(September 28, 2011) Shale gas is a burgeoning (if controversial) industry in the United States, but in China, which may have reserves to rival the U.S., development is only beginning. Liu Zhi, of Beijing’s Transition Institute, discusses the potential and the problems of China’s shale gas industry: while the government and state-owned companies are eager to develop the resource, technology bottlenecks, restrictions on foreign firms and the government’s market distortions all hinder development.

Read the full article below.

Shale Gas Development in China

Liu Zhi

Transition Institute, Beijing

As a non-conventional natural gas, shale gas is not only abundant but clean. It has attracted increasing attention from all over the world. Due to its successful commercial exploitation in the U.S., a worldwide energy revolution is about to take place. In China, few people know about shale gas even though it will play an important role in China, which is thirsty for energy resources. Some experts predict that shale gas will be a significant and valuable resource in the future and will be available for 100 to 200 years. Plans to develop shale gas have garnered the support of the government and state-owned enterprises. At present, the Ministry of Land and Resources (MLR) and the National Energy Board is planning to develop China’s shale gas reserves, investigating options and formulating relevant policies. With exclusive rights to the resource, the government and several state-owned enterprises are stepping up their exploration and exploitation of shale gas.

Though the potential for China’s shale gas resources to help meet the country’s energy needs is promising, the institutional and environmental challenges are real. Water contamination and increased seismic activity as a result of shale gas exploitation are known risks. Meanwhile China’s weak regulatory regime and legal system will handicap innovation that could ensure the safe, economic, and accountable development of the resource.

Exploration

The reserves of shale gas in China are thought to be large, perhaps as large as those in the U.S. But because the estimates of the size of these reserves vary so much from one government department or professional institution to another, no authoritative estimate exists. This may change by 2014 when the MLR is expected to complete a systematic evaluation of shale gas resources[i]. MLR has also ramped up its exploration of shale gas resources and its exploration fund from ￥23 million to￥58 million.

According to earlier explorative studies, southern China was found to have the richest and most concentrated marine shale gas reserves. In addition, Songliao, Ordos, Turpan-Hami, Junggar and other continental sedimentary basins also have suitable conditions for the exploitation of shale gas[ii]. In the southwest, Qijiang County in Chongqing Municipality, with the richest and most accessible shale gas reserves, is likely to be exploited first.

Exploitation

Chinese exploitation of shale gas is still in the experimental stage. The MLR has selected 20 shale gas zones in 5 key pilot test areas as the ones that are richest in shale gas and the most favorable to develop. These are in southern Sichuan, southeast Sichuan, north Guizhou Province, and the southeast and northeast regions of Chongqing Municipality, for a total estimated 8.5 – 14.72 trillion m³ of shale gas. In addition, two more pilot test areas are being explored in the Sichuan Basin and Ordos Basin.

The MLR is working in association with the China National Petroleum Corporation (CNPC)[iii] and the China Petrochemical Corporation (Sinopec)[iv] to test drill wells in the areas mentioned above; some of these test wells have been successful. Shale gas has been obtained from wells in the Songliao Basin and the Etong Basin. However, the output was only 1,000 m³ per year, which is very low.

In April of 2011, drilling at a well with a target depth of 1,500 meters began in the Chengong area of Guizhou province. The well, called “Chengong No.1” and funded by MLR, is the first exploration well that is several kilometers deep. Only a nominal quantity of shale gas has been obtained from the well. China still has some way to go to achieve successful commercial exploitation of shale gas. Nevertheless, experts estimate shale gas production by 2020 could account for as much as 8%-12% of China’s natural gas.

Technology bottleneck

In the field of shale gas exploitation, China has not made any technological breakthroughs and is still dependent on US shale gas technologies. Two key technologies for exploiting shale gas are hydraulic fracturing, and drilling horizontal wells. The U.S. has developed these two technologies for some time and China relies on U.S. expertise and cooperation of U.S. companies when mining shale gas.

With hydraulic fracturing, China has not accurately determined the ratio of sand and fluid that needs to be used to ensure the shale gas could be extracted. So, for the wells drilled by CNPC and Sinopec, Schlumberger and Baker Hughes, two private American companies were hired to do the fracturing.

China also exchanges resources for technology. In November 2009, CNPC began its collaboration with Shell to explore and exploit shale gas in the Fushun-Yongchuan region in the Sichuan Basin. If successful, Shell will receive 49% of the total gas output, while the CNPC will keep 51%.

Eager to obtain the key technologies required for exploiting shale gas, China is hoping to build up the technological expertise to allow it to exploit domestic shale gas reserves independently. Meanwhile, China’s access to technology from foreign companies will depend on the specific terms of the contracts it is able to negotiate with these companies.

International cooperation

China has several international collaborative agreements to extract domestic shale gas. In October, 2007, China’s first international cooperation agreement for shale gas extraction was signed between CNPC and the American company, Newfield, specifically to research extraction of shale gas in the Weiyuan area of Sichuan Province. Newfield was tasked with establishing the viability of exploiting the reserve.

