China

Faced with dramatic increases in energy demand resulting from rapid economic development and urbanization over the past two decades, serious environmental concerns over its reliance on high-sulfur coal, and the large amount of capital required to fund its energy exploration, production and distribution facilities, China's energy industry is in the throes of reform.

This is particularly true for China's gas industry, which, although largely dismissed in the past as simply peripheral to the oil industry, has over the past three years witnessed a major restructuring of its domestic players and a groundswell of interest in exploration and production activities backed by strong central government support.

Indeed, buoyed by aggressive growth forecasts and optimistic reserve reports, China is pushing ahead several very large gas development projects, including, most notably, a 4,000 kilometre west-east natural gas pipeline, which, when combined with upstream exploration in western provinces and downstream distribution facilities in Shanghai, is conservatively estimated to cost in excess of $17.7 billion. China also recently embarked on a pilot $600 million LNG regasification plant and trunkline project in Guangdong, which, like the West-East Pipeline Project, has been opened to foreign participation. The emerging opportunities in the China gas market, along with prospects for even greater market access following China's entry into the WTO, are catching the attention of global oil and gas companies. These are, however, still early days for the Chinese gas industry and the path to development is not without uncertainties. This article discusses the burgeoning opportunities in China's gas, and to a lesser extent its oil, industry, along with the concomitant challenges, and identifies the legal and commercial forces at play.

A market overview

With coal comprising about 90% of its estimated total fossil fuel reserves, China leads the world in coal production. With such vast indigenous coal supplies, it is no surprise that China relies on coal for the majority of its energy needs. Nevertheless, there is a growing awareness in China among the government and commercial players alike that, in spite of its abundance, coal alone cannot best satisfy China's energy requirements. This is in part because most of the country's coal has a high sulphur content and a relatively low thermal value — in short, China's coal is unenviably known as "dirty coal". Burned with little regard for the environment for years, coal is now considered the main culprit for China's high pollution rates. Moreover, in light of the fact that coal transport consumes an estimated 40% to 50% of China's entire rail transport capacity, widespread coal use also imposes significant strains on the mainland's transportation infrastructure.

In terms of other fuel sources, China is one of the top 10 oil producers in the world. However, it became a net oil importer in the early 1990s and is expected to rely on imports for roughly 50% of its oil consumption by the year 2010. Concerns over rising dependence on oil imports have almost certainly influenced the Chinese government's efforts to develop alternative, indigenous fuel supplies. Renewable energy, such as wind, solar and particularly hydropower, have promise for future development in this regard, but, due to their often remote locations, such sources alone cannot provide sufficient generating capacity to offer much relief from China's dependence on coal and oil.

Though coal, and to a lesser extent oil, will continue to meet the bulk of China's energy needs, gas, as a clean and strategically safe indigenous fuel, has emerged as an obvious candidate for increased development. Aside from the ecological benefits of gas, gas-fired power plants typically have lower construction costs and incremental (maintenance) costs than coal-fired power plants fitted with pollution-abatement equipment. Recognizing the potential of gas, the Chinese government is hoping to double annual gas production by 2010 and has set bullish growth targets for the gas market with estimates of 9% growth per year to 2010. The fact that China's known gas reserves are remotely located is apparently not discouraging the development plans. On the contrary, government reports indicate that China intends to build at least 12 pipelines in the next 10 years, nine of which will be for gas transmission. Whether or not China will succeed in boosting gas production and consumption to meet these ambitious projections depends on a wide range of political and economic considerations. However, recent government initiatives and the commercial activities of various Chinese and foreign companies do indicate a definite shift in momentum toward the development of the gas industry in China.

Key domestic players

Historically, the China National Petroleum & Gas Corporation enjoyed a monopoly over onshore oil and gas exploration and development (E&P) activities in China. This monopoly came to an end in 1998 when the Chinese government began restructuring or, perhaps more aptly put, commercializing, the onshore oil and gas industry by shifting China National Petroleum & Gas Corporation's assets into two new commercial entities, China National Petroleum Group Corporation (CNPC) and China Petrochemical Group Corporation (Sinopec Group). Originally, CNPC was involved primarily in upstream activities while Sinopec Group focused on downstream refining and distribution. Following a further reorganization and asset transfer between CNPC and Sinopec Group, each company became vertically integrated with CNPC and its affiliates operating predominantly in northern and western China, while Sinopec Group and its affiliates concentrated in the southern and coastal regions. Sinopec Group also held the majority of petrochemical production assets until the reorganization of the two main domestic players resulted in CNPC holding about 30% of the refining industry capacity in China with Sinopec Group having retained about 65%. The remaining refining capacity is controlled by a large number of small, locally operated refineries.

