INDUSTRY OVERVIEW OVERVIEW OF THE PETROLEUM INDUSTRY AND SUPPLY CHAIN

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1 Certain information and statistics set out in this section and elsewhere in this document are derived from various government and other publicly available sources, and from the market research report prepared by Nexant, an independent industry consultant that was commissioned by us (the Nexant Report ). We have agreed to pay Nexant a total fee of US$192, for the preparation of the Nexant Report. Nexant is a global advisory firm with over 7 employees globally, including those located in the PRC. Nexant provide high value-added services and software-based products for the global energy and chemicals industries. The information extracted from the Nexant Report should not be considered as a basis for investments in the H Shares or as an opinion of Nexant with respect to the value of any securities or the advisability of investing in our Company. We believe that the sources of such information and statistics extracted from the Nexant Report are appropriate in this context and we have taken reasonable care in extracting and reproducing such information and statistics. We have no reason to believe that the information and statistics are false or misleading or that any fact has been omitted that would render the information and statistics false or misleading in any material respect. The information has not been independently verified by us, the Joint Sponsors, the [REDACTED], the [REDACTED], the [REDACTED], the [REDACTED] or any of our or their respective directors, officers or representatives nor is any representation given as to its accuracy or completeness. Accordingly, you should not place undue reliance on such information and statistics. The Directors confirm that, after making reasonable enquiries, there were no material adverse changes in the market information since the date of the Nexant Report which may qualify, contradict or have an impact on the information in this section. OVERVIEW OF THE PETROLEUM INDUSTRY AND SUPPLY CHAIN The petroleum industry is one of the largest industries in the world, with the top 2 largest oil and gas companies combined annual revenue being estimated at more than US$4 trillion. The petroleum industry and supply chain mainly cover: (i) upstream industries: exploration and production of crude oil, (ii) midstream industries: transportation and storage of crude oil; and (iii) downstream industries: processing crude oil into refined petroleum and petrochemical products as well as distribution and marketing, which focus on delivering products to end users. These activities occur within a global marketplace, supported by an extensive physical infrastructure that includes drilling rigs, transportation, storage facilities, refineries, petrochemicals plants, product terminals and service stations. This infrastructure links an international network of industry participants comprising numerous producers, refiners, petrochemicals producers, marketers, consumers and traders buying as well as selling crude oil and products throughout this value chain. 78

2 Trade Analysis of Global Crude Oil Industry Crude Oil Trading Crude oil is one of the most actively traded commodities in the world. Crude oil trade is expected to grow as most of the refining activity growth is expected to take place in the locations where regional crude is declining or stagnating, with Asia s growing demand for refined petroleum products expected to boost trade over the next several years. Global Crude Oil Trade Flows (Source: BP Statistical Review of World Energy 218, IEA, Nexant Analysis) Import (million tonnes per year) Export (million tonnes per year) Crude Oil Pricing Crude oil is the major cost element of refinery operations, and the price of which is the primary driver of refined petroleum product pricing. Although there are many different types of crude oil traded on global markets, in most cases their prices move similarly based on factors including quality, regional supply and demand as well as international freight costs. Major benchmark grades for crude oil include: (i) West Texas Intermediate ( WTI ), commonly used as the marker for both North America and South America crude oil; (ii) Dubai, together with Oman crude oil, the key marker used to establish prices for Middle Eastern crude oil shipped to Asia; and (iii) Brent Crude, the marker used for the pricing of many low-sulphur crude oils globally including the North Sea and West African crude oils. Historic volatility in crude oil markets have been influenced by, among others, the global economic performance, Organization of the Petroleum Exporting Countries ( OPEC ) dynamics, recurrent regional political tensions, supply-demand dynamics, market perceptions and speculative investments, investment cycles for refinery infrastructure and natural disasters. 79

