China Gas Sector. Surviving the low-cost economics. Figure 1: City gas volume and dollar margin

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1 Asia Pacific/China Equity Research Electric Utilities Research Analysts Dave Dai, CFA Horace Tse Shuwei Chen China Gas Sector COMMENT Surviving the low-cost economics Figure 1: City gas volume and dollar margin Figure 2: Petrochina's gas pipeline earnings on a structural decline (Rmb bn) E 2017E 2018E 'Real' pipeline earnings Cheaper and cheaper. In the next phase of the natural gas industry, we expect further gas price cuts to stimulate demand. Besides a nationwide citygate price cut of Rmb0.3/m 3 in the next six months, extra retail price cuts are possible, following local government's price reviews in 2H16, where we only see a threat to high-margin coastal locations (ENN most exposed). In the medium term, cheaper direct LNG imports could bring further price pressure. Compared with street expectations, these forecasts point to lower prices. Better demand with new drivers. All these price efforts should improve demand, following a sharp slowdown in We forecast a rebound to 9% YoY in 2016 and a 10% CAGR over FY16-20E. We believe this forecast is more optimistic than street expectations (6-7%) and we also differentiate our view that there will be new drivers including heating and power, commercial and residential; when we dive deeper into these in this report. Given the difference in locations, CGH and CRG are best positioned among peers. De-monopolising supply. Another major change is that PetroChina s monopolistic gas supply position will be at threat with the opening up of direct LNG imports by city-gas operators and the potential opening up of third-party pipeline access both landmark changes to the current dominant position. As front-runners, SZG and ENN could start enjoying single-digit earnings benefits with their own terminals and imports in FY17-18E. Winners and losers. For upstream, we expect a structural deterioration in PetroChina s natural gas earnings amid competitive pricing pressure and lower core earnings on higher MI after pipeline sell-down; hence, we cut our earnings and TP further (TP of HK$3.80 suggests 25% downside). For downstream, new changes should selectively benefit players with dollar margin safety and room to tap into new demand drivers. CGH and CRG are best positioned (Outperform ratings maintained, TPs up 3-17%). We downgrade ENN as an inferior distributor to Neutral (TP: HK$44 from HK$53). Shuwei Chen assumes coverage of Shenzhen Gas with a NEUTRAL rating (Underperform previously) and TP of Rmb9.00 (from Rmb6.00). DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Shenzhen Guangxi Zhejiang Liaoning Hainan Jilin Shandong Shandong Tianjin Beijing Guangzhou Hubei Yunnan Anhui Shaanxi Henan Shanxi Heilongjiang Hebei Hunan Inner Jiangsu Chongqing Sichuan Zhejiang Shanghai 27 September 2016 Focus charts and table Figure 3: Gas is still very small 6% of total energy (2015) Figure 4: CS base-case China gas supply vs demand Rmb/cm 25% % 15% 10% 5% 0% Consumption YoY Supply YoY City-gate price (RHS) Figure 5: Likely C&I dollar margin after price review Figure 6: Household penetration rate helped by urbanisation Weighted dollar margin: Figure 7: Benefits from new demand drivers Figure 8: City-gas forward P/E vs gas demand and gas prices (X) 22 25% City-gate price 20 20% % 14 10% 12 5% % Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20 Demand YoY Sector forward PE Figure 9: Valuation comp table and key changes Company Ticker Rating Target price U/D EPS change Recurring EPS CAGR P/E ROE New Old New Old 16E 17E 18E 16-18E 17E 17E China Gas (top OUTPERFORM) 0384.HK O O % 0% 2% 4% 18% % CR Gas (top OUTPERFORM) 1193.HK O O % 1% 3% 7% 18% % ENN Energy 2688.HK N O % 0% -6% -4% 12% % Shenzhen Gas SS N U 9 6-4% 15% 13% 18% 13% % PetroChina (top UNDERPERFORM) 0857.HK U U % -55% loss -30% n.m. n.m. n.m. Note: Priced as of 23 September China Gas Sector 2

3 The golden decade of natural gas is over. A new landscape is emerging with changing demand, supply and lower prices Neglected new drivers like heating, power and commercial (hotels and hospitals) together could contribute substantially to demand LNG imports are an existing opportunity for SZG and ENN. There should be more upside if third-party access to gas infrastructure is allowed Accumulate CGH and CRG; lighten positions in PetroChina Surviving the low-cost economics Cheaper and cheaper It is acknowledged that the golden decade of China's natural gas industry is over. Gas is no longer in shortage, and demand is becoming more cyclical than structural. However, new drivers could still contribute incremental demand, and support ~10% gas volume growth for E. We are cautiously optimistic about China finding new gas buyers from markets including: (1) centralised and decentralised heating; (2) gas-fired power; (3) emerging commercial customers; and (4) continually ramping up residential. Supply monopoly should loosen not only because of long-planned oil & gas market-oriented reforms but also due to cheaper LNG imported by independent players to seize market share from onshore gas. Meanwhile, the natural gas price, in our view, is expected to come down so as to fulfil the primary energy mix change target. Companies with cheaper gas sources and effective projects exposure should be better positioned in this new gas demand-supply dynamics. Better demand with new drivers Demand from commercial and low-affordable markets could be easily neglected by pessimists. According to our estimates, although traditional demand drivers (industrials and vehicles) are expected to move back stage, heating, power and commercial (hotels and hospitals) become new drivers. Yet one setback behind the growth is potentially lower dollar margins for heating and power customers. Normally, city-gas companies are given lower dollar margins for these customers. We believe that an average Rmb0.6/m 3 dollar margin is reasonable compared with Rmb0.8/m 3 for industrial users. The rationale is similar for power, as most of the gas-fired power plants generate heat. We expect C&I dollar margin to be slightly reduced to around Rmb0.7/cm (ex-vat) and our demand test suggests much better volume prospects for CRG and CGH. De-monopolising supply Recently, a series of regulation policies has shown that gas reform is speeding up. From CS oil & gas view, it is price reform which might firstly see positive surprise, followed by the opening-up of third-party access to key infrastructure including LNG terminals. Independent players are expected to penetrate through already deregulated LNG. For city gas players that have been long relying on the oil majors to source supplies, an opportunity has arrived. SZG and ENN are the main beneficiaries. We do further research on two local markets, i.e. Guangdong and Zhejiang, who are frontrunners on diversifying gas supply. We found that LNG terminals will be a key supplier for incremental demand considering their cost competitiveness. Admittedly, if broader-based third-party access is allowed to gas infrastructure, upstream suppliers would need to defend their supply by offering further discounts. Winner and losers With the investment thesis becoming more complex, sustainable winners should offer dollar margin safety and the ability to tap into new demand drivers. For upstream, we expect a structural deterioration in PetroChina s natural gas earnings amid competitive pricing pressure and lower core earnings on higher MI after pipeline sell-down; hence, we cut our earnings and TP further (TP of HK$3.8 suggests 25% downside). For downstream, new changes should selectively benefit players with dollar margin safety and room to tap into new demand drivers. CGH and CRG are best positioned (Outperform ratings maintained, TPs up 3-17%). We downgrade ENN as an inferior distributor to Neutral (TP: HK$44 from HK$53). Shuwei Chen assumes coverage of Shenzhen Gas with a NEUTRAL rating (Underperform previously) and TP of Rmb9.0 (from Rmb6.0). China Gas Sector 3

