Shale GasDoes shale gas have a future in China?

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Contents

1 Does shale gas have a future in China?

2 What exploration of shale gas has taken place in China?

3 Who is interested in shale gas in China?

4 Who regulates shale gas?

5 Shale gas regulation

6 Shale gas production in China – key challenges

7 Pinsent Masons’ view

Pinsent Masons | Shale Gas

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Does shale gas have a future in China?According to the US Energy Information Agency, China has the largest known shale gas reserves in the world. China’s Ministry of Land and Resources (MLR) predicts that the country’s shale gas output could reach 6.5 billion cubic metres per annum by 2015 and increase more than tenfold to 100 billion cubic metres per annum by 2020.

In March 2012, MLR announced that a nationwide shale gas resources survey had found exploitable shale reserves of an estimated 25.08 trillion cubic metres. Initially, many claimed that China could replicate the shale gas push in the United States. However, recent sentiment is no longer quite so optimistic. For instance, the third round of bidding for exploration rights planned for late last year has been postponed. The delay is understood to be due to problems faced by existing licensees in accessing reserves for exploration purposes. Shale gas reserves in China tend to be deep underground and advancement in technology will be necessary before much of the country’s reserves can be commercially extracted.

Nevertheless, with the issue of the Shale Gas Industrial Policy by the National Energy Administration (NEA) in October last year, China appears focussed on providing the necessary framework for the regulation of shale gas extraction.

In this article, we look at the key risks and problems affecting the shale gas industry to gain better insight into the latest shift in optimism for China’s shale gas prospects.

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What exploration of shale gas has taken place in China?In 2011, MLR released the first round of shale gas blocks for tender. This initial round was only open to six state-owned enterprises (SOEs). Two SOEs were each awarded exploration rights to a single shale gas block; China National Petroleum Corporation (CNPC), the parent company of Petro China, and Henan Provincial Coal Seam Gas Development and Utilization Co.

In September 2012, 19 further shale gas blocks were released for tender. Each successful bidder was awarded exploration rights for three years with exploration to start within six months of the award date. 83 enterprises participated in the auction, including 55 SOEs, 26 private enterprises and two Sino-foreign joint ventures. Fourteen SOEs were successful with some enterprises receiving more than one block.

Successful SOE bidders in second round auction

Huadian Coal Industry Group Co. Ltd Shenhua Geological Exploration Co. Ltd

China Coal Geology Engineering Corporation China Huadian Engineering Co. Ltd

Tongren Energy Investment Co. Ltd Hunan Shale Gas Development Co. Ltd

Chongqing Energy Investment Group Huadian Hubei Power Company Limited

Chongquing Mineral Resources Development Co. Ltd Jiangxi Natural Gas (Jiangxi Cast Qi) Holding Limited

State Development & Investment Corp Anhui Province Energy Group Co. Ltd

Hunan Huasheng Energy Investment & Development Co. Ltd Henan Geological Exploration Investment Co. Ltd

Huadian Coal Industry Group Co. Ltd Shenhua Geological Exploration Co. Ltd

Two private Chinese enterprises were also successful; Huaying Shanxi Energy Investment Co. Ltd, a subsidiary of Wintime Energy Co. Ltd, and Beijing Taitantongyuan Natural Gas Technology Co. Ltd.

These enterprises report that exploration has been challenging due to very deep drilling depths and difficult geological operating conditions. This is not surprising as a large number of the companies that were awarded exploration rights have little extraction experience, particularly in relation to drilling into the ground. MLR reports that one such company has already sold its interest, prior to conducting any exploration. This suggests that there may be little prospect of successful extraction in the near future.

MLR had planned a third round of tenders at the end of 2013. However, this has been delayed into 2014 due to the inactivity of the successful second round tenderers. This planned third round is expected to offer only 8 to 10 shale fields for auction.

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Pinsent Masons | Shale Gas

Who is interested in shale gas in China?There are various parties who appear interested in shale gas in China. The two biggest investors are CNPC and another large, state-owned enterprise China Petroleum Chemical Corporation also known an SINOPEC. Both enterprises are strategically well positioned to control the shale gas market for two main reasons.

Firstly, they both have substantial monopolies over existing pipelines in China. CNPC owns the West-East Gas Pipeline, which accounts for approximately 90% of China’s existing pipeline structure. SINOPEC owns and operates the Shanghai Pipeline. It is unlikely that either party would be willing to part with its control easily. Secondly, CNPC and SINOPEC already hold the exploration and mining rights to certain existing oil and gas fields that overlap with shale gas fields. The Government has yet to address the overlap. This is cause for concern because the most lucrative shale gas fields in China are located within existing oil and gas fields already held by CNPC and SINOPEC.

