Time to get fracking

We first mentioned ‘Iron Man’ Wang Jinxi in WiC34. A shepherd-turned-oilman, Wang was revered for his commitment to China’s virgin oilfields in Daqing. In the most famous image, he is pictured waist-deep in a gushing well, battling to keep a single drop from being lost.

But fast-forward 60 years, and Wang’s modern-day equivalent is as likely to be snapped hosing fluid down a high-pressure borehole. Rather than striking oil, he’d be hoping to pipe up natural gas.

The context here is the rapid development of a new source of energy: shale gas. It has been sending tremors through the global markets this year, with plunging prices offering a glimpse of a new era of cheaper, cleaner power.

The earthquake analogy literally holds good too, following findings from the US Geological Survey in April that a “remarkable” increase in quakes in the mid-continental US is “almost certainly” the result of shale gas production.

The culprit? Probably wastewater being flushed back into disposal wells after the hydraulic fracturing (or ‘fracking’) of shale rock to release methane gas from deep underground.

Coverage of shale gas in the Chinese press has been sparse – but there are signs that this is starting to change. This month sees a new tender for a series of shale gas blocks, with non-state enterprises invited to apply for the first time. And 10 days ago, oil giant Sinopec announced that it had launched its first shale gas project successfully, with a plan to produce 300-500 million cubic metres of gas annually by the end of this year.

With others staking more of their futures on shale gas, China doesn’t want to miss out.

Why the interest in shale?

The raw economics, for one thing. The oil price is over $100 a barrel while US natural gas trades at an equivalent of $15 per barrel.

Admittedly the current gas price doesn’t look sustainable for the industry over the longer term and prices will start to rise once the recent surge in supply begins to be consumed by a wider range of users.

China knows that it has plenty of potential in shale gas itself. In the first formal forecast from the Ministry of Land and Resources earlier this year, recoverable resources were estimated at 25 trillion cubic metres, more than the US. And tapping into this reserve fits with plans to shift energy generation away from coal. Current experience in the United States offers a template here, with gas already eating into coal’s share of electricity output, which fell by about 6% in the first two months of this year, compared to 2011.

China is already forging a future in which gas meets more of its energy needs. But conventional gas supply is tight and imports are rising: piped in overland from Russia and central Asia, and with more liquefied natural gas (LNG) supply from Qatar and Australia on the horizon. Better to source more gas at home, which is why shale is expected to account for 20-30% of national gas consumption by 2020.

Then there are the risks in delaying too long on shale exploration. The outlook for cheap gas in the United States could be a game-changer, reducing American reliance on foreign oil even as China’s dependence grows. Plunging energy prices might also provide a fillip for US manufacturing at a time when Chinese costs are going up, shifting the competitive dynamic in favour of American firms. As a theory, it doesn’t have everyone convinced, not least as US manufacturing isn’t nearly as energy-intensive as China’s. But some industries (America’s chemical makers and steel pipe producers will be first, maybe) look well placed to cash in.

Any drawbacks to shale?

The sceptics say that the scale of shale resources, as well as the proportion of gas recoverable from them, has been overstated.

Environmentalists also argue that the industry’s green credentials have been overblown, and that rogue methane emissions at wellheads will see fracking contribute as much to global warming as coal-fired power.

Another concern is water pollution from the ‘slickwater’ that is pumped underground. The high-pressure flow is 99% water and sand but it also contains a small proportion of chemicals, some of which are harmful. This leads to fears about contamination of aquifers, as well as rising risks of groundwater pollution. About 30% of fracking flow ends up as wastewater that then needs to be collected and disposed of.

Industry spokespersons say the environmental risks can be managed, including safe capping of noxious gas emission (although China is less fortunate than the US here: its own shale is more likely to generate poisonous hydrogen sulfide as a by-product of extraction).

But even the most optimistic of industry-watchers will wonder how well Chinese firms will deliver on safety, not least as its heavy industries hardly have an unblemished record when it comes to preventing pollution.

Compare that to Europe, where there is hesitation about fracking on environmental grounds. The French and the Germans have banned it, although exploration has carried on in the UK, despite adverse publicity when a shale project was blamed for two earth tremors in the seaside town of Blackpool last year.

The driller, Cuadrilla Resources, later accepted that it was “highly probable” that its activities nearby had caused the quake.

This gives pause for thought, too. Fortunately, Blackpool is hardly a seismic hotbed, not something that can be said about a high-risk zone like Sichuan province (where 70,000 were killed in the most recent major earthquake in 2008).

Do the Chinese have any concerns themselves?

Speculation that China is risking man-made earthquakes isn’t new. Four years ago, local geologists queried whether engineering work on the Three Gorges Dam could have led to a quake in neighbouring Hebei province.

