China Shale Gas 2014

l Equity Research l China l Oil & Gas l
30 September 2013
China shale gas

Potential unearthed
China shale gas, emulating the US success: We have assessed Chinas shale gas development against the US blueprint. We see uncanny similarities in policies being implemented from fiscal incentives to gas price deregulation and the start of the privatisation of pipeline infrastructure. Our extensive on-the-ground checks also show China is successfully overcoming key challenges that had threatened its shale gas outlook. This leads us to believe the Chinese government sees shale as Chinas major source of gas supply in the long term and is determined to unearth its vast potential. From scepticism to belief: Like consensus, we were sceptical about Chinas shale gas prospects and the National Development and Reform Commissions production target of 60-100bn cm by 2020. However, our proprietary model based on our in-depth study of the US experience and analysis of Chinas challenges and advantages indicates output could indeed reach 61bn cm in 2020E, 2.5x the consensus estimate. To support this shale gas upsurge, we expect gas producers to accelerate investment in shale projects. In our base case, we estimate shale gas investment will grow 62% p.a. in 2013-20 and reach USD 21bn in 2020, equivalent to c.50% of PetroChina and Sinopecs total onshore E&P capex in 2012. Positive for producers and economic stability: Chinas shale story has had a positive impact on valuations in the gas services sector. We argue a case for producers, which have not enjoyed a similar boost. We expect shale gas production to start in 2014 and turn profitable from 2018. We forecast a normalised shale gas IRR of 16%, above the new project hurdle rate of c.13% for the Chinese NOCs. We forecast double-digit production growth until 2030, when we expect shale gas to represent 30% of gas supply, significantly reducing Chinas rel iance on imported gas (from 40% to c.25%). Sinopec and PetroChina likely to benefit: Among the producers, we believe Sinopec will be the main beneficiary of the shale story. We estimate recognising shale reserves would boost its oil and gas reserves volume by 158%/218% (base/bull case) and add 7%/11% to its NPV. Shale gas could increase PetroChinas upstream reserves volume 35%/54%, add 4%/6% to its NPV in our base/bull case, and enable it to reduce imports, which would lower this national service burden. Duke Suttikulpanich
Duke.Suttikulpanich@sc.com +65 6596 8512
Ying Wang
YingY.Wang@sc.com +852 3983 8707
Akash Gupta
Akash.Gupta@sc.com +65 6596 8513
Important disclosures can be found in the Disclosures Appendix

All rights reserved. Standard Chartered Bank 2013 http://research.standardchartered.com
Equity Research l China shale gas
Contents
Summary Learning from the US China: Mapping the US path Chinas challenges Chinas advantages Case study: Tight gas versus CBM Our proprietary China shale gas model China shale supply-demand impact Analysing impact on gas producers PetroChina (Outperform, PT HKD 11.00) Sinopec (Outperform, PT HKD 7.20) CNOOC (Outperform, PT HKD 18.00) Appendix I: From Barnett to a nationwide phenomenon the US success story Appendix II: Other factors supporting the US shale success Appendix III: Horizontal drilling Appendix IV: Hydraulic fracturing Appendix V: Chinas LNG re-gas capacity 6 18 25 38 44 48 53 63 66 70 76 81 86 88 89 90 91
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30 September 2013
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Figure 1: Chinas MLR estimates Chinas shale gas recoverable potential at 25.08tn cm, 32% larger than the US reserves
1.00 Junggar Basin 1.64 Songliao
0.29 Tuha Basin 0.03 Jiuquan Basin 0.56 Qaidam Basin
1.46 Tarim Basin
0.35 Mid and Small Basin
1.34 Bohai Bay Basin 2.71 Ordos 6.44 Sichuan Basin

0.14 Qinshui
0.86 Nanxiang
0.48 Subei
1.07 Lower Yangtze
1.87 Quan Zhong 0.01 Xichang
1.59 Middle yangtze
0.09 Ganxibei
0.16 Pingle
Legend
0.04 Chuxiong
uplif t depression Recoverable resources
0.26 Qian 0.34 0.26 Liupanshui Zhonglong Xiangdongnan 0.16 Dongnan 0.26 0.53 Guizhong Nan Panjiang 0.25 Baise-Nanning 0.14 Shiwan Dashan
Source: Ministry of Land and Resources, Standard Chartered Research
bn cubic metres
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Figure 2: History of the US shale gas boom
250
Precursor phase
00
Growth phase
200
1978: Department of Energy took over unconventional natural gas research programme 1978: Natural Gas Policy Act passed to deregulate the natural gas market and remove ceilings on natural gas prices 1985 & 1992: FERC Orders No. 436 and No. 636 issued to deregulate the pipeline market and unbundle natural gas and transportation costs into separate products 1992: Mitchell Energy acquired its first 3-D seismic Data Set in North Texas 1997: Mitchell engineers began experimenting with new approach to fracturing slick water fracturing
2002: Devon Energy purchased Mitchell Energy for USD 3.5bn; started drilling horizontal wells on a larger scale
150
2002 onwards: Prospect of high profit margins attracted firms; new entrants invest heavily in existing and new plays
1978
100
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
Early 2000s: 3-D seismic surveys became widespread application 1981: First Barnett well drilled by Mitchell Energy Late 1980s: Horizontal drilling achieved commercial viability, however Mitchell Energy does not capitalise on this technology 1994: Mitchell reduced cost of fracturing by improving hydraulic fracturing methods 1999: New reserve evaluation in Barnett increased gas-inplace estimate by a factor of 2.5-3x
50
0 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 USUS Shale Gas gas Production shale production
Source: EIA, Standard Chartered Research
bn cubic metres
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Figure 3: Chinas shale gas story, a mirror image of the US blueprint
Precursor phase
350
Growth phase
00
2010: PetroChina drilled China's first shale gas well, Wei201, in Sichuan Basin Early 2000s: China started closely observing shale gas development in the US, in hopes of repulicating the success 2010: China set up nation's first shale gas R&D centre at CNPC 2010: IOCs including Shell, Chevron and ConocoPhillips started forming parnterships with Chinese NOCs for shale gas exploration 2012: National Energy Administration (NEA) and the Ministry of Finance announced a production subsidy; NEA announced 12th Five-Year Plan for shale gas
300
2012: China's MLR held two rounds of shale gas auctions open to diversified investors inlcuding state-owned companies and private companies 2012: Sinopec drilled its first high-yield shale gas well, Jiaoye-1HF, in Sichuan Basin
250
China: Mapping the US shale story; On track towards a shale boom
200
2012: International oilfield service companies including Schlumberger and Halliburton started forming partnerships with Chinese private firms like Anton Oilfield and SPT Energy
2002 150
2009
2010
2011
2012
2011: Ministry of Land Resources (MLR) categorised shale gas as an independent mineral resource
2013
2014
2015
2016
2017
2018
2008/09: Government offiicals started voicing China's shale gas potential, drawing great public interest
2013: NEA approved set-up of China's shale gas technology standardization committeed at CNPC
2013: China announced plans to start deregulating gas prices with an intial15%-25% increase in wellhead gas prices 2013: PetroChina opened up pipeline investment to external investors and the NDRC issued rules to diversify investment in natural gas infrastructure projects End-2013: Sinopec Chairman Fu Chengyu said in August 2013 that Sinopec is likely to announce China's first largescale shale gas project by end-2013 2013/14: China's third shale gas auction expected
100
Early 2000s: IOCs including Shell and Total started forming partnerships with Chinese NOCs for tight gas development
2011: CNOOC obtained first shale gas block in Anhiui through negotiations with MLR
50
2011: Shanxi Yangchang Petroleum drilled first shale gas well in Ordos Basin
0 2002
2009
2010
2011
2012
2013
2014E
2015E
2016E
2017E
2018E
2020E
2030E
2040E
China's shale gas production

Source: Standard Chartered Research estimates
Summary
Over the past few years, the biggest story in the energy markets has been the surge of cheap shale gas in the US, and the ensuing impact on national economies and individual companies. Now that the euphoria surrounding the US has calmed, the focus is shifting to China. According to the US Energy Information Administration (EIA), China has the worlds largest shale gas reserves, exceeding even the US reserves. Can China be the next US in shale gas terms, or even outdo the shale pioneer? Extensive on-the-ground checks with major policy makers and operators suggest China is making significant progress in shale To arrive at an informed opinion of our own, we carried out exhaustive research on the topic to get a clearer sense of Chinas shale outlook. We conducted on-theground checks with key government regulators, key domestic players including China National Petroleum Corporation (CNPC), China Petroleum & Chemical (Sinopec), CNOOC and Shaanxi Yanchang Petroleum (non-listed). We also talked to foreign partners including Royal Dutch Shell (Shell), Total S.A. (Total), Chevron and BP, as well as oilfield services companies Anton Oilfield Services (Anton), SPT Energy, Termbray Petro-King Oilfield Services and Schlumberger. We expect China shale gas success to require USD 21bn of capex in 2020, c.50% of total onshore upstream capex in 2012 Our conclusion is that Chinas shale gas output will increase significantly. We expect production to rise to 61bn cubic metres (cm) in 2020, meeting the lower end of the National Development and Reform Commissions (NDRC) target range, and significantly exceeding consensus estimates, driven by increasing E&P investment. We expect Chinas shale gas development to require capex of USD 21bn in 2020, implying a 50% addition to PetroChina and Sinopecs 2012 onshore E&P capex, and forecast a growth rate of 62% p.a. in shale gas investment between 2013 and 2020. By 2030, we believe shale gas could contribute the majority of Chinas gas supply. This could help reduce import dependence from a peak of c.40% of supply in 201618E to c.25%, helping China maintain economic stability. We believe Chinese upstream producers, namely Sinopec and PetroChina, would be the leading beneficiaries of the shale gas success we forecast in this report. We also see oilfield services companies and gas distributors as key beneficiaries. In the longer term, Chinas petrochemical industry could also benefit from the availability of cheap gas feedstock. However, coal producers could see risk from lower demand as consumers switch to gas as a cleaner source of energy. Figure 4: Chinas long-term gas supply versus demand
700 600 bn cubic metres 500 400 300 200 100 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E 2028E 2029E 2030E
Source: Bloomberg, CEIC, Wood Mackenzie, Standard Chartered Research estimates
By 2030, we believe shale gas will be the largest component of Chinas domestic gas supply, at 30%
Conventional gas
Shale gas
Tight gas
CBM
CTG
LNG Import
Pipeline imports
Consumption
Incremental consumption from stronger government pushes and potential gas-based petrochemical plants
30 September 2013
China shale gas the next big thing

We expect meaningful contributions from shale gas in China in 2018, and believe the success of the shale story will bring dramatic changes to Chinas natural gas landscape as it has in the US. Our gas supply model indicates shale gas production will account for 15% of Chinas total gas supply in 2020E and 30% in 2030E. Shale gas likely to reduce Chinas reliance on imports Chinas shale gas success would impact the global gas market by reducing Chinas reliance on external gas supplies such as liquefied natural gas (LNG) and gas supplied via cross-border pipelines. Imports currently meet c.25% of Chinas natural gas demand, and we estimate the ratio will peak at c.40% in 2016-18. As a result of the shale gas success, we expect imports to decline to c.25% of demand by 2030. Increased shale gas output would reduce reliance on imports, benefiting PetroChina and Sinopec We believe Chinas natural gas producers and importers, namely PetroChina and Sinopec, will benefit in two ways. Firstly, through a substantial increase in reserves recognition and production growth as shale gas becomes economical. This will be accretive in terms of both asset valuation and earnings. Secondly, as both companies are now importing expensive LNG and/or pipeline gas, they could potentially see this state-mandated burden decline, either in absolute volume or as a proportion of overall supply. We analyse both the quantitative and qualitative effects of these changes in this report. Figure 5: We expect Chinas reliance on imported gas to decline when shale gas takes off in 2017-30E We forecast a 2015-30 shale gas production CAGR of c.30%, easing dependence on imported gas
0.50 0.40 0.30 0.20 shale gas contribution to total gas supply dependency on import
0.10
0.00 2008
2010
2012
2014E
2016E
2018E
2020E
2022E
2024E
2026E
2028E
2030E
On the other hand, Chinas reduced imports would be negative for the worlds major LNG suppliers, especially those in Southeast Asia, Australia and the Middle East, whose delivery contracts with Chinese buyers mostly lapse around 2030-36. Figure 6: Most of Chinas current gas import contracts lapse between 2030-36
Pipeline LNG - Others LNG - Indonesia LNG - Malaysia LNG - Yemen LNG - Qatar LNG Papua N. Guinea LNG - Australia 2006 2011 2016 2021 2026 2031 2036 2041
Source: Bloomberg, Standard Chartered Research estimates
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US the shale gas pioneer, and lessons learned

Contrary to general perception, the US shale gas story has not been a revolution but a drawn-out evolution. While resources and favourable geology are vital, the recent boom in shale gas would not have been possible without the support or will of the government and private sector. Our detailed study of the US experience shows that the foundations for shale gas success were laid by the government and the private sector almost 40 years ago. Industry deregulation triggered intense company involvement In our view, the US shale gas evolution began in 1978 with the passage of the Natural Gas Policy Act, which effectively deregulated gas prices. This was followed by the deregulation of pipeline assets and the introduction of fiscal incentives for unconventional gas development in the 1980s. This encouraged small but agile private companies like Mitchell Energy (Mitchell) to pursue shale gas development starting in 1981. This commitment paid dividends after US O&G giant Devon Energy acquired Mitchell Energy in 2002. From that moment, shale gas development began on a large scale in the US. Figure 7: Key factors underpinning the US shale success story
Driven by government/industry Technology development Favourable gas pricing Adequate and open pipeline infrastructure Access to land Well-developed road network
Source: Standard Chartered Research
Pricing and pipeline reforms and fiscal incentives encouraged the industry to develop the vast resource base
Natural Abundant resource Water availability Favourable geology Topography
US shale gas production grew 19% p.a. in 2002-05, rising from 2% of overall gas supply to 4%. US shale gas output is now c.265bn cm, implying 43% p.a. growth since 2005, and shale gas represents 39% of overall gas supply. Figure 8: US shale gas production reached critical mass in less than five years
300 US shale gas poduction (bcm)
250
200 150
100
50 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Energy Information Administration, Standard Chartered Research
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China: The protg

The US and China estimate Chinas shale gas resources are >30% greater than those in the US According to the EIA and Chinas Ministry of Land and Resources (MLR), China possesses even larger shale gas resources than the US. The EIA estimates China shale gas reserves at 32tn cm, 68% more than the US, while the MLR, taking a more conservative stance, estimates reserves in place at 25tn cm, still 32% above US reserves. So why is the street so sceptical about Chinas prospects of developing shale gas? Figure 9: Chinas shale gas resources exceed US resources
35 30 tn cubic metres 25 20 15 10 5 0 EIA MLR
Source: Energy Information Administration, Ministry of Land and Resources, Standard Chartered Research
Estimates of China's shale gas resources 32
EIA estimate of US shale gas resources
25
The challenges most commonly cited as reasons China will not be able to replicate the US success are: (1) higher production costs, because resources are deeper underground; (2) Chinas more complex topography and higher population density, which limit the scope of drilling; (3) the regulated nature of Chinas natural gas sector; (4) the lack of technological expertise; and last but not least (5) insufficient water resources. Figure 10: We think China will be able to overcome the key challenges to shale gas development
Key challenges Reserve depth Topography Pricing Technology Water Shale gas in China is 1-2km deeper than in the US. Topography is unfavourable, with mountainous terrain in some regions. Historical pricing regulations reduce economic benefits of developing unconventional gases. China is behind the US in key drilling technologies and expertise. Solutions China aims to increase the use of local equipment and technology to reduce costs associated with more complex well drilling. Designing innovative drilling equipment to suit China's particular topography. Deregulation of prices for unconventional gases in 2011 and industry-wide gas pricing reforms in July 2013 boost prospects of developing shale gas. China is catching up through: (1) proprietary R&D; (2) partnerships with IOCs; and (3) international acquisitions of major unconventional players.
Per capita water resources are much lower than Our findings show shale gas drilling will require <0.01% of water resources in the US. in most reserve-rich regions.
30 September 2013
China emulating US shale gas roadmap In this report, we examine Chinas key challenges in developing shale gas. First and foremost, we note that the government was by no means oblivious to these challenges when it set the production target at 60-100bn cm in 2020. In fact, what we have seen over the past year suggests China is not only utilising the technology developed by the US, but is also emulating the US policy roadmap we point to the fiscal incentives for shale gas, allowing onshore foreign investment in the sector, and the lifting/deregulation of gas prices. Given the US path, we think the deregulation of the pipeline sector will also be on the agenda in China. Figure 11: China tries to emulates the US shale gas roadmap
Key policy incentives Price deregulation Pipeline deregulation Fiscal incentives Diverse investment Plans announced by Chinese government Deregulated pricing for unconventional gases in 2011; prices of conventional gases raised further through price reforms announced in July 2013. Took the first step in pipeline deregulation in 2013 by allowing diversified investment in gas infrastructure construction. Announced production subsidy for shale gas in 2012, and the market expects the government to announce a VAT rebate policy once large-scale production commences. Aims to introduce diverse investment in shale gas development through public auctioning of blocks.
China shows entrepreneurial drive to tackle key challenges China has also shown entrepreneurial instincts to tackle the challenges that are unique to the country. On the cost issue arising from harsh terrain, for example, we found that costs can be reduced by as much as 50% if operators maximise the use of local equipment, technology and engineers. Topography has also stimulated innovations such as the foldable water tanks invented by an oil services company. Figure 12: China can reduce well costs significantly by using local content, RMB mn
well drilling
per-well cost with intense use of local equipment and technology fracking/acidization oil production test perforation well logging well cementing pre-drilling infrastructure finance costs formation testing admin costs drilling rig mobilization drilling design per-well cost with intense foreign partnership 0 10 20 30 40 50 60 70 80 90 2.6
15.6
14.3 10.0 2.8
1.7
1.0 0.9 0.5 0.4
0.3
0.1 100.0 100
Source: China National Petroleum Corporation, Standard Chartered Research
China has unique advantages in developing shale gas such as NOC support, vast reserves and robust demand
While acknowledging the challenges, we think China also possesses relative advantages, including: (1) the existence of national oil companies (NOCs) that will provide sustained financial backing; (2) huge reserves surpassing even the US; (3) faster demand growth to facilitate wider expansion in shale gas supply; and (4) the US example, which will help shorten the development timeframe.
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10
Case study: Tight gass shows the way

We point to the spectacular increase in tight gas output as the key example supporting our view that China can and will beat expectations on shale gas development given the combination of challenges, advantages and lessons learned outlined above. Tight gas: From negligible to 30% of national output in six years China classifies tight gas as conventional gas, so it does not enjoy the same preferential policy treatment as coal-bed methane (CBM) and shale gas. Despite the lack of policy boosts, the development of tight gas has grown exponentially in recent years, particularly since 2006-07 when development accelerated in the Ordos basin in northern China. Tight gas production jumped from 4.8bn cm in 2006 to 32bn cm in 2012, making China the worlds second-largest tight gas producer after the US.
Tight gas is natural gas produced from reservoir rocks with such low permeability that massive hydraulic fracturing is necessary to produce at economic rates
Figure 13: Shale gas is closer to tight gas in both formation and drilling techniques applied The tight gas success offers a benchmark for shale gas potential in China
Shale gas (drilling) Conventional gas (production) Coal-bed methane (production) Tight gas (production)
Coal seam
Top seal
Tight reservoir
Gas migration over geological times
Conventional permeable reservoir
Drilling techniques: horizontal drilling and multistage fracking
Shale formations with remaining gas not migrated
Shale gas is natural gas trapped in shale formations, with even lower permeability than tight gas; CBM is gas trapped in coal seams
PetroChina led the development of Chinas tight gas sector by leveraging its large acreage and the expertise of its international oil company (IOC) partners such as Shell and Total. Most active drilling for the gas type has been in the Ordos and Sichuan basins.
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11
Figure 14: Staggering 100% CAGR in Ordos drove six-fold increase in Chinas tight gas output in 2006-12 Tight gas production from Ordos grew from almost nothing in 2006 to 20bn cubic metres in 2012
40 35 Sichuan - LHS Growth, Sulige (Ordos) Sulige (Ordos) - LHS Growth, Changbei (Ordos) Changbei (Ordos) - LHS Growth, Total Growth, Sichuan 400% 300% 200% 75% 84% 28% 15% 15% 18% 16% 100% 0% -100% 2006 2007 2008 2009 2010 2011 2012 2013E
30
bn cubic metres 25 20 15 10 5 0
Source: Wood Mackenzie, CEIC, Standard Chartered Research estimates
Figure 15: Tight gas has risen from 8% of Chinas total gas output in 2006 to c.30%
Tight gas production Other natural gas production Tight gas output as % of nation's total natural gas output (RHS) 27% 25% 24% 23% 19% 12% 8%
140 120 100 bn cubic metres 80 60 40 20 0 2006 2007
31%
35% 30% 25% 20% 15% 10% 5% 0%
2008
2009
2010
2011
2012
2013E
Effective drilling proved critical to tight gas take-off in China PetroChina started research into developing tight gas in the early 1990s, but production was flat at about 30mn cubic feet per day until the mid-2000s, when Shell and Total stepped in. Effective techniques such as horizontal drilling and multi-stage fracking have been key to tight gas success in China New drilling solutions helped halve drilling time and double per-well production in Ordos tight blocks Tight gas production has picked up significantly since then. We attribute the rapid volume ramp-up to the application of effective drilling techniques such as horizontal drilling and multistage fracturing brought by the experienced IOCs. The technological advancements, coupled with the drilling techniques optimised over five years, have almost halved the duration of well drilling, to about 120 days, and doubled per-well daily gas flow to about 1.2mn cm. Tight gas example indicates shale prospects in China In our view, the development of the tight gas sector illustrates how the combination of lessons learned from the US, measures to tackle challenges and Chinas key advantages, can and will enable China to expand the success into shale gas.
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Proprietary model suggests 61bn cm of output in 2020

Based on these lessons, information drawn from the US experience, and on-theground checks, we have formulated a propriety shale gas supply model that forecasts shale gas production to 2040 and estimates the returns shale gas producers could achieve from the early investment cycle through to the production and mature phase of projects. Our 2020 output estimate is 2.5x the consensus expectation Our model suggests China could produce 61bn cm of shale gas in 2020, slightly above the low end of the official target and c.2.5x the consensus estimate. Our model uses estimates and assumptions for key inputs such as prospective shale basins and acreage, typical well production profile and drilling rates, which we detail in the report. It also estimates possible constraints such as capital spending and water usage. Our shale gas production estimate is above consensus Our model indicates a 2016-20 shale gas output CAGR of 85%. We expect the growth rate to moderate thereafter, and forecast a 21% CAGR over 2021-25 and 6% CAGR over 2026-30. We expect shale gas production to continue to grow c.3% p.a. through 2040. Figure 16: Shale gas production projection comparisons
Market consensus (LHS) 90 80 in bn cubic metres 70 60 50 40 30 20 10 0 2015E 2020E
Source: Bloomberg, National Development and Reform Commission, Standard Chartered Research estimates
NDRC target (LHS)
SCR estimate (LHS) 80.0 61.0
25.0 2.8 6.5 2.8
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Identifying the winners and losers

