ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS

General

This discussion should be read in conjunction with the information contained in Item 18. Financial Statements. For numerous reasons, including those relating to our combined offering of the H Shares and ADSs completed in June 1997 (the “Combined Offering”), the economic reform programs of the Chinese government, changes in Chinese government policies concerning crude oil supply and pricing, the introduction of new taxes or changes in existing taxes such as consumption tax, income tax and value added tax, and the revaluation of our assets, the Financial Statements may not be indicative of our future financial results.

Critical Accounting Policies

The following discussion and analysis is based on our financial statements, which have been prepared in accordance with IFRS. IFRS varies in certain material respects from accounting principles generally accepted in the United States of America. We have summarized these differences and their effect on our stockholders’ equity as of December 31, 2002 and 2003 and the results of our operations for each of the years in the three-year period ended December 31, 2003, in Note 27 to the financial statements. Our accounting policies are set out on pages F-8 to F-14 of our financial statements.

The preparation of financial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the years reported. We based our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of whom form the basis for making judgments about the carrying amounts of assets and liabilities that are not readily apparent from other sources. On an on-going basis, management evaluates its estimates. Actual results may differ from those estimates under different assumptions and conditions.

The fundamental objective of financial reporting is to provide useful information that allows a reader to comprehend our business activities. To aid in that understanding, our management has identified “critical accounting policies”. These policies have the potential to have a more significant impact on our financial statements, either because of the significance of the financial statement item to which they relate, or because they require judgment and estimation due to the uncertainty involved in measuring, at a specific point in time, events which are continuous in nature.

These critical accounting policies include:

Impairments

If circumstances indicate that the net book value of an asset may not be recoverable, this asset may be considered “impaired”, and an impairment loss may be recognized in accordance with IAS 36 “Impairment of Assets”. The carrying amounts of long-lived assets are reviewed periodically in order to assess whether the recoverable amounts have declined below the carrying amounts. These assets are tested for impairment whenever events or changes in circumstances indicate that their recorded carrying amounts may not be recoverable. When such a decline has occurred, the carrying amount is reduced to recoverable amount. The amount of impairment loss is the difference between the carrying amount of the asset and its recoverable amount. The recoverable amount is the greater of the net selling price and the value in use. It is difficult to precisely estimate selling price because quoted market prices for our assets are not readily available. In determining the value in use, expected cash flows generated by the asset are discounted to their present value, which requires significant judgment in relation to sales volume, selling price and amount of operating costs.

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For the periods presented, no impairment loss was recognized or reversed in the statements of operations.

Depreciation

Property, plant and equipment are depreciated on a straight-line basis over the estimated useful lives of the assets disclosed in Note 2(c)(iii) to the financial statements, after taking into account their estimated residual value. We review the estimated useful lives of the assets regularly in order to determine the amount of depreciation expense to be recorded during any reporting period. The useful lives are estimated at the time the asset is acquired and are based on our historical experience with similar assets and taking into account anticipated technological changes. The depreciation expense for future periods is adjusted if there are significant changes from previous estimates.

Revaluation

As required by the relevant PRC rules and regulations, our property, plant and equipment were revalued in connection with our Restructuring. Subsequent to that revaluation, property, plant and equipment are carried at the revalued amount, being the fair value as at the date of the revaluation, less subsequent accumulated depreciation and impairment losses. Revaluations are performed periodically to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date. The results of subsequent revaluations may have an impact on our future results to the extent the fair values of our property, plant and equipment change significantly.

Provision for Doubtful Debts

We maintain an allowance for doubtful accounts for estimated losses resulting from the failure of our customers to make the required payments. We base our estimates on the aging of our accounts receivable balance, customer credit-worthiness, and historical write-off experience.

Changes in provision for doubtful debts for each of the years in the three-year period ended December 31, 2003 are summarized as follows:

If the financial condition of our customers were to deteriorate, actual write-offs might be higher than expected.

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Overview of Our Operations

We are one of the largest producers of resins and plastics in China. The vast majority of our products fall within three principal product groups: (i) resins and plastics, (ii) synthetic rubber, and (iii) basic organic chemical products. We are also one of the largest producers of ethylene in China, accounting for approximately 11.8% of China’s total ethylene production in 2003. We use substantially all of the ethylene we produce to manufacture a broad range of downstream petrochemical products. We are a leading producer in China of LDPE, cis-polybutadiene rubber, butyl rubber, phenol, acetone, SBS and polypropylene.

