China’s shale frenzy and the technology hurdle

China’s shale frenzy and the technology hurdle

Kate Mackenzie

| Mar 12 10:50 | 22 comments Share

Hardly anyone, it seems, believes that China’s shale gas efforts are going to hit paydirt any time soon. Reuters wrote yesterday that the shale gas revolution risks ‘running further off track’ — and this is before it has even begun to produce any significant volumes. China early this year carried out the second auction for shale gas producing licences. As Reuters notes, the first shale auction two years ago was dominated by the likes of Cnooc and PetroChina, but this latest round was quite different — none of the 19 winning bidders had drilled a shale gas well before. In fact, it was a pretty scrappy field. The second auction attracted interest from more than 100 firms, an eclectic group that included a real estate developer, a grain trader and a tobacco dealer, lured by gas subsidies and aided by easy access to funds.

The profile of the bidders reflected both the fever pitch over shale and its potential and the government’s attempt to replicate the conditions that underpinned the U.S. shale revolution: competition among a myriad of independent drillers. Okay it’s first important to note that it’s not quite as bizarre as Reuters are making out. At least, none of the real estate or tobacco companies actually had winning bids: However don’t let the numerous ‘local energy investment’ winners distract you from the definite lack of experience. Reuters says these were all “freshly-formed under the auspices of local governments”. As Bernstein Research’s Neil Beveridge, Ying Lou and Lu Wang wrote in January, the experience among the winners really is nil. While China remains too dependent on PetroChina and Sinopec for the development of its shale industry, opening up acreage to provincial governments and companies with no experience in oil and gas (coal, power) can hardly be seen as a positive. We expect new JVs to form between acreage holders and experienced oil and gas companies seeking to explore for shale in China – although this will take time.

They add:

In our view the government target of 80bcm by 2020 is unrealistic, with 30bcm being more likely.

Shale gas extraction is all about technology — it’s only relatively recently that fracking, an old extraction technique, was adapted to successfully remove shale gas. Shale gas drillers are notoriously secretive about the composition of their fluids, to the chagrin of environmentalists and some landowners. And shale extraction technology is not something Chinese firms have in abundance. For example, this is from a report in December quoting a company close to the town where China’s first shale gas wells were drilled three years ago:

“We’re just starting to understand what we need to develop shale gas,” said Zhang Mi, chairman and president of the Hong Hua Group, a manufacturer of drilling rigs based in Chengdu, a city of 14 million residents about 140 kilometers (90 miles) north of Lao Chang.

Furthermore, these successful bidders paid a high price — winners were chosen on their development plans and in total, the winners committed to spend Rmb12.8bn ($2.1bn) over three years, which Bernstein Research calculates is seven times the minimum outlay the government was looking for. Let’s think about how the risks of overpaying for assets worked out for Marius Kloppers. Or indeed, for Chesapeake, the US shale independent that ended up having to sell assets to get its debts below its market value.

Chesapeake is an interesting example. Last month it agreed to sell a 50 per cent stake in its 850,000 acre Mississippi Lime formation assets, for a price that Bloomberg calculated was only a third of the level Chesapeake had valued those assets back in July 2012.

There are certainly things that bode well for China’s shale gas prospects. The geologyappears to have plenty of potential, at least from an initial assessement by the US Energy Information Agency, which estimates 1,275tn of ‘technically recoverable’ reserves (it should be noted that category is a broad one and includes undiscovered resources). Gas prices in China are higher than in the US (for now, at least). And in terms of environmental regulations or landowner opposition, there’s probably much less for the prospective shale gas prospector to worry about than most other countries; the Chinese authorities have shown a high tolerance for environmental risk as long it brings growth. In addition, energy security is a very important goal of Chinese policy, as the country now has a massive dependency on imported coal, gas and oil.

Oh, but this — again from Reuters:

But China’s shale deposits are mostly found deeper underground than in the U.S. and reserves are more scattered, making it difficult to adapt the technology that has worked in the United States to China’s geology.

Regional and geological variance is a big risk with unconventional gas anyway; even within the US, this means approaches to extracting shale gas have to be refined for each area.

So the less-than-ideal geology could well compound the lack of expertise and technology.

But in terms of getting hold of shale technology, it’s not like Chinese firms aren’t trying. The Sinopec/Chesapeake deal was all about the technology and not the assets, according to the pundits, which makes sense.

However this is the most interesting thing to us is right near the end of the Reuters story. Western drilling giants Halliburton and Schlumberger have both made moves signalling some interest in Chinese shale, but:

… concerns over intellectual property protection for technology means U.S. firms could limit initial deals to orders of fracturing fluids and support equipment, and that the winning firms may have to rely on small, local service companies for drilling, industry experts said.

Back in 2009, Barack Obama and Hu Jintao jointly announced a US-China initiative on shale gas. One of its key goals was technical co-operation: the countries would “conduct joint technical studies to support accelerated development of shale gas resources in China”.

Yet the longstanding wariness of many foreign companies over letting their intellectual property loose in China has arguably increased a lot since 2009. Many of the increasingly common incidents of data theft originating from China target companies and their intellectual property. Just on Monday President Obama’s national security adviser, Tom Donilon, made a speech asking China to recognise the urgency of the problem and take action to stop it — which the New York Times reckons to be the first such public confrontation over cyber espionage.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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