China's shale gas boom

China's natural gas market is expected to see strong growth in the next decade, with several leading factors.

First, China is striving to promote the transformation of energy structure and increase the use of clean energy. In the process, natural gas is regarded as a viable transitional energy source. Second, China's natural gas consumption is far below the global average, which indicates a huge growth potential. Finally, several economic drivers are conducive to promoting natural gas consumption. The most important thing is that China emphasizes urbanization development to promote future development.

The core of China's natural gas strategy is to develop its rich shale gas reserves, which is also a hot topic at home and abroad. With the world's largest collection of technology-recoverable shale gas reserves, China hopes to reproduce the shale gas development boom in the United States. China’s plan announced in March 2012 reflects this desire: China’s shale gas production target for 2020 is expected to be 60 billion to 100 billion cubic meters.

To this end, the Chinese government has adopted a series of policies to encourage and support shale gas development. But by the end of 2014, the State Council had cut China's 2020 shale gas production target to "more than 30 billion cubic meters." The sharp cut in official targets indicates that China is facing huge obstacles in the exploitation of shale gas resources.

At the same time, it is debatable whether China should prioritize the development of shale gas rather than conventional and other unconventional natural gas resources. China's conventional natural gas production continues to grow, with huge tight gas and coalbed methane (CMB) reserves. In addition, the technology of Chinese state-owned oil companies (NOCs) to exploit such unconventional natural gas has matured. Even China National Petroleum Corporation (CNPC), China's largest onshore oil and gas exploration company, has publicly advocated that it is more reasonable to focus on the development of tight gas and coalbed methane, rather than shale gas.

While acknowledging the existence of this debate, this article will focus on China's shale gas development and the future prospects of China's shale gas development in the context of China's decision to move toward the set goals. This article explores the fundamental challenges encountered in the development of shale gas resources in China, summarizes the policies that the Chinese government has implemented for this purpose, and concludes with some ideas on how China can overcome these challenges.

Fundamental challenge

Conceptually, shale gas development can be divided into two phases. The first phase, also known as the innovation phase, is the development of cost-effective mining techniques that can only be achieved through “learning while practicing” and technological innovation. Once the cost-effectiveness of the mining technology is verified, the development of shale gas will enter the second phase, which is the expansion phase, and the substantial increase in production is at this stage. Continuous improvement of technology in the second phase will help increase profitability and expand the development of new regions.

The difficulties in the first phase are far more than the second phase. Once drilling in a shale gas area proves to be profitable, it is not difficult to attract further capital investment in the exploration and development of shale gas mines and similar structures, especially when drilling is seeking investment.

However, China is still in the first stage. The fundamental challenge is to reduce the cost of extraction and extraction through technological innovation, so that the company will find shale gas drilling to be profitable. This is precisely because shale gas drilling is still unprofitable in China.

Take Sinopec (Sinopec) and PetroChina, two of China's largest shale gas companies, as an example to illustrate this point. By the end of 2013, Sinopec reported that the total investment in shale gas development reached US$370 million, and the total investment of PetroChina reached US$640 million, totaling more than US$1 billion. But in the same year, Sinopec's total commercial shale gas production was only 2.58 billion cubic feet, and PetroChina's total production was only 2.47 billion cubic feet.

Most of China's shale gas drilling is located in Sichuan Province, where the natural gas wellhead price is about $9.06 per thousand cubic feet (mcf) and the government's subsidy for shale gas is $1.81 per thousand cubic feet. Based on this estimate, the total revenue of the shale gas of the two major state-owned oil companies is only 54.4 million US dollars. In other words, by the end of 2013, the short-term losses of the shale gas business of the two major companies have reached nearly $1 billion.

Why is shale gas drilling currently not profitable in China? The reason is simple, it is costly. The so-called profit is the difference between the income and the cost, and the income is equal to the price multiplied by the quantity. Even if the price of shale gas can reach 15 US dollars / thousand cubic feet, the income of the two major state-owned oil companies is only 75.7 million US dollars, and the loss is still close to 1 billion US dollars. Various reports indicate that the single well cost of shale gas drilling in the Sichuan Basin is three to four times the cost of similar drilling in the United States of $3 million.

