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December 17, 2011 12:02 am

Shale gas developments herald big export opportunities

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This article is provided to readers by mergermarket—a news service focused on providing actionable, origination intelligence to M&A professionals.

The recent revelation that PetroChina successfully extracted natural gas from shale formations in China’s Sichuan Basin has confirmed the commercial viability of hydraulic fracturing, or “fracking”, in the country. The news also confirmed the major export opportunity that has emerged for the growing number of American companies that produce the array of equipment, chemicals and technologies that will be needed to exploit China’s vast shale gas reserves. At an estimated 1,275 trillion cubic feet, these reserves comprise the world’s largest source.

Because of the US’s leading position as a shale gas producer, American companies possess most of the specialized expertise used in the process of fracking, which entails pumping millions of gallons of water mixed with chemicals and other materials at extreme pressures thousands of feet underground through horizontally drilled wells in order to fracture shale rock formations and release the natural gas held within them. Their experience harnessing gas from formations which last year produced nearly five trillion cubic feet of gas natural gas, accounting for 23% of all such US gas production, has resulted in American companies possessing major competitive advantages when it comes to producing the tools needed to extract this gas.

The most established and prominent players in what some pundits say will become a 50 year-long American manufacturing boom include oil field service majors like Baker Hughes, Halliburton and National Oilwell Varco as well as ITT’s water treatment spin-off, Xylem. Barclays Capital oilfield services analyst, James West, expects US companies like these will add a combined USD 8 to 10bn in shale gas-related equipment and services economic activity over the next year.

However, many of these companies are looking ahead to exports.

National Oilwell Varco’s executives recently identified the opportunity to sell its shale gas equipment and technology to markets such as China as a significant future growth opportunity. The Houston, Texas-based oil and gas rig technology company’s CEO Merrill Miller stated during its recent earnings call that National Oilwell were big believers in first mover advantage, and named China alongside some other countries as sources of its investment in anticipation of future exports.

Similarly, Halliburton’s CEO, David Lesar, emphasized the Houston, Texas-based oil and gas equipment and services provider’s better positioning vis-a-vis many of its competitors when it came to capitalizing on this growing industry because of its export potential. Speaking at the company’s recent earnings call, Lesar said that international unconventional resources were highly undercapitalized from an equipment standpoint, and that the company could accelerate and transfer equipment to these international markets. The CEO’s comments on technology transfer were echoed later in the call by its President of Strategy and Corporate Development, Timothy Probert.

“We’re in the process of mobilizing horsepower to our Europe/Africa/CIS, Middle East/Asia and Latin America regions in support of these developments,” Probert said.

Multinational firms such as these are either already established, or have positioned themselves so that they soon will be. But the door is also wide open for the multitude of smaller American companies that provide fracking equipment and services but whose production capacity has been largely absorbed by the fast-growing US shale gas market.

However, many privately-owned US businesses, such as geophysical surveying consultant MicroSeismic, have also succeeded in capitalizing on the Chinese shale gas opportunity from the beginning. The Houston, Texas-based company, which manufactures seismic monitors and also analyzes the data its devices collect, has been involved in several Chinese shale gas projects, including two separate horizontal well developments with Sinopec and PetroChina. The company’s products, of which it sold USD 11.3m for the quarter ending 31 March 2010, provide drillers with visual feedback on the extent of fracturing in shale formations thousands of feet underground, thereby enhancing the process in terms of efficiency and environmental safety.

As with most US-based companies looking to break into the Chinese market, MicroSeismic partnered with local firms for the projects, including surveying equipment manufacturer Xiamen Geo-Tech Precision Instruments, a Fujian province-based surveying equipment manufacturer.

Neo Solutions, which manufactures water treatment chemicals, is also exploring ways to expand its business beyond the US. The Beaver, Pennsylvania-based company, which supplies drillers in the Marcellus Shale, is looking for partners to jointly develop fracking fluids and is also researching the regulatory requirements in a number of markets, including China. Neo Solutions’ business development manager Craig Iman said that such a partnership would allow it to build on its existing shale gas-related business which entails decontaminating the fluids used during the drilling and the hydraulic fracturing phase.

Smaller E&Ps taking the leap

Nearly all of the major Western energy companies have well-established positions in China. BP and its partner Sinopec completed a fracking exercise using US technology for the first time in the country in May 2010, and Royal Dutch Shell, working with PetroChina, completed China’s first horizontal shale gas well in March this year, according to reports.

But smaller energy firms are making moves to enter into the potentially lucrative market.

Breitling Oil and Gas is one such US E&P company. The privately-owned Irving, Texas-based driller’s CEO Chris Faulkner said he viewed the company’s extensive experience working on all the major US shale gas projects as a competitive advantage in its bid to gain a foothold in the fledgling Chinese market. The CEO was referring to its projects in the Bakkan, Eagle Ford, Haynesville, Marcellus and Woodford shale formations which produce a combined 4,800 barrels of oil equivalent (BOE) per day.

