Will ConocoPhillips Help China Tap Its Shale Gas Reserves?

ConocoPhillips (NYSE:COP) is considering expanding its China portfolio to include shale gas. This was revealed by Mark Nelson, ConocoPhillips’ vice president of commercial and sustainable development, on the sidelines of the U.S.-China Oil & Gas Industry Forum in San Antonio, where Chinese government officials and energy executives met with their U.S. counterparts to discuss energy policy and attempt to form partnerships. ((ConocoPhillips Looking to Enter Shale Gas in China, WSJ))

China is expected to put up 17 shale gas blocks for auction in the coming weeks in a bid to develop a robust shale gas industry. It is hoping to attract American energy firms to invest in the industry and form partnerships with domestic companies. It wants to see the success of the American shale gas industry replicated in China. China had no commercial shale gas production in 2011, but has set itself an ambitious target of producing 229.5 billion cubic feet of shale gas a year by 2015.

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Importance Of Shale Gas

Shale gas is natural gas that is trapped inside shale rock and is extracted by using a technology called hydraulic fracturing, where highly pressurized water mixed with sand and chemicals is used to crack open rocks. It has completely altered the energy calculus for the U.S., resulting in a natural gas supply glut which has sent prices crashing down.

The natural gas output in the U.S. rose to 66 billion cubic feet a day in 2011, up from 56 billion cubic feet a day in 2001, according to the U.S. Energy Information Administration. Shale gas accounts for about 40% of U.S.’s domestic natural gas output. Without the contribution made by shale gas, production natural gas would have declined and the U.S. would have had to import massive quantities of liquefied natural gas. Natural gas is considered to be a bridge fuel between crude oil and the clean hydrogen-based energy sources of the future. Without it, the demand for crude oil would have risen beyond the current demand figures, thus having an impact on prices as well as broader geopolitical relations. ((China sets target for shale gas development, Financial Times))

Why China Also Wants A Piece Of The Action

China’s demand for energy is becoming increasingly insatiable. It imports vast quantities of crude oil besides using humongous quantities of coal to keep its economic engine humming. However, given the current discourse surrounding climate change and its own residents’ constant complaints about the heavily polluted air and water, China is keen to move to cleaner fuels.

Natural gas is one such option. The country already imports vast quantities of the same from countries like Australia, but it would like to unlock the potential of its own domestic reserves. It is estimated that recoverable shale gas reserves in China stand at 1.28 trillion cubic feet while total reserves may stand at 26 trillion cubic meters. According to the EIA, Chinese consumers used 39 billion cubic feet a day of natural gas in the first quarter of 2012. This demonstrates ample market demand for gas. Developing domestic reserves would also reduce China’s energy imports bill, diversify its energy mix by reducing dependence on crude oil, and make it self-reliant to some extent. ((China Considers Shale-Gas Potential, WSJ))

Why Invite Western Companies Like ConocoPhillips

The shale gas extraction technology is largely a preserve of Western oil and gas companies as they have developed this expertise in-house over time. China is keen that its own companies learn these technological and engineering aspects, which is quickened if they form joint ventures with Western firms. Prior to this, China had been focusing on persuading other countries to share this technology, arguing that a better use of its own energy resources would ease pressure on tight global markets.

We believe that this argument hasn’t gained much traction with foreign governments that see no reason to give away proprietary technology free-of-cost. Hence, for all its reluctance to share a resource that could become a major growth area for output and profits, we believe that China doesn’t have a choice but to make commercial deals.

Why ConocoPhillips Might Be Interested

ConocoPhillips already has large shale gas operations in the U.S. However, low gas prices in the U.S. due to a supply glut have forced Conoco to announce cuts in its plans to develop shale assets in the U.S. We think that it is now more keen to focus on international markets, particularly in Asia, where demand is robust and gas prices are higher. Hence, it has taken a step towards exploration of shale reserves in Australia. Gas from here would feed into the LNG plants Conoco is developing with Chevron (NYSE:CVX) to cater to markets such as Japan and China. We feel that nothing could be better than the opportunity to produce in the targeted consumer market itself, in this case China. This would reduce costs and boost margins for its natural gas business which accounts for 15% of the Trefis price estimate for ConocoPhillips.

Also, we believe that environmental regulations in China are much more relaxed than in other countries, which would reduce risk of liabilities and penalties. Considering that Conoco’s presence would most likely be as a part of some joint venture with a Chinese company, this risk would be further reduced.

We recently revised the Trefis price estimate for ConocoPhillips to $60 which is in line with its market price.

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