The following interview with Xizhou Zhou [1] was carried out in Beijing on July 4, 2014 by Patrick Renz and Frauke Heidemann. The main focus of the interview was on the China-Russia pipeline deal, natural gas pricing, energy sector reform and the risk energy infrastructure faces in China. All footnotes are remarks by Patrick Renz and Frauke Heidemann, aimed at giving some additional background knowledge and especially giving the links to the cited documents so that the reader can follow up on these issues easily.

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. China-Russia Pipeline Deal

At your talk for the Foreign Correspondent’s Club of China [2] you mentioned the different responses the Russia-China gas pipeline deal got on a political and economic level. What do you see as the main drivers in Chinese discussions about supply diversification?

Obviously both components are important to look at. When there is a deal such as the gas pipeline deal, the geopolitical issues cannot be ignored. In many ways it is easier to look just at what it means for supply and demand as well as prices but oil and gas deals are never purely economic. This deal is no exception. From a geopolitical perspective, China needs to diversify supply sources and Russia needs to diversify its customer base as both have only a few large suppliers or customers. China today has Turkmen gas and Central Asian gas accounting for 15% of the country’s gas supply. [3] For Russia, Europe is a very dominant customer base. [4] Therefore, both countries are seeking diversification.

The pipeline negotiations started over ten years ago. The reason why it has taken so long is because of the price. Every year or two the heads of state and heads of the companies involved met and negotiated but the price was always missing in news coverage after the meetings. [5] The reason was that while they were negotiating, the global gas market, supply and demand fundamentals as well as pricing levels changed rapidly.

In the end, the deal was struck because there was a breakthrough on the commercial side and both sides finally agreed to the prices. This was also due to forces on the geopolitical front that enabled the final commercial terms to be reached. [6] So both commercial and geopolitical considerations were important.

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. Natural Gas Pricing

When looking at LNG imports for China, the oil-indexed pricing and thereby very high prices is one of the major issues. Is China pushing for a change of LNG pricing?

All the buyers in Asia want prices to come down, even some of the premium Asian buyers like Japan or Singapore. [7] But ultimately we are in a marketplace where supply, demand and cost will determine price levels. The past few years, the cost issue as well as a tight market condition have been driving prices up. However, these tight conditions will likely ease, which is good news for buyers. A lot of new projects are coming to the market: over the next two to three years, Australian projects will start to enter operations; from 2018 on, we will start seeing some of the North American projects and even longer term East African projects. [8] There is room for the Asian gas prices to come down from today’s very high levels. How low prices can go will be determined by marginal costs and unfortunately these won’t be very low as marginal costs will likely be determined by the more expensive projects in North America or Australia. In the mean time, term prices might come down from 15 to 12 USD, which is already quite significant. It might go even down further to 11 or 10 USD but below 10 USD is highly unlikely.

The other issue is whether prices will continue to be oil-indexed. [9] There are two things to mention here. First of all, in Asia it is difficult to see a true market-pricing hub that we see in the West like Henry Hub or NBP [10] because there is no integrated, unified network where multiple supply sources—none of them too dominant—can compete with each other and allow for full market liquidity. We don’t see it in Tokyo, Shanghai or Singapore. They all lack one aspect or another of the prerequisites for a fully liquid trading hub.

There might be some trading hubs in the future, but those will be regional Asian trading hubs that are not truly a fully liquid hub. Furthermore, as long as there is more supply, people can still negotiate prices down, even when it is oil-indexed. This means that you could always negotiate with your suppliers to lower the oil indexation slope in the formula. You could ask for natural gas market indexation or partial natural gas market indexation like indexing to the Henry Hub. Some of the new contracts are already introducing Henry Hub instead of just oil indexation, showing an alternative to completely moving away from oil indexation.

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. Chinese Shale Gas

From March this year on, Sinopec and CNPC have become very optimistic about their shale gas production potential, even though there used to be a lot of skepticism due to the different geology, higher costs and overly ambitious production targets. Have you seen anything that could explain this shift?

Something is very different about shale gas: compared to conventional gas, shale gas is a more probabilistic play. With conventional gas, once you have done very solid seismic work and you start drilling, you have a very decent chance of getting to the gas. With shale gas, you know the area, but the gas is not in a single reservoir. It is embedded in tight formations. The more you drill, the more likely you are going to hit the sweet spots in shale gas formations. In the US, initially people drilled and got to nothing for many years. There were hundreds of wells drilled and they found just a few with good gas flow rates and had to drill thousands more until they got to 2006 and people realized how much gas they had. If you look at China, it depends on whom you ask, but there have been about 400 wells drilled within two or three years of development. The US drills more than that each month. To put it by US standards, the Chinese shale gas industry is less than a month old. Before we can get to a much more significant drilling number, it is impossible for anybody to say how much proven reserves there are and how much it will cost to produce. The US reached today’s number after 15 years of drilling. Initially, they had very high capital costs as well.

Some of the short-term results are optimistic and some very pessimistic. Sinopec reported great flow rates from the new wells drilled in Fuling and are hoping that they found at least one sweet spot in the area. [11] This does however not give you a shale gas revolution. With what I just said in mind, whether or not China reaches the 2015 target [12] is probably not very important. If it does, it is great. If not, it also doesn’t mark the end of the Chinese shale gas industry. The country has a lot of resources and IHS is very optimistic about China’s resource base. We are much more concerned about whether there will be enough investment to enable thousands of wells to be drilled. If it is really just the three national companies drilling, we don’t believe there is enough money to drill enough wells. In China we are talking about maybe 10 or 20 million USD a well, so if you have to drill a thousand wells, you can do the math. No matter how big those state owned enterprises (SOE) are, they don’t have this kind of cash. So we do need more players. Our outlook is that by the 2020s, we will see some good areas being discovered and can start to commercialize them. But this will take time.

