The National Energy Administration published a set of guidelines for the shale gas industry in late October. The guidelines follow publication of a five-year plan for development of shale gas last year.

China considers shale gas development of national strategic importance, and more financial support for exploration and development of shale gas is expected from governments on both the local and national levels.

Environmental pressures are forcing large Chinese cities to switch from coal and oil to natural gas for heating and generating electricity. Beijing has already completed most of its transformation. However, this has put strains on gas supply. The three main gas suppliers in China — CNPC, Sinopec and CNOOC —lack the production capacity to meet the skyrocketing demand. China is expected to face a gas shortage this coming winter of more than 10 billion cubic meters.

The Chinese authorities are now blocking any further fuel switching to gas without first obtaining approval and sourcing the gas supply. The supply to some industrial users has been limited and even terminated in areas with the worst shortages, such as northern and eastern China. This is one reason why there is such strong interest in shale gas. The Chinese have watched the shale gas boom in the United States with great interest. China has the largest technically recoverable shale gas reserves in the world.

Output Figures

There have been two rounds of public tenders for shale gas. CNPC and Sinopec have already reached production targets in their respective blocks.

CNPC has built two national shale gas demonstration areas in its blocks in Changning, Weiyuan and Zhaotong. Its total investment to date is above RMB4 billion. Well #201 in the Changning block is the first commercial horizontal shale gas well in China.

CNPC had completed 44 wells by the end of August, 20 of which are horizontal wells. Of the 44 wells, only five of them can reach production levels of 100,000 cubic meters per day. The total annual commercial gas production in these blocks is around 60 million cubic meters. According to CNPC’s plan, gas production in the two demonstration areas will be 2 to 3 billion cubic meters a year, of which 1.5 billion cubic meters will be commercial gas.

Sinopec has increased its production estimate dramatically to 4 billion cubic meters a year by 2015 from its blocks in Fuling in Sichuan province and the blocks have been approved as a national shale gas demonstration area. The 30 test wells in the Fuling block should produce 500 million cubic meters in 2013. The daily production of one of the wells reaches 547,000 cubic meters, which is the highest output of all 150 existing shale gas wells in China as of September. These output figures should help

Sinopec greatly out distance the other major players in shale gas such as CNPC, CNOOC and Yanchang Oil.

China has set a goal of producing shale gas at a rate of 6.5 billion cubic meters a year by 2015.

Impediments

Most winners in the first two rounds have not begun their drilling work yet due to funding or technology limitations.

Funding and technology are still big barriers to entry. The new national guidelines require that anyone engaging in exploration and development of shale gas in China must have the financial capability to do so, sound financial standing and a sound accounting system. One of the reasons that winners in the first two rounds of tenders have not moved quickly is that they are mostly local state-owned enterprises without strong financial capability. They do not have the financial means to support high-risk exploration. It will be difficult for them to find a financial footing in the short term since China does not have a well-developed project finance market. Many are trying to raise money by transferring part of their interests in exploration blocks or by making other arrangements such as joint ventures or production sharing arrangements.

The new guidelines emphasize that the government encourages multiple investors, including private enterprises, to invest in shale gas exploration. In the second round tender, two private companies were granted blocks in Guizhou province that have the most difficult geographic conditions among all the offered blocks that round. One of the two private companies has been trying to transfer its rights due to lack of funding and exit the industry, but no buyer wants to take on the challenge. The company faces a potential loss of all its investment if it cannot find a buyer. The government will get the blocks back for free if the holders breach their investment commitments.

No private companies are allowed to do conventional oil and gas exploration in China. The technology related to conventional gas exploration is controlled by state-owned oil and gas companies. These companies have developed technologies that are specially adapted to the geology in China. Although private companies can obtain the rights to shale gas blocks, they have to rely on state-owned companies for access to technology, and the state-owned companies charge as much as foreign technology owners for licenses. Foreign technology holders have not been interested in licensing to private companies, preferring instead to partner with the major state-owned oil and gas companies.

The technology and equipment to be used in shale gas exploration receives a lot of attention in the new guidelines. China is interested in developing technologies that are suited for Chinese geological conditions and then keeping the intellectual property rights in the hands of Chinese companies. However, it is also interested in using advanced new technologies from places like the United States to increase the success rate in exploration.

The new guidelines encourage local manufacturing of equipment in order to save on cost and reduce dependence on foreign companies. Due to the limited research and development budgets of Chinese companies, the government established a National

Energy Shale Gas R&D Center in 2010 as a department under CNPC’s research institution in Langfang in Hebei province. The center needs to be made independent from CNPC. Otherwise, CNPC might be the only beneficiary of the center.

Foreign companies that possess advanced shale gas technologies are encouraged to cooperate with Chinese companies so that the Chinese companies can learn about the technologies and gain operational experience. At a China mining conference in November, officials from the Ministry of Land and Resources welcomed foreign investors who can enter the industry through cooperation with Chinese companies.

In the short term, there are not likely to be many private players in shale gas. Although shale gas is a new and open industry, it is still bound by the old regimes in oil and gas. Private participation may rise along with the energy industry reforms in China, but the reforms will take a while. Compared to foreign investors, private companies are in a much weaker position in terms of funding and access to technology.

Gas Shortage

Gas consumption is increasing by around 15% a year in China. China has been a net importer of gas since 2007. Gas imports accounted for 28.9% of Chinese gas consumption in 2012 and are expected to account for 35% by 2015 when 18% of the population, equal to 250 million people, will use gas. Currently, gas is only 5% of energy usage compared to the average international standard of 23.8%. Chinese gas consumption increased to 107.5 billion cubic meters in 2010 from 24.5 billion cubic meters in 2000. Gas consumption is growing currently by 20 billion cubic meters a year. At this rate, total consumption will be 230 billion cubic meters by 2015 and 350 to 400 billion cubic meters by 2020.

