by Jeremy Bowden, Head of Energy Research, Energy Transformation.

December 8, 2013

China’s shale gas reserves are thought to be the world’s largest at almost double the U.S. total. Their extraction could not only bring a U.S.-style energy revolution with all the associated economic, energy security and greenhouse gas emissions reduction benefits, but also provide a solution to the deadly smog that comes from heavy use of coal in Chinese cities. Technology aimed at reducing water usage in hydraulic fracturing and regulatory reforms to encourage investments, are both helping accelerate development towards ambitious production goals. 

While there is great shale gas potential in China, it is likely to take several years to develop, due to technical challenges, a lack of infrastructure and logistic capabilities, and the inflexible structure of China’s state-controlled oil and gas industry. State-owned CNPC, Sinopec and China United Coal Bed Methane hold much of the prospective shale acreage in conventional blocks, and while private Chinese companies are allowed to bid for shale blocks, only two have been successful so far. Overseas entities remain barred and can only access the sector through minority partnerships.

Nevertheless, in China there is none of the European hesitation over whether or not to encourage the development of shale gas, and in October the sector was designated as an emerging strategic industry, with all the tax breaks and other advantages that bestows. To help meet projected Chinese gas consumption of 350 to 400 billion cubic meters (bcm) in 2020 (up from 165 bcm in 2013), China has set ambitious shale gas production targets of 6.5 bcm in 2015 and 100 bcm per year by 2020. This is expected to require the drilling of around 20,000 wells, costing at least $80 billion (provided initial high costs per well can be cut closer to US levels), along with $65 to $100 billion for other infrastructure, according to official estimates.

Where that money will come from is unclear, but China certainly has the financial resources to invest into a strategic industry . Currently there is major debate in China over how to reform its economy towards a more competitive, private capital-based, consumer driven system. The intent to move forward appears to be there, although reform will be hampered by entrenched interests. Further dismantling of state monopolies is likely, including in oil and gas, particularly in relatively new areas like shale gas extraction. Against that backdrop, such ambitious investment targets are unlikely to be left to state firms and will require more private capital. If domestic funds or expertise are insufficient, the overwhelming benefits associated with shale gas could persuade policymakers to further open the sector to overseas investors, especially given the success of dynamic private operators in the US.

chris faulkner

“In the U.S., it has been private companies that have poured billions into developing the technologies necessary to reach shale reserves and the infrastructure required to process and transport them; in China, it remains to be seen whether the government will be able to provide enough incentives for outside investors to supply the necessary capital or whether it will choose to fund the research and development itself.” Chris Faulkner, CEO Breitling Energy

One aspect that could push expenditure higher is the cost of adapting fracking technology to Chinese shale, which varies significantly from that found in the US. The US shale gas revolution was launched largely on the flatlands of Texas, North Dakota, Pennsylvania, and other accessible areas. In China’s mountainous basins the formations are more faulted and folded, which makes it more difficult and less economic to drill long horizontal well bores. Chinese shale is also much deeper, with most deposits are found at 1,500 to 4,000 meters below ground in Sichuan, compared to 800 to 2,600 meters in the US, making it more difficult to get at.

To tackle the technology issues, Chinese state companies have invested in US shale fields. In 2012 alone, Sinopec acquired a 33.3% interest from Devon Energy in five shale oil and gas basins, CNOOC closed the $15.1 billion takeover of Nexen, (which holds shale gas assets in Canada), and PetroChina acquired a 49.9% interest from Encana in the Duvernay shale gas project in Canada. These same companies have also formed partnerships with foreign companies in China to tap unconventional hydrocarbons, including with Shell, Hess, BP, ExxonMobil, Chevron, Eni, Halliburton and Schlumberger, while the first production sharing agreement was signed Between Shell and CNPC in March 2013.

On December 5th, TouGas Oilfield Solutions GmbH announced that they have entered into a strategic partnership agreement with Petro-King, a leading China based oilfield service company to jointly develop and commercialize products that enable hydraulic fracturing without fresh water usage.

Chinese central government is certainly backing shale development. Earlier this year the National Energy Administration (NEA), China’s energy regulator, unveiled the country’s first policy covering shale gas projects, outlining rules and promises of increased financial support for shale gas exploration and extraction. This includes the designation of shale gas as one of the nation’s strategic emerging industries, provision of central and provincial government subsidies, tax reductions or exemptions for producers, and customs tariff exemptions for imported equipment. The policy also encourages development, innovation and Chinese-owned brands in shale gas exploration and extraction technologies.

The national shale gas development plan (2011-2015) had already established production targets for 2015, including a complete national survey of shale gas reserves, selection of 30 to 50 proven shale gas areas and 50 to 80 favourable target areas, and production by 2015 of 6.5 bcm – a huge leap from the estimated 2013 output of 200 million cubic meters. A half of this total is expected to be met by three state-controlled companies, with CNPC claiming it will produce 1.5 bcm and Sinopec 0.13 bcm by 2015, along with the Chongqing local government (in gas-rich Sichuan Province), which said it is planning to drill 200 shale gas wells to produce 1.3 to 1.5 bcm.