Our principal raw material is cracking feedstock, mainly light industrial oil substantially all of which is purchased from our parent. Through a process which we developed, we also use naphtha, VGO, cracking wax oil, and hydrogenated raffinate oil as a substitute for light industrial oil. Since the establishment of the Sinopec Group in 1998, prices of light industrial oil and naphtha have been determined jointly by the NDRC of the PRC and the Sinopec Group. In 2003, the average State Prices of light industrial oil fluctuated in line with crude oil price and increased by 14.0% over the 2002 average State Prices. This increase has put pressure on our margin. See Item 4, Information on Company - Business Overview - Raw Materials, Water and Energy Supply - Cracking Feedstock.

Due to the fact that costs of raw materials are effectively beyond our control, we generally seek to increase profits by a combination of increased production volume, more efficient use of raw materials through more efficient procedures and technologies, shifting production into higher margin products, strengthening marketing efforts, and, in particular minimizing the lag between changes in customer demand and changes in our production. In 2003, we were able to turn the Severe Acute Respiratory Syndrome (“SARS”) epidemic to our advantage by completing a plant overhaul during the ensuing one-month shutdown. The shutdown did reduce production during 2003, but the overhaul eliminated production bottlenecks and resulted in increased production capacity without major capital investment. These factors, together with strong price increase for our products, more than offset the rise in raw material prices, and resulted in positive results for 2003.

In 2003, in spite of the influence of the war between the United States and Iraq and the SARS outbreak in China, China’s economy continued to grow at a high speed and the demand for petrochemicals remained strong. As a result of China’s accession to the WTO in December 2001, the cost for foreign enterprises to export petrochemicals into China has been reduced. China’s accession to the WTO has also had a significant impact on Chinese enterprises in terms of management mechanisms, as more foreign capital enters the Chinese market. Facing intensified market challenges, through calm observation and conscientious thinking, and adherence to the development path of “low input, high output”, we were able to cope with the situation, seize market opportunities, follow the established development strategies and accomplish the following tasks, and therefore significantly increased our results for the reporting period:

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Looking forward to 2004, since the international economic situation has had further improvements recently, the Board of Directors believes that internationalization will be an increasingly common phenomenon in the domestic market of China as a result of China’s accession to the WTO. The establishment and commencement of production of a number of joint venture petrochemical enterprises in China will not only intensify market competition, but will also exert significant influence on the production and operations of the petrochemical industry in China. Nevertheless, the Board of Directors is confident that the momentum of the continuous growth of China’s economy will further stimulate the increase in demand for petrochemical products. We plan to closely monitor the market’s development, seize market opportunities, make use of the advantages gained in the completion of the technology upgrading program, and further improve our operating results through continuous implementation of our development strategies. See Item 4. Information on Company - Business Overview - Business Strategy.

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The following table sets forth as percentages of total sales the principal operating expenses associated with our business.

For the year ended December 31, 2003, our total sales increased by 21.5% from RMB 9,443.1 million in 2002 to RMB11,473.9 million in 2003, which was itself an increase of 92.0% from RMB 5,975.3 million in 2001. In 2003, due to a one-month shutdown and overhaul, the sales volume of our eight principal products decreased by 4.1%, as compared with 2002. However, due to strong market demand and an increase in the prices of raw materials, the prices of our principal products increased substantially, and our total sales and profit also increased. For 2003, we recorded a profit before taxation of RMB 877.1 million, an increase of RMB 546.4 million compared with our profit before taxation of RMB 330.7 million in 2002, an increase of RMB 1,287.3 million compared to our loss before taxation of RMB 410.2 million in 2001. In 2003, we recorded a net profit of RMB 633.9 million, an increase of RMB 424.8 million from our net profit of RMB 209.1 million in 2002, and an increase of RMB 906.4 from our net loss of RMB 272.5 million in 2001.

