china shale gas 2014
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Important disclosures can be found in the Disclosures AppendixAll rights reserved. Standard Chartered Bank 2013 http://research.standardchartered.com
l Equity Research l China l Oil & Gas l 30 September 2013
China shale gas
Potential unearthed
China shale gas, emulating the US success: We have assessed Chinas shale gas development against the US blueprint.
We see uncanny similarities in policies being implemented from fiscal incentives to gas price deregulation and the start of
the privatisation of pipeline infrastructure. Our extensive on-the-ground checks also show China is successfully overcoming
key challenges that had threatened its shale gas outlook. This leads us to believe the Chinese government sees shale as
Chinas major source of gas supply in the long term and is determined to unearth its vast potential.
From scepticism to belief: Like consensus, we were sceptical about Chinas shale gas prospects and the National
Development and Reform Commissions production target of 60-100bn cm by 2020. However, our proprietary model based
on our in-depth study of the US experience and analysis of Chinas challenges and advantages indicates output could
indeed reach 61bn cm in 2020E, 2.5x the consensus estimate. To support this shale gas upsurge, we expect gas producers
to accelerate investment in shale projects. In our base case, we estimate shale gas investment will grow 62% p.a. in 2013-20
and reach USD 21bn in 2020, equivalent to c.50% of PetroChina and Sinopecs total onshore E&P capex in 2012.
Positive for producers and economic stability: Chinas shale story has had a positive impact on valuations in the gas
services sector. We argue a case for producers, which have not enjoyed a similar boost. We expect shale gas production to
start in 2014 and turn profitable from 2018. We forecast a normalised shale gas IRR of 16%, above the new project hurdle
rate of c.13% for the Chinese NOCs. We forecast double-digit production growth until 2030, when we expect shale gas to
represent 30% of gas supply, significantly reducing Chinas reliance on imported gas (from 40% to c.25%).
Sinopec and PetroChina likely to benefit: Among the producers, we believe Sinopec will be the main beneficiary of the
shale story. We estimate recognising shale reserves would boost its oil and gas reserves volume by 158%/218% (base/bull
case) and add 7%/11% to its NPV. Shale gas could increase PetroChinas upstream reserves volume 35%/54%, add 4%/6%
to its NPV in our base/bull case, and enable it to reduce imports, which would lower this national service burden.
Duke SuttikulpanichDuke.Suttikulpanich@sc.com
+65 6596 8512
Ying WangYingY.Wang@sc.com
+852 3983 8707
Akash GuptaAkash.Gupta@sc.com
+65 6596 8513
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Contents
Summary 6
Learning from the US 18
China: Mapping the US path 25
Chinas challenges 38
Chinas advantages 44
Case study: Tight gas versus CBM 48
Our proprietary China shale gas model 53
China shale supply-demand impact 63
Analysing impact on gas producers 66
PetroChina (Outperform, PT HKD 11.00) 70
Sinopec (Outperform, PT HKD 7.20) 76
CNOOC (Outperform, PT HKD 18.00) 81
Appendix I: From Barnett to a nationwide phenomenon the US success story 86
Appendix II: Other factors supporting the US shale success 88
Appendix III: Horizontal drilling 89
Appendix IV: Hydraulic fracturing 90
Appendix V: Chinas LNG re-gas capacity 91
SCout is Standard Chartereds premium researchproduct that offersStrategic,Collaborative,Originalideas onUniversal andThematic opportunities
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Figure 1: Chinas MLR estimates Chinas shale gas recoverable potential at 25.08tn cm, 32% larger than the US reserves
Source: Ministry of Land and Resources, Standard Chartered Research
0.29
TuhaBasin
1.00JunggarBasin
1.46Tarim Basin
0.56
QaidamBasin
2.71Ordos
0.14Qinshui
0.86
Nanxiang
0.16Dongnan
0.14ShiwanDashan
0.26Nan Panjiang
6.44Sichuan Basin
0.26Liupanshui
1.64
Songliao
0.03JiuquanBasin
0.35Mid and
Small
Basin
1.87Quan
Zhong
0.25
Baise-Nanning
0.53 Guizhong
1.34BohaiBay Basin
0.48Subei
1.07Lower Yangtze
0.09Ganxibei
0.01 Xichang
0.04 Chuxiong
0.26 QianZhonglong
0.16Pingle
1.59
Middleyangtze
uplift
depression
Legend
Recoverable resources
0.34
Xiangdongnan
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Figure 2: History of the US shale gas boom
Source: EIA, Standard Chartered Research
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1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
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US Shale Gas Production
1978: Department ofEnergy took overunconventional natural
gas researchprogramme
Late 1980s: Horizontaldrilling achievedcommercial viability,however MitchellEnergy does notcapitalise on thistechnology
1985 & 1992: FERC Orders No.436 and No. 636 issued toderegulate the pipeline marketand unbundle natural gas andtransportation costs intoseparate products
1978: Natural Gas PolicyAct passed to deregulatethe natural gas marketand remove ceilings onnatural gas prices
1992: MitchellEnergy acquired itsfirst 3-D seismicData Set in NorthTexas
1997: Mitchellengineers beganexperimenting withnew approach tofracturing slickwater fracturing
2002: Devon Energypurchased Mitchell Energyfor USD 3.5bn; starteddrilling horizontal wells ona larger scale
2002 onwards: Prospectof high profit marginsattracted firms; newentrants invest heavily inexisting and new plays
Early 2000s: 3-D seismicsurveys became widespreadapplication
1981: First Barnettwell drilled by MitchellEnergy
1994: Mitchellreduced cost offracturing byimproving hydraulicfracturing methods
1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
1999: New reserveevaluation in Barnettincreased gas-in-place estimate by afactor of 2.5-3x
US shale gas production
Growth phasePrecursor phase
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Figure 3: Chinas shale gas story, a mirror image of the US blueprint
Source: Standard Chartered Research estimates
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2002 2009 2010 2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2020E 2030E 2040E
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China's shale gas production
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Precursor phase Growth phase
2010: China set upnation's first shale gasR&D centre at CNPC
2012: China's MLR held two rounds of shale gasauctions open to diversified investors inlcudingstate-owned companies and private companiesEarly 2000s: China
started closelyobserving shale gas
development in theUS, in hopes ofrepulicating thesuccess
2008/09:Government offiicalsstarted voicingChina's shale gaspotential, drawinggreat public interest
2011: CNOOCobtained first shale gasblock in Anhiui throughnegotiations with MLR
2012: Sinopec drilled its first high-yield shale gas
well, Jiaoye-1HF, in Sichuan Basin
End-2013: Sinopec Chairman Fu Chengyu said in August2013 that Sinopec is likely to announce China's first large-scale shale gas project by end-2013
2013: NEA approved set-up of China's shale gastechnology standardization committeed at CNPC
2013/14: China's third shale gas auction expected
China: Mapping
the US shale story;On track towards ashale boom
2011: Ministry of LandResources (MLR)categorised shale gasas an independentmineral resource
2010: PetroChinadrilled China's firstshale gas well, Wei-201, in SichuanBasin
2012: National Energy Administration (NEA) and theMinistry of Finance announced a production subsidy;NEA announced 12th Five-Year Plan for shale gas
2011: ShanxiYangchang Petroleumdrilled first shale gaswell in Ordos Basin
20092002 2010 2011 2012 2013 2014 2015 2016 2017 2018
2013: PetroChina opened up pipeline investment toexternal investors and the NDRC issued rules to diversifyinvestment in natural gas infrastructure projects
2013: China announced plans to start deregulating gasprices with an intial15%-25% increase in wellhead gasprices
2012: International oilfield service companies includingSchlumberger and Halliburton started formingpartnerships with Chinese private firms like Anton Oilfieldand SPT Energy
Early 2000s: IOCsincluding Shell and Totalstarted forming
partnerships with ChineseNOCs for tight gasdevelopment
2010: IOCs includingShell, Chevron andConocoPhillips startedforming parntershipswith Chinese NOCs forshale gas exploration
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SummaryOver the past few years, the biggest story in the energy markets has been the surge
of cheap shale gas in the US, and the ensuing impact on national economies and
individual companies. Now that the euphoria surrounding the US has calmed, the
focus is shifting to China. According to the US Energy Information Administration
(EIA), China has the worlds largest shale gas reserves, exceeding even the US
reserves. Can China be the next US in shale gas terms, or even outdo the shale
pioneer?
To arrive at an informed opinion of our own, we carried out exhaustive research on
the topic to get a clearer sense of Chinas shale outlook. We conducted on-the-
ground checks with key government regulators, key domestic players including China
National Petroleum Corporation (CNPC), China Petroleum & Chemical (Sinopec),
CNOOC and Shaanxi Yanchang Petroleum (non-listed). We also talked to foreign
partners including Royal Dutch Shell (Shell), Total S.A. (Total), Chevron and BP, as
well as oilfield services companies Anton Oilfield Services (Anton), SPT Energy,
Termbray Petro-King Oilfield Services and Schlumberger.