Other key players in China's oil and gas industry include the China National Offshore Oil Corporation (CNOOC), which enjoys exclusive and overall responsibility for exploiting offshore petroleum resources, and China National Star Petroleum Corporation, which was the fourth major state-owned oil and gas corporation and is now a subsidiary of Sinopec operating under the name Sinopec Star Petroleum.

All three of China's domestic oil and gas companies have tapped the capital markets for funding, with CNPC listing on the New York and Hong Kong stock exchanges in April 2000, through a company called PetroChina, China Petroleum and Chemical Corporation, or Sinopec (established by Sinopec Group), listing in New York, Hong Kong and London in October 2000, and CNOOC Limited (a subsidiary of CNOOC that has been given the exclusive right to exercise CNOOC's off-shore petroleum rights) listing on the New York and Hong Kong stock exchanges in February 2001 (See Table 1).

The Chinese regulatory environment

Gas E&P activities in China are not regulated by any single unified law or subject to the supervision of any one government body. Instead, gas E&P work is governed by a patchwork of legislation, some of which dates back to the early 1980s (see Table 2). In fact, the country's two largest gas projects under development (the West-East Pipeline Project and the Guangdong LNG Project) are proceeding largely in a legislative vacuum, without any unified supporting regulations issued by the relevant government authorities. In terms of regulatory supervision, the Ministry of Land and Natural Resources (MLNR) generally oversees the oil and gas industry, although the National People's Congress (NPC), the State Council, the State Development and Planning Commission (SDPC), the State Economic and Trade Commission (SETC) and, to a lesser extent, the Ministry of Environmental Protection Administration, all play an important role in shaping policies relevant to the gas industry in China as well as overseeing major projects (see Table 3). The Ministry of Foreign Trade and Economic Cooperation (Moftec) also plays a role in regulating foreign-funded E&P by reviewing and approving contracts for Sino-foreign cooperative E&P work in China.

Upstream (E&P)

The regulatory regime for foreign participation in offshore E&P activities is set out primarily in the 1982 Foreign Cooperation in the Extraction of Offshore Petroleum Resources Regulations (1982 Offshore Regulations), which grant CNOOC exclusive and overall responsibility for exploiting offshore petroleum resources in the PRC in cooperation with foreign enterprises. Onshore E&P activities are carried out pursuant to the 1993 Foreign Cooperation in the Extraction of Onshore Petroleum Resources (Onshore Regulations) which are broadly similar to the 1982 Offshore Regulations and grant CNPC's predecessor, China National Petroleum & Gas Corporation, now CNPC and Sinopec, the exclusive right to engage in onshore petroleum exploration, development and cooperation with foreign enterprises. CNOOC, CNPC, etc. invite foreign participation in offshore activities primarily by initiating rounds of competitive bidding, although they have occasionally also done so by way of direct negotiations.

Although China now has a law on bidding/procurement procedures (the Law of the PRC on Invitation and Submission of Bids; August 30 1999), a lack of transparency and limited access to field data critical to feasibility and cost assessments remain important issues of concern among foreign bidders. Anecdotes abound concerning the Wild West nature of the oil and gas industry in China, many of which are perhaps a vestige of the unfortunate experiences of some foreign oil companies in the late 1980s, which paid significant licence fees for exploration rights without any particularly positive results.