3 Historical Crude Oil Prices Brent and differentials with Dubai and WTI (US$ per bbl) bbl) per (US$ Price Brent (1) Crude Differentials Brent Price, FOB Crude Differential (Brent - WTI) Crude Differential (Brent - Dubai) Crude Oil Trading Activities Crude oil trading activities comprise physical shipments of the crude and financial transactions. Market participants principally conduct such financial transactions with financial instruments which are linked to crude oil prices to manage risks and lock in the price for future delivery commitments, such as crude oil futures. Overview of Global Refining Industry Global Demand for Refined Petroleum Products Global demand for major refined petroleum products, namely gasoline, diesel and kerosene, is estimated at a combined 2.8 billion tonnes in 217. Gasoline and diesel, which are predominantly used as transport fuel, have the largest demand relative to other refined petroleum products. North America and Asia have the largest demand for refined petroleum products and such demands are expected to grow steadily. Demand for gasoline experienced strong growth from 213 to 217, driven by a rapidly expanding global population and increased vehicle ownership, particularly in the developing countries. Diesel has also driven the demand for refined petroleum products but has experienced a slower growth in demand in the past five years. However, such growth is expected to continue, especially in the commercial transportation and industrial sectors. The continued growth in demand for kerosene/jet fuel is expected to be driven by increasing air travel in the developing countries. Impacts of International Maritime Organization Regulations In the near term, refining margins are expected to be impacted by the implementation of the International Maritime Organization (IMO) regulations which limit the sulphur content of bunker fuel oil for shipping from 22. This is expected to result in a tightening of diesel supplies as ships seek lower sulphur fuels as an alternative to installation of flue gas scrubbing equipment which may result 8

4 in widening price differentials between diesel and bunker fuel oil, increased volatility at the time of the change, and a potential near term increase in refining margins, especially for refineries which have the capability to process high sulphur crude oils and are equipped to upgrade fuel oil into middle distillates to meet the projected demand increase in diesel around 22. South East Asia Supply and Demand of Refined Petroleum Products South East Asia s demand for refined petroleum products has been growing steadily in recent years due to growth in population and consumer wealth, increased vehicle ownership and growing industrial activities. South East Asia has a significant deficit in gasoline and diesel supply, primarily in Indonesia which is a significant gasoline and diesel net importer. South East Asia relies on refined petroleum supply from other regions to meet its demand, including Middle East and India. Anticipated refinery capacity in Malaysia and Vietnam from 218 to 22 is not expected to meet the region s demand deficit. South East Asia Refined Petroleum Products Demand 12 1 Actual Forecast million tonnes Nelson Complexity Index (NCI) Gasoline Diesel Kerosene Nelson complexity index (NCI) compares the secondary conversion capacity of a petroleum refinery with the primary distillation capacity. The index provides an easy metric for quantifying and ranking the complexity of various refineries and units. To calculate the index, it is necessary to use complexity factors, which compare the cost of upgrading units to the cost of crude distillation unit. Refineries with a high NCI are sophisticated refineries which typically have a higher yield of more valuable products and can often process heavier and cheaper feedstock. As such, the NCI of a refinery may be considered a proxy for general cash margin potential of the refinery. Typical range of NCI for refineries globally is 4 to 15 with anything above ten representing a very complex refinery which mainly produces valuable products. In China, private-owned refineries generally have lower NCI compared to state-owned refineries. 81

5 Refining Margins Refining margins reflect trends in product supply-demand balances of feedstocks and end products and the resulting impact on plant operating utilization levels ( operating rates ). In the coming years, U.S. refineries are likely to benefit from the availability of low-cost crude oil and low fuel prices. European refineries are expected to be further threatened by the refinery upgrades underway in Russia to enable the production of vehicle fuels, particularly diesel, that meet EU emissions legislation and reduce the production of residual fuel oil. Asian refineries are expected to achieve slightly lower margins compared to refineries in the United States and experience a trend of higher investments in refining capacity compared to the rest of the world as well as integration with petrochemical production to provide margin enhancement. Global Gross Refining Margins (Source: Nexant Analysis, Forecast based on US$ 65 per bbl crude) 217) (constant bbl Actual Forecast per US$ Singapore - Complex NWE - Complex USGC - Complex China - Complex OVERVIEW OF THE PETROCHEMICAL INDUSTRY AND SUPPLY CHAIN Petrochemicals are chemical products derived from petroleum and other hydrocarbon sources. The substances are used in a wide variety of sectors include transportation, packaging, construction, agriculture, textiles, consumer goods and electronics. Therefore, petrochemicals demand typically closely reflect economic growth trends. Primary petrochemical building blocks can be divided into: (i) chemicals derived from methane such as methanol and ammonia; (ii) olefins, which primarily include ethylene and propylene; (iii) C4 Chemicals (including butadiene), which are especially used in the production of synthetic rubber and plastics; and (iv) aromatics, which includes benzene, toluene and xylenes, together as BTX. Petrochemical industry margins are subject to cyclicality with changes in supply and demand of feedstocks and end products as well as the operating rates being key factors that influence industry profitability. Additionally, the sector is highly capital-intensive. New investments usually occur following periods of sustained high profitability. 82

