april 3, 2012 natural gas transport equipment sector buy

Sector Research | HK & China Natural Gas Transport Equipment

For ratings definitions and other important disclosures, refer to the Information Disclosures at the end of this report. 1

April 3, 2012

Natural Gas Transport Equipment Sector BUY

Prepare for a ‘golden age’ of gas equipment

Investment highlights

Natural gas consumption on course to see impressive growth during the 12th Five-Year Plan period (2011-15). China ranks seventh in the world in terms of natural gas production, but the share of natural gas as a percentage of China’s energy consumption mix is still low. China targets to increase its annual natural gas consumption to 260 billion cubic metres by 2015, more than double from only 107.2 billion cubic metres in 2010, equivalent to a CAGR of 19.4%.

China to ensure natural gas supply through a combination of pipelines and LNG imports. China will also encourage the increase in natural gas imports to meet growing demand, which will benefit the natural gas equipment sector in our view. China targets to increase the total length of oil and gas transport pipelines to 150,000 km by 2015, representing a 90% growth from 2010. The combined annual capacity of LNG terminals in China is on track to reach 36.7 million tonnes by 2015.

Top Buys: Shengli Pipe (1080.HK), Chu Kong Pipe (1938.HK), CIMC Enric (3899.HK). We believe the anticipated pipeline construction boom will bring golden opportunities to steel pipe manufacturers, especially Shengli Pipe, the largest SSAW maker in China, and Chu Kong Pipe, the biggest LSAW producer. The increase in LNG imports will drive up demand for LNG storage and transport equipment, which will benefit CIMC Enric, China’s No.1 LPG, LNG and CNG tank manufacturer. These three companies will be able to tap into the anticipated ‘golden age’ of gas.

Exhibit 1: Valuation of major listed companies

Ticker Company Last price (HK$)

Market cap (HK$100 mn)

EPS (HK$) 2011 PE (s) Rating

09 10 11 1080.HK Shengli Pipe 0.91 23.30 0.35 0.04 0.05 19.6 Buy

1938.HK Chu Kong Pipe 2.72 26.80 0.60 0.08 0.28 9.6 Buy

3899.HK CIMC Enric 4.20 36.00 0.12 0.17 0.37 11.3 Buy

Source: Guosen Securities (HK), company data, Bloomberg, data as at April 1, 2012

Analyst

John Lu 00852-2899 8300 [email protected] SFC CE No.: AVT518

Sales Contact

Dan Weil Global Head of Institutional Sales and Trading Managing Director +852 2248 3588 [email protected] Chris Berney Managing Director +852 2248 3568 [email protected] Joe Chan Director +852 2248 3578 [email protected] Cancy Kong Vice President +852 2248 3538 [email protected] Jiafeng Li Vice President +852 2899 7281 [email protected] Shunei Kin Vice President +852 22483536 [email protected]

Natural Gas Transport Equipment Sector April 3, 2012 | HK & China

Guosen Securities (HK) Brokerage Co., Ltd.

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Natural gas is a cleaner, cheaper and more sustainable energy source enjoying growing popularity globally. Natural gas exploration is growing, as this energy source is much more abundant than oil. The International Energy Agency (IEA) forecasted in a report that we are entering a ‘Golden Age of Gas’ during 2010-2035. The global use of natural gas will rise by more than 50%, and natural gas is on course to replace coal as the second biggest energy source in the world by 2035, with its share in the world’s overall energy demand rising four percentage points from 2008, IEA forecasts. Looking at the big picture, the emergence and development of unconventional natural gas (such as shale gas) will help to make it a more dominant energy source, and could finally enable it to replace oil as the world’s largest energy source, in our view.

Given the aforementioned advantages of natural gas over oil, the Chinese government is on track to offer vigorous support to natural gas in China’s energy mix adjustment process, and the natural gas equipment sector stands to benefit enormously from the rapid development of the natural gas market, in our view. Given these considerations, this report seeks to explore investment opportunities in HK-listed natural gas transport equipment companies.

1 Natural gas in China

1.1 China ranks seventh in the world in terms of natural gas production, but its per capita gas production is less than 1/6 of the global average

According to data released by BP, the US and Russia are the world’s two largest natural gas producers, with a market share of about 20% each. China’s natural gas production reached 96.8 billion cubic metres in 2010, accounting for 3% of the world’s total production, making it the seventh largest natural gas producer in the word.

However, China lags well behind the major developed countries and even the global average in terms of per capita natural gas production, which reached only 72 cubic metres in 2010, equivalent to only 15.5% of the global average.

Exhibit 2: China’s overall natural gas production & per capita natural gas production (2010)

Ranking Country Annual production (100 million cu m) Share Population

(100 mn) Per capita production

(cu m) 1 The US 6,110 19% 3.13 1,955

2 Russia 5,889 18% 1.43 4,121

3 Canada 1,598 5% 0.34 4,634

4 Iran 1,385 4% 0.76 1,827

5 Qatar 1,167 4% 0.02 68,670

6 Norway 1,064 3% 0.05 21,389

7 China 968 3% 13.40 72

8 Saudi Arabia 839 3% 0.27 3,092

9 Indonesia 820 3% 2.38 345

10 Algeria 804 3% 0.36 2,215

Global 31,933 100% 68.67 465

Source: BP Statistical Review of World Energy June 2011，Wikipedia，Guosen Securities (HK)

The US and Russia are the world’s top natural gas producing nations, accounting for a combined 37% of the global output.

The Chinese government is expected to offer strong policy support to encourage the conversion to the use of natural gas from oil and coal.



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1.2 China’s natural gas production and consumption experienced rapid growth in the past decade

According to the National Bureau of Statistics, China’s natural gas production increased from 27.2 billion cubic metres to 94.8 billion cubic metres over 2000-10, while the natural gas consumption surged from 25.4 billion cubic metres to 107.2 billion cubic metres over the same period, representing growth rates of 250% and 340% respectively.

Natural gas accounted for only about 2% of China’s energy consumption before 2000, but China’s natural gas consumption saw an inflection point in 2000, as the 1st phase of the West-East gas pipeline project went into operation that year. By 2010, the share of natural gas as a percentage of China’s total energy consumption doubled from 2.2% in 2000 to 4.4%.