Rollover King Coal

Non-greenhouse gas pollutants from coal burning constitute the bulk of the appalling smog endemic to China’s cities, which is believed to be responsible for thousands of deaths every year, making the replacement of coal an even more urgent matter than in Europe or the US. “Gas produces 200-250g carbon dioxide per KWh, while coal produces two to four times this along with particulates, nitrogen and sulphur oxides – gas has none of those,” said Remi Eriksen, CEO of DNV in an interview.

Tore.Land

“Ultimately, the carbon profile on this planet is determined by two economies; the United States and China…So if we collectively, [European] companies and regulators, want to do something meaningful to reduce carbon emissions, let us help develop technologies and commercial processes which help China reduce its dependency on coal.” Tore Land, President & CEO, TouGas Oilfield Solutions.

Coal-fired power plants are already being converted to run on gas in Beijing, where 263 coal plants will be replaced by gas turbines by the end of 2014. Other cities, including Zhengzhou, Lanzhou and Xian, are following suit. But while gas for Beijing comes from expensive LNG or Russian pipeline imports, along with a bit of domestic conventional production, for less important and poorer cities, locally sourced shale gas is the only commercially viable option. “China will only substitute gas for coal if the gas can be domestically sourced, and that means shale gas,” according to Mr Scaroni, CEO of Eni.

Any shale gas that is produced is beneficial for China, either cutting expensive gas imports or lowering coal use, which reduces smog and saves lives. Even poorly developed shale gas wells are a major step up from Chinese coal mines, which not only cause earth tremors and far worse pollution, but also many direct deaths from accidents every year. In areas of high renewable potential the gas is still needed to supply backup for intermittent wind and solar plants.

China’s state is not as influenced by popular protests or fashionable opinions as in Europe, where the focus is on potential risks rather than benefits, and it is clear that for China – whether on economic, energy security or environmental grounds (as a replacement for coal) – efficiently extracted shale gas is a clear winner. The challenge of social acceptance remains, but it is localised and does not contain the same potential to derail development as in democratic Europe. China’s struggle for success in shale will be more over how to replicate an energy revolution that was a creation of the US’ intensely competitive free market system, in a system that is dominated by state run giants with insufficient technology, and where prices are not yet determined in a market.

While China has shown itself more than capable of replicating the manufacturing success of the developed world, it has had less success in areas of innovation and risk taking, including of the sort traditionally associated with oil and gas exploration. In a market system, you can have many small and large players all specializing in different pieces of the process. But according to many of the contributors to this report, fracking has become an industrial process rather than traditional exploration and production venture, making it a prime candidate for successful adoption by the Chinese system.

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Remi Eriksen, CEO, DNV

DNV’s Remi Eriksen said hydraulic fracturing and the extraction of shale gas had been “transformed into an industrial process by scalability, where multiple wells are drilled from single pads over a wide area.” Once the technology has been learnt and adapted to local conditions, it can be replicated and fine-tuned to reduce costs and environmental impact. So if China can access shale technology and apply it to its tougher geology, then the country may well go on to surpass the achievements of shale development in the US, as it has done in so many other process industries. In addition, state-owned enterprises are not expected to face funding challenges because of their easy access to cheap long term loans from Chinese state-owned banks, while private capital’s need for quick returns may limit interest.

Nevertheless, the whole system is currently being scrutinised in China, and history may be on the side of private capital. The state oil giants have monopoly power that many Chinese people and government reformers would like to see curbed. In China’s third shale gas licensing round – due in early 2014 – the regulator said it wants to spread the award of licenses more widely. In the first round shale gas tender, PetroChina and Henan CBM were awarded licenses in exchange for funding commitments of just RMB800 million ($128 million). In the second round, 16 winning bidders, which included two private Chinese companies, agreed to contribute RMB12.8 billion by 2015. Critics claim many of the licenses went to state utilities with no upstream experience.

The third round is expected to offer more acreage than the first two combined, but foreign participation must still be through a Chinese majority-held equity joint venture, with at least RMB300 million of registered capital. Apart from PetroChina’s first round award, the three Chinese national oil companies have not been active bidders, as they hold the rights to most of the high potential oil and gas blocks already, with considerable associated shale potential in many. Some of them actually overlap new shale blocks, which discourages bidders concerned over conflicting claims. Spending commitments in the third round will need to be higher if the state oil and gas giants (and their overseas partners) are not to dominate production.

While major foreign oil and gas companies have partnered the Chinese state oil and gas companies under joint study agreements, most would prefer to enter the market through product sharing agreements (PSAs), with which they are familiar in conventional exploration and production. In early 2013 the first shale gas PSA was signed between Shell and CNPC, and approved by the Chinese government, for drilling in the Fushun-Yongchuan block in the Sichuan Basin. Shell and CNPC have so far found it both technically challenging and bureaucratic, with government regulators taking about a year to approve the formal deal.