4 China Gas Sector 4 Figure 10: China oil and gas valuation summary Name Ticker Rating Price TP Mkt cap P/E (x) P/B (x) Yield (%) ROE (%) EPS CAGR (recurring) bn US$ 16E 17E 16E 17E 16E 17E 16E 17E 16-18E China City Gas sector China Gas Holdings Ltd 0384.HK O China Resources Gas 1193.HK O ENN Energy Holdings Ltd 2688.HK N Beijing Enterprises Holdings 0392.HK O Hong Kong and China Gas 0003.HK U Shenzhen Gas Corporation SS N Simple average Integrated & E&P PetroChina - H 0857.HK U PetroChina - A SS U Sinopec - H 0386.HK N Sinopec - A SS N CNOOC 0883.HK U n.a. Simple average OFS & Engineering COSL - H 2883.HK O n.a. COSL - A SS U n.a. Sinopec SSC - H 1033.HK U Sinopec SSC - A SS U Sinopec Engineering 2386.HK U COOEC SS O Yantai Jereh SZ O Anton Oil 3337.HK U SPT Energy 1251.HK N n.a. Hilong 1623.HK O Simple average Pipeline & Infrastructure Kunlun Energy 0135.HK U Sinopec Kantons 0934.HK O Simple average Refining & Chemicals Sinopec SPC - H 0338.HK O Sinopec SPC - A SS U Wanhua Chemical SS O Simple average Source: Based on closing prices as of 23 September Source: Bloomberg, Credit Suisse estimates

5 E 2017E 2018E 2019E 2020E 27 September 2016 Gas dynamics are becoming more cyclical Gas was 6% of total primary energy supply in 2015 Cheaper and cheaper The golden decade of China's natural gas industry is over. Gas is no longer in shortage, and demand is becoming more cyclical than structural. More importantly, competing fuels are even cheaper. To defend the competiveness of natural gas, government policies have also become more involved. In addition to the two gas price cuts in 2015, National Development and Reform Commission (NDRC) also recently launched the regulation process of crossprovincial pipeline tariffs and asked local governments to review local gas prices. The changing industry dynamics create rising uncertainties but also opportunities to be captured. In this report, we reassess our relatively positive investment thesis by tackling some of the bearish arguments for the city gas industry such as: (1) local government will cut gas prices to reduce cost pressure for the economy in 2H16; (2) the central NDRC will regulate returns for city-gas assets which appear very profitable; and (3) a slowing economy and cheaper alternative fuels mean demand will be slower than before. China still loves gas Yes, the golden period of 15-20% demand growth a year is unlikely to be repeated. But gas remains a small proportion, contributing only 6% to the overall primary energy supply in While the 13 th five-year plan ( ) on the oil & gas industry is yet to be released, industry forecasts point to 10% of China's primary energy supply by 2020 as a consensus target. This implies that demand needs to grow ~10% a year for the next five years. Figure 11: Primary energy mix (2015) Figure 12: China natural gas demand growth Bn cm % 23% 16% 17% 17% 12% 10% 20% 13% 22% 15% 6% 6% 9% 10% 11% 10% 9% 25% 20% 15% 10% 5% 0% Natural gas consumption YoY Source: CEIC Source: CEIC, Credit Suisse estimates These targets are not without challenges. In 2015, a slowing economy and cheaper oil prices resulted in the lowest demand growth in a decade (5.7%). As a result, China chose a substantial gas price reduction in November 2015, whereby province-gate prices were cut by Rmb0.7/m 3 (or 28%). To stimulate sustainable demand growth, China needs to further lower gas prices, in our opinion. In our base case, we expect another city-gate price cut of Rmb0.3/m 3 to take place in the next six months. Based on our house view of Brent crude oil price (US$45/bbl by end-2016 and US$54/bbl in 2017), we expect a mild province-gate price cut of Rmb0.3/m 3 (or 15%) by end-2016 or early Some of the excessive province-gate prices may also be adjusted down (similar to Zhejiang's decision in April 2016) by ~Rmb /m 3. The question is whether the combined reduction of Rmb /m 3 is sufficient to boost demand. China Gas Sector 5