Chinas clean energy strategy is positive for producers of cleaner energies, including natural gas Gas versus coal Chinas government is pushing the use of natural gas in a wide range of applications due to environmental concerns, and the contribution of more polluting fuels to Chinas energy mix will decline over the long term. The NDRC has set a target of reducing the contributions of coal and oil to 63%/17% in 2015 from the current 68%/19%. Our discussions with government policy advisors and key energy producers suggest coal is likely to fall to 60% of the energy mix in 2020, while the combined share of natural gas and non-fossil fuels should rise to 24% from c.15% currently. While experience has shown there might be certain execution issues associated with achieving the target, the trend is obviously towards greater consumption of cleaner energy. The beneficiaries of Chinas long-term energy strategy are likely to be companies along the cleaner energy value chain, i.e. natural gas companies and producers of renewable energy like wind and solar, while producers and distributors of more polluting energy, especially coal, will be negatively impacted on lower demand and reduced margins, in our view. Figure 17: China aims to increase the use of natural gas and renewable energy to reduce reliance on oil and coal
Coal
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2015E 2020E
Source: CEIC, National Development and Reform Commission, China National Petroleum Corporation, Standard Chartered Research estimates
Oil
7% 3% 19%
Gas
Non-fossil fuel
7% 3% 19% 8% 4% 18% 8% 4% 18% 9% 4% 19%
6% 2% 22%
8% 2%
7% 2%
22%
7% 3% 21%
7% 3%
7% 3% 20%
8% 5%
19%
11% 8% 17%
14% 10% 16%
22%
21%
69%
68%
68%
70%
70%
71%
71%
71%
70%
70%
68%
68%
63%
60%
Impact on the natural gas value chain We expect a broadly positive impact on companies with exposure to the natural gas business, given our view that demand for the cleaner burning fuel will be robust in coming years. Upstream producers, led by PetroChina and Sinopec, will benefit from the eventual full deregulation of gas prices amid resilient demand, and appreciation of their reserve valuations, while the service names will see more orders rise as E&P capex rises. Downstream consumers should also benefit over a longer-term horizon, with costs coming down as supply increases towards the second half of our forecast period (2020-30). Impact on upstream producers We expect shale gas projects to be profitable from 2018 onwards as production exceeds the profitability threshold. In the long term, our model forecasts an IRR of 16% for shale gas projects, above the 13% IRR for projects by Chinese NOCs. PetroChina and Sinopec hold c.75% of Chinas shale gas acreage and will have 75% of production in the long term. Based on our production projections, we estimate shale gas would add 7% to Sinopecs valuation in our base case and 11% in our bull case and 4%/6% to PetroChinas valuation in our base/bull case. In this SCout report, we focus on analysing the impact on upstream producers.
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We forecast an IRR of 16% for shale gas projects, above the 13% average project IRR for Chinas NOCs
Figure 18: Sinopecs 2020E shale gas output could be equivalent to c.60-90% of 2015E gas sales
100%
Upside from shale gas in 2020 80% 60% 40% 23% 20% 0% Base case
Figure 19: PetroChinas 2020E shale gas output could be equivalent to c.15-25% of 2015E gas sales
PetroChina Upside to 2015E gas sales Upside to 2015E oil and gas sales 26%
Sinopec Upside to 2015E gas sales
Upside to 2015E oil and gas sales 89% Upside from shale gas in 2020
30% 25% 20% 15% 10%
58%
15% 9% 5%
15%
5%
0%
Bull case
Base case
Bull case
Figure 20: Shale gas could add 7-11% to our valuation for Sinopec
15% Upside to fair value from shale gas Sinopec 11% 10% 7% 5%
Figure 21: Shale gas could add 4-6% to our valuation for PetroChina
10% Upside to price target from shale gas PetroChina
6% 5% 4%
0% Base case
0% Bull case Base case

Bull case
Private oilfield service companies should be long-term beneficiaries of Chinas shale gas story
Impact on oilfield service names Increased capex on upstream E&P related to shale gas will also drive orders for oilfield service companies. We expect international service companies such as Schlumberger and Halliburton to be heavily involved in the initial stage over the next two to three years as China seeks foreign partnerships to overcome technological barriers. However, we also expect increasing demand for domestic oil service and equipment companies like Hilong (equipment), Anton Oilfield Services (oil services) and SPT Energy (oil services). This is because: (1) their lower service charges and operational flexibility give domestic names a competitive advantage as explorers seek to reduce costs; (2) the greater involvement of companies without oil and gas exploration experience will increase demand for external services; (3) the explorers ambitious production targets will force NOCs to outsource the service work; and (4) the private companies previous service track records should give them an edge in gaining additional orders.
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15
Gas distributors will benefit from strong volume growth, driven by diversified gas supply particularly shale gas
Impact on midstream distributors Although the discounted pass-through of upstream prices (well-head prices) may hurt margins at gas distributors in the short term, we believe the governments eventual goal of achieving free market pricing for natural gas will gradually lead to stabilised profitability at distributors. Double-digit growth in gas demand and additional sources of gas supply, particularly the potential shale gas take-off, will accelerate volume growth in the expanded gas distribution network. Strong volume expansion should be another long-term catalyst for distributors with the capacity to expand operations and penetrate underdeveloped markets. Impact on downstream petrochemical plants There are other less obvious implications for the downstream petrochemical market. As in the US, Chinas petrochemical producers will have access to cheaper gas; over the long term this could replace oil (naphtha) as the key petrochemical feedstock. We could see petrochemical plants with set ups similar to PTT Global Chemical in Thailand or Petronas Chemical in Malaysia being constructed in China. We see hidden value in Sinopec in this respect due to its large exposure to the downstream refining business and its early preparations for such a potential shift. In June 2013, Sinopec asked Chinas environmental authorities to review its plan for building Chinas first gas-based ethylene plant (USD 3bn, with an annual capacity of 1mn tonnes) in Qingdao, Shandong province. We view the move as part of the companys long-term strategy to take advantage of the potential shale gas boom in China. While a detailed discussion of the downstream segment is outside the scope of this report, the downstream impact of shale gas is a likely reality should Chinas shale gas market evolve as we expect.
Downstream petrochemical plants with integrated capacity would benefit from a shift to gas feedstock, which costs less than oil
Sinopec plans Chinas first gasbased ethylene plant
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Figure 22: Shale gas value chain in China
Field services and equipment companies China CNPC Great Wall Drilling CNPC Xibu Drilling Engineering CNPC Chuanqing Drilling Engineering CNPC Bohai Drilling Engineering CNPC Daqing Drilling Engineering Sinopec Oilfield Service Corp Anton Oilfield Services Group (3337.HK) SPT Energy (1251.HK) Honghua Group (196.HK) Hilong Holding (1623.HK) Petro-king (2178.HK) Greka Drilling (GDL.LN) GI Technologies (300309.CH) Haimo Technologies (300084.CH) Kingdream Public Ltd (000852.CH) LandOcean Energy Services (300157.CH) Renzhi Oilfield Technology Services (002629.CH) International Schlumberger (SLB.US) Halliburton (HAL.US) Baker Hughes (BHI.US) CGG Group (CGG.FP)
Upstream producers NOCs PetroChina (857.HK) China Petroleum & Chemical (Sinopec, 386.HK) CNOOC (883.HK) Shaanxi Yanchang Petroleum IOCs Royal Dutch Shell (RDSA.LN) ConocoPhillips (COP.US) Eni (ENI.IM) Chevron (CVX.US) BP (BP/.LN) Exxon Mobil (XOM.US) Total (FP.FP) Chinese non-oil companies Hunan Huasheng Energy Investment (600156.CH) Henan Provincial Coal Seam Gas China Coal Geology Engineering Huaying Shanxi Energy Investment Beijing Taitan Tongyuan Natural Gas Technology Tongchuan City Energy Investment Chongqing City Energy Investment Chongqing Mineral Resources Development State Development and Investment Shenhua Geological Exploration Huadian Coal Industry Group China Huadian Engineering Hunan Provincial Shale Gas Development Hudian Hubei Power Generation Jiangxi Natural Gas Holdings Anhui Provincial Energy Investment Henan Yukuang Geological Exploration Investment
Midstream distributors Kunlun Energy (135.HK) ENN Energy Holdings (2688.HK) Beijing Enterprises Holdings (392.HK) Guanghui Energy (600256.CH) China Resources Gas (1193.HK) Hong Kong & China Gas (3.HK) China Gas Holdings (384.HK) China Oil and Gas (603.HK) NewOcean Energy (342.HK) Zhongyu Gas (3633.HK) Henan Tian Lun Gas (1600.HK) Tianjin Jinran Public Utilities (1265.HK) Binhai Investment (8035.HK) Towngas China (1083.HK)
Downstream consumers China Petroleum & Chemical (Sinopec, 386.HK) China Bluechemical (3983.HK) China XLX Fertiliser (1866.HK) Sinopec Shanghai Petrochemical (338.HK) Sinopec Yizheng Petrochemical (1033.HK) Sinofert Holdings (297.HK) NewOcean Energy (342.HK) Beijing Jingneng Clean Energy (579.HK) GCL Poly Energy Holdings (3800.HK) CNOOC Gas & Power Group Shenzhen Energy (000027.CH)
Note: Companies without exchange tickers are not publicly listed. Source: Standard Chartered Research
Learning from the US

Shale gas exploration and development has been a major success in the US, with shale gas rising from 2% of total gas output in 2000 to 39% in 2012. While the US has abundant resources and favourable topology, the government and private sectors commitment also played a key role in the sectors development. We chart the course of the shale gas story, starting with the US government policy reforms in the late 1970s, to the endeavours of Mitchell Energy in the Barnett shale basin and the output boom in the 2000s with the development of other players. The US shale gas phenomenon can be divided in two distinct phases: (1) a slow precursory phase from 1978 to 2002; and (2) the industry take off after 2002. Figure 2 illustrates the US shale gas timeline. Much has been made of the take-off phase, with shale gas rising from 1.6% of total US natural gas production in 2000 to 39% in 2012. Since 2005, US shale gas production has grown at a CAGR of 43%. However, it was the visionary groundwork laid by the government and the private sector during the precursory phase that made the recent boom possible. Figure 23: Key factors that underpinned the US shale success story
Driven by government/industry Technology development Favourable gas pricing Adequate and open pipeline infrastructure Access to land Well developed road network
The seeds of shale gas development were sown in 1978, but the industry only took off after 2002
Natural Abundant resource Water availability Favourable geology Topography
In this section, we analyse the extraordinary shale gas boom in the US and determine the reasons behind the emergence of the shale gas industry there. This is crucial to our analysis and understanding of the current shale gas situation in China. Figure 24: Shale gas now forms over 30% of total US gas output
800 700 US gas output (bcm) 600 500 400 300 200 100 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Nonassociated onshore
Associated with oil
Coalbed methane
Nonassociated offshore
Alaska
Tight gas
Shale gas
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Nature has to be on your side

Abundant gas The most basic factor for shale gas success is the availability of the resource itself. According to the latest EIA estimates, the US has the fourth largest shale gas resource base in the world at 19tn cm, equivalent to 18% of total US oil and gas resources. The abundance of shale gas in the US made the rapid production growth since 2000 possible, with annual (dry) shale gas output jumping 30x over 2000-12. Figure 25: US ranks fourth in terms of global shale gas resources
40 32 30 23 (tcm) 20 10 Australia Russia Argentina Mexico Technically recoverable shale gas resource
Figure 26: Shale gas forms 18% of total recoverable oil and gas resources in the US
Share of recoverable resource in US
20
19
16
15
12
11
36%
64%
47% 18%
Algeria
South Africa
China
Canada
Brazil
US
Oil
Gas
Shale Gas
Other Gas
Water resources Hydraulic fracturing (required to produce shale gas) involves the pumping of large amounts of water mixed with additives into shale reservoirs to create fractures that improve the flow of gas. Data from the major shale gas producing basins such as Barnett and Marcellus show that a typical well uses 3-4mn gallons of water. In good shale formations deeper horizontal wells can use up to 6mn gallons. The major sources of water include surface water from rivers, lakes etc., discharge from wastewater treatment plants, re-use of fracturing water and underground water. While water shortages in some areas of the US are a growing concern, the water needed for fracturing has generally been available. US per capita renewable water resources are much higher than the global average. Figure 27: A typical shale gas well uses 3-4mn gallons of water
5,000 Water use per well ('000 gal) Drilling Fracking Total 10,000 8,000
Figure 28: The US has a relative abundance of water resources

Total renewable water resources per capita 9,802 7,684
4,000
3,000 2,000 1,000 0 Barnett Fayetteville Haynesville Marcellus
(m3/inhab/yr)
6,000 4,000 2,000 US World average
Source: Accenture Consulting
Source: UN database
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Favourable geology The geology of a shale gas basin, including the depth of the shale, its thickness, porosity and quantity of organic content, is a key determinant of the ease and cost of extraction, and ultimately profitability. As shown in Figure 29, the major shale gas basins in the US, such as Barnett and Marcellus, have geological conditions that are conducive to commercial gas production. Figure 29: Geological characteristics of US shale gas plays with optimal values
Characteristic Depth (m) Thickness (m) Porosity Total organic content (TOC) Optimal 1,000-4,500 >50 >5% >2% Barnett 2,290 90 5% 4% Marcellus Fayetteville Haynesville 2,060 40 8% 12% 1,220 30 5% 7% 3,660 80 9% 2%
Source: Energy Information Administration, Advanced Resources International
Topography The topography of most of the shale basins in the US is favourable, characterised by relatively low-lying areas. This has helped lower costs and the time required for tasks such as site preparation and drilling. Figure 30: Much of the shale gas development in the US has been in relatively low-lying areas
Source: US Geological Survey, Standard Chartered Research
But human endeavour was equally important

Shale gas was not produced commercially before 1978 despite the knowledge of its existence. The difficulty of extracting gas from low-permeability geological plays made it economically unviable. In addition, the natural gas industry was heavily regulated, which discouraged companies from exploring and developing new sources of gas.
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The precursor phase; laying the foundations

Role of government in promoting shale gas development The US government had policies in place to regulate the natural monopolies dominating the natural gas industry, including price ceilings to prevent monopolies from charging excessively high prices. The result was a disincentive for companies to explore and develop new gas reserves. However, the oil crisis in the late 1970s focused government attention on exploring unconventional fuels to cool the energy markets. Recognising the shortage in natural gas, the government eventually adopted several policies to stimulate supply. At the peak of the oil crisis in 1978, the Natural Gas Policy Act (NGPA) was passed with the following intentions: (1) creating a single national natural gas market; (2) equalising supply and demand; and (3) allowing market forces to establish the wellhead price of natural gas. Price deregulation The NGPA heralded the deregulation of natural gas prices in the US. The act required the phased removal of wellhead price controls and provided higher pricing for developing new gas, such as from unconventional sources. Pipeline deregulation Another key regulatory step was the change in how pipeline companies sold natural gas to customers. In the past, pipeline companies bought natural gas from producers and sold the gas as a bundle with the transportation service. The cost incurred by the end-consumer was high, and caused a significant number of industrial customers to switch from natural gas to other forms of energy. Starting in 1985, the US unbundled transportation and marketing services for pipelines In 1985, Federal Energy Regulatory Commission (FERC) Order No. 436 changed how interstate pipelines were regulated, allowing pipeline companies to sell the transportation service and natural gas separately. Although this was voluntary, the major pipeline systems eventually took part. In 1992, FERC order No. 636 mandated that pipeline services and transportation had to be sold separately. Customers could now select the most efficient method of obtaining their gas. These policies also allowed open access to interstate natural gas pipelines and natural gas storage facilities. We conclude that the unbundling of the transportation service and the sale of natural gas contributed to an increase in demand for natural gas, and a more efficient production and transportation ecosystem. Fiscal incentives To promote the development of unconventional gas, the US government introduced several financial incentives to encourage activity in relatively higher cost natural gas. Section 107 of the NGPA provided for incentive pricing for unconventional gas. This early deregulation of unconventional gas resulted in deregulated gas selling at more than twice the price of regulated natural gas in the 1980s. In 1980, the Energy Research and Development Administration initiated the Crude Oil Windfall Profit Tax Act, which provided tax credits for producing unconventional fuels. Unconventional gas wells developed between January 1980 and end-1992 were eligible for tax credits. These tax credits were as much as 30% of the realised price for unconventional gas.
The Natural Gas Policy Act of 1978 required the phased removal of well-head gas price controls
The US also provided incentives including higher prices and tax credits for unconventional gas producers
Contribution to R&D Simultaneously, the Department of Energy initiated an unconventional natural gas research programme, which analysed and tested technologies important to shale gas development. Federal spending on energy research more than doubled between 1973 and 1976. Other initiatives include the Gas Research Institute, which planned, managed and financed R&D programmes in the industry, including research assessing shale play volume and distribution, and the testing of sophisticated logging and completion technology. In our view, the steps taken by the US government to deregulate the natural gas markets and increase interest in unconventional gas were the catalysts for the development of shale. The rise in natural gas prices following deregulation meant increasing profitability for natural gas producers. Role of private industry: Mitchell Energy and the Barnett shale The deregulation of the natural gas industry meant that companies had more incentives to develop and explore new sources of energy. Mitchell Energys private entrepreneurship in the Barnett shale was the next major catalyst in developing the natural gas market. Between 1981 and 1997, Mitchell Energy invested about USD 250mn in the Barnett play. Before Mitchell Energys involvement, there was limited knowledge of the shale resources in the Barnett region. The initial incentive for Mitchell to develop Barnett was the idea that a new source of natural gas was available in the region. This was driven by Mitchells obligations to fulfil its long-term contractual obligations to the Natural Gas Pipeline Company of America (NGPL) and to feed a large gas plant and gas-gathering system. As a listed company and the largest gas producer in Texas, Mitchell Energy was also in a financial position to invest in risky operations. Technological developments in the Barnett shale With the help of government-financed R&D projects, Mitchell Energy stimulated early Barnett exploratory wells with various types of foam fracturing. Foam fracturing had been used to stimulate wells in the Devonian shale in the eastern United States and was thought to be applicable to the Barnett shale. In 1984, Mitchell started using gelled water fractures, a mixture of water and a crosslinked gel, improving cost efficiency. In 1997, Mitchell engineers developed the slick water fracturing technique, which reduced the cost of stimulation by about 50% while maintaining production rates. In 1992, Mitchell acquired its first 3-D seismic data set and used it to evaluate Barnett in 1994. These 3-D seismic evaluation techniques enabled companies to gain a greater understanding of shale regions.
Mitchell Energy was instrumental in proving the commerciality of shale gas in the Barnett play
The take-off phase; reaping the benefits

Merger of Mitchell Energy and Devon Energy Shale gas plays differ greatly in terms of geology and, consequently, profitability. Mitchells Barnett acreage was one of the most geologically favourable shale formations in the US. Mitchell Energy raised awareness of the Barnett shale by leasing more land, drilling additional wells and expanding gathering and processing facilities. This paid off in 2002 when Devon Energy purchased Mitchell Energy for USD 3.5bn and accelerated the development of Barnett. Subsequently, other shale basins such as Fayetteville, Marcellus and Haynesville were also developed.
For most of the 2000s, natural gas prices in the US remained above break-even for the key shale gas plays
Favourable gas pricing The high natural gas prices in the 2000s made production of shale gas profitable and contributed to the output boom. In 2003-08, US natural gas prices were mostly above USD 5/mmbtu, above the break-even price of USD 3.6-4.9/mmbtu for the major shale gas plays. Even currently, with US gas prices hovering around USD 4/mmbtu, we estimate plays such as Fayetteville and Marcellus are still profitable. A major reason for the high natural gas prices in 2003-08 was the declining production of conventional natural gas and robust economic growth. However, the seeds of high natural gas prices were sown in the 1970s and 80s when the US government deregulated gas prices. The NGPA required the phased removal of wellhead price controls and provided higher pricing for developing new gas, such as from unconventional sources. Complete deregulation of wellhead prices was implemented thorough the Natural Gas Wellhead Decontrol Act. Thus, all price regulations were removed as early as 1 January 1993, allowing the market to completely determine the price of natural gas at the wellhead.
Figure 31: US gas prices were above USD 5/mmbtu for most of 2003-08...
20 16 USD/mmbtu Henry Hub spot price
Figure 32: ...Encouraging higher shale gas output due to favourable economics
5 4 3.6 Breakeven gas price 4.6 4.9
3.8
USD/mmbtu
Mar-02 May-04 Jul-06 Sep-08 Nov-10 Jan-13
12
3 2 1 0 Fayetteville Marcellus Barnett Haynesville
8
4 0 Jan-00
Source: Bloomberg
Source: Wood Mackenzie, Standard Chartered Research
Adequate and open pipeline infrastructure The United States already had an extensive network of pipelines to transport gas from the shale basins before the boom in shale output in the early 2000s. More importantly, the US employed the policy of open access to interstate natural gas pipelines (as well as natural gas storage facilities) as a result of FERC orders in the 1980s (Order No. 436) and early 1990s (Order No. 636). As per these orders, all pipeline customers had a choice in selecting their gas sales and transportation services from any provider, in any quantity. Essentially, this meant the unbundling of gas transportation and merchant sales. The production and marketing arms of interstate pipeline companies were required to be restructured as arms-length affiliates, and these affiliates could not have any advantage over other potential users of the pipeline. This open-access policy helped create a more competitive wholesale natural gas market. All natural gas sellers were placed on an equal footing in gaining access to end-users, while customers could choose the most efficient source of gas.
Figure 33: US gas pipeline network in 2002 (before the shale gas boom) and major shale plays
Technological advancements meant that Fayetteville achieved the same output as Barnett in less than one-third the time
Continued technological development Due to its low permeability, shale has lower gas-flow rates than conventional gasbearing rocks such as sandstone, carbonates and siltstone. As a result, to obtain commercial volumes of gas from these reservoirs, techniques such as horizontal fracturing and hydraulic fracturing are needed to tap large parts of the gas-bearing rock and increase flow rates (please see Appendices III and IV for details). These technologies were first used on a commercial scale in the Barnett shale basin by Mitchell Energy. The technological learning curve in Barnett paved the way for the more rapid commercial exploitation of shale gas reserves in other US basins. For instance, while it took over 25 years for output in Barnett to cross 2bcf/d (57mmcm/d), Fayetteville shale output reached the same level in just seven years. Figure 34: Technological developments accelerated shale gas development
80 70 Gas output (mmcm/d) 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 Year
Barnett
Fayetteville
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China: Mapping the US path

We expect Chinas shale gas development to exceed consensus expectations Both Chinas MLR and the US EIA estimate China has the worlds largest shale gas deposits. The Chinese government is seeking to duplicate the US shale success in China by: (1) deregulating pricing for shale gas (2011) and raising the costs of competing sources through the reforms announced in July 2013; (2) allowing diversified investment in gas pipeline construction aimed at a freer market; (3) introducing fiscal incentives including a production subsidy double that for CBM; and (4) encouraging diversified investment in the sector. On-the-ground checks with Chinas official shale gas office and key players support our findings Our discussions with Chinas shale gas reserve assessment centre (under the MLR), major explorers including PetroChina, Sinopec and Shell, and key oilfield services players including Schlumberger, Anton and SPT, suggest China is making progress in shale gas development that is likely to surprise the market.
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Chinas own assessment of its shale gas potential