Severe geological conditions

Why is the cost of shale gas drilling in China so high? The two main reasons are the lack of “learning by practice” and economies of scale, and the geological conditions in China are more complicated.

Regarding the first reason, the number of shale gas wells drilled in China is very small. As of the end of 2013, there were about 60 wells, all of which were drilled by PetroChina and Sinopec. The scarcity of drilling will also affect development costs in several ways.

First, it shows that the two major state-owned oil companies have not accumulated enough experience and lack the means to learn how to improve technology and reduce the cost of drilling and hydraulic fracturing. Second, the high fixed costs required for drilling (eg, assessing mine reserves and understanding the cost of the target reservoir geology, and the cost of building infrastructure such as roads and pipelines) are not effectively shared through large numbers of wells, meaning The cost of a single well is higher than it should be. Third, drilling and fracturing machinery may not be fully utilized.

Another reason for the high cost of shale gas drilling in China is the complex geological conditions. According to domestic and foreign engineers, the geological conditions of China's shale gas resources are far less favorable than the United States. According to the US Energy Information Administration (EIA), “most of China's shale basins have complex geological structures, many faults, and some faults are active in seismic activity, which is not conducive to the development of shale resources.”

The US Energy Information Administration's report further pointed out that the southwestern quadrant of the Sichuan Basin (accounting for more than 50% of China's total shale gas reserves) is the most promising area for shale gas in China. The geological conditions, water resources and existing conditions here. Pipes and access to major urban markets are relatively advantageous. However, the report quoted several engineers from China National Petroleum Corporation as saying, “The geological structure here is quite complex, with a lot of folds and faults, indicating a major risk of shale gas development.” The report author stressed in another report that The geological conditions in the Sichuan Basin are huge obstacles, such as a large number of faults (some are active), steep strata, high tectonic stress zones, slow drilling in hard formations, and high levels of hydrogen sulfide and carbon dioxide in some areas."

These geological challenges increase the cost of the prior art, even with some of the best available technologies available. PetroChina and Sinopec may not have the world's leading technology, but they have successfully drilled tight gas wells for many years using horizontal drilling and hydraulic fracturing techniques. Even Shell, which has a production sharing contract with PetroChina and is supposed to have the world's most advanced technology, has not achieved much success in drilling in the Sichuan Basin for many years.

This shows that complex geological formations are one of the major obstacles. Although Shell's drilling and testing have shown that Sichuan's reserves are promising, it also has “significant problems associated with faults, such as frequent drilling outside the block, and the resulting changes make drilling completion more complicated.”

In addition to geological conditions, water scarcity can also lead to high drilling costs, so that some potential shale gas reserves cannot be drilled. The current hydraulic fracturing technology requires a lot of water, so it is no accident that China first developed shale gas in the Sichuan Basin, which is rich in water resources. However, the water shortage in the Tarim Basin, Xinjiang, the second largest shale gas reservoir in China, is very serious.

According to the World Resources Institute, “more than 95% of the gas field in the Tarim Basin is not only facing extremely high baseline water pressure or drought, but also faces very serious groundwater shortages and seasonal fluctuations. These disadvantages will be obtained for the company. Water resources pose huge challenges."

If the geological conditions (and depth) of the shale gas resources in the Sichuan Basin are assumed to be very close to the main well sites in the United States, the mining company will undoubtedly have a great incentive to drill here. As mentioned above, with government subsidies, shale gas prices in Sichuan can reach $11/mcf. In contrast, US natural gas prices have been hovering around $4/mcf in recent days, but the company is still profitable to drill shale gas wells in the United States.

It is true that China's mining shale gas infrastructure is lacking, the terrain is rugged, and technology needs to be transferred from the United States, which will lead to rising production costs. But these costs can be accurately calculated and can certainly drop to less than $7/mcf.