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Raw material expenses were the largest component of the operating expenses. In 2001, 2002 and 2003, approximately 52.3%, 52.2% and 51.2% respectively of the cost of goods sold were expenses relating to purchases of cracking feedstock. In 2003, the total expense for purchasing cracking feedstock was RMB 4,976 million, as compared with RMB 4,366 million in 2002. This increase was largely because the prices of cracking feedstock increased in 2003 when compared with 2002 prices. The average price of the cracking feedstock in 2003 increased by 14.3% when compared with 2002 prices. In addition, the lower-priced cracking feedstock expense increased to 49.0% of the total cracking feedstock expense, as compared to 43.8% for year 2002.

Similar to other producers in the petrochemical industry and other bulk manufacturing industries, we are highly leveraged operationally. Because a significant portion of our expenses is either fixed (as in the case of depreciation expense for a given piece of equipment) or consists of stable unit costs (as in the case of cracking feedstock), fluctuations in sales, particularly those caused principally by changes in product prices, have tended to cause disproportionately larger fluctuations in profitability. In 2003, our operating margin increased to 9.1% from 5.7% in 2002 as a result of the large increase in the prices of our principal products and benefits from economies of scale.

Year ended December 31, 2003 compared with year ended December 31, 2002

Sales increased to RMB 11,473.9 million in 2003 from RMB 9,443.1 million in 2002, representing an increase of RMB 2,030.8 million, or 21.5%. The increase in sales was mainly due to the large increase in the prices of our principal products in 2003. Due to strong market demand and an increase in the prices of raw materials, petrochemical products in China maintained at a high price level in 2003, which resulted in an increase of 25.9% in the weighted average sales price of our eight principal products as compared to that of 2002 (the aggregate sales of the eight principal products representing 79.1% and 78.6% of the total sales for 2002 and 2003, respectively). The sales volume of our eight principal products decreased by approximately 4.1% in 2003 as compared with that of 2002 due to the one-month shutdown and overhaul; nevertheless, our sales revenue increased significantly.

Sales of resins and plastics, which accounted for 55.2% of our total sales, increased by 14.8% from RMB 5,514.1 million in 2002 to RMB 6,332.3 million in 2003. This increase was primarily attributable to the 21.2% increase of our weighted average price for resin and plastic products in 2003 as compared to that of 2002.

Sales of synthetic rubber, which accounted for 16.8% of our total sales, increased by approximately 35.6% from RMB 1,418.9 million in 2002 to RMB 1,923.8 million in 2003. The increase was primarily due to the 26.6 % increase in the sales price of synthetic rubber products in 2003 as compared to that of 2002.

In 2003, sales of basic organic chemical products, which accounted for 23.5% of our total sales, increased by 26.2% from RMB 2,140.2 million in 2002 to RMB 2,700.0 million in 2003. This increase was primarily a result of an increase in the price of our basic organic chemical products.

Sales of other products, which accounted for 4.5% of our total sales, increased by approximately 40.0% to RMB 517.8 million in 2003 from RMB 369.8 million in 2002.

Cost of sales increased by 16.2% to RMB 9,723.6 million in 2003, up from RMB 8,368.0 million in 2002. This increase was mainly due to the increase in the prices for raw materials and increased overhead costs resulting from normal shutdown and overhaul. Our gross profit increased by 62.8% from RMB 1,075.0 million in 2002 to RMB 1,750.4 million in 2003, as gross margin rose from 11.4% in 2002 to 15.3% in 2003.

Selling, general and administrative expenses increased by RMB 190.8 million (36.0%) to RMB 721.4 million in 2003 from RMB 530.6 million in 2002. This increase in selling, general and administrative expenses was primarily due to the increase in research and development expenses and other expenses.

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Our profit from 2003 operations was RMB 1,043.0 million, representing an increase of 92.6% when compared with the RMB 541.6 million from 2002 operations. Our operating margin increased to 9.1% in 2003, as compared with 5.7% in 2002. The increase in operating margin reflects improvement of the market operating situation as well as a realization of the benefits from our economies of scale.

Net financing costs in 2003 decreased by RMB 44.9 million from RMB 210.8 million in 2002 to RMB 165.9 million 2003. This decrease was primarily due to the repayment of certain bank loans in 2003 along with the increase of cash generated from operating activities and the corresponding significant decrease in expenditure of loan interest.

