Potential Behind the Challenge: Overview of China Shale Gas I

Over the past few years, shale gas has been one of the hottest topics among worldwide energy industries. The low price of shale gas makes it an attractive investment option for individuals and companies. After the successful exploitation of shale gas by Americans, many countries also have published its policies supporting the development of shale gas. According to the US Energy Information Administration (EIA), China has the world’s largest shale gas reserves, exceeding even the US reserves. Although China has abundant resources of shale gas, these resources are not located evenly on the Chinese land. Most of the shale gas in China is located in the Sichuan and Tarim Basins in the southern and western regions and the northern and northeastern basins. EIA estimates from its recent study and reports on shale oil and gas resources that China’s technically recoverable shale gas reserves are 1,115 Tcf, the largest shale gas reserves in the world. However, there are also undeniable difficulties to be solved by Chinese engineers. Hydraulic fracturing, the technology revolution invented by the Americans, could not be simply used in Sichuan Basin or Tarim Basin to exploit shale gas. On one hand, hydraulic fracturing requires the usage of huge amounts of water which may ruin the local environment system, especially in Tarim Basin. On the other hand, both Sichuan Basin and Tarim Basin are populous areas, which means the noise and quake would cause much trouble to the residents. It is unrealistic for Chinese NOCs to copy how the American companies developed shale gas directly.

Despite all the difficulties mentioned above, the future of Chinese shale gas production is still positive due to its vast reserves. According to the equity research by Standard Chartered, China’s shale gas output will increase significantly in the coming decades. By 2030, Charter Standard believes that shale gas could contribute to the majority of China’s gas supply, which would help China reduce its reliance on imported natural gas. Chinese upstream producers, those NOCs such as Sinopec and PetroChina, will become the biggest beneficiaries of the increasing shale gas production. China’s reliance on coal for electricity might also be reduced due to the emergence of shale gas, and the air environment might be improved. For now, most of the exploitations of shale gas in China are located in the Sichuan Basin.

China is pushing forward to publish the energy law regulating the whole energy market. However, for now, the laws and regulations of energy in China is limited and foreign capitals are not allowed to invest Chinese upstream industry. Chinese NOCs still dominate shale gas development. Foreign capital could only participate in the conventional upstream market by entering into production sharing contracts (PSCs) with those companies. In 2011, the Ministry of Land and Resources (MLR) issued Announcement No. 30, giving shale gas a new legal classification as an “independent mining resource” not included in the category of “conventional natural gas”. This new definition allows the private and foreign capital to invest in the exploitation of shale gas through forming joint venture with Chinese companies. In the shale gas field, IOCs tend to choose CNPC or Sinopec as the cooperator. CNPC and SINOPEC are well positioned to be the controllers for two main reasons. One is that most of the discovered shale gas fields in China is controlled by CNPC and Sinopec at present. The other reason is that both enterprises own substantial monopolies over existing pipelines in China. On one side, by cooperating with the giants of the energy field, IOCs could be able to take full advantage of the resources held by Chinese NOCs. On the other side, CNPC and SINOPEC are also eager to work with IOCs such as Chevron, Shell, and BP, which have rich experiences in exploiting shale gas around the world. Lack of laws and regulations also makes it easier for both sides to reach a deal that could satisfy all the needs of both parties.

The regulator for the shale gas industry in China is also chaotic.  At least seven authorities are supervising the Shale Gas industry, and there is considerable overlap in their functions. MLR is the most important department, which is responsible for granting exploration rights, ensuring the utilization and forming the Shale Gas development policies. Exploration licenses or rights are registered and issued by MLR to licensees in the form of three-year leases on a case-by-case basis, and can be extended due to certain reasons and applications.

The Chinese government has led efforts to initiate R&D campaigns and set up experimental projects. The National Energy Administration (NEA), China’s top energy policy authority, designated CNPC to set up the National Energy Shale Gas R&D (Experiment) Centre in August 2010, to oversee China’s technological capacity building. The center covers almost the whole shale gas value chain, from reservoir assessment/analysis, block development solution design, drilling, and stimulation to well completion. Meanwhile, the faster demand growth in China will also contribute to the development of the shale gas market. It is believed that China will become the country with the largest energy consumption in the next decade. China has been unsatisfied about its heavy reliance on the import of oil and natural gas for a long time and keeps trying to change the situation. Shale gas is a great opportunity for China to reduce its reliance on the import of energy resources.

As for now, there are no detailed laws or regulations concerning the exploitation or utilization of shale gas. If an issue arises, the common opinion of the resolution is applying Mineral Resources Law, which widely governs the exploitation of different kinds of mineral resources. The environmental issues that happened during the mining process could be governed by the Environmental Production Law. The shale gas industry policy released by the National Energy Administration (NEA) contains detailed rules and procedures relating to shale gas exploration and external cooperation. To sum up, the Chinese government is still working on designing laws and regulations to supervise the energy market. During this period of time, there will be more flexible space for business negotiation.

Part II. 

Considering the lack of laws and regulations regarding the exploitation of shale gas in China, business negotiation would be quite flexible. The Chinese laws and regulations require foreign capital, which is interested in investing and exploiting shale gas in China, to form a joint venture with Chinese NOCs like CNPC and SINOPEC. Without detailed regulations raising requirements, there could be flexible space for negotiation in reaching a contract satisfying all needs of both sides.

