Shale Gas in China: How Far from Dream to Reality?
Shale gas has become one of the hottest topics in the Chinese energy market since the country’s first round tender for shale gas exploration in June 2011.
At the end of 2011, the State Council decided to regulate shale gas as an independent mineral from other oil and gas.
The sector has attracted interest from state-owned enterprises, especially those in traditional oil and gas, the coal mining and power industries as well as from private companies and foreign investors. The sector feels on the verge of a boom.
The Chinese government has been watching the shale gas boom in the United States and does not want to be left behind. It has been holding out incentives to shale gas producers in the form of tax benefits, grants and easy access to cheap credit. This has created great interest in the sector, but many of the companies crowding in have no technologies and little experience with shale gas.
Large Potential Reserves
According to a 2011 report by the US Energy Information Agency called “World Shale Gas Resources: An Initial Assessment of 14 Regions Outside the United States,” China has 107 trillion cubic feet of proven natural gas reserves and is one of only five countries with proven natural gas reserves of more than 100 trillion cubic feet. The other four countries are the United States, Australia, Algeria and Venezuela. The amount of technically-recoverable shale gas in China is 1,275 trillion cubic feet, 50% more than the 862 trillion cubic feet in the United States.
Chinese official figures differ from the US estimates. A paper by the CNPC Economics and Technology Research Institute in July 2012 estimates that the recoverable shale gas in China is 36.0825 trillion cubic meters (equivalent to 1,275 trillion cubic feet), around 20% of the world total proven reserves of 187 trillion cubic meters (equivalent to 6,607.77 trillion cubic feet). The figure quoted in this report is similar to the EIA estimate.
However, in March 2012, the Ministry of Land and Resources (MLR) said in a report that the recoverable shale gas in China is only 25.1 trillion cubic meters (equivalent to 886.93 trillion cubic feet). This conservative estimate is still more than the reserve of 862 trillion cubic feet in the United States. The shale gas development plan (2011-2015) issued by MLR in the same month repeats this estimate.
By April 2012, 58 shale gas wells had been completed in China. The first well, Yuye Well 1, was drilled in Pengshui, Chongqing in 2009. By contrast, thousands of shale gas wells have been drilled in the United States. The few operating wells in China make the reserve estimate less reliable.
Most of the on-shore shale gas is in the following five areas: the Upper Yangzi, Dian, Qian and Gui region, the Middle and Down Yangzi and South-East region, the North China and North –East region, the North-West China region and Qing Zang region. The Upper Yangzi, Dian, Qian and Gui region and the North China and North-East China region have around 46% and 20% of the total shale gas reserves in China respectively. The national oil companies (CNPC, Sinopec and CNOOC) are holding large blocks with shale gas potential there.
In terms of provincial distribution, Sichuan, Xinjiang, Chongqing, Guizhou, Hubei, Hunan and Shaanxi provinces or municipalities are relatively rich in shale gas and have nearly 68.8% of the total resource in the country.
In the two rounds of public tenders for 26 shale gas blocks in 2011 and 2012, the MLR did not provide any geological information or surveys to bidders. The information does not exist yet.
The national shale gas development plan (2011-2015) establishes the following targets by 2015: a complete national survey of shale gas reserves, selection of 30 to 50 proven shale gas areas and 50 to 80 favorable target areas, and production by 2015 of 6.5 billion cubic meters (229.52 billion cubic feet).
The plan lists 19 shale gas areas for exploration: Changning, Weiyuan, Zhaotong, Fushun-Yongchuan, Er West and Yu East, Chuan West-Langzhong, Chuan North-East, Anshuan-Kaili, Jiyang, Yanan, Shenfu-Lingxing, Qinyuan, Shouyang, Wuhu, Hengshanbao, Nanchuan, Xieshan, Liao River North and Cengong-Songtao. The shale gas blocks for the coming third round public tender are expected to be mostly in those areas. The plan also commits to increase the investment in shale gas exploration in these areas during the period 2016 through 2020 if there has been a breakthrough in exploration technology. Shale gas production is expected to reach 60 to 100 billion cubic meters by 2020. Compared to the US target of 250 billion cubic meters by 2020, China’s output is expected to be much smaller due to the late start and shortage of technologies.
Growing environmental concerns in China and scarcity of water are potentially limiting factors.
Some experts believe that the 2015 targets will be difficult to achieve. The main challenges are limited access to technologies, complex geological conditions (compared to the US), regulatory conflicts and weak infrastructure such as pipelines and liquefaction terminals.
On the other hand, the state-controlled oil companies are bullish. CNPC estimates that it will produce 1.5 billion cubic meters and Sinopec estimates 0.13 billion cubic meters. One local government, Chongqing, is planning to drill 150 to 200 shale gas wells by 2015 whose annual production will be 1.3 to 1.5 billion cubic meters. These plans could account for almost 50% of the national target of 6.5 billion cubic meters by 2015. The other local governments’ plans are still works in progress. One official in the MLR said that the estimate of 6.5 billion cubic meters is conservative.