Exhibit 3: China’s natural gas production and consumption increased steadily

Exhibit 4: The share of natural gas as a percentage of total energy consumption gradually increased in China

Source: WIND, Guosen Securities (HK) Source: WIND, Guosen Securities (HK)

1.3 The share of natural gas in China’s energy mix is still low

Natural gas is one of the three largest energy sources in the global energy mix after oil and coal, accounting for 24% of the world’s total energy consumption, but in China, natural gas makes up only 4.4% of the total primary energy consumption, while coal and oil account for 70% and 18% respectively.

Although this distribution is understandable, given China’s energy reserve structure of “rich in coal, but poor in oil and gas”, China should still make more effort to increase the use of natural gas, as it’s cleaner, more efficient, and more convenient compared to oil and coal. We believe the share of natural gas in China’s energy mix is excessively low, and the government will release favourable policies to encourage the use of natural gas going forward.

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Share of natural gas as a percentage of total energy production Share of natural gas as a percentage of total energy consumption

Natural gas as a percentage of China’s total energy consumption doubled from 2.2% in 2000 to 4.4%.

Coal and oil still account for a disproportionally high share of China’s energy mix at 70% and 18% respectively.



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Exhibit 5: China’s primary energy consumption mix Exhibit 6: Global primary energy consumption mix

Source: BP Statistical Review of World Energy June 2011，Guosen Securities (HK)


2 China plans to encourage natural gas use and increase natural gas imports

2.1 Natural gas consumption is on track to see impressive growth during the 12th Five-Year Plan period

The Chinese government will further encourage the use of natural gas during the 12thFive-Year Plan period (2011-15).According to the plan, China targets to double the share of natural gas in its energy mix to 8.3% over 2011-15.Based on the guideline issued in the government work conference held in 2011 regarding energy, China’s annual natural gas consumption will reach 260 billion cubic metres, more than double from only 107.2 billion cubic metres in 2010, equivalent to a CAGR of 19.4%. Under such scenario, China’s natural gas consumption will enjoy impressive growth during the 12thFive-Year Plan period.

Exhibit 7: China plans to double the share of natural gas in its total energy consumption during the 12thFive-Year Plan period (2011-15)

Source: WIND, Guosen Securities (HK)

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Share of natural gas as a percentage of total energy consumption

China’s annual natural gas consumption is expected to double to 260 billion cubic metres, under the government’s work plans.



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2.2 China’s natural gas shortage is worsening, as the pace of production growth lags consumption growth

China’s natural gas production recorded a CAGR of 13.3% over 2000-10, while the CAGR of natural gas consumption reached 15.9%, suggesting that the pace of production growth lags consumption growth.

China’s natural gas market was able to achieve balance between supply and demand before 2008, but natural gas supply began to fall behind demand in 2009, and the gap between supply and demand has widened dramatically since then. China’s natural gas production of 94.8 billion cubic metres and consumption of 107.2 billion cubic metres indicate a supply shortfall of 12.4 billion cubic metres in 2010, equivalent to 12% of China’s total natural gas consumption, compared to only 5% in 2009.

Exhibit 8: China’s natural gas shortage worsening


According to the guideline issued in the 2011 government work conference regarding energy, China’s natural gas consumption will reach about 260 billion cubic metres, equal to 2.4 times that in 2010, out of which 170 billion cubic metres will come from domestic gas producers, while the remaining 90 billion cubic metres (35% of the total) will depend on imports, which means the Chinese government will encourage import of natural gas in order to bridge the widening gap between demand and supply. According to our calculation based on the aforementioned targets, China’s natural gas imports will see a six fold jump over 2010-15.

Exhibit 9: China’s natural gas shortage is expected to surge in the next 10 years (100 million cu m)

Year Natural gas production

Natural gas consumption Supply shortfall

The share of supply shortfall as a percentage of total

natural gas consumption 2009 852.69 895.20 42.51 5%

2010 948.48 1,072.00 123.52 12%

2015E 1,700.00 2,600.00 900.00 35%


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Natural gas supply shortfall (100 million cu m, LHS)

Supply shortfall’s share as a percentage of China’s total natural gas consumption (RHS)

Natural gas shortage in China amounted to 12.4 billion cubic metres in 2010, or equivalent to 12% of the country’s consumption.

Around 35% of China’s natural gas requirement will be met by imports, according to the government’s work plans. We estimate China’s natural gas imports will jump six fold over 2010-15.



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3 To ensure supply through a combination of pipeline gas transport and LNG imports

3.1 China’s natural gas supply network under construction

China plans to accelerate the construction of key natural gas pipeline projects, including the West-East gas pipeline project, North-South gas pipeline project and Offshore-Onshore gas transport project, while uphold the principle that “demand from nearby areas comes first” to ensure natural gas supply during the 12th Five-Year Plan period.

The West-East gas pipeline project aims to transport natural gas from western provinces and regions including Xinjiang, Qinghai, Shaanxi, Sichuan, etc, as well as Central Asian Countries to the coastal areas of eastern China. The North-South gas pipeline project aims to transport natural gas imported from Russia to domestic customers. The Offshore-Onshore natural gas project targets to transport gas from offshore gas fields and LNG (liquefied natural gas) terminals to onshore customers.

In terms of supply channel, China’s natural gas supply will mainly depend on pipeline gas transmission and LNG routes.

Exhibit 10: China’s planned natural gas supply routes during the 12th Five-Year Plan period

Supply source: Dalian LNG(Starting time: 2012E)

Supply source: Tangshan LNG(Starting time: 2014E)

Supply source: Qingdao LNG(Starting time: 2014E)Supply source: Jiangsu LNG(Starting time: 2011)Supply source: Shanghai LNG(Starting time: 2009)Supply source: Zhejiang LNG(Starting time: 2012E)Supply source: Fujian LNG(Starting time: 2008)

Supply source: Myanmar(Starting time: 2013E)

China’s onshore natural gas producing areas

Supply source: Central Asian countries(Starting time: 2010)

Supply source: Shenzhen LNG(Starting time: 2013E)

Supply source: Dapeng LNG(Starting time: 2006)

Source: CNPC Tubular Goods Research Institute, Guosen Securities (HK)

China will uphold the principal of “demand from nearby areas comes first” to ensure natural gas supply.