Generally speaking, most contracts on shale gas exploitation between IOCs and Chinese NOCs are Production Sharing Contracts (PSC). The feature of PSC is that the IOC is entitled to recover contract costs and the government is the owner of petroleum. In a PSC, the country’s government awards the execution of exploration and production activities to an oil company. The oil company bears the mineral and financial risk of the initiative and explores, develops and ultimately produces the field as required. When successful, the company is permitted to use the money from produced oil to recover capital and operational expenditures, known as “cost oil”. The remaining money is known as “profit oil” and is split between the government and the company. In most of the production sharing agreements, changes in international oil prices or production rate affect the company’s share of production. In China, since CNPC and SINOPEC are authorized by the government to cooperate with foreign companies to exploit shale gas, it is salient to understand the interests and concerns of Chinese NOCs. Chinese NOCs have enough funds and workers to exploit every acre of Sichuan Basin. However, without the advanced technology of IOCs, Chinese NOCs are unable to exploit shale gas buried under the soil of the Sichuan Basin. Compared with the United States, most China shale is buried in the deeper ground. The less-pressured geographic conditions make it expensive to maintain the well integrity. In addition, because Sichuan is a place where most of the lands are mountainous areas, finding a sweet spot with high pressure could be a task tougher than engineers’ original expectations. Therefore, Chinese NOCs need to cooperate with IOCs to gain their advanced technology in exploitation. During a negotiation, Chinese companies might be willing to make compromises on another side to gain the support and training of IOC’s experienced experts in shale field as an exchange.

The first issue needed to be carefully discussed during the negotiation is the members of Joint Management Committee (JMC). JMC is created to help both parties to manage the whole exploitation process of shale gas. By creating a committee comprised of members coming from both Chinese NOC and IOC, JMC is authorized to approve important decisions of the exploitation process and provide advice to those actions which are relatively less important. The provisions could ask NOC and contractor to each appoint an equal number of members on JMC. Chairman and vice chairman should come from different sides. In the PSC of shale gas, the way to organize a JMC is just like other PSCs of oil and gas. However, considering that the contractor is making a deal with Chinese NOC which is supported by the Chinese government, the contractor should also be concerned about how this committee works and casts reasonable limitations on the power of the Chinese NOCs. For example, when negotiating the terms of JMC, the contractor needs to take care of a unanimous vote. Unanimous vote means the affirmative vote of representatives representing partners holding 100% of the total percentage interests, which is designed to ensure that every salient business decision could be supported by everyone from both sides. However, in the practice, IOC is responsible for assuming geologic risks and need to follow the mandatory work program to exploit shale. This provision may increase unnecessary time and costs in waiting for a unanimous vote and reaching mutual consent with Chinese NOC. When the contractor needs to make an emergency change to the development operation to deal with urgent issues, the contractor must convince the government first, which might cause the failure of avoiding unnecessary damages. Considering that national-owned enterprises are not famous for their efficiency, the contractor should not underestimate the potential risk of tardy response from Chinese NOCs.

The second issue could be other discoveries during the exploitation process. When discovering the shale gas in a specified area, the contractor may also find other natural resources which are not required or mentioned by the contract. In this situation, a provision about these newly-found hydrocarbons could be helpful to protect IOC’s rights. For instance, in case that the contractor has discoveries of hydrocarbons other than shale gas during the exploitation, the contractor shall negotiate with NOC and request to participate in the exploitation of other hydrocarbons discovered by the contractor. The PSC could approve the contractor to exploit other hydrocarbons at a favorable rate because it is the contractor who makes these discoveries. It is reasonable to expect that during the mining process, other hydrocarbons such as oil, natural gas or other resources might be discovered by the contract. By adding this provision, the contractor may recover the potential loss of failing to discover shale.

The third issue is the determination of commerciality. After the contractor find that the production of shale could meet the demand of making profits, then it could announce commerciality of this field. Generally speaking, there is a timeframe in the contract underlying the process of discovery and production. When negotiating with NOCs about the determination of commerciality, the contractor should also pay attention to the provision of sole development. For example, “If the Contractor does not consider the certain Sub-area to have commercial value, the NOC may develop the field, and Contractor can later decide to participate before the DCCP by paying its share of the development costs plus an additional fee. If the Contractor does not participate before the DCCP, the field will be excluded from the Contract Area—but development and production operations should still be carried out by the Contractor.  If the NOC does not consider a sub-area to have commercial value, the Contractor may solely develop the field at its own costs and risks, and without NOC working interest.” Here the sole development provision offers the contractor an opportunity to develop the field without collaboration with Chinese NOCs. In addition, the provision may also allow IOC to expand multi-pad drilling productions at its own risk for the purpose of encouraging the development of shale gas. Pad drilling, sometimes called multi-well pad drilling, is a drilling practice that allows multiple wellbores to be drilled from a single, compact piece of land known as a pad. To be considered pad drilling, multiple wells must be drilled on a single pad, and those wells must be drilled during the same visit of a drilling rig. By allowing the Contractor to use multi-pad drilling at its sole risk, the contractor could save costs and time in developing shale gas. However, these activities shall be approved by the JMC under the consideration of avoiding any interference to the processing exploration itself.

If you have further questions about this or any other aspects of business law, a business lawyer in Dallas, TX can answer your questions. Contact a law office today.

Thanks to Brandy Austin Law Firm, PLLC for their insight into business law and an overview of China Shale Gas.