Motivated by the profound change brought by the development of shale gas in the US, China started closely observing and researching the sectors development in the early 2000s in the hope of replicating the success. Chinas MLR began assessing shale reserves in 2005 Chinas MLR began preparative work assessing Chinas shale gas resources in 2005, following a study of the US profile. The initial assessment in 2008-09 showed that China potentially held the worlds largest shale gas resources, and government officials from the NDRC and MLR have since indicated their intention to support shale gas development in China, attracting immense public attention. The initial estimate was confirmed in March 2012 when the MLR announced its official findings that China had 25.08tn cm of recoverable shale gas resources. In June 2013, the EIA estimated China had 31.6tn cm of recoverable shale resources. To put this in context, the EIA estimated US shale gas recoverable reserves at 19tn cm, 40% below its estimate for China.
The US EIA estimates Chinas shale gas resources are significantly greater than those in the US
Figure 35: The MLR estimates Chinas shale gas recoverable potential at 25.08tn cm
1.00 Junggar Basin 1.64 Songliao
0.29 Tuha Basin 0.03 Jiuquan Basin 0.56 Qaidam Basin
1.46 Tarim Basin
0.35 Mid and Small Basin
1.34 Bohai Bay Basin 2.71 Ordos 6.44 Sichuan Basin

0.14 Qinshui
0.86 Nanxiang
0.48 Subei
1.07 Lower Yangtze
1.87 Quan Zhong 0.01 Xichang
1.59 Middle yangtze
0.09 Ganxibei
0.16 Pingle
Legend
0.04 Chuxiong
uplif t depression Recoverable resources
0.26 Qian 0.34 0.26 Liupanshui Zhonglong Xiangdongnan 0.16 Dongnan 0.26 0.53 Guizhong Nan Panjiang 0.25 Baise-Nanning 0.14 Shiwan Dashan
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Large reserve base boosts market sentiment Reassured by the resource potential, companies started showing intense interest in shale gas after 2009, and the government began rolling out policy incentives in order to create an environment similar to the early years of US shale gas development. The MLR wants to encourage diversified investment in shale gas development To facilitate diverse investment, in 2011 the MLR categorised shale gas as a mineral resource independent from conventional oil and gas. In 2012, the ministry held two rounds of shale gas auctions to allow competition among various investors. It is preparing for a third round that is likely to take place in 2H13 or early 2014. Figure 36: Chinas shale gas production estimates
Market consensus (LHS) 90 80 in bn cubic metres 70 60 50 40 30 20 10 0 2015E 2020E
Source: Bloomberg, National Development and Reform Commission, Standard Chartered Research estimates
NDRC target (LHS)
SCR estimate (LHS)
80.0 61.0
25.0
2.8
6.5
2.8
In November 2012, China announced a shale gas production subsidy double that for CBM
In November 2012, Chinas National Energy Administration (NEA) and the Ministry of Finance (MoF) announced a production subsidy of RMB 0.4/cm for shale gas development through 2015. We think the subsidy will likely be extended for at least another two to three years and believe the authorities could be studying additional incentives including a potential rebate on the value-added tax and the exemption from royalty payments. The governments shale gas development plan, released in March 2012, sets the goal of producing 6.5bn cm of shale gas in 2015 and 60-100bn cm in 2020. Progress made exceeds consensus estimates Although most of our peers consider Chinas official target excessively aggressive given the technical and geological challenges, we are encouraged by recent developments following our discussions with officials from the MLRs China Geological Survey, CNPC, Sinopec, Shell, Total, Chevron, Schlumberger and the National Energy Shale Gas R&D (Experiment) Centre.
China announced shale gas production targets in 2012
Actual shale gas drilling progress has been encouraging
China has drilled c.50 evaluation wells and c.90 exploration wells (of which about a third are horizontal and two thirds vertical) since work started in 2009. Most of the wells are in Sichuan, Chinas largest shale gas reserve, and about one third have been tested with gas flows. The most promising wells are able to produce c.150k cm of gas per day, according to the operators we spoke to. In Sichuan, PetroChina has started building a 93-km pipeline to transport gas from its shale reserves in the Changqing block as it is confident of the commerciality of developing the resources.
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Figure 37: Shale gas wells drilled as of end-March 2013 are mainly located in Sichuan, Chongqing and Shaanxi
Songliao Basin
Junggar Basin Urumqi
Harbin
Changchun
Tuha Basin Tarim Basin

Hohhot
Shenyang Beijing Bohai Bay Basin Qinshui Basin

Jinan
Qaidam Basin
Xining
Yinchuan
Ordos Basin
Lanzhou
Xian
Zhengzhou South Huabei Basin Nanxiang Basin Hef ei Nanjing

Wuhan
Shanghai
Sichuan Basin Chengdu

Chongqing
Legend
Chuxiong Basin
Pingle Depression Changsha

Fuzhou
uplift depression
Shale gas exploration well
Kunming
Guiyang Basin
Nanpanjiang Basin Nanning

Guangzhou Hong Kong
Our proprietary production model suggests China will be able to meet its 2020 shale gas target
We base our China shale gas production analysis on the most recent data provided by the MLR and EIA. Our findings show China should be able to produce 2.8bn cm of shale gas in 2015 (in line with consensus) and 62bn cm in 2020 (versus consensus of 25bn cm). Recent developments in Chinas natural gas industry have convinced us that China is on the right track to unlocking its vast shale gas resources. We see Sichuan, Tarim and Ordos as the most promising regions.
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Mirroring the US growth

We further benchmark the current stage of Chinas shale gas development against the US history and conclude that China is moving towards a US shale roadmap with its abundant resource, deregulated pricing, increased competition in pipeline operations, adequate water availability, fiscal incentives and a focus on technological advancement. Abundant resource Working with major oil companies, petroleum universities and geological survey providers, the MLR finished the initial evaluation of shale gas potential in March 2012, putting Chinas recoverable resources at 25.08tn cm and total resources in place at 134.42tn cm. This implies a recovery rate of 19% and makes China the holder of the worlds largest shale gas reserves. Chinas MLR divides Chinas shale gas reserves into four regions The MLR divides the prospective areas into four broad zones: (1) the Upper Yangtze and Yunnan-Guizhou region (46% of total recoverable potential, Sichuan basin inclusive); (2) the Mid-Lower Yangtze and Southeast region (19%, Greater Subei inclusive); (3) the Northwest region (15%, major basins including Tarim, Junggar and Qaidam); and (4) North China and the Northeast region (20%, major basins including Songliao and Ordos). Figure 38: Chinas estimates of shale gas Figure 39: Chinas estimate of recoverable shale gas resources, bn cm
12 10 8 Upper Yangtze & YunnanGuizhou (62.6 bcm) 46% 6 4 2 0 Upper Yangtze & Yunnan-Guizhou Mid-Lower Yangtze & Southeast Northwest Nouth China and Northeast 18% 16% 19% 25% Recoverable Recovery ratio 30% 25% 20% 15% 10% 5% 0%
North China and Northeast (26.8 bcm) 20%
Northwest (19.9 bcm) 15%
Mid-Lower Yangtze & Southeast (25.2 bcm) 19%

The EIA cut its estimate of Chinas shale gas resources in June 2013, but China remains the worlds largest holder
In June 2013, the US EIA estimated China sits on 31.6tn cm of recoverable shale gas resources (13% below its previous estimate), due to a reduction in prospective area in the Qiongzhushui formation in the Sichuan Basin (from 56,875 sq miles to 6,500 sq miles) and the Lower Cambrian shales in the Tarim Basin (from 53,560 sq miles in 2011 to 6,520 sq miles). This is still 26% above Chinas own estimate of 25.08tn cm. The EIA groups Chinas shale gas potential into seven prospective basins. The largest technically recoverable reserves are in Sichuan (17.7tn cm), followed by Tarim (6.1tn cm), Junggar (1.0tn cm) and Songliao (0.5tn cm). The rest is buried in the smaller, structurally more complex Yangtze Platform, and the Jianghan and Subei basins.
Most shale gas resources in the EIAs assessment overlap the MLRs evaluated acreage
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Figure 40: EIAs assessment of shale resources in China
The EIA excludes Ordos from its shale gas assessment due to its Lacustrian nature
Both the MLR and EIA identify Sichuan as the largest holder of recoverable shale gas resources. The most obvious difference between the two estimates is that the EIA excludes the Ordos basin. According to our discussions with the head of the shale gas office under the MLRs resources evaluation centre and other leading industry experts this is because the EIA lacks the data and experience to assess Ordos Lacustrian reserves.
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Figure 41: EIA estimates of Chinas major shale gas formations

Technically recoverable Gas in place, tn cm reserves, tn cm 14.2 32.5 20.3 5.1 11.8 1.3 0.8 1.1 0.8 4.1 0.2 5.0 10.7 7.5 4.6 4.9 5.3 4.4 134.4 3.5 8.1 6.1 1.3 2.9 0.3 0.2 0.3 0.2 1.0 0.1 1.2 2.7 1.7 0.5 0.5 0.5 0.5 31.6 Recovery ratio 25% 25% 30% 25% 25% 24% 25% 25% 24% 25% 25% 25% 25% 23% 10% 10% 10% 10% 23% Prospective area, sq miles 6,500 10,070 20,900 3,250 5,035 1,280 1,900 3,830 2,040 10,970 1,640 6,520 19,420 21,380 15,920 7,400 8,600 6,900 153,555
Basin Sichuan
Shale gas block Qiongzhusi Longmaxi Permian L. Cambrian L. Silurian Niutitang/Shuijintuo Longmaxi Qixia/Maokou Mufushan
Yangtze
Jianghan
Greater Subei
Wufeng/Gaobiajian U. Permian L. Cambrian L. Ordovician M.-U. Ordovician Ketuer Pingdiquan/Lucaogou Triassic Qingshankou
Tarim
Junggar Songliao Total
China deregulated pricing of unconventional gases in 2011
Price deregulation Starting in 2011, China has deregulated the pricing of unconventional gases (shale gas, coal-bed methane and coal-to-gas) to encourage upstream development by allowing producers to pass through higher costs. Suppliers have since been able to negotiate selling prices with consumers, while prices of conventional gases are still capped at the city-gate level. In July 2013, partially to increase the competitiveness of more expensive unconventional gas, China raised city-gate natural gas prices c.15% on average and promised to move prices towards international parity by end-2015, implying a c.60% rise from current levels. This marks a shift in Chinas natural gas pricing mechanism from the previous cost-plus method to nationwide net-back pricing, which bases the selling prices of gas on oil-linked substitutes like fuel oil and LPG. More importantly, the changes are only the start of long-term reforms that will eventually lead to full deregulation of the natural gas market regardless of gas source, according to the NDRC. As in the US in the 1960s, when gas prices were regulated under a cost-plus pricing, the artificially low prices in China have discouraged upstream production and subsidised wasteful consumption of natural gas, leading to a nationwide gas shortage over the past few years.
In July 2013, China announced natural gas pricing reform aimed at eventual free market pricing
Higher gas prices will facilitate Chinas shale gas exploration and development
We believe higher prices will help facilitate the healthy development of Chinas natural gas industry and further boost consumption of the fuel, because: (1) higher margins will incentivise supply of gas, including unconventionals, unlocking pent-up demand; and (2) higher natural gas prices after the adjustments will keep the fuel competitive against substitutes like LPG, diesel and electricity. We expect faster development of unconventional gases due to the clearer margin visibility at fields and resilient demand expansion.
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Figure 42: Chinas gas price reforms incentivise unconventional development

9 8 7.00 Breakeven gas price 2015E well-head price 8.50
7
6 in USD/mcf 5
4.59 3.72 2.79
4
3 2 1 0 Sichuan shale
Ordos tight
Qinshui CBM
Conventional gas (Tarim)
Source: Wood Mackenzie, National Development and Reform Commission, Standard Chartered Research estimates
Figure 43: Estimated gas prices after 2015 deregulation would still keep natural gas competitive (all prices in RMB/cm)
9 8 7 6 5 4 3 2 1 0 Residential electricity LPG Fuel oil Industrial electricity Coal Naphtha Diesel Gasoline Alternative fuel price Average end-user gas price: industrial Average end-user gas price: residential Average end-user gas price: CNG vehicular
Note: Alternative fuel prices are converted to gas equivalent prices in RMB/cm based on their heat values. Source: ENN Energy, National Development and Reform Commission, Wind, Bloomberg, C1 Energy, Standard Chartered Research estimates
Pipeline deregulation Pipeline deregulation the separation of gas sales and pipeline transportation services was conducive to the fast growth of the natural gas industry in the US. Although PetroChina still monopolises Chinas natural gas pipeline network with a c.80% market share, we are seeing diversified investment in the sector as the central government encourages market competition. The NDRCs 10 July 2013 natural gas pricing reforms also moved the control of prices from the well-head point to city-gate levels. In our view, this establishes the framework for a deregulated pipeline market as gas sources and pipeline construction increase going forward.
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China encourages diversified investment in natural gas pipeline construction
The NDRC has also indicated it will announce the Management Guidance on Natural Gas Infrastructure Construction and Operations soon. The rules are aimed at standardising the pipeline chain from project approval, construction and pricing to operations, to facilitate rapid growth in gas infrastructure construction. We believe a diverse body of investors, including some privately-owned companies, is set to enter the sector as more supportive policies are announced. PetroChina is also opening its pipeline construction and operations to external investors. The most recent example is the involvement of a steel company and two fund managers in the construction of the RMB 116bn West-East Pipeline III, announced in December 2012.
Figure 44: PetroChina operates c.80% of Chinas gas pipeline network, which CPPE expects to double in length over the next 5-10 years
Kanasi Daban
WEP-V Yining - Zhongwei
WEP-IV Kanasi Daban - Jingbian
Zhuaji
Daqing
Heilongjiang
Huoerguosi
Harbin
WEP-III Huoerguosi - Fuzhou Xinjiang
Lunnan
ShaanxiBeijing IV
Qinhuangdao Shenyang ShaanxiBeijing I Beijing Hebei WEP-I
Changchun
Jilin
Shenyang Harbin
Shenyang
Liaoning
Westen Section of WEP-II
Dunhuang
ShaanxiInnerBeijing Mongolia I & II
Dalian Shenyang
Yinchuan
Ningxia
Yulin
Golmud
Qinghai
Seninglan Pipeline Xizang
Shanxi Jingbian
Shandong
Taian
Shandong gas pipelines
Lanzhou Gansu
Shaanxi
Henan Pingdingshan
Lianyungang
Jiangsu
Lhasa
Nandu
Zhongwei - Guiyang Sichuan Chongqing Zhongwu Pipeline China - Myammar Hubei
Anhui
Shanghai
Shanghai
Nanchang
Hunan Xiangtan
Zhejiang Eastern Section of WEP-II
Guizhou
gas pipelines under construction/ ready for operational start-up
Jiangxi
Jian Fujian
Fuzhou
Taipei
Taiwan
gas pipelines in operation

major LNG import terminals Ruili
Guiyang
Yunnan Guangxi Guangdong
Nanning
Shenzhen
major cities
Shenzhen LNG pipelines Hainan
Source: China Petroleum Pipeline Engineering, Standard Chartered Research
Jieyang
Length of Chinas natural gas pipelines likely to double over the next 5-10 years
The total length of Chinas natural gas pipeline as of end-2012 was c.50,000 km, merely one tenth of that in the US. We expect accelerated growth in gas pipeline construction in coming years to accommodate the upstream exploration incentivised by higher prices and as more investors get into the business. China Petroleum Pipeline Engineering (CPPE), Chinas largest pipeline construction company by market share, expects the length of Chinas natural gas pipelines to double in the next 5-10 years due to additional nationwide and cross-border pipelines.
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Gas liquefaction plants would provide an alternative in areas where pipelines are not yet connected
Most pipeline facilities are linked to the major gas fields in Tarim, Ordos and Sichuan (see map above), where we expect significant shale gas production due to the larger recoverable reserves. In regions where there is currently no pipeline access, the alternative means of transporting future shale gas production is LNG plants and truck transports, which already supply c.4% of Chinas natural gas consumption. The construction of LNG plants in China will continue to rise due to the limited access to pipelines, offering a medium-term solution for shale gas production without pipeline access, in our view. We expect faster growth in vehicular LNG consumption, which will continue to drive local LNG production as the government pushes for increased use of vehicles fuelled by natural gas (which we estimate will still be c.40% cheaper than gasoline and diesel after the expected price increases through 2015). Figure 45: Chinas LNG plant capacity in major gas producing regions
6,000 5,000 4,000 3,000 2,000 1,000 0 Northwest (Tarim) North China (Ordos) Soutwest (Sichuan) East China South China Northeast 81% LNG plant capacity, in mcm/yr 75% 62% 60% 38% 63% Avg LNG plant utilization (RHS) 90%
Vehicular gas consumption will drive Chinas LNG demand
80%
70% 60% 50% 40% 30% 20% 10% 0%
Source: C1 Energy, Standard Chartered Research
Shale gas currently has the highest production subsidy among competing sources CBM and tight gas
Fiscal incentives The Chinese government has been aggressive in introducing financial incentives to boost the development of unconventional gases. Besides the full market pricing allowed for shale gas and other unconventional gases in 2011, shale gas developers enjoy a subsidy of RMB 0.4/cm for shale gas produced between 2012-15. This is double the CBM production subsidy, and we think the financial aid is likely to be extended for at least two to three years beyond 2015. Our discussions with market participants suggest the government is also still debating whether and when to introduce extra policy incentives for shale gas; potential benefits include the exemption from a royalty payment (5-10%) and a full rebate on the production VAT (13%). Figure 46: Comparison of major policy support, CBM versus shale gas
CBM VAT (13%) Sales subsidy Full refund. Power generation - RMB 0.25/kWh; household use: RMB 0.2/cm. Double declining balance or sum of the years digits. Shale gas Likely to enjoy full refund upon commercial production. RMB 0.4/cm.
Depreciation method allowed
Pending.
Source: Government documents, Standard Chartered Research estimates
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Chinas MLR is trying to duplicate the US shale gas success by encouraging diversified investment in the sector
Diversify investment to boost shale prospects Although we believe NOCs will play the critical role in developing Chinas shale gas resources, the increased involvement of IOCs and non-oil domestic operators will also help boost upstream prospects by introducing high-end technologies and increasing competition to drive efficiency in the market. In the next section we take a look at the major non-NOC players. IOCs International oil companies including Shell, ConocoPhillips and Eni have shown immense interest in seizing the shale opportunities in China, with Shell being the most aggressive, in our view. Foreign companies are currently not allowed to directly enter the upstream exploration space, and must form an alliance with an NOC in the form of joint production sharing meaning IOCs carry out the risky exploration at the initial stage and once there is commercial output the NOCs have the right to take 51%. Recent examples include the Ministry of Commerces March 2013 approval of the production sharing contract (PSC) between Shell and CNPC in the FushunYongchuan block in Sichuan. This was the first shale PSC in China, a key milestone for foreign investors seeking a foothold in Chinas unconventional gas industry. Figure 47: Timeline of major IOC agreements in China shale gas
Shell and CNPC sign JSA for FushunYongchuan, Nov. 2009 Shell and CNPC sign PSC for FushunYongchuan, subject to government approvals, March 2012
Major IOCs in Chinas shale gas partnership projects include Shell, ConocoPhillips, Chevron and Eni
Eni and CNPC sign JSA for Rongchang block, Sichuan, March 2013
May-10
May-11
May-12
Jan-12
Jan-10
Jan-11
Nov-12
Nov-09
Sep-10
Nov-10
Sep-11
Nov-11
Sep-12
Mar-10
Mar-11
Mar-12
Jan-13
Jul-10
Jul-11
Jul-12
Chevron and Sinopec signs JSA for Longli block in Qiannan block, April 2011
Source: Companies, Standard Chartered Research
ConocoPhillips and Sinopec sign JSA for Qijiang block, Sichuan, Dec. 2012
ConocoPhillips and CNPC sign JSA for Neijiang-Dazu block, Sichuan, Feb. 2013
Chinese non-oil companies have entered Chinas shale gas business through shale block auctions
Chinese non-oil companies The Chinese authorities, led by the MLR, believe an open market has been key to the shale success in the US. The ministry has tried to introduce increased competition by auctioning blocks especially through the second round of bidding, which was open to all companies. Bidders in the second-round shale gas block auction included coal companies, power companies and privately-owned project developers (detailed below). These companies, having little upstream exploration expertise, would likely hire either the oilfield service subsidiaries of NOCs or privately-owned field service providers (like Anton and SPT) to help them with the actual drilling.
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In May 2013, for example, a China Shenhua Group (Shenhua) subsidiary hired Sinopecs oilfield service unit to conduct the 2-D seismic survey for the block it was awarded (the Baojing block in Hunan province). Shenhua budgeted RMB 874.5mn to explore the block, and the initial 2-D seismic study will cost RMB 29.1mn. Given their lack of drilling expertise, non-oil companies could require third-party oilfield services We expect exploration and development by non-oil companies to be limited compared to that by NOCs, due to the large capex requirements and the lowerquality blocks they obtained through the public bidding process. However, their presence will enhance market efficiency by increasing competition, in our view. First round of shale auctions The Chinese governments first shale gas auction in June 2012 offered four blocks near Chongqing in southwestern China. The auction was by invitation and conducted in a closed-door format. It received nine bids from the following companies: (1) PetroChina; (2) Sinopec; (3) China United Coalbed Methane (CUCBM); (4) Shaanxi Yanchang Petroleum; and (5) Henan Provincial Coal Seam Gas Development and Utilization (Henan Provincial Coal). Sinopec and Henan Provincial Coal won the three-year exploration rights of the Nanchuan (Sinopec) and Xiushan (Henan Provincial Coal) blocks, as they proposed the highest number of wells drilled with the largest spending pledge. The other two blocks failed to attract sufficient interest from the companies and were not sold. Figure 48: Major blocks auctioned through the first shale gas auction
Nanchuan Block: 2,197.94 sq km; exploration rights valid for three years Spending pledge, Bidder RMB mn Sinopec 591.10 China United Coalbed Methane PetroChina Xiushan Block: 2,038.87 sq km; exploration rights valid for three years Henan Provincial Coal Seam Gas China United Coalbed Methane Shaanxi Yanchang Petroleum
The MLR held Chinas first shale gas auction (closed-door) in June 2012
No. of exploration wells proposed 11 5 11
218.84 150.00
247.56 164.92 192.85
10 6 5
The MLR adopted an open and transparent approach in the second shale auction, in September 2012
Second round The second round was held in September 2012, and the MLR demonstrated more openness by allowing a much wider range of companies to participate in an open format. All Chinese companies and Chinese-controlled foreign JVs with a registered capital of not less than RMB 300mn were eligible to bid if they had the oil/gas exploration qualifications or a partnership with companies with such qualifications. The scale of blocks was also much larger, with 20 up for sale, covering 20,239 sq km in eight provinces and regions (Chongqing, Guizhou, Hubei, Hunan, Jiangxi, Zhejiang, Anhui and Henan). As in the first bid, the right to explore in the blocks auctioned were valid for three years, but the new terms required successful bidders to spend at least RMB 30,000 per sq km per year and specified that the number of exploration wells drilled must exceed two for each 500 sq km on average. The second round attracted interest from 91 companies, and 83 eventually submitted bids. Sixteen companies won the exploration rights for 19 blocks and one block was not sold due to a lack of interest.
Successful bidders in the shale auctions committed to a minimum spending per km in the blocks
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Figure 49: Companies that submitted bids in the second round, by type
Figure 50: Successful bidders in the second round, by type
Privately owned 31%
Centralgovernment owned 25% Localgovernment owned 41%
Privately owned 13%
Centralgovernment owned 37%
Sino-foreign JVs 3%
Localgovernment owned 50%
Figure 51: Details of successful bidders in Chinas second shale gas auction
Minimum spending for three years (RMB mn) 92.21 94.80 92.74 105.07 82.32 114.52 90.19 91.89 79.02 107.07 36.04 68.43 88.40 33.23 207.60 53.85 52.21 124.01 125.64 1,739.23
Block Suiyang Fenggang-1 Fenggang-2 Fenggang-3 Cengong Qianjiang Youyang East Chengkou Longshan Baojing Huangheng Sangzhi Yongshun LaifengXianfeng Hefeng Xiuwu Basin Lin'an Wenxian Zhongmou Total
Size (sq km) 1,024.53 1,053.37 1,030.40 1,167.49 914.63 1,272.40 1,002.09 1,020.95 878.00 1,189.72 400.43 760.36 982.23 369.23 2,306.71 598.28 580.09 1,377.91 1,395.99 19,324.81
Location Guizhou Guizhou Guizhou Guizhou Guizhou Chongqing Chongqing Chongqing Hunan Hunan Hunan Hunan Hunan Hubei Hubei Jiangxi Zhejiang Henan Henan
Successful bidder Huadian Coal Industry Group China Coal Geology Engineering Huaying Shanxi Energy Investment Beijing Taitan Tongyuan Natural Gas Technology Tongchuan City Energy Investment Chongqing City Energy Investment Chongqing Mineral Resources Development State Development and Investment Hunan Huasheng Energy Investment Shenhua Geological Exploration China Huadian Engineering China Coal Geology Engineering Hunan Provincial Shale Gas Development Hudian Hubei Power Generation Hudian Hubei Power Generation Jiangxi Natural Gas Holdings Anhui Provincial Energy Investment Henan Yukuang Geological Exploration Investment Henan Yukuang Geological Exploration Investment
Type of company Central govt. Central govt. Private (600167.CH) Private Local govt. Local govt. Local govt. Central govt. Local govt. Central govt. Central govt. Central govt. Local govt. Central govt. Central govt. Local govt. Local govt. Local govt. Local govt.
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Chinas challenges
We think the market has overestimated Chinas challenges or failed to recognise companies ability to overcome them While we acknowledge the challenges facing China in terms of cost, topography, water resources and technology, our findings lead us to believe the market has either overestimated the issues or underestimated Chinese companies ability to overcome them. Drilling costs: Our discussions with major explorers indicate China should be able to reduce drilling costs per well by up to 50% if local equipment, personnel and technologies are used intensively. Topography: Equipment manufacturers are developing products to suit conditions in China, such as the mountainous terrain in some areas. Water: Data show that the potential drilling activities would consume only <0.01% of available water resources. Actual drilling data in Sichuan also suggests that water supply is less of an issue than widely believed for shale gas development. Technology: We expect China to achieve rapid technological upgrades through: (1) proprietary R&D efforts by major NOCs; (2) partnership with global oil majors in China; and (3) acquisitions of key unconventional players in North America.
The cost issue

