Media images these days of China’s capital city of Beijing often include people in surgical masks, trying to protect themselves from the city’s heavy pollution.

A recent study conducted by Michael Greenstone, an environmental economics professor at the Massachusetts Institute of Technology, found that the heavily polluted Beijing air has cut more than five years from city inhabitants’ average life expectancy and that burning coal for both heat and electricity is a major contributor to the problem.

This pollution crisis is driving China’s evolution toward cleaner-burning natural gas; below we highlight our two favorite plays on this trend.

While Beijing has become the poster child for Chinese air pollution, the situation is the same in many Chinese cities.

October marks the beginning of peak Chinese heating season and already in the city of Harbin, the air density of fine particulate matter is reading well above 600 micrograms per cubic meter (mpcm). Some readings have even exceeded 1,000 mpcm. By way of astounding comparison, the World Health Organization reports that the minimally safe reading is 25 mpcm.

Some highways and schools have been closed and flights cancelled due to low visibility caused by smog.

As the Chinese government battles air pollution, it has increasingly added renewable energy sources such as solar into its electricity generating mix and it’s continuing to build nuclear power stations. But the country remains heavily reliant on coal for electricity generation, which accounts for 79 percent of generation in 2006 and is forecast to still account for three quarters of generation by 2030:


But the Chinese understand that coal fired electricity plants are the main culprit in the country’s pollution and, as a result, the government has embarked on a transformation to rely more on natural gas. While China is quickly becoming a leader in installed renewable-fueled electricity generation, it is simply too big and too spread out to not rely on fossil fuels to a great extent. That, coupled with the fact that natural gas is relatively inexpensive, makes the transition to a cleaner burning fossil fuel such as natural gas logical.

That transition has been several years in the making, resulting in China becoming a net natural gas importer in 2007 and consumption is expected to continue growing at a rapid clip:



US-based General Electric Co (NYSE: GE) recently released a white paper which forecast that China’s natural gas demand will grow at an annual rate of 8 percent and the natural gas market in the country will be 2.5 times larger than it is today by 2025. That’s largely due to the fact that by 2025, China’s electricity demand is expected to double, from 4,200 terawatt hours today to nearly 9,000.

As the Chinese government continues to rely more heavily on natural gas in its battle against pollution, GE says that gas will likely reach 6 percent of total electricity generation by 2025.

Electricity generation isn’t the only area in which natural gas is becoming increasing popular; it’s also being more commonly used to heat homes and to fuel fleet vehicles such as taxis and buses.

Two Gassed-Up Plays

Long-Term Portfolio holding China Petroleum & Chemical (NYSE: SNP), otherwise known as Sinopec, is an excellent play on China’s growing need for natural gas.

The second largest of China’s national energy companies by market cap, Sinopec is a major producer of both oil and natural gas, holds an extensive midstream network and is the county’s dominant refiner. It is also one of only a handful of companies licensed to engage in exploration and production (E&P) in China.

In the first half of this year, Sinopec increased its crude oil production to 165.4 million barrels from 163.1 million in the same period last year, a 1.4 percent increase. Natural gas production shot up by 11.8 percent to 324.1 billion cubic feet. Overall, Sinopec expects to grow its crude production by just 0.8 percent on a year-over-year basis in 2013, while it expects natural gas production to rise by 8.5 percent.

At the same time, while the company’s realized selling price on crude oil fell by 9.3 percent compared to the same period last year to USD96.15, its realized gas price rose 2.4 percent year-over-year to USD5.94.

Despite the fact that Sinopec’s revenue rose by 5 percent year-over-year in the first half to RMB1.4 trillion and net profit was up 23.6 percent to RMB30.3 billion, the company’s shares have been under pressure much of this year on Chinese growth concerns.

Because of those worries, Sinopec shares are trading at just 8 times trailing one-year earnings versus an average of 9.7 for its primary competitors, despite that fact that it has grown revenue by an industry beating 27.5 percent on average over the past three years.

Thanks to its diversification, as I wrote in last week’s Passport to Profits, the company will also benefit from the growing number of automobiles on China’s roads in the coming years. Sinopec is the dominant refiner and distributor of gasoline in the country.

China Petroleum & Chemical remains a buy at current prices.

A purer, though more volatile, play on Chinese natural gas demand is Kunlun Energy Company (Hong Kong: 0135).

A wholly owned subsidiary of PetroChina (NYSE: PTR), Kunlun has traded on the Hong Kong Stock Exchange since 1993 and is involved in the E&P of oil and natural gas with projects in China, Kazakhstan, Oman, Peru, Thailand, Azerbaijan and Indonesia.

In the first half of this year, Kunlun sold 3.3 billion cubic meters of natural gas, a year-over-year increase of 52.9 percent. Revenue from natural gas sales was up 64 percent to HKD9.3 billion. About 12.3 billion cubic meters of gas were transported through the company’s pipelines in the first six months of 2013, while its two liquefied natural gas terminals unloaded 26 shipments of LNG amounting to 2.7 million tons.

Overall, the company generated revenue of HKD19.4 billion in its fiscal first half, a nearly 25 percent jump versus the same period last year. On that gain, total shareholder profit was up 5.1 percent to HKD3.7 billion.

Revenue is expected to continue on its current trajectory, as Chinese demand for natural gas grows for the foreseeable future. To meet that demand, in addition to expanding its E&P operations, Kunlun is on track to open three more LNG processing plants while two others are still under construction.

China National Petroleum Corp, the parent company of PetroChina, also recently spun down its Shaanxi-Beijing natural gas pipeline to Kunlun as part of Beijing’s program of natural gas reform. The deal will increase Kunlun’s transported gas volumes by nearly 25 percent, while giving it greater control of the gas market in China’s capital region.

A more volatile but purer play on growing Chinese natural gas demand, Kunlun Energy Company is a buy up to HKD18.