Foreign participation in exploration, production and marketing of petroleum reserves, onshore and offshore, is generally carried out through a "petroleum contract", which is effectively a form of production-sharing contract that is subject to Moftec review and approval. Unless a petroleum contract provides otherwise, the foreign contractor will be responsible for funding and performing all exploration operations, and must bear all risks associated therewith. Once a commercially viable discovery is made, the contractor may recover its costs, although the Chinese party will then take up to a 51% participating interest and may also take over operations of the field. Assets purchased or built by the foreign contractor in carrying out a petroleum contract will then be owned by the Chinese party after the foreign contractor has recouped its investment. The relevant regulations require that, in carrying out petroleum contracts, foreign contractors give priority to domestically sourced equipment, services, personnel, etc, and transfer technology and management expertise to their Chinese counterpart. The Chinese government has recently amended similar language in several Sino-foreign investment laws to avoid direct violation of the "national treatment" principles of the WTO (although, interestingly, the bid documents for both the Guangdong LNG and the West-East Pipeline Project required that bidders specify their commitment to using domestically sourced materials and services).

There is well established precedent in China for foreign participation in the offshore E&P industry. The best-known example is the BP (formerly Arco) led involvement with the development of the Yacheng 13-1 offshore gas field, which dates back to 1983. In fact, over 60% of CNOOC's currently producing oil and gas properties have been developed under petroleum contracts with foreign parties, with CNOOC having reportedly signed close to 150 petroleum contracts with some 70 foreign companies by the end of 2000. Onshore, CNPC and Sinopec have also sought to forge cooperative relationships with foreign oil companies as a means of sharing exploration costs.

Midstream (pipeline transportation)

The 1982 Offshore Regulations also apply to offshore pipeline projects. Foreign participation is allowed in these projects and includes the well known precedent for foreign participation of, once again, BP's involvement in the Yacheng 13-1 pipeline, which takes gas from offshore Hainan to Hong Kong. The offshore Pinghu field is also connected by subsea oil and gas pipelines to Shanghai, and the Energy Development Corporation (China), a subsidiary of Nobel Affiliates, has received approval for development plans in the Bohai Bay which includes the installation of a five-mile pipeline to onshore facilities.

Until recently, opportunities for foreign participation in gas pipeline systems were confined to offshore operations. However, following a revision in 1997 to the 1995 Investment Catalogue of Foreign Investment Industries (Investment Catalogue) foreign investment in construction and operation of oil and gas delivery pipes is now "encouraged" subject to certain restrictions on foreign ownership percentages and to the exclusion of urban gas distribution networks which are still not open to foreign investment. The most notable prospect for foreign participation in gas pipeline projects is the 4,000 kilometre West-East Pipeline Project that will transport natural gas from the Xinjiang region in the remote western part of China to the Shanghai municipality and four provinces along its path (Jiangsu, Zhejiang, Henan and Anhui provinces). In a widely publicized speech on July 12 2000, the vice chairman of the SDPC, Zhang Guobao, laid out the various preferential benefits that would be offered to foreign participants in the project, including, for example, access to urban gas pipeline construction (see table 2). Since then, the project has been tendered and foreign partners are currently under evaluation. However, to date, detailed legislation has not been issued concerning the implementation of the project or the preferential benefits offered.

Downstream

Gas processing

The Investment Catalogue does not expressly forbid or restrict foreign investment in gas processing facilities and therefore, such activities are arguably allowed (although not expressly encouraged). The most significant indication that the Chinese government will, in fact, allow foreign participation in gas processing facilities is the Guangdong LNG project which includes a 30% foreign stake (won by BP) in the joint venture company that will own and operate the 3 MTPA (rising to 5 MTPA) regasification plant in the Shenzhen Special Economic Region of Guangdong Province. This is China's first LNG importation project and appropriate legislative details have yet to be provided. Three other LNG reception and regasification terminals, to be located at Shanghai and in the Shandong and Fujian provinces, are reportedly in various stages of planning.

Foreign participation in the LPG industry also has precedent. The Canadian company Propak Systems has contracted with Shanghai Petroleum Corporation to provide a cryogenic LPC recovery plant to process gas from the Pinghu offshore gas field, and the US-based Largo Vista Group has three LPG depot farms in China, including a recent lease of an LPG depot in the Guizhou Province from PetroChina. Shell has also been active in investing in LPG on the mainland, although recent reports indicate that Shell is now selling off its LPG assets in China.

Wholesale and retail oil products

At present, foreign oil companies are not alllowed to engage directly in China's wholesale market for refined oil products. A foreign enterprise that is a party to a petroleum contract may export its share of the petroleum, but any sale of the products to the Chinese domestic market must be exclusively made to designated domestic enterprises.