By 2015, domestic gas supply will be around 176 billion cubic meters, of which conventional gas will be 138.5 billion cubic meters, coal-to-gas 15 to 18 billion cubic meters and coal-bed methane 16 billion cubic meters.

China is planning to build 39 coal-to-gas projects with total production of around 176.5 billion cubic meters per year. This plan has come in for criticism because of the carbon emissions, high water consumption and pollution.

New rules for coal-bed methane were published in September. The estimated annual grant to this industry will be RMB7.5 billion. Despite this level of government support, most of the coal-bed methane producers have not achieved their production goals this year.

The rest of the 6.5 billion cubic meters will be filled in by shale gas, according to the national shale gas plan released last year.

The shortfall between demand and domestic supply will be filled in part by importing gas through pipelines between China and central Asian countries, Russia and Burma, as well as by sea shipment. China has signed import contracts for gas that will deliver 93.5 billion cubic meters in 2015. Russia will supply another 38 billion cubic meters of gas to China annually beginning in 2018 for 30 years. During Chairman Xi’s visit to Turkmenistan in September, the two countries signed an agreement for Turkmenistan to supply 65 billion cubic meters of gas a year starting in 2020.The China-Burma gas pipeline was completed in late October. The third central Asia-China pipeline C will be completed at the end of this year and pipeline D is in design now.

Matching supply to demand will remain not only a challenge, but also a risk to domestic shale gas producers. Considering the increase in other alternative energy supplies (such as wind and solar) and projected rate of growth in the Chinese economy, the oversupply of gas like in the United States might happen in China in 10 to 15 years. According to the new shale gas guidelines, shale gas prices at the well will be determined by the market. However, the retail price is still regulated. Gas prices for residential users are expected to remain stable. Retail prices for industrial users can be increased by 0.4RMB per cubic meter.

Shale gas has to compete with conventional gas. The shale gas extraction cost is around RMB1.40 per cubic meter, which is more than the costs to produce conventional gas of RMB1.28 per cubic meter in Sichuan province and RMB1.00 per cubic meter in Xinjiang. How to reduce the extraction cost will be a challenge for shale gas to be competitive.

Another big cost in moving shale gas to market is the cost of connecting to pipelines. CNPC has built and controls 70% of oil pipelines and 90% of gas pipelines in China. Recent corruption scandals involving CNPC have led to a debate on whether the pipelines should be removed from CNPC. The National Energy Administration published draft opinions for public comment in late October proposing that the pipelines should remain with CNPC. However, the pipelines and other related infrastructure are supposed to be open to third parties on a non-discriminatory basis, and the National Energy Administration will enhance its regulation of pipelines.

It is hard to establish a forward price curve for gas. Shale gas producers will not have a predictable and transparent price until gas pricing reforms are completed in a couple years.

Environmental Challenges

Air, soil and water pollution are a major concern for the shale gas regulators. The new guidelines require that equal stress be placed on shale gas exploration and ecological protection. During drilling, fracturing and other processes, and in the construction of ground works, land occupation should be kept as minimal as possible.

Drillers have to recycle the drilling and fracturing fluid and any gas that escapes during production must be flared.

An environmental impact assessment must be conducted in accordance with the environmental law.

Chinese environmental laws are weak, as the deterioration of the environment in the past 35 years proves. China lacks the assessment technologies it needs to evaluate the effects of shale gas exploration on the environment. It will be difficult for the environmental authorities to implement the new guidelines formulated by the National Energy Administration.

Shale gas exploration is forbidden in natural preserves, scenic spots, areas that provide drinking water and geologic-disaster-prone areas.

Opportunities

Investors should keep an eye on the full industrial chain related to shale gas.

Equipment is one of the reasons that drilling wells costs so much in China. China has no ability to manufacture most of the equipment or its own equipment cannot meet the technical and environmental requirements. CNPC and Sinopec have some alternative equipment used in conventional gas or oil exploration that could be adapted for use in shale gas exploration. Some equipment cannot physically be transported to sites due to road and other geographic limitations. China has set a goal of developing shale gas equipment that is suitable for the geological conditions in China and that is light, can be carried by vehicles, is easy to transport and is low in pollution and cost.

By 2020, assuming that shale gas production reaches 60 billion cubic meters a year, 40,000 wells will need to have been drilled and the total equipment demand will be around RMB200 billion. In the following nine years, the demand for shale gas equipment is expected increase by 50% annually. By 2020, demand for shale gas equipment will account for one fifth of total oil and gas equipment needs.

Foreign investors need to move quickly if they want to build market share. The Hong Kong-based TSC Group, a one-stop solutions service provider to the oil and gas sector and a highly-respected manufacturer of drilling equipment, has committed to start its third marine and shale gas industrial base of 100,050 square meters in Qingdao in Shandong province soon. TSC aims to achieve US$1 billion in revenue by the end of 2016.

The third round public tender for shale gas is expected to be announced in 2014. The tender procedure and requirements for participants are expected to be revised dramatically with the goal of encouraging more private and foreign investor participation in the bidding.

Due to environmental concerns, the proposed shale gas blocks will be limited to Sichuan, Chongqing and Hubei. The shale gas rich areas such as the Erdos basin may not be included in the proposed blocks list due to its weak ecological condition and shortage of infrastructure.

New measures, such as new tax subsidies, are expected to be issued in the near future for shale gas. The new measures will be aimed at increasing foreign investor interest in the sector.

There are multiple potential points of entry for foreign investors. They need not limit themselves to exploration. Shale gas will be a test laboratory for experiments with market pricing. The Chinese government is trying to withdraw its “visible hand” from the economy as quickly as possible.