OREANDA-NEWS.  Fitch Ratings has affirmed Kunlun Energy Company Limited's (Kunlun) Long-Term Foreign-Currency Issuer Default Rating (IDR) of 'A', with a Stable Outlook. Fitch has also affirmed Kunlun's senior unsecured rating and the rating on Kunlun's US dollar senior unsecured notes at 'A'.

Kunlun's ratings are closely aligned with the credit profile of its ultimate parent China National Petroleum Corporation (CNPC; A+/Stable), in line with Fitch's Parent and Subsidiary Linkage methodology. Kunlun is rated one notch below CNPC's rating due to the close strategic and operational linkages, and the significant support Kunlun has received from CNPC and its subsidiary PetroChina Company Limited (PetroChina; A+/Stable).

Kunlun plans to acquire another CNPC group company, Kunlun Gas Co Ltd (Kunlun Gas) and expects to complete the transaction by 1H16. Fitch believes this proposed transaction reinforces the linkage between Kunlun and its parent. Fitch currently assesses Kunlun's standalone credit profile at 'A-', and the acquisition of Kunlun Gas could weaken its credit metrics if the transaction is entirely funded by debt. Fitch will re-assess Kunlun's standalone profile when there is greater clarity on the funding arrangement for the acquisition and the combined entity's investment plans.

KEY RATING DRIVERS

Credit Linked to Parent: Kunlun is 58.33%-owned by PetroChina, and its ultimate parent CNPC has a direct stake of 3.43%. Kunlun's operational linkage with its parent is highlighted by the substantial related-party sales and purchases and heavy reliance on funding from PetroChina. At end-2015, 44% of Kunlun's loans were extended by companies in the CNPC group. The percentage of loans from CNPC group companies declined from 86% at end-2014, as Kunlun started to tap more external funding. This commercially driven funding approach is not viewed by Fitch as a weakening in linkage.

Acquisition Reinforces Linkages: Kunlun plans to acquire 100% of Kunlun Gas, which is focused on downstream gas distribution, from PetroChina. Fitch believes the transaction reinforces Kunlun's strategic importance to PetroChina and establishes the company as the sole platform in natural gas distribution and utilisation under the CNPC group. Kunlun also plans to divest its exploration and production operations over time to focus on its gas mid- and downstream operations.

Ownership of Strategic Asset: Kunlun owns 60% of the Shaanxi-Beijing Line, which is the only natural gas pipeline supplying Beijing and which satisfies the bulk of the capital's gas demand. This asset, which accounted for around 60% of Kunlun's EBITDA historically and over 80% in 2015, provides highly predictable cash flow. Transmission volume continued to increase in 2015 with strong gas demand from Beijing, largely driven by the increase in gas-fired power generation capacity in the city.

The risk of structural subordination due to Kunlun's 60% ownership of the pipeline is balanced by the low debt levels at the subsidiary holding this asset, which has also led to strong dividend flow to Kunlun. Fitch's calculation of FFO for Kunlun excludes dividends attributed to minority shareholders of the subsidiary.

Credit Metrics to Weaken: Kunlun's EBITDA (excluding impairments and profit/loss of associate companies) declined 13% in 2015 to HKD13.9bn due to weakness in its upstream exploration and production operations amid low oil prices and weak LNG sales. However, pipeline EBITDA rose due to volume growth. The company managed to record positive free cash flows in 2015 because part of the capex for Shaanxi-Beijing Line IV was deferred. However, we expect Kunlun's capex to pick up from 2016, which would lead to negative free cash flows over the medium term and weaker credit metrics. Fitch expects capex to increase to CNY11bn (HKD14bn) in 2016 from HKD5.9bn in 2015. Kunlun's future financial profile also hinges on the final funding arrangement for the acquisition of Kunlun Gas.

LNG Return Still Low: Kunlun made substantial investments in liquefied natural gas (LNG) in previous years, in line with its parent's strategy. This business is less stable than Kunlun's core pipeline segment as the market is more competitive and demand for LNG is weak as prices for alternative fuels decline. The management is now committed to improve the utilisation rates of its LNG processing plants by expanding sales to new regions and new end-customers, and making very limited new investment in this segment.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Kunlun include:
- Single-digit growth for pipeline transmission volume, but decline in transmission tariff
- Mid- to high-single-digit growth in gas sales volume; unit gas sales margin below historical average
- EBITDA margin of 35%-40% in 2016-2019
- Annual capex of around HKD10bn-15bn in 2016-2019 (excluding payment for Kunlun Gas acquisition)

RATING SENSITIVITIES

Negative: Developments that may, individually or collectively, result in negative rating action include:
- Evidence of weakening linkages between CNPC and Kunlun
- Negative rating action on CNPC.

Positive: Developments that may, individually or collectively, result in positive rating action include:
- Positive rating action on CNPC, provided the linkages between Kunlun and CNPC remain intact
- Development of closer linkages with CNPC.

For the rating of CNPC, the following sensitivities were outlined by Fitch in its Rating Action Commentary of 20 November 2015:

Negative: Future developments that may, individually or collectively, lead to negative rating action include:
- A negative rating action on the sovereign
- CNPC's 'AA-' standalone profile may be lowered if its FFO-adjusted net leverage is over 2x and FFO fixed-charge cover is under 10.0x, on a sustained basis

Positive: Future developments that may, individually or collectively, lead to positive rating action include:
- A positive action on the sovereign, provided the rating linkages between the state and CNPC remain intact or CNPC's standalone credit profile remains at 'AA-'.