EQUITY RESEARCH. Rising Natural Gas Consumption in China Set to Intensify. In this Report. March 13, 2013

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1 In this Report Chongqing, China, February 3, 2013 Rising Natural Gas Consumption in China Set to Intensify Several major forces are driving natural gas consumption in China: its rapidly expanding economy (averaging 10% growth over the past decade), the fact that China is the world s largest energy consumer 1, the region s energy-intense heavy industry and infrastructure development, and its low penetration of natural gas. 2,3 Now another driver is adding further pressure demand for cleaner energy sources. Mounting pollution levels have increased the pressure within China to continue moving toward cleaner energy sources, particularly natural gas. Read why we see natural gas distributor Kunlun Energy (PARG. HK; BMG5320C1082) downstream operator for parent company Petro- China and equipment and service provider CIMC Enric Holdings (ENRC.HK; KYG2198S1093) as names to know. Although China has historically put more emphasis on economic growth than environmental concerns in its sourcing of energy, that is beginning to change at least in part because of very high pollution in the region. On January 12, 2013, an air monitor at the U.S. Embassy in Beijing showed that the PM2.5 level the measure of tiny particulates that are especially hazardous because they penetrate tissue and can lead to diseases reached a level 35 times the World Health Organization s recommended standard. On January 13, Beijing issued its first-ever orange fog warning, an alert to children, the elderly, and those suffering from respiratory disease to stay indoors. 4 These high levels of pollution have intensified public demand for measures to reduce carbon emissions and enact greater environmental protection measures, moves that further drive growth for clean energy providers and related service companies in the region. This report gives an in-depth look at two Hong Kong energy sector companies poised to benefit: Kunlun Energy (PARG.HK) and CIMC Enric Holdings (ENRC.HK) u.s. air quality index Bejing s AIR QUALITY INDEX SOARED TO 755 Beyond the Scale Hazardous very unhealthy unhealthy Unhealthy for sensitive groups US cities normally have AQI ratings well below 100 Source: guardian.co.uk, January 15, 2013 Page 1

2 PARG.HK As of 3/12/2013 Market Kunlun Energy (PARG.HK) China Market Cap (US $ million) 16,711 P/E Ratio Return on Equity, % Pretax Margin, % Source: PANARAY Kunlun Energy was added to our Global Focus List (GFL) after breaking out of a 30-week, cup-with-handle base in late October 2012 on 3.5 times the average daily volume. It has since provided a doubledigit return. The clean energy applications of natural gas fit nicely with China s goal to reduce carbon intensity 17% by 2015, providing future growth for Kunlun Energy. Its steady contributions from exploration and production, double-digit growth in its gas distribution pipeline and natural gas end-users segment, and its unique position as the downstream operator for parent company PetroChina (and the potential asset injections that entails) put Kunlun Energy in position to become the market-leading LNG producer and supplier in China Sales Change, % 45 Three-year earnings growth rate, % 40 Three-year sales growth rate, % 88 Filling stations in operation in 2011 Number of filling stations added in After breaking out of a 28-week consolidation in early October 2012, CIMC Enric Holdings was added to our GFL and has since generated a 70% return. It boasts a relative strength of 92 in a ENRC.HK As of 3/12/2013 Market CIMC Enric (ENRC.HK) China, U.S., Europe, Southeast Asia Market Cap (US $ million) 1,467 P/E Ratio Return on Equity, % Pretax Margin, % Sales Change, % 68 Three-year earnings growth rate, % 69 Three-year sales growth rate, % 18 Source: PANARAY Page 2

3 strong-performing Hong Kong market. Given its market-leading position in energy equipment in China, expanding capacity, and the increasingly supportive government policies and initiatives in the growing CNG and LNG markets, the stock has considerable fuel to continue its run. Kunlun Energy on path to become China s leading LNG producer/supplier Kunlun Energy was formed to become the largest natural gas distributor in China. 6 The Company is the only listed subsidiary of PetroChina Company Limited (PECH.HK), the largest oil and gas producer and distributor in China, itself controlled by China National Petroleum Corporation, one of three state-owned national oil companies in China. 7 PetroChina accounted for 76% of China s natural gas output in 2010, as well as 70% of the total length of the country s natural gas pipelines. 8 Kunlun serves an important segment in the natural gas industry chain of PetroChina, developing the mid- and downstream end-user business. It is engaged in the exploration of oil and gas and various aspects of the sale and transmission of natural gas. Pipelines Kunlun s natural gas pipelines delivered billion cubic meters (bcm) of gas in first-half 2012, a 23% increase from first-half The segment accounted for 38% of total revenues and generated revenue growth of 26%. The Construction on the Wuyin line (Wuhai, Inner Mongolia-Yinchuan, Ningxia), the first long-distance coke oven gas transmission pipeline in China, was also completed in late 2012 and recently commenced operation. 9 Thus far, Kunlun has invested in three nationwide pipelines and three local pipelines in developing its pipeline network. China is expected to consume 260bcm of natural gas per year by 2015, according to the 12 th Five-Year Plan, more than triple the 81bcm used in Kunlun is thus positioned to profit from strong growth in the natural gas market with its expanding transmission pipelines. Its parent company, PetroChina, controls over two-thirds of the length of China s natural gas pipeline including seven national and other local pipelines and further asset injections are likely. 10 Though pipeline operators are subject to pipeline transportation rates set by the National Development and Reform Com- Page 3

