January 7, 2014 7:24 pm

Oil and gas: A new frontier

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Western energy companies are flocking to China to help unlock its shale reserves
To match Special Report CHINA-SHALE/©Reuters

An emergency drill at an appraisal well run by Sinopec in Sichuan province, one of the hotbeds of Chinese exploration

Last month, Weir Group held its first ever Christmas party for contacts in the Chinese oil and gas industry. It was not a particularly large or lavish event: 75 of Weir’s customers and suppliers gathered to celebrate the festive season in the usual British style at the Park Tavern pub in Shanghai. But the guests were part of a potentially momentous phenomenon: the birth of China’s shale gas industry.

Is the China shale revolution a threat for the US?

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Weir, which is based in Scotland but runs its oil and gas business from the heartland of the shale boom in Texas, is one of the world’s leading manufacturers of the pumps used for hydraulic fracturing or “fracking” – injecting water, sand and chemicals into wells at high pressure to open up shales and other rocks that do not give up their resources easily.

As China seeks to unlock its shale oil and gas, it offers the potential to eventually become a huge market for western companies such as Weir. “It’s going to be a long time before China reaches the US level,” says Keith Cochrane, Weir’s chief. “But there’s no question they are serious.”

China's production and demand forecast

China's production and demand forecast

Chinese planners have watched with envy as the US shale revolution has cut American energy costs and imports. For its part, the US views China’s effort to generate its own shale boom as a golden opportunity for American business. If China can spark its own shale revolution, energy costs for its manufacturers would fall and its oil and gas industry could emerge as a powerful force in world markets. But the Obama administration believes the potential benefits greatly outweigh any potential damage to US business.

ExxonMobil, Chevron and ConocoPhillips of the US, and Royal Dutch Shell, Total and Eni from Europe, are among the international oil companies that have signed deals to explore shale resources in China.

For companies providing services for oil and gas production, from drilling to fracking to water management, the prizes could be even greater. Schlumberger, Halliburton, Baker Hughes and Weatherford, the world’s largest private-sector oil services companies, are boosting their presence in China.

Yet for all the excitement, the future of China’s shale remains cloudy. Progress so far has been disappointing, and shale production in China faces many challenges. Ultimately, its development will be a test not only of the country’s geology and the ingenuity of its engineers, but of its entire economic model.

China’s potential is certainly vast. By some estimates it has the world’s largest shale gas resources, with about 68 per cent more technically recoverable gas than the US, according to the US Energy Information Administration. Yet progress has been slow. The Chinese government is still sticking to its official production target of 6.5bn cubic metres of gas from shale by 2015 and 60bn-100bn cubic metres by 2020, but at current rates of production that is unlikely to happen.

Shell bet big on China’s potential, earmarking $1bn and developing the country’s best performing well to date. But it now says significant shale developments outside the US could take decades.

Recent successes achieved by Sinopec, the second-largest state-controlled Chinese oil group, in the Sichuan basin have revived hopes that shale production can be made to work in China. Yet shale still seems unlikely to meet the country’s growing demand for gas. In addition to prioritising domestic production, China is diversifying international supply, including coming closer to signing a gas supply deal with Russia.

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China’s shale reserves are often more challenging than those in the US. Chinese geologists are envious of the Bakken oil shale in North Dakota, or the Marcellus gas shale of Pennsylvania, where reserves can be just a mile below the surface. In the steep hills of Sichuan, they are three miles down in structures warped by active faultlines.

China also lacks the pipelines that criss-cross North America. Beijing has had to offer incentives to build gas liquefaction or compression plants near shale gas zones, allowing gas to be trucked out of valleys with no accessible infrastructure. And in most of China’s promising areas for shale gas, such as the Tarim Basin in the northwest, there are limited supplies of water needed for fracking.

Yet more than any of these physical differences, it may be the “soft” factors, including the lack of an open and competitive business environment, a mature legal structure and private land ownership, that are holding back China’s shale revolution.

“There’s so much money to be made in shale in China but it is developing very slowly so there must be a problem,” says Lin Boqiang, director of the China Center for Energy Economics Research at Xiamen University.

In the view of many executives and analysts, the crucial difference between the US and China is in the structure of the industry. As Chen Liming, president of BP China, put it at a recent discussion in Beijing: “I think America has succeeded because of its open market. Without competitiveness they wouldn’t succeed. So there is constant improvement. Through competition, you can greatly increase efficiency and costs will fall.”

The US shale revolution was led by the country’s small and medium-sized companies, which tried many different approaches to “crack the code” and unlock oil and gas. The US also has a rich ecosystem of oil services companies – as many as 10,000 by some counts. In China, by contrast, shale developments are dominated by two state-controlled groups: Sinopec and CNPC, parent of PetroChina. All the shale exploration deals with large western companies have been signed by one of those two, but the Chinese companies still harbour doubts about shale’s potential.

There’s so much money to be made in shale in China but it is developing very slowly so there must be a problem

- Lin Boqiang, director of the China Center for Energy Economics Research at Xiamen University

Because production from individual shale wells declines quickly, companies have to drill more and more wells just to keep total output up, requiring heavy capital spending, and the Chinese oil majors are leery of the commitments that involves.