Our conclusion is that Chinas shale gas output will increase significantly. We expect
production to rise to 61bn cubic metres (cm) in 2020, meeting the lower end of the
National Development and Reform Commissions (NDRC) target range, and
significantly exceeding consensus estimates, driven by increasing E&P investment.
We expect Chinas shale gas development to require capex of USD 21bn in 2020,
implying a 50% addition to PetroChina and Sinopecs 2012 onshore E&P capex, and
forecast a growth rate of 62% p.a. in shale gas investment between 2013 and 2020.
By 2030, we believe shale gas could contribute the majority of Chinas gas supply.
This could help reduce import dependence from a peak of c.40% of supply in 2016-
18E to c.25%, helping China maintain economic stability.
We believe Chinese upstream producers, namely Sinopec and PetroChina, would be
the leading beneficiaries of the shale gas success we forecast in this report. We also
see oilfield services companies and gas distributors as key beneficiaries. In the
longer term, Chinas petrochemical industry could also benefit from the availability of
cheap gas feedstock. However, coal producers could see risk from lower demand as
consumers switch to gas as a cleaner source of energy.
Figure 4: Chinas long-term gas supply versus demand
Source: Bloomberg, CEIC, Wood Mackenzie, Standard Chartered Research estimates
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2011 2012 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E 2028E 2029E 2030E
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Conventional gas Shale gas Tight gas CBM CTG LNG Import Pipeline imports Consumption
Incremental consumption fromstronger government pushes andpotential gas-based petrochemicalplants
Extensive on-the-ground check s
with m ajor pol icy m akers and
operators suggest China is making
signi f icant progress in shale
We expect Chin a shale gas
succ ess to require USD 21bn of
capex in 2020, c.50% of total on -
shore upst ream capex in 2012
By 2030, we believe shale gas will
be the largest compon ent of
Chinas domesticgas supply , at30%
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China shale gas the next big thingWe expect meaningful contributions from shale gas in China in 2018, and believe the
success of the shale story will bring dramatic changes to Chinas natural gas
landscape as it has in the US. Our gas supply model indicates shale gas productionwill account for 15% of Chinas total gas supply in 2020E and 30% in 2030E.
Shale gas likely to reduce Chinas reliance on imports
Chinas shale gas success would impact the global gas market by reducing Chinas
reliance on external gas supplies such as liquefied natural gas (LNG) and gas
supplied via cross-border pipelines. Imports currently meet c.25% of Chinas natural
gas demand, and we estimate the ratio will peak at c.40% in 2016-18. As a result of
the shale gas success, we expect imports to decline to c.25% of demand by 2030.
We believe Chinas natural gas producers and importers, namely PetroChina and
Sinopec, will benefit in two ways. Firstly, through a substantial increase in reserves
recognition and production growth as shale gas becomes economical. This will be
accretive in terms of both asset valuation and earnings. Secondly, as both companies
are now importing expensive LNG and/or pipeline gas, they could potentially see this
state-mandated burden decline, either in absolute volume or as a proportion of
overall supply. We analyse both the quantitative and qualitative effects of these
changes in this report.
Figure 5: We expect Chinas reliance on imported gas to decline when shale gas
takes off in 2017-30E
We forec ast a 2015-30 shale gas
produc tion CAGR of c.30%, easing
dependence on imported gas
Source: Bloomberg, CEIC, Wood Mackenzie, Standard Chartered Research estimates
On the other hand, Chinas reduced imports would be negative for the worlds major
LNG suppliers, especially those in Southeast Asia, Australia and the Middle East,
whose delivery contracts with Chinese buyers mostly lapse around 2030-36.
Figure 6: Most of Chinas current gas import contracts lapse between 2030-36
Source: Bloomberg, Standard Chartered Research estimates
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2008 2010 2012 2014E 2016E 2018E 2020E 2022E 2024E 2026E 2028E 2030E
shale gas contribution to total gas supply dependency on import
2006 2011 2016 2021 2026 2031 2036 2041
LNG - Australia
LNG Papua N. Guinea
LNG - Qatar
LNG - Yemen
LNG - Malaysia
LNG - Indonesia
LNG - Others
Pipeline
Increased shale gas output would
reduce reliance on import s,
benefiting PetroChina and Sinopec
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US the shale gas pioneer, and lessons learnedContrary to general perception, the US shale gas story has not been a revolution but
a drawn-out evolution. While resources and favourable geology are vital, the recent
boom in shale gas would not have been possible without the support or will of thegovernment and private sector. Our detailed study of the US experience shows that
the foundations for shale gas success were laid by the government and the private
sector almost 40 years ago.
Industry deregulation triggered intense company involvement
In our view, the US shale gas evolution began in 1978 with the passage of the
Natural Gas Policy Act, which effectively deregulated gas prices. This was followed
by the deregulation of pipeline assets and the introduction of fiscal incentives for
unconventional gas development in the 1980s.
This encouraged small but agile private companies like Mitchell Energy (Mitchell) to
pursue shale gas development starting in 1981. This commitment paid dividends
after US O&G giant Devon Energy acquired Mitchell Energy in 2002. From that
moment, shale gas development began on a large scale in the US.
Figure 7: Key factors underpinning the US shale success story
Driven by government/industry Natural
Technology development Abundant resource
Favourable gas pricing Water availability
Adequate and open pipeline infrastructure Favourable geology
Access to land Topography
Well-developed road network
Source: Standard Chartered Research
US shale gas production grew 19% p.a. in 2002-05, rising from 2% of overall gas
supply to 4%. US shale gas output is now c.265bn cm, implying 43% p.a. growth
since 2005, and shale gas represents 39% of overall gas supply.
Figure 8: US shale gas production reached critical mass in less than five years
Source: Energy Information Administration, Standard Chartered Research
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
US shale gas poduction (bcm)
Pricing and pipeline reform s and
fiscal incentives encouraged the
industry to develop the vast
resource base
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China: The protgAccording to the EIA and Chinas Ministry of Land and Resources (MLR), China
possesses even larger shale gas resources than the US. The EIA estimates China
shale gas reserves at 32tn cm, 68% more than the US, while the MLR, taking a moreconservative stance, estimates reserves in place at 25tn cm, still 32% above US
reserves.
So why is the street so sceptical about Chinas prospects of developing shale gas?
Figure 9: Chinas shale gas resources exceed US resources
Source: Energy Information Administration, Ministry of Land and Resources, Standard Chartered Research
The challenges most commonly cited as reasons China will not be able to replicate
the US success are: (1) higher production costs, because resources are deeperunderground; (2) Chinas more complex topography and higher population density,
which limit the scope of drilling; (3) the regulated nature of Chinas natural gas sector;
(4) the lack of technological expertise; and last but not least (5) insufficient water
resources.
Figure 10: We think China will be able to overcome the key challenges to shale gas development
Key challenges Solutions
Reserve depth Shale gas in China is 1-2km deeper than in theUS.
China aims to increase the use of local equipment and technology toreduce costs associated with more complex well drilling.
Topography Topography is unfavourable, with mountainous
terrain in some regions.
Designing innovative drilling equipment to suit China's particular
topography.Pricing Historical pricing regulations reduce economic
benefits of developing unconventional gases.Deregulation of prices for unconventional gases in 2011 and industry-widegas pricing reforms in July 2013 boost prospects of developing shale gas.
Technology China is behind the US in key drillingtechnologies and expertise.
China is catching up through: (1) proprietary R&D; (2) partnerships withIOCs; and (3) international acquisitions of major unconventional players.
ater Per capita water resources are much lower thanin the US.
Our findings show shale gas drilling will require
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China emulating US shale gas roadmap
In this report, we examine Chinas key challenges in developing shale gas. First and
foremost, we note that the government was by no means oblivious to these
challenges when it set the production target at 60-100bn cm in 2020. In fact, what we
have seen over the past year suggests China is not only utilising the technology
developed by the US, but is also emulating the US policy roadmap we point to the
fiscal incentives for shale gas, allowing onshore foreign investment in the sector, and
the lifting/deregulation of gas prices. Given the US path, we think the deregulation of
the pipeline sector will also be on the agenda in China.
Figure 11: China tries to emulates the US shale gas roadmap
Key policy incentives Plans announced by Chinese government
Price deregulationDeregulated pricing for unconventional gases in 2011; prices of conventional gases raised further through pricereforms announced in July 2013.
Pipeline deregulationTook the first step in pipeline deregulation in 2013 by allowing diversified investment in gas infrastructure
construction.
Fiscal incentivesAnnounced production subsidy for shale gas in 2012, and the market expects the government to announce a VATrebate policy once large-scale production commences.