Chinas shale gas is buried deeper, meaning higher drilling costs Chinas shale gas reserves are believed to be 2,000-3,000 meters deep, versus 1,000-2,000 meters in the US, and the depth issue, together with more complex geological conditions, will result in higher drilling costs, particularly in the initial phase. We think the higher costs can be addressed through technological innovations to enhance production efficiency or through increased use of local content, including local engineers, equipment and tools. Chinas privately-owned oilfield service companies pay their site service engineers a day rate of c.USD 220, while foreign counterparts from global companies like Schlumberger normally cost c.USD 1,400 per day, our checks show. To put things in context, companies including Petrohawk have reported that it costs c.USD 9mn (c.RMB 56mn) to drill a well on average in the US, while the exploration wells drilled in China by PetroChina and its foreign partners like Shell cost c.USD 16mn (c.RMB 100mn). However, our discussions with CNPC indicate it believes perwell cost can be brought down to as low as USD 8mn (c.RMB 50mn) by maximising the use of local manpower, equipment and technology. Drilling and fracking are the costliest elements of total cost, each accounting for about a third of costs. We illustrate the detailed cost structure of a typical shale gas horizontal well below.
China hopes to counter the cost issue through improving project economics or increasing use of local content
Intensive use of local technology and equipment could reduce drilling costs by up to half
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Figure 52: CNPCs shale gas wells drilled with high local content cost up to 50% less than wells with intense foreign partnership, RMB mn
well drilling fracking/acidization oil production test perforation well logging well cementing pre-drilling infrastructure finance costs formation testing admin costs drilling rig mobilization drilling design 15.6 14.3 10.0 2.8 2.6 1.7 1.0 0.9 0.5 0.4 0.3 0.1 100.0 0 10 20 30 40 50 60 70 80 90 100
per-well cost with intense foreign partnership
Figure 53: Cost structure of a typical shale gas well drilled by CNPC
Pre-drilling infrastructure, 2.0% Well cementing, 3.4% Well logging, 5.1% Perforation, 5.5% Oil production test, 19.9%
per-wellt cost with intense use of local equipment and technology
Figure 54: Local field service engineers are c.80% cheaper than their international counterparts in China
9,000 8,400
Others, 4.2% Well drilling, 31.3%
8,000 7,000 6,000 RMB/day 5,000 4,000
3,000
2,000 Fracking/acidisation , 28.6% 1,000 0 Local Foreign
1,400
Topography and population

Topographical challenges apply to unconventional gas and conventional gas already under development Parts of China, particularly in the south and west, are mountainous, and underdeveloped roads can also hamper the transport of large-scale drilling equipment such as pressure pumps and drilling rigs. However, the development of conventional gases faces the same issues in places like Sichuan, which still contributes c.25% of the nations total gas output. Our discussions with industry operators and experts show that there are still quite a few places with favourable topography and rich shale reserves. During our recent trip to Sichuan it was also encouraging to see that companies including the Honghua Group, a leading drilling equipment manufacturer, have begun designing and manufacturing equipment and tools suitable for Chinas topography. For example, Honghua plans to promote its foldable water tanks made of soft durable materials, which are easy to fold and transport.
Equipment companies are developing products to suit Chinas particular conditions
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Figure 55: Honghuas foldable water tanks, designed for shale gas development
Source: Honghua Group, Standard Chartered Research
Chinese companies are upgrading HSE standard to minimise risks to local populations
Population China has the worlds largest population, and Sichuan, the countrys largest shale gas reserve, has a population density of 166 people per sq km, 20% above the national average. Poor management of gas development can therefore have serious consequences for the local population. In December 2003, an explosion at a natural-gas field operated by PetroChina in Sichuan sent toxic fumes into the air, killing c.200 people and injuring at least 290 others. More than 40,000 people living near the site were evacuated. The accident was negative for PetroChinas reputation, and then-chairman Ma Fucai resigned to take responsibility. Chinese companies have since been ordered to lift safety standards. Safety awareness and precautionary measures to prevent production accidents have substantially improved at upstream work facilities, as domestic companies increased spending and international oil companies including Shell, Total and Chevron, brought international practices to China through intensified partnerships.
The deadly accident in 2003 taught the Chinese government and NOCs a lesson on safety
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Risks still exist due to the high population density, but the environmental impact can be minimised and accidents prevented if adequate precautionary measures are taken. Figure 56: Population density is above national average in Sichuan and Chongqing, where much of Chinas prospective shale gas reserves are buried
450 400 Person/sq. kilometre 350 300 250 425 351 Population density (LHS) National average population density (LHS) Land area (RHS) 1.8 1.6 1.4 mn sq. kilometres 1.2 197 1.0
310
308
297
295
200
150 100 50 0 Anhui Chongqing Hunan Hubei Fujian Liaoning
181
166
144
0.8
0.6 0.4 22 13 Xinjiang 8 Qinghai 0.2 -
Guizhou
Shaanxi
Sichuan
Jilin
Inner Mongolia
Source: CEIC, Standard Chartered Research
Water resources
Water supply is vital in developing shale gas, as a typical well needs c.4mn gallons of water, mostly during the fracking process. The above-average per capita water resources in the US contributed to the success of shale gas there, and various forecast agencies have pointed to water scarcity as one of the major challenges facing Chinas shale gas industry. But our findings, based on provincial water resources and consumption data provided by the Ministry of Water Resources, suggest water consumption (residential, industrial, agricultural and ecological maintenance) accounts for 10-60% of water resources in most shale-gas-rich provinces (led by Sichuan and Guizhou), meaning at least half of the remaining resources are available for additional consumption. Shale gas drilling likely to require only <0.01% of water resources in most reserve-rich regions We assume a higher water consumption per well in China given its more complex geological formations. Still, our shale gas supply model shows drilling activities would consume less than 0.01% of water resources in most regions in China. We believe the environmental impact will be within a controllable range, based on the experience in the US.
Figure 57: Over 50% of water resources are available for use in most shale-rich regions
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Inner Mongolia Liaoning Residents Industry Agricultural Geological maintenance Water available for other uses
Jilin
Anhui
Fujian
Hubei
Hunan
Sichuan
Guizhou
Yunnan
Shaanxi
Qinghai
Xinjiang
Source: Ministry of Water Resources, CEIC
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Technology
We believe China will be able to catch up in shale gas technology through proprietary R&D and learning from the US experience Technological upgrading is vital to reducing costs and optimising efficiency so as to make the economics attractive enough for large-scale development. Although China still lags behind, we believe local companies current strategy of proprietary res earch, partnering with global heavyweights and learning from direct involvement in overseas blocks acquired through acquisitions will enable them to catch up fast. The successful experience in the US and widely available technical analysis will also provide China with a short cut to meaningful advancement, in our view. Upgrading technology is key to achieving shale gas economics Experience in the US shows horizontal drilling, multi-stage fracking and accurate seismic surveys are among the technologies crucial for achieving shale-gas economics. For example, enhanced drilling solutions helped shale pioneer Mitchell Energy cut drilling costs by half, allowing exploration projects to reap a 10% return with wellhead gas prices at merely c.USD 4/mcf (<RMB 1/c m). The Chinese government has led efforts to initiate R&D campaigns and set up experimental projects. The National Energy Administration (NEA), Chinas top energy policy authority, designated CNPC to set up the National Energy Shale Gas R&D (Experiment) Centre in August 2010, to oversee Chinas technological capacity building. The centre covers almost the whole shale gas value chain, from reservoir assessment/analysis, block development solution design, drilling and stimulation to well completion. It has helped with the shale core tests of 12 wells drilled by PetroChina, Sinopec and the China University of Geosciences. Figure 58: Chinas first shale gas experiment centre helped explorers assess resource potential in Sichuan Basin The R&D centre has assessed the reserve quality of 12 wells
The Chinese government set up the first national shale gas experimental centre in August 2010
Source: National Energy Shale Gas R&D (Experiment) Centre, Standard Chartered Research
Chinese companies aim to learn advanced experience and management through foreign partnerships
In addition to internal capacity building, service companies are also linking up with foreign research institutes or oilfield service super-majors to service the growing market in China. PetroChina, for example, has been working with Shell, Chevron, ConocoPhillips and Eni on joint explorations, primarily in the Sichuan basin. As in the offshore blocks, the domestic companies and their foreign counterparts work under a typical PSC, under which overseas companies take the full risks during the exploration phase while the NOCs have claims to 51% of volume once production commences.
42
30 September 2013
Chinese oilfield service companies form joint partnerships to advance their service and equipmentmanufacturing abilities
On the service side, both private and state companies are extending their partnerships with experienced foreign leaders in hopes of getting technical know-how in return for the market share they can offer. In 2012, Anton Oilfield Services, SPT Energy and the Honghua Group, Chinas leading private-sector oilfield services companies, signed agreements to cooperate with Schlumberger, Halliburton, and Baker Hughes, respectively, on service and equipment research focused on Chinas expanding unconventional space. According to media reports, Sinopecs newly reshuffled service arm, Sinopec Oilfield Service, is in advanced discussions with Weatherford on setting up a similar partnership on a larger scale. Finally, China oil companies recent overseas acquisitions, led by CNOOC, PetroChina and Sinopec in North America, have concentrated on unconventional sources including shale oil/gas, CBM and oil sands. We believe the costs paid for the hands-on experience in the developed markets will pay off eventually. Figure 59: Chinese companies acquisitions of North American unconventional plays surged to USD 21bn in 2005-12, value of acquisitions p.a.
25 20.9 20 USD bn 15 10.9 10 5 0.8 0 2006 2007 2008 2009 2010 2011 2012
Source: Bloomberg, Standard Chartered Research
Chinese oil companies are aggressively acquiring overseas unconventional players in hopes of gaining advanced technology
12.9 7.9
0.2
0.1
Identifying the optimal drilling technique is critical to successful shale gas development
Regardless of technological proficiency, successful resource development depends on finding optimal drilling solutions as the geological formations of blocks vary. Even when the technology is readily available, it normally takes five to eight years for developers to identify the best way to extract the resources in the most economical way. China started actual drilling of shale gas in 2009 and we expect a reasonable take-off of commercial shale gas production after 2015.
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Chinas advantages
Chinas advantages: NOC dominance and faster demand growth We believe the dominant role NOCs PetroChina and Sinopec play in Chinas unconventional development will prove to be an advantage for China, since they hold most shale gas resources and have a greater ability to take risks. Pricing reform will further incentivise the state companies to accelerate shale gas development, in our view. The double-digit growth in natural gas demand, supported by the governments environmental push and pent-up consumption demand, will facilitate faster expansion of shale gas production.
Reliance on NOCs
PetroChina and Sinopec will dominate Chinas shale gas development PetroChina and Sinopec will continue to play the dominant role in unlocking Chinas shale gas reserves because they: (1) own c.75% of Chinas shale gas resources as assessed by the MLR; (2) are able to take the greater risks required by capitalintensive exploration projects due to their stronger balance sheets; (3) have better access to transport facilities given they hold >80% of Chinas natural gas pipelines; and (4) are leading the R&D campaigns to drive technical innovations. We believe Chinas shale gas industry will benefit from the heavy involvement of the large NOCs, particularly as the government has raised gas prices to incentivise upstream exploration. The MLR has identified 180 blocks that are favourable for exploration with the current technical and resource availability, covering a total prospective area of 1.11mn km; 77% of this is in oil and gas exploration acreage owned by PetroChina and Sinopec. The best quality blocks are in the southern and eastern sections of the Sichuan Basin (scattered in the provinces of Sichuan, Hubei and Sichuan municipality) and the Ordos Basin (in Shaanxi province), according to the MLR. Figure 61: Official estimate of favourable shale gas blocks by ownership
Gas reforms will incentivise NOCs to accelerate shale gas development NOCs have c.75% of Chinas total shale gas acreage
Figure 60: Official estimate of no. of favourable shale gas blocks by region
70
60 50 40 30 20 10 0 Upper Yangtze & Yunnan-Guizhou Mid-Lower Yangtze & Southeast Northwest Nouth China and Northeast 25 38 60 57
Not allocated 23%
NOC-owned 77%
NOCs announced production targets account for c.50% of the NDRCs national goal in 2015
All government-backed explorers except CNOOC have announced explicit shale gas production targets for 2015: PetroChina targets 1.5bn cm, Sinopec 1bn cm, and Shaanxi Yangchang Petroleum (Yanchang) 0.5bn cm, implying a total output of 3bn cm, compared with the NDRCs national target of 6.5bn.
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PetroChinas exploration work has so far concentrated on the Sichuan blocks, which have some of the highest quality gas deposits in China. It forecasts project commerciality given the higher-than-expected gas flow, and is building Chinas first shale-gas pipeline, linking its Changning block with the regional trunk lines. PetroChina management is more positive on shale gas than previously, according to our discussions with management. Sinopecs shale gas potential has far exceeded its expectations Sinopec has drilling operations in more diversified locations, including Sichuan, Anhui, Hunan and Guizhou, and its findings have far exceeded the previous expectations, chairman Fu Chengyu noted in August 2013. Mr Fu also guided that the company is likely to announce Chinas first large-scale commercial shale gas project by end-2013. Almost all of CNOOCs upstream production is offshore, but it is planning to enter the onshore shale gas space. It obtained its first shale gas acreage (4,000 sq km) in the central province of Anhui after individual negotiations with the MLR. While we see an edge for CNOOCin its recent aggressive acquisition of shale gas players in North America (like Nexen and Chesapeakes assets), we expect slower progress from CNOOC than peers given its much smaller shale block holdings. Figure 62: 2015 NOC shale gas targets versus NDRCs national goal, bn cm
NDRC's national target 6.5
CNOOCs shale gas advantage is its recent acquisition of unconventional gas plays in North America
Yanchang
0.5
Sinopec
PetroChina 0
1.5 1 2 3 4 5 6 7
Source: Companies, National Development and Reform Commission, Standard Chartered Research
Shaanxi Yanchang is ambitious about drilling Lacustrian reserves in Ordos
Yanchang, an oil company owned by Shaanxi province, is one of the main explorers for shale gas in the Lacustrian reserves in the Ordos Basin. It drilled its first shale gas evaluation well in April 2011, in the Xiasiwan district of Yanan, Shaanxi Province. In September 2012, the NDRC approved the building of Chinas first Lacustrine-shale pilot zone (covering 4,000 sq km) in Yanchangs acreage. It has drilled 30 shale gas wells and fracked 23. It targets annual shale gas capacity of 500mn cm in 2015 and 1bn cm in 2020. Still, Yanchangs operations are much smaller than PetroChina and Sinopecs, and its Lacustrian acreage will prove more challenging to develop due to its high clay content.
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Figure 63: Yanchang Petroleums shale gas blocks near Yanan, Shaanxi Province
Source: Company, Standard Chartered Research
Faster demand growth in China

Faster gas demand growth in China will facilitate accelerated supply from shale gas Natural gas consumption in the US expanded 2% p.a. on average in 2008-12, with a CAGR of 39% in shale gas production over the same period. Chinas natural gas demand grew an annualised 18% in 2008-12, and we forecast growth of c.15% p.a. through 2015. This implies a much greater demand for all sources of gas, including shale. As explained in our 18 July 2013 report (PetroChina: Addressing concerns after gas reform), we expect strong growth in demand for natural gas over the long term despite the likely continuous increases in prices, because: (1) the low consumption base and pollution problems should ensure government commitment to its policy incentives; (2) the adjusted prices will allow natural gas to remain competitive against most comparables; and (3) rising production and import volumes should release pent-up demand.
Environmental issues and pent-up demand in China should support higher gas demand
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We believe faster growth in demand for natural gas, coupled with higher prices giving operators clearer margin visibility, will facilitate the development of unconventional gases in China. Figure 64: China gas demand growth versus US gas demand growth
30% 25% 20% 15% 10% 5% 0% -5% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: CEIC, Standard Chartered Research
China
US
9-year average, China
9-year average, US
18%
1.1%
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Case study: Tight gas versus CBM

The tight gas success highlights the importance of involving major NOCs and identifying the optimal drilling techniques Tight gas historically classified as a conventional gas and ineligible for policy incentives registered an astonishing six-fold growth in production in 2006-12. In contrast, CBM production has consistently missed the governments production targets despite 20 years of development plus VAT rebates and production subsidies. We consider tight gas a better benchmark for Chinas potential shale gas development than CBM, given shale and tight gas similar geological formations, drilling techniques (both need horizontal drilling and multi-stage fracking), and development path (from joint partnership to self development). In our view, the success of tight gas without policy incentives means growth in shale gas production is likely to be even faster once there are breakthroughs in technology and project economics which we expect to be around 2018.
Shale gas is closer to tight gas than CBM
Tight gas in China

PetroChina has led tight gas development in China China has technically recoverable tight gas reserves of 9-12tn cm, mainly in the major sedimentary basins including Ordos, Tarim and Sichuan. PetroChina has led the development of the tight gas sector by leveraging its large acreage and the expertise of its IOC partners such as Shell and Total. Most active drilling for tight gas has been in Ordos and Sichuan. There has been astonishing growth in tight gas despite higher costs and a lack of policy incentives China classifies tight gas as conventional gas, so it does not enjoy the same preferential policies as CBM and shale gas. Despite the lack of policy boosts, tight gas production has grown exponentially over the past few years, particularly since 2006-07 when development accelerated in the Ordos basin. Total tight gas production surged from 4.8bn cm in 2006 to 32bn cm in 2012, making China the worlds second-largest tight gas producer after the US. In the Ordos basin alone, annual production skyrocketed from 0.3bn cm in 2005 to c.20bn cm in 2012.
Figure 65: Staggering 100% CAGR in Ordos drove c.six-fold increase in Chinas tight gas output in 2006-12 Tight gas production from Ordos grew from almost nothing in 2006 to 20bn cm in 2012
Sichuan - LHS 40 35 bn cubic metres 30 25 20 15 10 5 0 2006 2007 2008 2009 2010 2011 2012 2013E
Sulige (Ordos) - LHS Growth, Changbei (Ordos)
Changbei (Ordos) - LHS Growth, Total
Growth, Sichuan 400% 350% 300% 250% 200% 150%
Growth, Sulige (Ordos)
75%
84% 28% 15% 15% 18% 16%
100% 50% 0% -50%
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Figure 66: Shale gas closest to tight gas in both formation and drilling techniques applied The tight gas success offers a benchmark for shale gas potential in China
Coal-bed methane (production) Conventional gas (production) Shale gas (drilling) Tight gas (production)
Coal seam
Top seal Tight reservoir
Gas migration over geological times Conventional permeable reservoir
Drilling techniques: horizontal drilling and multistage fracking Shale formations with remaining gas not migrated
Figure 67: Tight gas contribution to Chinas total gas output increased from 8% in 2006 to c.30%
150
Tight gas production Other natural gas production Tight gas output as % of nation's total natural gas output (RHS)
23% 19% 24% 25% 27%
40% 31% 30%
100 bn cubic metres
20%
50
12% 8% 10%
0 2006 2007 2008 2009 2010 2011 2012 2013E