With regard to participation in petrol sales at the retail level, foreign companies may currently only set up directly owned service stations in China ancillary to their investments in highway projects, although some foreign companies have settled for indirect participation in the retail market through entrustment and licensing arrangements (consider that foreign companies currently control approximately 400 petrol stations in China). BP, Shell and Exxon Mobil have also all reportedly agreed to form joint ventures with Sinopec that would allow each to establish some 500 petrol stations respectively, divided regionally with BP operating in Zhejiang, Shell in Jiangsu, and Exxon Mobil in Fujian province.

During 1999 and 2000 there was intense competition and price escalation for petrol stations as Sinopec and PetroChina both embarked on aggressive campaigns to beef up their respective retail networks by acquiring large numbers of existing petrol stations. Competition between the two companies is expected to remain heated given a recent announcement by the SETC that PetroChina and Sinopec are the only authorized domestic companies alllowed to open new petrol stations — a move presumably aimed at shoring up the two majors' positions prior to China's entry into WTO and the resulting further opening of the market.

Pricing

Prices in the oil and gas industry have long been subject to government control (pursuant to the Catalogue of Prices for Heavy Industrial Commodities and Transportation set by State Price Bureau and Relevant Departments on August 29 1992), although loosening of restrictions, particularly for crude and processed oil, have been introduced in recent years. Under the Pricing Catalogue of the SDPC and Relevant Departments of the State Council (Pricing Catalogue) promulgated in July 2001, pricing for crude oil and processed oil will still be subject to earlier pricing measures. Reserve petroleum and pipeline transmission pricing will be subject to the SDPC and relevant State Council departments, while onshore-produced natural gas will be subject to the SDPC control.

Crude and processed oil

One of the first significant liberalizations in China's state-controlled petroleum pricing scheme came about in June 1998, with the Crude Oil and Processed Oil Pricing Reform Scheme (Oil Pricing Reform Scheme) promulgated by the SDPC. Under the Oil Pricing Reform Scheme, strict government controls were lifted and crude oil prices were subjected to a "market price". Specifically, the reforms called for the SDPC to publish on a monthly basis benchmark prices for crude oil (divided into four categories, ie light crude oil, heavy crude oil, medium oil I and medium oil II) based on FOB Singapore prices. Crude oil would then be sold at these benchmark prices plus surcharges (or less discounts), reflecting income duties, transportation costs, oil quality and so on, as per the terms of the relevant contracts. Then, in March 2001, SDPC promulgated the Circular of Relevant Issues Concerning Crude Oil (Crude Oil Price Circular) which provided that SDPC would no longer issue the monthly benchmark prices and that crude prices could be set by oil companies themselves based on FOB Singapore prices and in accordance with the principles set out in the Oil Pricing Reform Scheme.

Pursuant to the Oil Pricing Reform Scheme, the pricing policy for processed oil, which was previously inflexible, is now guided by the state. The SDPC promulgates standard retail prices for gasoline and diesels for each province and autonomous region that are then, in practice, adjusted by SDPC on a monthly basis. CNPC and Sinopec Group must then set prices within 5% of the guidance prices, provided that they adjust the prices not less than every two months (absent SDPC approval otherwise) and register such prices with SDPC. CNPC and Sinopec Group are free to set ex-factory and wholesale prices for gasoline and diesel, subject to registration of the relevant prices with SDPC.

Prices for other refined products and prices of jet fuel and heavy oil for fertilizer production (for export) are still directly determined by SDPC, while prices for kerosene, heavy oil and LPG must be set by CNPC and Sinopec Group in line with SDPC pricing measures. Other oil companies must then set prices in line with CNPC and Sinopec Group's prices.

Reserve petroleum

Until last year, China did not have an oil reserve system — a fact that has no doubt caused considerable concern to the Chinese government as the country's dependence on oil imports steadily increases. According to SDPC's current schedule, China is now considering building up a 24-million m³ oil reserve capacity within the next five years. These plans will obviously require significant investment, including storage and transport costs, and are rumoured to have been met with less than enthusiastic responses from China's domestic oil and gas majors. Prices for state reserve petroleum (including crude oil and processed oil) are listed in the Pricing Catalogue, pursuant to which SDPC and other relevant government departments must set ex-factory and ex-warehouse prices.