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3.2 Pipelines and LNG routes are China’s two main import channels

Pipelines and LNG routes have become China’s main natural gas import channels. According to BP, China imported 16.35 billion cubic metres of natural gas in 2010, out of which 12.8 billion cubic metres were transported through LNG routes, equivalent to 78% of the total, while about 3.55 billion cubic metres were transported through pipelines, equivalent to 22% of the total.

Exhibit 11: China’s natural gas import channels in 2010 Exhibit 12: China’s natural gas import source countries in 2010



China began to import natural gas through pipelines in 2010, following the construction of China’s 2th phase of West-East gas pipeline project at the end of 2009, which is 4,895 km in length with an annual transport capacity of 30 billion cubic metres. This project, marking China’s first natural gas pipeline designed to transport gas from foreign counties, mainly Central Asian countries, went into operation in 2010, when Turkmenistan began to supply natural gas to China. China’s gaseous natural gas imports was about 3.6 billion cubic metres in 2010, and will see strong growth momentum with the second West-East gas pipeline coming online, in our view.

LNG import has a longer history in China compared with pipeline gas transport. In 2006, Phase 1 of Guangdong Dapeng LNG terminal, China’s first LNG import terminal, came on line in Shenzhen with an annual capacity of about 3.7 million tonnes (equivalent to 5 billion cubic metres). At present, there are altogether four operating LNG terminals in coastal areas, with a combined annual capacity of 12.8 million tonnes (equivalent to 17.3 billion cubic metres per year). China’s LNG imports reached 12.8 cubic metres in 2010, representing a y-o-y growth of 68%, most of which came from countries including Australia, Indonesia, Malaysia, Qatar, etc.

22%

78% Natural gas imports by pipeline

Natural gas imports by LNG routes

3%

22%

10%

4% 32%

15%

10%

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Russia Turkmenistan Qatar Yemen Australia Indonesia Malaysia Others

China’s LNG imports surged 68% y-o-y in 2010.



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Exhibit 13: China began to import natural gas through pipelines in 2010


3.3 Pipeline construction boom ready to take off

Pipelines are generally the most economical way to transport large quantities of oil and natural gas over long distances as only small additional investments are needed after they come on line. And as the only channel for large-scale transportation of natural gas over land, pipeline transport has become widely used. According to statistics, natural gas pipelines account for about half of the combined length of the pipelines globally. Nearly 50% of the gas and oil transport pipelines1

The Chinese government plans to vigorously support the development of the oil and gas transport pipeline industry during the 12thFive-Year Plan period. According to the 12thFive-Year Plan for this industry, China will complete the construction of a number of oil and gas pipeline projects over 2011-15, including the Phase 2 of the Sino-Kazakhstan Crude Oil Pipeline Project, the China section of the Sino-Myanmar Oil and Gas Pipeline, Phase 2 of the Sino-Central Asian Natural Gas Pipeline, Phase 3 and Phase 4of the West-East Gas Pipeline, etc. China targets to increase the total length of oil and gas transport pipelines to 150,000 km by 2015, representing a 90% growth from 2010 and an annual increase of 14,000 km, equivalent to nearly 1/5 of China’s total transport pipeline length in 2010. As such, China is on course to see a pipeline construction boom in the next five years.

constructed in China are natural gas pipelines, and this figure is on course to rise going forward, as China accelerates the construction of natural gas pipeline networks.

1“Transport pipelines” mean trans-regional& transnational trunk and lateral pipelines in China designed to transport oil or gas from region to region in this report, while “urban gas pipelines” mean pipelines designed to distribute natural gas within cities.

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China's gaseous natural gas imports (10,000 tonnes)

The government will lend strong support to the development of the oil and gas transport pipeline industry during the 12th Five-Year Plan. It plans to increase the total length of pipelines by around 90% during the period or by 14,000 km per year.



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Exhibit 14: The total length of China’s oil and gas transport pipelines will almost double over 2011-2015

Exhibit 15: Natural gas pipelines account for nearly 50% of the total length of China’s oil and gas transport pipelines


3.4 LNG imports to see strong momentum

Natural gas can be condensed into LNG at close to atmospheric pressure by cooling it to approximately -162℃. LNG can achieve a higher reduction in volume, which makes it cost efficient to transport over long distances where pipelines do not exist. LNG routes are the second most commonly used transport channel after pipelines in international natural gas trades.

There were altogether three operating LNG terminals in China in 2010, with a combined annual capacity of 9.3 million tonnes (equivalent to about 12.6 billion cubic metres), and China’s total LNG imports reached 12.8 billion cubic metres in the same year.

There are nine LNG terminals under construction in China, with a combined annual capacity of 24 million tonnes (equivalent to about 32.4 billion cubic metres), implying a doubling of current capacity. The total annual capacity of LNG terminals in China is on track to reach 36.7 million tonnes by 2015 (equivalent to about 49.7 billion cubic metres), which is 3.9 times China’s total LNG imports in 2010.

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Total length of China's oil and natural gas transport pipelines (10,000 km)

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Oil products transport pipelines

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Nine LNG terminals are being constructed right now, which will double capacity.



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Exhibit 16: Combined capacity of LNG receiving terminals on track to come online in the next few years

Source: icis-china.com, Bloomberg, Reuters, Guosen Securities (HK)

3.5 The pipeline and LNG equipment manufacturing industries set to benefit from the anticipated golden age of gas

We believe the rapid development of China’s natural gas industry will create considerable opportunities for related manufacturing companies during the 12th Five-Year Plan period. Particularly, pipeline manufactures stand to benefit from the pipeline construction boom, while LNG equipment manufacturers will become beneficiaries of the growing demand for gas storage and transport due to the increase in LNG imports.