6 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 Aug-15 Feb-16 Aug-16 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun September 2016 Figure 13: CS base-case China gas supply vs demand Rmb/cm 25% % % % % % E 2017E 2018E 2019E 2020E Consumption YoY Supply YoY City-gate price (RHS) Source: CEIC,NDRC, Credit Suisse estimates Who are the new customers? New drivers: heating & power, commercial and residential During the last decade, industrials and transportation were the two key demand drivers. This was especially powerful when factories and vehicle drivers had a choice between cheaper natural gas and expensive oil products. With oil prices likely to stay at depressed levels in the next few years and China's industrialising economy going through structural changes, we expect industrial gas demand growth to stay in the single-digit range. For vehicles, CNG-based passenger cars are facing rising challenges from electric vehicles and vehicle hailing services, and LNG-based trucks suffer from lower industrial demand. Figure 14: China's industrial production growth 25% 20% 15% 10% 5% 0% Figure 15: Electric vehicles vs CNG vehicles 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 gasoline/cng dual-fuel vehicle plug in hybrid electric vehicle Source: CEIC Source: CEIC, Credit Suisse estimates However, we are cautiously optimistic about China finding new gas buyers. With recent indications from city-gas results in 1H16, emerging trends clearly embrace: (1) centralised and decentralised heating moving from coal to gas (categorised under residential), which explains the big national demand pick-up during 1Q16; (2) gas-fired power becoming economical again after cheaper gas prices; (3) accelerating commercial customer numbers (such as hotels, restaurants and public services); (4) sustainable residential demand growth with still-low penetration and continuing urbanisation. For the industry as a whole, we forecast total demand to reach 312 bcm in 2020, a 10% CAGR for China Gas Sector 6

7 Figure 16: CS China bottom-up natural gas demand model bcm E 2017E 2018E 2019E 2020E Total demand (NDRC) YoY 19.6% 21.8% 12.6% 15.0% 5.6% 5.7% 9.4% 10.3% 11.4% 9.9% 9.1% Mining YoY 5% 6% 9% 5% 7% 4% 4% 4% 4% 4% 4% Manufacturing YoY 16% 36% 17% 20% 9% 6% 6% 6% 6% 5% 5% - Petroleum, Coking and Nuclear Fuel % 55% 45% 39% 4% 3% 4% 4% 5% 5% 5% - Chemical Material and Product % 34% 7% 11% 5% 3% 3% 3% 3% 2% 0% - Non Metallic Mineral Product % 40% 8% 17% 16% 10% 8% 8% 8% 8% 8% - Ferrous Metal Smelting and Pressing % 33% 16% 15% 14% 9% 9% 11% 10% 9% 9% - Non Ferrous Metal Smelting and Pressing % 54% 87% 32% 24% 15% 16% 18% 16% 15% 15% - Others % 26% 23% 26% 17% 10% 8% 5% 5% 5% 5% Power and Heating YoY 42% 21% 2% 10% 6% 8% 16% 18% 21% 15% 13% Transport, Storage & Telecom Service YoY 17% 30% 12% 14% 22% 14% 10% 10% 8% 8% 8% Commercial YoY 12% 14% 18% 5% 17% 17% 18% 20% 20% 18% 15% Residential YoY 28% 17% 9% 12% 6% 7% 10% 12% 15% 13% 12% Subtotal YoY 21% 24% 12% 14% 10% 8% 9% 10% 11% 10% 9% Others (adjustment balance) More supply but low-cost imports taking market share Currently, China s natural gas supply mainly consists of: (1) domestic production (conventional and non-conventional); (2) onshore West-East piped gas; and (3) offshore LNG imports. We forecast domestic production to expand from 133 bcm to 199 bcm, or an 8% CAGR from Gas imports should grow faster with onshore piped gas and LNG seeing 15% and 11% CAGRs during the same period. By 2020, imported piped gas and LNG should account for 37% of total gas supply. The incremental volume addition of LNG could be especially nimble from , with most new LNG terminals starting operations. China Gas Sector 7

8 Figure 17: CS China bottom-up natural gas supply model bcm E 2017E 2018E 2019E 2020E Domestic gas production Conventional gas PetroChina Sinopec CNOOC Coal gas & others Unconventional Gas CBM Shale Gas Total Domestic Gas Supply YoY % 11.2% 8.3% 4.3% 9.9% 8.6% 5.6% 10.1% 9.5% 7.3% 7.0% 6.6% Import natural gas Turkmenistan Myanmar Kazakhstan Turkmenistan II Uzbekistan Russia 1 5 Total import piped gas YoY% 210.0% 41.9% 26.9% 16.4% 8.2% 18.5% 15.6% 27.0% 8.2% 6.0% Total import LNG YoY % 69.4% 30.5% 20.5% 22.7% 10.3% -1.1% 16.7% 13.7% 15.3% 11.1% 0.0% Total China Gas Supply YoY % 21.4% 19.8% 10.7% 14.0% 10.3% 3.9% 11.3% 9.6% 11.3% 9.3% 9.0% Source: Bloomberg, Credit Suisse estimates Coupled with worldwide spot LNG prices, the latest long-term contracts have also been much lower. We forecast that the proportion of imported LNG in China's natural gas supply should increase since LNG is expected to be even cheaper due to regional excess in Asia from E, according to CS global LNG experts' view. Domestic gas production 1. Conventional gas: Our bottom-up supply forecast driven by China's oil trio PetroChina, Sinopec & CNOOC suggests that domestic conventional gas production will grow by 4.8% p.a. over E. The growth is primarily driven by production ramp-up from PetroChina's Tarim and Changqing gas fields, CNOOC's Liwan and Lingshui gas field. 2. Unconventional gas: We forecast 10.5 bcm of unconventional gas production in 2016 (shale gas + CBM), growing to 39 bcm in 2020E. We lower shale gas and CBM 2020E target respectively to 24 bcm and 21 bcm due to weak demand. Considering the oversupply market situation and accompanying low gas price, we believe that the NDRC and the oil trio would not continue to encourage cost inefficient unconventional gas projects. Piped gas imports Our piped gas import forecasts factor in the existing pipeline import contracts that have already been signed to date. These include W-E II piped gas imports from Turkmenistan and Uzbekistan (30 bcm at its peak), Myanmar piped gas imports (4 bcm at its peak) and W-E III piped gas import from Kazakhstan and Turkmenistan (30 bcm at its peak). W-E III is expected to start from 4Q16. We assume 7 bcm of import volumes in 2016E, ramping up to 30 bcm in 2020E. For Russia's first import contract which was signed in May 2014, we postpone the commission year to 2019 and also lower the import volume to 5 bcm in 2020E according to a meeting attended by CEO of Gazprom and Vice Premier of China in Sochi. China Gas Sector 8

