The Chinese energy sector is in a period of transition. It seeks simultaneously to consolidate a period of rapid expansion while laying the groundwork for projects which will position the country for a further surge in demand in the medium to long term future; it is endeavoring to transition from a conventional carbon-based energy market to one that more actively pursues cleaner forms of energy; and it does all of this against a backdrop of economic and sector-wide stress at a local and global level.
State of the energy sector
The past 12-18 months have seen demand fluctuations in the energy and utilities sector, reflecting broader industrial and economic issues in China. At a retail level, pricing controls continue to be a challenge for energy producers and their suppliers, although high-level governmental support for market liberalization may provide some comfort in this area. At a wholesale level, a slow-down in demand means that oversupply has become an issue, however this has also provided an opportunity for purchasers to re-negotiate pricing and offtake commitments under certain existing supply contracts as well as re-balancing their supply source portfolios.
Risks and challenges in today's market
Managing short-term production and supply issues, while continuing to plan for significant long-term demand projections that see China and other Asian countries driving global energy consumption, remains the major challenge for industry participants in today's market.
Uncertainty about volume and pricing is a key concern of executives. Throughout 2015 we heard a recurring sentiment that unstable pricing (rather than low prices per se) was hampering the efforts by companies to undertake strategic planning. Going into the second half of 2016, there seems to be a belief that prices have levelled off and will steadily appreciate into the medium term, providing a more solid platform for acquisitions, disposals and restructuring.
We sense that the continuing anti-corruption initiatives in China's state-owned sector, which have led to a more cautious approach to new deals and a slowdown in the decision-making processes, is also having an impact, however we do not think this has been or will be the key factor in the short to medium term direction of corporate activity in the energy sector.
Developments in the energy mix
China's regulatory and policy initiatives over the past 12 months have been guided largely by the State Council's Energy Development Strategy Action Plan (issued at the end of 2014) which frames the country's energy strategy for the period 2014-2020 with a focus on clean, efficient, safe and sustainable energy systems. In practical terms, the plan targets at least 10% of energy to be supplied from natural gas and a maximum 62% from coal by 2020.
In part, the plan can be viewed as a response to China's significant environmental pollution concerns, particularly in urban and industrial areas. However, at a broader level it reflects in government policy what had already been occurring at a practical level, with China's adoption of non-fossil fuel energy sources (solar in particular) having been amongst the most aggressive globally in recent years. Likewise the increasing interest in nuclear power should be viewed from this perspective. However, it should be observed that there remain significant technical and commercial hurdles to achieving these targets, given that the country remains the largest user of coal-derived electricity (providing 74% of its electricity (3959 TWh per year) in 2014).
The plan (and related measures) also targets an open energy market, and the path for foreign investors has been smoothed by the revised Foreign Investment Industrial Guidance Catalogue (jointly issued by the NDRC and MOFCOM in March 2015) which has reduced restrictions on foreign investment in the energy sector.
Legal Transaction Trends
Despite increased pricing and other pressures in the energy space, we have not seen a significant uptick in restructuring initiatives (distressed or otherwise) in the local market. That said, over recent years there has been a growing openness in Mainland China to restructuring as an alternative to insolvency or similar proceedings, notably by reference to the established restructuring environment in Hong Kong, and there is the potential for this model to be used at a regional or national level in the future.
In terms of strategic restructuring, there has been speculation over the past 12 months about the possible disaggregation of one or more of the vertically integrated state-owned energy companies, either separating the upstream, midstream and downstream businesses, or splitting off certain international operations. To-date, we have not seen any concrete moves in this respect.
Although 2015 was a strong year for general M&A in Mainland China and Hong Kong, M&A activity (outbound and inbound) in the energy sector has been relatively low over the past 12 months. The continuing slower pace of M&A activity is (in part) attributable to local and global external pressures (including the impact of oil prices) as well as the strategic concerns of the parties involved (for example in Sinopec's investment in Russia's SIBUR).
It should also be noted that, while pure M&A activity has slowed over the past 12 months (particularly for upstream M&A), we have seen an increasing trend for energy companies investing in downstream project development transactions, including LNG projects, refineries and storage facilities.