Diverse investment Aims to introduce diverse investment in shale gas development through public auctioning of blocks.
Source: Standard Chartered Research estimates
China shows entrepreneurial drive to tackle key challenges
China has also shown entrepreneurial instincts to tackle the challenges that are
unique to the country. On the cost issue arising from harsh terrain, for example, we
found that costs can be reduced by as much as 50% if operators maximise the use of
local equipment, technology and engineers. Topography has also stimulated
innovations such as the foldable water tanks invented by an oil services company.
Figure 12: China can reduce well costs significantly by using local content, RMB mn
Source: China National Petroleum Corporation, Standard Chartered Research
While acknowledging the challenges, we think China also possesses relative
advantages, including: (1) the existence of national oil companies (NOCs) that will
provide sustained financial backing; (2) huge reserves surpassing even the US; (3)
faster demand growth to facilitate wider expansion in shale gas supply; and (4) the
US example, which will help shorten the development timeframe.
100.0
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per-well cost with intense foreign partnership
drilling design
drilling rig mobilization
admin costsformation testing
finance costs
pre-drilling infrastructure
well cementing
well logging
perforation
oil production test
fracking/acidization
well drilling
per-wellc
ostwithintenseuseoflocal
equipmentandtechnology
China has unique advant ages in
developing shale gas such as NOC
support, vast reserves and robust
demand
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Case study: Tight gass shows the wayWe point to the spectacular increase in tight gas output as the key example
supporting our view that China can and will beat expectations on shale gas
development given the combination of challenges, advantages and lessons learnedoutlined above.
Tight gas: From negligible to 30% of national output in six years
China classifies tight gas as conventional gas, so it does not enjoy the same
preferential policy treatment as coal-bed methane (CBM) and shale gas. Despite the
lack of policy boosts, the development of tight gas has grown exponentially in recent
years, particularly since 2006-07 when development accelerated in the Ordos basin
in northern China. Tight gas production jumped from 4.8bn cm in 2006 to 32bn cm in
2012, making China the worlds second-largest tight gas producer after the US.
Figure 13: Shale gas is closer to tight gas in both formation and drilling techniques applied
The tight gas success offers a benchmark for shale gas potential in China
Source: Standard Chartered Research
PetroChina led the development of Chinas tight gas sector by leveraging its large
acreage and the expertise of its international oil company (IOC) partners such as
Shell and Total. Most active drilling for the gas type has been in the Ordos and
Sichuan basins.
Tight gasis natural gas producedfrom reservoir rocks with such low
permeabil ity that massive hydraulic
fractur ing is necessary to produce
at econom ic rates
Shale gas is natural gas trapped in
shale formations, wit h even lower
permeabil ity th an tight gas; CBM is
gas trapped in coal seams
Conventional gas
(production)
Shale gas (drilling) Coal-bed methane(production)
Drilling techniques:
horizontal drilling andmultistagefracking
Top seal
Gas migration overgeological times
Coal seam
Shale formations with remaining
gas not migrated
Tight reservoir
Conventionalpermeable reservoir
Tight gas
(production)
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Figure 14: Staggering 100% CAGR in Ordos drove six-fold increase in Chinas tight gas output in 2006-12Tight gas production from Ordos grew from almost nothing in 2006 to 20bn cubic metres in 2012
Source: Wood Mackenzie, CEIC, Standard Chartered Research estimates
Figure 15: Tight gas has risen from 8% of Chinas total gas output in 2006 to
c.30%
Source: Wood Mackenzie, CEIC, Standard Chartered Research estimates
Effective drilling proved critical to tight gas take-off in China
PetroChina started research into developing tight gas in the early 1990s, but
production was flat at about 30mn cubic feet per day until the mid-2000s, when Shell
and Total stepped in.
Tight gas production has picked up significantly since then. We attribute the rapid
volume ramp-up to the application of effective drilling techniques such as horizontal
drilling and multistage fracturing brought by the experienced IOCs.
The technological advancements, coupled with the drilling techniques optimised over
five years, have almost halved the duration of well drilling, to about 120 days, and
doubled per-well daily gas flow to about 1.2mn cm.
Tight gas example indicates shale prospects in China
In our view, the development of the tight gas sector illustrates how the combination of
lessons learned from the US, measures to tackle challenges and Chinas keyadvantages, can and will enable China to expand the success into shale gas.
75% 84%
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Sichuan - LHS Sulige (Ordos) - LHS Changbei (Ordos) - LHS Growth, Sichuan
Growth, Sulige (Ordos) Growth, Changbei (Ordos) Growth, Total
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Tight gas production
Other natural gas production
Tight gas output as % of nation's total natural gas output (RHS)
Effective techniques such as
horizontal dril l ing and multi-stage
frackin g have been key to tight gas
success in China
New dri l l ing solut ions helped halve
dri l l ing t ime and double
per-wel l production in Ord os tight
blocks
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Proprietary model suggests 61bn cm of output in 2020Based on these lessons, information drawn from the US experience, and on-the-
ground checks, we have formulated a propriety shale gas supply model that forecasts
shale gas production to 2040 and estimates the returns shale gas producers couldachieve from the early investment cycle through to the production and mature phase
of projects.
Our model suggests China could produce 61bn cm of shale gas in 2020, slightly
above the low end of the official target and c.2.5x the consensus estimate.
Our model uses estimates and assumptions for key inputs such as prospective shale
basins and acreage, typical well production profile and drilling rates, which we detail
in the report. It also estimates possible constraints such as capital spending and
water usage.
Our shale gas production estimate is above consensus
Our model indicates a 2016-20 shale gas output CAGR of 85%. We expect the
growth rate to moderate thereafter, and forecast a 21% CAGR over 2021-25 and 6%
CAGR over 2026-30. We expect shale gas production to continue to grow c.3% p.a.
through 2040.
Figure 16: Shale gas production projection comparisons
Source: Bloomberg, National Development and Reform Commission, Standard Chartered Research estimates
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Market consensus (LHS) NDRC target (LHS) SCR estimate (LHS)
Our 2020 output estim ate is 2.5x
the consensus expectation
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Identifying the winners and losersGas versus coal
Chinas government is pushing the use of natural gas in a wide range of applications
due to environmental concerns, and the contribution of more polluting fuels to Chinasenergy mix will decline over the long term. The NDRC has set a target of reducing
the contributions of coal and oil to 63%/17% in 2015 from the current 68%/19%. Our
discussions with government policy advisors and key energy producers suggest coal
is likely to fall to 60% of the energy mix in 2020, while the combined share of natural
gas and non-fossil fuels should rise to 24% from c.15% currently. While experience
has shown there might be certain execution issues associated with achieving the
target, the trend is obviously towards greater consumption of cleaner energy.
The beneficiaries of Chinas long-term energy strategy are likely to be companies
along the cleaner energy value chain, i.e. natural gas companies and producers of
renewable energy like wind and solar, while producers and distributors of more
polluting energy, especially coal, will be negatively impacted on lower demand and
reduced margins, in our view.
Figure 17: China aims to increase the use of natural gas and renewable energy to reduce reliance on oil and coal
Source: CEIC, National Development and Reform Commission, China National Petroleum Corporation, Standard Chartered Research estimates
Impact on the natural gas value chain
We expect a broadly positive impact on companies with exposure to the natural gas
business, given our view that demand for the cleaner burning fuel will be robust in
coming years. Upstream producers, led by PetroChina and Sinopec, will benefit from
the eventual full deregulation of gas prices amid resilient demand, and appreciationof their reserve valuations, while the service names will see more orders rise as E&P
capex rises. Downstream consumers should also benefit over a longer-term horizon,
with costs coming down as supply increases towards the second half of our forecast
period (2020-30).
Impact on upstream producers
We expect shale gas projects to be profitable from 2018 onwards as production
exceeds the profitability threshold. In the long term, our model forecasts an IRR of
16% for shale gas projects, above the 13% IRR for projects by Chinese NOCs.
PetroChina and Sinopec hold c.75% of Chinas shale gas acreage and will have 75%
of production in the long term. Based on our production projections, we estimate
shale gas would add 7% to Sinopecs valuation in our base case and 11% in our bull
case and 4%/6% to PetroChinas valuation in our base/bull case. In this SCout report,
we focus on analysing the impact on upstream producers.
