Friday, April 4, 2008

Gauging Sinopec's Refining Losses

Losses at Sinopec's refining division have been driven by the high world market price of oil and a fixed price for gasoline within the domestic Chinese market. It is noted that Sinopec presents its financial results in an unusual manner -- reporting its refining activities in a separate division from its marketing (gasoline stations and pipelines) activities, in an apparent effort to show losses, in order -- it is argued here -- to influence China's Ministry of Finance for direct subsidies and China's central government for price increases in the domestic price of gasoline. If Sinopec's refining and marketing divisions were kept together, the company would not have shown losses in this division in any year since 1997, without subsidies (up until 2006, the last date for which year end segment data is available). Future increases in the world price of oil is likely to be met with some increases in the Chinese domestic price of gasoline -- according to statements from China's National Development and Reform Commission (NDRC) -- leading to most likely manageable losses at Sinopec's refining division. Future higher world prices for oil and natural gas will benefit Sinopec's underestimated and rapidly growing Exploration and Production division.

Sinopec Segment Analysis:

Sinopec has been historically consistently profitable in all divisions except for refining. Sinopec for financial reporting divides its overall operations into 4 divisions:

1. Exploration & Production -- ownership and production of reserves of oil and natural gas,
2. Refining -- large scale chemical conversion of crude oil to premium petroleum products,
3. Marketing --operation gas stations and pipelines and
4. Chemicals -- production of petrochemicals from oil and natural gas feedstocks.

Note that Sinopec's largest division by profitability is its E&P Division -- as is the case with almost all integrated majors -- by operating profits, which accounted for approximately 75% of operating profit in 2006 (the last date for which information is available as of early 4/08). It is generally standard practice within the integrated oil universe to present financial results in three segments, with refining and marketed combined -- for example, Exxon Mobil reported its 2007 results by segment in as "Upstream" (E&P), Downstream (refining and marketing and pipelines) and "Chemicals." Further, Sinopec's domestic rival firm, PetroChina, combines its Refining and Marketing divisions for financial reporting purposes -- and has not shown a loss in its Refining and Marketing division up until 2006 and has not received state subsidies for refining. The following chart shows division operating profit, without subsidies, for Sinopec's reporting divisions as far back as 1997 (note that at the date of the writing of this article (4/08), the 2007 20-F for Sinopec is not available, so up to 2006 data is shown only).

Chart 1:

Source: Sinopec Annual Reports Note: segment operating profit does not include state subsidies of RMB 10Bn in 2005 and RMB 5Bn in 2006 to SNP's refining division

The chart above with reported Sinopec financial statements looks alarming in terms of losses in the refining division, however, if refining and marketing are included in one segment, Sinopec has not reported losses in the the refining and marketing division since 1997, as shown in the chart below:

Chart 2:

Note: Results above are presented without state subsidies of RMB 10Bn in 2005 and RMB 5Bn in 2006 -- and an estimated RMB 12.5Bn in 2007 (as segment data for Sinopec is not available at the date of this writing).

Chart 2 above shows several interesting facts. First, losses in Sinopec's refining and marketing division have not historically occurred, despite several media reports within China and outside of China that have predicted that refining losses would "wipe out profits for Sinopec as a whole." These reports predict future losses for Sinopec, -- not historical -- so future losses will be analyzed in the next section. As a second interesting fact, it is noted above that Sinopec's Exploration & Production division is the major source of operating profits and value for the firm as a whole. It would not be too far off in the author's opinion to state the following: interested investors in Sinopec should review SNP's Exploration & Production division first and foremost with regards to future valuation, and significantly subordinate in terms of profitability or potential losses Sinopec's refining and marketing and chemical divisions.

Estimates of Future -- 2008 and Onward -- Losses in Sinopec's Refining Division:

Goldman Sachs Sinopec Analyst analyst Kelvin Koh in a March 17, 2008 report titled: "China Petroleum and Chemical: How Bad is the Refining Squeeze?" forecasted losses of RMB 20Bn for Sinopec's refining division in 2008, after subsidies of RMB 25Bn -- so total refining losses of RMB 45Bn. Koh estimates that Sinopec's refining division lost between RMB 17.8Bn and RMB 18.4Bn in the first quarter of 2008, partially offset by approximately RMB 7.4Bn of subsidies in the first quarter of 2007. The report did not mention Sinopec's marketing division or provide segment calculations -- and did not mention potentially offsetting profitability at Sinopec's Marketing segment.

