China disrupts the oil and gas industry--again

07/30/2010 10:30 am EST


Jim Jubak

Founder and Editor,

You wouldn’t think that anybody, especially an anybody as savvy as ExxonMobil (XOM), could overlook China.

But that may be exactly what ExxonMobil did in formulating its plan to pin the company’s growth on natural gas—and in particular on liquefied natural gas (LNG).

According to U.K. oil and gas consulting company Wood Mackenzie, China looks like it will need only half as much additional liquefied natural gas in the decade beginning in 2020 than big oil companies such as Royal Dutch Shell (RDS), BP (BP), Chevron (CVX), and, yes, ExxonMobil had projected. 

Projects such as ExxonMobil’s Qatargas Trains 4 and 5, RasGas, Al Khaleej Gas, the South Hook liquefied natural gas terminal, and the Golden Pass LNG terminal—and this is only a partial list of ExxonMobil’s planned investments in LNG in 2009 and 2010--that made investment sense when it looked like China would be importing an additional 16 million tons of LNG annually in the coming decade now face a scenario in which China will need to add only half as much to its annual imports.

 That will hit all the international oil companies hard but it will hit ExxonMobil especially strongly because the company has based its investing strategy on natural gas in general and liquefied natural gas in particular.

 What’s changed since, say, March 2010 when ExxonMobil announced that it will increase capital spending by 4% in 2010 to almost $28 billion in a big bet on natural gas on top of its purchase of U.S. natural gas producer XTO Energy for $28 billion?

 Projections on how quickly China will put to work new technologies, pioneered in the United States, to release natural gas trapped in layers of relatively non-porous shale.

Up until very recently oil and gas industry analysts were predicting that Europe would be the next region to put these technologies to work. The U.S. gas shale boom began in the Barnett Shale formation of Texas and then spread eastward to Arkansas, Louisiana, and, most recently, to the Marcellus Shale formation that underlies most of the Appalachian region. Companies that developed fracturing and drilling technologies to release the gas during that boom had been looking to Europe as the next frontier. The last three to five years have seen an explosion of mapping and exploration from France eastward into Austria.

 But while so much attention was focused on Europe, Chinese energy companies, led by Petrochina (PTR) had started to map, explore, and, tentatively, develop natural gas fields in that country’s own shale formations. From that early work it now seems likely that China will be able to produce 12 billion cubic feet of natural gas a day by 2030 from those shale formations and from ongoing investment in coal gasification and coal-bed methane.

 That’s equal to roughly a fifth of China’s current production of natural gas—and more than enough to change the global economics of natural gas. (For context, the U.S. will produce about 60 billion cubic feet a day of natural gas this year.)

How does rising production of unconventional gas in China change the game?

 First, it turns the opportunity for LNG open-ended boom into a window of opportunity. During the next two or three years China will need to import LNG in the quantities that oil companies investing in natural gas have projected. But as China’s own supplies of gas from unconventional sources gradually come on line, a gap will open between what China was projected to need when oil companies drew up their plans for investing in LNG and what China actually imports. That gap is huge: China will need to import only about half of what was projected not so long ago by 2020.

Second, growing production from unconventional sources in China won’t just damp imports of LNG; they’ll radically reduce China’s need to import conventional natural gas through pipelines from central Asia and Siberia. Recent years have seen a barrelful of deals between China and natural gas producers in Russia to build pipelines and secure supply. Those deals, like the investment in LNG, now come with a ceiling: By 2020 China will still be importing natural gas by pipeline but it won’t need any new pipeline capacity after that date, according to Wood Mackenzie.

Third, China now meets a relatively small percentage of its energy needs—about 4%--from natural gas. (Coal accounted for 68% of primary energy use. Oil for 19%.) That will change as domestic supply grows and as China’s government continues its policy of reducing carbon emissions by shifting to natural gas and alternative energy sources such as wind and solar. A likely winner from this shift is CNPC Hong Kong (HK: 135), a subsidiary of PetroChina that looks likely to be the parent company’s vehicle for increasing natural gas distribution. Other names to check out include China Oil & Gas Group (HK: 603), and China Resources Gas Group (HK: 1193), as well as giant PetroChina (PTR).

Fourth, China’s diminishing need for increased supplies of LNG (a change in the rate of acceleration to all you Isaac Newton fans) changes the economics of the natural gas industry in Europe more than anywhere else. China looks to be emerging as the No. 2 market for shale gas investment and technology deals—instead of Europe. (Depending, of course, as always with China on the kind of profits China will allow non-Chinese companies and investors.)  China’s shift to domestic, unconventional sources of natural gas means that new LNG capacity coming on line in say 2015, or so, will keep prices for LNG low. Perhaps low enough (and I’m speculating here but so, I’m sure, are oil company CEOs right now) to make importing LNG into Europe more attractive than exploring for and developing unconventional shale gas reserves in Europe itself.

Fifth, the growth of the LNG market pushed natural gas toward the status of a global commodity. That’s now a fact of life even if the oil and natural gas industry decides to cut back on investment in new LNG capacity. Because natural gas had been so hard to transport across ocean barriers—pipelines under anything but a short stretch of water are so expensive that they add too much to the price of natural gas—natural gas sold in a series of continental or national markets with the price determined by supply and demand in that market. The growing global supply of LNG that could be shipped long distances changed that. Cheap LNG from Qatar competed with domestic natural gas to depress the price of natural gas at hubs in Louisiana. As the rate of increase in China’s demand for additional LNG slows over the next decade, prices for LNG are likely to stay so low that only the lowest cost producers (or the state-controlled producers who are willing to subsidize national companies) will find the business attractive. That’s likely to lead to a reduction in new investment in LNG, but because these projects have such long lead times, LNG capacity that was planned based on China’s projected need for 16 million tons of new LNG imports by 2020 will still be coming on line during a good part of this decade. I think we can count on a long period of low prices for natural gas in the United States.

Sixth, all this makes the $4 billion in subsidies to encourage the use of natural gas as a fuel for trucks to fuel trucks included in the stripped down national energy bill proposed by Senate Majority Leader Harry Reid (Dem. Nev.) a reasonable first step in a transition away from an crude oil based transportation system. Natural gas is likely to remain abundant and low-priced long enough for such a policy to produce results and the market isn’t likely to force prices so hard to the upside that a move toward natural gas will turn into an expensive dead end. (Besides $4 billion for natural gas vehicles, the $15 billion legislation so far includes $5 billion in rebates for energy efficiency retrofits of houses, and $400 million for research on electric cars. It would also remove the current $75 million cap on oil company liability for an offshore oil spill. Retroactively. For more on why the proposed energy bill is as wimpy as it is see my post )

Now all this is based on projections, not on actual natural gas production. And as any wildcatter will tell you, studies don’t produce a calorie of energy—unless you burn them.

Right now there’s a lot of debate about exactly how much natural gas these shale formations will ultimately produce. Recent projections that have just about doubled U.S. natural gas reserves based on projected production from these shales, for example, are based on assumptions about the productive life of a natural gas well extrapolated from the life of conventional natural gas wells. There’s enough data now so that skeptics have begun to argue that these projections are wildly wrong because wells tapping unconventional shale reservoirs of gas show much faster rates of decline than wells in conventional fields. If that’s true, somewhere down the road, years away but sooner than we now think, that abundant supply of natural gas is going to get much tighter.

I’ll take a look at the state of the natural gas debate in the fall.

Full disclosure: I don’t own shares in any company mentioned in this post.

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