Even if the 2015 targets are reasonable, the 2020 targets seem more ambitious. Some experts think that production will reach around 11 billion cubic meters by 2020, less than coal-bed methane production of 17 billion cubic meters. Realization of the 2020 target will require drilling 20,000 wells and US$65 to $100 billion for drilling and other infrastructure.
Time to Jump into the Pool?
Both wholesale and retail natural gas prices are regulated by the National Development and Reform Commission (NDRC). The residential use natural gas price is three times higher than in the US. For example, in Beijing, the current residential use natural gas price is RMB2.28 (US37¢) per cubic meter compared to roughly US14¢ per cubic meter in the United States. Although gas producers and importers such as PetroChina are facing huge losses in the upstream business, the government is reluctant to let them raise the downstream price for fear of a public backlash.
Shale gas investors will need to predict the gas price level in the future when any gas they produce will be brought to market. The natural gas pricing system is expected to undergo reforms with the goal of raising the price. Some gas producers in China are exporting gas even though the domestic gas demand cannot be met, in order to press policymakers for a domestic price increase.
Due to geological differences, gas wells cost 10 times more to drill in China than in the US. The drilling cost per shale gas well in the United States is between $2.7 million and $3.7 million compared to $27 million to $37 million in China.
The funding requirement for 20,000 wells by 2020 will be RMB400 to 600 billion (approximately US$65 to 92 billion). Regulators are hoping to spread the licenses in order to attract funding from more sources. In the first round shale gas tender, PetroChina and Henan CBM [coal-bed methane] were awarded licenses in exchange for funding commitments of RMB800 million. In the second round, 16 winning bidders agreed to contribute RMB12.8 billion by 2015. The majority of the funds will be used for drilling wells and related exploration activities. The winning bidders in the first two rounds included only two private companies and the rest are national or local state-owned enterprises. The state-owned enterprises are not expected to face funding challenges because of their easy access to cheap loans from Chinese state-owned banks. In the longer term as more private and foreign investors engage in the sector, there will be more concern about their financial strength and willingness to endure since they will have high capital spending initially without making a profit in a short term.
Demand for natural gas is expected to grow rapidly in the coming years in China, and the gap between demand and supply will widen. Shale gas will be needed. The growing demand for gas is being driven by a number of factors. First, air pollution is becoming of greater concern; a shift to gas helps. Coal-fired power plants and community heating plants in urban areas are being converted to run on gas. In Beijing, 263 turbines at coal-fired power plants will be replaced by gas turbines by the end of 2014. In Zhengzhou, the capital of Henan province and around 680 kilometers south of Beijing, 145 such turbines will be replaced by gas turbines. Other cities, such as Lanzhou and Xian, are also formulating their conversion plans. Second, a continuing trend toward urbanization in China will increase the number of residential gas consumers. Third, the amount of gas used to run autos and factories will increase. Chinese natural gas consumption is roughly 165 billion cubic meters in 2013, but it is expected to reach 350 to 400 billion cubic meters in 2020 and 500 to 550 billion cubic meters in 2030.
The technologies used to extract shale gas in the United States may not work in China. The geological conditions differ in China. Most Chinese shale gas is found at 1,500 to 4,000 meters below ground in Sichuan compared to 800 to 2,600 meters in the United States. New technologies may have to be found for use in China.
Horizontal well and fracking technologies used by American companies have been tried in China. Both technologies are controlled by foreign companies. PetroChina has cooperated with such companies as Shell, Chevron, Halliburton and Schlumberger, in different blocks, in order to learn about the technology.
Chinese companies seek any opportunity to acquire intellectual property from foreign partners. In 2012, three national oil companies completed major overseas acquisitions that were closely connected with shale gas. Sinopec acquired a 33.3% interest from Devon Energy in five shale oil and gas basins and said in March 2013 that it is looking for other overseas shale gas assets to acquire. CNOOC closed on a $15.1 billion takeover of Nexen, which holds shale gas assets in Canada. PetroChina acquired a 49.9% interest from Encana in the Duvernay shale gas project in Canada.
Water consumption, wastewater treatment, greenhouse gas emissions and other environmental pollution are being raised by opponents of shale gas development.
Water consumption will be a challenge since China is a country badly lacking in water. According to a report by Accenture, a consultancy, drilling and fracking will consume around 19,000 tons of water per well. Except for the Sichuan and Jianghan Basins, all the other shale gas accumulation areas overlap with water shortage areas. For example, in north Western and northern China, underground water must be extracted first and then injected back into the shale gas wells. The polluted surface water is not useable. The vast amount of extraction of underground water will reduce the water table and could lead to salt-water encroachment.
Water pollution is another major concern. The water injected into shale gas wells is accompanied by around 700 kinds of additives and poisonous materials, such as lead. This could cause pollution of underground water. Even under the strictest and most advanced environmental regulation in the US, such pollution seems inevitable. Very tough environmental regulation is expected in China as China tries to learn from the US experience.
The “shale gas curse” is another headache for gas producers. In the United States, producers would like to flare the extracted gas during periods when low gas prices and high transportation costs make gas uneconomic to produce. This is an alternative to shutting in wells. Flaring will not be an option in China in the next five to 10 years. But potential gas producers in China may have no alternative if the infrastructure, such as pipelines and liquefaction terminals, are not ready when the gas wells come on line. PetroChina and Sinopec are concentrating on construction of pipelines in order to control a potential bottleneck for other producers. During the exploration period, some flaring of gas is inevitable. However, the air pollution from carbon dioxide and methane emissions during exploration have shocked investors and environmentalists.