0%
Techniques such as horizontal drilling and multi-stage fracking key to tight gas success
We attribute the rapid volume ramp-up to the application of effective drilling techniques, such as horizontal drilling and multi-stage fracturing, brought by experienced IOCs like Shell and Total. PetroChina began research into developing tight gas in the early 1990s, but production was flat at about 30mn cf per day until the mid-2000s, when Shell and Total stepped in. PetroChina signed the final PSCs with Shell to develop the Changbei block in Ordos in 2005, and with Total for the South Sulige block in 2006. Drawing on its international experience of technically challenging projects, Shell developed the dual lateral well solution to tackle the low permeability and poor continuity issues, with the horizontal sections being about 2,000 meters each and completed with multi-stage fracturing.
Optimal drilling solutions helped halve drilling time and double perwell production at Ordos tight blocks
The technological advancement, coupled with the drilling techniques optimised over five years, has almost halved the duration of well drilling, to about 120 days, and doubled per-well daily gas flow to about 1.2mn cm. The dual lateral well design, in particular, is vital to increasing exposure to the gas reservoir and therefore enhancing production efficiency. Although horizontal drilling and dual lateral wells mean much higher costs (at USD 12mn per well in Shells case, versus c.USD 3mn for the conventional vertical well drilled in Tarim), increased production makes the economics attractive in Ordos. Based on its own data, Wood Mackenzie estimates Shells full-cycle tight gas project at Ordos will yield an IRR of 17%, compared with the average 11% for other major tight gas blocks globally. Figure 69: Ordos requires a gas price of USD 4.4/mcf to break even, versus the global average of USD 5.1/mcf
8 7 6 5 4 3 2 1 0 Oman Perth, Australia Neuquen, Argentina Montney, Canada Ordos, China
Figure 68: Full-cycle tight gas project IRR of 17% at Ordos at higher end in global terms
35% 30% 25% 20% 15% 10% 5% 0%
Oman Perth, Australia Montney, Canada Neuquen, Argentina Ordos, China
USD/mcf
17%
4.4
Almond-Wamsutter, US
Lance Pinedale, US
Lance Jonah, US
Mesaverde Piceance, US Wasatch Mesaverde, US Niobrara Wattenberg, US
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Mesaverde Piceance, US Wasatch Mesaverde, US Niobrara Wattenberg, US

50
Almond-Wamsutter, US
Lance Pinedale, US
Lance Jonah, US
PetroChina applied techniques proven by IOCs to broader fields in Ordos, enabling robust output growth
Following Shells successful developments, PetroChina applied the proven techniques to a wider range of blocks in Ordos, using more local equipment and labour. This rapidly increased production and reduced overall drilling costs. In 200405 PetroChina began massive applications of the horizontal drilling that has been effective in developing low permeability resources, achieving a 2005-12 natural gas production CAGR of 13%, production rising to 72.5bn cm in 2012. Figure 70: PetroChinas natural gas production accelerated in 2004-05
80 70 total gas output (LHS) incremental output (RHS) 9 8 7 bn cubic metres 6 5 4 3 2 1 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
60
bn cubic metres 50 40 30 20 10 0
In July 2013, ExxonMobil entered Ordos to jointly develop tight gas with PetroChina
Shell is so far the only IOC major that has established a solid foothold in Chinas upstream gas space. Building on the fruitful growth in Ordos, it signed another PSC with PetroChina to jointly develop the Jinqiu tight gas block in March 2010, and bought the operating stake in Zitong, another tight gas block in Sichuan, from Ivanhoe Energy in 2012. Other IOCs are also vying for a share of the market: on 29 July 2013 ExxonMobil signed an initial agreement with China National Petroleum, PetroChinas Beijing based parent company, to jointly study the Changdong block in Ordos, following at least three years of negotiations.
Sinopec followed PetroChina in developing tight gas in Ordos
Sinopec is another tight gas player in Ordos, and began developing its Daniudi field in the northern part of the basin in 2005. In 2007, it began using the multi-stage fracking technique, tripling production per well to c.60,000 sqm/day. The completion of a new pipeline from Yulin to the eastern province of Shandong allowed increased sales from the project. In 2012, Sinopec produced 2.8bn cm of tight gas from Daniudi and plans to increase output to 3.4bn cm in 2013 (as of 15 August 2013 production YTD was 2bn cm).
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Coal-bed methane
CBM production has consistently missed targets despite a production subsidy and other fiscal incentives Despite the large reserve base and early push from the government (since 1992), CBM production has been disappointing. Extraction of the fuel trapped in coal seams rose from 2.3bn cm in 2005 to 8.8bn cm in 2010 still c.20% short of the NDRC target. Figure 71: Chinas CBM output has been short of government targets and we think it is likely to miss the 2015 goal of 30bn cm
30 25 bn cubic metres 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2015
Source: National Development and Reform Commission, China United CBM, Standard Chartered Research
target
actual output
30
10
While the lack of pipeline infrastructure also affecting development of other unconventional gases has been a factor, the dispute over extraction rights with coal mining companies is the primary cause of the slow CBM growth. For example, CBM developers may have the licences to extract the gas underground, but still have to negotiate individually with coal mining companies for access to the land. Since CBM blocks and coal mining concessions often overlap, disagreements over the ownership of resources and uses of coal seam gas are common due to a conflict of interests. Coal mining companies are required to reduce methane gas underground to enhance safety, so they prefer to simply vent the CBM extracted to accelerate mining instead of capturing, piping and marketing the gas. The tight gas story seems more analogous to shale gas, considering the similarities in geological formations and the typical drilling techniques horizontal drilling and multi-stage fracturing. Given the policy incentives for shale gas we think the successful development of tight gas without policy incentives suggests shale gas is even more likely to boom once companies enhance their understanding of the reserves and achieve technical breakthroughs.
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Our proprietary China shale gas model

We expect shale gas output in China to grow c.85% p.a. over 2015-20 and reach 61bn cm in 2020. Our estimates suggest that even 100bn cm of shale output could be achievable in 2020, albeit with more aggressive drilling and spending plans. We assume drilling rates and well production profiles in line with US experience, but have assumed lower well density to account for topographical differences. We also show that capital spending requirements and water resource availability are unlikely to be impediments to rapid shale gas development.
Government and company targets

The NDRC has set ambitious shale gas output targets of 6.5bn cm in 2015, and 60100bn cm in 2020. In addition, PetroChina, Sinopec and Yanchang Petroleum have set individual production targets that imply a total of 3.0bn cm of production in 2015. Figure 72: China aims to produce 6.5bn cm of shale gas in 2015, and 60-100bn cm in 2020
Shale gas output targets 2015 target 12th Five-Year Plan PetroChina Sinopec Yanchang Petroleum 2020 target 12th Five-Year Plan
Source: Companies, National Development and Reform Commission, Standard Chartered Research
bn cm 6.5 1.5 1.0 0.5 60-100
Using the US shale gas development experience as a reference, we have developed supply models to understand the operational and financial resource requirements necessary for China to achieve the official shale output targets. Based on our assessment, we believe 60bn cm of shale gas supply in 2020 is achievable, and 100bn cm of output cannot be ruled out.
Our supply model: 61bn cm in 2020E

To understand the trajectory shale gas development in China could follow, our supply model uses estimates and assumptions for key inputs such as prospective shale basins and acreage, typical well production profile, and drilling rates. In addition to annual shale gas supply, the model estimates possible constraints such as capital spending and water usage. Our base case shale gas forecast for 2015 is 3bn cm, below the official target of 6.5bn cm We estimate China could produce 61bn cm of shale gas supply in 2020, slightly above the lower end of the official target. However, we think output in 2015 is likely to be c.3bn cm, below the government target of 6.5bn cm, given the current level of drilling activity in China and the historical drilling growth rate trend in the US. Nonetheless, the output we estimate in 2015 still represents a marked improvement from the current output of virtually nil. In our base case, we estimate shale gas output could grow c.85% p.a. over 2016-20. Thereafter, we expect the growth rate to moderate, with output growing at CAGRs of 21% over 2021-25 and 6% over 2026-30. We expect production to grow c.3% p.a. through 2040.
Figure 73: Base case: Shale gas output estimates for China, and comparison with US
Shale gas production China (bn cm) Sichuan Tarim Subei, Jianghan and Yangtze Total Preceding 5-yr CAGR (China) US (bn cm) Preceding 5-yr CAGR (US) 21 138 45% 251 13% 3 0 0 3 50 1 10 61 85% 313 5% 113 8 38 159 21% 364 3% 143 22 51 216 6% 401 2% 163 40 59 262 4% 434 2% 178 56 65 299 3% 473 2% 2005 2010 2015E 2020E 2025E 2030E 2035E 2040E
Source: Energy Information Administration, Standard Chartered Research estimates
Prospective basins and acreage

In our shale supply forecasts we assume production from the Sichuan, Jianghan, Subei, Yangtze and Tarim basins. The EIA estimates these basins contain risked recoverable resources of 1,064tn cf (30tn cm), compared to a recoverable resource base of 665tn cf (19tn cm) in the US. These basins contain marine shales, the same type that has proved prospective in North America. We therefore believe they are most likely to be developed over the next few years. We do not include Lacustrine shales in basins like Ordos in our base case as they are more challenging than marine shales The EIA considers the Sichuan basin Chinas premier shale gas area due to its existing gas pipelines, abundant surface water supplies, and close proximity to major cities. Most of the recent activity has been concentrated in this region. We expect Sichuan to be the first basin to be developed extensively, and activity in the more structurally complex broader Yangtze area, including Jianghan and Subei, to follow. While the Sichuan basin and broader Yangtze (including Jianghan and Subei) areas are likely to lead shale gas development in China, we expect Tarim to be explored and developed at a later stage. The basins structure is relatively simple but there are other significant challenges: remoteness, low concentration of water resource and high shale depth. We have not considered prospective shale resources in the Ordos, Junggar and Songliao basins, as their Lacustrine shales are characterised by high clay content that makes hydraulic fracturing more challenging. Clay-rich shales also absorb water and fractures are less likely to remain open. These basins are likely to require new types of frac designs and proppants and full-scale development could therefore take much longer than in the marine shale basins. However, given the speed of technological development in the past few years, these challenges could potentially be overcome. As such, shale gas production from these regions could provide significant upside to our assumptions. We have estimated the number of maximum number wells likely to be drilled in these basins (Sichuan, Yangtze, Jianghan, Subei and Tarim) using prospective areas for shale gas basins based on EIA estimates and our well spacing assumptions. Since the basins contain multiple overlapping shale formations, we use a lower, adjusted number for prospective basin acreage.
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Figure 74: Shale acreage assumptions by basin, after adjusting for overlaps among various layers
Region Shale formation Qiongzhusi Sichuan Longmaxi Permian L. Cambrian Tarim L. Ordovician M.-U. Ordovician L. Cambrian Subei U. Ordovician L. Silurian U. Permian L. Cambrian Yangtze L. Silurian L. Cambrian Jianghan L. Silurian Permian Total
Size - EIA estimate (sq miles) 6,500 10,700 20,900 6,520 19,420 21,380 2,040 14,990 1,640 3,250 5,035 1,280 1,900 3,830 119,385
Size - our assumption (sq miles) Comments We take 75% of the total size implied by EIA 28,575 numbers to reflect the significant overlap of the shale formations. The span of the Ordovician formation (including upper, middle and lower layers) largely encompasses the Lower Cambrian formation.
40,800
We take 75% of the total size implied by EIA 25,474 numbers to reflect the significant overlap of the shale formations.
94,849
Well production profile

We use the US Barnett shale play as the base for our China wellproduction profile; recent data suggests initial production rates could be better In its latest assessment, the EIA estimates that the shale-rich basins in the Sichuan, Jianghan, Subei and Yangtze platforms are roughly comparable to North American counterparts such as Barnett and Marcellus. For our analysis, we assume a Barnett shale analogue for shale gas wells in China, in line with Wood Mackenzie estimates. Output for a typical shale gas well drops off sharply after the initial peak, and c.50% of total recoverable gas is produced within the first five years of well life. Our well profile assumes initial production of 0.07mmcm/d in the first month and output of 0.04mmcm/d (13.5mmcm) in the first year. We base these numbers on Wood Mackenzie estimates in the absence of sufficient well data for China. However, we note that a recently fractured well in the Changning block in Sichuan has been tested at a higher initial production rate of c.0.15mmcm/d, double the volume we assume. Figure 75: We base our production profile assumption for China shale gas wells on the US Barnett shale experience
16 14 Annual production (mmcm) 12 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Year 16 17 18 19 20 21 22 23 24 25 26 27 0% 40% 20% 80% 60% Annual production (mmcm) Assumed well production profile Cumulative production (RHS) 100%
Source: Wood Mackenzie, Standard Chartered Research estimates
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Wells drilled
While official data is not available, we estimate that c.40 shale gas wells were drilled in China in 2012. We have assumed 48 exploration and appraisal wells will be drilled in 2013 in the Sichuan and adjoining basins, an increase of c.20% YoY. We forecast well drilling to accelerate markedly in 2014, with a total of 138 wells drilled, including 45 production wells. Our output estimates factor in a total of c.9,100 wells in China by 2020E, compared to c.45,000 already drilled in the US We expect rapid growth in total well numbers over 2015-20, with the number of wells drilled across basins rising to c.2,900 in 2020E. This would imply a total of c.9,100 wells drilled between 2013 and end-2020, compared to c.45,000 shale gas wells already drilled in the US, as per Wood Mackenzie data. Our assumption of rapid growth in well drilling during initial years is in line with the experience of major US shale plays such as Marcellus, Haynesville and Fayetteville. For example, wells drilled each year in Marcellus and Fayetteville increased by a factor of 2.5x p.a. during the first five years of their development. The number of wells drilled in Marcellus jumped 34x to over 430 in 2009, from just 13 in 2005. In Fayetteville, the number of wells grew over 50-fold from 13 in 2004 to 680 in 2008. Figure 76: We have assumed rapid growth in shale gas wells in China through 2020, wells drilled p.a.
4,000 Shale gas wells drilled in China
3,000 2,170 2,000 1,126 1,000 48 0 2013E 2014E 2015E 2016E 2017E 2018E 2019E 138 398 821 1,564
2,868
2020E
Figure 77: Our assumed drilling rate during initial years for Figure 78: ...Is in line with the trend at key US shale plays Chinas shale gas basins
64 Rate of rise in wells drilled (x) Sichuan Tarim Subei, Jianghan & Yangtze Rate of rise in wells drilled (x) 64 Marcellus Haynesville Fayetteville
16
16
1 1 2 3 Year 4 5
1 1 2 3 Year 4 5
Note: We use 2013 as the base year for Sichuan, Subei, Jianghan and Yangtze, and 2014 for Tarim. Source: Standard Chartered Research estimates
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We do not foresee any potential constraints in terms of rig requirements based on our current well drilling projections. As of 2011, China had 2,350 land rigs according to the latest data from the China Petroleum & Petrochemical Equipment Industry Yearbook. We project 2,868 wells (including exploration wells) to be drilled in 2020. Drilling rig availability is not a constraint to our assumptions Assuming that a well will be drilled in two months, we estimate c.480 shale gas rigs will be needed in 2020. This represents just 20% of the current fleet of land rigs in China. Our checks suggest these rigs can be easily modified for shale well drilling. Figure 79: We do not expect rig availability to be an issue
Number of wells drilled in China in 2020E Estimated time to drill one well (months) Implied number of rigs needed Number of land-rigs in 2011 Rig requirement in 2020 vs. latest rig availability
Source: China Petroleum & Petrochemical Equipment Industry Yearbook 2012, Standard Chartered Research estimates
2,868 2 478 2,350 20%
We assume higher well spacing in China than the US, given higher population density and more difficult terrain
Well spacing Our supply projections implicitly assume that at the peak shale gas acreage in Sichuan will average 2.4 wells per sq mile. Our peak well spacing assumption for the Jianghan, Subei and Yangtze basins is just one well per sq mile, and we assume less than one well per sq mile at peak for Tarim. According to EIA data, shale plays in the US have about eight wells per sq mile on average, and our lower spacing assumption at peak for China reflects the higher population density and more difficult terrain. Sichuan and the other shale basins in South China are some of the most densely populated regions in China, and securing sites for shale well drilling will be difficult in these areas. The Tarim basin is a vast desert, and intensive shale gas activity will be impeded by the lack of adequate infrastructure. Figure 80: We assume a peak well spacing for China acreage much lower than in the US
Sichuan
Well spacing (wells/sq. mile)
Tarim
Subei, Jianghan & Yangtze
Typical US shale play

8
6 8
4 2.4 0.9 0.4
2013E
2018E
2023E
2028E
2033E
2038E
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Figure 81: Chinas population density and key shale gas basins
Junggar
Songliao
Tarim
Subei Sichuan Jianghan
Population density
Low High
South China/ Yangtze Platform
Gas reserves
We assume c.20% of recoverable resources will be produced commercially, in line with the US experience Our production estimates through 2050 imply commercial reserves in Sichuan and adjoining basins of 3.9tn cm and 1.4tn cm, respectively, or just 22% of the total technically recoverable resource base in these basins in the EIAs June 2013 assessment. We estimate the proportion of commercial reserves in the total resource base is in line with the experience for US shale plays, where just over 20% of technically recoverable resources are classified as commercial on average. For Tarim, we estimate just 15% of the technical resources will be produced through 2050, recognising the specific infrastructure challenges. Figure 82: Technical resources and commercial reserve estimates for shale gas
Technical recoverable resource (as per EIA) 17.7 5.7 6.3 29.7 Commercial reserve estimate (based on output through 2040) 3.9 0.8 1.4 6.1 Commercial as % of technical resources 22% 15% 22% 21%
(tn cm) Sichuan Tarim Jianghan, Subei and Yangtze platform Total
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Potential constraints
We assume a high drilling cost initially, but expect costs to decline as operators gain experience and the supply chain improves Capital expenditure Based on our well drilling estimates, we expect shale gas development to require capex of c.USD 2bn in 2014, rising to USD 11bn in 2018 and USD 21bn in 2020. We have assumed a well drilling cost per well of USD 15mn in 2013-14, but expect this to decline to USD 7mn per well in 2018. For comparison, an average well in the US costs c.USD 6mn to drill. Our initial drilling cost assumption is based on estimates by Wood Mackenzie, and includes costs for surface gas production facilities. We expect the bulk of the early development through 2020 to be undertaken by Chinese majors PetroChina and Sinopec in partnership with IOCs such as Shell, ConocoPhillips and Eni. Assuming a 51:49 JV structure in favour of Chinese NOCs, we estimate PetroChina and Sinopec will have to spend USD 1.1bn each in 2015, equivalent to 4% and 9%, respectively, of their 2012 domestic E&P capex. We estimate capex requirements for PetroChina/Sinopec will increase to USD 4.3bn/US D 3.6bn in 2020, or 14%/30% of their 2012 domestic E&P spending. This compares to 31% and 36% YoY increases in their domestic E&P capex in 2012. Figure 83: We assume a well cost of USD 15mn in 2013-14, but expect declines through 2018
20 15 15 13 11 10 9 7 5 7 7 Drilling cost per well
Our 2020 shale gas capex estimates for PetroChina/Sinopec represent 14%/30% of their 2012 domestic E&P spend
15 USD mn
0 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E
Figure 84: We estimate PetroChina and Sinopecs combined capex requirements will rise to USD 8bn in 2020
Capex (USD bn) PetroChina and partners PetroChina Partners Sinopec and partners Sinopec Partners Others Total capex
2013E 0.3 0.2 0.2 0.3 0.2 0.1 0.1 0.7
2014E 1.1 0.5 0.5 0.7 0.4 0.4 0.3 2.1
2015E 2.2 1.1 1.1 2.2 1.1 1.1 0.7 5.2
2016E 4.3 2.2 2.1 3.2 1.6 1.6 1.6 9.0
2017E 4.3 2.2 2.1 3.3 1.7 1.6 2.5 10.1
2018E 4.5 2.3 2.2 3.4 1.7 1.7 3.1 10.9
2019E 6.4 3.3 3.1 5.1 2.6 2.5 4.0 15.5
2020E 8.5 4.3 4.2 7.0 3.6 3.4 5.4 20.9
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Using UN data, we estimate shale gas would require less than 1% of internal renewable water resources
Water availability In the US, a typical shale gas well needs c.4mn gallons of water. However, up to 6mn gallons of water are needed for deep wells in good shale formations. In China, we have assumed c.6mn gallons of water per shale gas well in 2014, declining to 4mn by 2020. We also assume 25% of the water needed is re-used, bringing the net water requirement to 4.3mn gallons in 2014 and 3mn gallons in 2020. Figure 85: We assume c.4mn gallons of water (net of recycling) per shale well in 2014, falling to 3mn gallons in 2020
5 4.3 4 mn gallons 3 2 1 4.1 Net water usage per well 3.9 3.6
3.4
3.2
3.0
0
2014E 2015E 2016E 2017E 2018E 2019E 2020E
Some have voiced concerns on the availability of water for shale gas exploration and development in China. However, our estimates, which use data from the United Nations AQUASTAT database, suggest water requirements for shale gas will be a miniscule share of internal renewable water resources in the shale basins, and water is therefore unlikely to be a constraint. For example, we forecast that 2,695 wells will be drilled in the Sichuan and surrounding basins in 2020. The region has higher than (national) average rainfall, and contains the Yangtze River system, which constitutes c.35% of Chinas internal renewable water resources. We estimate water requirements for shale gas in 2020 would be just 0.003% of the water resources in the region. Figure 86: Water availability for Sichuan, Subei, Jianghan and Yangtze platform shale gas
Total number of wells drilled in 2020E Water needed per well (mn gallons) Implied water requirement in 2020E (mn gallons) Internal renewable water resources (tn gallons) Water needed for shale as % of internal renewable resources
Source: UN AQUASTAT, Standard Chartered Research estimates
2,695 3 8,086 254 0.003%
In Tarim, we estimate water required for shale gas drilling in 2020 would form just 0.002% of renewable water resources. Our well drilling assumptions for Tarim are much lower than for Sichuan, and factor in difficulties related to the remote and dry terrain. Despite these challenges, the region does contain rivers such as the Aksu and Ili, which could provide the water needed for shale gas development.
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Figure 87: Water availability for Tarim shale gas

Total number of wells drilled in 2020E Water needed per well (mn gallons) Implied water requirement in 2020E (mn gallons) Internal renewable water resources (tn gallons) Water needed for shale as % of internal renewable resources
Source: UN AQUASTAT, Standard Chartered Research estimates
172 3 517 34 0.002%
Bull case of 100bn cm in 2020E: What is needed?