6 Global Supply and Demand for Petrochemical Products Global demand for major petrochemical products such as ethylene, butadiene, styrene and those in the polyesters value chain are expected to increase steadily from 218 to 222. Global Demand for Petrochemical Products and Market Share for China & Asia, 217 C onsumption CAGR (%) 6 1% 5 EVA MEG PX PTA PET 8% 4 HDPE Ethylene 6% EO 3 BD 4% SM 2 1 2% Bubble size = 217 demand at 5 million tons per year % Annual Average Consumption Increase (million tonnes per year) Olefins and derivative products Polyester value chain products China Share in Global Consumption Ethylene BD HDPE EVA Styrene EO PX MEG PTA China Asia Excl China Other Regions PET Demand for various petrochemical building blocks are impacted by the demands for their corresponding derivatives, which are further affected by the market dynamics of various downstream industries where such derivatives are applied. CHINA PETROLEUM AND PETROCHEMICAL INDUSTRY Overview of China Petroleum and Petrochemical Industry China s economic development has encouraged increases in consumption of refined petroleum and petrochemical products. In light of this growing need, the PRC refining and petrochemicals industry has experienced increased investment and production, as well as industry vertical integration and the development of related industries. The demand for refined petroleum and petrochemical products in China is primarily driven by population growth, industrial activity, transportation demands and affected by environmental policy and other regulations. The industry is expected to continue growing and adapting to challenges such as feedstock procurement, rising investment costs, further vertical integration and environmental pressures as well as shifts in the Chinese economy away from heavy industry. China Crude Oil Demand and Trading Analysis China is the largest crude oil importer in Asia with an estimated import quantity of 42 million tonnes in 217. China imports crude oil mainly from the Middle East and West Africa as well as countries such as Russia, though it has sought to diversify its source of supplies in recent years to enhance China s energy security. To satisfy China s increased demand, China s national oil companies have invested in overseas oil and gas production assets for the past two decades. 83

7 Crude oil trading in China is highly regulated. Only the companies with permits and quotas issued by the PRC government are able to import crude oil. The government typically grant crude import quotas on a periodic basis. The PRC government started allowing private-owned companies to import crude oil in 215 in an effort to increase competition in the oil and petroleum trading and domestic refinery industries, and to attract private investment and liberalize the sector. China Petroleum and Petrochemical Industry Policy Analysis China s petroleum industry is subject to extensive regulation by the central government. In particular, the NDRC has the authority to regulate all oil and gas projects in China. However, China has been moving towards a market-based pricing mechanism, as well as exhibiting a trend of improving environmental protection, increasing energy-efficiency, greater competition and more investments in high-value technology areas. In particular, government policies for pricing mechanisms have become more market-driven, with the government stepping in only when abnormal fluctuations occur. Policy changes in the PRC that have led to an increase in the number of crude oil import quotas granted to private-owned companies, and the lifting of restrictions on the construction of refineries by private-owned companies have increased the number of participants in the PRC refining industry. Crude oil pricing in China is market-based. However, refined petroleum products pricing remains subject to government guidance. The NDRC promulgated reforms for the refined petroleum market in March 213. Changes included adjusting product prices every ten working days to better reflect price fluctuations in the global oil market. Petrochemical product pricing in the PRC is relatively less-regulated compared to the refined petroleum products. There is no regulatory pricing controls nor caps and generally petrochemical product pricing reflects the supply-demand dynamics of the market. CHINA REFINING INDUSTRY Demand of Major Refined Petroleum Products in China China s demand for refined petroleum products namely, gasoline, diesel and kerosene, has grown at an CAGR of 3.3% from 213 to 217. Particularly, gasoline demand has grown rapidly, driven by rising consumer income, further urbanization and increased passenger travel as well as the increased demand for high quality fuels. China is gradually moving away from a manufacturing and export-oriented economy, leading to weaker diesel demand in the industrial, mining, construction and commercial transportation sectors. However, diesel demand in the shipping industry is expected to increase, as ship owners partially switch to diesel to meet the IMO s fuel mandate, starting in 22. See Overview of the Petroleum Industry and Supply Chain Overview of Global Refining Industry Impacts of International Maritime Organization Regulations. 84