However, more severe geological conditions and other unfavorable factors mean that the cost of shale gas production in China is difficult to reduce in the short term. Achieving economies of scale through thousands of wells, coupled with continuous innovation, can reduce costs, but requires huge initial capital and continued investment in innovation. Given the significant uncertainty in whether shale gas drilling can be profitable and when it is profitable, the company may still be reluctant to invest heavily in drilling.

China's current shale gas policy

But these uncertainties have not prevented the Chinese government from actively planning and supporting the development of shale gas. In March 2012, the four ministries and commissions jointly issued the “Twelfth Five-Year Development Plan for Shale Gas”. In October 2013, the National Energy Administration (NEA) issued a shale gas industry policy document to list shale gas development as a national strategic emerging industry.

This series of policies includes financial and R&D funding to promote shale gas development, open market access, reform of natural gas pricing systems and pipeline transportation. The following is a brief discussion of each policy.

(1) Open market access

First, a brief description of the status of China's oil and gas industry. The three vertically integrated state-owned oil companies – CNPC, Sinopec and CNOOC – have basically monopolized the production, service and transportation of China's oil and gas industry. The three companies are controlled by the Chinese government. The company's executives are directly appointed by the central government. They are dual-employed and are motivated by both economic and political aspects.

The Chinese central government has the mining rights to extract oil and natural gas. Land rights are independent of mineral rights, and urban land is owned by the state but collectively owned in rural and suburban areas. According to China's oil and gas mineral rights policy, state-owned oil companies are required to register their oil and gas resources in the Ministry of Land and Resources (MLR), and no investment will be recovered after maturity. But the latter restriction has never been implemented.

Nearly 80% of the shale gas reserves with the highest potential reserves overlap with conventional oil and gas reserves, and the exploration rights in overlapping areas have been granted to state-owned oil companies. The fact that these production blocks are controlled by state-owned oil companies means that new entrants have nowhere to enter, resulting in competition in the shale gas industry far below that of the United States. In the United States, developers of shale gas are entrepreneurs who take risks and are not rash. In China, even the smallest of the three state-owned oil companies and CNOOC, which has historically been engaged in offshore oil and gas production, is difficult to compete with CNPC and Sinopec in the shale gas field.

Therefore, if China wants to introduce more competition in the shale gas industry, it is crucial to open up the market to new entrants. In fact, this is one of the most obvious policy initiatives of the government.

As a first step in implementing this policy, the Ministry of Land and Resources conducted a tender for the first round of shale gas blocks in June 2011. A total of six companies were invited to participate in the bidding for four shale gas blocks, including three state-owned oils. Enterprises, a provincial oil company, and two state-owned coalbed methane companies. Finally, Sinopec and a coalbed methane company each invested in a block.

The second step is the approval of the shale gas by the State Council in December 2011 to become a new independent mineral. On the one hand, it allows state-owned oil companies to continue to maintain their conventional oil and gas resources, and on the other hand allows the Ministry of Land and Resources to open up the shale gas development market to new entrants, including private enterprises.

The third important step was the second round of tenders conducted by the Ministry of Land and Resources in September 2012. The tender included 20 shale gas blocks that did not overlap with conventional oil and gas resources. Although it is generally believed that the geological conditions and infrastructure conditions of most of the blocks in this round of bidding are not as good as those already owned by state-owned oil companies, this round of bidding basically covers all registered capital of 300 million yuan (US$50 million) or more. Domestic companies (and joint ventures controlled by domestic companies) are open. At the beginning of December, the Ministry of Land and Resources announced that 16 of the 83 bidding companies won the bid, and 19 of the 20 bidding blocks were obtained.

However, the result of this tender is somewhat strange. First, state-owned oil companies did not win any of the blocks, and none of the successful bidders had experience in oil and gas exploration and development. Some successful bidders are engaged in power generation, some are energy investment companies, and some have just been established a few months before the bid. Secondly, the average committed investment amount per block of the winning bidder is 670 million yuan ($110 million), which is much higher than the minimum requirement of 90 million yuan ($15 million) per block.

