fracking

Fracking's hottest year in China

April 11, 2014: 6:50 AM ET

A new discovery pushes China closer to meeting its shale gas production goals.

140122171413-fracking-620xaFORTUNE -- For more than a year, China's goal of recovering 6.5 billion cubic meters of natural gas by 2015 via hydraulic fracturing, or fracking, seemed like a pipe dream. The figure was announced in 2012, along with the government's even more ambitious goal of producing at least 60 billion cubic meters by 2020. How do you grow that fast in just a few years from basically zero, especially when your country is new to fracking, a controversial method of drilling that blasts water and chemicals into rock formations to release trapped gas?

Analysts had been dismissive.

Until late last month. That's when everyone's outlook changed after the state oil and gas giant Sinopec (SNP) announced "significant breakthroughs" at its Fuling shale gas field in the country's southern Sichuan province. Sinopec, which along with China's other state-owned oil and gas giant CNPC controls 75% of shale fields in China, said it will almost single-handedly meet China's goal and produce 5 billion cubic meters by 2015 at Fuling. Sinopec said by 2017 it would produce 10 billion cubic meters at China's first big shale gas field and that the company was pushing hard for more shale gas discoveries. Its chairman told reporters that Sinopec would use proceeds from selling a stake in its gas station business to fund more shale fields.

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The Fuling discovery might not have happened if the Chinese government hadn't changed the incentives for drilling shale gas reserves, which the country's Ministry of Land and Resources estimates to be the world's largest and a third-larger in size than America's. Most importantly the government raised the prices paid to Sinopec and others for new gas supply by up to 40% and tied future increases to global oil prices. The price of natural gas for nonresidential users in Chinese cities rose by 15%. Fuling's gas headed to China's eastern markets like Shanghai now has a profit margin, says Nate Taplin, energy analyst at Gavekal Dragonomics in Hong Kong. Just a couple years ago it was a money-losing proposition.

The other important government reform came via China's National Energy Administration, which said that all natural gas pipelines would be made open to third-party drillers, the small operators that dominate the landscape in the U.S. Before, smaller Chinese drillers weren't guaranteed transport for their gas from drilling sites. CNPC, the parent of PetroChina, operates 80% of the natural gas pipelines, and it wasn't handing out invitations to use its network. Even though Sinopec and CNPC still control three-quarters of the country's shale blocks, at least now the companies bidding on the other 25% of reserves are one step closer to getting their gas to market.

The political winds have also encouraged shale gas fracking in China. Sinopec's rival CNPC dominates production of conventional natural gas in the country, with around 75% market share. It didn't have many reasons to push into unconventional shale gas plays. But China's new administration lead by President Xi Jinping and Premier Li Keqiang has diminished CNPC's stature after targeting top CNPC officials in a nationwide corruption crackdown -- most notably the former CNPC chairman and minister of public security Zhou Yongkang. Because of its reduced influence, CNPC is now less likely to push back against the government's fracking goals.

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Sinopec looks like the biggest winner for now. It's building a liquefied natural gas plant near its Fuling field to move shale gas into the LNG market, where prices are unregulated by the government and can trade higher. "For shale gas, since production is not as big as natural gas, in the beginning it will probably be traded in LNG market," says Liao Na, a vice president at energy consultant ICIS in Guangzhou.

Over the longer-term, CNPC and multinationals will all help China realize its shale gas potential. Shell (RDSA), Chevron (CVX), and ConocoPhillips (COPare circling China's massive shale fields. The U.S. Energy Information Administration is more aggressive than its Chinese counterpart, estimating that China's shale gas reserves are 68% higher than those in the U.S.

Challenges for China remain: The country's topography is more problematic than America's, and deposits are sometimes buried twice as deep in the ground, making shale gas costlier to excavate; the water-intensive fracking process is a drain on China's already scarce resources; and the country still lacks some necessary technology. But Sinopec's new forecast makes it undeniable that China is moving closer to realizing its shale gas potential.

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