Natural gas and pipeline transmission fees

Under the new Pricing Catalogue, ex-factory prices for onshore-produced natural gas are set by SDPC, while fees for pipeline transmission are subject to SDPC and other "relevant government departments". Prices of natural gas and pipeline transmission fees often vary depending on the relevant usage of the gas. For example, natural gas prices for household consumers, as compared with those for fertilizer plants, sometimes vary, so indirectly reflecting government subsidization and attempts to encourage certain uses.

As per the PRC Price Law adopted by the National People's Congress on December 29 1997, natural gas prices and pipeline transmission fees in respect of public consumers fall within the category of "public utilities, public interest service and naturally-formed monopoly commodities" and, as such, require a hearing for government departments to set prices. The newly promulgated Interim Measures of Government Pricing Hearings (Hearing Measures) set forth detailed requirements and procedures for these types of pricing hearings. While the Hearing Measures confirm that consumers or organizations may be heard at such hearings, the Measures (not surprisingly) do not wrest ultimate control over pricing issues from the government.

The changing landscape

With China's entry into the WTO a foregone conclusion, the oil and gas industry is bracing itself for even more changes. The three main WTO-related changes that will directly affect the China oil and gas industry are the reduction of tariffs, the elimination of certain non-tariff barriers to trade, and the opening of markets to foreign participation (eg retail, wholesale). Ancillary WTO reforms, such as the introduction of more transparent and streamlined approval processes, will also provide more general benefits, although the extent and timing of what will ultimately be sweeping, systemic changes remains uncertain.

Reductions in tariffs

As illustrated by table 4, China's WTO entry will affect tariffs on some, but by no means all, oil and gas products.

Elimination of non-tariff barriers

China has agreed to eliminate quotas and licences on the import of refined petroleum products by 2004 and to increase quotas annually by 15% during the period leading up to 2004. Details of whether or not China will retain quotas and licences on the import of crude oil have not been made public, although the PRC/US WTO Agreement does include, in addition to the schedule regarding elimination of quotas and licences for refined oil products, a general statement that "all quotas will grow by 15% annually until eliminated". The current import ban on gasoline and diesel, and the quantity-restricting registration system for crude oil imports, will also reportedly be lifted upon WTO entry.

Enhanced market access

Retail distribution will be opened to foreign suppliers of processed petroleum oil by 2003, without any geographical, quantitative and ownership restrictions. As discussed above, BP, Shell and Exxon Mobil are all gearing up to take advantage of the market liberalizations by taking preliminary steps to put retail joint ventures in place.

Wholesale distribution of crude petroleum oil and processed petroleum oil will also open to foreign participation by 2005, without any geographical, quantitative or ownership restrictions. However, state-owned enterprises, such as Sinochem, will retain exclusive trading rights for imported crude oil and refined products. China did make some concessions in the WTO agreement concluded with the EU to break the state monopoly over imports by agreeing to allow the private sector to import 7.2 million tons of crude oil and 4 million tons of processed oil a year.

Challenges to development

Although there is great potential for expansion of the gas industry in China, there are still challenges to its development. The cost and time required to develop remote fields, the abundance of coal and reforms in the legal system and power industry all lead to questions on gas's role in China.

Competitiveness of gas - While gas is viewed objectively as a much more efficient source of energy than coal, any such comparative analysis in China must factor in the high costs of developing a new, remotely located resource, as well as the indigenous availability of alternative, cheaper fuels. Looking at the West-East Pipeline Project by way of example, the issue of whether the expected gas supply can be sold at competitive prices is one that foreign bidders have raised. Indeed, absent government intervention to reduce the primacy of coal in certain regions and stave off competition from other fuel sources, including natural gas from other sources, gas consumption from the pipeline may be seriously inhibited.

Role of coal - While there is no question that coal will continue to play a significant role in China's energy market in the significant future, there is some question as to how much market share will be yielded to gas and at what political and economic costs. Oil and gas companies are also no doubt watching with some trepidation China's continuing experiments with various types of clean coal technology and efforts to gain experience with IGCC (integrated gasification combined cycle technology). Areas such as Guangdong province where demand for power is booming may provide clues as to how far the government will bend to ensure that energy demands are met and "reasonable" prices are maintained. In this regard, some analysts have predicted that in Guangdong even small, less efficient coal-fired plants that are known polluters may ultimately be retained simply as a means of ensuring that demand is met and prices are controlled.