Exhibit 17: The development path of the natural gas industry and related companies

China’s annual natural gas production will reach 170 billion cubic metres by 2015

China’s annual natural gas consumption will reach 260 billion cubic metres by 2015

Importing natural gas through pipelines Importing natural gas through LNG routes

The total length of China’s oil and gas transport pipelines is on course to increase 90% over 2011-15, equivalent to an annual increase of 14,000 km

The combined annual capacity of LNG terminals in China is on course to reach 33.7 million tonnes, 5.6 times China’s LNG imports in 2010

SSAW manufacturing: SSAW pipes account for 70% of China’s trunk and lateral transport pipelines;LSAW manufacturing: LSAW pipes account for 25% of China’s trunk and lateral transport pipelines; Urban pipeline networks mainly use LSAW or ERW pipes

LNG receiving terminalsLNG peak-shaving stationsLNG storage and transport equipment

Constructing natural gas pipelines

Constructing LNG receiving terminals

Main beneficiaries Main beneficiaries

Constructing natural gas pipelines

China will face a natural gas supply shortfall of 90 billion cubic metres by 2015

SSAW manufacturing: Shengli Pipe (1080.HK)LSAW manufacturing: Chu Kong Pipe (1938.HK)

CIMC Enric (3899.HK)

Beneficiary Beneficiary


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Combined capacity of LNG terminals already in operation (1 million tonnes) Combined capacity of newly constructed LNG terminals (1 million tonnes)

The rapid development of China’s natural gas industry will create considerable opportunities for pipeline makers and LNG equipment manufacturers.



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4 Golden opportunities for China’s oil & gas pipeline manufactures

4.1 SSAW& LSAW pipes

China plans to increase its total length of oil and gas transport pipelines from 79,000km at the end of 2011 to 150,000km in the next five years, equivalent to an annual increase of 14,000km, which will stimulate demand for oil and gas transport steel pipes.

There are mainly two types of steel pipes used in long-distance oil and gas transport, the Spiral Submerged-arc Welded (SSAW) type and the Longitudinal-seam Submerged Arc Welded (LSAW) type. SSAW captures a market share of 70% due to lower price, but it’s generally used in Level 1 and 2 areas due to relatively poor quality compared with LSAW. In contrast, LSAW has a market share of only 25% due to relatively high price, but it can be used in Level 3 and 4 areas with higher quality.

Exhibit 18: Different types of oil and gas transport pipelines

Pipe Market share Diameter range Characteristics

SSAW 70% 406mm-1625mm Price is lower, but quality is relatively poor; can be used in Level 1 and 2 areas only

LSAW 25% 273mm-1625mm Price is higher, but quality is better compared with SSAW. Can be used in Level 3 and 4 areas

ERW 5% 152mm-660mm Generally with small diameter, and quality is poorer than LSAW

Note: *share in China’s oil and gas transport pipeline network Level 1 area: areas with no more than 15 users Level 2 area: areas with 15 to 100 users Level 3 area: areas with no less than100 users Level 4 area: areas with a large number of tall buildings (buildings with at least four floors), busy traffic and a large quantity of underground facilities; urban natural gas pipeline networks mainly cover Level 4 areas

Source: CNPC Tubular Goods Research Institute, Guosen Securities (HK)

The global debate on the pros and cons of LSAW and SSAW has lasted for years, as major developed countries hold widely varying views on this issue.

According to a report released by CNPC Tubular Goods Research Institute in 2009, Japan and the US generally prefer LSAW given the higher quality, although SSAW has enjoyed increasing popularity in the US in recent years, as it’s widely used in the Cheyenne Plains Gas Pipeline project and Rockies Express Pipeline. Canada and Russia generally favour SSAW, with SSAW capturing a 70% share in Canada’s total length of trunk gas pipelines. Besides, there are two kinds of different viewpoints on this issue in Germany and Italy.

SSAW dominates the Chinese market with a 70% share in China’s oil and gas transport pipelines. According to Tubular Goods Research Institute’s report, China’s SSAW manufacturing technique has reached a higher level of maturity. The quality of domestic produced SSAWs should be close to that of UOE 2

2 UOE refers to a manufacturing process where the material is formed into a “U”, then an “O” shape, before being expanded to the final dimensions

LSAWs, if pre-welding & precision-welding technology and mechanical expanding process are adopted in the production line.

The view on whether SSAW or LSAW steel pipes is better varies greatly around the world.



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Exhibit 19: Different countries have different view towards SSAW and LSAW

Country Attitude

Japan Generally disfavours SSAW; holds the view that SSAW should mainly be used in low pressure transport networks, rather than trunk &lateral transport pipeline networks

The U.S. LSAW captured nearly 100% market share before 2003, but SSAW has enjoyed increasing popularity in recent years

Russia generally favours SSAW

Germany two kinds of different viewpoints

Italy two kinds of different viewpoints

Canada SSAW accounts for 70% of its trunk transport pipelines

Source: Tubular Goods Research Institute, Guosen Securities (HK)

With SSAW, LSAW, and ERW (Electric Resistance Welding) capturing a market share of 70%, 25% and 5% respectively in China’s oil and gas transport pipeline networks, based on our assumption that the current distribution structure will largely remain the same in the foreseeable future, we believe SSAW steel pipe manufacturers will benefit the most, while LSAW producers should be the second largest beneficiary during the anticipated pipeline construction boom in the next few years.

Exhibit 20: Share of SSAW, LSAW, and ERW pipes in China’s oil and gas transport pipeline networks

Source: Guosen Securities (HK), company websites

4.2 SSAW market on track to see tight supply during the 12thFive-Year Plan period

Although competition in the SSAW manufacturing industry is increasingly fierce given relatively low technical barriers to entry, only a small handful of SSAW makers are able to produce large-scale high-pressure steel pipes. Companies with this key competitive edge usually establish long-term cooperative relationships with CNPC and Sinopec.

Given that trunk and lateral oil & gas transport pipelines is an important part of China’s oil and gas development strategy, the two oil majors should be very cautious while selecting pipeline providers in our view, and only large vendors that have established long-term relationship with them stand a chance of winning the contracts. As a result, these projects are actually monopolised by large vendors.

