngas. Earnings pressure over the past year under the combined impact of COVID restrictions and high gas costs, as well as rising capital expenditure (capex) and investments have eroded the ratings buffer on these entities.

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We expect the capex and investment levels of China Oil and Gas Group Ltd., China Resources Gas, ENN Energy, and Kunlun to be broadly stable over the next three years, and fully covered by their operating cash flows. Capex will focus on core investments in pipeline construction, integrated energy projects, and acquisition of city gas projects.

Towngas and Hong Kong and China Gas will see double-digit increases in capex as they expand in the distributed solar-power business. However, the pace of investment will be more prudent as they pare back on capacity installation targets amid a soft national economy.

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Volatility Remains On The Horizon

The price of imported LNG will continue to mimic high volatile crude oil prices, and European hub prices, without the cushion of Russian piped gas supply. Price jumps caused by demand spikes or supply disruptions will raise the cost base of distributors. Imports make up around 45% of China's national gas supply.

In addition, further weakness in economic or industrial sector recovery will compress volume growth while constricting headroom for cost passthrough. This will resemble a similar situation faced by distributors in a COVID-hit 2022.

Still, we believe the long-term growth trajectory for natural gas demand in China remains intact, given China's decarbonization efforts to replace coal. Policy advances in cost-passthrough mechanisms, if properly executed, should also increase earnings stability.

Editor: Jasper Moiseiwitsch

Related Research

• China Oil And Gas Group Ltd., Aug. 29, 2023
• China Resources Gas Group Ltd., July 25, 2023
• Kunlun Energy Co. Ltd., July 12, 2023
• ENN Energy Holdings Ltd., June 6, 2023
• The Hong Kong and China Gas Co. Ltd. and Towngas Smart Energy Co. Ltd., Dec. 12, 2022
• China Gas Sector Easing Into Lower Demand, Nov. 21, 2022