9 Sep-06 Apr-07 Nov-07 Jun-08 Jan-09 Aug-09 Mar-10 Oct-10 May-11 Dec-11 Jul-12 Feb-13 Sep-13 Apr-14 Nov-14 Jun-15 Jan-16 Shandong Yunnan Shandong Shaanxi Hubei Sichuan Liaoning Shenzhen Chongqing Shanxi Jilin Zhejiang Hebei Hunan Jiangsu Guangxi Henan Anhui Guangzhou Hainan Inner Mongolia Zhejiang Heilongjiang Shanghai Beijing Tianjin 27 September 2016 LNG imports Since the imported LNG price responds quicker to weak demand, LNG makes a competitive alternative natural gas source for coastal cities. A number of LNG import contracts commenced in and are ramping up in E, including PNG LNG (Sinopec), QCLNG (CNOOC), Gorgon (PetroChina), APLNG (Sinopec) and the BG portfolio contract (CNOOC). At the same time, independent players like city-gas companies can also build and own LNG terminals (ENN's Zhoushan project and SZ gas' SZ project). All these combined mean that China should see an incremental 14 bcm of LNG imports over E. This is a conservative estimate since lower-price LNG should drive out dormant gas demand. Surviving the local price reviews Ongoing local price review an imminent risk A more imminent overhang is whether local gas prices could be cut as the local governments are assessing any excessive pricing by 30 December As a background, on 31 August 2016, the NDRC issued a notice to strengthen regulation of local natural gas pricing with the objective to reduce costs to the end-users (consistent with the general supply reform). Unlike the notice issued in early August targeting crossprovincial pipelines, this version now requires local government to review any unreasonable prices including provincial pipeline, distribution and retail prices. This is also the first time that distribution prices were mentioned in NDRC documents. While the local pricing bureaus may adopt different methods, we believe comparing local gas tariffs with prices of key substitutes is more reasonable. We use LPG as a key comparison given it is the cleanest oil product and much more encouraged by local governments than others such as fuel oil and gas oil. By converting to the same natural gas equivalent price (Rmb/m 3 ) for industrial users, we find that, in general, LPG prices are competitive in the coastal areas but more expensive in the inland. First, we bring back end-user prices to at least a 15% discount in every single location. Second, any likely cuts may be shared between provincial pipelines and city-gas projects (Zhejiang is a good example). As a result, the weighted dollar margin (weighted by location demand) for industrial users (excluding VAT) is around Rmb0.70/m 3. This excludes a few high-margin outliers such as Shenzhen. Figure 18: Imported LNG vs LPG's historical price Rmb/cm Figure 19: Current NG vs LPG price by province LPG NG Import LNG price Import LPG price Note: LPG price is converted into thermal equivalent LNG price Note: LPG price is converted into thermal equivalent NG price China Gas Sector 9

10 Shenzhen Heilongjiang Guangxi Zhejiang Guangzhou Liaoning Shanghai Hainan Jilin Shandong Shandong Tianjin Beijing Hubei Yunnan Anhui Zhejiang Shaanxi Henan Shanxi Hebei Hunan Inner Jiangsu Chongqing Sichuan Shenzhen Guangxi Zhejiang Liaoning Hainan Jilin Shandong Shandong Tianjin Beijing Guangzhou Hubei Yunnan Anhui Shaanxi Henan Shanxi Heilongjiang Hebei Hunan Inner Jiangsu Chongqing Sichuan Zhejiang Shanghai 27 September 2016 Figure 20: City-gas dollar margin and provincial charges 2.50 Figure 21: Adjusted city-gas dollar margins for industrials City dollar margin Provincial charge Weighted dollar margin: Source: CEIC, Credit Suisse estimates For the listed gas companies, not every company separates industrial and commercial users, but the average dollar margin appears generally below Rmb0.67/m 3. If the price account is required to be larger, such as 25% instead of 15%, then the weighted dollar margin hurdle moves down to Rmb0.71/m 3. We are less certain whether commercial (hotels, restaurants, and public services) tariffs may be cut but if yes, downside risks are larger for ENN, which makes sense given its large exposure to coastal locations. Figure 22: C&I dollar margin comparison (Rmb0.7/m 3 as a new benchmark) (Dollar margin) Incl. VAT ex. VAT FY15 1H16 FY15 1H16 ENN - C&I CRG - C&I Industrial Commercial CGH - C&I 0.78 n.a n.a. - Industrial 0.75 n.a n.a. - Commercial 0.85 n.a n.a. Mid-stream regulation is a risk Mid-stream pipeline regulation may take place in 2017 In early August, the central NDRC issued a consultation paper on the pricing regulation of gas transmission tariffs. The document targets long-distance cross-provincial pipelines (mid-stream) and provincial governments are allowed to issue similar policies for intraprovincial pipelines. City-gas distribution networks (operated by most city-gas companies) are not yet regulated, according to the document. Regulated returns will be based on related assets (including relevant net fixed assets, net intangible assets and working capital) multiplied by a 8% ROA, assuming a pipeline utilisation of no less than 75%. If this is pushed forward, we see possible earnings downside for transmission pipeline operators such as Kunlun Energy and Beijing Enterprises (BJE), owning 60/40% of the Shaanxi- Beijing pipeline. We believe this project's ROA on total initial investments should be in the low teens and the return on net assets (after years of depreciation) based on Kunlun's financials is around 19%. There are uncertainties on which parts of the assets will eventually be regulated but in the worst-case scenario, Kunlun and BJE could see 44% and 19% earnings impacts in FY17E. Timing is uncertain as the consultation needs to be approved, followed by cost inspections by the government. We doubt this could be implemented in 2016, and the cut for the Shaanxi-Beijing pipeline may take place following completion of the Phase 4 construction, which may be by end of China Gas Sector 10