China’s oil and gas pipeline projects are generally dominated by seven vendors, out of which six vendors are subsidiaries of CNPC or Sinopec, and Shengli Pipe is the only privately owned enterprise (Shengli’s predecessor is also a subsidiary of Sinopec).

70%

25%

5%

SSAW

LSAW

ERW

Based on our analysis, we believe SSAW makers will benefit the most from the expected steel pipeline construction boom in the next few years in China.

China’s oil and gas pipeline projects are generally dominated by seven vendors, out of which six vendors are subsidiaries of CNPC or Sinopec, and Shengli Pipe(1080.HK) is the only privately owned enterprise.



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Exhibit 21: Seven major SSAW manufacturers in China

No. Company SSAW capacity in

2011E (10,000 tonnes)

Market share (%) Notes

1 Shengli Pipe 115 34% Privately owned enterprise

2 Baoji Steel Pipe 55 16% A subsidiary of CNPC, began the construction of a 120,000-tonne production line in Xinjiang in July 2011, which is expected to come online in 1~2 years.

3 North China Steel Pipe 50 15% A subsidiary of CNPC

4 Shashi Steel Pipe 40 12% A subsidiary of Sinopec

5 Ziyang Steel Pipe 30 9% A subsidiary of CNPC

6 CNPC pipeline bureau Liaoyang Pipe Steel

26 8% A subsidiary of CNPC

7 Shanghai Baoshiwei Petro-Pipe

25 7% A subsidiary of CNPC

Total 341 100%

Source: Guosen Securities (HK), company websites

According to the 12th Five-Year Plan, China targets to construct 71,500km of oil and gas transport pipelines over 2011-15. Assuming that SSAW accounts for 70% of the pipes used in these projects, 50,000 km out of the 71,500km of oil and gas pipes will be SSAW.

According to CNPC Tubular Goods Research Institute’s calculation, SSAW’s average weight per km was 300 tonnes in China in 2008, and this figure is on course to increase to 380tonnes by 2015. Assuming the average weight per km during the 12thFive-Year Plan period is 340 tonnes, total demand for SSAW will reach 17.02 million tonnes over 2011-15, suggesting an annual demand of 3.4 million tonnes.

Exhibit 22: China’s average annual SSAW demand should reach 3.4 million tonnes during the 12th FYP period

Item No. Value Transport pipeline length in 2010 (10,000 km) A 7.9

Transport pipeline length in 2015E (10,000 km) B 15.0

Length of newly constructed transport pipelines during the 12th FYP period (10,000 km)

C=B-A 7.15

SSAW’s share（%） D 70%

Average weight of pipeline per km (tonne /km) E 340

Total SSAW demand (10,000 tonnes) F=C*D*E 1,702

Average annual SSAW demand (10,000 tonnes) G=F/5 340

Source: Guosen Securities (HK)

We estimate the combined capacity of the seven major SSAW manufactures reached 3.41 million tonnes by the end of 2011. However, given the diversified specifications of different pipelines, there is limited chance the manufactures can operate at 100% capacity utilisation. Shengli Pipe operated at 83.7% capacity utilisation during the 2009 boom. Assuming the manufactures’ average capacity utilisation reaches 85%, their combined capacity will be about 2.9 million tonnes, indicating a supply shortfall of 500,000 tonnes, which will provide a golden opportunity for SSAW manufacturers.

We assume that SSAW accounts for 70% of the pipes used under the 12th Five-Year Plan to build 71,500 km of oil and gas pipelines.

We assume a supply shortage of 500,000 tonnes of SSAW pipes in China.



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Exhibit 23: China’s SSAW supply shortfall should reach 500,000 tonnes during the 12thFive-Year Plan period (2011-15)

Item No. Value Average annual SSAW demand (10,000 tonnes) A 340

Combined capacity of seven major manufacturers (2011; 10,000 tonnes) B 341

Capacity ultilisation (%) C 85%

Actual capacity of seven major manufacturers (2011, 10,000 tonnes) D=B*C 290

Supply shortfall (10,000 tonnes) E=D-A -50


4.3 LSAW market to see robust demand given the rapid development of urban pipeline networks

In contrast with SSAW, LSAW pipes can be used in level 2 to level 4 areas, as well as crossing sections and deep water pipelines. LSAW and ERW are two major types of pipelines used in urban natural gas pipeline networks.

The construction of lateral pipeline and urban pipeline network usually goes hand in hand with the construction of trunk pipelines. Over 2002-10, the length of urban natural gas pipelines constructed in China grew from 50,000 km to 260,000 km, which is 3x that of oil and gas transport pipelines3

Under such scenario, we expect the LSAW market to see growing demand.

, implying a CAGR of 23%, much higher than 13%, the CAGR of the length of oil and gas transport pipelines in China over the same period.

Exhibit 24: China’s urban natural gas pipeline distribution by length

Exhibit 25: The total length of China’s urban natural gas pipelines


3“Transport pipelines” mean trans-regional& transnational trunk and lateral pipelines in China designed to transport oil or gas from region to region in this report, while “urban gas pipelines” mean pipelines designed to distribute natural gas within cities.

10.8%

9.6%

9.3%

6.8%

6.0% 57.5%

Jiangsu

Shandong

Sichuan

Shanghai

Beijing

Others

0

5

10

15

20

25

30

2002 2003 2004 2005 2006 2007 2008 2009 2010

10,000 km

Total length of China's urban natural gas pipelines (10,000 km)

Total length of China's oil and gas transport pipelines (10,000 km)

The length of urban natural gas pipelines grew from 50,000 km to 260,000 km between 2002 and 2010.



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5 Increase in LNG supply will stimulate the development of the LNG equipment industry

Long-distance ocean shipping has become an increasingly important way to transport LNG. As an important part of the LNG industry chain, LNG receiving terminals regasify the LNG they receive from base load LNG plants, and offer the products to customers. As a result, LNG receiving terminal is not only the terminal point of long-distance LNG ocean transportation, but also the starting point of onshore gas supply.

In the past, the development of downstream LNG markets was hindered due to lack of LNG supply. However, this problem will hopefully be solved soon, as the construction of several LNG receiving terminals is on track to be completed in the coming years, and a number of domestic LNG liquefaction plants will come online.