(2) Financial incentives

In November 2012, the Ministry of Finance (MoF) and the National Energy Administration jointly issued a circular to provide $1.81/mcf of financial subsidies to shale gas production between 2013 and 2015, but the shale gas definition in the notice The standard is too strict. According to an official from the Ministry of Land and Resources, the shale gas that meets the subsidy standard is only 5-7 trillion cubic meters (tcm), while the Ministry of Land and Resources estimates the total amount of shale gas resources in China is 25 trillion cubic meters. The subsidy period is also shorter, but the notice also states that depending on the development of shale gas, the subsidy period may be extended beyond 2015.

The shale gas industry policy announced by the National Energy Administration also includes other financial support. First, the two types of mining resource fees for shale gas development will be cut or waived. Secondly, importing equipment that cannot be made in China will be exempt from customs duties. Third, the government will also study further tax incentives. However, there seems to be disagreement between government ministries on the financial support for shale gas. According to reports, the Ministry of Finance insists that the existing fiscal policy can meet the needs of China's shale gas development and will not provide more preferential fiscal policies.

(3) Research and development

The Shale Gas Development Plan (2011-2015) refers to the R&D policy in general, but does not include specific details. According to the plan, the government aims to increase investment in the investigation and assessment of shale gas resources in China, and to include key technologies for shale gas as key national science and technology projects. The plan further pointed out that the government aims to strengthen the construction of the national shale gas development R&D center and other key shale gas laboratories, and establish a shale gas demonstration area. The Shale Gas Development R&D Center was established in 2010 and is affiliated to PetroChina's China Petroleum Exploration and Development Research Institute.

Some of the content in the plan is not new. The Chinese government has supported several large-scale shale gas R&D projects through the National Key Basic Research and Development Program (973 Program) and several other major science and technology funding support programs. In fact, most of the contents of the five-year plan are the contents of the National Energy Technology “Twelfth Five-Year Plan” issued by the National Energy Administration in December 2011.

Unclear details in the plan may reflect the fact that most R&D will come from state-owned oil companies because they basically monopolize oil and gas exploration and production. This also means that research and development expenses will also be mainly borne by these companies, rather than direct central allocation. In general, the government is pushing these companies to adopt the most advanced technology.

(4) Natural gas pricing

For a long time, the price of conventional natural gas and tight gas formulated by the Chinese government has been lower than the market equilibrium price. Domestic natural gas prices are also lower than import prices. Therefore, natural gas shortages sometimes occur. In view of this, China has initiated the reform of the natural gas pricing system. According to the new pricing mechanism announced by the National Development and Reform Commission (NDRC) in June 2013, the maximum price of the gates in specific cities in the province will be linked to the import prices of two types of alternative fuels (fuel oil and liquefied petroleum gas), basically natural gas. Pricing mechanism linked to price and oil price.

However, this pricing mechanism applies only to incremental gas (rather than stock gas) and non-residential gas. This transitional pricing mechanism is still far from the ultimate goal, that is, the price of natural gas wellheads is determined by the market, and the government only regulates the price of pipeline transportation.

However, this pricing mechanism is still a step forward. The shale gas well price has been released, although the door price is still subject to the maximum price depending on the way of sales and transportation.

(5) Pipeline

Insufficient natural gas pipeline infrastructure and the lack of openness of existing pipelines are often attributed to obstacles to shale gas development. This status quo is partly due to the fact that state-owned oil companies own and operate almost all major pipelines.

In February 2014, the National Development and Reform Commission announced a new policy on the development and operation of natural gas infrastructure, requiring pipeline operators to maintain independent accounts and open unused pipeline operations to new customers on a fair and non-discriminatory basis. This is a limited pipeline open policy – ​​new customers can only get the capacity that is not currently used by existing customers and pipeline operators.

Where will China's shale gas boom go?

Regarding the discussion on whether China's priority to develop shale gas rather than conventional natural gas and tight gas is not mentioned, it is reasonable to assume that the development of shale gas resources is reasonable, and whether our policy on the Chinese government can promote shale gas. A brief assessment of the goal of the development boom.

