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 [email protected]

+65 6596 8512

Ying [email protected]

+852 3983 8707

Akash [email protected]

+65 6596 8513


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Equity ResearchlChina shale gas

30 September 2013 2

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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30September2013

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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

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QaidamBasin

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0.14Qinshui

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Nanxiang

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0.14ShiwanDashan

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Basin

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uplift

depression

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Recoverable resources

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Xiangdongnan


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Figure 2: History of the US shale gas boom

Source: EIA, Standard Chartered Research

0

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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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30 September 2013 6

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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30 September 2013 7

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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30 September 2013 8

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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300

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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30 September 2013 9

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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30 September 2013 10

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.


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.

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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


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.

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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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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%

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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


15/94



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


Figure 19: PetroChinas 2020E shale gas output could be

equivalent to c.15-25% of 2015E gas sales


Figure 20: Shale gas could add 7-11% to our valuation for

Sinopec


Figure 21: Shale gas could add 4-6% to our valuation for

PetroChina


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


16/94



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


17/94


legas

30September2013

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


18/94



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


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


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


19/94



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


20/94



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.


21/94



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


22/94



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


23/94



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


24/94



Figure 33: US gas pipeline network in 2002 (before the shale gas boom) and

major shale plays


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


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


25/94



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


26/94



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


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


27/94



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


28/94



Figure 37: Shale gas wells drilled as of end-March 2013 are mainly located in Sichuan, Chongqing and Shaanxi


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


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


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


32/94



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


Second round

The second round was held in September 2012, and the MLR demonstrated more

openness

china shale gas 2014

Documents