Sinopec has publicly renounced statements that it its refining segment would suffer huge losses with high oil prices -- these reports have been driven by Sinopec Vice Chairman Zhou Yuan's comments on March 7, 2008 that Sinopec is losing RMB 2000 for every ton of crude oil that it refines. A simple calculation that shows that Sinopec refined approximately 150M tons of crude oil last year would result in an incredible refining loss of RMB 300 Bn for the full year 2008 at oil above $100, from Zhou Yuan's estimates, which is clearly unprecedented in Sinopec's history. Sinopec on March 14, 2008 stated that "All such information [concerning refining losses] is factually incorrect and misleading." (from Platts Commodity News, "Sinopec Refutes Report on Possible 1H 2008 Loss, March 14, 2008). However, reports of massive losses in Sinopec's refining division continue to circulate, including an article from China Knowledge Press on April 2, 2008 titled: "Sinopec's Refining Unit Suffers Huge Loss in First 2 Months" which stated Sinopec as a whole "booked an amazing loss of RMB 1.37Bn" in the first 2 months of 2008. However, Goldman Sachs analyst Koh has called these reports of overall Sinopec firm losses "factually incorrect."

Which estimate of losses for 2008 and beyond should the investor trust? As a rule, Investment Banks tend to be more well informed than other commentators, so Goldman Sachs' estimate of RMB 45Bn loss pre-subsidy to RMB 20Bn loss post subsidy is more likely to be correct than other estimates. As Goldman has not published Sinopec's Marketing division's expected profitability for 2008 to the author's knowledge, a very rough estimate will be presented here. If we assume continued operating profits in the RMB 30Bn range in 2008 as in 2006 for SNP's marketing division -- likely the profits will be higher due to expansion in the number of outlets and higher levels of product sold -- then refining and marketing combined will show a manageable loss for the year (RMB 15Bn) without subsidies and will be show a net operating profit (RMB 5Bn) with the assumed RMB 20Bn subsidies (again with the conservative assumption that marketing's operating profits do not grow year to year). Note that this calculation does not include Sinopec's E&P division, which had over RMB 60Bn in operating profit in 2006, when oil prices were at approximately $60 -- with oil prices at $100, Sinopec's E&P division's operating profits should increase substantially.

Is Sinopec at Risk due to the Fact that Sinopec's Refining Division has to Source the Majority of its Oil from Outside (non-Chinese) Sources?

Sinopec's Exploration & Production segment supplies only approximately 21% of the crude oil supplied to Sinopec's refining division -- and crude oil sourced from Chinese firms (PetroChina and CNOOC and Sinopec combined) supplied 30% of Sinopec's refining divisions throughput. However, it should be noted that this ratio of company supplied crude oil to refining products is closer to the norm than for integrated oil majors than the exception. According to Exxon Mobil's 2007 10-k, Exxon Mobil produced approximately 2.6M barrels per day of oil and natural gas liquids (excluding equity interest oil production) and refined approximately 5.7M barrels per day of crude oil, for a ratio of Company supplied crude oil of 45%. Chevron produced 460K barrels per day in 2007 of crude oil and refined approximately 1.8M barrels per day of oil, translating to a ratio of company supplied oil of approximately 26%.


Company Supplied Oil to Refining Segment*







Exxon Mobil






Conoco Philips


Royal Dutch Shell


* This ratio is calculated as the crude oil and liquids production of the company -- excluding natural gas production -- divided by the company's refining throughput for the last reported financial year

It is standard practice in the oil industry that Exploration & Production divisions are segregated from refining divisions for financial reporting purposes and refining divisions are charged a market price for oil, even if the oil is sourced from the parent company's E&P division. As such, the exploration & production division of any oil major should report record profits with higher oil prices, regardless of how the refining and marketing segments perform. If there is a higher ratio of non-parent Company sourced oil, losses in the refining division could more than offset overall company profitability. (note that this fact stresses that a large exploration and production division is the key indicator of a profitable integrated oil major). One could paraphrase, that a larger ratio in Chart 3 above shows that the respective integrated majors have higher percentages of revenues and income from their E&P divisions verses their downstream divisions.

