The Price of Kinship in an Oil Empire

From Corporation, page 25 issue 383 September 1 2008
Translated by Liu Peng
Original Article: [Chinese]

PetroChina may be hurting on the books and in stock charts, but the EO has learned that much of the pain revealed in its August half-year report came from expensive linked transactions between it and subsidiaries under the same umbrella group, China National Petroleum Company (CNPC).

In the report, state-owned PetroChina revealed a 30% decrease in profits coupled with nearly 70% increase in costs for the first half of 2008 when compared to the same period last year.

The EO has learned that the performance hit in part came as unlisted sister subsidiaries demanded high prices for related-party transactions with their listed counterparts. And in the absence of timely agreements on prices, open contracts have left mounting accounts payable to the listed firms.

A related-party transaction is a business deal or arrangement between two parties who are joined by a special relationship.

Higher Transaction Price
On August 28th, PetroChina released its interim report showing that its turnover had reached 549.5 billion yuan, a year-on-year increase of 39.9%, in the first half of 2008. Despite this, its profit dropped 34.5% to 53.6 billion yuan, and operating expenses jumped by 66.3%. Much of that was due to a leap in expenses paid to CNPC and its subsidiaries, which rose to 38.35 billion yuan from 11.65 billion in the same period last year.

An oilfield equipment sales manager from PetroChina who wished to remain anonymous said the related transaction prices between the listed PetroChina and the CNPC's non-listed companies were high. The manager cited an example where a set of oil extraction equipment, which on the open market to a non-related client would have been sold for 100,000 yuan, but to an affiliated listed oil field company the same equipment would have cost 120,000 yuan.

"They have the same boss... It's like moving money from one pocket to another," he added.

The source stressed that, as mutual suppliers in the same corporate family, measures are used as a form of market protection. The listed companies guarantee that the non-listed companies 'have work and have food on the table', no matter how the market changes."

Many of the contracts between the listed and unlisted firms would usually lay out more general, large-scale committments, leaving specific product orders for later contracts. Prices would also leave room for adjustment over time.

For example, in August, non-listed companies under the PetroChina Daqing Oilfield Company raised prices on oil pumping equipment being sold to a listed company under the CNPC by 15%.

In an internal meeting last year, CNPC vice president Liao Yongyuan said that if contracts continued in such a way, "both winners and losers would continue to complain, and each side would stubbornly hold their ground and point fingers." Liao called for strict control of such pricing measures and the prevention of dulled enthusiasm for competition in the open market.

Open Contract Problem
High prices were just one issue. Impasses during negotiations have led to the use of open contracts, which have other consequences for balance sheets.

PetroChina CFO Zhou Mingchun said that in recent years, open contracts - which left prices unset - by unlisted CNPC subsidiares for services and products rendered to listed ones had created a lag in the settlement of payments. The high number of accounts payable had affected the disclosure of the listed firms' accounting information and CNPC's profits.

Industry insiders said that for many transactions between the listed and unlisted firms, the former would start off by setting a budget that the latter deemed too low to accomplish the job. Therefore, they either refused to sign a contract at all or signed an open contract instead.

A mid-level manager at CNPC thought that because these unlisted subsidiaries had been isolated from the market for so long, many of their products remained nailed to high prices. Meanwhile, PetroChina, as a listed company, was under pressure to integrate with the international market and thus had to squeeze its production costs. As a result, negotiations dragged on.

"Every year, CNPC's listed subsidiaries would sit down with the unlisted ones. Ultimately, the listed firms would give in," he added.