An untapped resource

Major governmental agencies

Following government reorganisation of the energy sector in 1998, the oil and gas regulatory functions were allocated to various ministries, including the State Economic and Trade Commission, the State Development Planning Commission (now, National Development and Reform Commission (NDRC) and MOLAR. Under the current regulatory regime, responsibility for the energy sector is shared between various governmental bodies, including the NDRC and its National Energy Bureau, MOLAR, the State Administration of Work Safety, the Ministry of Commerce (MOC), the State Administration of Taxation, the Ministry of Finance and the Ministry of Environmental Protection.

Exploration block registration and licence

The Measures for the Administration of Registration of Mineral Resource Exploration Blocks (矿产资源勘查区块登记管理办法) are applicable to foreign investment in mineral resources and govern the registration of exploration blocks. China has a unified block registration system for the exploration of mineral resources and, under these regulations, each area open to exploration is divided into units.

Only blocks with prior NDRC approval may be made available for foreign investment and an exploration licence must be obtained before operations may commence. The applicant and the owner of an exploration licence, in the case of foreign-invested activities, must be the Chinese partner. It is the Chinese partner that must submit the plans for the exploration and development of the block and documents showing the qualifications of the party to carry out the project operations.

Exploitation registration and licence

Once a commercial discovery is made, the Measures for the Administration of Registration for Exploitation of Mineral Resources (矿产资源开采登记管理办法) will apply. As with the exploration licence, the application for a development or production licence must be submitted by the Chinese partner and accompanied by evidence of the qualifications of the party conducting operations, the project's development or production plans and an environmental impact report. In addition, the application must include an area delineation of the block that the parties plan to develop.

The term of the development licence is proposed in the overall development plan, which must be approved by the NDRC. The term of a production licence will vary depending on the size of the projects: large projects attract up to a 30-year term; medium scope projects receive up to 20 years; and small projects may have up to 10 years. Each term is subject to an extension. Issuance of the production licence is preceded by the preparation of a reserve report, which identifies the anticipated productive life of the field, which in turn determines the initial term of the licence. Where the production licence is part of a production sharing contract (PSC), the production period is normally fixed at 15 to 20 years, subject to extension.

MOLAR has principal responsibility for issuing production licences at the national-level, though some projects may still be subject to scrutiny by provincial and local governments depending on their size.

China has set a cumulative target of 6.5 bcm of unconventional gas production by 2015 and 80 bcm by 2020. However, to date, aside from the general framework for mineral exploitation discussed above, China has not established a legal framework to facilitate the development of shale gas on such a scale.

Foreign Investment Industrial Guidance Catalogue

Concurrently with the announcement of shale gas as the 172nd mineral asset, in December 2011, shale gas was added to the encouraged category under the Foreign Investment Industrial Guidance Catalogue (外商投资产业指导目). As a result, shale gas development projects may be carried out through equity joint ventures or contractual/cooperative joint ventures (JVs). Foreign investment through Sino-foreign JVs is highly regulated in China and subject to various foreign investment regulations, ranging from general JV regulations to specific restrictions on foreign investments in certain industries.

Additional guidelines

After classifying shale gas development as an encouraged activity, China adopted several guidelines in 2012 to foster the development of shale gas resources. These include the Shale Gas Development Plan for 2011-2015 (页岩气发展规划 2011 to 2015) (Shale Gas Plan) published on March 13 2012 and a Circular on Strengthening Relevant Work on the Exploration and Exploitation of Shale Gas Resources and the Regulation Thereof
(关于加强页岩气资源勘查开采和监督管理有关工作的通知) (Shale Gas Circular) effective from October 26 2012.

The Shale Gas Plan calls for increased government investment in shale gas surveys and appraisal, the development of shale gas technology, exploration and production systems, introduction of incentive policies and improvement of shale gas infrastructure. The Shale Gas Circular sets out a number of important principles for the development of shale gas resources including: (a) the exploration licence holder must be a legal entity incorporated in China with certain financial capability and exploration qualifications; (b) foreign investors with shale gas exploitation technology are encouraged to participate in the exploration of shale gas through the JV model; and (c) shale gas areas that are within areas registered for conventional oil and gas exploitation but are not developed quickly must be relinquished to MOLAR for future auction.