Breitling is now looking to get involved in China. It is in talks with several potential joint venture partners with the aim of developing projects in the Sichuan Basin. While the partnerships could involve any unconventional resource plays, the primary focus will be on natural shale gas. The company expects to finalize on one or two partners by the second quarter of next year. Smaller companies that want to get involved in China’s shale gas revolution will have to act fast, Faulkner warned, as there is currently a scramble to identify and partner with local firms.

While small and medium-sized US drillers such as Breitling will have an immediate advantage in terms of experience as they expand into China, local companies are rapidly catching up. China’s largest offshore oil and gas producer CNOOC invested USD 1.27bn, in Oklahoma-based Chesapeake Energy to cover operational costs and receive a 33% stake in its shale gas projects in Wyoming and Colorado. CNOOC’s primary rationale for the investment was access to the Chesapeake’s shale gas extraction methods and technology.

Another example of the shifting dynamics in competitive advantage can be found in the production of the proppants used in fracking fluid. Proppants are small ceramic spheres or industrial sand, which are mixed with the fluids and water which are pumped into the shale gas wells to create the fractures that are release the gas from the rock formations. The proppants specifically help create and hold apart the fractures.

Houston, Texas-based CARBO Ceramics and French multinational Saint-Gobain are two large suppliers of ceramic proppants with major manufacturing operations in the US. Both companies are trying to increase capacity in anticipation of more fracking projects, but at the same time are facing pricing pressures from several China-based manufacturers of ceramic proppants, said one US-based distributor who declined to be named. Further, the jury is still out on whether ceramic proppants are better than industrial sand in creating effective fractures. Ceramic proppants can withstand higher pressures and have advantages in terms of consistency of shape and size, but sand remains a widely used proppant. This may be because sand is much cheaper than engineered ceramic and Chinese drillers could source those products from within China or other nearby countries, the distributor said.

Regulatory obstacles begin at home

While the exporting opportunities presented by the development of fracking are significant, companies could find the regulatory complexities that are involved just as overwhelming. Finding a joint venture partner is the most common means of accessing the Chinese market used by foreign companies. Even high-profile multinationals with extensive local contacts and resources face regulatory hurdles because the energy sector is considered as a strategically-sensitive industry. For this reason the Chinese government typically requires local Chinese company participation and/or the use of Chinese content, conditions that it expects will help the country to develop its own shale gas expertise, said Greg Husisian, an international trade and export controls attorney with Foley & Lardner. This local participation requirement is a long-standing, Chinese regulatory tradition which the government has used to foster domestic manufacturing capabilities in a range of industries. And while IP theft and other competitive risks should not be underestimated, a number of industry sources played down their significance when compared with the advantages gained by forming a partnership with a well-connected local company that understands how to operate within local customs and laws.

In fact, Husisian views issues relating to America’s very own Foreign Corrupt Practices Act (FCPA) as a more significant obstacle than anything else US companies operating in China have to address. The gravity of the issue was underlined this week by the record USD 1.6bn in total settlements made by Siemens, the German industrial technology giant, as a result of the US Justice Department and the Securities Exchange Commission’s charges that the company bribed local officials to land a USD 1bn contract to provide identity cards to the Argentinean government.

Howard Kim, senior vice president of legal reform initiatives at the US Chamber Institute for Legal Reform (ILR), believes some US corporations are unwilling to engage overseas as they are scared of retaliation from the US government over FCPA violations. Kim cited an example whereby a US firm faced an FCPA investigation after giving a five dollar taxi voucher to a healthcare official after a business event in China.

The FCPA forbids the bribery of foreign officials and, for publicly traded companies, requires appropriate internal controls and the maintenance of accurate books and records, including those of joint ventures that are majority-owned by a US publicly traded company. Husisian pointed out the FCPA’s definition of a foreign “official” is wider than companies that have only operated in the US may have anticipated. For this reason, he says that any dealings involving foreign entities should be scrutinized very carefully. This wide definition of a foreign official is applicable in this instance given that many Chinese oil and gas companies involved in shale gas development are state-owned enterprises and also because the Chinese government has control over what acreage can be developed.

US FCPA authorities expect a strict level of due diligence and transparency, even when the US company is operating through a third party, such as an agent, consultant, or joint venture partner. Husisian warns that it can be very difficult for a US company to demonstrate that it did not have knowledge of any bribe that was made after the fact. This point is important for US energy companies because, the attorney says, many prefer to limit their involvement in any bidding for shale oil development rights on the assumption that this will limit their potential liability under the FCPA. Husisian says that the reality is that operating in this way increases the chance of an FCPA violation on the basis this constitutes “willfully blind” behavior due to a company’s failure to conduct sufficient due diligence or to adequately oversee its partner.

Despite the large number of FCPA cases involving US companies operating in China in recent years, Husisian says the business climate there is steadily improving. He says that the fear of incurring millions of dollars in FCPA penalties, and even larger costs for conducting internal investigations, has resulted in the attorney’s clients adopting a more upfront approach to conducting business with their foreign partners and discovering more ways to finish projects which do not entail paying bribes. This seems to be influencing some countries known for corruption, including China, to begin to conduct business in a more open and transparent fashion, Husisian said.

Additional reporting by Raymond Barrett in Washington, DC


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