69% 68% 68% 70% 70% 71% 71% 71% 70% 70% 68% 68% 63% 60%
22% 22% 22% 21% 21% 20% 19% 19% 18% 18% 19% 19%17%
16%
2% 2% 2% 3% 3% 3% 3% 3% 4% 4% 4% 5%8%
10%
6% 8% 7% 7% 7% 7% 7% 7% 8% 8% 9% 8% 11% 14%
0%
10%
20%
30%40%
50%
60%
70%
80%
90%
100%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2015E 2020E
Coal Oil Gas Non-fossil fuel
Chinas clean energy strategyis
positiv e for produc ers of cleanerenergies, including natural gas
We forecast an IRR of 16% for
shale gas projects, abov e the 13%
average project IRR for ChinasNOCs
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Impact on oilfield service names
Increased capex on upstream E&P related to shale gas will also drive orders for
oilfield service companies. We expect international service companies such as
Schlumberger and Halliburton to be heavily involved in the initial stage over the next
two to three years as China seeks foreign partnerships to overcome technologicalbarriers. However, we also expect increasing demand for domestic oil service and
equipment companies like Hilong (equipment), Anton Oilfield Services (oil services)
and SPT Energy (oil services). This is because: (1) their lower service charges and
operational flexibility give domestic names a competitive advantage as explorers
seek to reduce costs; (2) the greater involvement of companies without oil and gas
exploration experience will increase demand for external services; (3) the explorers
ambitious production targets will force NOCs to outsource the service work; and (4)
the private companies previous service track records should give them an edge in
gaining additional orders.
Figure 18: Sinopecs 2020E shale gas output could be
equivalent to c.60-90% of 2015E gas sales
Source: Standard Chartered Research estimates
Figure 19: PetroChinas 2020E shale gas output could be
equivalent to c.15-25% of 2015E gas sales
Source: Standard Chartered Research estimates
Figure 20: Shale gas could add 7-11% to our valuation for
Sinopec
Source: Standard Chartered Research estimates
Figure 21: Shale gas could add 4-6% to our valuation for
PetroChina
Source: Standard Chartered Research estimates
58%
89%
15%23%
0%
20%
40%
60%
80%
100%
Base case Bull case
Ups
ide
froms
ha
legas
in2020
Sinopec
Upside to 2015E gas sales Upside to 2015E oil and gas sales
15%
26%
5%
9%
0%
5%
10%
15%
20%
25%
30%
Base case Bull case
Ups
ide
froms
ha
legas
in2020
PetroChina
Upside to 2015E gas sales Upside to 2015E oil and gas sales
7%
11%
0%
5%
10%
15%
Base case Bull case
Ups
ide
tofa
irva
lue
froms
ha
legas
Sinopec
4%
6%
0%
5%
10%
Base case Bull case
Ups
ide
topri
ce
targe
tfroms
ha
legas
PetroChina
Private oilfield service com panies
should be long-term benefic iaries
of Chinas shale gas story
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Impact on midstream distributors
Although the discounted pass-through of upstream prices (well-head prices) may hurt
margins at gas distributors in the short term, we believe the governments eventual
goal of achieving free market pricing for natural gas will gradually lead to stabilised
profitability at distributors. Double-digit growth in gas demand and additional sources
of gas supply, particularly the potential shale gas take-off, will accelerate volume
growth in the expanded gas distribution network. Strong volume expansion should be
another long-term catalyst for distributors with the capacity to expand operations and
penetrate underdeveloped markets.
Impact on downstream petrochemical plants
There are other less obvious implications for the downstream petrochemical market.
As in the US, Chinas petrochemical producers will have access to cheaper gas; over
the long term this could replace oil (naphtha) as the key petrochemical feedstock. We
could see petrochemical plants with set ups similar to PTT Global Chemical in
Thailand or Petronas Chemical in Malaysia being constructed in China. We see
hidden value in Sinopec in this respect due to its large exposure to the downstream
refining business and its early preparations for such a potential shift.
In June 2013, Sinopec asked Chinas environmental authorities to review its plan for
building Chinas first gas-based ethylene plant (USD 3bn, with an annual capacity of
1mn tonnes) in Qingdao, Shandong province. We view the move as part of the
companys long-term strategy to take advantage of the potential shale gas boom in
China. While a detailed discussion of the downstream segment is outside the scope
of this report, the downstream impact of shale gas is a likely reality should Chinas
shale gas market evolve as we expect.
Downstream petrochemical plants
with integrated capacity would
benefit from a shift to gas
feedstock, which costs less than oi l
Sinopec plans Chinas first gas-based ethylene plant
Gas distributor s will benefit from
strong volum e growth, dr iven by
diversified gas supply
particularly shale gas
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17
Figure 22: Shale gas value chain in China
Field services and equipment companiesChinaCNPC Great Wall DrillingCNPC Xibu Drilling EngineeringCNPC Chuanqing Drilling EngineeringCNPC Bohai Drilling EngineeringCNPC Daqing Drilling EngineeringSinopec Oilfield Service Corp
Anton Oilfield Services Group (3337.HK)SPT Energy (1251.HK)Honghua Group (196.HK)Hilong Holding (1623.HK)Petro-king (2178.HK)Greka Drilling (GDL.LN)GI Technologies (300309.CH)Haimo Technologies (300084.CH)Kingdream Public Ltd (000852.CH)LandOcean Energy Services (300157.CH)Renzhi Oilfield Technology Services (002629.CH)
International
Schlumberger (SLB.US)
Halliburton (HAL.US)Baker Hughes (BHI.US)CGG Group (CGG.FP)
Upstream producersNOCsPetroChina (857.HK)China Petroleum & Chemical (Sinopec, 386.HK)CNOOC (883.HK)Shaanxi Yanchang Petroleum
IOCs
Royal Dutch Shell (RDSA.LN)ConocoPhillips (COP.US)Eni (ENI.IM)Chevron (CVX.US)BP (BP/.LN)Exxon Mobil (XOM.US)Total (FP.FP)
Chinese non-oil companiesHunan Huasheng Energy Investment (600156.CH)Henan Provincial Coal Seam GasChina Coal Geology EngineeringHuaying Shanxi Energy InvestmentBeijing Taitan Tongyuan Natural Gas TechnologyTongchuan City Energy Investment
Chongqing City Energy InvestmentChongqing Mineral Resources DevelopmentState Development and InvestmentShenhua Geological ExplorationHuadian Coal Industry GroupChina Huadian EngineeringHunan Provincial Shale Gas DevelopmentHudian Hubei Power GenerationJiangxi Natural Gas Holdings
Anhui Provincial Energy InvestmentHenan Yukuang Geological Exploration Investment
Midstream distributorsKunlun Energy (135.HK)ENN Energy Holdings (2688.HK)Beijing Enterprises Holdings (392.HK)Guanghui Energy (600256.CH)China Resources Gas (1193.HK)Hong Kong & China Gas (3.HK)
China Gas Holdings (384.HK)
China Oil and Gas (603.HK)
NewOcean Energy (342.HK)Zhongyu Gas (3633.HK)Henan Tian Lun Gas (1600.HK)Tianjin Jinran Public Utilities (1265.HK)Binhai Investment (8035.HK)Towngas China (1083.HK)
Downstream consumersChina Petroleum & Chemical (Sinopec, 386.HK)China Bluechemical (3983.HK)China XLX Fertiliser (1866.HK)Sinopec Shanghai Petrochemical (338.HK)Sinopec Yizheng Petrochemical (1033.HK)Sinofert Holdings (297.HK)NewOcean Energy (342.HK)Beijing Jingneng Clean Energy (579.HK)GCL Poly Energy Holdings (3800.HK)CNOOC Gas & Power GroupShenzhen Energy (000027.CH)
Note: Companies without exchange tickers are not publicly listed.Source: Standard Chartered Research
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Learning from the US Shale gas exploration and development has been a major success in the US, with
shale gas rising from 2% of total gas output in 2000 to 39% in 2012.
While the US has abundant resources and favourable topology, the government
and private sectors commitment also played a key role in the sectors
development.
We chart the course of the shale gas story, starting with the US government policy
reforms in the late 1970s, to the endeavours of Mitchell Energy in the Barnett shale
basin and the output boom in the 2000s with the development of other players.
The US shale gas phenomenon can be divided in two distinct phases: (1) a slow
precursory phase from 1978 to 2002; and (2) the industry take off after 2002. Figure
2 illustrates the US shale gas timeline.
Much has been made of the take-off phase, with shale gas rising from 1.6% of total
US natural gas production in 2000 to 39% in 2012. Since 2005, US shale gas
production has grown at a CAGR of 43%. However, it was the visionary groundwork
laid by the government and the private sector during the precursory phase that made
the recent boom possible.
Figure 23: Key factors that underpinned the US shale success story
Driven by government/industry Natural
Technology development Abundant resource
Favourable gas pricing Water availability
Adequate and open pipeline infrastructure Favourable geology
Access to land Topography
Well developed road network
Source: Standard Chartered Research
In this section, we analyse the extraordinary shale gas boom in the US and
determine the reasons behind the emergence of the shale gas industry there. This is
crucial to our analysis and understanding of the current shale gas situation in China.