As early as 2009, CNPC and Royal Dutch Shell Plc (Shell) began a joint shale gas assessment of the Fushun-Yongchuan block in Sichuan. They have been in joint production since March 2012, successfully extracting shale gas. This is the first production sharing agreement approved by the Government, and it is likely that others will follow. CNPC has also been cooperating with Chevron in Sichuan. In June 2013, CNPC began construction of the first pipeline between a shale gas field and one of its existing major pipelines, marking a strong commitment towards shale gas production in China.

Similarly, SINOPEC has entered into joint venture arrangements with foreign energy partners to explore shale gas in China. Alongside Conoco Phillips, it is assessing the potential of the Sichuan Basin with plans to begin exploratory drilling. With British Petroleum (BP), it is conducting joint assessments of the Kaili block in Guizhou and the Huangquao block in Jiangsu. Since April 2011, SINOPEC and Chevron have been exploring the potential of the Longil County in Guizhou. Negotiations are also reported to have taken between the French oil company, Total S.A, and SINOPEC for a potential joint assessment in Anhui.

These companies are also acquiring overseas assets and technology. In March 2010, CNPC and Shell acquired a Queensland coal seam gas asset and the proposed site for a LNG plant on Curtis Island at Gladstone in Australia. CNPC reportedly intends to apply lessons learned in Australia to boost expertise in shale gas extraction and transportation in China. In October 2011, SINOPEC acquired more than 300,000 acres of land in Alberta, Canada rich with oil and natural gas from Daylight Energy, a Canadian shale gas producer. These acquisitions demonstrate that China is keen to obtain, advance and improve its own shale gas technology.

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Who regulates shale gas?Shale gas exploration and production is under the combined management of the Chinese central Government and the separated management of provincial Governments. There are at least seven authorities supervising the shale gas industry. One of the challenges for China and its shale gas future is how these organisations are going to cooperate effectively together as there is considerable overlap in their function.

MLR is one of the most important departments in charge of shale gas resource management. They are responsible for granting exploration and mining rights, as well as ensuring and enabling the utilisation of land for shale gas exploration. In 2008, MLR set up the shale gas project “Shale Gas Resource Potential in Key Regions and Preferential Selection of Favourable Regions” for the Government’s assessment of regions for viable shale gas production. MLR was also responsible for the study and research that formed China’s shale gas development policy, which took effect during 2011.

In December 2011, MLR announced the legal status of shale gas as the 172nd independent mining resource. This means that shale gas is now exempt from the restrictive legal regime currently in effect for exploration and hydrocarbon production in China.

As mentioned above, licensing also falls under the domain of MLR’s powers. There are no detailed rules that regulate the licensing, exploration or production of shale gas. SOEs, domestic enterprises and foreign enterprises may be granted mining rights so long as the various statutory conditions are complied with. Exploration licenses or rights are registered and issued by MLR to licensees in the form of three-year leases. If shale gas deposits are discovered, the licensee may apply for a two-year renewal or retention of the exploration permit for a maximum of four years or two extensions. However, outside of the formal bidding processes discussed earlier, MLR has previously stated that it has not received any application for mining rights. When MLR receives such an application, it will issue mining licenses for shale gas on a case-by-case basis.

The National Development and Reform Commission (NDRC) is another key department. In January 2012, NDRC announced that foreign direct investment into the shale gas industry in China fell into the “encouraged” category of the Foreign Investment Industry Guidance Catalogue. As such, foreign investors may invest in China’s shale gas industry and enjoy relief from customs duty on imported equipment. The Catalogue provides that foreign investors may enter into a Sino-foreign equity or contractual joint venture. Although there is no requirement in the Catalogue regarding the shareholding of the joint venture, during the second round of shale gas block tendering only foreign investment enterprises that had a Chinese controlling shareholder (51% minimum) were allowed to participate.

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Pinsent Masons | Shale Gas

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Shale gas regulationIn March 2012, the NDRC, Ministry of Finance, MLR and NEA jointly issued a development plan designated for China’s shale gas development. The Plan applies to shale gas development activities and initiatives in China from 2011 to 2015. It sets down milestones to be achieved by China during this period, including the Government setting up designated funds to support shale gas surveys and appraisals. It also provides for increased support from the Government, which plans to classify shale gas technology research as a ‘significant national project’ with a primary goal to establish research and development that will put Chinese shale gas technology at the forefront of the industry. The Government also states in the Plan that it will accelerate the permitting process for “quality investors”.

More recently, the NEA under the NDRC released the Shale Gas Industry Policy in October 2013. The Policy contains detailed rules and procedures relating to shale gas exploration and external cooperation. The main parts of the policy are summarised below.

Qualifications for shale gas companies: Shale gas exploration companies need to be financially sound, have well established accounting systems and be subject to MLR’s technical specifications relating to shale gas including in relation to the calculation of reserves, seismic prospecting and drilling.

Energy efficiency and environmental protection: Shale gas exploration companies must comply with environmental regulations, use water and energy efficiently, assess environmental impacts of proposed projects and comply with applicable environmental standards. In addition, installations for the prevention and control of pollution must be designed, incorporated, and commissioned into a shale gas project.