China has not promulgated any implementing regulations or issued any guidance on how to implement a shale gas project using the JV model. While some foreign investors are discussing the JV model with potential Chinese partners, others are still trying to negotiate a structure akin to a PSC with which they are more familiar. This approach gained legitimacy with foreign investors as a result of Shell's announcement in March 2012 that it had entered into the first and only shale gas PSC in China with CNPC. The commercial terms of the Shell PSC remain unknown to the public.

Development subsidy

Following issuance of the Shale Gas Circular, in November 2012, the Ministry of Finance and NDRC issued a notice that the subsidy for shale gas projects from year 2012 to year 2015 would be Rmb0.4 /m3, which is twice the subsidy granted to CBM projects. More incentive policies, such as preferential tax treatment, are under consideration.

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Entering the shale gas market

Private negotiations

Currently, most foreign investors are pursuing their interest in shale gas via private negotiations with Chinese national oil and gas companies over a joint studies agreement, with the hope of acquiring the right to enter into a PSC in the future if the joint study area proves promising. Notwithstanding the reported Shell PSC, due to the lack of regulations on the royalty and tax treatment of shale gas projects, foreign investors may have difficulties arriving at a fully termed PSC with Chinese partners.

Public auction

Foreign investors may also enter the market by way of the auction process by forming a JV with a Chinese entity. If the JV wins a block on auction, the JV will receive an exploration licence from MOLAR, the term of which may be a maximum of three years. The JV will be the 100% interest owner of the shale gas block. During the three-year term, the JV must fulfil the minimum work programme and budget included in its bid or the exploration licence will be revoked. When a commercial discovery is made, the JV will have priority to obtain a mining permit from MOLAR to bring the project into production.

During the second auction, a number of Chinese entities that held exploration qualifications but lacked adequate technology or funds to support a shale gas project began looking for foreign investors. Unsurprisingly, none of the winners was a JV. This is probably due to the difficulties associated with the formation of a JV in China, which takes three to six months. Thus, it would have been very difficult, if not impossible, for any JVs to have been incorporated and positioned to participate in the auction during the short period of time between notice of the MOLAR bid invitation and the submission deadline. The adoption of a JV model requires significant discussion among the parties, and the lack of specific regulations regarding JVs for shale gas projects would only slow down the negotiations between partners. We are aware of negotiations of JVs between a number foreign inventors and Chinese entities, but it is difficult to predict the outcome of these negotiations.

MOLAR is currently planning its third auction. An official of MOLAR revealed at the Fifth Conference of China Unconventional Gas that the third auction may be held by the end of this year. Eight to 10 blocks are expected to be available for the auction. While foreign investors may be encouraged to participate in the third auction, they may only invest in shale gas projects by way of a joint venture in accordance with the Foreign Investment Industrial Guidance Catalogue and then only as a minority partner insofar as 100% foreign ownership of a PRC joint venture is not permitted.

JV model

As mentioned earlier, China has not yet adopted any specific regulatory requirements governing the JV model to be used for the development of shale gas resources. Theoretically, the JV model should not be different from any other type of Sino-foreign joint venture investment in China, where foreign companies make profits through dividends distributed by the JV. Our recent experience representing international oil and gas companies making shale gas investments in China suggests that notwithstanding the Shell PSC announcement, the Chinese national oil and gas companies are still inclined to utilise a JV model for their projects rather than a PSC model.

If a foreign investor and its Chinese partner wish to develop a shale gas block through a JV, they will need to be prepared for a number of differences between the PSC model and the JV model, see figure 1 for a list of the key differences.

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Challenges ahead

Despite the strong interest in shale gas and the opportunity that it poses to help address China's energy deficit, China still faces numerous challenges in developing these resources:

• First, and perhaps foremost, no single set of rules exists to facilitate or regulate the licensing, exploration and production of shale gas, and preferential policies, other than the recently adopted subsidy to support its development.
• Most of China's shale gas resources are located in mountainous, rocky or desert areas, which makes exploitation more complicated and more costly than operations in other shale gas rich countries like the United States.
• Due to the remote location of the shale gas reserves, their distance from China's existing pipeline network could impede shale gas development.
• Like elsewhere, shale gas development consumes a significant amount of water; many areas in China with abundant shale gas resources already face serious water supply issues.
• Finally, there are growing concerns that hydraulic fracturing may have a harmful effect on the environment, and that the participation of private companies in the pursuit of shale gas may place further pressure on the environment.

The authors wish to thank Vivi Zhou of the Beijing Office and Ostiane Goh-Livorness of the Hong Kong Office for their assistance in the process of preparing this article

Mike Arruda and Joanne Du, Jones Day, Hong Kong