8 Demand for kerosene in China is driven primarily by the civil aviation industry. China Refined Petroleum Products Demand (Source: National Bureau of Statistics of China, Nexant Analysis) million tonnes Actual Forecast Gasoline Diesel Kerosene Gasoline Diesel Kerosene CAGR ('13-'17) 7.6% -.3% 9.7% CAGR ('18-'22) 3.3% 3.1% 4.2% Total 3.3% 3.3% China Refining Capacities China s refining capacity has grown from 12.1 million barrels per day (bpd) in 213 to 14.6 million bpd in 217. Two of China s large state-owned oil companies own a majority of China s overall refining capacity in 217. Additionally, private-owned refineries account for almost 3% of overall refining capacity. International oil companies have also sought to establish positions within the Chinese refined petroleum products sectors. Recent development in China s regulations and environmental protection is likely to result in obsolescence of smaller, simpler and less efficient refineries. China Refining Capacity (Source: Nexant Analysis) Refining Capacity Refinery Ownership by Company, 217 per day million barrels Actual Forecast Company D 2% Sinochem 2% Other 25% Company C 5% Company B 38% Company A 28% 85

9 Trade Analysis of China Refined Petroleum Products Although the growth of the refining capacity in the PRC has outpaced the growth in demand for refined petroleum products, the government continues to monitor and manage the excess capacity. The PRC government strictly controls the export quotas for gasoline, diesel and kerosene, and both state-owned and private-owned refineries can only export refined petroleum products within given quotas every year. Accordingly, China s refining industry remains principally focused on supplying domestic needs. China Refined Petroleum Products Export (Source: National Bureau of Statistics of China, GTIS, Nexant Analysis) 25 Actual Forecast million tonnes Gasoline Diesel Kerosene CHINA PETROCHEMICAL INDUSTRY Supply and Demand of Selected Olefins and Derivatives Industry in China Driven by rapid urbanisation and industrial development, China s petrochemical industry has grown at a much faster pace compared to other countries or regions in the world. Growth remains closely linked to China s overall economic growth with several products growing faster than GDP growth. The pace of China s industrial growth is illustrated by China s ethylene consumption share of global demand which has increased from 5% in 2 to 12% in 21 and 16% in 217. Despite being somewhat constrained by feedstock availability, significant supply growth has been achieved by greater integration between refining and petrochemicals as well as investment in coal based technologies. With ethylene a key building block for the petrochemical industry, strong ethylene supply growth has encouraged significant downstream industry investment. Despite this significant development in the Chinese petrochemical industry, many products remain in deficit and require significant imports to meet demand. This includes products such as HDPE, EVA and styrene monomer. Over the forecast period through 219 to 222, the country is expected to be more self-sufficient for some products due to domestic capacity additions in excess of 86

10 demand growth. However, import requirements for HDPE is expected to increase, supported by high demand growth. HDPE and SM are currently in deficit and are expected to remain so in 222. Generally, demand growth for ethylene, butadiene, HDPE, EVA and SM in China is higher than the global average. Consumption and Net Trade of Selected Olefins and Derivatives Products in China (213, 217, 222) Consumption Net Trade tonnes per year Million tonnes per year Million '13-'17 Growth '17-'22 Growth -6 (Import) -7 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 Ethylene Butadiene HDPE EVA SM EO Ethylene Butadiene HDPE EVA SM EO 7.5% 3.4% 6.3% 9.7% 2.1% 9.9% 6.9% 5.6% 4.5% 4.% 3.6% 1.8% Supply and Demand of the Polyester Value Chain in China China is by far the world s largest consumer of polyester chain products including MEG, PX, PTA and polyesters. The whole polyester industry is mainly driven by textile industry. Consumption of polyester products in China represented more than 5% of the global consumption in 217. Demand for fiber-grade polyesters account for more than 8% of the total polyester demand in China whilst the remaining portion is demand for bottle-grade PET and film. PX and MEG are the key raw materials for the polyester value chain. PX production is typically closely integrated with crude oil refining through aromatics production, whilst MEG is mainly produced from ethylene which is typically integrated to crude oil refining or via coal based MEG plants in China. PX and MEG are currently in deficit and are expected to remain so until 222. Consumption and Net Trade of Polyester Value Chain in China (213, 217, 222) Million tonnes per year Growth Growth Consumption Million tonnes per year -14 (Import) -16 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 '22 '13 '17 ' PX PTA MEG Polyesters PX PTA MEG Polyesters 9.2% 6.8% 7.% 6.8% 4.8% 4.4% 4.6% 4.8% Net Trade (Export) 87