Subsidies and incentives: Central and local Governments will provide a range of financial support to shale gas production from subsidies to tax reductions or exemptions. For example, imported equipment will be exempt from customs tariffs in order to promote technological advancement.

Marketing: The Government will continue to encourage public and private investment in the exploration, extraction and trading of shale gas. It has promised to create an open and fair market for investors. Shale gas will be priced according to market demand and supply.

Although introducing the Policy is an important development towards shale gas commercialisation in China, there is still no single set of detailed rules to regulate shale gas activity. Issues relating to exploration and utilisation are regulated under laws applicable to mineral resources and environmental protection.

The principal law regulating shale gas extraction is the Mineral Resources Law, which requires the registration of all entities engaged in exploration or mining activities in China and establishes a system for the application and granting of exploration and mining rights. Once a permit is issued there are certain obligations that must be complied with. For example, there are scheduled minimum exploration expenditures and reporting requirements with the local licensing authority.

The principal environmental law that is generally applicable to the shale gas industry is the Environmental Protection Law (EPL). Article 13 of the EPL requires enterprises (including shale gas enterprises) to assess the environmental impact of proposed projects and comply with applicable environmental standards. Article 16 of the EPL requires that installations for the prevention and control of pollution at a construction project must be designed, built and commissioned together with the principal part of the project. Further laws dealing with environmental pollution by solid waste, water pollution, noise pollution and atmospheric pollution, as well as the protection of wildlife, must also be adhered to.

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Shale gas production in China – key challenges There are a number of key challenges to overcome in order for shale gas to succeed in China.

Need for adequate infrastructure: At the exploration stage, proper drilling wells need to be assembled. Later on, in the production phase, sufficient pipelines and access roads are necessary for efficient extraction. This is where China falls considerably short. It does not have the required pipelines to transport gas to where it is needed. Experts say that the construction of adequate pipelines will be a long term process.

Costs of extraction: Shale gas in China tends to be located in mountainous, rock and desert areas. As a result, the transportation and installation of essential equipment can be an arduous and costly process. The average cost of drilling in China is reported to be up to 10x the average cost in the United States. As shale gas will have to compete with natural gas, either the price of natural gas will have to rise significantly or the cost of extracting shale gas will need to fall significantly before China’s shale gas can become competitive.

Environmental challenges: Environmental concerns also bring about considerable risk to those entering the shale gas market, and those who do must be prepared to mitigate these risks. For instance, China lacks a steady supply of water due to drought conditions, and water is essential in the process of hydraulic fracturing. The proposed alternative is the use of chemically diluted water but this will raise environmental risk, particularly with regards to ground water contamination. It is feared that since the treated water contains high amounts of toxic chemicals, in the event of poor environmental regulation these chemicals could seep into drinking water underground. This presents reputational risk if ground water contamination results in bad publicity with the company having to bear the risks and the costs of decontamination. In addition, experts report that shale gas in China contains high levels of non-hydrocarbon gasses, which run the risk of damaging drilling equipment and air pollution. Strict emissions standards may need to be enforced by the relevant authorities in order to control this risk.

Technological challenges: The technology currently available to China was developed by the United States where the drilling depth for shale is substantially shallower than is predicted and has been found in China. In the United States, the average drilling depth is 800 – 2,600 metres compared to China where the average drilling depth is 1,500 – 4,000 metres. China is beginning to modify and develop technology on its own through knowledge transfer gained from overseas acquisitions and expert advice. However, at present, it appears this knowledge is still insufficient for China to extract shale gas of any significant scale without the assistance of foreign parties.

Regulation: A transparent and predictable regulatory framework is also essential to developing large-scale shale gas production. This includes clear access to licenses and Government subsidies for private companies who take the risk to invest. The Government has been urged to introduce preferential subsidy schemes to support shale gas development but has only so far offered limited tax benefits and easier access to credit.

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Pinsent Masons | Shale Gas

Pinsent Masons’ viewThe introduction of a Shale Gas Industrial Policy in October 2013 is a positive step towards the development of a domestic shale gas industry in China. However, as discussed above, the lack of a comprehensive regulatory regime and the need to address other commercial and technical risks mean China is still some way from commercialising its shale gas potential. But we believe it is just a matter of time before we see a clearer and more robust regulatory environment for shale gas given the twin factors of China’s huge potential for shale gas and the need to find cleaner alternatives to burning coal to power its economic growth.

John YeapPartnerProjectsHong Kong T: +852 2294 3485E: john.yeap@pinsentmasons.com

Kate TerryRegistered Foreign Lawyer (England & Wales) Senior AssociateProjectsHong Kong T: +852 2294 3317E: kate.terry@pinsentmasons.com

Arthur LingTrainee SolicitorProjects Hong Kong T: +852 2294 3374E: arthur.ling@pinsentmasons.com

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