China's Shale Gas Industry May Be Booming, But It Still Provides Just A Fraction Of Needed Energy

Primary Credit Analysts: Lawrence Lu, CFA, Hong Kong (852) 2533-3517; law.lu@standardandpoors.com Leo L Hu, Hong Kong +852 2533 3594; leo.hu@standardandpoors.com

Table Of Contents
Is The Production Breakthrough An Industry Game-Changer? A Regulatory Framework Is Needed To Support The Nascent Industry Upstream Oil And Gas Companies Should Benefit The Developing Industry Faces Many Hurdles Shale Gas Will Provide Just A Fraction Of Overall Energy Needs

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 21, 2014 1

1299490 | 301447691

China's Shale Gas Industry May Be Booming, But It Still Provides Just A Fraction Of Needed Energy
For the past decade, China has been searching far and wide for energy sources to fuel its rapid economic growth. However, it's also been looking within its own borders and, along with other strategies, turning its attention to shale gas. The state-run China Petroleum & Chemical Corp. (Sinopec), announced recently that its first commercial shale gas field--in rural Fuling--should reach production capacity of 1.8 billion cubic meters (bcm) of gas in 2014. Moreover, Sinopec forecasts 5bcm capacity next year, which is 10 times more than its previous forecast and quite significant considering China's total shale gas output was just 200 million cubic meters in 2013. As is always the case with shale gas, many obstacles lie ahead. For example, an adequate water supply must be readily available for the extraction process, more cost-effective technologies are needed to reach China's extra-deep reserves, and progress needs to be made in developing government policies in order to allow more private sector participation. To retrieve natural gas from shale formations, China will have to overcome these hurdles, and more, while maintaining environmental integrity and ensuring operational safety during the intensive hydraulic-fracturing (fracking) process. Nevertheless, China has set its sights on producing 60bcm to 100bcm of shale gas annually by 2020. Though we can't be certain that China will reach those numbers, Standard & Poor's Ratings Services expects continued progress in shale gas development, with increasing annual production volume. Assuming China is successful, we believe the result could be a positive credit factor for the country's upstream oil and gas companies. Overview China's new shale gas initiative is likely to ramp up production quickly. Shale gas development will likely be a positive credit factor for China's upstream oil and gas companies, as well as provide opportunities for independent oil and gas service companies. Still, large increases in shale gas production will satisfy only a small share of China's overall energy needs, meaning the country's energy trading patterns likely won't change soon.

Is The Production Breakthrough An Industry Game-Changer?

Sinopec made a splash in 2013 with news of its first major shale gas project. The field at Fuling, in the city of Chongqin (near the Sichuan Province basin), has delivered steady production, totaling 265 million cubic meters so far, and is ready to start delivering gas to customers. Fueled by its success in Fuling, Sinopec has sped up its shale gas exploration. At the same time, we understand Sinopec's largest competitor in China--China National Petroleum Corp.--has reported a 2015 shale gas production target of 2.6bcm. Combined, these factors increase the chances that the country's shale gas output will reach the 6.5bcm target set by the National Energy Administration of China for 2015. The government and China's exploration and production companies are wasting no time commercializing shale gas. In

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 21, 2014 2

1299490 | 301447691

China's Shale Gas Industry May Be Booming, But It Still Provides Just A Fraction Of Needed Energy

March, Sinopec and the Chongqing municipal government signed a strategic cooperation agreement, under which the Chongqing government will help finance infrastructure for the project. Sinopec is establishing China's first shale gas-based liquefied natural gas production facilities in Chongqing to sell gas locally, while also constructing pipelines to send gas to central and eastern China. These accomplishments come as no surprise, as robust Chinese energy demand, the need for energy security, and a push for low-emission fuel all support quick commercialization of any meaningful domestic shale gas discoveries. In addition, the benefit to local economies has prompted local governments to build infrastructure like roads and electricity networks to support the projects.