Figure 24: Shale gas now forms over 30% of total US gas output
Source: Energy Information Administration, Standard Chartered Research
0
100
200
300
400
500
600
700
800
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
USgasou
tpu
t(bcm
)
Nonassociated onshore Associated with oil Coalbed methane Nonassociated offshore Alaska Tight gas Shale gas
The seeds of shale gas
developm ent were sown in 1978,
but the industry only took off after2002
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Nature has to be on your sideAbundant gas
The most basic factor for shale gas success is the availability of the resource itself.
According to the latest EIA estimates, the US has the fourth largest shale gasresource base in the world at 19tn cm, equivalent to 18% of total US oil and gas
resources. The abundance of shale gas in the US made the rapid production growth
since 2000 possible, with annual (dry) shale gas output jumping 30x over 2000-12.
Figure 25: US ranks fourth in terms of global shale gas
resources
Figure 26: Shale gas forms 18% of total recoverable oil
and gas resources in the US
Source: Energy Information Administration, Standard Chartered Research Source: Energy Information Administration, Standard Chartered Research
Water resources
Hydraulic fracturing (required to produce shale gas) involves the pumping of largeamounts of water mixed with additives into shale reservoirs to create fractures that
improve the flow of gas. Data from the major shale gas producing basins such as
Barnett and Marcellus show that a typical well uses 3-4mn gallons of water. In good
shale formations deeper horizontal wells can use up to 6mn gallons.
The major sources of water include surface water from rivers, lakes etc., discharge
from wastewater treatment plants, re-use of fracturing water and underground water.
While water shortages in some areas of the US are a growing concern, the water
needed for fracturing has generally been available. US per capita renewable water
resources are much higher than the global average.
Figure 27: A typical shale gas well uses 3-4mn gallons of
water
Figure 28: The US has a relative abundance of water
resources
Source: Accenture Consulting Source: UN database
32
2320 19
16 1512 11
8 7
-
10
20
30
40
China
Argentina
Algeria
US
Canada
Mexico
Australia
SouthAfrica
Russia
Brazil
(tcm)
Technically recoverable shale gas resource
36%18%
47%
Share of recoverable resource in US
Oil Gas Shale Gas Other Gas
64%
0
1,000
2,000
3,000
4,000
5,000
Barnett Fayetteville Haynesville Marcellus
Wa
teruseperwe
ll('000ga
l)
Drilling Fracking Total
9,802
7,684
-
2,000
4,000
6,000
8,000
10,000
US World average
(m3/in
ha
b/yr)
Total renewable water resources per capita
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Favourable geology
The geology of a shale gas basin, including the depth of the shale, its thickness,
porosity and quantity of organic content, is a key determinant of the ease and cost of
extraction, and ultimately profitability. As shown in Figure 29, the major shale gas
basins in the US, such as Barnett and Marcellus, have geological conditions that are
conducive to commercial gas production.
Figure 29: Geological characteristics of US shale gas plays with optimal values
Characteristic Optimal Barnett Marcellus Fayetteville Haynesville
Depth (m) 1,000-4,500 2,290 2,060 1,220 3,660
Thickness (m) >50 90 40 30 80
Porosity >5% 5% 8% 5% 9%
Total organic content (TOC) >2% 4% 12% 7% 2%
Source: Energy Information Administration, Advanced Resources International
Topography
The topography of most of the shale basins in the US is favourable, characterised by
relatively low-lying areas. This has helped lower costs and the time required for tasks
such as site preparation and drilling.
Figure 30: Much of the shale gas development in the US has been in relatively
low-lying areas
Source: US Geological Survey, Standard Chartered Research
But human endeavour was equally importantShale gas was not produced commercially before 1978 despite the knowledge of its
existence. The difficulty of extracting gas from low-permeability geological plays
made it economically unviable. In addition, the natural gas industry was heavily
regulated, which discouraged companies from exploring and developing new sources
of gas.
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The precursor phase; laying the foundationsRole of government in promoting shale gas development
The US government had policies in place to regulate the natural monopolies
dominating the natural gas industry, including price ceilings to prevent monopoliesfrom charging excessively high prices. The result was a disincentive for companies to
explore and develop new gas reserves.
However, the oil crisis in the late 1970s focused government attention on exploring
unconventional fuels to cool the energy markets. Recognising the shortage in natural
gas, the government eventually adopted several policies to stimulate supply. At the
peak of the oil crisis in 1978, the Natural Gas Policy Act (NGPA) was passed with the
following intentions: (1) creating a single national natural gas market; (2) equalising
supply and demand; and (3) allowing market forces to establish the wellhead price of
natural gas.
Price deregulation
The NGPA heralded the deregulation of natural gas prices in the US. The act
required the phased removal of wellhead price controls and provided higher pricing
for developing new gas, such as from unconventional sources.
Pipeline deregulation
Another key regulatory step was the change in how pipeline companies sold natural
gas to customers. In the past, pipeline companies bought natural gas from producers
and sold the gas as a bundle with the transportation service. The cost incurred by the
end-consumer was high, and caused a significant number of industrial customers to
switch from natural gas to other forms of energy.
In 1985, Federal Energy Regulatory Commission (FERC) Order No. 436 changed
how interstate pipelines were regulated, allowing pipeline companies to sell the
transportation service and natural gas separately. Although this was voluntary, the
major pipeline systems eventually took part.
In 1992, FERC order No. 636 mandated that pipeline services and transportation had
to be sold separately. Customers could now select the most efficient method of
obtaining their gas. These policies also allowed open access to interstate natural gas
pipelines and natural gas storage facilities.
We conclude that the unbundling of the transportation service and the sale of naturalgas contributed to an increase in demand for natural gas, and a more efficient
production and transportation ecosystem.
Fiscal incentives
To promote the development of unconventional gas, the US government introduced
several financial incentives to encourage activity in relatively higher cost natural gas.
Section 107 of the NGPA provided for incentive pricing for unconventional gas. This
early deregulation of unconventional gas resulted in deregulated gas selling at more
than twice the price of regulated natural gas in the 1980s.
In 1980, the Energy Research and Development Administration initiated the Crude
Oil Windfall Profit Tax Act, which provided tax credits for producing unconventional
fuels. Unconventional gas wells developed between January 1980 and end-1992
were eligible for tax credits. These tax credits were as much as 30% of the realised
price for unconventional gas.
Starting in 1985, the US unbundled
transportat ion and marketing
services for pipelines
The US also provided inc entives
including higher prices and tax
credits for unc onventional gas
producers
The Natural Gas Policy A ct of 1978
required the phased removal of
well-head gas price controls
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Contribution to R&D
Simultaneously, the Department of Energy initiated an unconventional natural gas
research programme, which analysed and tested technologies important to shale gas
development. Federal spending on energy research more than doubled between
1973 and 1976.
Other initiatives include the Gas Research Institute, which planned, managed and
financed R&D programmes in the industry, including research assessing shale play
volume and distribution, and the testing of sophisticated logging and completion
technology.
In our view, the steps taken by the US government to deregulate the natural gas
markets and increase interest in unconventional gas were the catalysts for the
development of shale. The rise in natural gas prices following deregulation meant
increasing profitability for natural gas producers.
Role of private industry: Mitchell Energy and the Barnett shale
The deregulation of the natural gas industry meant that companies had more
incentives to develop and explore new sources of energy. Mitchell Energys private
entrepreneurship in the Barnett shale was the next major catalyst in developing the
natural gas market. Between 1981 and 1997, Mitchell Energy invested about USD
250mn in the Barnett play.
Before Mitchell Energys involvement, there was limited knowledge of the shale
resources in the Barnett region. The initial incentive for Mitchell to develop Barnett
was the idea that a new source of natural gas was available in the region. This was
driven by Mitchells obligations to fulfil its long-term contractual obligations to the
Natural Gas Pipeline Company of America (NGPL) and to feed a large gas plant and
gas-gathering system. As a listed company and the largest gas producer in Texas,
Mitchell Energy was also in a financial position to invest in risky operations.
Technological developments in the Barnett shale
With the help of government-financed R&D projects, Mitchell Energy stimulated early
Barnett exploratory wells with various types of foam fracturing. Foam fracturing had
been used to stimulate wells in the Devonian shale in the eastern United States and
was thought to be applicable to the Barnett shale.
In 1984, Mitchell started using gelled water fractures, a mixture of water and a cross-
linked gel, improving cost efficiency. In 1997, Mitchell engineers developed the slick
water fracturing technique, which reduced the cost of stimulation by about 50% while
maintaining production rates.
In 1992, Mitchell acquired its first 3-D seismic data set and used it to evaluate Barnett
in 1994. These 3-D seismic evaluation techniques enabled companies to gain a
greater understanding of shale regions.