In 2003, we recorded a profit before taxation of RMB 877.1 million, representing an increase of 165.2% when compared with the profit before taxation of RMB 330.7 million in 2002. Our net profit for 2002 was RMB 209.1 million, and the net profit for 2003 was RMB 633.9 million, representing an increase of 203.2% compared to that of 2002. The net profit margin for 2003 increased to 5.5%, compared to 2.2% for 2002.

Year ended December 31, 2002 compared with year ended December 31, 2001

Sales increased to RMB 9,443.1 million in 2002 from RMB 5,975.3 million in 2001, representing an increase of RMB 3,467.8 million or 58.0%, and this was mainly due to the large increase in the production and sales volume of our principal products upon expansion of production. Due to market conditions, the price of petrochemical products in China remained at a low level in the first half of 2002, and the weighted average sales price of our eight principal products, which accounted for 74.0% and 79.1%, respectively, of total sales revenue of 2001 and 2002, decreased by 7.0% in 2002. However, the sales volume of these eight principal products increased by 81.6% in 2002 as compared with that of 2001, and thus increased sales revenue by large margins.

Sales of resins and plastics, which accounted for 58.4% of our total sales, increased by approximately 72.1% from RMB 3,203.2 million in 2001 to RMB 5,514.1 million in 2002. This increase was principally attributable to the commencement of operation of our expanded ethylene facilities that enabled us to increase the output of resin and plastic products from 553,000 tons per year to 1,055,000 tons per year. Although the weighted average price of resin and plastic products decreased by 10.1% in 2002, as compared with that of 2001, the large increase in the sales volumes has nevertheless resulted in a large increase in sales revenue.

Sales of synthetic rubber, which accounted for 15.0% of total sales, increased by approximately 53.3% from RMB 925.5 million in 2001 to RMB 1,418.9 million in 2002. The increase was primarily due to an increase in both the sales volume and the sales price of synthetic rubber products in 2002.

Sales of basic organic chemical products, which accounted for 22.7% of total sales, increased by approximately 55.9% from RMB 1,373.2 million in 2001 to RMB 2,140.2 million in 2002, primarily as a result of an increase in the output after renovation of our phenol and acetone units as well as an increase in the sales price resulting from the restoration of market share.

Sales of other products, which accounted for 3.9% of total sales, decreased by approximately 21.9% to RMB 369.8 million in 2002 from RMB 473.4 million in 2001.

Cost of sales increased to RMB 8,368.0 million in 2002 from RMB 5,660.2 million in 2001. The increase was mainly due to an increase in output, which also resulted in an increase in the consumption of raw materials and an increase in depreciation of the units newly put into use. Our gross margin increased from RMB 315.1 million in 2001 to 1,075.0 million in 2002, as gross profit rate mounted up from 5.3% in 2001 to 11.4% in 2002.

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Selling, general and administrative expenses decreased by RMB 34.8 million, or 6.2%, to RMB 530.6 million in 2002 from RMB 565.4 million in 2001. This decrease was primarily due to the substantial improvement in marketing efficiency and effectiveness, attained by the reorganization of our marketing system.

Our profit from operations in 2002 was RMB 541.6 million, compared with a loss of RMB 350.6 million in 2001. Our operating margin increased to 5.7% in 2002, as compared with -5.9% in 2001. The increase of operating margin has reflected the initial realization of benefits from the economies of scale upon completion of our expansion.

Net financing costs have seen a comparatively large increase to RMB 210.8 million in 2002 from RMB 59.6 million in 2001, primarily due to the capitalization of RMB 153.7 million loan interest during the period of constructions made under the Ethylene Project in 2001.

In 2002, we recorded a profit before taxation of RMB 330.7 million, as compared with a loss before taxation of RMB 410.2 million in 2001. Our net profit for 2002 was RMB 209.1 million, yielding a profit margin of 2.2%, as compared with our net loss of RMB 272.5 million and net profit margin of -4.6% in 2001.

