China's Shale Round Focuses on Cash Not Expertise

China's Huadian Corporation, one of the country's top power producers, which won four licences in the second shale gas licensing round last year, will tender for engineering and drilling services to meet its commitment to prospect for gas in blocks across Hubei, Hunan and Guizhou provinces.

"We will be looking for professional services from seismic survey to drilling via a tender towards late this year," a company official told an industry seminar on Monday .

The second licensing round, which closed in October 2012, has met with much scepticism from outside observers because few of the winners had any experience with drilling for oil and gas. Licence holders will all need to contract with service companies like Halliburton, Schlumberger and local equivalents like Anton Oilfield Service Group .

But the critics have missed the point. The purpose of the second licensing round was not to identify companies with existing expertise.

Big established players like China National Petroleum Corporation (CNPC) and Sinopec are already prospecting in Sichuan following an earlier licensing round, in partnership with international majors like Shell.

In addition, Chevron is prospecting in southwestern Guizhou. And ENI has recently signed a joint study agreement with CNPC to develop Sichuan's Rongchang shale gas block.

However, existing license holders have been criticised for making slow progress and not spending enough drilling exploration and appraisal wells. Only a couple of dozen pilot and exploratory wells have been drilled in total over the last three years.

"Since most licences for gas exploration have been allocated to the three domestic companies CNPC, CNOOC and Sinopec, these three companies form an oligopoly in the upstream sector in terms of licences and the bulk of domestic production," according to the authors of a recent study on "Gas Pricing and Regulation" prepared by the International Energy Agency (IEA) with input from China's regulators.

"There is little room for small and medium-sized companies as they own few licences, often with less competitive economics. As the threshold for exploration to be performed in order to keep the licence low, these companies usually keep the licences preventing new entry, and other companies have few chances to get these licences through relinquishment," the IEA explained.

The agency contrasted the situation with the UK North Sea, where bidders are required to submit detailed field development programme, and must adhere to them or have their exploration rights taken away and given to another company.

"Drill or drop clauses may apply in the licence, stimulating the licensed party to keep up with the agreed upon work programme," according to the IEA.

WALLETS, NOT DRILLS

The central objective of the second licensing round was to award licences to a broader range of companies and, crucially, to extract enforceable promises from them to invest heavily in drilling wells.

It doesn't matter that these companies have little or no experience with oil and gas exploration. It has always been assumed they would contract the work to domestic and international companies with the relevant expertise. The key point is that all the second round licence winners are cash rich and can afford to invest heavily in drilling.

Huadian is a case in point. The second round winners are often portrayed as small and inexperienced. But Huadian is one of the country's largest power producers, with more than 100 Gigawatts of installed generating capacity, which means it has far more potential output than the United Kingdom or the state of California.

Huadian has been able to commit to spending 2.7 billion yuan ($434 million) drilling 24 exploration and appraisal wells over the next three years, mostly cheaper horizontal boreholes, with an additional 20 to be drilled if commercial volumes of gas are found.

As a major power producer, Huadian has a strong interest in finding and developing its own sources of natural gas to reduce its reliance on gas purchased from others, or coal.

Coal producer Shenhua Corporation was another second round winner. Other licences have been awarded to companies with strong backing from provincial governments in areas thought to contain shale gas deposits, which therefore have a strong financial interest in developing them as quickly as possible.

It is far from clear that awarding exploration licences to inexperienced investors and then expecting them to contract with service companies to do the actual drilling is the most efficient way to run the domestic shale gas programme.

But existing gas producers have fallen far behind schedule with their own work. The government probably sees a different approach as the best way to reinvigorate the country's domestic shale programme.

The new system is almost guaranteed to be highly inefficient. But it could start to open up China's domestic shale gas sector to a much wider range of companies and start building the critical infrastructure of drilling, fracking and other services firms that have been critical to the success of the shale revolution in North America.

Schlumberger Chief Executive Paal Kibsgaard told investors at a conference on Monday that "the customer base in China is expanding quickly after shale activity opened up to a wide range of companies outside the traditional exploration and production industry."

"While we see solid activity growth in the shale basins in the medium term, we still expect the strongest activity growth in 2013 to come from onshore areas and complex conventional land developments," Kibsgaard noted.

China's shale sector faces a long development timeline. But involvement of major engineering companies like Huadian suggests the sector is poised for substantial expansion by the end of the decade, in line with Schlumberger's estimates for the take off of unconventional gas elsewhere.