Shell's Massive Investment in China

One of the world's biggest energy companies, Royal Dutch Shell (RDS.A) is planning to invest $1 billion per year in China's massive shale gas reserves. This natural gas, which has long been considered uneconomical to produce, has in the last decade captured investor attention due to a combination of cost effective modern drilling and extraction methods, such as fracking.

Earlier this year, China's resource ministry revealed that it had discovered 25.1 trillion cubic meters of untapped shale gas reserves, which could fuel the country's current natural gas needs for 200 years. The U.S. Energy Information Administration has also confirmed that China has at least 50% more shale gas in its reserves than the U.S. does, officially.

The resource ministry also recognized that, unlike the U.S., the country neither has the skills nor the technology to extract this natural gas. China has been monitoring the rise of the American energy industry and the significant role shale gas has played in it, as the U.S. has now become a net exporter of petroleum products for the first time in decades. 

Shell is already the major supplier of LNG to the China. The company is also planning an enormous $12.6 billion refinery in eastern China while it also develops its Kitimat LNG project in Canada, which will be used to export gas to China. Japan's Tepco and Malaysia's state oil company, Petronas, are also involved in turning Kitimat into the LNG terminal to the Pacific Rim. 

Interestingly, it is worth mentioning that developing refineries in China are not considered profitable ventures, primarily due to the government policy and interference. Shell is looking to change this impression. Furthermore, the company will also build an unconventional oil and gas research centre in China and shift its regional coal bed methane business unit to the country.

China looks much more favorably today on those multinationals that invest directly in China as opposed to just using it as an outsourced supply of cheap labor and factory equipment.  Intel (INTC), for example, has built massive chip plants and research facilities there and has more planned for the future. This difference makes KFC, owned by Yum Brands (YUM), so successful there while McDonald's (MCD) continues to struggle to gain acceptance.  Shell investing in China on the ground in this way will pay them major dividends for years to come.

Shell is certainly focused on the country for its long-term growth. If it goes ahead with its refinery plan then this would be the largest foreign investment, ever, by a single company in China. Its competitors, such as Exxon Mobil (XOM) and Chevron (CVX), are keen to get a slice from the Chinese pie for themselves but none of their plans are as significant as Shell's. Shell is looking for the first-mover advantage in China's infant oil and gas industry.  If history is any guide, this is a powerful advantage.

Shell is looking to partner CNPC and its subsidiary PetroChina (PTR) for both the shale gas and the refinery project. Out of the three leading Chinese oil and gas firms (CNOOC, PetroChina and SinoPec), PetroChina is the ideal choice. It dominates the country's oil and gas sector with 60% of crude oil and more than 70% of China's natural gas production. It also enjoys premium acreage across China.  In effect, PetroChina is paying a significant price to get access to Shell's expertise and technology.

The two have collaborated before. In the Kitimat LNG project, Shell is partnering with three other firms, including PetroChina, on the LNG export facility. The two companies successfully drilled China's first shale gas well through horizontal drilling in March, 2011. The year before that, Shell and PetroChina, jointly acquired Australia's Arrow Energy Pty Ltd.

Unconventional shale gas will play a major role in the coal dependent Asian economies. The natural gas is undoubtedly a cleaner and efficient alternative to coal and is quicker and easier to bring online to add marginal production. With improvements in the fracking process as well as the high demand creating higher prices; it is becoming more financially feasible.

China has just started drilling shale gas wells and is targeting 6.5 billion cubic meters produced by 2015. This will put pressure on coal prices, or at least keep them flat. This will necessitate a shift for heavy coal exporters like Indonesia and especially Australia. Mongolia's vast coal reserves will be coming into the market in quantity soon at far lower prices than those two countries can provide ($75/ton vs. $225/ton from Australia).

Indonesia has seen this coming for its coal industry and has been working on four different shale gas exploration projects as well.  With GDP growth to rival China's (6.5% in Q2) and more than 240 million people Indonesia wouldn't be exporting much energy in the future anyway.

Shale gas is looking to change the oil and gas industry's market dynamics, particularly in Asia, where demand is high and the price willing to be paid is commensurate. The fracking process requires enormous amounts of water, a resource which is already in short supply in China and India, something that cannot be overlooked as well. But the American and European experience will provide great opportunities to develop the technology locally.