11 Figure 23: Initial FY17E earning impact analysis (1) ROA = 8% (2) IRR = 8% Kunlun -44% -26% BJE -19% -11% Industry re-regulation is not threatening ROA-based regulation for city gas is not threatening At this point, we do not know whether city-gas distributors will be subject to similar assetbased regulations. Recall that in 2015, the Hebei government attempted to introduce regulation for its local gas projects with a concept of a project IRR: (1) An 8% return on equity IRR for projects calculated using full project life calculations I (30 years); and (2) 7% of ROA for projects based on cost-plus calculations. To assess the potential risks, we conducted the following calculations for city gas companies. We first adjusted the reported earnings by excluding: (1) vehicle gas (deregulated); (2) other income such as value-added services; (3) finance income related to the intra-group lending; (4) associates and JVs; (5) other businesses such as LPG. For the denominator, we take the net PP&E (may be slightly overstated given the inclusion of headquarter assets). The result is a range of 6-8% ROA based on FY15 financials. Now the question is whether connection income should be included. If such one-off fees are excluded from our calculation, adjusted ROA then becomes even much lower, so limited downside if the NDRC introduces an 8% ROA like the mid-stream pipelines. Figure 24: Major city-gas companies' ROA and ROE calculation 2015 (in millions of reporting curr.) China Gas CR Gas ENN BJE SZG Core earnings 3,720 2,996 2,739 5, Associate & JV profits n.a Vehicle gas profits (estimated) n.a. 0 - LPG core earnings Other income (gov subsidies, interest income, etc.) n.a. 8 Core gas earnings 1,735 1,471 1,431 1, ROA 8% 6% 7% 6% 8% ROE 10% 9% 11% n.a. 9% PP&E (2015) 20,338 22,717 21,121 22,677 6,106 PP&E (2014) 18,794 21,491 19,441 22,243 5,584 Goodwill (2015) 2, , Goodwill (2014) 2, , Working capital (2015) 530 1, Working capital (2014) 517 1, Shareholder equity (2015) 18,396 16,065 12,098 n.a. 7,128 Shareholder equity (2014) 17,853 17,009 13,468 n.a. 5,429 Western markets have adopted asset-based regulations As a comparison, gas projects are based on an asset-based approach in many developed markets. For example, in the UK, gas distributors are regulated based on regulated asset base (RAB), which is reviewed and approved by the regulator every five to eight years. China Gas Sector 11

12 Figure 25: Asset-based regulatory framework Simplified, high-level illustration of regulatory framework Regulated periods typically between 5 and 8 years Well established, transparent regulatory process Inflation-linked mechanisms Weighted Average Cost of Capital (WACC) is calculated with Capital-Asset-Pricing-Model (CAPM) and the elements in the formula (cost of equity/notional gearing/beta) are set by regulators with transparent methodologies Actual operating expenditure can be different than planned operating expenditure Regulated Asset Base (RAB) x WACC + Depreciation + Operating expenditure + Tax = Regulated revenue Source: Ofgem China Gas Sector 12

13 Better demand with new drivers In our base of gas demand forecasts, we expect two traditional volume drivers industrials and vehicles to slow, while new drivers such as heating, power and commercials should spark new growth charges. While we forecast all three to have ample room to grow, one setback is a potentially lower dollar margin for heating and power customers. Normally, balancing household affordability to gas-based heating and resilience of such demand against economic cycles, city-gas companies (such as Beijing city) are given lower dollar margin for these customers. We believe that an average Rmb0.6/m 3 dollar margin is reasonable compared with Rmb0.8/m 3 for industrial users. The rationale is similar for power as most of the gas-fired power generates heat. Together with our prior assessment of the local gas price reviews, we expect the C&I dollar margin to be slightly reduced to around Rmb0.7/m 3 (ex-vat) and the following demand test suggests much better volume prospects for CRG and CGH. Figure 26: Dollar margin by customer (RMB/cm) Figure 27: City-gas volume CAGR and dollar margin 0.0 Vehicle Commercial Industrial Heating Power Residential Source: Company data Northern China could see huge room for expansion in heating demand Heating is a huge and expanding market Given China's challenging air problem, especially in the Beijing-Tianjin-Hebei area (BTH) and other northern cities, the government has laid out a strong commitment to curb emissions. As urban centralised heating is a major source of air pollution during the winter heating season, promoting coal-substitution (to convert heating boilers from coal-based to clean energy-based) is a way to significantly reduce emissions during the winter heating season. Following slow implementation, the process is believed to have been quickened by the city gas players in the past winter, following the two price cuts in Currently, Beijing and a number of smaller cities have achieved the status of "gas-heated", and all remaining areas still rely on coal as the main fuel during the heating season. In 2014, the BTH zone accounted for about 23% of total heating supply in China and the northeast regions accounted for another 34%. Shortage of gas supplies used to be a key bottleneck in the past but is no longer a problem with the status moving into oversupply. To estimate the potential size of China's urban heating market, we use China's total urban heat supply (in units of Joule) in 2014, and convert it into the amount of gas equivalent based on assumptions of gas heating value (8.5kCal/35.6kJ per m 3 ) and the efficiency of gas boilers (80%). This results in a potential urban gas heating market of 116 bcm in 2014 or 122 bcm in 2015E, and the latter is already 61% of the 2015 national gas consumption target. By the 13 th five-year plan, the gas heating market will be 156 bcm in 2020 (assuming a 3% CAGR of heat supplied from E). One thing to notice here is that the number also includes co-generation. Apparently, the estimate could see upside if heating demand from suburban and rural areas is included. China Gas Sector 13