Trevor Houser, a consultant with the Rhodium Group, says: “If the big US oil groups, ExxonMobil and Chevron, had held 90 per cent of US shale acreage, the pace of development would not have been nearly so fast.”

Impatient with the slow pace of the Chinese oil giants, central ministries threw the nation’s second round of shale tenders open to other players. But industry insiders say these newcomers, which include power companies, coal miners and a steel mill, are not meeting minimal spending commitments, in part because they underestimated the barriers posed by the state giants’ dominance.

Having won land tenders, the newcomers find it hard to hire oil services companies, most of which are affiliated to state organisations. They also struggle to ship into higher-priced urban markets, since the state-owned majors control the pipelines too.

Representatives of the state-owned oil giants and the state planning agencies emphasise the need for Chinese solutions to China’s unique geology. For instance, drillers tend to encounter more mud in Chinese shale wells, which can choke off the flow of gas and cause water to pool up, ultimately destroying the well’s productivity.

Chinese oilfield software firm Recon Technology is offering a data monitoring system to detect such blockages earlier. Jiang Xinmin, vice-director of the Energy Research Institute, part of the National Development and Reform Commission, China’s powerful planning agency, says: “It’s hard to succeed with US technology, but we also have our own technology.”

PetroChina is applying for a domestic patent for a fracturing truck developed by one of its engineering units, which it tested in Sichuan in September. The company is also working on developing its own imaging technology. However, that remains very basic compared with the system developed by Baker Hughes of the US.

China’s industrial structure means that indigenous shale technology is most likely to be developed if it becomes a central government priority, something that has not happened yet, say Chinese industry sources.

“A private Chinese company can’t do it because they would need the work of the research institutes and the Chinese Academy of Science,” says a senior manager at a Chinese oil giant. “It’s not like in the US where everyone is investing in innovation and everyone reaps the benefits.”

That creates opportunities for the international oil services groups, which control critical technology for shale production. China only represents a modest slice of their business, but for some it is growing quickly. Today the in-house services companies of the state-owned groups control about 90 per cent of the market, according to James West, an analyst at Barclays, but he expects that to “shift dramatically” as the industry seeks international expertise.

Schlumberger, the world’s largest oil services group, has been particularly active, opening a research centre in Beijing in 2012 and a new laboratory in Chengdu last year. Mr West, who toured the company’s Chinese operations last year, estimates its revenues onshore could rise tenfold in five years.

The risk for western companies, though, is that China will seek ownership of technology just as the country’s shale development takes off. Chinese industry has a long record of copying or reverse-engineering technology to provide much cheaper, “good enough” versions that squeeze expensive foreign equipment out of all but the high end of the market.

A government policy known as “indigenous innovation” seeks to develop homegrown versions of dominant technologies to encourage Chinese manufacturing and avoid paying licensing fees. Robert Ivy, Beijing-based director of the China office of the US Department of Energy, argues that the larger western companies should be able to avoid that threat. “When we talk about the major companies we engage with in the US, they say the technologies they are bringing here are the one-off technologies, they are not our cutting edge,” he says. “They are already years ahead looking for the next innovation.”

There are signs that western oil services companies are treading carefully with their intellectual property – and are holding back some of their critical knowledge. American companies have refused to give the Chinese the proprietary breakdown of the ingredients in their fracking fluids, despite Chinese requests.

Mr Ivy argues that the Chinese government is well aware that it needs to address issues such as intellectual property protection if the country’s shale industry is to succeed. “They understand they have to work on the regulatory environment, they have to get the environmental protections in place, they need to get their legal system in place,” he says.

Looking at the US shale revolution, the decisive factors are clear: a competitive industry, responsive capital markets, scope for local initiative and innovation, and strong property rights, including intellectual property.

All of those conditions are more or less absent in China. If the country is to make its industry a success, it will need to bring a different kind of shale revolution to its institutional landscape.

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Drilling together – for now

For China, developing shale reserves offers a triple benefit. Increased gas production could replace coal for power generation, reducing the smog that blights many Chinese cities, as well as lowering energy costs and curbing dependence on foreign energy – an increasingly pressing issue since the nation last year claimed the crown as the world’s largest oil importer.

Its ambition is supported by the US, which has held an annual oil and gas forum with China for more than a decade to bring together businesses and officials working in the industry. President Barack Obama also launched a series of energy co-operation initiatives in 2009, including a shale gas programme that organises workshops and study tours.

David Sandalow of Columbia University’s Center on Global Energy Policy, who until last year was assistant secretary with responsibility for international affairs at the US energy department, says helping China develop its shale gas reserves meets several American policy objectives.

“Chinese shale development could help reduce pressures on global oil and gas markets,” Mr Sandalow says. “It could provide significant commercial opportunities to US companies. It could dramatically reduce the air pollution that afflicts Chinese cities and help fight global warming.”

However, US support for China’s shale industry could one day rebound. Chinese oil services companies working on shale projects are trying to learn skills that could allow them to compete for business in the much more actively developed North American shale fields, some of which already have Chinese investment. In the future, it may be Chinese companies who see American shale as the business opportunity they cannot afford to miss.

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