After the success of the Newfield project, China stepped up its international cooperation initiatives to mine shale gas. Since 2010, NCPC and Shell have worked together to exploit shale gas in the Fushun area and the Zhongqiu area of Sichuan Province.

In April 2011, France’s Daoer announced that it would collaborate with NCPC to invest $2 billion to build a non-conventional natural gas production project. It is expected to be put into production in 2012 or 2013.

NCPC is not the only company looking for international collaboration to develop China’s shale gas reserves. Sinopec and CNOOC[v] are also collaborating with foreign energy companies and investing in a few large projects. CNOOC has cooperated with U.S. Chesapeake twice and purchased 1/3 of the shares of two shale gas projects in the U.S. CNOOC is planning to buy a 50% share in 5 exploration licenses which were obtained by the Australian Exoma Company in Australia’s Galilee Basin. Meanwhile, press reports indicate that Sinopec will collaborate with the Chevron Corporation to exploit shale gas in China’s southwest.

Institutional factors

Due to a lack of technology, capital and other factors, the Chinese government may allow and, in fact, encourage both Chinese and foreign private enterprises to collaborate and compete in the field of shale gas development. In accordance with the MLR plan, all future licenses for exploiting domestic shale gas will no longer be distributed through administrative grants but by competitive bidding, representing the first auction of mining rights in the oil and gas field in China. According to the plan, the MLR would hold two to three auctions for the mining rights of several shale gas blocks in 2011 and private enterprises, as well as state-owned ones, would be permitted to take part in these auctions. The first auction took place in July when the MLR auctioned off rights to two shale blocks. Sinopec bought rights to Nanchuan, in Chongqing Municipality and Guizhou Province, and Henan Provincial Coal Seam Development and Utilization Co. bought rights to Xiushan, in Chongqing Municipality, Guizhou and Hunan Provinces. Sinopec has invested￥591 million, and Henan CSG has invested ￥247 million. However, according to an administrative regulation, foreign companies are prohibited from directly extracting oil and gas in China, though they can participate in the industry by partnering with CNPC or Sinopec.

Institutional innovation in shale gas development in China takes its example from America’s success in the industry. The free flow of capital into shale gas development in the U.S. triggered technical innovations and cost efficiencies that made the exploitation of shale gas resources commercially viable.

Meanwhile, China must learn cautionary lessons from its own domestic exploitation of coal bed methane (CBM).[vi] National state-owned enterprises held CBM mining rights which overlapped with local coal mining rights. The ensuing entanglement has greatly impeded CBM development. If shale gas investment suffers from the same institutional impediments, development will be impossible.

The auction of mining rights is only the first step in the development of a successful shale gas industry. There are many more issues which have to be resolved, such as inadequate transmission pipeline networks and a poorly functioning price mechanism that prohibits competition and the proper allocation of risk. For example, could shale gas be distributed in the natural gas pipeline? This is an option which private enterprises are considering. At present, domestic oil and gas pipelines are held by several big state-owned enterprises and are not independently operated, making it difficult for other companies to use these pipelines. Perhaps this problem could be solved by liquefying the gas and then transporting it, but in light of safety concerns about LNG, a better option would be to break up the monopoly of the state-owned pipelines giving access to the pipeline to all gas suppliers.

Of greater concern to the shale gas industry is the fact that gas prices are not determined by the market but are controlled by the government. This system is inefficient and introduces risks into the market that inhibit investment and overshadow prospects for shale gas development as a result. To address this insecurity, the Chinese government is formulating financial subsidies and tax breaks to promote the industry: unfortunately, these subsidies and tax breaks introduce yet another distortion when the goal should be to remove distortions. It is said that the policies for the shale gas industry will be similar to the policies for CBM. At present, the financial subsidy for CBM is ￥0.25/m³, of which ￥0.2 is paid by the central government, and ￥0.05 is paid by the provincial government. Customs duties for machines imported for exploiting CBM are exempted, and import VAT is refunded.

All these issues need to be addressed before China’s shale gas resources can be successfully exploited, with full cost internalization. The hope is that reform of the shale gas sector, in the interest of competition and full cost accounting, would extend to the energy sector in general. If this happens, and subsidies to all forms of energy are removed and costs are internalized by all energy developers, China’s shale gas resources could usher in an energy revolution and an institutional revolution in the way China’s energy sector is managed.

Environmental Protection

Due to the delayed development of this industry in China, there has been almost no research on the environmental and climatic effects of shale gas exploitation. The media has carried a few reports on the research into, and the protests against, shale gas exploitation overseas. Foreign research shows that methane leaks during the exploitation of shale gas could contribute to the greenhouse effect, and that the chemicals and large quantities of water used for fracturing could pollute ground and surface water. In addition, the process for extracting shale gas by fracturing rock deep underground could cause earthquakes.

However, these findings are still controversial and are being debated in other countries. Because the Chinese public is ill-informed on the possible harm shale gas extraction could cause, it is essential that NGOs and experts disseminate information to the public, and pressure governments and developers to release relevant information. It is also important that institutional and legal mechanisms be developed and enforced to ensure that shale gas developers be held liable for any damage caused and risks created.