Some of the policies discussed above – subsidies, price incentives, and R&D policies – are designed to help expand company revenues and improve existing technologies to increase the attractiveness of shale gas production to the company. Other policies – natural gas pricing mechanism reform and pipeline openness policy – ​​aim to promote the development of the natural gas market as a whole. These policies are mutually supportive in principle and reasonable from an economic perspective.

For example, based on the development of shale gas with social and economic benefits (by replacing the use of coal), financial subsidies and R&D support are reasonable. Reform of market pricing mechanisms and open channels can reduce market distortions and increase their efficiency. It is worth noting that the US federal government adopted these policies in the late 1970s and early 1990s to promote the development of the US natural gas industry.

The development of shale gas to new entrants is a major policy initiative aimed at breaking the monopoly nature of state-owned oil companies and introducing more competition for shale gas development. This policy is undoubtedly in line with the Chinese government's goal of making the market play a decisive role in resource allocation.

This policy will enable newly-entered companies to gain experience and expertise in oil and gas exploration and development and contribute to the future growth of the shale gas industry in China. The investment of these companies for exploration will also help China better assess its shale gas resource reserves.

However, this is only the first step in a journey of a thousand miles. It does not in itself contribute to overcoming the fundamental difficulties (reducing costs through “learning while practicing” and innovation).

Although the new entrants won in the second round of bidding, they were reluctant to fulfill their promised investment because they could not avoid the bad luck that suffered huge losses in the near future.

The new entrants have no experience in oil and gas drilling, and their winning shale gas blocks are inferior to the blocks obtained by PetroChina and Sinopec in terms of geology and infrastructure. It is obviously unrealistic to expect these companies with no experience in conventional oil and gas drilling to develop shale gas reserves with unfavorable geological conditions.

In fact, it is reported that as of the end of September 2013, the second-order seismic acquisition of the second round of shale gas winning blocks has only completed 14.2%, and drilling work has not yet begun. 15 Due to the slow progress of the second round of successful bidders, the third round of bidding has still been postponed.

(1) American experience

It is useful to compare these new entrants with a pioneering American company, Michelle Energy and Development ("Michel Energy"). This is a medium-sized company that is known for its initial investment in shale gas drilling and plays a key role in the creation of the US shale gas industry.

Unlike new entrants in China's shale gas industry, Michelle Energy has always needed to find new natural gas resources to meet its contractual obligations, as well as many incentives to minimize economic losses and ultimately generate huge returns through early investment. .

One of the reasons is that Michelle Energy has an outstanding team of geologists and engineers with first-class expertise in fracturing and tightness. The company began drilling in shale gas blocks with favorable geological conditions and multi-layer natural gas reserves, so that once the shale gas reserves were found to have no production value, they could choose to drill conventional gas wells.

There is also a mechanism that allows the company to ultimately achieve a huge return on investment. Under the mechanism, the company can lease large tracts of land and related mining rights at an early low price and then sell the land and company at far higher prices. The United States enforces private ownership of land and mineral rights, so this mechanism is feasible in the United States, and it helps to overcome the problem of monetization of technological innovation in the oil and gas industry.

(2) Different incentives and vested interests

Even if the Chinese government decides to auction some of the most favorable shale gas blocks, it is doubtful whether new entrants will invest a lot of money for shale gas drilling in the short term.

Unlike the bidding block for the second round of shale gas development, most of the shale gas blocks with the most favorable geological conditions overlap with conventional oil and gas reservoirs. If new entrants win such a block, they should be allowed to simultaneously mine overlapping conventional oil and gas reservoirs. It is forbidden for new entrants to drill economically in conventional oil and gas reservoirs, and it is difficult to enforce the policy of prohibiting the drilling of conventional oil and gas reservoirs.

Ironically, once new companies enter the shale gas block, they are more motivated to develop conventional oil and gas resources and postpone drilling of shale gas reservoirs because of the development of conventional oil and gas reservoirs relative to shale gas. Layers are more cost-effective under the prior art and are therefore more profitable and less risky than developing shale gas reservoirs.