14 Figure 28: Provincial heating statistics and the gas equivalent Quantity of heat supplied (10,000GJ, 2014) Gas equivalent (if fully converted) (bcm) By steam By hot water Total % E 2020E Beijing ,300 35,466 11% Tianjin 1,538 11,254 12,792 4% Hebei 5,684 19,144 24,828 8% Shanxi ,067 15,901 5% Inner Mongolia ,585 27,767 8% Liaoning 6,521 43,494 50,015 15% Jilin ,465 22,922 7% Heilongjiang 2,497 35,482 37,979 11% Zhejiang 10,857-10,857 3% Anhui 2, ,916 1% Shandong 14,020 25,005 39,025 12% Henan 3,150 5,572 8,722 3% Hubei 1, ,323 0% Shaanxi 2,150 5,872 8,022 2% Gansu 88 9,175 9,263 3% Qinghai % Ningxia 985 4,109 5,094 2% Xinjiang 1,221 15,920 17,141 5% National Total 54, , , % Note: 1GJ=10^9 J. Source: China Statistics Year Book (2014) CGH is best positioned to take into heating demand Unlike provided centralised heating in northern China (see below coverage map), in the southern provinces (a much larger area south of the Yellow River), heating demand via household heating furnaces could also pick up. According to our industry research, the sales of gas-fired heating furnaces saw strong growth momentum in recent years, with the number sharply increasing from around 0.7 mn in 2010 to 1.64 mn in 2014, at an annual growth rate of 25%. Given the much higher costs involved and lower household affordability, there is a possibility that local governments will provide subsidies to cover a large part of the costs and the remaining to be shared by heat users (residential and C&I) and city gas companies (meaning to give up a part of the unit dollar margin). Anecdotally, Shijiazhuang city's pilot heating programme requires additional costs to be shared by users, gas distributors, and the local government; dollar margin estimated for city gas is roughly >Rmb0.6/m 3. This is still lucrative to local distributors as there will be limited capex involved given the existing infrastructure in the city project; unlocking such customers would only boost the sales scale. China Gas Sector 14

15 Figure 29: Exposure to heating areas Rank Province Heating potential (bcm) ENN CGH CRG 1 Liaoning Shandong Heilongjiang Beijing Inner Mongolia Hebei Jilin Xinjiang Shanxi Tianjin Gansu Shaanxi Ningxia Qinghai Total projects % 26% 48% 31% Improving profitability of gas-fired power A second driver is gas-fired power, which should turn from loss to profit following the two gas price cuts last year. In 2015, gas-fired power capacity grew by 24% but is still only 0.6% of overall supply. With China adapting to a low-price gas industry model, we expect further growth in the gas-fired power industry. In 2020E, the capacity of gas-fired plants is expected to be ~100GW and the corresponding gas consumption will amount to bcm. We believe investment in gas-fired projects should continue to ramp up quickly in E. For a typical gas-fired power plant, without significant fuel subsidies from the local government, project returns are unlikely to be profitable with the current tariff and end-user gas prices. We take a typical gas-fired project in Shenzhen as an illustration of profit analysis. Currently, with tariff price of Rmb0.7/kWh (including ~Rmb0.2/kWh subsidies) and gas cost of Rmb2.5/m 3, gas-fired project's profit has already turned positive. In the following sensitivity table, we show that the leveraged project IRR could jump to +8% with gas price cut from Rmb2.5/m 3 to Rmb2/m 3 even if local governments halve the subsidies, and could be much more profitable if the cut is larger. Figure 30: IRR sensitivity to assumptions of gas-fired power Leveraged IRR On-grid tariff (Rmb/kWh) Gas price (current) 0.8 (Rmb/m 3 ) 1.5 Loss 11% 26% 39% 51% 1.75 Loss Loss 18% 32% 45% 2 Loss Loss 8% 24% 37% 2.25 Loss Loss Loss 15% 30% 2.5 (current) Loss Loss Loss 5% 21% China Gas Sector 15

