In last week’s issue of The Energy Letter, we focused on the growing gap between China’s domestic supply of natural gas and rising demand among utilities, industrial users and residential customers in urban centers.

International oil companies have invested huge sums in large-scale projects to export natural gas produced in Australia’s coal-bed methane formations and offshore fields. However, foreign investment in developing China’s shale gas resources lagged for some time, primarily because of political restrictions and memories of subpar returns from previous ventures in the sector.

That being said, interest in China’s shale oil and gas fields has picked up over the past six months. In fact, the intervening week brought news of two new agreements between international oil companies and China-based operators.

Barred from developing unconventional resources in France, Total (Paris: FP, NYSE: TOT) reportedly has inked a pre-agreement with China Petroleum & Chemical Corp (Sinopec) to explore for shale gas in China. The Wall Street Journal reported that the proposed joint venture will be submitted to the Chinese government for approval. Details on where the companies will drill exploratory wells have yet to be released.

As we noted last week, Royal Dutch Shell (LSE: RDSA, NYSE: RDS A, RDS B) has been the most active Western operator in China’s unconventional plays. The London-based international oil company on March 20 announced that the firm had inked a production-sharing contract (PSC) with close partner China National Petroleum Corp (CNPC). The deal covers the 3,500-square kilometer (1,351-square mile) Fushun-Yongchuan Block and marks the first PSC between a Western oil company and a China-based operator.  

Royal Dutch Shell and CNPC first signed a joint evaluation agreement for this acreage in 2009; two years later, the international oil company spent USD400 million drilling 15 shale gas wells in China. Most of the between 20 and 25 shale wells that Royal Dutch Shell plans to sink in 2012 will be in the Fushun-Yongchuan block. The PSC suggests that CNPC expects output from this block to contribute significantly to management’s stated goal of achieving 1 billion cubic meters (35.3 billion cubic feet) of annual shale gas production by 2015.

These deals came shortly after the National Development Reform Commission (NDRC) on March 13 issued its long-awaited National Shale Gas Development Plan for 2011-15. The document calls for a preliminary, two-year survey of China’s shale formations, with the goal of identifying between 50 and 80 blocks for exploration. This process will involve drilling roughly 200 wells to map the distribution of these resources and determine which areas are prospective for development. A related study will focus on the resource potential of 12 specific basins.

The NDRC’s shale gas plan also outlined some ambitious appraisal and production goals, including the identification of 600 billion cubic meters (about 21 trillion cubic feet) of shale gas resources. According to the plan, China aims to produce 6.5 billion cubic meters (229 billion cubic feet) of shale gas by 2015 and between 60 and 100 billion cubic meters (2.1 and 3.5 trillion cubic feet) by 2020.

Whether the China will be able to achieve the production goals laid out by the NDRC hinges in part on several geological and political challenges.

On the Rocks

To have a chance of meeting the NDRC’s near-term goal for annual output, producers will likely focus on Weiyuan, Yuanba and other already discovered gas fields in the Sichuan Basin. As China’s earliest conventional gas-producing region, the Sichuan Basin boasts a robust pipeline network and ready access to oil-field services. The cities of Chongqing and Chengdu and nearby industrial centers, which have grown significantly since the NDRC launched its “Go West” initiative, will ensure that there’s ample demand for this additional production.

The Sichuan Basin contains two shale gas formations: Longmaxi, which averages 560 feet in thickness and is located between 7,800 and 13,500 feet deep in areas most prospective for development; and Qiongzhusi, which averages about 120 feet in thickness and is located at a mean depth of almost 9,200 feet.

Much of the natural gas produced from tight-gas and conventional plays in the Sichuan Basin is believed to have originated from these underlying shale plays, leading to assumptions that output from these deeper formations will also contain elevated levels of hydrogen sulfide, a volatile and corrosive gas that can complicate production.

Thus far, much of the appraisal work has focused on the Sichuan Basin. CNPC drilled China’s first horizontal well targeting shale gas in the Weiyuan Block and has sunk several successful pilot wells in the region. Meanwhile, the national oil company’s collaboration with Royal Dutch Shell in the Fushun-Yongchuan Block yielded about 15 appraisal wells in 2011, while plans for 2012 call for another 20 to 25 wells. Thus far, drilling efforts have sought to test well performance.