But the dangers of pollution from faulty fracking aren’t being covered in any detail in the Chinese media. Water shortage, on the other hand, is being discussed as an issue, as many of the shale basins are in regions with severe water deficits. That’s not ideal when fracturing technology relies on 11 to 26 million litres of water flow per well, according to a report this year from China Greentech, an advisory group.

Water is the key issue, agrees Lin Boqiang, an energy expert at Xiamen University. “I think the reserves estimates aren’t realistic, because without water how can you develop them?” he told the Financial Times last month.

There are also reservations about access to shale resources. China has seven major onshore shale basins, most of them in mountainous and relatively remote locations. Many of the fields are buried more deeply than their North American equivalents and they suffer from higher clay content, making them more difficult to frack.

Can’t these problems be fixed?

Another drawback: Chinese companies lack experience in shale, especially in the techniques that have enabled US firms to bring drilling costs down to economic levels.

One way to resolve that is to find a foreign partner, and Sinopec worked with BP to be first to extract shale gas successfully within China’s borders in May 2010. PetroChina was then supported by Shell in drilling the country’s first horizontal exploration well in Sichuan last year.

Shell’s CFO Simon Henry told Reuters in March that collaborations of this type would help bring costs down closer to the $5-6 per million British thermal units (Btu) range needed to make extraction profitable. That also brings it into the cost bracket for conventional gas production in China, says Reuters. Significantly, it would be well below the prices currently being asked for imported LNG, at closer to $16 per million Btu.

Others aren’t so sure. “There’s no procedure in the US that we can just lug over here and apply to this geology and expect to have the same results,” Chris Faulkner, chief executive at Breitling Oil and Gas, warned the FT in April.

Nonetheless, the quid pro quo is now well understood: the foreign partner crosses its fingers in hope of a share of the future proceeds, while the host does its best to learn the technological ropes in a hurry. As an arrangement, it often seems to result in both parties feeling short-changed. But it’s also the only option for the international firms, who have been barred from bidding for China’s shale gas blocks directly.

The private sector could put its foot on the gas too?

Winners of bids in the current tender round have been warned by the Ministry of Land and Resources that it will seize back blocks from those that fail to invest pre-determined amounts. That should dissuade speculators from buying blocks but then sitting on them. But it also hints that policymakers want to see faster progress. The National Business Daily implied as much last week, noting that the capital going into shale exploration in China over the last two years has trailed investment in prospecting for conventional oil and gas by a huge margin. Breitling’s Faulkner agrees, telling the press that only 50 shale gas wells have been drilled in China in the past year, compared with 1,300 a month in the US.

The current tendering process is also open to private sector companies for the first time, with Xinjiang Guanghui Group one of those mentioned as likely to throw its hat into the ring. Could that be interpreted as a go-faster move? National Business Daily says to expect conflict when newcomers start to challenge the state-owned oil majors, who already own large blocks for conventional drilling, but which could also be suitable for shale exploration.

Here the new use-it-or-lose-it regulations could come into play if owners don’t get their fracking act together.

The expectations that smaller drillers might have an outsized impact may have been influenced by the history of shale exploration in the US, where much is made of the fact that it was the independents (rather than the oil giants) that contributed most to establishing the sector. Pride of place tends to go to wildcatter George Mitchell, who made the commercial case for the Barnett Shale near Fort Worth before selling his firm to Devon Energy 10 years ago. Only more recently have heavyweights like Exxon and BP started buying in.

But industry onlookers like Lin Boqiang from Xiamen University query whether the private sector can really afford to lead the charge in China, with the onerous financial and technical thresholds putting projects beyond the reach of many non-state enterprises.

It’s also not true that the shale gas sector was brought about by market forces alone. Without research funding from the Department of Energy, the mapping, drilling and fracturing breakthroughs that revolutionised the industry are unlikely to have occurred. Without the tax credits on offer, few firms would then have invested in the new technology, as there was no market for shale gas at the time.

How best to provide a similarly supportive environment is now something for the Chinese authorities to consider, including priority land approvals, tax-free equipment imports and subsidies for companies tapping unconventional fuels.

There are other issues worth pondering. China lacks a comparable distribution network to the US, and the oil majors are strongly represented in existing pipelines, meaning that there will be competition issues to resolve. Another fundamental question is whether to let retail gas prices rise in general, thereby encouraging investors to risk more capital in the sector.

With these types of uncertainties, new entrants can be forgiven for viewing the sector with caution. And that means it’s more likely that state-owned giants like PetroChina and Sinopec will dominate the fracking frontline for the foreseeable future.

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