11 CHINA STORAGE AND LOGISTICS ANALYSIS Overview of China s Storage and Logistics for Third Party Customers The storage and logistics industry links the supply and demand sides of the petroleum and petrochemical industries. Operators provide commercial storage and logistics services as well as other value-added services for third-party customers including trading companies, distributors, the PRC government and various industry participants. Such operators differentiate themselves from their competitors by the geographic and capacity of their storage facilities, size of storage facilities, access to logistics infrastructure and transportation, customer relationship, reputation, as well as their ability to provide various value-added services. The industry average storage utilization in China is approximately 75%-85% depending on the nature of the storage facility. The storage and logistics industry in China is fragmented with many players, including state-owned companies, private-owned companies and international storage operators offering storage facilities for crude oil, refined petroleum and petrochemical products. Storage and Logistics Industry Dynamics In China, the main industry participants and their market share are shown below: Commercial Storage Capacity of Key Players by Product, 217 (Excluding SPR and facilities exclusively for internal use) (Source: Nexant Analysis) Commercial Storage Capacity of Key Players by Product 6, Capaciy/ thousand cbm 5, 4, 3, 2, 5,14 4,19 4,112 3,988 3, ,964 2,46 2,2 1,82 1, Sinochem Company E Company B Company F Company G Company A Company H Company I Company J Company C (1) Crude Refined Petroleum Products Fuel Oil Other Oil/Gas Chemicals Note: (1) Certain storage tanks used to store crude oil can also be used to store fuel oil. 88

12 CHINA MARKETING AND DISTRIBUTION Overview of China Marketing and Distribution Industry Refined petroleum products are distributed from refineries and storage facilities to end consumers via wholesalers or retailers. Wholesale deliveries are usually made directly from refineries to large customers, such as diesel for coal mines and factories. Retail sales of gasoline and diesel generally take place entirely at service stations. For wholesale businesses, competitiveness tends to be driven by their logistical capabilities and customer relationships rather than business size and site throughputs. Service station operators seek to differentiate themselves by their location and size, efficient logistics, brand image and scope of other services provided. Growing vehicle ownership, coupled with ongoing investment in road infrastructure, have driven the need for retail network expansion and increased site throughputs. China Marketing and Distribution Industry Policy Analysis The PRC government has historically sought to streamline the refined petroleum products retail sector through strict services station quotas, license approval processes and operational criteria. Recently, the government has been liberalizing the fuel retail business by encouraging private investment. Opportunities exist for further investments in merchandise and service activities such as convenience stores and related services. Such merchandise sales have grown significantly in Chinese cities as consumers have an increasing need for a one-stop lifestyle shop. Service stations are increasingly adopting new technologies such as e-payment to provide consumers with faster and more efficient services, as well as relying on digitization to optimize their supply chain. China Marketing and Distribution Industry Dynamics There are currently approximately 13, service stations in China, among which are a large number of service stations operated by many different private-owned petroleum companies. These independent companies are less competitive than state-owned companies and foreign-invested joint ventures due to their smaller scale, lack of vertical integration and limited logistics network. 89

13 China Refined Petroleum Products Retail Market, 217 (Source: Nexant Analysis) Domestic Refined Petroleum Products Market Share by Number of Stations Domestic Refined Petroleum Products Market Share by Volume Distributed Company B 24% Independent 25% Company B 37% Independent 56% International JV 2% Company A 16% Company C 1% Sinochem 1% International JV 8% Sinochem 1% Company C 1% Company A 28% Retail Refined Petroleum Products Pricing Mechanism In China, while the price of refined petroleum products is largely dictated by market factors, downstream retail prices are controlled via government reference prices. The NDRC may adjust such reference prices when fluctuations in international crude prices cause a change of more than RMB5 per ton of gasoline or diesel within a period of ten working days. Such pricing system takes into account the varieties of crude used to calculate the price changes. In addition, based on the current policy, retail refined petroleum products prices will not be raised if international crude oil prices rise above US$13 per barrel, or cut if prices fall below US$4 per barrel. Consumption tax, along with VAT and other minor taxes such as urban construction tax, additional tax of education, local additional tax of education and corporate income tax, also contribute heavily to the retail prices of gasoline and diesel. 9