4 mission (NDRC), the Company is shielded from the impact of caps placed on the price charged for natural gas, as PetroChina absorbs losses from importing gas at international prices and selling at lower prices set by the government. Distribution As of December 2011, Kunlun Energy distributed gas in 22 provinces. The Company s market presence is primarily concentrated in Guangdong, Hainan, Hebei, Inner Mongolia, Shaanxi, Shandong, Sichuan, and Xinjiang, and these markets have a natural gas penetration rate of about 20% on average. 11 Because the penetration rate is relatively low in the areas it serves, and the Company has a secure natural gas supply from PetroChina, Kunlun s natural gas sales volume has been growing at a faster rate than its peers. The natural gas volume delivered in the first half 2012 hit 2.18bcm, up 30% from first-half The segment accounted for 33% of total first-half 2012 revenues, an increase of 31% year-over-year. Source: Kunlun Energy website In addition to aggressively consolidating the city gas operations acquired from PetroChina, the Company is also focusing on the transportation market. As of December 2011, Kunlun Energy operated 190 compressed natural gas (CNG) filling stations and 47 liquefied natural gas (LNG) filling stations. CNG and LNG are clean-burning alternative energy sources, with CNG primarily used in passenger vehicles as well as some industrial and commercial applications, while LNG is more practical for heavy-duty trucks, mass transport, and vessels. During 2012, the Company developed 28,000 LNG-powered vehicles, 15 LNG-powered vessels, and 48 drillers for natural gas. With the anticipated increase in use of natural gas versus oil as a fuel source for vehicles, and in line with the goal to reduce emission intensity, Kunlun added 227 new gas refilling stations during On February 17, 2013, Kunlun s Daguan Road LNG refueling station (see photo on page 5) in Guangzhou commenced operation, fueling the first fleet of 310 LNG-powered buses. The refueling station has designed capacity of 40,000 cubic meters per day, enough to refuel 500 buses. By the end of 2013, the Company plans to expand its LNG-powered buses to a total of 3,000 vehicles. 13 LNG Processing and Storage Roughly half of China s natural gas imports are in the form of LNG. 14 LNG is more cost-effective and environmentally friendly than other fuels and is a viable alternative for powering vehicles and vessels. Page 4

5 Daguan Road LNG refueling station in Gauangzhou. Source: Kunlun Energy website Compared with gasoline, LNG results in 60-90% less smog-producing pollutants, as well as 30-40% less greenhouse gas emissions, and is also less expensive. 15 LNG allows vehicles to achieve much greater hauling ranges, because it is stored at low pressures and its storage mass is light, thus offering numerous advantages over other fuel sources. 16 Within its natural gas segment, separate from filling stations, Kunlun is also engaged in LNG processing, transportation, and storage. The Company operates two coastal LNG receiving terminals as well as six LNG processing plants, two of which came online in It is in the process of constructing 12 additional LNG processing plants. Two were scheduled to begin construction in 2012, and the remaining processing plants are expected to begin production within the next two years, which would make Kunlun the largest domestic onshore LNG producer and supplier in China. 17 Though Kunlun s LNG processing and storage business is just getting under way it accounted for only 8% of total revenues in firsthalf 2012 the segment s revenues grew more than 900% from firsthalf 2011, when LNG operations accounted for only 1% of total revenues. Our comparison table (page 6) shows that Kunlun boasts the greatest 2011 return-on-equity of its peers and a considerably higher pretax margin, while providing a lower price-to-earnings ratio. All three companies have double-digit sales and earnings growth rates confirming growing demand for gas but Kunlun Energy is again the top performer, with an impressive 88% three-year sales growth rate and 40% three-year earnings growth rate. The Company was also the most aggressive in adding filling stations in Page 5