Where do you see the importance to include more private companies and SOEs from outside the major national oil companies (NOC) in this sector?

It can be SOEs or private companies that are willing to come in and drill. It is important to know that the main upstream investors in this country have been the NOCs and their international partners like Shell or Chevron. The main challenge facing NOCs and international oil companies (IOC) is their relatively flat overall production of oil and gas combined with escalating costs for all of them. This means that their margins are being squeezed and their shareholders are getting concerned. Many shareholders are asking for dividends now instead of further investing in company cash. Now if we look at all these companies, NOCs and IOCs, most of them have already announced capital cost reduction in the next couple of years or a flat capital cost expenditure. This means that the big companies traditionally investing in China are not going to increase their upstream share substantially. If we need to drill thousands of shale wells, we have to ask where the additional money will come from. In the Chinese market, the obvious choice for the government is to allow other players into the gas and oil upstream market. Those can be private companies and SOEs from different sectors willing to invest. Due to the dominance of the NOCs in the past decade, all of these companies are new to the upstream industry. This means they are in need of expertise, knowledge and know-how to be successful. We have so far not seen them do anything too significant. They have to study what is required, what are the risks, and they are very difficult to manage and organize.

So what role do you see IOCs playing in the Chinese shale gas production given this reduced willingness to invest in new projects?

They will still invest in it but not on the scale that some of them have announced in the past two or three years. They are not pulling out of China and in fact they will continue to have a significant presence with joint ventures and production sharing contracts. Additionally, the international oilfield service companies are already working for Chinese companies. On the technology side there is not really any significant artificial barrier in getting the technology into the shale gas basins to operate. The main obstacle is that whoever drills has to pay for it. In the US, a shale gas well is about 5 million USD, in China the cost is much higher. In the end, someone has to pay for that, whether it is the NOCs or their international partners such as Shell, BP or ExxonMobil. The same is true for other Chinese SOEs or private companies involved. They could hire international service companies to do the drill jobs for them, but already a lot can be done by domestic drilling companies.

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. Energy Sector Reform

Do you see the pipeline monopoly by PetroChina and CNPC being loosened at some point?

The pipeline monopoly was a problem. Power companies that decide to produce shale gas in Sichuan want to be able to sell it to the market and make profit. They don’t want to sell it at the wellhead to PetroChina. The ongoing pipeline reform is therefore very important. One of the principles spelled out at the 3rd Plenum [13] last year was that natural monopoly segments of the business needed to become much more transparent and unbundled from segments of business that could be opened up for competition – that is basically upstream and downstream. At the highest level you rarely see something as specific as natural monopolies being mentioned. Then, in February this year, the government issued the Third Party Access Regulation, [14] which requires that anybody who owns such infrastructure must let others use it if there is spare capacity.For example, if you have a LNG import terminal and you are using 2/3 of it, and someone else signs an LNG contract overseas and wants to use your facility, you should allow them to use it for a standard fee. We have already heard some companies talking to terminal operators and getting agreements to use the infrastructure. The separate question of whether or not CNPC should own the pipeline is much more thorny. Whoever owns it, has to abide by the rules the government issued on third party access.

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Thank you very much for the interview.

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[1] More about Xizhou Zhou at: http://www.ihs.com/info/all/xizhou-zhou.aspx.
[2] The talk of Xizhou Zhou was on “The Russia-China Deal and the Future of China’s Gas Supply” and was delivered at the Norwegian Embassy in Beijing on July 3.
[3] More on Chinese natural gas imports from Central Asia and the existing pipeline network at: http://www.eia.gov/countries/cab.cfm?fips=chand about the recent pipeline string that was launched at: http://www.ihs.com/products/cera/energy-report.aspx?ID=1065990708.
[4] According to the U.S. Energy Information Administration, Russia exports about 76% of its natural gas to customers in Western Europe: http://www.eia.gov/countries/cab.cfm?fips=RS.
[5] The challenge of the price negotiations is further elaborated on by Bloomberg: http://www.bloomberg.com/news/2014-05-21/russia-signs-china-gas-deal-after-decade-of-talks.html.
[6] The deal was signed in midst of the still ongoing crisis in Ukraine in which Russia and the EU are holding opposing positions.
[7] More on the high prices especially for LNG imports in Asia: http://online.wsj.com/news/articles/SB10001424052702304315004579382261761664926.
[8] More on the different LNG exports coming to the market in the near future: http://www.platts.com/latest-news/natural-gas/rome/interview-us-australia-lng-exports-to-promote-26784758.
[9] For more information on natural gas pricing and the oil indexation of the natural gas prices: http://blogs.platts.com/2014/03/07/lng-pricing/.
[10] While the Henry Hub is the distribution hub in Erath, Louisiana, in the US for natural gas, NBP is the national balancing point and is a virtual trading location for the sale and purchase and exchange of UK natural gas.
[11] For more on the tests at Fuling site and the most recent estimates with regard to proven reserves: http://in.reuters.com/article/2014/07/17/china-sinopec-shalegas-idINL4N0PS2BX20140717.
[12] The Chinese shale gas production target for 2015 is 6.5 billion cubic meters per year. About the recent optimism with regard to the possibility that this target might be achieved: http://www.bloomberg.com/news/2014-03-11/china-on-course-to-exceed-2015-shale-gas-target-with-fuling-find.html.
[13] A comprehensive overview over the reform decisions made at the 3rd Plenum in 2013: http://carnegieendowment.org/2013/11/01/china-s-third-plenum-limited-reform.
[14] For an analysis of the new Third Party Access Regulation: http://www.platts.com/latest-news/oil/singapore/china-to-open-oil-gas-pipelines-for-third-party-27970194.

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