Outside the Sichuan Basin, development of prospective shale plays will be slowed by difficult terrain, a lack of water for hydraulic fracturing and a dearth of midstream infrastructure–challenges that will require substantial investment and some time to overcome.

With no wells in commercial production and plenty of appraisal work remaining, China’s energy industry is in the nascent stages of developing the nation’s shale gas resources.

Political and Economic Challenges

Although the NDRC has laid out ambitious goals for shale gas development and production in China, the government will need to take actions of its own to make these targets achievable. The Ministry of Land & Resources’ (MLR) first shale gas licensing round, held in June 2011, illustrates some of the political and economic challenges that could inhibit China’s shale gas revolution. 

For one, the MLR limited participation in the auction to only six companies, all of which have experience with exploration and production: CNPC, Sinopec, China National Offshore Oil Corp (CNOOC), China United Coalbed Methane, Yanchang Petroleum and Henan Coal Bed Methane (CBM). The MLR also downsized the licensing round from to only four blocks, reportedly to stimulate competition among the bidders.

The plan backfired. In this first licensing round, only blocks that received at least three tenders were eligible for award. This restriction, coupled with tepid interest, meant that only two of the exploration blocks were awarded: Sinopec won the Nanchuan Block in the Sichuan Basin and committed to invest USD93.5 million over the next three years to appraise and develop the play, while Henan CBM landed the Xiushan Block and agreed to spend about USD38.1 million to fund three years’ worth of drilling.

Reports from China indicate that the MLR and NDRC learned their lessons from the disappointing first licensing round. Although the format of the a second licensing round tentatively slated for this summer has yet to be officially announced, speculation suggests that about 20 blocks could be involved and that the MLR will open the bidding to a wider range of domestic companies.

To that end, land-rig manufacturer Honghua Group and a handful of other companies have recently announced their intention to pursue shale gas exploration and development. If companies with slimmer upstream credentials are allowed to participate, this would likely open the door for more partnerships with Western firms.

Regulated natural gas prices represent another political and economic hurdle to China’s shale gas revolution: With domestic natural gas prices at regulated levels that are well below the price of imported liquefied natural gas, utilities operate at a loss during peak demand season. Appraisal and development of China’s shale gas resources–a process that will involve much higher costs than conventional production–will require Beijing to liberalize natural gas prices.

Thus far the government has made a few moves in this direction. The MLR in 2011 classified shale gas as an independent mineral resource, distinguishing production from conventional output and coal-bed methane. This critical move sets the stage for a separate set of regulations to encourage shale gas development.

The Verdict

Although China’s shale gas resources show promise, the NDRC’s ambitious production targets will be difficult to meet unless the Chinese government makes moves to stimulate large-scale development. We’ll continue to monitor these developments.

Around the Portfolios

Knightsbridge Tankers reported net income of $9.5 million and earnings per share of $0.39 for the fourth quarter, compared to net income of $9.1 million and earnings per share of $0.37 for the third quarter of 2011. Net income increased primarily due to an improvement in the results of the VLCC Kensington, which is operating in the spot market. The average daily time charter equivalents earned by the company’s very large crude carriers (VLCC) and Capesize vessels were $26,900 and $36,500, respectively, compared with $25,300 and $36,800 in the preceding quarter.

The problem is a glut of new tankers and dry-bulk carriers have entered the global fleet over the past 18 months, swamping demand and pushing day-rates to multiyear lows. Major shareholder Golden Ocean Group (OSLO: GOGL, OTC: GDOCF) recently filed to sell about 2.5 million shares of Knightsbridge Tankers, while one of the tanker company’s customers, the troubled Japan-based Sanko Steamship (Tokyo: 9112), announced it couldn’t pay its bills on time.

Knightsbridge Tankers should be able to maintain its current dividend payout for the next two to three years, but the risks are rising and there are no upside catalysts for the stock until tanker rates turn. Sell Knightsbridge Tankers for a 5.9 percent loss.