The combined capacity of LNG receiving terminals already in operation is expected to have reached 15.8 million tonnes by 2011, 1.7 times that in 2010. Two large-scale LNG terminals, including Phase 1 of Nantong LNG receiving terminal which has already come on line in May 2011 with an annual capacity of 3.5 million tonnes, and the 3-million-tonne level LNG receiving terminal in Dalian that have started operation in November 2011, played an important role in boosting LNG supply.

Given the increase in upstream LNG supply, demand for LNG transport equipment, including LNG receiving terminals (mainly large-scale LNG tankers), LNG gasification stations, LNG satellite stations, CNG & LNG trailers, high-pressure cylinders, LNG fueling stations, etc, will grow accordingly.

Exhibit 26: LNG industry chain


5.1 Natural gas peak-shaving station

Natural gas demand is highly seasonal, and could vary significantly from day to day or even hour to hour. As a result, the natural gas market sees robust demand for peak shaving, which aims to store natural gas, mainly in underground storage tanks, constant pressure storage tanks, and LNG storage tanks, when the demand is relatively weak, and send the gas back to urban natural gas pipeline networks during peak hours. LNG storage tanks are acknowledged as the best storage method, as they can help save space, and enable operators to react quickly togas supply shortages.

Upstream

• Natural gas exploration, dissociation, purification, liquification

Midstream

• Storage & transport: LNG receiving terminal, LNG satellite station, LNG peak-shaving station, LNG trailer, LNG fueling station, etc

Downstream

• End user: households, power plants, industrial production

In the past, the development of downstream LNG markets was hindered due to lack of LNG supply.



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With the construction of LNG peak-shaving stations progressing smoothly, demand for related LNG storage and transport equipment (e.g. LNG storage tanks, and LNG trailers) will surge accordingly.

5.2 Natural gas fueling stations

China’s natural gas vehicle market witnessed robust growth in the past decade, with the number of natural gas vehicles in China increasing from less than 10,000 units in 2000 to 1 million units in 2010.China has become the fourth largest natural gas vehicle market in the Asia-Pacific region, and the sixth largest natural gas vehicle market in the world, which is indicative of the strong demand for natural gas fueling stations in China.

Exhibit 27: The number of natural gas vehicles in different countries in 2010

Source: Asia Pacific Natural Gas Vehicles Association, Guosen Securities (HK)

At present, natural gas vehicles can be divided into two types, Compressed Natural Gas Vehicles (CNGV) and Liquefied Natural Gas Vehicles (LNGV). CNGVs are used for short-distance transport, mainly in urban areas, while LNGVs can be used for long-distance freight transport, as they can travel over 400 km on a single charge.

Natural gas vehicles enjoy an obvious advantage in terms of cost when used as buses, long-distance coaches, heavy trucks, taxis, etc. Taking long-distance freight vehicles as an example, assuming LNG price is equivalent to 80% of gas oil price, and a vehicle runs 100,000 km per annum, using a natural gas vehicle can help save RMB37,000 per annum, which means the upgrade fee can be recouped in only two years, and the recoupment period could be shortened to 0.7 year, if we assume LNG price is equivalent to 60% of gas oil price. Given this key advantage over other vehicles, natural gas vehicles have seen strong demand in China.

However, there are still several obstacles hindering the development of natural gas vehicles, including lack of natural gas supply. The natural gas vehicle market will add another engine of growth, and the construction of fueling stations will further accelerate if this problem can be solved, in our view.

Pakistan, 230

Argentina, 180

Iran, 170

Brazil, 160 India, 100

China, 100

Others, 386

10,000 units

Pakistan Argentina

Iran Brazil

India China

Others

China is the world’s sixth largest natural gas vehicle market in the world.

The number of natural gas vehicles in China grew from less than 10,000 units in 2000 to 1 million units in 201, indicating the strong demand from fueling stations.



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Exhibit 28: LNG long-distance freight vehicles enjoy considerable advantages in terms of cost

Vehicle Fuel Fuel price (RMB)

Fuel Consumption

per km

Fuel cost per

km (RMB)

Cost LNG saves per km (RMB)

Share of the cost saved in the total

cost

Cost can be saved per

annum (RMB 10,000)

Upgrade cost (RMB

10,000)

Recoupment period (Year)

Long-distance freight vehicle

Gas oil 7.5 per litre

45 litres

337.5

LNG (Scene 1: assuming LNG price is equivalent to 80% of gas oil price )

6 per cu m

50 cu m

300.0 37.5 11.1% 3.8 8 2.13


4.5 per cu m

50 cu m

225.0 112.5 33.3% 11.3 8 0.71

Long-distance bus

Gas oil 7.5 per cu m

33 cu m

247.5


6 per cu m

35 cu m

210.0 37.5 15.2% 3.8 5 1.33


4.5 per cu m

35 cu m

157.5 90.0 36.4% 9.0 5 0.56


6 HK-listed natural gas transport equipment companies

Among HK-listed machinery companies, there are mainly three companies with large portfolio of natural gas transport equipment assets, including Shengli Oil & Gas Pipe (1080.HK), Chu Kong Petroleum and Natural Gas Steel Pipe (1938.HK) and CIMC Enric Holdings (3899.HK).

Out of the three aforementioned companies, two companies, namely Shengli Pipe and Chu Kong Pipe are pipeline manufacturers, with Shengli Pipe being the largest SSAW manufacturer, and Chu Kong Pipe being the largest LSAW manufacturer in China. We expect these two companies to benefit from China’s pipeline construction boom.

CIMC Enric is a natural gas storage and transport equipment manufacture. As a subsidiary of CIMC Group, CIMC Enric has the ability to provide one-stop solutions for specific natural gas-related needs, and has become China’s No.1 LPG, LNG and CNG tank manufacturer.