China has set a target of 6.5bn cm of shale gas output in 2015, and an upper-end goal of 100bn cm in 2020. To assess the feasibility of these targets, we have calculated the implied drilling rates and capex requirements using our supply model. To achieve higher output (as in the bull case), companies would need to commit 37-94% more capex through 2020E vs. our base case Apart from assuming a more aggressive drilling programme over the next few years, we have included production from shale resources in Ordos starting from 2016. The MLR has ascribed technical recoverable reserves of 2.7tn cm to the Ordos basin. However, it contains Lacustrine shales, which are more technically challenging than the marine shales that have yielded successful plays in the US. Our base case, presented above, includes only marine shales in Sichuan and adjoining basins and Tarim. Our bull case also assumes that 21-30% of technical gas resources across basins will be commercially extracted through 2050, compared to 15-22% in our base case. Figure 88: Bull case: Shale gas output estimates for China, and comparison with the US
Shale gas production China (bn cm) Sichuan Tarim Ordos Subei, Jianghan and Yangtze Total Preceding 5-year CAGR (China) US (bn cm) Preceding 5-year CAGR (US) 21 138 45% 251 13% 6 0 6 81 5 1 13 100 74% 313 5% 158 18 8 54 237 19% 364 3% 195 43 22 73 334 7% 401 2% 221 59 42 84 406 4% 434 2% 241 68 51 93 453 2% 473 2% 2005 2010 2015E 2020E 2025E 2030E 2035E 2040E
Higher drilling rates and capex We estimate China would need to drill 37-94% more wells p.a. than in our base case to achieve output of 100bn cm in 2020. In addition, our 2013 bull case well estimate of 66 represents a 60% increase from 2012. Figure 89: China would need to drill 37-79% more wells through 2020 to achieve 100bn cm of output by 2020
Total shale gas wells drilled Bull case Base case Bull vs. base
2013E 66 48 37%
2014E 256 138 85%
2015E 771 398 94%
2016E 1,343 821 63%
2017E 1,962 1,126 74%
2018E 2,622 1,564 68%
2019E 3,624 2,170 67%
2020E 4,301 2,868 50%
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Assuming a well cost profile similar to the base case, capex would also have to be 37-94% higher p.a. to achieve an output of 100bn cm. Based on a JV structure for shale gas development, we estimate PetroChina/Sinopec would need to increase spending to USD 7bn/USD 5bn in 2020, 23% and 42% above their 2012 domestic E&P capex, respectively. Figure 90: Higher drilling rates would also entail a proportional increase in spending requirements
Capex (USD bn) PetroChina and partners PetroChina Partners Sinopec and partners Sinopec Partners Others Total capex (bull case) Total capex (base case) Bull vs. base case
2013E 0.3 0.2 0.2 0.3 0.2 0.2 0.3 1.0 0.7 37%
2014E 1.4 0.7 0.7 1.4 0.7 0.7 1.0 3.8 2.1 85%
2015E 4.1 2.1 2.0 3.4 1.7 1.7 2.5 10.0 5.2 94%
2016E 6.9 3.5 3.4 4.2 2.1 2.1 3.7 14.8 9.0 63%
2017E 8.6 4.4 4.2 4.8 2.5 2.4 4.3 17.7 10.1 74%
2018E 8.6 4.4 4.2 5.2 2.7 2.6 4.6 18.4 10.9 68%
2019E 11.7 6.0 5.8 7.7 3.9 3.8 6.4 25.9 15.5 67%
2020E 13.6 6.9 6.7 9.9 5.1 4.9 7.8 31.3 20.9 50%
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China shale supply-demand impact

We expect shale gas to make a meaningful contribution to Chinas gas landscape after 2018. We forecast a 2015-30 shale gas production CAGR of c.30%, reducing Chinas dependence on imported gas to c.25% We see unconventional gases as the main incremental volume driver after conventional sources peak in 2016-17E, while demand should remain robust given Chinas environmental drive. China is likely to see meaningful contribution from shale gas after 2018 We expect the success of Chinas shale story a meaningful contribution after 2018 to drastically change Chinas natural gas landscape, just as shale gas did to the US market. Based on our gas supply model, we estimate shale gas production will account for 15% of Chinas total gas supply in 2020 and 30% in 2030. This would reduce Chinas reliance on imports through LNG importing terminals and cross-border pipelines. Imports currently meet c.25% of Chinas natural gas demand, and we think the ratio will peak at c.40% in 2017-18 before gradually declining to c.25% in 2030, due to the rapid rise in shale gas production. Reduced purchases from China would have a negative impact on major LNG suppliers in Southeast Asia, Australia and the Middle East, whose delivery contracts with Chinese buyers mostly lapse around 2030. (Chinas large LNG importers, including PetroChina, would also see their facility utilisation rate decline as trade volumes fall.) Figure 91: We expect Chinas reliance on gas imports to decline when shale gas takes off in 2017-30E We forecast a 2015-30 shale gas production CAGR of c.30%, reducing Chinas reliance on gas imports
0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 shale gas contribution to total gas supply dependency on import
We think shale gas will almost halve Chinas gas import dependency
0.00 2008
2010
2012
2014E
2016E
2018E
2020E
2022E
2024E
2026E
2028E
2030E
Positive implications for downstream consumers
The key implication for the downstream market is lower prices due to the increased supply of gas. Key beneficiaries over the long term in the oil and gas space would include refining/petrochemical operators that can make an effective shift to gasbased facilities. We prefer Sinopec under this theme due to its large exposure to the downstream refining business and early preparations for the potential change as seen from its recent plan to build Chinas first gas-based ethylene plant. Other regional players without easy access to cheap gas could lose competiveness as a result.
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Sinopec preparing for a shift to gas-based petrochemicals
In June 2013, Sinopec asked Chinas environmental authorities to review its plan to build Chinas first gas-based ethylene plant (worth USD 3bn, with an annual capacity of 1mn tonnes) in Qingdao, Shandong province. We view the move as part of the companys long-term strategy to take advantage of the potential shale gas boom in China. Sinopec will also benefit from the expertise and technology gained from operating the plant, in our view. Modelling Chinas gas supply Chinas natural gas supply consists of domestic production (c.75%, onshore and offshore conventional gas, tight gas, CBM) and imports (LNG and cross-border pipelines).
We expect unconventional gases to drive Chinas incremental gas supply after 2016-17, when conventional sources peak
We expect Chinas conventional gas production to peak in 2016-17, followed by a decline of about 5% p.a. as fields age through 2030 (the end of our forecast period). We think the deficit will be offset by faster growth in unconventional sources, particularly shale gas (c.30% production CAGR in 2015-30). Other forms of unconventional gas in our assumption include tight gas (2015-30 production CAGR of 6%), CBM (9% CAGR over the same period) and coal-to-gas (15% CAGR). Our import forecast is based on the current terms of 19 long-term LNG agreements with suppliers in countries including Australia, Qatar, Yemen, Malaysia and Indonesia. Pipeline sources include Turkmenistan, Kazakhstan, Myanmar and Russia. Most of these contracts are valid for a period of 20-30 years, with expirations concentrated around 2030 (pipeline accords lapse about five years later). Import volumes under the agreements are broadly stable YoY, meaning a gradually reduced share of expanded total supply (from a peak of c.40% in 2017-18E to c.25% in 2030E).
Import contribution will decline as domestic production rises
Figure 92: Most of Chinas current term gas import contracts lapse between 2030-36
Pipeline LNG - Others LNG - Indonesia
LNG - Malaysia
LNG - Yemen LNG - Qatar
LNG Papua N. Guinea

LNG - Australia 2006 2011 2016 2021 2026 2031 2036 2041
Source: Bloomberg, Standard Chartered Research
On the demand side, we expect consumption of natural gas to grow faster than other forms of energy. We forecast c.10-15% growth p.a. in natural gas demand between now and 2020 and 3-5% p.a. for the following decade. The use of dirtier energy sources like oil and coal will grow more slowly, in our view.
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The robust demand growth in natural gas will be primarily driven by: (1) the governments drive to improve environmental conditions by replacing oil/coal with cleaner-burning gas; and (2) faster growth in supply, which will help unlock pent-up demand. Figure 93: Chinas long-term gas supply versus demand
700 600 bn cubic metres 500 400 300 200 100 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E 2028E 2029E 2030E
Conventional gas
Shale gas
Tight gas
CBM
CTG
LNG Import
Pipeline imports
Consumption
Incremental consumption from stronger government pushes and potential gasbased petrochemical plants
Figure 94: China aims to increase the use of natural gas and renewable energy to reduce reliance on oil and coal
Coal 100% Oil 7% 3% 20% Gas 7% 3% 19% Non-fossil fuel 7% 3% 19% 8% 4% 18% 8% 4% 18% 9% 4% 19% 8% 5% 19% 11% 8% 17% 14% 10% 16%
90%
80% 70% 60% 50% 40% 30% 20% 10% 0%
6% 2%
22%
8% 2% 22%
7% 2% 22%
7% 3% 21%
7% 3% 21%
69%
68%
68%
70%
70%
71%
71%
71%
70%
70%
68%
68%
63%
60%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2015E
2020E
Source: CEIC, National Development and Reform Commission, China National Petroleum Corporation, Standard Chartered Research estimates
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Analysing impact on gas producers

PetroChina and Sinopec hold c.75% of the prospective shale blocks in China, as per official data. We further use Wood Mackenzie data to estimate resource potential for the companies for each basin. We estimate PetroChina will produce 42% of Chinas shale gas through 2050 and Sinopec 34%, based on their potential resource bases. We believe shale gas development is viable we expect gas prices in China to rise to USD 8.5/mcf by 2015, compared to the break-even price of USD 7/mcf. Apart from the two majors and IOCs, players in Chinese shale gas include both oil and non-oil local companies
Key players
The participants in the nascent shale gas industry in China largely fall into three categories the twin majors (PetroChina and Sinopec), major IOCs (Shell, ConocoPhillips, Chevron and ENI), and other Chinese companies. The final category includes both oil and non-oil industry players. Apart from PetroChina and Sinopec, the Chinese oil companies that could play an important role in developing shale gas are NOCs CNOOC and Shaanxi Yanchang Petroleum. Among non-oil companies, coal and power companies such as China Shenhua and China Huadian have also won bids for shale gas blocks in earlier auction rounds. We think these non-oil companies could overcome the experience hurdle by hiring either the oilfield service subsidiaries of NOCs like CNPC and Sinopec or privately-owned field service providers (like Anton and SPT).
MLR data indicates that Sinopec and PetroChina hold c.75% of Chinas shale gas blocks
Reserves and output

While both the US EIA and Chinas MLR estimate shale gas resources by region, no company-specific data is available. Even data regarding the acreage of individual companies in basins rich in shale gas is not in the public domain. However, Chinas official estimate does note that c.75% of prospective shale gas blocks are owned by PetroChina or Sinopec. We have assumed PetroChina and Sinopec hold 75% of the prospective acreage and reserves in the Sichuan and Yangtze Platform basins. In Tarim, we assume 80% of shale acreage and reserves will be developed by the two majors, given the infrastructure challenges, while we assume they will develop 70% of net acreage in Ordos, factoring in the significant presence of Shaanxi Yanchang Petroleum.
In Sichuan, PetroChina holds twice Sinopecs conventional gas resources we use the same proportion for shale gas
Further, we apportion our shale reserve estimates for individual basins between PetroChina and Sinopec in a ratio similar to their conventional gas reserves, using data from Wood Mackenzie. For example, in Sichuan, PetroChina has roughly twice Sinopecs conventional gas reserves, according to Wood Mackenzie estimates. In our Sichuan shale gas analysis, we divide the 75% reserves assumption for the companies using this ratio. Figure 95: Estimated breakdown of commercial shale gas reserves, by basin
Sichuan PetroChina Sinopec Others 48% 27% 25% Tarim 76% 4% 20% Subei, Jianghan and Yangtze platform 2% 73% 25% Ordos 65% 5% 30%
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In our base case, we estimate over 95% of shale gas output in 2015 will be from Sinopec and PetroChina
Our production estimates use the companys 2015 targets for reference. We expect PetroChina to meet its 2015 shale gas output target of 1.5bn cm. While Sinopec targets production of 1bn cm by 2015, we estimate actual output could reach c.1.2bn cm, based on our estimate of its acreage and current progress on shale gas development. In our base case (61bn cm total production in 2020), we estimate PetroChina and potential IOC partners will produce 54%/41% of total shale gas output in 2015/2020. We estimate Sinopec (and potential partners) will produce 43%/34% of total shale gas output in 2015/2020.
However, smaller players would need to contribute significant volumes to achieve our bull-case 2015E output of over 6bn cm
In our bull-case scenario (over 6bn cm in 2015, and 100bn cm in 2020), we have assumed c.70% higher output volumes from PetroChina and Sinopec in 2015. Other players would also need to contribute significant production volumes by 2015 to achieve the bull case. We assume output from other players would form 26% of Chinas total shale production in 2015 (in line with their acreage share), while PetroChina/Sinopec would contribute 42%/32% of total output.
Figure 96: Base case shale gas output estimates

Shale gas output (bn cm) PetroChina (and partners) Sinopec (and partners) Others Total 2015E 1.5 1.2 0.1 2.8 2020E 24.9 20.5 15.7 61.1 2025E 61.2 58.0 39.3 158.6 2030E 86.9 76.2 52.9 215.9 2035E 110.1 88.2 63.4 261.8 2040E 129.2 97.4 71.9 298.5
Figure 97: Bull case shale gas output estimates

Shale gas output (bn cm) PetroChina (and partners) Sinopec (and partners) Others Total 2015E 2.6 2.0 1.6 6.2 2020E 44.1 31.3 24.9 100.3 2025E 95.6 82.9 58.9 237.4 2030E 143.0 108.4 82.4 333.7 2035E 179.6 125.4 100.5 405.5 2040E 202.5 138.0 112.4 453.0
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Other key assumptions

To understand the financial and valuation impact of shale gas development on Chinese upstream players, we have performed detailed cash-flow analyses using the assumptions below. Other key inputs such as production, well drilling rates and costs have already been discussed. Fiscal regime Chinas first shale gas PSC between Shell and CNPC was approved in March 2013. The full terms have not been disclosed. However, we think shale gas PSCs are likely to resemble existing agreements for conventional production, with changes to the cost recovery ceilings and profit splits. For our DCF analysis, we have assumed the fiscal terms shown in Figure 98 using other PSC contracts for reference. We have assumed capital and operating costs are shared according to equity shares. It is currently unclear whether shale gas development will be exempt from the 5% resource tax on oil and gas extraction applied to conventional fields. For our analysis, we have assumed a resource tax levy. In addition, shale gas produced through 2015 will receive a government subsidy of USD 1.80/mcf (RMB 0.4/cm). However, we expect shale gas volumes produced by end-2015 to be relatively small, and the total subsidy will therefore be insignificant for long-term projects. We have not assumed any government subsidy for our analysis. Figure 98: Fiscal regime assumptions in DCF analysis of shale gas development
Fiscal regime type Government subsidy Resource tax Cost recovery ceiling Government share of profit Corporate tax
Our financial analysis uses a PSC regime with terms resembling those for conventional production
Production sharing contract Nil 5% 70% of revenue 15% 25%
Based on the July 2013 gas price reform, we expect upstream gas prices to rise 15% p.a. over 201415, to USD 8.5/mcf in 2015
Gas price In July 2013, China announced gas price reforms that included decontrol of well-head gas price prices and an announcement that the NDRC expects gas prices in China to move towards international parity by 2015. Based on the policy outline, we expect prices for gas producers (including shale gas) to rise 15% p.a. in 2014-15 to USD 8.5/mcf in 2015. Thereafter, we assume gas prices will rise 2% each year. We estimate higher gas prices will make shale gas development economical and spur increased activity. Based on our well drilling rate and cost assumptions, we estimate a break-even gas price for shale gas development of USD 7/mcf. We note that upstream gas prices before the July 2013 reforms were below USD 6/mcf, rendering large-scale shale development unviable.
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We estimate break-even price at USD 7/mcf for shale gas in China higher producer prices should make development viable
Our break-even gas price estimate for China is above that for US shale plays such as Barnett and Marcellus. There are two main reasons for this. Firstly, we have assumed much higher well drilling costs in initial years. The US drilling cost is c.USD 6mn per well, we have assumed costs of USD 9-15mn per well in China over 201417, taking into account costs for associated infrastructure development. Secondly, the Chinese shale basins will require intensive exploration and appraisal activity over the next few years to identify the best prospects. This will increase costs (and the break-even gas price), while US shale plays are already at an advanced stage of development.
Figure 99: We forecast upstream gas prices to rise 15% p.a. in 2014-15 following price decontrol in July 2013...
10 8.5 8 6.4 USD/mcf 6 4 2 0 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E
Figure 100: ...This should enable producers to earn more than the break-even price and promote shale development
8 7.0 Break-even gas price
Upstream gas price 8.7 8.8 9.0
9.2
9.4
7.4
6 4.6 USD/mcf 4 3.6 3.8
4.9
China
Fayetteville
Marcellus
Barnett
Haynesville
Source: Wood Mackenzie, Standard Chartered Research estimates
Operating costs In addition to well drilling costs, we factor in operating costs of USD 1/mcf in 2014 in our DCF analysis, in line with Wood Mackenzie estimates. We assume operating costs rise 2% p.a. thereafter.
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PetroChina (Outperform, PT HKD 11.00)

PetroChina is currently drilling 15 wells in the Changning block in Sichuan to assess the feasibility of full-scale development, which would involve drilling c.400 wells in the block over the next three years We estimate PetroChinas shale gas output from Sichaun and other basins by 2020 could present 15-26% upside to 2015E gas sales. We estimate shale gas development presents potential upside of 4-6% to our valuation for PetroChina. PetroChina targets to produce 1.5bn cm of shale gas in 2015E (versus 4bn cm of CBM and 28bn cm of tight gas). The company drilled Chinas first shale gas well, Wei-201, in Weixian county in Sichuan province in 2010. The company also leads Chinas shale gas R&D efforts and worked with the government to set up the national shale gas experimental and research centre. Gas flow from its most promising well, Ning201-H1, has remained stable at an impressive c.0.15mmcm/d (versus our estimated 0.07mmcm/d average for China). Reassured by the commerciality of the well, it is constructing a 98.8-km pipeline to connect it with the regional distribution network. In our base case, we expect shale gas to contribute 0.9% of PetroChinas 2015 natural gas sales volume, and think the business is likely to turn profitable around 2018 as production ramps up. NPV from PetroChinas shale gas operations (with an estimated project IRR at c.16%) would likely bring c.4% value accretion to our current valuation of HKD 11.00/share. Figure 101: PetroChina drilled Chinas first shale gas well, Wei -201, in Sichuan in 2010
Source: Weixian country government, Sichuan Province, Standard Chartered Research
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PetroChina began assessing shale gas potential in 2009, and drilled its first well in 2010
Major development achieved

PetroChina began assessing Chinas shale gas potential and preliminary exploration in 2009. The key blocks in its current drilling plans are Weiyuan (), Changning (), Zhaotong () and Fushun-Yongchuan (-). In 2009, PetroChina drafted plans to set up two pilot development zones Changning-Weiyuan and Zhaotong in the Sichuan basin, among Chinas most promising shale gas blocks. It signed a joint study agreement with Shell for the Fushun-Yongchuan block in November 2009, followed by a PSC in March 2012. Other foreign partners in shale gas partnerships with PetroChina include ConocoPhillips, Eni and Newfield Exploration. In 2010, PetroChinas parent company CNPC worked with the National Energy Administration to set up the National Energy Shale Gas R&D (Experiment) Centre, Chinas primary shale gas technology research centre. In 2012, the centre developed breakthroughs in fracking techniques used in vertical and horizontal wells and successfully applied the technology to help reduce costs at the two pilot projects, according to a news report by the official Xinhua News Agency. In July 2013, PetroChina received government approval to establish the Shale Gas Technology Standardization Committee to facilitate technological advancement along the full value chain.
It is studying the feasibility of fullscale development of the Changning block in Sichuan
As of end-March 2013, PetroChina had drilled 16 shale gas wells in the ChangningWeiyuan region and tested gas flow from 12 wells after fracking. Daily output at the vertical wells is 2,000-22,000 cm and daily production at horizontal wells varies from 10,000-160,000 cm. It is drilling 15 horizontal wells in the Changning block to assess the feasibility of full-scale development. Development of the block would involve 400 shale wells over the next three years with a capex of c.RMB 30bn, according to media reports. Convinced by the shale potential, PetroChina is building Chinas first shale gas pipeline. The pipeline will connect its Ning201-H1 well in the Changning block in Sichuan with the regional Naxi (Sichuan)-Anbian (Yunnan) ( ) network. The 98.8-km pipeline will have a daily transportation capacity of 4.5mn cm. At the Zhaotong block, PetroChina has drilled seven wells and has finished fracking two of them, testing 2,500 cm of gas flow per day from vertical wells and 15,00036,000 cm from horizontal wells. Figure 102: PetroChinas 2015E unconventional gas production targets
30 25 bn cubic metres 20 15 28
10
5 0 CBM shale gas tight gas 4 1.5
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Potential upside from shale gas development

For our analysis of potential output and cash flow from shale gas, we have assumed development will take place in partnership with an IOC under a PSC structure. We have further assumed a 51% PetroChina stake in shale gas projects. This is probably conservative, since the company could choose to develop its acreage by itself after it has gained sufficient technical expertise from its foreign partners. Production and reserves In our base case, we assume shale gas production in China will pick up pace from 2015, and reach 61bn cm in 2020. We also present a bull case in which China achieves 6bn cm of output in 2015E, and 100bn cm in 2020E. Given that PetroChina currently holds the most prospective acreage in the key basins of Sichuan, Tarim and Ordos, we expect the company (and its potential partners) to contribute 41% of total shale gas output in 2020E in our base case and 44% in our bull case. In our base case, we estimate PetroChinas shale gas output (net to company, assuming a 51% stake) could reach 0.8bn cm in 2015. This would imply an upside of 0.9% to our 2015 gas sales estimate (based on output from conventional sources), and 0.3% upside to our 2015 total oil and gas sales estimate. However, we believe PetroChinas shale gas volume could potentially grow significantly and reach 13bn cm in 2020, or 15% of our 2015 gas sales estimate (our latest explicit forecast for the company). 2020E shale gas output could present 15-26% potential sales upside from 2015E for PetroChina In our bull case, we estimate PetroChinas shale gas production could reach 1.3bn cm in 2015, and 22.5bn cm in 2020. This implies upside of 1.5% to our 2015 gas sales estimate. In this scenario, 2020 shale output would be equivalent to 26% of 2015E gas sales. Figure 104: If China produces 100bn cm of shale gas in 2020, we estimate output net to PetroChina would be 26% of its 2015E gas sales
Bull case
Upside to 2015E oil and gas sales 15% 30% Upside to 2015E gas sales Upside to 2015E oil and gas sales 26%
Figure 103: If China produces 61bn cm of shale gas in 2020, we estimate output net to PetroChina would be 15% of its 2015E gas sales
Base case
20% Upside to 2015E gas sales
Upside from shale gas
15%
20%
10% 5% 0.9% 0% 2015E 2020E 0.3%
10% 1.5% 0% 2015E 2020E
9%
5%
0.5%
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We estimate shale gas output through 2050 could add 68% to PetroChinas 2012 gas reserves
In addition to increased output, shale development would also boost PetroChinas gas reserves. As of 2012, it reported proved gas reserves of 1.9tn cm (67.6tcf), half of its total oil and gas proved reserves. In the base case we estimate shale output through 2050 would add another 1.3tn cm (68%) to gas reserves over time. In the bull case, we also assume development of shale gas in Ordos and higher commercial recovery rates, and thus more potential reserves added over time (2.0tn cm).
Earnings upside potential

