Attractive Dividend and Share Buyback To Support Sinopec’s Share Price

Senior Equity Analyst

Chokwai Lee

China Petroleum & Chemical, better known as Sinopec, is the listed arm of one of China's two integrated oil majors and one of Asia's largest refiners and chemical companies in terms of revenue. Owing in part to historical legacy, Sinopec’s revenue and assets are more heavily weighted toward its downstream activities and the company relies on external sources of oil to meet its refining and processing needs. As a result, Sinopec’s earnings are generally less sensitive to oil prices swings than peer PetroChina's, and so it benefits less in a rising oil price environment but is also more stable when prices fall.

Sinopec’s key Shengli oilfield, which makes up close to 70% of the group’s domestic oil reserves in 2021, is maturing and it is a higher-cost producer of oil and gas than its peers. This is the main reason we think Sinopec has no moat. However, the group’s refineries do enjoy logistical advantages, as they are located close to customers, have scale benefits, and are relatively complex. Sinopec has also benefited from the country moving to a more market-oriented pricing mechanism that better matches petrol product pricing to input costs. However, a key risk remains the government’s willingness to pass on higher costs to consumers in an inflationary environment.

We think the likely spinoffs of its marketing arm will further boost Sinopec's financial position but the timing of this is not finalized. In future, we believe Sinopec will continue to focus on natural gas exploration and production, and to improve downstream value-added products. The latter is helping to support refining margins.

Business Strategy & Outlook

We don't believe Sinopec can consistently generate economic profit in the next decade. As a result, the company does not earn an economic moat. From 2012-21, Sinopec has failed to earn returns that are above its cost of capital, supporting our view.

Sinopec’s upstream portfolio fails to qualify for a moat amid cost inflation and reserve depletion. The majority of the firm's upstream assets are mature Chinese oilfields that have been producing for more than four decades. Most notable is Sinopec's largest source of production (representing 59% of oil production in 2020), the Shengli oilfield, which was put into production in 1964. Shengli is now producing 454,000 barrels per day in 2020 from 541 thousand in 2009. The firm has done a respectable job of maintaining production in recent years, but it has relied on deployment of enhanced recovery techniques, and this strategy has increased costs. Lifting cost for Sinopec has increased to USD 15.24 per barrel of oil equivalent, or boe, in 2020 from USD 12.79/boe in 2009.

In addition, Sinopec's reserve life of around seven years in 2021 falls below our preferred threshold of 10 years. Although the firm can acquire oil and gas reserves from its parent company to extend its reserve life, we remain skeptical about the cost-competitiveness of these assets. Additionally, given Sinopec's size, it needs projects of a certain size and quality in order to increase reserves and production cost-effectively, but that will be difficult, in our view.

Refining is a fragmented, capital-intensive, and competitive industry where firms have little pricing power on feedstock and end products. Sinopec does benefit at home from its leadership position in downstream operations, but a lack of pricing power persists with petrol product pricing determined by the government. Moreover, Sinopec has limited access to low-cost source of crude, as it relies on higher-cost imports or domestically sourced production sold at market rates. In 2020, approximately 88.6% of the crude oil required for its refinery business was imported.

In our view, Sinopec’s refining margins are expected to normalize over the longer term, and we think competition will remain intense in the downstream sectors going forward. According to CNPC Economics & Technology Research Institute, China’s total annual oil refining capacity is about 860 million tons in 2019. The institute estimated that China’s oil refining industry has excess capacity of at least 150 million tons per year. Similarly, Sinopec’s chemical segment margins are not expected to exceed that of other global chemical companies on a maintained basis. As such, we see no moat in its refining and chemical operations. On the other hand, while Sinopec’s marketing segment has posted stable profitability in the last decade, returns were not significant considering average operating margin of 2.2% over 2015-21.

Material environmental, social, and governance, or ESG, exposures also create additional risks for oil and gas producers, including carbon emissions in their operations, use of their products, and emissions, effluents, and waste generated in operations. In particular, the risk from carbon emissions is most likely to materialize through some form of carbon pricing, which can increase the price of end products to consumers and reduce demand for oil and gas over time. In addition, the ongoing low-carbon trends (such as the gradual transition to lower-emitting fuels) could eventually lower demand for oil and gas. We expect carbon taxes to gain greater adoption over time but think the impact on hydrocarbon demand remains more than a decade away.

We note that China’s three national oil companies (CNOOC, PetroChina and Sinopec) are trying to manage these risks through low-carbon business strategies, such as focusing more on gas production, renewable energy, and alternative fuels such as hydrogen. However, details remain scant on these strategies and there is no evidence that the low-carbon businesses will grow meaningfully in the near term. Furthermore, as China is a net importer of oil and gas, we think it will be challenging for the three national oil companies to significantly cut exposures rapidly, given their roles in the country’s energy security.

None

Economic Moat

China Petroleum & Chemical

China Petroleum & Chemical Corp. engages in oil and gas and chemical business. The oil and gas business includes exploration, development and production of crude oil and natural gas; pipeline crude oil and natural gas; refining crude oil into petroleum products; and marketing crude oil, natural gas, and refined oil. The chemical business includes the manufacture and marketing of a wide range of industrial chemical products. The company was founded on February 25, 2000 and is headquartered in Beijing, China.

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Leverage on Integration Advantages, Campaign of Overcoming Difficulties and Creating Efficiency Mark Remarkable Results Total Cash Dividends Reaches RMB 24.2 Billion, Maintains High Payout Ratio BEIJING, CHINA / ACCESSWIRE / March 29, 2021 / China Petroleum & Chemical Corporation ("Sinopec Corp." or the "Company") (HKEX:386)(SSE:600028)(NYSE:SNP) today announced its annual results for the twelve months ended 31 December 2020. Financial Highlights In accordance with IFRS, the Company's turnover and other operating revenues reached RMB 2.11 trillion; Profit attributable to shareholders of the Company was RMB 33.1 billion.

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