Pricing mechanisms – Closely related to the above discussion is the issue of how gas prices and transmission fees will be set and implemented. While the SDPC recently announced the lifting of price restrictions on 107 commodities and services, natural gas is one of the 13 remaining categories of goods/services still subject to central level pricing. The issuance of more detailed legislation on gas pricing and transmission fees would certainly provide welcome clarification. However, even with such legislation in place, investors should not lose sight of the fact that energy prices are ultimately political animals. This means that even a tariff that is set strictly in line with relevant regulations could be vulnerable if it is above what the government considers a politically acceptable level. Indeed, disputes in recent years concerning tariff approval and implementation have been the bane of many IPPs in China and have exposed the regulatory wrangling among various levels of authorities (ie, central level SDPC versus their provincial level counterparts), industry in-fighting (ie, SDPC versus State Power Corporation), and socio-political issues that can pervade pricing issues.

Timing of supply and demand – Commercializing China's remote gas reserves requires the development not only of the transport facilities (a huge undertaking in itself) but also the infrastructure to ensure that demand will exist once the gas begins to flow. For example, in the West-East Pipeline Project in which demand is expected to be met by both industrial and residential users, anchor gas-fired plants with hook-up equipment and urban gas networks with requisite hook-ups must be operational simultaneous with the completion of the various stages of the pipeline. An insight into the need for overall project scheduling is provided by the 850 kilometre Jingbian to Beijing gas pipeline, which was designed and constructed at a cost of around $500 million by a joint venture between CNPC and the Beijing city government. Although the envisioned annual delivery rate was 3 bcm of gas per year, the actual initial fill and carriage gas quantities were below this figure because downstream phases of the project were not completed simultaneously.

Developing legal/regulatory system – Investors in China's gas industry must also contend with the fact that they are operating in an evolving legal environment that lacks a single regulator or governmental agency with ultimate decision making power over their projects. While the central government does appear committed to the development of the gas industry, strong cooperation among the various domestic players and regulatory bodies will be critical to driving forward the development plans.

Reforms of the power industry - Also affecting the future of gas in China are the continuing reforms of the China power industry. Restructuring of the power industry began in earnest in 1998 when responsibility for regulating and running the power industry was transferred from the now defunct Ministry of Electric Power to the SETC, the State Power Corporation, and the SDPC. Shortly thereafter, a surplus of generating capacity led to an announcement by the SDPC that it would shift its planning policies away from building new power stations towards improving power distribution and, as a result, would impose a moratorium (subject to certain exceptions) on approvals for new coal-fired plants. These pronouncements, coupled with relatively widespread disputes concerning tariff implementation and dispatch arrangements for foreign-funded power projects, lead to a general chilling of foreign investment in the power industry. While most IPPs are still reticent about investing in China's power generating sector, electricity demand has now made a strong recovery from the lows of 1998 and 1999. The Chinese government has also launched (albeit with middling to nil success) pilot competitive power pools in several provinces and has reiterated its commitment to effecting a separation of operation and ownership of the power grids from that of generation assets — a move that is imperative if China is to realize its long term goal of having true merchant power plants. With demand for power rising and in light of the lessons offered from the recent power problems in California, most are hopeful that China will complete the reforms of the power industry before demand significantly outstrips supply. For oil and gas companies, the introduction of policies aimed at jump-starting development of gas-fired plants and the conversion of coal-fired plants to gas will be of obvious importance. Confirmation of the legal status of long-term take-or-pay PPAs and the implementation of transparent tariff approval procedures should also help lure back disillusioned IPPs and enhance the ability to finance power projects in China.

Conclusion

While the challenges mentioned above are indeed significant, China's plans for developing its gas industry are generally viewed with conservative optimism and are bolstered by the fact that gas is a proven clean and efficient energy resource. That commercialization of China's gas reserves carries a multi-billion dollar price tag may very well galvanize the commitment of the central government to ensuring its success. After all, at this critical juncture in China's economic development the government simply cannot afford to make such an expensive miscalculation.