The take-off phase; reaping the benefitsMerger of Mitchell Energy and Devon Energy
Shale gas plays differ greatly in terms of geology and, consequently, profitability.
Mitchells Barnett acreage was one of the most geologically favourable shale
formations in the US. Mitchell Energy raised awareness of the Barnett shale byleasing more land, drilling additional wells and expanding gathering and processing
facilities. This paid off in 2002 when Devon Energy purchased Mitchell Energy for
USD 3.5bn and accelerated the development of Barnett. Subsequently, other shale
basins such as Fayetteville, Marcellus and Haynesville were also developed.
Mitchell Energy was instrum ental in
proving the commerciali ty of shale
gas in th e Barnett play
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Favourable gas pricing
The high natural gas prices in the 2000s made production of shale gas profitable and
contributed to the output boom. In 2003-08, US natural gas prices were mostly above
USD 5/mmbtu, above the break-even price of USD 3.6-4.9/mmbtu for the major shale
gas plays. Even currently, with US gas prices hovering around USD 4/mmbtu, we
estimate plays such as Fayetteville and Marcellus are still profitable.
A major reason for the high natural gas prices in 2003-08 was the declining
production of conventional natural gas and robust economic growth. However, the
seeds of high natural gas prices were sown in the 1970s and 80s when the US
government deregulated gas prices.
The NGPA required the phased removal of wellhead price controls and provided
higher pricing for developing new gas, such as from unconventional sources.
Complete deregulation of wellhead prices was implemented thorough the Natural
Gas Wellhead Decontrol Act. Thus, all price regulations were removed as early as 1
January 1993, allowing the market to completely determine the price of natural gas at
the wellhead.
Figure 31: US gas prices were above USD 5/mmbtu for
most of 2003-08...
Figure 32: ...Encouraging higher shale gas output due to
favourable economics
Source: Bloomberg Source: Wood Mackenzie, Standard Chartered Research
Adequate and open pipeline infrastructure
The United States already had an extensive network of pipelines to transport gas
from the shale basins before the boom in shale output in the early 2000s. More
importantly, the US employed the policy of open access to interstate natural gas
pipelines (as well as natural gas storage facilities) as a result of FERC orders in the
1980s (Order No. 436) and early 1990s (Order No. 636).
As per these orders, all pipeline customers had a choice in selecting their gas sales
and transportation services from any provider, in any quantity. Essentially, this meant
the unbundling of gas transportation and merchant sales. The production and
marketing arms of interstate pipeline companies were required to be restructured as
arms-length affiliates, and these affiliates could not have any advantage over other
potential users of the pipeline.
This open-access policy helped create a more competitive wholesale natural gas
market. All natural gas sellers were placed on an equal footing in gaining access to
end-users, while customers could choose the most efficient source of gas.
0
4
8
12
16
20
Jan-00 Mar-02 May-04 Jul-06 Sep-08 Nov-10 Jan-13
USD/mm
btu
Henry Hub spot price
3.63.8
4.64.9
0
1
2
3
4
5
Fayetteville Marcellus Barnett Haynesville
USD/mm
btu
Breakeven gas price
For most of t he 2000s, natural gas
prices in the US remained above
break-even for the key sh ale gas
plays
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Figure 33: US gas pipeline network in 2002 (before the shale gas boom) and
major shale plays
Source: Energy Information Administration, Standard Chartered Research
Continued technological development
Due to its low permeability, shale has lower gas-flow rates than conventional gas-
bearing rocks such as sandstone, carbonates and siltstone. As a result, to obtain
commercial volumes of gas from these reservoirs, techniques such as horizontal
fracturing and hydraulic fracturing are needed to tap large parts of the gas-bearing
rock and increase flow rates (please see Appendices III and IV for details). Thesetechnologies were first used on a commercial scale in the Barnett shale basin by
Mitchell Energy.
The technological learning curve in Barnett paved the way for the more rapid
commercial exploitation of shale gas reserves in other US basins. For instance, while
it took over 25 years for output in Barnett to cross 2bcf/d (57mmcm/d), Fayetteville
shale output reached the same level in just seven years.
Figure 34: Technological developments accelerated shale gas development
Source: Energy Information Administration, Standard Chartered Research
0
10
20
30
40
50
60
70
80
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Gasou
tpu
t(mmcm
/d)
Year
Barnett Fayetteville
Technological advancements
meant th at Fayettevil le achieved
the same output as Barnett in less
than one-third the time
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China: Mapping the US path Both Chinas MLR and the US EIA estimate China has the worlds largest shale
gas deposits.
The Chinese government is seeking to duplicate the US shale success in China
by: (1) deregulating pricing for shale gas (2011) and raising the costs of competing
sources through the reforms announced in July 2013; (2) allowing diversified
investment in gas pipeline construction aimed at a freer market; (3) introducing
fiscal incentives including a production subsidy double that for CBM; and (4)
encouraging diversified investment in the sector.
Our discussions with Chinas shale gas reserve assessment centre (under the
MLR), major explorers including PetroChina, Sinopec and Shell, and key oilfield
services players including Schlumberger, Anton and SPT, suggest China is making
progress in shale gas development that is likely to surprise the market.
We expectChinas shale gasdevelopment to exceed consensus
expectations
On-the-ground checks with Chinasofficial shale gas office and key
players support o ur findings
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Chinas own assessment of its shale gas potentialMotivated by the profound change brought by the development of shale gas in the
US, China started closely observing and researching the sectors development in the
early 2000s in the hope of replicating the success.
Chinas MLR began preparative work assessing Chinas shale gas resources in
2005, following a study of the US profile. The initial assessment in 2008-09 showed
that China potentially held the worlds largest shale gas resources, and government
officials from the NDRC and MLR have since indicated their intention to support shale
gas development in China, attracting immense public attention.
The initial estimate was confirmed in March 2012 when the MLR announced its
official findings that China had 25.08tn cm of recoverable shale gas resources. In
June 2013, the EIA estimated China had 31.6tn cm of recoverable shale resources.
To put this in context, the EIA estimated US shale gas recoverable reserves at 19tn
cm, 40% below its estimate for China.
Figure 35: The MLR estimates Chinas shale gas recoverable potential at 25.08tn cm
Source: Ministry of Land and Resources, Standard Chartered Research
0.29TuhaBasin
1.00Junggar Basin
1.46Tarim Basin
0.56Qaidam Basin
2.71Ordos
0.14Qinshui
0.86
Nanxiang
0.16Dongnan
0.14ShiwanDashan
0.26Nan Panjiang
6.44Sichuan Basin
0.26Liupanshui
1.64
Songliao
0.03Jiuquan Basin
0.35Mid andSmall
Basin
1.87QuanZhong
0.25Baise-Nanning
0.53 Guizhong
1.34Bohai Bay Basin
0.48Subei
1.07Lower Yangtze
0.09Ganxibei
0.01 Xichang
0.04 Chuxiong
0.26 QianZhonglong
0.16Pingle
1.59Middleyangtze
uplift
depression
Legend
Recoverable resources
0.34Xiangdongnan
Chinas MLR began assessingshale reserves in 2005
The USEIA estimates Chinasshale gas resources are
significant ly greater than those in
the US
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Large reserve base boosts market sentiment
Reassured by the resource potential, companies started showing intense interest in
shale gas after 2009, and the government began rolling out policy incentives in order
to create an environment similar to the early years of US shale gas development.
To facilitate diverse investment, in 2011 the MLR categorised shale gas as a mineral
resource independent from conventional oil and gas. In 2012, the ministry held two
rounds of shale gas auctions to allow competition among various investors. It is
preparing for a third round that is likely to take place in 2H13 or early 2014.
Figure 36: Chinas shale gas production estimates
Source: Bloomberg, National Development and Reform Commission, Standard Chartered Research estimates
In November 2012, Chinas National Energy Administration (NEA) and the Ministry of
Finance (MoF) announced a production subsidy of RMB 0.4/cm for shale gas
development through 2015. We think the subsidy will likely be extended for at least
another two to three years and believe the authorities could be studying additional
incentives including a potential rebate on the value-added tax and the exemption
from royalty payments.
The governments shale gas development plan, released in March 2012, sets the
goal of producing 6.5bn cm of shale gas in 2015 and 60-100bn cm in 2020.
Progress made exceeds consensus estimates
Although most of our peers consider Chinas official target excessively aggressive
given the technical and geological challenges, we are encouraged by recent
developments following our discussions with officials from the MLRs China
Geological Survey, CNPC, Sinopec, Shell, Total, Chevron, Schlumberger and the
National Energy Shale Gas R&D (Experiment) Centre.