16 Commercial is another low-hanging fruit CRG is best positioned for commercial demand Another emerging trend during the recent few quarters of demand slowdown is the acceleration of commercial gas sales (CRG recorded impressive 29% growth in these customers in 1H16). This group normally contains hotels, restaurants, hospitals, schools and other general public services. One clear advantage of serving these customers is strong affordability as utility cost is normally a small part of their operating costs. We estimate commercial may be 5-10% of overall gas demand in China currently, but in developed areas especially in metropolitan cities, such demand can be more than 20%. In the following table, we estimate a few sizeable but neglected gas demand markets: (1) household heating furnaces could potentially turn into annual demand of 75 bcm; (2) hotels and hospitals could respectively represent another 22 bcm and 21 bcm per year; (3) schools are a small market <1 bcm; and (4) restaurants and other public services are additional drivers. Figure 31: Other neglected but solid sources of gas demand RESIDENTIAL (southern area) Typical southern household gas used (m 3 p.a.) 240 Fully renovated household (kitchen & bathroom & space hearting) (m 3 p.a.) 1,200 No. of household in southern area (mn) Conversion ratio 50% Total gas demand from residential gasification (bcm p.a.) 75.2 HOTEL Typical central star-rated hotel coal used (ton p.a.) 3,000 Coal to gas (m 3 p.a.) 1,875,000 No. of star-rated hotels 11,970 Adjustment ratio 100% Total gas demand from hotel after coal-gas (bcm p.a.) 22.4 HOSPITAL Typical northern hospital coal used (ton p.a.) 12,500 Coal to gas (m 3 p.a.) 7,812,500 No. of hospitals 26,000 No. of public hospitals 13,300 Adjustment ratio 20% Total gas demand from hospital after coal-gas (bcm p.a.) 20.8 SCHOOL Typical northern school coal used (ton p.a.) 13 Coal to gas (m 3 p.a.) 8,125 No. of schools 493,889 Adjustment ratio 20% Total gas demand from school after coal-gas (bcm p.a.) 0.8 Total gas demand (bcm p.a.) Source: CEIC, Credit Suisse estimates This is clearly positive for the listcos with national footprint. For example, in the top 10 provinces with high hospital density, CRG and CGH have much more geographical exposure than ENN. And for hotels, once again, CRG is best positioned, followed by CGH and ENN. As a result, we would not be surprised if in future years, CRG keeps the leading pace in commercial gas demand growth. China Gas Sector 16

17 Figure 32: Hospital exposure of main city-gas distributors Rank Province Hospital no. ENN CGH CRG 1 Sichuan 5,104 2 Shanxi 3,726 3 Shandong 3,531 4 Shaanxi 3,482 5 Henan 3,481 6 Hebei 3,385 7 Hunan 3,058 8 Heilongjiang 2,570 9 Jiangsu 2, Anhui 2,507 Overall exposure score Note: <5 projects one tick; 5-15 projects two ticks; >15 three ticks. Figure 33: Hotel exposure of main city-gas distributors Rank Province Hotel no. ENN CGH CRG 1 Guangdong Zhejiang Shandong Yunnan Jiangsu Hunan Guangxi Sichuan Liaoning Hebei 377 Overall exposure score Note: <5 projects one tick; 5-15 projects two ticks; >15 three ticks. Residential driven by urbanisation Ongoing urbanisation could prolong household penetration growth When someone says "a company's household penetration is now 50% and the pace could peak in the next few years", this is likely overstating the pace. In our view, urbanisation is a missing factor in the investment thesis, as it could enlarge the nominator and therefore create more years of connection opportunities. Based on the announced urbanisation plan for , total urbanisation of the permanent population could increase from 53% in 2012 to 60% in 2020 and the government said urbanisation could rapidly increase during the range of 30-70%. If we take the population projections from the United Nations, the implied urban population could increase from 726 mn to 860 mn, a 21% increase! China Gas Sector 17

18 Figure 34: China's rapid urbanisation changes in the past decade Source: CEIC This matters to city gas distributors as they predominantly sell gas in cities and counties where there is the growing presence of urbanisation. If we assume a 3% CAGR in the urban population and assume the annual connection amounts to remain the same, China could have its total penetration rate up to 45% by Excluding the urbanisation factor, penetration will be much higher at 51%. This means that the household penetration of natural gas is unlikely to peak or slow down on a country-wide basis in this decade. It should retain its structural growth profile. Figure 35: Natural gas penetration rate in the two scenarios Source: CEIC, Credit Suisse estimates CRG and CGH are well positioned This is a crucial factor to the outlook of new household connections as city gas companies' reported pipes (connectable households) may have not reflected these changes. China Gas Sector 18

19 Figure 36: Household penetration (1H16) CGH* CRG ENN BJE SZG Household penetration 48% 45% 55% >80% >50% Volume CAGR past five years 17% 22% 22% 15% 24% * March year-end. Our differentiated sales forecasts Putting all the overall demand strength together, we believe that CGH is overall well positioned as the largest winner in heating while CRG is best positioned in commercial and residential volume areas. Figure 37: Demand strength for the new growth drivers ENN CGH CRG Heating Commercial Residential Score CGH and CRG have better volume CAGR prospects Based on these, we now forecast different growth paths by customers for different gas companies. We believe this is a differentiated analysis as the analysts usually model in uniform segmental growth for all the gas companies. As a result, CGH should register the best growth CAGR (19% during the next three years), followed by CRG (18%) and ENN (13%). Figure 38: Main city-gas distributors' volume outlooks (mcm) 2011A 2012A 2013A 2014A 2015A 2016E 2017E 2018E E CAGR ENN Residential ,030 1,221 1,487 1,785 1,963 2,160 10% C&I 3,592 4,345 5,538 6,675 7,001 7,554 8,340 9,224 11% Vehicle ,187 1,419 1,566 1,630 1,730 1,834 6% Trading ,232 2,217 3,103 3,662 29% Total 5,373 6,460 8,125 10,120 11,286 13,185 15,136 16,880 13% CRG Residential 2,097 2,520 3,023 3,467 3,863 4,442 5,109 5,875 15% C&I 4,208 5,587 7,567 8,576 9,337 10,749 13,006 15,795 21% Vehicle 856 1,110 1,397 1,617 1,713 1,966 2,123 2,293 8% Total 7,161 9,217 11,987 13,660 14,913 17,157 20,238 23,963 18% CGH Residential ,130 1,340 1,545 1,822 2,095 2,404 15% Commercial ,245 1,430 1,716 2,145 2,681 25% Industrial 1,704 2,179 2,783 3,097 3,167 3,325 3,658 4,097 11% Vehicle ,072 1,153 1,406 1,546 1,701 10% Trading 2,003 2,379 2,382 2,221 2,565 3,431 4,367 5,546 27% Total 5,563 6,825 8,045 8,975 9,860 11,700 13,812 16,429 19% YoY 2012A 2013A 2014A 2015A 2016E 2017E 2018E ENN Residential 13% 11% 19% 22% 20% 10% 10% C&I 21% 27% 21% 5% 8% 10% 11% Vehicle 34% 27% 20% 10% 4% 6% 6% Trading -5% 49% 117% 53% 80% 40% 18% CRG Residential 20% 20% 15% 11% 15% 15% 15% C&I 33% 35% 13% 9% 15% 21% 21% Vehicle 30% 26% 16% 6% 15% 8% 8% CGH Residential 18% 35% 19% 15% 18% 15% 15% Commercial 32% 17% 25% 15% 20% 25% 25% Industrial 28% 28% 11% 2% 5% 10% 12% Vehicle 15% 30% 41% 8% 22% 10% 10% Trading 19% 0% -7% 15% 34% 27% 27% China Gas Sector 19

