SINOPEC Corp's joint bid to buy China Gas Holdings Ltd last week signals that a new wave of consolidation may be brewing in China's gas distribution sector, putting Sinopec in more direct competition with rival PetroChina Co.

The HK$16.7 billion (US$2.2 billion) offer for Hong Kong-listed China Gas, though rejected initially, could help Sinopec, Asia's largest oil refiner, to expand rapidly into downstream gas distribution.

That would be in keeping with the company's strategy to transform itself into an integrated energy company. It would also be in keeping with the Chinese government's goal of tripling the nation's gas consumption in the next decade to 300 billion cubic meters, thereby reducing dependence on expensive oil and dirty coal.

Sinopec and ENN Energy Holdings, another city piped-gas distributor, bid HK$3.50 a share for all outstanding shares of China Gas. The offer was at a 25 percent premium to its previous close.

"The offer made to China Gas indicates another round of consolidation may be underway in the gas distribution industry, which should help support the valuations of gas distributors," China International Capital Corp analysts Stephen Zhang and Xia Ziying wrote in a note.

If a deal was done, ENN and China Gas would become the largest listed downstream gas utility in China, with combined sales of more than 10 billion cubic meters a year, analysts estimated.

Returns on investment

Chinese gas distribution companies purchase gas primarily from PetroChina at prices set by the National Development and Reform Commission. They then sell the gas on at prices set by local government bodies.

Analysts said returns on investments in the business, where regulatory risk appears low, are attractive amid strong gas demand, and the commissioning of China's second west-to-east gas pipeline will save city gas distributors the cost of trucking gas into provinces such as the industrial hub of Guangdong.

Still, gas distributors, as intermediaries, may face margin pressures that they cannot offset. Notwithstanding the various new pipelines and liquefied natural gas terminals being built, disruption in gas supply is outside of the control of the distributors, many of them privately owned.

The natural gas sector has become a beehive of corporate activity.

China Resources Gas Group in October offered HK$795.13 million to take its 56.9 percent-owned unit, Zhengzhou China Resources Gas Co, private. It said the move was aimed at reducing potential conflicts in allocating resources or investments and acquisitions.

For its part, PetroChina has been injecting city piped-gas assets into its Kunlun Energy Co unit. On Tuesday night, Kunlun said it received approval from the Ministry of Commerce for its acquisition of the 60 percent interest in Beijing Gas Pipeline Co from PetroChina. This is the last regulatory approval requirement for the major deal that will make Kunlun a play on Chinese gas consumption growth.

Last June, the parents of PetroChina and China Resources formed a strategic alliance on gas distribution and other businesses.

Sinopec's upstream gas production is only a fifth that of PetroChina's, and its cross-provincial pipeline network and gas sales volumes are also dwarfed by its rival, according to Nina Yan, analyst at UBS Securities.

Buying China Gas - which operates 151 city piped-gas projects in 20 provinces, supplying 6.6 million residential customers and nearly 42,000 industrial and commercial users - would help Sinopec catch up in the downstream gas sector as the company ramps up gas production, Yan said.

China Gas also owns some compressed natural gas refilling stations that could complement Sinopec's auto-related gas business and some distribution projects for liquefied petroleum gas, for which Sinopec is China's largest producer, she said.

Maximum cash

ENN Energy, based in Langfang in Hebei Province, an hour's drive from Beijing, has 100 franchises in China, supplying 6.1 million households and 21,146 industrial and commercial users.

According to the Sinopec-ENN offer announcement last Tuesday, the maximum cash consideration for the acquisition is HK$16.7 billion, assuming all China Gas stock option holders exercise their options and accept the offer.

ENN would finance 55 percent of the deal, while Sinopec, which now owns a 4.8 percent stake in China Gas, would cover the rest, the announcement said. That would result in ENN controlling 52.4 percent of the company and Sinopec 47.6 percent.

Ultimately under the proposal, China Gas would continue as a publicly traded entity, with the partners issuing new shares or selling some to leave a 25 percent free float.

China Gas was quick to reject the offer, calling it "wholly unsolicited" and "opportunistic." The bid fails to reflect the fundamental value of the company, the takeover target said.

That leaves several options for ENN and Sinopec: sweeten the bid, walk away or go hostile.

Analysts at Sanford C. Bernstein said increasing the offer price now would be a mistake despite the attractiveness of the deal for Sinopec's expansion strategy.

"At this point, Sinopec needs to focus on re-investment in upstream growth rather than adding downstream gas assets," the analysts said in a note.

Sinopec Chairman Fu Chengyu seems to agree.

Speaking at a shareholders' meeting in Beijing last Thursday, Fu said now is "not the time" to talk about raising the offer. He suggested the China Gas board give the bid more serious consideration, according to Bloomberg News.

Analysts looking at the deal have raised synergy and financing issues on the ENN end of the bid. The company said a stake in China Gas would help improve its own management efficiency, reduce costs and optimize the use of resources. The analysts did generally agree that ENN would not be overpaying for China Gas at HK$3.50 per share.

Actual synergies

The operational synergies of the deal are limited for ENN because of the joint-venture structure and because both China Gas and ENN are strong players in several of the same provinces. ENN has 23 franchises, for example, in Guangdong and Fujian provinces, while China Gas has 40.

The acquisition wouldn't allow ENN to eliminate all of China Gas's head office costs, and since all these businesses function as citywide monopolies, actual synergies would be limited to mid-stream pipelines, some maintenance crews and bulk, Bernstein analysts said.

"ENN's initiative is outside of our expectations as the company has been focusing on organic growth and a prudent acquisition strategy," Goldman Sachs said. The transaction could result in negative free cash flow next year for ENN, which had net debt of 4.2 billion yuan (US$662 million) at the end of June, Goldman said. State-owned Sinopec is just cash-rich.

Bernstein said the proposed deal is looking to recast the structure of the Chinese gas distribution sector when the existing structure is actually beneficial for ENN.

ENN Energy has the opportunity to lower its capital spending, accrue cash and increase its dividend by simply selling more gas to its 100 franchises while the rest of the industry does the difficult and expensive job of building the last mile of gas distribution to the remaining 200-odd cities in China that require such networks, analysts said.

ENN, also listed in Hong Kong, saw its stock price fall almost 10 percent in the two days after the offer was announced. China Gas was up about 20 percent while Sinopec was little changed during the same period.