Exhibit 29: Three HK-listed natural gas equipment manufacturers

Company Ticker Core business Market cap(RMB100 mn)

Revenue 2010(RMB100 mn)

Net profit in 2010(RMB100 mn) Note

Shengli Pipe 1080.HK SSAW manufacturing 21.0 11.3 0.9 Largest SSAW manufacturer in China

Chu Kong Pipe 1938.HK LSAW manufacturing 19.8 16.8 0.7 Largest LSAW manufacturer in China

CIMC Enric 3899.HK Natural gas storage and transport equipment 46.0 40.0 2.8

Largest LPG, LNG, CNG tank manufacturer in China, able to provide one-stop natural gas solution


6.1 Shengli Pipe: well positioned to see profits rebound over 2011-2012

Shengli Pipe is the largest SSAW manufacturer in China. The company’s products are mainly used in China’s trunk oil and gas transport pipelines, with CNPC and Sinopec

Shengli Pipe (1080.HK) is China’s biggest SSAW manufacturer. Chu Kong Pipe (1938.HK) is the largest LSAW producer in China. CIMC Enric (3899.HK) is China’s no.1 PLG, LNG and CNG tank maker.

Shengli’s capacity almost doubled from 640,000 tonnes in 2010 to 1.15 million tonnes in 2011.



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contributing over 90% of its total revenue. Shengli Pipe’s results were under pressure in 2010 as the government deferred the construction of most large-scale pipeline projects. However, 2011 proved to be a turning point for the company, as the construction of a number of gas and oil pipeline projects started in 2011 under the 12thFive-Year Plan, which enabled the company to operate at high capacity ultilisation since the second half.

Shengli’s production capacity almost doubled from 640,000 tonnes in 2010 to 1.15 million tonnes in 2011. As China restarts and accelerates the construction of oil and gas transport pipeline networks, Shengli is on track to see its results significantly rebound over 2012-13, and its profits could possibly exceed that in the 2009 boom.

Exhibit 30: Shengli Pipe’s capacity has continued to grow Exhibit 31: Shengli Pipe’s revenue is likely to rebound in 2012E and 2013E, surpassing the 2009 boom

Source: Shengli Pipe, Guosen Securities (HK) Source: Shengli Pipe, Guosen Securities (HK)

6.2 Chu Kong Pipe: enjoying competitive edges in terms of production capacity and R&D

Chu Kong Pipe is the first Chinese company to introduce UOE production method in its LSAW production line and master deep-water pipeline manufacturing technology. Since its establishment in 1993, Chu Kong Pipe has been engaged in LSAW production, ranking No.1 in China for 10 consecutive years.

Chu Kong Pipe’s LSAW production capacity reached 1.3 million tonnes by the end of 2011, which is 2.6x that of the No.2 LSAW manufacture, implying a significant competitive edge in terms of capacity.

Besides, Chu Kong Pipe is a leading company in terms of R&D. As the first Chinese company to master deep-water LSAW manufacturing technology, Chu Kong Pipe has won CNOOC’s Liwan deep-water supply project.

Chu Kong Pipe delivered a total of 460,000 tonnes of pipes in 2011. As of December 2011, undelivered orders on hand already amounted to 380,000 tonnes, indicating the company is on course to enjoy strong momentum in 2012. At present, the stock trades at about 9x 2011E earnings.

0

20

40

60

80

100

120

140

160

2006A 2007A 2008A 2009A 2010A 2011E 2012E 2013E

10,000 tonnes

SSAW production capacity (10,000 tonnes) LSAW production capacity (10,000 tonnes)

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2009A 2010A 2011E 2012E 2013E

RMB mn

Shengli Pipe's revenue (RMB1 million)

As of September 2011, Chu Kong Pipe has received new orders of 755,000 tonnes of steel pipes.



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Exhibit 32: Major LSAW manufactures in China

Company Production line

LSAW capacity (10,000 tonnes)* Specification (mm) maximum

length (metre) Maximum

steel grade Note

Chu Kong Pipe JCOE+UOE 160 406-1,829 12.8 X80 Privately owned company

Shanghai Baosteel UOE 50 508-1,420 18.3 X100 State-owned company

Julong Steel Pipe JCOE 30 406-1,422 12.2 X80 A subsidiary of Sinopec

Wanchi pipe JCOE 30 508-1,524 12.2 X70 A subsidiary of Wanchi Group, the largest LSAW manufacturer in Taiwan

Shashi Steel Pipe JCOE 20 329-1,422 12.2 X80 A subsidiary of Sinopec

BSS Petro Pipe JCOE 20 508-1,422 12.2 X100 A subsidiary of CNPC

Source: Guosen Securities (HK) Note: * production capacity in 2011E

6.3 CIMC Enric: one-stop natural gas solution provider well positioned to seize potential opportunities

CIMC Enric is an important platform for CIMC Group to increase its influence in the energy equipment market. The company’s energy equipment portfolio includes but not limited to:

CIMC Jingmen Hongtu Special Aircraft Manufacturing Co., Ltd. (the largest LPG storage and transport equipment manufacturer in China with a market share of over 70%)

Shijiazhuang Enric Gas Equipment Co., Ltd (the first CNG tank manufacturer in China, capturing a share of over 60% in China’s CNG storage and transport equipment market)

Zhangjiagang CIMC Sanctum Cryogenic Equipment Co., Ltd (a leading LNG tank manufacturer capturing a share of over 50% in stationary LNG tank market, NO.3 LNG vehicle cylinder and skid-mounted LNG fueling equipment manufacturer)

Nanjing Yangzi Petrochemical Design Engineering Company Limited (the company holds Class A certificate of qualification for engineering design, Class A certificate of qualification for engineering consultation, as well as certificate in pressure vessel design and pressure pipeline design, employs a first-class research team, and has over 10-year experience in engineering design)

We believe Zhangjiagang Sanctum will be the main engine driving the development of CIMC Enric, as it recorded a CAGR of more than 20% over the past five years. Sanctum’s business covers the entire LNG storage and transport process, including stationary cryogenic storage tank manufacturing, tank truck manufacturing, steel cylinder manufacturing, LNG mobile fueling station business, etc. CIMC Enric could only offer equipment to general contractors that were in responsible for the design work due to lack of the certificate in large-scale LNG storage station design, but the acquisition of Nanjing Yangzi Petrochemical Design Engineering has enabled CIMC Enric to combine design business with equipment manufacturing business to provide one-stop service, which further strengthens its market position.