This means that if China allows new entrants in the shale gas industry to develop conventional natural gas resources (including tight gas) and let the market determine oil and gas prices, it will accelerate the development of conventional natural gas resources.

However, it is difficult for the Chinese government to liberalize the development of conventional oil and gas resources to new entrants. This will greatly affect the interests and operations of state-owned oil companies. It is foreseeable that they will vigorously lobby the government to oppose such policies. For example, they may point out that natural gas prices below market prices will cause them to be reluctant to invest more money in developing conventional natural gas and tight gas, and also point out that taking on many social responsibilities (such as retaining redundant workers) will reduce state-owned oil companies. Benefits.

(3) Encouraging private enterprises

From a political point of view, it is more difficult for China to implement policies to encourage new entrants, especially private companies, to enter the market and undertake huge and high-risk investments to develop shale gas. Private companies often expect a reasonable return on their investment, but it can be quite difficult to do this in China.

Let's take a look at the example of the United States. If a new venture company makes a huge upfront investment in shale gas drilling, successfully improving technology and reducing costs, how will it monetize its innovative technology?

In the United States, independent oil and gas companies such as Michelle Energy do not monetize technology by selling new technologies because such technologies are rarely patentable and difficult to keep secret (because operators and service providers are cooperative) ).

Conversely, US companies tend to secure the return on venture capital through low-cost leasehold land and related mining rights: investment drilling and mining technology innovations will increase land value. The economic rewards of selling land as a valuable asset are enough to attract US independent oil and gas companies to take great risks.

But in China, the government will not allow land and mining rights to be private. Therefore, the viable way for private companies to get a return on investment is for the government to allow the company to control large areas of land and mining rights. But from a political point of view, it is difficult to achieve a large amount of oil and gas reserves in the private sector, so that the owners of oil and gas reserves, rather than the government, have the opportunity to obtain greater economic returns.

(4) State-owned oil companies to rescue?

From this point of view, China's greatest hope of overcoming the fundamental challenges of shale gas development falls on state-owned oil companies. Whether in terms of technology, experience, funding or policy, they have far more advantages than new entrants.

PetroChina and Sinopec have rich experience in the development of tight gas, and therefore have advanced technologies for horizontal drilling and hydraulic fracturing. It is worth noting that before the rise of shale gas development in the United States, there has been a significant increase in tight gas production. Therefore, the government will hope to bet on PetroChina and Sinopec, which have rich experience in developing tight gas.

At the same time, the two giant state-owned enterprises of PetroChina and Sinopec have invested billions of dollars in the acquisition of shale gas-related assets in North America, even though these acquisitions will ultimately help them to obtain the best mining technology.

In addition, the two state-owned oil companies have been drilling in shale gas blocks with the most favorable geological conditions and infrastructure conditions in China, and have also established national demonstration areas. (PetroChina has two demonstration projects and cooperates with Shell on another demonstration project. Sinopec has a demonstration area and announced in March 2014 that the demonstration area has made a major breakthrough).

Assuming that China's policy of prioritizing and supporting shale gas development is reasonable, then the key question remains how to better encourage state-owned oil companies to invest in shale gas drilling. One of the possible methods is to include shale gas investment in the important evaluation criteria of state-owned oil company executives. Many scholars believe that competition among government officials and relevant cadre evaluation systems is one of the main drivers of China's rapid economic development.

By increasing such political incentives, it is possible to motivate state-owned oil companies to carry out high-risk investments in shale gas drilling, while paying less attention to the economic benefits behind such investments. However, blindly promoting political incentives without considering economic benefits cannot be a reasonable policy, because it will lead the government to provide more subsidies to make up for the losses of state-owned oil companies.

The severe smog in many Chinese cities reminds the central government's policy makers every day that China urgently needs to replace coal with natural gas. But unfortunately, China does not seem to have a shale gas boom in the short term. The cost-effectiveness of shale gas technology must be increased, and this requires strong incentives and a considerable amount of time to achieve.

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