China has drilled c.50 evaluation wells and c.90 exploration wells (of which about a
third are horizontal and two thirds vertical) since work started in 2009. Most of the
wells are in Sichuan, Chinas largest shale gas reserve, and about one third have
been tested with gas flows. The most promising wells are able to produce c.150k cm
of gas per day, according to the operators we spoke to. In Sichuan, PetroChina has
started building a 93-km pipeline to transport gas from its shale reserves in the
Changqing block as it is confident of the commerciality of developing the resources.
2.8
25.0
6.5
80.0
2.8
61.0
0
10
20
30
40
50
60
7080
90
2015E 2020E
inbncu
bicme
tres
Market consensus (LHS) NDRC target (LHS) SCR estimate (LHS)
The MLR wants to encourage
diversified investm ent in shale gas
development
In November 2012, China
announced a shale gas produc tion
subsidy dou ble that for CBM
China announced sh ale gas
produc tion targets in 2012
Actual shale gas dril l ing prog ress
has been encouragin g
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Figure 37: Shale gas wells drilled as of end-March 2013 are mainly located in Sichuan, Chongqing and Shaanxi
Source: Ministry of Land and Resources, Standard Chartered Research
We base our China shale gas production analysis on the most recent data provided
by the MLR and EIA. Our findings show China should be able to produce 2.8bn cm of
shale gas in 2015 (in line with consensus) and 62bn cm in 2020 (versus consensus
of 25bn cm).
Recent developments in Chinas natural gas industry have convinced us that China is
on the right track to unlocking its vast shale gas resources. We see Sichuan, Tarim
and Ordos as the most promising regions.
Songliao Basin
Urumqi
Tuha Basin
JunggarBasin
Tarim Basin
Qaidam Basin
Ordos
Basin
Xining
Lanzhou
Yinchuan
Hohhot Beijing
Qinshui BasinJinan
Zhengzhou
South Huabei Basin
Hefei NanjingShanghai
Pingle Depression
Fuzhou
Changsha
Guangzhou
Wuhan
Xian
Nanxiang Basin
Hong KongNanning
Nanpanjiang Basin
Guiyang Basin
Chongqing
ChengduSichuan Basin
Chuxiong Basin
Kunming
Harbin
Changchun
Shenyang
uplift
depression
Shale gas exploration well
Bohai Bay Basin
Legend
Our proprietary prod uction m odel
sugg ests China w ill be able to meet
its 2020 shale gas target
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Mirroring the US growthWe further benchmark the current stage of Chinas shale gas development against
the US history and conclude that China is moving towards a US shale roadmap with
its abundant resource, deregulated pricing, increased competition in pipelineoperations, adequate water availability, fiscal incentives and a focus on technological
advancement.
Abundant resource
Working with major oil companies, petroleum universities and geological survey
providers, the MLR finished the initial evaluation of shale gas potential in March
2012, putting Chinas recoverable resources at 25.08tn cm and total resources in
place at 134.42tn cm. This implies a recovery rate of 19% and makes China the
holder of the worlds largest shale gas reserves.
The MLR divides the prospective areas into four broad zones: (1) the Upper Yangtze
and Yunnan-Guizhou region (46% of total recoverable potential, Sichuan basin
inclusive); (2) the Mid-Lower Yangtze and Southeast region (19%, Greater Subei
inclusive); (3) the Northwest region (15%, major basins including Tarim, Junggar and
Qaidam); and (4) North China and the Northeast region (20%, major basins including
Songliao and Ordos).
Figure 38: Chinas estimates of shale gas Figure 39: Chinas estimate of recoverable shale gas
resources, bn cm
Source: Ministry of Land and Resources, Standard Chartered Research Source: Ministry of Land and Resources, Standard Chartered Research
In June 2013, the US EIA estimated China sits on 31.6tn cm of recoverable shale gas
resources (13% below its previous estimate), due to a reduction in prospective area
in the Qiongzhushui formation in the Sichuan Basin (from 56,875 sq miles to 6,500 sq
miles) and the Lower Cambrian shales in the Tarim Basin (from 53,560 sq miles in
2011 to 6,520 sq miles). This is still 26% above Chinas own estimate of 25.08tn cm.
The EIA groups Chinas shale gas potential into seven prospective basins. The
largest technically recoverable reserves are in Sichuan (17.7tn cm), followed by
Tarim (6.1tn cm), Junggar (1.0tn cm) and Songliao (0.5tn cm). The rest is buried in
the smaller, structurally more complex Yangtze Platform, and the Jianghan and Subei
basins.
Upper Yangtze& Yunnan-
Guizhou (62.6bcm)46%
Mid-LowerYangtze &Southeast(25.2 bcm)
19%
Northwest(19.9 bcm)
15%
North Chinaand Northeast
(26.8 bcm)
20%
16%
18% 19%
25%
0%
5%
10%
15%
20%
25%
30%
0
2
4
6
8
10
12
Upper Yangtze &Yunnan-Guizhou
Mid-LowerYangtze &Southeast
Northwest Nouth China andNortheast
Recoverable Recovery ratio
Chinas MLRdividesChinas shalegas reserves into four regions
The EIA c ut its estim ate ofChinasshale gas resources in June 2013,
but China remainsthe worldslargest holder
Most shale gas resources in the
EIAs assessment overlap theMLRs evaluated acreage
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Figure 40: EIAs assessment of shale resources in China
Source: Standard Chartered Research
Both the MLR and EIA identify Sichuan as the largest holder of recoverable shale gas
resources. The most obvious difference between the two estimates is that the EIA
excludes the Ordos basin. According to our discussions with the head of the shale
gas office under the MLRs resources evaluation centre and other leading industry
experts this is because the EIA lacks the data and experience to assess Ordos
Lacustrian reserves.
The EIA excludes Ord os from its
shale gas assessm ent due to its
Lacustrian nature
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Figure 41: EIA estimates of Chinas major shale gas formations
Basin Shale gas blockGas in place,
tn cm
Technicallyrecoverable
reserves, tn cmRecovery
ratio
Prospectivearea, sq
miles
SichuanQiongzhusi 14.2 3.5 25% 6,500Longmaxi 32.5 8.1 25% 10,070
Permian 20.3 6.1 30% 20,900
YangtzeL. Cambrian 5.1 1.3 25% 3,250
L. Silurian 11.8 2.9 25% 5,035
Jianghan
Niutitang/Shuijintuo 1.3 0.3 24% 1,280
Longmaxi 0.8 0.2 25% 1,900
Qixia/Maokou 1.1 0.3 25% 3,830
GreaterSubei
Mufushan 0.8 0.2 24% 2,040
Wufeng/Gaobiajian 4.1 1.0 25% 10,970
U. Permian 0.2 0.1 25% 1,640
Tarim
L. Cambrian 5.0 1.2 25% 6,520
L. Ordovician 10.7 2.7 25% 19,420
M.-U. Ordovician 7.5 1.7 23% 21,380
Ketuer 4.6 0.5 10% 15,920
JunggarPingdiquan/Lucaogou 4.9 0.5 10% 7,400
Triassic 5.3 0.5 10% 8,600
Songliao Qingshankou 4.4 0.5 10% 6,900
Total 134.4 31.6 23% 153,555
Source: Energy Information Administration, Standard Chartered Research
Price deregulation
Starting in 2011, China has deregulated the pricing of unconventional gases (shale
gas, coal-bed methane and coal-to-gas) to encourage upstream development by
allowing producers to pass through higher costs. Suppliers have since been able tonegotiate selling prices with consumers, while prices of conventional gases are still
capped at the city-gate level.
In July 2013, partially to increase the competitiveness of more expensive
unconventional gas, China raised city-gate natural gas prices c.15% on average and
promised to move prices towards international parity by end-2015, implying a c.60%
rise from current levels. This marks a shift in Chinas natural gas pricing mechanism
from the previous cost-plus method to nationwide net-back pricing, which bases the
selling prices of gas on oil-linked substitutes like fuel oil and LPG. More importantly,
the changes are only the start of long-term reforms that will eventually lead to full
deregulation of the natural gas market regardless of gas source, according to theNDRC.
As in the US in the 1960s, when gas prices were regulated under a cost-plus pricing,
the artificially low prices in China have discouraged upstream production and
subsidised wasteful consumption of natural gas, leading to a nationwide gas shortage
over the past few years.
We believe higher prices will help facilitate the healthy development of Chinas
natural gas industry and further boost consumption of the fuel, because: (1) higher
margins will incentivise supply of gas, including unconventionals, unlocking pent-up
demand; and (2) higher natural gas prices after the adjustments will keep the fuel
competitive against substitutes like LPG, diesel and electricity. We expect faster
development of unconventional gases due to the clearer margin visibility at fields and
resilient demand expansion.