6 As of 3/12/2013 Peer Comparison LNG/CNG Operators Kunlun Energy (PARG.HK) China Resources Gas Group (LOGI.HK) ENN Energy Holdings (XINA.HK) Market China China China Market Cap (US $ million) 16,711 5,275 5,549 P/E Ratio Return on Equity, % Pretax Margin, % Sales Change, % Three-year earnings growth rate, % Three-year sales growth rate, % Filling stations in operation in 2011 Number of filling stations added in CIMC is China s dominant player in CNG transportation Energy suppliers are not the only ones benefiting from China s growing clean energy demand. Equipment and service providers in the sector, such as CIMC Enric Holdings (ENRC.HK), are also flourishing. Energy equipment accounted for 52% of CIMC s firsthalf 2012 revenues up from 49% in first-half 2011 and 56% of the Company s profit from operations. CIMC specializes in the manufacture and sale of a wide range of equipment used in the storage, transportation, processing, and distribution of natural gas, such as CNG trailers, CNG seamless pressure cylinders, LNG trailers, LNG storage tanks, liquefied petroleum gas (LPG) tanks, LPG trailers, natural gas refueling stations, and natural gas compressors. CIMC s broad customer base includes industry heavyweights such as PetroChina, ENN Energy (XINA.HK), China Resource Gas Group (LOGI.HK), Xinjiang Guanghui (XGS.CN), Air Products (APD), EXSIF, TAL International (TAL), and Sinochem International (SIO.CN). CIMC is a dominant player in China s CNG transportation market, with an estimated 70% market share and is also one of the largest suppliers of cryogenic LNG tanks and trailers, with about 50% market share. 18 For first-half 2012, CNG and LNG storage and Page 6

7 transportation equipment were the main contributors to the segment s growth. 19 To meet growing demand for CNG and LNG applications, the Company is in the process of increasing production capacity of its energy equipment through expansion of existing production plants as well as construction of new production lines in Bengbu and Shijiazhuang. Comparing CIMC Enric against other energy equipment suppliers in other regions shows that it has a much stronger return on equity and provides a more solid earnings track record, with an impressive 69% three-year earnings growth rate. With a 2011 revenue growth rate of nearly 70% and a lower price-to-earnings ratio than its peers in other regions, the Company is a standout. As of 3/12/2013 Market Peer Comparison Energy Equipment CIMC Enric (ENRC.HK) China, U.S., Europe, Southeast Asia Chart Industries (Nasdaq:GTLS) U.S., Germany, Czech Republic Everest Kanto Cylinder (EKC.IN) India, Middle East Market Cap (US $ million) 1,467 2, P/E Ratio N/A (net loss) 2011 Return on Equity, % Pretax Margin, % Sales Change, % Three-year earnings growth rate, % Three-year sales growth rate, % City governments in China have implemented policies to support the growth of CNG passenger cars and LNG trucks and mass transport, such as preferential gas price policies, and they have also constructed CNG/LNG refill stations. More than 80 cities across China had gas filling stations, and the number of CNG/LNG refill stations totaled more than 1,000 at the end of It is projected that during the course of China s 12 th Five-Year Plan, an additional 1,000 refill stations will be constructed, further driving demand for CNG and LNG equipment. 20 CIMC also offers project engineering services for LNG application and other projects. In January 2012, CIMC completed the acquisition of Nanijing Yangzi Petrochemical Design and Engineering, a company engaged in the consultancy, design, service, procurement, and contracting for petrochemical projects; pressure Page 7

8 vessels and pressure piping design; and computer software development. 21 The move enhances CIMC s manufacturing and engineering service capability and enables the Company to expand into the upstream customer network in the energy and chemical segments. The technological development and expanded market reach following this acquisition has allowed the Company to offer one-stop engineering and procurement services as well. 22 ENDNOTES: htm?collcc= & 8. Guosen Securities (HK), June 25 th 2012, Kunlun Energy, An Alternative to Sinopec in China s natural gas distribution industry Guosen Securities (HK), June 25 th 2012, Kunlun Energy, An Alternative to Sinopec in China s natural gas distribution industry UOBKayHian, April 24 th, 2012, CIMC Enric Holdings. The Best Proxy to China s LNG Investment Boom Holdings-Turnover-Up-23-3-to-RMB Million-for-1H-2012-Profit-Attributable-to- Eq / William O Neil + Company, Incorporated Offers the world s leading institutional investment managers a distinct blend of quantitative, fundamental, and technical expertise in global stock buyand-sell recommendations. Its core method profiles stocks displaying the characteristics of outperformance proven persistent over market history drawn from the firm s industry-leading database. William O Neil + Co., Incorporated is a Registered Investment Advisor with the State of California and certain other states. The firm and its affiliates may now or in the future have positions in the securities mentioned in this or other publications. Charts are intended to be used as tools to assist institutional investors in identifying equity ideas worthy for further review. Charts provide certain current and historical information, but are not a substitute for comprehensive analysis of the individual stocks. For further information about our business and legal policies, please see williamoneil.com/legal. Page 8