CIMC Enric will benefit a great deal from the anticipated LNG boom, given its dominant position in a number of sub-industries (China’s largest LNG, CNG and LPG storage and

We believe Zhangjiagang Sanctum will be the main engine driving the development of CIMC Enric.

Zhangjiagang Sanctum’s business covers the entire LNG storage and transport process.



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transport equipment manufacturer in terms of market share), as well as its proactive efforts to seize potential opportunities.

Exhibit 33: CIMC Group’s presence in the energy equipment market

Offshore exploration

Oil products

Drilling Drilling

Extraction and Storage Extraction and Storage

Gas & oil seperation and processing Gas & oil separation and processing

Exploration

Drilling

Extraction

Oil & gas processing

LPG

Land transport

Natural gas

LNG gasification dock/export

station

Onshore LNG gasification

satation

Oil products depot Dock

Onshore exploration

Ocean transport PipelineLand

transportOcean

transportPipeline

LNG tank

station

Ocean transport

LPG storage and distribution station

LNG receiving terminal

LNG satellite receiving station

Residential consumption, Business, Industrial production, Auto...

SecondaryLNG/LCNG fueling station

Secondary CNG

fueling station

Land transport

Primary CNG fueling

station

Standard CNG fueling

station

LPG fueling station

Land transport

Petrol station

pressure regulating

station

Land transport

Land transport

Storage and transport

Terminal

Zhangjiagang Sanctum

Shijiazhuang Enric Gas Equipment

Jingmen Hongtu

Source: CIMC Group, Guosen Securities Note: Zhangjiagang Sanctum, Shijiazhuang Enric Gas Equipment and Jingmen Hongtu are subsidiaries of CIMC Enric

7 Risk Factors

Pipeline construction activities turn out to be slower than expected. As the funding for pipeline projects mainly come from CNPC and Sinopec, pipeline construction activities could slowdown due to lack of financial support and fail to achieve targets outlined in the 12thFive-Year Plan. Besides, if the central government tightens policies, the construction of large-scale pipeline networks could also slow down, which will in turn exert negative impact on pipeline manufacturing companies.

China’s LNG import growth lacks momentum. China’s natural gas equipment market will be highly dependent on natural gas supply in the next few years. As a main source of imported natural gas, LNG supply has significant impact on demand for downstream natural gas equipment, such as natural gas tanks, natural gas fueling equipment, etc. If LNG imports miss expectation, demand for downstream LNG equipment will weaken accordingly.

The three key risks for the gas transport industry in general are: 1) if financial support weakens; 2) pipeline construction slows as the government tightens regulations; and 3) the lack of LNG supply impacts the demand for downstream equipment.



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Exhibit 34: Valuation of major listed companies

Ticker Company Last price (HK$)

Market cap (HK$100 mn)

EPS (HK$) 2011 PE (x)

Rating 2009A 2010A 2011A

1080.HK Shengli Pipe 0.91 23.30 0.35 0.04 0.05 19.6 Buy

1938.HK Chu Kong Pipe 2.72 26.80 0.60 0.08 0.28 9.6 Buy

3899.HK CIMC Enric 4.20 36.00 0.12 0.17 0.37 11.3 Buy

Source: Guosen Securities (HK), Company data, Bloomberg, data as at April 1, 2012



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Information Disclosures

Stock ratings, sector ratings and related definitions Stock Ratings: Buy: A return potential of 10 % or more relative to overall market within 6 – 12 months. Neutral: A return potential ranging from -10% to 10% relative to overall market within 6 – 12 months. Sell: A negative return of 10% or more relative to overall market within 6 –12 months. Sector Ratings: Buy: The sector will outperform the overall market by 10% or higher within 6 –12 months. Neutral: The sector performance will range from -10% to 10% relative to overall market within 6 –12 months. Sell: The sector will underperform the overall market by 10% or lower within 6 – 12 months.

Interest disclosure statement The analyst is licensed by the Hong Kong Securities and Futures Commission. Neither the analyst nor his/her associates serves as an officer of the listed companies covered in this report and has no financial interests in the companies. Guosen Securities (HK) Brokerage Co., Ltd. and its associated companies (collectively “Guosen Securities (HK)”) has no disclosable financial interests (including securities holding) or make a market in the securities in respect of the listed companies. Guosen Securities (HK) has no investment banking relationship within the past 12 months, to the listed companies. Guosen Securities (HK) has no individual employed by the listed companies.

Disclaimers The prices of securities may fluctuate up or down. It may become valueless. It is as likely that losses will be incurred rather than profit made as a result of buying and selling securities. The content of this report does not represent a recommendation of Guosen Securities (HK) and does not constitute any buying/selling or dealing agreement in relation to the securities mentioned. Guosen Securities (HK) may be seeking or will seek investment banking or other business (such as placing agent, lead manager, sponsor, underwriter or proprietary trading in such securities) with the listed companies. Individuals of Guosen Securities (HK) may have personal investment interests in the listed companies. This report is based on information available to the public that we consider reliable, however, the authenticity, accuracy or completeness of such information is not guaranteed by Guosen Securities (HK). This report does not take into account the particular investment objectives, financial situation or needs of individual clients and does not constitute a personal investment recommendation to anyone. Clients are wholly responsible for any investment decision based on this report. Clients are advised to consider whether any advice or recommendation contained in this report is suitable for their particular circumstances. This report is not intended to be an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. This report (including any information attached) is issued by Guosen Securities (HK) Brokerage Co., Ltd, a member of Guosen Securities Co., Ltd. Some parts of the report may have been originally published in Chinese, within the People’s Republic of China, by Guosen Securities Co., Ltd. That material has been reviewed, translated and, where applicable, adapted by Guosen Securities (HK) Brokerage Co., Ltd. This report is for distribution only to clients of Guosen Securities (HK). Without Guosen Securities (HK)’s written authorization, any form of quotation, reproduction or transmission to third parties is prohibited, or may be subject to legal action. Such information and opinions contained therein are subject to change and may be amended without any notification.

april 3, 2012 natural gas transport equipment sector buy

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