US GAAP Reconciliation

Our accounting policies conform with IFRS, which differ in certain significant respects from US GAAP. See Item 18. Financial Statements - Note 27 for a discussion of the nature and effect of such differences. As a result of these differences and the tax effect therefrom:

Under IFRS, revaluation of property, plant and equipment is permitted and depreciation is based on the revalued amount. For the year ended December 31, 2003, additional depreciation arising from the revaluation of property, plant and equipment was approximately RMB 48 million for 2003, RMB 50 million for 2002, and RMB 50 million for 2001. Under US GAAP, property, plant and equipment is required to be stated at cost. Hence, no additional depreciation from the revaluation is recognized under US GAAP.

In 2001, we sold a polypropylene production facility of original cost of RMB 811.4 million and zero net book value to Yanshan Company, a related company, at a consideration of RMB 167.9 million, with a net gain of RMB 156.5 million. Under US GAAP, the gain from transfer of assets between entities under common control should be recorded as a capital transaction. See Item 7.B. Related Party Transactions.

In 2001, our parent bore staff redundancy cost of approximately RMB 100.8 million. Under US GAAP, the amount is treated as our expense with a corresponding increase in shareholders’ equity.

Currency Exchange

We have not historically received or utilized material amounts of foreign currency in our business operations, as substantially all of our sales are made in Renminbi and substantially all of our non-capital expenses are in the same currency. However, a significant portion of our capital expenditures, typically in connection with technology, machinery and equipment, are denominated in foreign currencies. In the past, we have satisfied our need for foreign exchange generally through foreign currency loans provided by PRC financial institutions (prior to the Restructuring, these loans were made through our then parent, Yanshan Company), and believe we will be able to continue to do so as necessary to meet our planned capital expenditure program.

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Taxation

We have been subject to China’s uniform income tax rate of 33% for all domestic enterprises throughout the periods covered by the Financial Statements.

Inflation

We believe that inflation within China has had only a limited effect on our operational results. Prices for our products have risen and fallen from time to time in a manner consistent with global petrochemical prices, regardless of the rates of inflation prevailing in China. However, we do believe that inflation has had an effect on certain of our expenses, such as those for utilities. In addition, inflation may have macroeconomic effects in China, which affect not only the pricing of our products and materials, but also overall levels of demand. For example, while we could benefit from a reduced rate of inflation, corrective government measures aimed at controlling inflation could also have the effect of inhibiting economic activity in China, which could, in turn, lead to adverse effects on our operational results.

B. Liquidity and Capital Resources

Our liquidity is primarily dependent on the ability to maintain adequate cash inflow from operations to meet debt obligations as they become due, and on the ability to obtain adequate external financing to meet its committed future capital expenditures. See Item 3. Key Information — Risk Factors - “Market cyclically and our high operational leverage may have a significant effect on our profitability” and “Our business may be adversely affected if we are unable to refinance our current short-term indebtedness with an equally favorable financing arrangement”. As of December 31, 2003, we had approximately RMB 231.4 million in cash and cash equivalents, RMB 1,088.4 million in short-term bank loans and RMB 1,596.4 million in long-term bank loans. We believe that our working capital and available bank loans are sufficient for our present requirements.

Our net cash flow derived from operating activities is generally much higher than net profit, mainly due to substantial depreciation. In 2003, our net cash flow from operating activities was RMB 1,616.6 million, representing an increase of RMB 579.5 million from RMB 1,037.1 million in 2002, and primarily adjusted by (i) profit before taxation of RMB 877.1 million, (ii) depreciation expense of RMB 890.8 million, and (iii) interest expenditure of RMB 142.8 million.

In 2002, our net cash flow from operating activities was RMB 1,037.1 million, representing an increase of RMB 655.8 million from RMB 381.3 million in 2001, and primarily adjusted by (i) profit before taxation of RMB 330.7 million, (ii) depreciation expense of RMB 806.1 million, which is partly offset by (iii) an increase of inventories in the amount of RMB 247.3 million, and (iv) an increase in trade and bills receivables of RMB 104.0 million.

In 2001, our net cash flow from operating activities was RMB 381.3 million, primarily adjusted by (i) loss before taxation of RMB 410.2 million, (ii) depreciation expense of RMB 525.4 million and (iii) a net decrease of RMB 269.2 million in operating assets and a RMB 428.9 million net increase in operating liabilities. Cash flow from operating activities was also reduced due to the payment of interest in the amount of RMB 207.1 million and income tax paid of RMB 128.3 million.