In the case of Sinopec, the potential for losses in refining are partially mitigated by the fact that China has been raising the price of gasoline year to year with higher oil prices, although not as high as the US and EU, but at a faster rate than Malaysia and Indonesia and several other countries. China's National Development and Reform Commission (NDRC) released an outline in February 2007 of a more market-based formula for gasoline pricing based on a basket of international crude prices, with the aim of bringing China's domestic gasoline prices more in line with western levels. ("Outline Emerges of China's Freer Products Price Formula" 2/5/07, International Oil Daily) According to the International Oil Daily, NDRC 's process of setting gasoline prices appears to be opaque, but China appears intent on allowing continued rises in the price of gasoline going forward, in order to support its refining industries and encourage economical use of fuel, balanced with economic considerations.

Further, Sinopec is also likely to continue to subsidize Sinopec, which is the consensus view of investment banks such as UBS and Goldman. Note that many countries around the world, including Russia, many Middle Eastern countries, India, for example keep domestic gasoline prices artificially low to benefit their economies, and also have a practice of subsidizing their domestic oil refining companies.

Note: Exploration and Production is Unusually the Major Source of Value for Most Integrated Oil Companies:

Upstream divisions generally comprise the majority of profits for most integrated oil companies, and Sinopec is no different in this regard. For example, Exxon Mobil's exploration and production segment comprised 65.3% of total Exxon net income in 2007, according to Exxon's 2007 10-k. It is argued here that Sinopec should be viewed as an typical integrated oil major, with an emphasis on upstream assets. With this idea in mind, how attractive is Sinopec's E&P division?

Quick Overview of Sinopec's Exploration & Production Segment:

Sinopec's Exploration and Production division is large currently with 3.7Billion Barrels of proven oil and natural gas reserves (87% oil, 13% natural gas) at the end of 2006-- in comparison ConocoPhillips reported 3.1 Billion Barrels of proven reserves including affiliates at the end of 2007. Further, Sinopec's exploration and production division is likely to almost double reserves at the end of 2008 due to inclusion in SNP's reserve statement of the very large Puguang natural gas discovery in China's Sichuan province. Sinopec expects to maintain high international upstream growth in states such as Iran, Angloa, Australia and Venezuela.

The fact that Sinopec's upstream assets are sizable and likely to grow significant is probably a surprise to many investors who are not familiar with the Company. Sinopec (SNP) is commonly viewed by investors as primarily a downstream oil company, with profitability mainly dependent on refining, petrochemicals and marketing. This perception stems to a large degree from the historical (pre-1998) division of China's oil industry -- with the restructuring in 1998, Sinopec took over previously CNPC's southern oil fields, including the Shengli oil field -- the second largest oil field in China -- while CNPC took ownership of previously Sinopec's northern refining and marketing operations -- which, incidentally, were and are less efficient and technologically advanced than Sinopec's southern refining divisions.

Sinopec as mentioned in a previous article has stated that it will obtain overseas assets from its parent company, Sinopec Group -- the most attractive of these assets that is upcoming in the short to intermediate term is the Yadavarian Oil field in Iran with reserves of over 3 Billion barrels of oil, which is currently undeveloped. Sinopec is active in Angola, Venezuela and Russia, among other international locations. Further, Sinopec discovered the largest gas field in China's history, the Puguang field in Sichuan, with approximately 2-3 BBOE of natural gas, and further domestic exploration within China is promising. A fuller discussion of Sinopec's Upstream assets and prospects will be upcoming in a future article.


Apprehension on the part of investors towards future losses in Sinopec's refining division has resulted in a relatively low market capitalization for Sinopec of approximately $US85Bn -- a low valuation by most measures for a major National Oil Company. It is likely that these fears are overblown due to the unusual segment reporting and also underestimation by investors of reserve and production growth at Sinopec's Exploration & Production division.

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