In terms of earnings contribution, we estimate shale gas development will not be profitable until 2018, as contribution from gas production will not be sufficient to offset depreciation of assets already in place. As such, we estimate losses from shale gas operations could lower PetroChinas 2015 net profit c.1%. However, we expect profit to show robust growth from 2018 with a sustained rise in gas production. We estimate shale gas earnings could form c.3% of PetroChinas 2015E net profit by 2020 in our base case. If shale output is higher, as in the bull case, we estimate profit from shale gas operations could represent c.6% of PetroChinas 2015E profit (our latest explicit forecast for the company). Figure 105: Shale gas earnings could form 3-6% of 2015E profit by 2020
Base case RMB mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas 2015E 1,446 (72) (177) (2,094) (54) (952) 0 (952) 2020E 26,047 (1,302) (3,188) (13,599) (977) 6,981 (1,745) 5,236 Bull case 2015E 2,456 (123) (301) (3,436) (92) (1,495) 0 (1,495) 2020E 46,185 (2,309) (5,653) (23,696) (1,732) 12,795 (3,199) 9,596
2015E net profit Shale gas earnings as % of 2015E profit

153,071
-1%
3%
-1%
6%
Spending requirements
We estimate spending by PetroChina and its partners would need to rise to USD 2.2bn by 2015 to achieve gas output of 1.5bn cm. Assuming it has a 51% share in projects, PetroChina would therefore need to spend USD 1.1bn. This represents c.3%/2% of our current E&P/total capex estimates. Based on our base case well drilling assumptions, we estimate PetroChinas net shale gas spending requirement would rise to USD 4.3bn in 2020. We estimate PetroChina will need to spend USD 1.1-2.1bn on shale gas in 2015, 2-4% above our current capex estimate In the bull case, we assume shale gas capex by PetroChina and its partners would rise to USD 4.1bn by 2015, implying net spending of USD 2.1bn by PetroChina. This is c.5%/4% above our current E&P/total capex estimates. PetroChina would need to increase shale gas spending to USD 6.9bn in 2020, based on our assumption for wells drilled in the bull case.
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Figure 106: We estimate 2015 shale gas capex of USD 1.1bn in our base case, 2% above our current capex estimate
8 Shale gas E&P capex (USD bn) 7 Base case Bull case 6.9
6 5
4 3 2 1 0 2013E 2014E 2015E 2016E 2017E 2018E 0.2 0.2 0.5 0.7 1.1 2.1 2.2 3.5 2.2 2.3 4.4 4.4 3.3
6.0
4.3
2019E
2020E
Value accretion
As discussed earlier, with the recent gas price reforms, we expect higher gas prices to make shale gas development economical. We estimate PetroChina can earn an IRR of c.16% from its shale gas operations through 2050, above the companys hurdle rate of 13%. We estimate the NPV of its shale gas assets would add 4%/6% to our valuation in our base/bull cases. We use an industry standard discount rate of 10% to compute NPV. Figure 107: Shale gas development could add 4-6% to our valuation of PetroChina
Base case Estimated IRR for shale gas development NPV (USD mn, at 10% discount rate) NPV (HKD mn, at 10% discount rate) Outstanding shares (mn) NPV (HKD/share) Upside to current valuation
Bull case 16% 15,107 117,836 183,021 0.64 6%
16% 9,425 73,515 183,021 0.40 4%
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Figure 108: Base case: PetroChinas share of profit and cash flows from shale gas development through 2030E, assuming 51% stake in projec ts
USD mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas Add: Depreciation Less: Capital expenditure Net cash flow 2013E 0 0 0 (33) 0 (33) 0 (33) 33 (163) (163) 2014E 57 (3) (8) (136) (2) (92) 0 (92) 136 (550) (506) 2015E 233 (12) (29) (338) (9) (153) 0 (153) 338 (1,145) (960) 2016E 671 (34) (82) (704) (25) (174) 0 (174) 704 (2,168) (1,638) 2017E 1,067 (53) (131) (1,005) (40) (162) 0 (162) 1,005 (2,212) (1,369) 2018E 1,715 (86) (210) (1,261) (64) 94 0 94 1,261 (2,285) (930) 2019E 2,796 (140) (342) (1,662) (105) 547 (7) 541 1,662 (3,264) (1,061) 2020E 4,201 (210) (514) (2,193) (158) 1,126 (281) 844 2,193 (4,320) (1,282) 2021E 6,002 (300) (735) (2,827) (225) 1,915 (479) 1,436 2,827 (5,361) (1,098) 2022E 7,542 (377) (923) (3,437) (347) 2,457 (614) 1,843 3,437 (5,876) (596) 2023E 8,926 (446) (1,093) (3,990) (510) 2,888 (722) 2,166 3,990 (6,204) (48) 2024E 10,196 (510) (1,248) (4,482) (593) 3,363 (841) 2,522 4,482 (6,451) 553 2025E 11,419 (571) (1,398) (4,932) (678) 3,840 (960) 2,880 4,932 (6,731) 1,081 2026E 12,627 (631) (1,546) (5,356) (764) 4,330 (1,083) 3,248 5,356 (7,050) 1,553 2027E 13,850 (693) (1,695) (5,768) (854) 4,840 (1,210) 3,630 5,768 (7,417) 1,981 2028E 15,115 (756) (1,850) (6,183) (949) 5,377 (1,344) 4,033 6,183 (7,842) 2,374 2029E 16,450 (823) (2,014) (6,614) (1,050) 5,951 (1,488) 4,463 6,614 (8,337) 2,739 2030E 17,887 (894) (2,189) (7,075) (1,159) 6,569 (1,642) 4,927 7,075 (8,918) 3,083
Note: Cash flow figures have been presented until 2030. However, our analysis included projections through 2050. Source: Standard Chartered Research estimates
Figure 109: Bull case: PetroChinas share of profit and cash flows from shale gas development through 2030E, assuming 51% stake in projects
USD mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas Add: Depreciation Less: Capital expenditure Net cash flow 2013E 0 0 0 (33) 0 (33) 0 (33) 33 (164) (164) 2014E 60 (3) (8) (174) (2) (128) 0 (128) 174 (738) (691) 2015E 396 (20) (48) (554) (15) (241) 0 (241) 554 (2,076) (1,763) 2016E 1,066 (53) (131) (1,147) (40) (304) 0 (304) 1,147 (3,517) (2,675) 2017E 1,974 (99) (242) (1,792) (74) (233) 0 (233) 1,792 (4,374) (2,815) 2018E 3,295 (165) (403) (2,307) (124) 296 0 296 2,307 (4,367) (1,764) 2019E 5,306 (265) (649) (3,043) (199) 1,149 (126) 1,022 3,043 (5,987) (1,922) 2020E 7,449 (372) (912) (3,822) (279) 2,064 (516) 1,548 3,822 (6,937) (1,567) 2021E 9,915 (496) (1,214) (4,702) (372) 3,132 (783) 2,349 4,702 (8,222) (1,172) 2022E 11,977 (599) (1,466) (5,504) (577) 3,830 (958) 2,873 5,504 (8,713) (336) 2023E 13,958 (698) (1,708) (6,257) (794) 4,501 (1,125) 3,375 6,257 (9,266) 366 2024E 15,887 (794) (1,945) (6,967) (927) 5,254 (1,313) 3,940 6,967 2025E 17,841 (892) (2,184) (7,663) (1,065) 6,037 (1,509) 4,528 7,663 2026E 19,874 (994) (2,433) (8,368) (1,212) 6,868 (1,717) 5,151 8,368 2027E 22,041 (1,102) (2,698) (9,108) (1,370) 7,763 (1,941) 5,822 9,108 2028E 24,399 (1,220) (2,986) (9,910) (1,542) 8,741 (2,185) 6,555 9,910 2029E 27,015 (1,351) (3,307) 2030E 29,442 (1,472) (3,604)
(10,800) (11,641) (1,734) 9,824 (2,456) 7,368 10,800 (1,909) 10,816 (2,704) 8,112 11,641
(9,810) (10,444) (11,190) (12,070) (13,115) 1,098 1,746 2,330 2,861 3,350
(14,361) (15,004) 3,807 4,749
Sinopec (Outperform, PT HKD 7.20)

Sinopecs recent commentary suggests progress in shale gas exploration has exceeded the companys expectations. We think it is likely to announce Chinas first large-scale commercial project by end-2013. We estimate shale gas output by 2020 could present 60-90% upside to our 2015 gas sales estimate. We estimate shale gas development presents upside potential of 7-11% to our valuation. Our recent discussions with management, drilling engineers and third-party oilfield service companies (Petro-king) suggest Sinopecs progress in shale gas exploration has significantly exceeded the companys expectations. In August, chairman Fu Chengyu noted that Sinopec expects to announce Chinas first large-scale commercial shale gas project before the end of 2013. Sinopec has drilling operations in more diversified geological locations than PetroChina, including Sichuan, Anhui, Hunan and Guizhou. The company started drilling its first high-yield shale gas well, Jiaoye-1HF, in Sichuan in February 2012 and finished it in September 2012. It applied 15-stage hydraulic fracking in November and tested stable daily production between 28 November and 11 December. The well is 3,654 meters deep with a horizontal section 1,008 meters long. As of 21 July 2013, Sinopec had produced 15mn cm of shale gas from the well, sold in the form of CNG to the nearby Chongqing market. Production has averaged c.66,000 cm/day. Figure 110: Fracking site of Sinopecs first shale gas well, Jiaoye-1HF
Sinopec is already selling small volumes of shale gas as CNG in Chongqing
In May 2013, Sinopecs Petroleum Engineering Technology Research Institute announced key breakthroughs in five areas, including completion tools and drilling fluids, after two years of research work. The company expects application of the technological improvements to reduce costs and expedite project commerciality.
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In 2011, Sinopec signed joint study agreements with ExxonMobil and Chevron to assess shale gas potential in Guizhou and Sichuan, respectively. Other foreign partners include Total (JSC for Anhui block), ConocoPhillips (JSC for Sichuan), Hess (JSC for Shengli) and BP (Guizhou and Jiangsu). Sinopec targets production of 1bn cm of shale gas in 2015. In May 2012, it announced plans to build facilities in the Fuling block in Sichuan with an annual capacity of 300-500mn cm by end-2012, expanding capacity to 1bn cm by end-2013.
Upside potential from shale gas development

As with PetroChina, we have assumed Sinopec will undertake shale gas development in partnership with an IOC under a PSC structure. We assume a 51% Sinopec stake in shale gas projects. Production and reserves Sinopec is the second-largest holder of prospective shale gas acreage in China (behind PetroChina), and we expect it and its potential partners to contribute 34% of total shale gas output in 2020 in our base case and 31% in our bull case. 202E shale gas output could present 60-90% potential upside to 2015E gas sales for Sinopec In the base case, we estimate Sinopecs shale gas output (net to company, assuming 51% stake) could reach 0.6bn cm in 2015. This would imply an upside of 3% to our 2015 gas sales estimate (based on output from conventional sources), and an upside of c.1% to our 2015 total oil and gas sales estimate. Shale gas volume for Sinopec could potentially grow to 10.5bn cm in 2020, which would represent c.60% of our 2015 gas sales estimate. In our bull case scenario, we estimate Sinopecs shale gas production could reach 1bn cm in 2015, and 16bn cm in 2020. This implies an upside of 6% to our 2015 gas sales estimate. In this scenario, 2020E shale output would represent an upside of c.90% to 2015E gas sales. Figure 111: If China produces 61bn cm of shale gas in 2020, we estimate output net to Sinopec would be c.60% of 2015E gas sales
Base case 80% Upside to 2015E gas sales Upside to 2015E oil and gas sales 58% 100%
Figure 112: If China produces 100bn cm of shale gas in 2020, we estimate output net to Sinopec would be c.90% of 2015E gas sales
Bull case Upside to 2015E gas sales Upside to 2015E oil and gas sales 89%
60%
75%
40% 15% 3% 0% 2015E 2020E 1%
50% 23% 6% 0% 2015E 2020E 1%
20%
25%
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We estimate shale gas output through 2050 could increase Sinopecs 2012 gas reserves by over 5x
In addition to increased output, shale development would also boost Sinopecs gas reserves. In 2012, the company reported proved gas reserves of 191bn cm (6.7tcf), which amounted to c.30% of its total oil and gas proved reserves. In our base case, we estimate shale output through 2050 would add another 1.1tn cm, increasing gas reserves by more than 5x over that period. In the bull case, we also assume development of shale gas in Ordos and higher commercial recovery rates, pushing potential reserves addition over time to 1.5tn cm.

In terms of earnings contribution, we believe shale gas development will not be profitable for Sinopec for the next four to five years, as the contribution from gas production will not offset depreciation of assets already in place. We estimate losses from shale gas operations could lower 2015E net profit c.1% in our base case. However, with a sustained rise in gas production, we estimate robust profit growth from 2019. In our base case, we think shale gas earnings could form c.6% of 2015E net profit in 2020. In the bull case, we think profit from shale gas operations could represent as much as 9% of 2015E net profit in 2020. Figure 113: Shale gas earnings could form 6-9% of 2015E profit in 2020E
Base case RMB mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas 2015E 1,144 (57) (140) (1,882) (43) (979) 0 (979) 2020E 21,494 (1,075) (2,631) (10,891) (806) 6,091 (878) 5,213 Bull case 2015E 1,905 (95) (233) (2,972) (71) (1,467) 0 (1,467) 2020E 32,831 (1,642) (4,019) (15,898) (1,231) 10,042 (2,511) 7,532

87,977
-1%
6%
-2%
9%
Spending requirements
We estimate Sinopec will need to spend USD 1.1-1.7bn on shale gas in 2015, 3-5% above our current capex estimate We estimate spending by Sinopec and its partners would need to rise to USD 2.2bn in 2015 to achieve gas output of 1.2bn cm. Assuming a 51% share in projects, Sinopec would need to spend USD 1.1bn. This represents c.8% of our current E&P capex estimate, and 3% of our total 2015 capex estimate. Based on our base case well drilling assumptions, we estimate Sinopecs net shale gas spending requirement would rise to USD 3.6bn by 2020. In the bull case, we assume shale gas capex by Sinopec and its partners rises to USD 3.4bn in 2015, implying net spending of USD 1.7bn by Sinopec. This is c.12% above our current E&P capex estimate, and 5% above our total capex estimate. We estimate Sinopec would need to further increase shale gas spending to USD 5.1bn in 2020, based on our bull case assumption for wells drilled.
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Figure 114: We estimate 2015 shale gas capex of USD 1.1bn in our base case, 3% above our current capex estimate
6 Shale gas E&P capex (USD bn) 5 4 3 2 1.1 1 0.2 0.2 0 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E
Base case
Bull case
5.1 3.9 2.7 1.7
3.6
1.7 0.7
2.1 1.6 1.7
2.5
2.6
0.4
Value accretion
We estimate Sinopec can earn an IRR of 16% from its shale gas operations through 2050, in line with our estimate for PetroChina. The NPV of its shale gas assets would also add 7%/11% to our valuation in our base/bull cases, according to our estimates. We use an industry standard discount rate of 10% to compute NPV. Our estimated valuation upside of 7-11% from shale gas development for Sinopec is higher than the 4-6% upside we estimate for PetroChina. This highlights the better potential for Sinopec to re-rate if shale gas development in China proceeds as we expect, and the company meets its output growth targets. Figure 115: Shale gas development could add 7-11% to Sinopecs valuation
Bull case 16% 11,823 92,222 116,565 0.79 11%
16% 7,983 62,267 116,565 0.53 7%
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Figure 116: Base case: Sinopecs share of profit and cash flows from shale gas development through 2030E, assuming 51% stake in projects
USD mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas Add: Depreciation Less: Capital expenditure Net cash flow 2013E 0 0 0 (30) 0 (30) 0 (30) 30 (152) (152) 2014E 22 (1) (3) (100) (1) (83) 0 (83) 100 (378) (361) 2015E 184 (9) (23) (304) (7) (158) 0 (158) 304 (1,118) (972) 2016E 420 (21) (51) (568) (16) (236) 0 (236) 568 (1,625) (1,293) 2017E 727 (36) (89) (788) (27) (214) 0 (214) 788 (1,671) (1,097) 2018E 1,202 (60) (147) (977) (45) (27) 0 (27) 977 (1,730) (780) 2019E 2,065 (103) (253) (1,299) (77) 332 0 332 1,299 (2,590) (958) 2020E 3,467 (173) (424) (1,757) (130) 982 (142) 841 1,757 (3,586) (988) 2021E 5,200 (260) (637) (2,388) (195) 1,721 (430) 1,291 2,388 (4,914) (1,235) 2022E 6,910 (345) (846) (3,071) (317) 2,331 (583) 1,748 3,071 (5,801) (982) 2023E 8,410 (420) (1,029) (3,699) (489) 2,772 (693) 2,079 3,699 (6,210) (433) 2024E 9,677 (484) (1,185) (4,227) (567) 3,215 (804) 2,411 4,227 (6,342) 296 2025E 10,827 (541) (1,325) (4,677) (642) 3,641 (910) 2,731 4,677 (6,477) 931 2026E 11,893 (595) (1,456) (5,065) (717) 4,061 (1,015) 3,046 5,065 (6,617) 1,494 2027E 12,897 (645) (1,579) (5,405) (790) 4,479 (1,120) 3,359 5,405 (6,763) 2,001 2028E 13,855 (693) (1,696) (5,706) (864) 4,896 (1,224) 3,672 5,706 (6,914) 2,465 2029E 14,782 (739) (1,809) (5,979) (938) 5,316 (1,329) 3,987 5,979 (7,071) 2,895 2030E 15,688 (784) (1,920) (6,231) (1,013) 5,739 (1,435) 4,305 6,231 (7,237) 3,299
Figure 117: Bull case: Sinopecs share of profit and cash flows from shale gas development through 2030E, assuming 51% stake in projects
USD mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas Add: Depreciation Less: Capital expenditure Net cash flow 2013E 0 0 0 (33) 0 (33) 0 (33) 33 (164) (164) 2014E 66 (3) (9) (164) (2) (113) 0 (113) 164 (689) (638) 2015E 307 (15) (38) (479) (12) (237) 0 (237) 479 (1,741) (1,498) 2016E 671 (34) (82) (812) (25) (282) 0 (282) 812 (2,143) (1,613) 2017E 1,222 (61) (150) (1,141) (46) (176) 0 (176) 1,141 (2,458) (1,493) 2018E 2,060 (103) (252) (1,446) (77) 181 0 181 1,446 (2,664) (1,037) 2019E 3,514 (176) (430) (1,941) (132) 836 (44) 791 1,941 (3,920) (1,188) 2020E 5,295 (265) (648) (2,564) (199) 1,620 (405) 1,215 2,564 (5,058) (1,279) 2021E 7,627 (381) (934) (3,428) (286) 2,598 (650) 1,949 3,428 (6,882) (1,506) 2022E 10,199 (510) (1,248) (4,441) (597) 3,402 (851) 2,552 4,441 (8,496) (1,503) 2023E 12,149 (607) (1,487) (5,291) (714) 4,049 (1,012) 3,036 5,291 (8,691) (363) 2024E 13,874 (694) (1,698) (6,011) (821) 4,651 (1,163) 3,488 6,011 (8,888) 611 2025E 15,458 (773) (1,892) (6,627) (925) 5,241 (1,310) 3,931 6,627 (9,093) 1,465 2026E 16,941 (847) (2,074) (7,163) (1,029) 5,828 (1,457) 4,371 7,163 (9,309) 2,226 2027E 18,350 (917) (2,246) (7,638) (1,132) 6,416 (1,604) 4,812 7,638 (9,537) 2,913 2028E 19,709 (985) (2,412) (8,066) (1,237) 7,008 (1,752) 5,256 8,066 (9,779) 3,544 2029E 21,037 (1,052) (2,575) (8,460) (1,342) 7,607 (1,902) 5,706 8,460 2030E 22,323 (1,116) (2,732) (8,821) (1,448) 8,205 (2,051) 6,154 8,821
(10,037) (10,265) 4,129 4,710
CNOOC (Outperform, PT HKD 18.00)

CNOOC has one shale gas block in Anhui province, but has indicated it could acquire more blocks in future auctions or through direct negotiations. We estimate CNOOCs shale gas output by 2020 from the block could present 1216% upside to our 2015 gas sales estimate. We estimate shale gas from the block in Anhui could add 1-2% to our valuation. CNOOC acquired the 4,800 sq km shale block in Anhui province in December 2011. It has drilled four exploration wells in the block and has guided that it will drill two more wells to assess the reserves. It will then decide on further exploration and development plans. It has indicated it could acquire additional shale gas blocks in future auctions or through direct negotiations with the MLR. We believe CNOOC could also potentially grow via acquiring smaller players if shale gas development takes off in China over the next few years. The Anhui block falls in the Yangtze platform basin as specified by the EIA; we assume a similar resource density for the block In our analysis, we have assumed contribution only from the Anhui block, which is in the Yangtze platform basin specified by the EIAs latest shale gas assessment report. We have assumed a similar resource density (technical resource/prospective area) for the Anhui block. In our base case, we assume 22% of the technical resource is commercially extracted through 2050 (in line with our assumption for the larger basin). We assume a 30% recovery factor in the bull case. We also assume CNOOC will develop the block using a 51:49 JV partnership, and the fiscal regime will be determined by a PSC. Production and reserves Our base case well-drilling assumptions suggest CNOOC (and partners) could achieve 0.14bn cm of output in 2015 from the Anhui block. Net to CNOOC, shale gas production would be 0.07bn cm in 2015E. This would imply upside of 0.3% to our 2015 gas sales estimate (based on output from conventional sources), and an upside of 0.1% to our 2015 total oil and gas sales estimate. However, shale gas volume from the block could grow significantly and reach 2.8bn cm by 2020, which would represent 12% of 2015E gas sales. 2020E shale gas output could present potential upside of 12-16% to 2015E gas sales for CNOOC In the bull case, we assume a higher reserve recovery factor (30% versus 22%). We have also assumed a proportional increase in the number of production wells drilled each year needed to produce from the reserves. In this scenario, we estimate shale gas production could reach 0.1bn cm in 2015 and 3.8bn cm in 2020, implying upside of 0.4% and 16% to 2015E gas sales, respectively.
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Figure 118: In our base case, 2020E output from the Anhui block is equivalent to 12% of CNOOCs 2015E gas sales
Base case 15% Upside to 2015E gas sales Upside to 2015E oil and gas sales 12% Upside from shale gas 10%
Figure 119: In our bull case, 2020E output from the Anhui block is equivalent to 16% of CNOOCs 2015E gas sales
20% Bull case Upside to 2015E gas sales Upside to 2015E oil and gas sales 16% Upside from shale gas 15%
10% 4% 0.4% 0% 0.1% 2020E
5%
3%
5%
0.3%
0%
0.1% 2020E
2015E
2015E
Figure 120: In our bull case, we assume more production wells are drilled to achieve higher reserve recovery
300 250 Wells drilled 200 150 100 56 50 4 4 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E
Base case
Bull case 219
261 193
261 193
166 124 70
162
8 8
26 30
Our estimated shale gas resource (net to CNOOC) in Anhui implies 78% upside to its latest proved gas reserve
In addition to increasing output, shale development would also boost CNOOCs gas reserves. In 2012, it reported proved gas reserves of 185bn cm (6.5tcf), or c.30% of its total oil and gas proved reserves. In our base case, we estimate shale output from the Anhui block through 2050 will add another 144bn cm (78%) to reserves over time. In the bull case, with a higher commercial recovery rate, potential reserves addition over time could reach 195bn cm.

