Source: China Oil Trader
Once bitten, twice shy. At least, that’s how it’s supposed to work.
Ever since CNOOC, one of China’s “big three” national oil companies, made an ill-fated bid to take over Unocal Corporation in 2005, Sino-U.S. energy relations have been marred with mistrust. Foreign acquisitions by China’s national oil companies thereafter have largely avoided the United States. Many were thus caught off guard by recent reports that Sinopec has emerged as a leading suitor for some of the $7 billion in natural gas assets that Chesapeake Energy must shed to avoid a breach of its debt covenants. Yet upon closer inspection, the move is deft and bears the imprint of lessons well-learned. Chinese national oil companies know from prior experience that in the United States they must wear kid gloves to avoid getting burned.
With U.S. natural gas prices projected to remain at $2-4/Mmbtu and far higher returns on investment elsewhere around the globe, why would Sinopec pour capital into American shale gas production when so many U.S. companies are shutting down rigs? There are a number of macro- and micro-dynamics at play here.
China’s demand for gas is expected to grow rapidly in the coming years. Natural gas currently accounts for only 4 percent of the country’s energy mix, but the International Energy Agency projects this rising to 13 percent by 2035. The same organization predicts that China will account for roughly a quarter of global gas demand growth over the same period. There is also a high level of uncertainty over how reliant the country will be on foreign gas. Much of this will depend on China’s ability to exploit its vast domestic shale gas resources. If unconventional development is well-orchestrated, Chinese gas imports as a share of total demand could be as low as 20 percent in 2035. Alternatively, slow progress in unconventional gas development could lead to a dependency rate north of 50 percent, according to the IEA.
In either scenario, a stake in Chesapeake’s gas assets could potentially pay dividends for China. Chesapeake was one of the first to commit wholeheartedly to the potential of shale gas in the United States. It has snatched up vast swaths of shale acreage, and possesses the technology and know-how to efficiently extract unconventional gas from these basins. Sinopec would love nothing more than to gain firsthand experience with hydraulic fracturing and horizontal drilling techniques that could eventually be applied to China’s massive shale resources. According to the U.S. Energy Information Administration, technically recoverable shale gas reserves in China are at least 50 percent greater than the sizeable shale endowment in the United States.
Sinopec drilled its first shale gas well in Chongqing on June 9, but until it develops the capacity to unlock domestic resources en masse at low cost, acquisitions are the quickest way to bolster its gas reserves. The company might be seeking to secure a dedicated stream of U.S. natural gas production for shipping to China as liquefied natural gas in the future. This is a complicated proposition, especially considering that the scale of U.S. LNG exports is highly uncertain. The prospect of rising domestic gas prices as a consequence of satiating Chinese demand would become a thorny political issue, whether merited or not.
At the corporate level, Sinopec’s own characteristics reveal an internal logic to the prospective Chesapeake deal. The move is driven by its international market-oriented new boss, Fu Chengyu. Fu served at the helm of CNOOC until 2010 and his failure to secure the Unocal deal in 2005 will undoubtedly inform his current attempt. Evidence of this can already be seen in Sinopec’s preference for partial assets over outright ownership. Of course, Sinopec precluding itself from an operational role also potentially distances it from the technologies and methodologies that it covets.
Nevertheless, Fu has remains tempted by U.S. shale gas assets with attractive valuations. Sinopec has been slower getting into America than its rival CNOOC, which recently entered into two billion-dollar joint ventures with Chesapeake in the Niobrara and Eagle Ford shale. Moreover, Sinopec suffers from an unbalanced portfolio, with too many loss-making refineries and too few premiere upstream assets. Oil and gas projects in Iran that have been abandoned by Western companies would normally be an attractive target, but Beijing has increasingly pressured national oil companies to curtail involvement in the pariah state.
Unsurprisingly, Sinopec has recently returned its gaze to the United States. Although U.S. natural gas won’t offer lucrative returns until prices rise, Chesapeake’s acreage is likely to sell at a discount and would allow Sinopec to hedge its holdings in more geopolitically tenuous markets. After his $2.5 billion deal with Devon Energy in January for stakes in five different liquids-rich shale plays, a tie-up with Chesapeake would solidify Fu’s reputation as a shrewd CEO.
For China, the deal offers another geopolitical hedge—the opportunity to turn dollar-denominated treasury bills into real energy assets. The Chinese government would likely play a key role in financing any large deals pursued by its national oil companies. This is an aspect of the deal worth watching. CNOOC’s critics back in 2005 objected to the assortment of low-interest and interest-free loans backed by Chinese government coffers. Were Sinopec to rely on a similar arrangement of state support, it might be met with resistance in the United States. But the U.S. congress is in a much weaker position than it was in 2005. Partial asset ownership is not the wholesale surrender of a strategic corporation, and the American natural gas industry would welcome with open arms the capital inflow.
This points to the most constructive way forward for both Washington and Beijing. China is still trying to grow a domestic shale gas industry without opening the market to international players. During the second round of shale gas bids in China, a small window was opened for other domestic companies, but none of them have more sophisticated technology than CNPC, Sinopec, or CNOOC. Sooner or later, China will realize that there are no shortcuts if shale gas is to be developed safely, efficiently, and responsibly. It should follow its own offshore oil exploration model, offering up its domestic market in return for cutting-edge technology. The Chesapeake deal may pay dividends to both the United States and China, but the synergy will go even further if Beijing eventually returns the favor at home.