A Regulatory Framework Is Needed To Support The Nascent Industry

China's energy imports have grown so quickly over the past decade that the government is growing concerned that swings in international energy trade spending could restrain domestic economic growth (see "Asia-Pacific Energy Trade: A Hungry Region Extends Its Global Footprint" and "China's Search For Energy Leads It Outside The Region," published April 21, 2014, on RatingsDirect). In theory, at least, ramping up production of domestic shale gas and oil could help alleviate that pressure. China's shale gas reserves total as much as 1,115 trillion cubic feet and its oil reserves 32.2 billion barrels, according to the Energy Information Administration of the U.S. Therefore, we expect China's regulators to continue setting up a regulatory and policy framework supporting shale gas development, and to establish higher production targets for 2015-2020. In past years, the government had initiated supportive industry policies, including direct subsidies to shale gas producers (of Chinese remninbi (RMB) 0.4 per cubic meter produced) until 2015 and a waiver of certain resource taxes, among other perks. In addition, the government permits a market-pricing mechanism for shale gas, in contrast to regulated pricing for domestic natural gas.

Upstream Oil And Gas Companies Should Benefit

Greater development of these resources will benefit the business risk profiles of China's upstream companies by diversifying their hydrocarbon resources and significantly increasing their nonconventional reserves. Moreover, once companies develop these resources, their cash flow and profits will grow. In addition, increased shale gas production should provide more opportunities for China's independent energy service and equipment companies. Based on the geological features of China's shale gas reserves (which are deeper than in the U.S.), the per-well capital expenditure required could be more than RMB80 million, significantly higher than in the U.S. We expect the affiliates of China's national oil companies will benefit most from the capital spending but independent companies that can provide superior equipment, drilling, and production services, as well as enhanced efficiency and environmental protection, should also see a considerable amount of demand from upstream companies. The independent companies could do even better should China further open shale gas development to the private sector, which is more likely to turn to independent service providers for better operating efficiency. In fact, various independent companies in China already are developing a new generation of fracking equipment and more sophisticated services, through both their own research and partnerships with international leaders in the industry.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 21, 2014 3

1299490 | 301447691

China's Shale Gas Industry May Be Booming, But It Still Provides Just A Fraction Of Needed Energy

The Developing Industry Faces Many Hurdles

Developing cost-effective new technology will be key to maximizing volumes from shale wells and slowing the speed at which those decline. Improved technology can also enable more efficient use of water during fracking, which is especially important in gas-rich, water-poor basins in northwest China. Even where water is relatively abundant, China's large population places enormous demands on water resources. Efficient water use and better gas-extraction technology might also lessen the chances that fracking will induce minor seismic activity in earthquake-prone shale areas. Decreasing these risks could help open up more acreage for shale gas development. In the most recent round of bidding for shale gas reserves in 2012, the government awarded contracts to only two private companies, while 17 winning bids came from central or local state-owned enterprises. Moreover, state-owned companies currently control the majority of the most easily recoverable reserves. However, should the government permit more private sector participation in shale gas development, we believe the participating companies would likely invest more heavily in the sector, which could lead to accelerated technology development and increased commercial production as has happened in the U.S.

Shale Gas Will Provide Just A Fraction Of Overall Energy Needs

Of course, even rapid shale gas development will only slightly reduce China's energy trade deficit, at least for the next few years. According to a BP Statistical Review of World Energy (June 2013), China had an oil and gas consumption-production gap of more than 300 million metric tons (of oil and oil equivalent) as of 2012. If this gap remains the same, the 2015 shale gas production target of 6.5bcm (equal to less than six million metric tons of oil equivalent) still represents less than 2% of the gap. In other words, no matter how much shale gas China finds, the bulk of its oil and gas production will continue to come from conventional resources (which was 207.5 million metric tons and 107.2bcm, respectively, as of 2012). Nevertheless, the 1,115 trillion cubic feet of estimated China shale gas reserves is undoubtedly one of the resources that will help the country move toward energy self-sufficiency. The Fuling project provides China with the hope that energy independence is more than just a dream. As a result, we expect further breakthroughs in China. In the near future, the Chinese government will hold a third round of bidding for shale gas reserves. The quality of assets on the auction block, the number of private sector bidders, and the number of those that win bids will all be clues to how much potential lies ahead for shale gas in China. Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 21, 2014 4

1299490 | 301447691

Copyright 2014 Standard & Poor's Financial Services LLC, a part of McGraw Hill Financial. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 21, 2014 5

1299490 | 301447691