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With imports expected to account for 80% of China’s oil demand by 2030, China is revisiting its energy policy to meet current and future energy supply challenges.
|China's oil consumption has outpaced domestic productions since 1993. The country's conventional oil production is expected to peak at 3.9 Million b/d early in the next decade. (Source: EIA International Petroleum. Images courtesy of IHS)|
Since 1993, when China became a net importer of oil, demand has grown at a pace 4.7 times faster than the growth of domestic production. According to the Energy Information Agency, China’s consumption in 2007 reached 7.8 million b/d, with imports accounting for 49% of demand.
China’s conventional oil production is expected to peak at 3.9 million b/d early in the next decade and then to begin to decline. Oil imports will jump from 3.5 million b/d in 2006 to 13.1 million b/d in 2030, accounting for 80% of demand.
Making up the shortfall
Burgeoning energy consumption has caused the Chinese government to look both internally and externally for sources of supply. In the international arena, China is striving to diversify its sources of supply by pursuing an aggressive strategy of investing in equity stakes to obtain control of overseas energy assets, sometimes at substantially higher premium.
Between 1995 and 2005 the Chinese state oil companies increased their net overseas equity holding interest from 1,634 to 285,696 sq miles (4,234 to 739,955 sq km), investing heavily in Africa, Asia Pacific, the Middle East and Latin America. While the expansion of the Chinese oil companies overseas started soon after China became a net importer, it intensified after Sept.11, 2001, in response to a perception of greater risk to energy supply. China increased its overseas presence from three countries in 1995 to over 50 countries in 2007.
While the Chinese national oil company (NOC) expansion overseas is spread around the globe, Africa is getting the lion’s share of investments. Since 1995, five Chinese national oil companies signed more than 70 contracts in 16 African countries, with their net acreage holdings reaching 249,420 sq miles (646,000 sq km) in 2007. China’s share of crude oil imports from Africa has increased significantly with supplies coming from 17 countries.
In spite of this aggressive campaign to obtain overseas equity interests, the amount of equity oil that actually goes to China is modest. According to the US-China Economic and Security Review Commission, equity oil flowing into China in 2006 amounted to only 320,000 b/d, which accounted for roughly 9% of the total oil imports for the same year. The ability of the Chinese NOCs to market their share of equity oil could be impaired by contractual obligations to sell the oil in the domestic market or by obstacles preventing transportation of oil to China.
Inside the Great Wall
While China’s energy policy with respect to overseas investment has drawn a lot of attention lately, the other equally important and somewhat overlooked issue is China’s domestic energy policy and what opportunities, if any, it presents for foreign investors.
On the domestic front China is trying to enhance its energy policy and restructure its regulatory and institutional framework to meet the current and future energy supply challenges. The efforts focus on environmental protection and energy efficiency, accelerating the process of energy technologies, promoting foreign investment in areas where domestic capabilities are weak and reformation of the institutional and regulatory framework.
China’s oil and gas sector is largely dominated by NOCs that were established in the 1980s. CNPC and China Petrochemical Corp. (Sinopec), China’s second largest oil producer, share the onshore foreign cooperation rights, while China National Offshore Oil Corp. (CNOOC), China’s largest offshore oil producer, has offshore rights.
Since the 1980s, when China opened oil and gas E&P to foreign investment, western companies have gradually increased their presence in China’s energy sector, with super majors owning stock in Chinese NOCs as well as equity participation in offshore acreage. Foreign investment, however, has always been restricted. The Chinese government has maintained a tight grip on upstream oil and gas investment, only offering for joint exploration those blocks that require high investment levels or advanced technology, such as onshore marginal fields or deepwater acreage.
Recognizing that foreign investment and advanced technologies will improve China’s level of exploration activity and give China a better chance of meeting rising demand, the Chinese government is trying to encourage investment in certain upstream activities, while ensuring control by Chinese NOCs or Chinese entities. The recently amended petroleum regulations released in September 2007 preserved the requirement for a foreign investor to enter into a partnership with either CNP or Sinopec for onshore oil and gas blocks and CNOOC for offshore acreage. A recent example is the deal signed between Petrochina and Chevron in December 2007 for the joint development of the Chuandongbei natural gas area in central China. Chevron will take over the role of operator and hold a 49% participating interest, while PetroChina will hold 51% interest in the project.
Restricted participation of foreign investments was further reinforced by the Foreign Investment Guidelines that were revised in December 2007. Under the new guidelines, upstream investments fall under the “encouraged” category; however, a joint venture with a Chinese company or a controlling Chinese interest still is required. Exploration and development of unconventional fields, gas hydrates, low-permeability oil reserves, coalbed methane are among the encouraged but restricted categories.
China’s upstream oil and gas sector has shown a greater appetite for foreign investment over the last couple of years. Acreage to be offered for investment by CNOOC progressively over the next few years includes 22 blocks covering nearly 27,027 sq miles (70,000 sq km). CNPC also is opening acreage for foreign investment as it grapples with stagnant oil production. Since 1996 it has offered 12 blocks in the Tarim basin covering 42,471 sq miles (110,000 sq km). The success of major onshore deals brought in by major oil companies such as Shell and Total has lead CNPC to consider offering more acreage with the aim of gaining further expertise in enhanced oil recovery techniques, especially that of CO2 injection.