China deregulated pricing of
unc onvent ional gases in 2011
In July 2013, China announced
natural gas pricing reform aimed at
eventual free market pricing
Higher gas prices will facil i tate
Chinas shale gas exploration anddevelopment
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Figure 42: Chinas gas price reforms incentivise unconventional development
Source: Wood Mackenzie, National Development and Reform Commission, Standard Chartered Research estimates
Figure 43: Estimated gas prices after 2015 deregulation would still keep natural
gas competitive (all prices in RMB/cm)
Note: Alternative fuel prices are converted to gas equivalent prices in RMB/cm based on their heat values.Source: ENN Energy, National Development and Reform Commission, Wind, Bloomberg, C1 Energy, Standard CharteredResearch estimates
Pipeline deregulation
Pipeline deregulation the separation of gas sales and pipeline transportation
services was conducive to the fast growth of the natural gas industry in the US.
Although PetroChina still monopolises Chinas natural gas pipeline network with a
c.80% market share, we are seeing diversified investment in the sector as the central
government encourages market competition.
The NDRCs 10 July 2013 natural gas pricing reforms also moved the control of
prices from the well-head point to city-gate levels. In our view, this establishes the
framework for a deregulated pipeline market as gas sources and pipeline
construction increase going forward.
7.00
3.72
4.59
2.79
8.50
0
1
2
3
4
5
6
7
8
9
Sichuan shale Ordos tight Qinshui CBM Conventional gas (Tarim)
inUSD/mc
f
Breakeven gas price 2015E well-head price
0
1
2
3
4
5
6
7
8
9
Residentialelectricity
LPG Fuel oil Industrialelectricity
Coal Naphtha Diesel Gasoline
Alternative fuel price Average end-user gas price: residential
Average end-user gas price: industrial Average end-user gas price: CNG vehicular
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Most pipeline facilities are linked to the major gas fields in Tarim, Ordos and Sichuan
(see map above), where we expect significant shale gas production due to the larger
recoverable reserves. In regions where there is currently no pipeline access, the
alternative means of transporting future shale gas production is LNG plants and trucktransports, which already supply c.4% of China s natural gas consumption. The
construction of LNG plants in China will continue to rise due to the limited access to
pipelines, offering a medium-term solution for shale gas production without pipeline
access, in our view.
We expect faster growth in vehicular LNG consumption, which will continue to drive
local LNG production as the government pushes for increased use of vehicles fuelled
by natural gas (which we estimate will still be c.40% cheaper than gasoline and
diesel after the expected price increases through 2015).
Figure 45: Chinas LNG plant capacity in major gas producing regions
Source: C1 Energy, Standard Chartered Research
Fiscal incentives
The Chinese government has been aggressive in introducing financial incentives to
boost the development of unconventional gases. Besides the full market pricing
allowed for shale gas and other unconventional gases in 2011, shale gas developers
enjoy a subsidy of RMB 0.4/cm for shale gas produced between 2012-15. This is
double the CBM production subsidy, and we think the financial aid is likely to be
extended for at least two to three years beyond 2015.
Our discussions with market participants suggest the government is also still
debating whether and when to introduce extra policy incentives for shale gas;
potential benefits include the exemption from a royalty payment (5-10%) and a full
rebate on the production VAT (13%).
Figure 46: Comparison of major policy support, CBM versus shale gas
CBM Shale gas
VAT (13%) Full refund. Likely to enjoy full refund uponcommercial production.
Sales subsidy Power generation - RMB0.25/kWh; household use:RMB 0.2/cm.
RMB 0.4/cm.
Depreciation method allowed Double declining balance orsum of the years digits.
Pending.
Source: Government documents, Standard Chartered Research estimates
81% 75%
62%60%
38%
63%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
0
1,000
2,000
3,000
4,000
5,000
6,000
Northwest
(Tarim)
North China
(Ordos)
Soutwest
(Sichuan)
East China South China Northeast
LNG plant capacity, in mcm/yr Avg LNG plant utilization (RHS)
Gas liquefaction plants would
provid e an alternative in areas
wh ere pipelines are not y et
connected
Vehicular gas consumption wil l
drive Chinas LNG demand
Shale gas current ly has the highest
production subsidy among
competing sources CBM andtight gas
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Diversify investment to boost shale prospects
Although we believe NOCs will play the critical role in developing Chinas shale gas
resources, the increased involvement of IOCs and non-oil domestic operators will
also help boost upstream prospects by introducing high-end technologies and
increasing competition to drive efficiency in the market. In the next section we take a
look at the major non-NOC players.
IOCs
International oil companies including Shell, ConocoPhillips and Eni have shown
immense interest in seizing the shale opportunities in China, with Shell being the
most aggressive, in our view. Foreign companies are currently not allowed to directly
enter the upstream exploration space, and must form an alliance with an NOC in the
form of joint production sharing meaning IOCs carry out the risky exploration at the
initial stage and once there is commercial output the NOCs have the right to take
51%. Recent examples include the Ministry of Commerces March 2013 approval of
the production sharing contract (PSC) between Shell and CNPC in the Fushun-
Yongchuan block in Sichuan. This was the first shale PSC in China, a key milestone
for foreign investors seeking a foothold in Chinas unconventional gas industry.
Figure 47: Timeline of major IOC agreements in China shale gas
Source: Companies, Standard Chartered Research
Chinese non-oil companies
The Chinese authorities, led by the MLR, believe an open market has been key to the
shale success in the US. The ministry has tried to introduce increased competition by
auctioning blocks especially through the second round of bidding, which was open
to all companies.
Bidders in the second-round shale gas block auction included coal companies, power
companies and privately-owned project developers (detailed below). Thesecompanies, having little upstream exploration expertise, would likely hire either the
oilfield service subsidiaries of NOCs or privately-owned field service providers (like
Anton and SPT) to help them with the actual drilling.
Shell and CNPC signJSA for Fushun-Yongchuan, Nov.
2009
Chevron andSinopec signs JSAfor Longli block in
Qiannan block, April
2011
Shell and CNPC signPSC for Fushun-
Yongchuan, subjectto government
approvals, March2012
ConocoPhillips andCNPC sign JSA for
Neijiang-Dazu block,Sichuan, Feb. 2013
ConocoPhillips andSinopec sign JSA for
Qijiang block,Sichuan, Dec. 2012
Eni and CNPC signJSA for Rongchang
block, Sichuan,March 2013
Nov-0
9
Jan-1
0
Mar-10
May-1
0
Jul-10
Sep-1
0
Nov-1
0
Jan-1
1
Mar-11
May-1
1
Jul-11
Sep-1
1
Nov-1
1
Jan-1
2
Mar-12
May-1
2
Jul-12
Sep-1
2
Nov-1
2
Jan-1
3
Mar-13
Chinas MLRis trying to dupl icatethe US shale gas success by
encouraging diversi f ied investm ent
in the sector
Major IOCs in Chinas shale gas
partnership project s include Shell,
Conoc oPhil l ips, Chevron and Eni
Chinese non-oil com panies have
enteredChinas shale gas businessthrough shale block auctions
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In May 2013, for example, a China Shenhua Group (Shenhua) subsidiary hired
Sinopecs oilfield service unit to conduct the 2-D seismic survey for the block it was
awarded (the Baojing block in Hunan province). Shenhua budgeted RMB 874.5mn to
explore the block, and the initial 2-D seismic study will cost RMB 29.1mn.
We expect exploration and development by non-oil companies to be limited
compared to that by NOCs, due to the large capex requirements and the lower-
quality blocks they obtained through the public bidding process. However, their
presence will enhance market efficiency by increasing competition, in our view.
First round of shale auctions
The Chinese governments first shale gas auction in June 2012 offered four blocks
near Chongqing in southwestern China. The auction was by invitation and conducted
in a closed-door format. It received nine bids from the following companies: (1)
PetroChina; (2) Sinopec; (3) China United Coalbed Methane (CUCBM); (4) Shaanxi
Yanchang Petroleum; and (5) Henan Provincial Coal Seam Gas Development and
Utilization (Henan Provincial Coal). Sinopec and Henan Provincial Coal won the
three-year exploration rights of the Nanchuan (Sinopec) and Xiushan (Henan
Provincial Coal) blocks, as they proposed the highest number of wells drilled with the
largest spending pledge. The other two blocks failed to attract sufficient interest from
the companies and were not sold.
Figure 48: Major blocks auctioned through the first shale gas auction
Nanchuan Block: 2,197.94 sq km; exploration rights validor three years
BidderSpending pledge,
RMB mnNo. of exploration
wells proposed
Sinopec 591.10 11
China United Coalbed Methane 218.84 5
PetroChina 150.00 11
Xiushan Block: 2,038.87 sq km; exploration rights validor three years
Henan Provincial Coal Seam Gas 247.56 10
China United Coalbed Methane 164.92 6
Shaanxi Yanchang Petroleum 192.85 5
Source: Ministry of Land and Resources, Standard Chartered Research
Second round
The second round was held in September 2012, and the MLR demonstrated more
openness
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