We estimate shale gas development from CNOOCs Anhui block will not be profitable until 2017. However, we expect losses from shale gas operations to amount to less than 1% of our 2015 net profit estimate. Driven by rising gas production, we expect robust profit growth from 2017. We estimate shale gas earnings from the block could amount to c.2% of CNOOCs 2015E net profit in 2020.
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Figure 121: Shale gas earnings could form c.2% of 2015E profit in 2020E
Base case RMB mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas 2015E 131 (7) (16) (302) (5) (198) 0 (198) 2020E 5,731 (287) (701) (2,663) (302) 1,777 (444) 1,333 Bull case 2015E 174 (9) (21) (329) (7) (191) 0 (191) 2020E 7,743 (387) (948) (3,553) (428) 2,427 (607) 1,820

73,616
-0.3%
2%
-0.3%
2%
Spending requirement
In 2015, we estimate the shale gas project in Anhui will require additional capex equal to 2% of our current forecast Based on our base case assumption for wells drilled, we estimate CNOOC and its partners will need to increase spending to c.USD 340mn in 2015. Assuming a 51% share in projects, CNOOC would need to spend c.USD 170mn. This represents just 2% of our current capex estimate. We estimate CNOOCs net shale gas spending requirement in the Anhui block could rise to c.USD 720mn in 2020. In the bull case, we estimate shale gas capex by CNOOC and its partners could rise to c.USD 380mn by 2015, implying net spending of c.USD 200mn by CNOOC. This is c.2% above our current capex estimate. CNOOC could further increase shale gas spending to USD 970mn in 2020, based on our bull case assumption for wells drilled. Figure 122: In our base case, we estimate 2015 shale gas capex of c.USD 170mn, 2% above our current estimate
1,200 Shale gas E&P capex (USD mn) 1,000 800 600 400 200 31 31 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E
Base case
Bull case 949 763 569 782 578 702 968
716
393 314
172196 64 62
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Value accretion
We estimate CNOOC can earn an IRR of c.16-17% from developing its Anhui shale gas block, above the companys hurdle rate of c.13%. We estimate the NPV of its shale gas assets could add c.1-2% to our current valuation, using a discount rate of 10%. The potential upside to CNOOCs valuation from shale development is much lower than our estimates for Sinopec and PetroChina. This is understandable as we have considered just one shale gas block for CNOOC. The company could potentially increase the size of its acreage through later auctions or direct negotiations with the MLR. Increasing the scale of its shale gas activity would likely result in a proportionate rise in upside potential. Figure 123: Shale gas development could add 1-2% to CNOOCs valuation
Bull case 17% 1,767 13,784 44,821 0.31 2%
16% 1,256 9,798 44,821 0.22 1%
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Figure 124: Base case: CNOOCs share of profit and cash flows from shale gas development through 2030E, assuming 51% stake in projects
USD mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas Add: Depreciation Less: Capital expenditure Net cash flow 2013E 0 0 0 (6) 0 (6) 0 (6) 6 (31) (31) 2014E 1 (0) (0) (18) (0) (17) 0 (17) 18 (64) (64) 2015E 21 (1) (3) (49) (1) (32) 0 (32) 49 (172) (156) 2016E 95 (5) (12) (102) (4) (26) 0 (26) 102 (314) (239) 2017E 311 (16) (38) (195) (12) 50 0 50 195 (569) (324) 2018E 530 (27) (65) (272) (20) 147 (29) 118 272 (578) (188) 2019E 754 (38) (92) (358) (28) 238 (60) 179 358 (702) (166) 2020E 924 (46) (113) (430) (49) 287 (72) 215 430 (716) (71) 2021E 1,073 (54) (131) (490) (60) 339 (85) 254 490 (730) 14 2022E 1,209 (60) (148) (541) (69) 391 (98) 293 541 (745) 89 2023E 1,333 (67) (163) (585) (78) 441 (110) 331 585 (760) 155 2024E 1,450 (72) (177) (623) (87) 490 (123) 368 623 (775) 215 2025E 1,560 (78) (191) (656) (95) 539 (135) 405 656 (791) 270 2026E 1,665 (83) (204) (686) (104) 588 (147) 441 686 (806) 321 2027E 1,767 (88) (216) (714) (112) 636 (159) 477 714 (822) 368 2028E 1,866 (93) (228) (739) (121) 685 (171) 514 739 (839) 413 2029E 1,964 (98) (240) (762) (129) 734 (183) 550 762 (856) 457 2030E 2,061 (103) (252) (784) (138) 783 (196) 587 784 (873) 499
Figure 125: Bull case: CNOOCs share of profit and cash flows from shale gas development through 2030E, assuming 51% stake in projects
USD mn Revenue Resource tax Operating costs Depreciation Government share of profit Profit before tax Income tax Profit/(loss) from shale gas Add: Depreciation Less: Capital expenditure Net cash flow 2013E 0 0 0 (6) 0 (6) 0 (6) 6 (31) (31) 2014E 0 (0) (0) (17) (0) (17) 0 (17) 17 (62) (62) 2015E 28 (1) (3) (53) (1) (31) 0 (31) 53 (196) (173) 2016E 129 (6) (16) (121) (5) (19) 0 (19) 121 (393) (291) 2017E 419 (21) (51) (249) (16) 82 (2) 80 249 (763) (433) 2018E 717 (36) (88) (356) (27) 210 (53) 158 356 (782) (268) 2019E 1,019 (51) (125) (474) (47) 322 (81) 242 474 (949) (233) 2020E 1,249 (62) (153) (573) (69) 391 (98) 294 573 (968) (101) 2021E 1,450 (73) (178) (656) (82) 463 (116) 347 656 (987) 16 2022E 1,633 (82) (200) (726) (94) 532 (133) 399 726 (1,007) 118 2023E 1,802 (90) (221) (786) (106) 599 (150) 449 786 (1,027) 209 2024E 1,959 (98) (240) (838) (117) 665 (166) 499 838 (1,047) 290 2025E 2,108 (105) (258) (884) (129) 731 (183) 548 884 (1,068) 364 2026E 2,250 (112) (275) (925) (140) 796 (199) 597 925 (1,090) 433 2027E 2,387 (119) (292) (963) (152) 861 (215) 646 963 (1,111) 497 2028E 2,521 (126) (309) (997) (163) 926 (232) 695 997 (1,134) 558 2029E 2,653 (133) (325) (1,029) (175) 992 (248) 744 1,029 (1,156) 617 2030E 2,785 (139) (341) (1,059) (187) 1,059 (265) 794 1,059 (1,180) 673
Appendix I: From Barnett to a nationwide phenomenon the US success story

Technologies such as hydraulic fracturing and horizontal drilling were first used in the Barnett shale basin in the US, and then transferred to other basins developed in the late 2000s. Haynesville The first Haynesville shale well was permitted in 2006 by Encana Oil & Gas. Production in the Haynesville shale began in 2008 when Chesapeake Energy announced that its exploratory wells were successful. While many companies were aware of the natural gas resources in the Haynesville shale, it was thought to be less feasible than other plays like Barnett and Marcellus, due to its lower permeability and greater depth. Subsequent improvements to horizontal drilling and hydraulic fracturing technology eventually made the region viable without having to incur high costs. Marcellus Activity in the Marcellus shale play began in 2004, when Range Resources drilled and completed a producing well. The company began producing gas in 2005 in the basin. However, rapid drilling activity has resulted in Marcellus becoming the highest producing shale gas basin in the US since late 2012. Fayetteville In 2002, Southwestern Energys Arkansas subsidiary SEECO used the fracturing technique used in the Barnett shale on an older well in the Fayetteville shale. This confirmed estimates of the commercial gas levels in Fayetteville. By late 2004, the discovery was well known within the industry and heavy land-leasing efforts were underway. Figure 126: Shale gas production by basin
1.0 Antrim (MI, IN, and OH) Marcellus (PA and WV) 0.8 Barnett (TX) Eagle Ford (TX) Fayetteville (AR) Bakken (ND) Woodford (OK) Other US shale gas Haynesville (LA and TX)
0.6 bcm/d 0.4 0.2 0.0 Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
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Figure 127: US shale basin comparison

Barnett Key Players Location Production in 2012 (bn cm) Estimated basin area (sq mile) Depth (m) Thickness (m) Well spacing (wells/sq mile) Breakeven cost, USD per mmbtu Cost per well (USD mn)
Source: Energy Information Administration
Marcellus Range Resources, Chesapeake, Dominion Pennsylvania, New York, Ohio and West Virginia 65 94,893 2,060 38 8 3.8 6.2-6.6
Haynesville
Fayetteville
Devon Energy, Chesapeake, XTO Energy Texas 49 6,458 2,290 90 5.5-8 4.6 1.2-2.4
Southwestern Energy, Chesapeake, Encana Corp, Petrohawk Chesapeake, XTO Energy Oklahoma 69 9,000 3,660 76 8 4.9 9.0 Arkansas 29 9,000 1,220 34 8 3.6 2.7
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Appendix II: Other factors supporting the US shale success

Access to land In the US, large tracts of land and associated underground mineral rights are held privately. This allowed smaller gas players such as Mitchell Energy to lease the land through private deals. In comparison, countries like China have held auction rounds to grant land access rights, which make it harder for smaller entrepreneurial firms to compete with the larger companies. Well-developed road network Oil and gas drilling and production activities are extremely transportation intensive. Many vehicles are needed to transport equipment and other supplies to the drilling site. Oil and gas specialists in the US estimate an average oil and gas well requires 300-1,400 truckloads of equipment to produce. In the US, road infrastructure is generally available for these activities. Figure 128: The numerous truck-mounted pumps and temporary storage tanks needed in shale gas operations wells require adequate road infrastructure
Source: US Department of the Interior
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Appendix III: Horizontal drilling

Horizontal drilling came to the fore around 1988 and has been further developed since. As conventional onshore sources of hydrocarbons were believed to have been fully exploited, engineers thought of exploring untested sources by drilling into shale. However, this rock was dense and not conducive to production due to limited flow capability. In addition, even if the oil could flow in a limited amount, the end of the vertical well was only in contact with the oil bearing formation for a few feet. The solution to increase the contact point between the drill and oil bearing rock was to drill horizontally. As a result of improving technologies, horizontal drilling has become an increasingly popular method of recovering oil and gas from reservoirs in which hydrocarbons occupy horizontal space. This is because it offers greater contact area with the productive layer than vertical drilling. While the nominal cost factor for horizontal drilling can be twice as expensive as a vertical well, production can reportedly be enhanced as much as 15-20 times, making it highly economical.
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Appendix IV: Hydraulic fracturing

The technology that made production from unconventional resources possible is multi-stage hydraulic fracturing. Multi-stage fracturing is also referred to as a completion method. This is a well stimulation process used to maximise the extraction of underground resources. The oil and gas industry uses hydraulic fracturing to enhance subsurface fracture systems to allow oil or natural gas to move freely from the rock pores to production wells that bring the oil or gas to the surface. The process of hydraulic fracturing begins with building the necessary site infrastructure, including well construction. Production wells may be drilled in the vertical direction only or paired with horizontal or directional sections. Vertical well sections may be drilled hundreds to thousands of feet below the land surface and lateral sections may extend 1,000-6,000 feet from the well. Fluids, commonly water and chemical additives, are pumped into a geologic formation at high pressure during hydraulic fracturing. When the pressure exceeds the rock strength, the fluids open or enlarge fractures that can extend several hundred feet from the well. After the fractures are created, a propping agent is pumped into the fractures to keep them from closing when the pumping pressure is released. After fracturing is completed, the internal pressure of the geologic formation cause the injected fracturing fluids to rise to the surface where they may be stored in tanks or pits prior to disposal or recycling. Recovered fracturing fluids are referred to as flowback. Disposal options for flowback include discharge into surface water or underground injection.
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Appendix V: Chinas LNG re-gas capacity

Figure 129: Wood Mackenzie expects LNG re-gasification capacity in China to rise to 81bn cm in 2018, from 27bn cm/year in 2012
100
80
bcm/year 60 40 20 0
2011
2010
2012
2014E
2017E
2013E
2015E
2016E
2018E
2019E
2020E
2021E
2022E
2023E
2024E
2025E
2026E
2027E
2028E
2029E
Source: Wood Mackenzie
Figure 130: Current and under-construction LNG re-gasification terminals in China

Re-gas capacity (bn cm/year) Terminal Caofeidian (Tangshan) Dalian LNG Capacity holder PetroChina PetroChina 2010 0.0 0.0 9.3 3.6 0.0 0.0 0.0 0.0 4.1 0.0 0.0 0.0 0.7 0.0 0.0 0.0 17.6 2011 0.0 0.5 9.3 3.6 0.0 0.0 2.8 0.0 4.1 0.0 0.0 0.0 0.7 0.0 0.0 0.0 20.9 2012 0.0 4.1 9.3 3.6 0.0 0.0 4.7 0.0 4.1 0.0 0.0 0.0 0.7 0.0 1.0 0.0 27.4 2013E 0.0 4.1 9.3 3.6 0.0 0.0 4.7 0.0 4.1 0.0 1.5 0.0 0.7 0.0 4.1 1.2 33.2 2014E 4.7 4.1 9.3 3.6 0.0 1.1 8.8 3.1 4.1 0.0 3.0 0.0 0.7 0.0 4.1 4.8 51.3 2015E 4.7 4.1 12.3 3.6 0.0 2.7 8.8 4.1 4.1 0.0 3.0 0.0 0.7 0.0 4.1 4.8 56.9 2016E 4.7 4.1 12.3 3.6 4.1 2.7 8.8 4.1 8.1 4.1 3.0 0.0 1.1 1.4 4.1 4.8 70.9 2017E 4.7 4.1 12.3 3.6 4.1 2.7 13.6 4.1 8.1 4.1 3.0 0.0 1.1 2.7 4.1 4.8 77.1 2018E 4.7 4.1 12.3 3.6 4.1 2.7 13.6 4.1 8.1 4.1 3.0 4.1 1.1 2.7 4.1 4.8 81.2 2019E 4.7 4.1 12.3 3.6 4.1 2.7 13.6 4.1 8.1 4.1 3.0 4.1 1.1 2.7 4.1 4.8 81.2 2020E 4.7 4.1 12.3 3.6 4.1 2.7 13.6 4.1 8.1 4.1 3.0 4.1 1.1 2.7 4.1 4.8 81.2
Dapeng LNG (Guangdong) CNOOC Fujian Guangxi LNG Hainan LNG Rudong (Jiangsu) Shandong LNG Shanghai LNG Shenzhen LNG (CNOOC) Tianjin LNG (CNOOC) Tianjin LNG (Sinopec) Wuhaogou LNG Yuedong LNG Zhejiang Zhuhai LNG Total China
Source: Wood Mackenzie
CNOOC Sinopec CNOOC PetroChina Sinopec CNOOC CNOOC CNOOC Sinopec Shenergy Group CNOOC CNOOC CNOOC
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91
Disclosures appendix
The information and opinions in this report were prepared by Standard Chartered Bank (Hong Kong) Limited, Standard Chartered Bank Singapore Branch, Standard Chartered Securities (India) Limited, Standard Chartered Securities Korea Limited and/or one or mor e of its affiliates (together with its group of companies, SCB) and the research analyst(s) named in this report. THIS RESEARCH HAS NOT BEEN PRODUCED IN THE UNITED STATES. Analyst Certification Disclosure: The research analyst or analysts responsible for the content of this research report certify that: (1) the views expressed and attributed to the research analyst or analysts in the research report accurately reflect their personal opinion(s) about the subject securities and issuers and/or other subject matter as appropriate; and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this research report. On a general basis, the efficacy of recommendations is a factor in the performance appraisals of analysts. Where disclosure date appears below, this means the day prior to the report date. All share prices quoted are the closing p rice for the business day prior to the date of the report, unless otherwise stated. SCB and/or its affiliates owns 1% or more of any class of common equity securities of the following companies: China Petroleum & Chemical Corporation Class H. SCB makes a market in securities issued by the following companies: CNOOC Limited, PetroChina Co. Ltd. Class H and China Petroleum & Chemical Corporation Class H.
HKD
7.41
Recommendation and price target history for Sinopec (China Petroleum & Chemical)
4
6.92
3 5 6 2
8 7
6.42 5.93 5.44
4.95 Oct-10
Date 1 15 Oct 10 2 8 Oct 11
Jan-11
IN-LINE
Apr-11
Jul-11
Oct-11
Date 6.15 5.38
Jan-12
Apr-12
Jul-12
Oct-12
7.31 6.38 5.85
Jan-13
Date
Apr-13
Jul-13
Oct-13
Price target 6.54 7.20
Recommendation UNDERPERFORM
Price target
Recommendation
Price target
Recommendation IN-LINE
4 27 Mar 12 IN-LINE 5 26 May 12 IN-LINE IN-LINE
7 5 Feb 13
8 16 Aug 13 OUTPERFORM
3 6 Jan 12 IN-LINE 6.38 6 3 Jul 12 Source: FactSet prices, SCB recommendations and price targets
HKD
22.00 19.87
1 2 3
Recommendation and price target history for CNOOC

4 6 7 8 9
17.74 15.60 13.47 11.34 Oct-10

Date 1 28 Oct 10
Jan-11
OUTPERFORM
Apr-11
Jul-11
Oct-11
Date
Jan-12
Apr-12
Jul-12
Oct-12
22.00 15.00 18.00
Jan-13
Date
Apr-13
Jul-13
Oct-13
Price target 20.00 19.00 18.00
Recommendation
Recommendation OUTPERFORM IN-LINE OUTPERFORM
Price target
Recommendation OUTPERFORM
4 14 Jul 11 5 8 Oct 11
7 29 Mar 12 OUTPERFORM 8 3 Jul 12 9 21 Aug 12 OUTPERFORM
2 25 Nov 10 OUTPERFORM
3 5 Apr 11 SUSPENSION SUSPENSION 6 6 Jan 12 Source: FactSet prices, SCB recommendations and price targets
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HKD
13.50
2
Recommendation and price target history for PetroChina

6 4 1 5 3 8 7
12.37
11.24 10.12 8.99 7.86 Oct-10

Date 2 12 Apr 11
Jan-11
Apr-11
Jul-11
Oct-11
Date 4 6 Jan 12 5 9 Mar 12
Jan-12
IN-LINE IN-LINE
Apr-12
Jul-12
Oct-12
12.00 11.00 13.50
Jan-13
Date
Apr-13
Jul-13
Oct-13
Recommendation IN-LINE
Recommendation
Price target
Recommendation OUTPERFORM
1 25 Nov 10 OUTPERFORM
7 2 Jul 13
8 23 Aug 13 OUTPERFORM
3 8 Oct 11 IN-LINE 10.00 6 11 Jan 13 Source: FactSet prices, SCB recommendations and price targets
OUTPERFORM
Recommendation Distribution and Investment Banking Relationships % of covered companies currently assigned this rating OUTPERFORM IN-LINE UNDERPERFORM As of 30 June 2013 Research Recommendation Terminology OUTPERFORM (OP) IN-LINE (IL) UNDERPERFORM (UP) Definitions The total return on the security is expected to outperform the relevant market index by 5% or more over the next 12 months The total return on the security is not expected to outperform or underperform the relevant market index by 5% or more over the next 12 months The total return on the security is expected to underperform the relevant market index by 5% or more over the next 12 months 52.6% 34.3% 13.1% % of companies assigned this rating with which SCB has provided investment banking services over the past 12 months 14.3% 16.1% 9.0%
SCB uses an investment horizon of 12 months for its price targets. Additional information, including disclosures, with respect to any securities referred to herein will be available upon request. Requests should be sent to scer@sc.com. Global Disclaimer: Standard Chartered Bank and/or its affiliates ("SCB) makes no representation or warranty of any kind, express, implied or st atutory regarding this document or any information contained or referred to in the document. The information in this document is provided for information purposes only. It does not constitute any offer, recommendation or solicitation to any person to enter into any transaction or adopt any hedging, trading or investment strategy, nor does it constitute any prediction of likely future movements in rates or prices or represent that any such future movements will not exceed those shown in any illustration. 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China Shale Gas 2014

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l Equity Research l China l Oil & Gas l

China shale gas

Important disclosures can be found in the Disclosures Appendix

Equity Research l China shale gas

Equity Research l China shale gas

1.00 Junggar Basin 1.64 Songliao

0.29 Tuha Basin 0.03 Jiuquan Basin 0.56 Qaidam Basin

1.46 Tarim Basin

0.35 Mid and Small Basin

1.34 Bohai Bay Basin 2.71 Ordos 6.44 Sichuan Basin

1.87 Quan Zhong 0.01 Xichang

1.59 Middle yangtze

uplif t depression Recoverable resources

Source: Ministry of Land and Resources, Standard Chartered Research

Equity Research l China shale gas

Figure 2: History of the US shale gas boom

Equity Research l China shale gas

Figure 3: Chinas shale gas story, a mirror image of the US blueprint

China: Mapping the US shale story; On track towards a shale boom

China's shale gas production

Equity Research l China shale gas

Equity Research l China shale gas

China shale gas the next big thing

Source: Bloomberg, CEIC, Wood Mackenzie, Standard Chartered Research estimates

Source: Bloomberg, Standard Chartered Research estimates

Equity Research l China shale gas

US the shale gas pioneer, and lessons learned

Natural Abundant resource Water availability Favourable geology Topography

Equity Research l China shale gas

China: The protg

Estimates of China's shale gas resources 32

EIA estimate of US shale gas resources

Source: Standard Chartered Research

Equity Research l China shale gas

Source: Standard Chartered Research estimates

Source: China National Petroleum Corporation, Standard Chartered Research

Equity Research l China shale gas

Case study: Tight gass shows the way

Gas migration over geological times

Conventional permeable reservoir

Drilling techniques: horizontal drilling and multistage fracking

Shale formations with remaining gas not migrated

Source: Standard Chartered Research

Equity Research l China shale gas

140 120 100 bn cubic metres 80 60 40 20 0 2006 2007

35% 30% 25% 20% 15% 10% 5% 0%

Source: Wood Mackenzie, CEIC, Standard Chartered Research estimates

Equity Research l China shale gas

Proprietary model suggests 61bn cm of output in 2020

NDRC target (LHS)

SCR estimate (LHS) 80.0 61.0

25.0 2.8 6.5 2.8

Equity Research l China shale gas

Identifying the winners and losers

14% 10% 16%

Equity Research l China shale gas

Sinopec Upside to 2015E gas sales

30% 25% 20% 15% 10%

0% Bull case Base case

Equity Research l China shale gas

Sinopec plans Chinas first gasbased ethylene plant

Equity Research l China shale gas

Figure 22: Shale gas value chain in China

Equity Research l China shale gas