Investment for conventional hydrocarbons, whether it is onshore or offshore, is carried out under a production-sharing agreement in which the Chinese company is fully carried by the international oil company (IOC) during the exploration phase and backs into production with an equity share not exceeding 51%. The foreign investor must pay a royalty on gross production ranging from 0% to 12.5% based on production levels. Profits obtained after application of a cost recovery ceiling are shared on an incremental sliding scale linked to average daily production.
The foreign investor’s liability also includes payment of a corporate income tax, withholding tax, value added tax and export duty. Typical of Chinese petroleum agreements is the option for the NOC to take over operatorship once the project has reached payback. While such a deal ensures the transfer of technology and expertise from the IOC to the NOC, it is not the preferred model for a foreign operator.
The surge in oil prices over the last few years has caused governments around the world to revisit the terms of contracts signed during a low-oil-price environment and redress what they perceive as imbalance in revenue distribution between the government and the IOCs. The trend that started in Latin America with the renegotiating of existing agreements by the governments of Venezuela, Bolivia and Ecuador has spread to other parts of the world. In an effort to capitalize on the high-oil-price environment, China introduced a windfall profits tax that applies to all oil production when the price of oil is above $40/bbl. The windfall profits tax, which ranges between 20% and 40%, has led to a 22% increase in state take. This places China among the NOCs that demand a significantly high state take.
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Such actions shake investor confidence in signed deals. The model contract stipulates that the parties must make the necessary revisions to the contract provisions to maintain the contractor’s normal economic benefits if subsequent legislation results in a material change in the contractor’s benefit. While what constitutes “normal economic benefits” may be arguable, high oil prices do not necessarily translate to greater returns. The combined effect of increases in capital costs witnessed over the last five years and the changes in fiscal terms have contributed to a shrinking of the profit margins worldwide. While at least one operator has stated that it will seek international arbitration for adverse changes in fiscal terms, the majority seems to have acquiesced and is pursuing further deals within the country.
China’s significant coalbed methane (CBM), oil shale, and heavy oil resources have led the country to formulate policies that encourage heavy oil development and to draft recommendations related to oil sands and oil shale development. Although China has a long history of exploiting oil shale, which supplied almost half of the country’s demand in the 1950s, massive conventional crude oil discoveries in Daching and Bohai Gulf have caused the industry to languish.
Recent reports from Petrochina indicate that China’s onshore basins hold an estimated 241 billion bbl of proved oil shale reserves with in-place resources that are second only to the United States. China is evaluating its mining and retort processes at three main oil shale projects at Fushun, Maoming and Huadian and expects to increase oil shale production from 2.1 million bbl in 2007 to 35 million bbl by 2020.
Oil sands have been less explored than oil shale. According to government sources, recoverable reserves are estimated to be around 3 billion metric tons (22 billion bbl). However, only 30% of such reserves are located in less than 100 m (328 ft) below the surface, and most of it has a fairly low oil content.
Given the high cost of capital and the technological challenges associated with developing oil sands and oil shale, the government is taking a cautious approach. In its first White Paper on China’s Energy Condition and Policy published in December 2007, the government expressed its intent to actively develop unconventional energy resources only to the extent that the costs are reasonable.
With CBM resources totaling about 37 Tcm, the Chinese government is trying to expand foreign investment by opening up the possibility for other Chinese entities to enter into deals with foreign investors. This effectively ends China United Coalbed Methane Corp.’s exclusive right to foreign cooperative deals. The regulatory amendment signed by the Premier Wen Jiabao on Sept. 18, 2007, provides for other companies to be selected by the State Council to enjoy the right to cooperate with foreign partners in CBM development. While no entities have been selected, it is believed that Petrochina, whose CBM acreage is second to China United, will become one of the licensed Chinese partners.
Companies investing in CBM are looking into carbon credits to make the projects commercially viable. While CBM producers face fewer exploration risks than companies searching for conventional oil and gas, the technological challenges that they face can raise costs and reduce recoverable volume. In an effort to speed up the commercialization of CBM, the Chinese government has introduced significant fiscal incentives and tax subsidies over the last 18 months. The fiscal incentives comprise exemptions from corporate income tax, resource tax, value added tax and import duties.
While such incentives are starting to pay off, the CBM industry in China faces significant challenges resulting from a limited natural gas pipeline infrastructure. To address the problem in the short term, the Chinese government plans to expedite the construction of two major pipelines for CBM transmission. They are expected to be completed by 2010.
The road ahead
In its quest to meet the present and future supply challenges the Chinese government will aggressively pursue international deals to diversify the sources of energy supply by obtaining oil equity interests overseas while encouraging the development of conventional and unconventional oil and gas resources at home. The oil sector will continue to be dominated by the Chinese NOCs, with openings for sino-foreign joint ventures only when the acreage requires high capital investment and advanced technology. Deep-water acreage will continue to present more attractive opportunities for foreign investors since the prospects are brighter than onshore. However, attractive on-shore opportunities that present technological challenges for the NOCs may be available.
The Chinese government’s eagerness to develop unconventional resources has opened the door for investments by large and small oil companies. While there is no imminent threat to adverse changes of terms applying to unconventional resources, a stable fiscal and contractual environment is essential in the successful development of unconventional resources.