Under the deal, Shell will contribute its technology and operating expertise in an effort to reduce the drilling cost per well from $12 million to $4 million. The deal is viewed as the first commercial shale gas project in China, and Shell has committed to contribute a minimum of $1 billion per year on exploration. Some other joint study agreements are expected to be switched to PSAs now the Shell-CNPC deal has gone through.

Above ground issues

At the moment prices are actually way above US levels, presenting an attractive opportunity for efficient and experienced US companies to raise returns – if they can access the market and adapt technology. For example, in Beijing, the current residential natural gas price is RMB2.28 (US37¢) per cubic meter compared to roughly US14¢ per cubic meter in the US. What’s more, PetroChina and other gas importers are facing huge losses because import prices are even higher, meaning domestic levels are only like to go up. Domestic prices were raised in July 2013 in an effort to close the gap with import prices.

Both wholesale and retail natural gas prices are regulated by the National Development and Reform Commission (NDRC), which moves them in line with international propane and fuel oil prices. There is far more demand than supply, requiring demand management by NDRC, resulting in shortages or forced fuel switching. Alternatives to the current pricing mechanism include the Shanghai spot LNG market, which began operation in July 2012 and the Singapore LNG market, which come complete with futures contract – something that proved important in the US shale roll-out. Both are likely to represent a level that reflects northeast Asian seaborne LNG – the most expensive gas market in the world – providing plenty of incentive for investors. China is also moving forward with a domestic gas market experiment in the southern provinces of Guangdong and Guangxi, with a decision due shortly on whether this pilot is rolled out in other areas.

The policy direction is also towards the opening of pipeline infrastructure, which is dominated by CNPC, to third parties. There are also moves towards the unbundling of supply chains, as well as a massive network expansion partly funded by private capital – but such policies will inevitably encounter resistance from the major state owned enterprises.

China will also benefit from the impact of shale development elsewhere. China is heavily dependent on imports of oil and gas, and the close correlation between global oil and gas prices, means any increase in gas supply tends to dampen oil prices, reducing China’s import bill. US shale gas production alone should produce enough additional LNG for global markets to ensure oil rises nowhere near the danger price that could damage the world economy – something that remains among the biggest of global security threats, according to Gal Luft, Senior Adviser to the US Energy Security Council. Speaking at the FT’s recent shale energy conference, he also emphasised the potential for greater methanol exports from the US to China, for use as a transport fuel – which could displace oil use.

Given its rising import dependency on an increasingly unstable Middle East, hydraulic fracturing to enhance oil recovery from conventional fields or liquids from shale is especially important in China, whether it is as part of a conventional field or shale. “There is up to an additional 400 million barrels of oil available worldwide from existing wells from EOR [enhanced oil recovery]… and at $90 a barrel, 90% of that tight oil is economic to recover,” according to Peter Jackson, head of upstream at IHS. As in the US, Chinese producers could also use liquids production to kick-start or sustain uneconomic shale gas projects.

The application and enforcement of standards in China is another major challenge. Both Chevron and Shell claim the highest standards are adhered to by contractors and others working with them, which can “have a more flexible interpretation of standards than we do”, said Douglas Ichihara of Chevron. Development of a carbon market could help improve the economics of shale gas compared to coal, and help avoid flaring.

Water Crucial in China

Conventional fracking requires large volumes of water, which will be a challenge in China, where many regions are drought-prone. Except for the Sichuan and Jianghan Basins, all the other shale gas prospects overlap with areas suffering significant water shortages. In the dry north Western and northern regions, underground water is currently extracted and then the waste water is re-injected back into disposal wells. This could affect the water table and lead to salt-water encroachment.

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Kurt Lonsway, Acting Director of Energy, African Development Bank (AfDB)

If water is not available locally at all, drilling companies have to build extensive networks of temporary piping and storage tanks to supply fracking operations. Water pollution is another major concern, but “very tough environmental regulation is expected in China” as it tries to learn from the US experience, according to Mr Wo of China Huadian, a major utility.

Given that water is such a key issue in China, advanced water saving gellants or other advances from small innovators like TouGas (see main report). The advanced gellants recently developed by TouGas, not only remove the need for fresh water, they also allow fracking to take place at much higher temperatures, which will permit development of the deeper shale deposits that occur in China and elsewhere.

Reduced water use is also crucial in parts of Africa. Development of South Africa’s most promising shale play in the Karoo could only take place if water saving technology were employed, according to Kurt Lonsway, acting Director of Energy at the African Development Bank (AfDB). Like China, South African energy is dominated by coal, while almost all oil and gas must be imported. The AfDB estimates 350,000 to 850,000 direct and indirect jobs could be created in South Africa as a result of shale gas development.

“The challenge for us [in Africa] is to ensure we are using the latest technology available, not cheap out of date technology. If technology can bring costs and water use down that is great, but we don’t want old more polluting technologies used just because they are cheaper”, says Lonsway.