CHINA is banking on tamer inflation as it begins the trial run of a new natural gas pricing system that is expected eventually to result in higher costs for consumers.

The new system, which went into effect last week in the southern province of Guangdong and neighboring Guangxi Zhuang Autonomous Region, seeks to link gas prices to those of imported fuel oil used for power generation and liquefied petroleum gas used in cooking. Natural gas is increasingly replacing both fuels in China.

The big beneficiaries of the new pricing system will be PetroChina Co and other state energy giants.

The reform will bring prices more in line with global commodities markets, encouraging production and imports, and discouraging inefficient use of fuel, analysts said.

"The future trend for rising domestic gas prices has been confirmed, and this will benefit upstream suppliers," China International Capital Corp analyst Guan Bin said.

Shares in PetroChina, which has the highest gas production and reserves among China's top three energy players, jumped 6.5 percent in Hong Kong in the four trading days since the pilot project was unveiled in late December. Sinopec Corp has risen 3.9 percent, while CNOOC Ltd gained 3.2 percent.

Old system to phase out

The reforms aim to phase out a pricing system largely based on domestic production costs. The old system doesn't reflect increasingly diversified gas supply sources and the commissioning of new pipelines. More importantly, it makes importing gas a losing proposition.

PetroChina, for example, has estimated it lost about 20 billion yuan (US$3.2 billion) in its gas business in 2011 because it was forced to import high-cost gas from Central Asia, then sell it at artificially low domestic prices.

Gordon Kwan, head of energy research at Mirae Asset Securities, said he expects the Chinese government to roll out the new pricing system to other provinces in the second half this year, starting with wealthier provinces and eventually moving to lesser developed regions where people can least afford higher prices.

Under the new system, the National Development and Reform Commission will set a "gate price" ceiling for each province. That cap is derived from a benchmark price in Shanghai, a diversified market that receives its piped gas from Sichuan Province, Central Asia and the East China Sea, and its liquefied natural gas from Malaysia.

Downstream gas distributors can negotiate prices with upstream producers as long as prices don't exceed the cap.

Price variation

The Shanghai benchmark is pegged to the cost of imported fuel oil and liquefied petroleum gas in the city. The gate prices will vary from province to province, depending on local pipeline charges and economic conditions.

Analysts said passing on any price increases to residential end-users could be problematical because public hearings might be called on such a sensitive issue. That could mean city gas distributors having to bear the brunt of any price hikes created by the pass-through formula, at least initially.

Still, the timing is as ripe as it could be for a drastic overhaul in natural gas pricing.

For one thing, natural gas currently accounts for less than 4 percent of the nation's primary energy mix, making the impact of the change less onerous. Gas consumption in China is expected to triple to 300 billion cubic meters by 2020, with imports playing a bigger role.

China is constructing a cross-border gas pipeline with Myanmar and another two with Russia. It is operating, building or planning a dozen liquefied natural gas terminals along the east coast to process cargoes from Australia, Malaysia and elsewhere.

Inflation eases

Then, too, the pricing reform comes against the backdrop of moderating inflation. That gives the government a hedge against the likelihood of household gas prices going up. China's inflation fell to a 14-month low of 4.2 percent last November. Standard Chartered Bank forecasts inflation will average 2 percent this year.

End users in Guangdong and Guangxi, where the system is being tried out, aren't expected to see any immediate rise in natural gas prices.

The NDRC chose those two regions because they rely heavily on high-cost LNG from overseas and other provinces. Guangdong, which sits next door to Hong Kong, is among China's wealthiest provinces.

The NDRC set the gate price in Guangdong at 2.74 yuan per cubic meter and at 2.57 yuan for Guangxi. The caps were based on 2010 prices, when crude oil was selling globally at about US$80 a barrel. Crude was trading above that level last year, rising above US$100 a barrel in the first few trading days of January.

Based on the gate price cap, Goldman Sachs estimates that the end tariff for piped gas in Guangdong will go just above 3.3 yuan, which is competitive with existing prices. For example, the pre-trial natural gas price in Guangzhou, capital of Guangdong, was 3.45 yuan for residential users and 4.85 yuan for industrial and commercial users.

Bigger impact later

Goldman estimates the price for gas in Guangxi will reach just over 3.2 yuan per cubic meter. In Nanning, the capital, it was 4.37 yuan for residential users and 5.73 yuan for non-residential users, the US investment bank said.

Analysts said the reform will have a bigger impact in later stages, especially after the system is expanded nationwide. Gate prices will be adjusted annually at first and later on a quarterly basis, the NDRC said.

The major energy companies will reap the rewards of higher prices. Mirae's Kwan estimates the system roll-out will potentially raise PetroChina's earnings per share by between 5 percent and 15 percent in the next two years. The EPS boost for Sinopec is estimated anywhere from 3 percent to 8 percent, and for CNOOC, from 2 to 5 percent, based on existing company operations, according to him.

The NDRC, the country's top economic planning body, said its long-term goal is a price-driven market, with the government's role limited to managing pipeline transmission prices.

The trial run of the new gas pricing policy signals that reforms across a broad spectrum of energy and resources may be accelerated, Guosen Securities analyst Huang Xuejun said.

The NDRC has said it plans to liberalize the well-head prices for unconventional gases such as shale, coal-bed methane and coal gas as part of the gas pricing reform to give companies more production incentives.

At the same time, Chinese companies have been acquiring overseas shale gas projects to gain technical know-how, especially from the United States, where technological advances have overturned the nation's dependence on imported gas.

But questions remain.

CICC's Guan asks: How will imported liquefied natural gas be priced after the super-chilled fuel is re-gasified in Chinese coastal terminals and pumped to users via pipelines?

The latest NDRC statement did not give an answer to that question.