20 Figure 39: China gas LNG terminals and demand drivers map LNG terminals in operation LNG terminals under construction Pink area: centralized heating area Projects exposure > 5: CGH CRG ENN % number: residential penetration ratio Hotels exposure > 350: Hospital exposure > 2000: Xinjiang 59% Tibet 10% Qinghai 36% Yunan 6% Heilongjiang 33% Jilin 36% Liaoning 34% Sichuan Gansu 42% 28% Ningxia 65% Inner Mongolia Shaanxi Chongqing Guizhou 10% 34% 39% 60% Shanxi 42% Hubei 36% Hunan Hebei Henan 34% 28% Beijing 77% Tianjin 62% Shandong Anhui 21% Jiangxi 23% 21% 42% Jiangsu 41% Shanghai Zhejiang Fujian 16% 71% 26% CNOOC Yingkou LNG CNOOC Caofeidian LNG ENN Zhoushan LNG CNOOC Putian LNG Taiwan PetroChina Dalian LNG CNOOC Tianjin LNG Sinopec Tianjin LNG Sinopec Qingdao LNG Guanghui Qidong LNG PetroChina Rudong LNG CNOOC Shanghai Yangshan LNG CNOOC Ningbo Zhejiang LNG CNOOC Wenzhou LNG Guangxi 12% Guangdong 22% CNOOC Yuedong LNG SZG Shenzhen LNG Jovo Dongguan LNG CNOOC Dapeng &Shenzhen LNG CNOOC Zhuhai LNG Sinopec Beihai LNG CNOOC Hainan LNG Hainan China Gas Sector 20

21 Supply competition is an element of the industry reform De-monopolising supply The ongoing oil & gas industry reform implies a new opportunity for gas companies to import LNG directly. As various industry experts highlighted, the key objectives of such reforms are: (1) separation of assets (i.e., upstream producers do not monopolise ownership in midstream infrastructure such as the cross-provincial pipelines) by opening investments to social capital including private money; (2) transition of regulated pricing to market-based pricing (infrastructure return to be regulated and pricing will depend on demand-supply over time); and (3) the opening-up of third-party access to key infrastructure including LNG terminals, storage and transportation (most are currently operated by oil majors). Figure 40: Recent natural gas policy and key news Infrastructure ownerships to social capital. Since 2014, public capital has been allowed to invest in key infrastructure. For example, PetroChina announced it would sell 100% of Eastern Pipeline Company which holds West-East I-II projects. Sinopec announced it would dispose of 30% of the sales & marketing unit and 50% of its Sichuan-East China gas pipeline. In 2H15, crude oil imports were deregulated, and independent refiners were given importing quotas. Increased frequency of price-setting. In 2012, the NDRC announced a formula to price city-gate gas prices based on a pre-set formula, allowing China to adjust domestic prices along with movements in imported LPG and fuel oil prices. This was executed twice in 2015 during the downtrend. Also, the Shanghai Gas Exchange was established to allow more short-term spot trading. Reregulating returns. As analysed in the previous section, in 2016, the NDRC announced it would regulate cross-provincial pipelines with a target 8% ROA/IRR and has also asked local authorities to review excessive local gas prices. Price reform: A new natural gas pricing mechanism was created: gas price is set by a formula and linked to crude oil; gas price jumped by 24% and 18% respectively in 2013 and 2014 but dropped 28% in 2015 as oil price declined. Oil & gas assets divesture: Sinopec announced it would sell 30% of its sales-and-marketing unit to 25 investors; PetroChina announced it would sell 100% of Eastern Pipeline Company which holds W-E I~II projects. Another gas asset divesture: Sinopec announced it would sell 50% of its Sichuan-East China gas pipeline. Feb 2014 August 2016 July 2013 May 2014 Access to gas infrastructure: First pipeline, second LNG terminals and last importing and exporting right; Oil trio is required to open up their gas infrastructure to independent players. Regulation on pipeline & liberalisation on end market: Return of mid-stream (or cross-provincial) pipeline assets is limited to the 8% level; operation status of intra-provincial pipeline assets are under review and the transmission fee might face downward adjustment. Door is open to direct imports For city gas players that have been long relying on the oil majors to source supplies, an opportunity has arrived. As part of the reform, access to infrastructure (including both pipeline and LNG terminals) could be made possible, especially with private capital already commanding large ownerships of demand-side infrastructure. According to the LNG industry association's data, 50% of LNG plants and almost 100% of gasification plants are owned by private capital; 68% of LNG stations are owned by independent players like city-gas companies. China Gas Sector 21