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Net cash used in investing activities were RMB 2,046.0 million, RMB 716.4 million and RMB 348.6 million in 2001, 2002 and 2003, respectively.

Our short-term and long-term loans are primarily obtained from PRC financial institutions. In 2003, we repaid RMB 3,065.1 million in short-term loans and RMB 719.8 million in long-term loans, and borrowed RMB 2,560.0 million in short-term loans and RMB 205.7 million in long-term loans. As of December 31, 2003, our total bank loans decreased by 27.5 % to RMB 2,684.8 million (including RMB 1,070.0 million in short-term loans and RMB 18.4 million in long-term loans due within one year) from RMB 3,703.9 million (including RMB 1,575.0 million in short-term loans, and RMB 201.4 million in long-term loans due within one year) as of December 31, 2002. As of December 31, 2003, our long-term bank loans of US$ 88.4 million were guaranteed by the Yanshan Company.

As of December 31, 2003, we were in compliance with the related financial covenants. There were no existing financial covenants that would impair our ability to undertake additional debt or equity financing. We believe that we will continue to comply with the financial covenants so that there will be no adverse effect on our ability to refinance funding from PRC financial institutions.

We believe that, based on our current estimates, our existing cash flow from operating activities will be sufficient to meet our financial requirements, including for our research and development activities and our anticipated capital expenditures.

C. Research and Development, Patents and Licenses, etc.

In 2003, we employed approximately 2,378 persons in research and development functions, of which 1,603 persons were engineering and technical personnel. We have a research and development department and a Resin Application Research Unit that focus on the development of product processing and new product applications. Each of our production units has a research team and pilot facilities, forming an integrated scientific research test system. In addition, our parent’s research and development unit provides us with research services in connection with new technologies, production processes and equipment for our business.

Our expenditures for research and development were approximately RMB 53.8 million, RMB 59.0 million and RMB 79.0 million in 2001, 2002 and 2003, respectively, accounting for approximately 0.9%, 0.6% and 0.7%, respectively, of our sales. We intend to increase our annual research and development budget as market needs require.

We continue to participate in a research and development program originally sponsored by China Petroleum and, subsequent to the Industry Restructuring, sponsored by the Sinopec Group, pursuant to which we typically pay an annual research and development fee in exchange for the right to utilize all new production processes, technologies, new products and new product applications developed by the Sinopec Group’s research institute for a nominal charge.

We use the trademark “yansan” which is owned by Yanshan Company. Yanshan Company has agreed to our use of this trademark. The detailed terms and conditions of the relevant licensing agreement are currently under discussion between Yanshan Company and us.

D. Trend Information

China’s market will become more internationalized as a result of China’s accession to the WTO. The establishment and commencement of production of a number of new joint venture petrochemical enterprises in the following years will further intensify market competition. The significant flotation in the prices of crude oil and petrochemical products in the international markets will also increase the difficulty in predicting the domestic market in the future.

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Nevertheless, due to the completion and stable running of our ethylene facilities with the Rated Capacity of 710,000 tons, the production process of our major products have reached the international level. Benefits from scale are fully implemented. We are restructuring our internal operation process to further improve our management and enhance our core competence.

We are confident that the momentum of gradual recovery of the world economy and high speed growth of China’s economy will continue to stimulate the increase in demand for domestic petrochemical products. We will closely monitor the market’s development, seize market opportunities, make use of the advantages gained in the completion of the Ethylene Project to further improve our operating results through continuous implementation of its development strategies.

E. OFF-BALANCE SHEET ARRANGEMENT

As of December 31, 2003, we do not have any off-balance sheet arrangements that have or are reasonably likely to have an effect on our financial condition, revenues or expenses, results of operations or liquidity, and that are material to investors.

We expect to incur capital expenditures of RMB 300 million, RMB 400 million and RMB 400 million in 2004, 2005 and 2006, respectively. Such capital expenditures will be used mainly for the technical improvement projects. We believe the cash flows from our operating activities and new bank loans will be sufficient to cover our expected capital expenditures for the above periods.

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