Earthquakes are another potential nightmare for shale gas development. Some countries, such as France, Bulgaria and Switzerland, have held shale gas producers at bay due to concern about the potential for induced earthquakes. Even in the United States, the state of New Jersey still bans fracking for natural gas. In May 2008 and again in April 2013, earthquakes occurred in Sichuan which is believed to be the richest area of shale gas.
Regulation of the shale gas industry is jointly undertaken by at least six authorities at ministerial level, including the National Development and Reform Commission (NDRC), Ministry of Land Resources (MLR), Ministry of Finance (MOF), Ministry of Environmental Protection (MEP), Ministry of Science and Technology (MOST) and the State Administration of Taxation (SAT).
The challenge will be how to get so many regulators on the same page.
NDRC is responsible for shale gas industrial policies and planning, including targets, transportation, consumption and pricing. MLR is in charge of public tenders of shale gas blocks and the thresholds for entry. MOF and SAT work jointly on fiscal incentives, such as grants and preferential tax policies. MOST runs a program for improving and inventing technologies that work in Chinese geological conditions. MEP will also play a significant role because of its responsibility for underground and surface water protection, wastewater treatment and recycling, air pollution and protection of species of animals and plants.
The government will also have to address legal issues with overlapping of shale gas blocks with traditional oil and gas blocks. To date, China has issued only two or three rules about shale gas. Shale gas producers are looking for guidance otherwise to regulations on producing coal-bed methane. Coal-bed methane was an area of great interest to domestic and foreign investors from the 1990s until three or four years ago when investors decided the government would not solve the problem of overlapping rights to coal miners and coal-bed methane producers. Shale gas will have the same problem. The national oil companies hold the rights to most of the high potential oil and gas blocks, including some that overlap with shale gas blocks. It is one reason that they did not participate in the second round tender last year.
There is also uncertainty around a short-term grant program for shale gas. Chinese national and local government grants are only available for shale gas between 2012 and 2015. The national government offers cash grants of RMB0.4 (about US6.5¢) per cubic meter. Local governments may supplement the national grant. Blocks in the first two rounds of tenders will not be in production by the end of 2015.
Notwithstanding all of the issues, foreign investors are welcome in the shale gas sector. The third round public tender for shale gas is expected to be announced in the second half of 2013. The aggregate size of the blocks offered in round three may be more than the total size of 24,236.77 square kilometres in the first two rounds. Although no foreign investors were awarded blocks, directly or indirectly, in the first two rounds, the Chinese government has made the participation thresholds clear: participation by foreign investors must be through a sino-foreign equity joint venture in which a Chinese party holds a majority of the shares, with at least RMB300 million of registered capital, and the venture or the partners must have experience in oil or gas exploration.
Most major foreign oil and gas companies prefer to enter into product sharing agreements or PSAs. They have been using the PSA model for Chinese oil fields since coming to China years ago. A shale gas PSA between Shell and CNPC was approved by the Chinese government on March 27 this year for drilling in the Fushun-Yongchuan block in the Sichuan Basin. This is the first PSA approved for foreign involvement in the shale gas sector. Shell will contribute its technology and operating expertise in an effort to reduce the drilling cost per well from $12 million to $4 million. This block is viewed as the first commercial shale gas project in China. Shell committed to contribute $1 billion at a minimum each year of the joint venture to fund exploration. An advantage of the PSA model is that Shell can exit easily without having to go through a complicated approval procedure.
The other oil giants like Statoil, ConocoPhillips, BP, Chevron and Exxon Mobil have signed joint study agreements with Chinese national oil companies. Following Shell’s PSA, these giants will probably pursue the PSA model by transforming their study agreements into PSAs.
Another approach to entry is to acquire or enter into a cooperation agreement with a local oil or gas field service provider. The well drilling and completion service market is expected to grow in the next five to 10 years from the current RMB100 billion to RMB180 billion in 2015 and RMB400 billion in 2020.
The Path Forward
The European Union has been proceeding cautiously to embrace shale gas, and Aleksey Miller, CEO of the Russian gas giant Gazprom, believes that shale gas is a “soap bubble” and will burst soon. The Russian government appears not want to follow the American “seducement.“ In contrast, China, the country with the largest energy consumption, is keenly interested in any brand new programs proposed by the US in sectors like coal-bed methane and shale gas. China wants energy supply security. Its weak innovation capability requires that it try to learn from what others are doing.
Shale gas is a great opportunity for investors, but it poses more challenges and risks for China. Fresh water, clean air and a healthy environment are becoming significant political issues in China. Before tumbling headlong into rapid development of shale gas, China needs to do more homework into the technology, environmental protection, incentive policies, shale gas licensing reform and infrastructure construction. It needs to avoid the same mistakes as in renewable energy, where a rapid expansion of the sector was followed by overcapacity. There is still a significant distance to go from dream to reality.