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25 June 2012 Asia Pacific/China Equity Research

Energy / Oil & Gas

China Oil and Gas Sector SECTOR REVIEW

Chinese shale gas: 'Embryonic energy'? Figure 1: US actual versus CS China shale gas production scenarios

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Source: US EIA, NDRC, Credit Suisse estimates

China recently announced aggressive shale gas production targets: 6.5 Bcm by 2015 and 60-100 Bcm by 2020. In this report, we look at China’s embryonic shale gas story, to assess both progress and prospectivity thus far.

■ The driver—energy security: Without shale gas, China will be 50% dependent on imported gas by 2020, but would not need further gas imports if shale production hits the upper target of 100 Bcm.

■ The main challenge—‘time on the block’: Water will be an issue, but no more so than in the US; indigenous rig capability is reasonable, while the horsepower is lacking—we conclude that a lack of experience with the Chinese shale geology is the largest challenge to the 2020 target.

■ The math—60 Bcm by 2020 is aggressive, but not ridiculous: Our base case suggests that 1,600 wells p.a. could be required by 2020 to hit the lower end of the production target (60 Bcm).

■ Still in the learning phase—look to service providers: Given the embryonic state of the shale story in China we suspect the theme is better played through service sector providers, both rig producers, well drilling/fracturing contractors as well as drill pipe providers.

Research Analysts

David Hewitt 65 6212 3064

[email protected]

Horace Tse 852 2101 7379

[email protected]

[email protected] FIRST LAST 06/26/12 01:09:01 PM Hong Kong Highpower

25 June 2012

China Oil and Gas Sector 2

Focus charts Figure 2: Effect of shale gas on China’s gas production

balance—60 Bcm case by 2020

Figure 3: China un-contracted gas import requirements—

three scenarios

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Figure 4: China—shale gas supply cost vs. LNG/Central

Asia imported gas

Figure 5: China NDRC’s shale gas production target range

vs. the US

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Figure 6: US actual versus China drill-up scenarios Figure 7: China—extrapolated US growth to 2023

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25 June 2012


Shale gas in China: ‘Embryonic energy’? China recently announced aggressive shale gas production targets: 6.5 Bcm (0.6 Bcf/d) by 2015 and 60-100 Bcm (5.8–9.7 Bcf/d) by 2020. In this report, we look at China’s embryonic shale gas story, to assess both progress and prospectivity thus far.

The driver: Energy security China is learning the hard way the challenges of being significantly dependent on imported crude oil going forward. With an abundance of indigenous unconventional gas we suspect China’s planners are keen to avoid the same degree of dependence in gas. With no domestic shale gas production, by 2020 China would have to commit to a further 80 Bcm of gas imports—but if domestic shale does hit the target range (60-100 Bcm by 2020) the need for further gas imports would be largely obviated. This is clearly important from an energy security perspective but would also significantly reduce the input cost of that incremental gas, assuming that domestically sourced shale gas could significantly undercut pipeline and LNG imports.

The main challenge: ‘Time on the block’ We look through the primary challenges for shale developments in China, concluding that while water is precious in China its use in shale would be no more of a challenge that in the US (and a very small percentage of the national total), that China has both indigenous rig construction capability and a reasonably large (if not specialised for shale) fleet and that pipeline would be an issue if the ambitious planned gas pipe expansions were not achieved. The real challenge, in our opinion, will be building experience exploring/ exploiting Chinese shale to reach the production take-off point the US hit in 2006.

The math: 60 Bcm by 2020—aggressive, but not ridiculous We run a base case, assuming an average initial well production (IP) of 4 mmcfd and an average Estimate Ultimate Recovery (EUR) of 2.3 Bcf per well. Under such a scenario China would need to be drilling 1,500-1,600 shale wells annually from 2018 to hit the 60 Bcm target. If the US experience is in any way Chinese production in 2015 will be important. Applying the US 2006-11 experience to China (2015-20) suggests it could hit the 60 Bcm target by 2022, and 100 Bcm the following year.

Still in the learning phase—look to service suppliers The upcoming award of 20 new shale gas blocks will spark a wave of exploratory activity in the sector, building on the initial work being done on the ‘trial’ blocks. With a meaningful potential production ramp-up in China it would seem logical to focus on the shale service sector. We look through the sector value chain identifying Chinese players like rig-maker Honghua (0196.HK, Not Rated), Pressure pump supplier Yantai Jereh (002353.SZ, Not Rated), proppant supplier Enti (unlisted), and drilling service players Anton Oil (3337.HK, Not Rated), SPT Energy (1251.HK, Not Rated) and Sinopec Engineering (unlisted).

China clearly doesn’t want gas to have the same degree of dependency as oil

Experience in exploring/ exploiting Chinese shale could be the real challenge, in our opinion

China will need to drill 1,500-1,600 shale wells p.a. from 2018 to reach the 60 Bcm

We identify a few listed OFS players that are exposed to the potential shale gas boom


25 June 2012


Sector valuation Figure 8: China’s shale gas value chain

Upstreamplayer

Equipment/materialssupplier

Oilfield Serviceprovider

Mid/downstreamoperator

PetroChina (857 HK)Sinopec (386 HK)CNOOC (883 HK)Shell (RDSa.L)Chevron (CVX)

Land rigs:Honghua (196 HK)BOMCO (not listed)Lanzhou Lanshi (not listed)RG Petro Machinery (not listed)

Pressure pumps:Yantai Jereh (002353 SZ)

Proppants:Carbo (CRR US)Saint-Gobain (SGO FP)Yixing Orient Petroleum Proppant(not listed)ENTI (not listed)

Anton Oil (3337 HK)SPT Energy (1251 HK)Hilong (1623 HK)COSL (2883 HK)Sinopec Engineering(not listed)Orion Energy (not listed)

Water purification:Aegis (not listed)

CNG/LNG transportation:CIMC Enric (3899 HK)

NGV:Weichai-Westport (not listed)Kunlun Energy (135 HK)

Source: Credit Suisse estimates

Figure 9: China’s shale gas value chain—valuation comps Price TP Mkt cap 6M trading vol P/E (x) EV/EBITDA (x) P/B (x) ROE (%) Net D/E

Company Ticker FX Rat. LC/sh LC/sh US$ mn US$ mn 12E 13E 12E 13E 11A 12E 13E 11A

Upstream players

PetroChina 0857.HK HK$ O 10.46 13.30 246,707 98 10.2 10.9 5.2 5.1 1.57 14.1% 12.2% 26%

Sinopec 0386.HK HK$ N 7.00 7.05 78,213 82 8.1 14.8 4.6 5.6 1.05 12.1% 6.5% 44%

CNOOC 0883.HK HK$ O 14.98 18.30 86,188 119 6.5 6.3 3.4 3.2 2.09 25.7% 22.1% Net cash

Royal Dutch Shell RDSa.L £ N 2,131 2,530 85,395 113 4.5 4.2 2.3 2.1 0.78 15.4% 15.1% 15%

Chevron CVX US$ O 100.0 130.0 198,265 209 7.0 6.2 2.9 2.7 1.62 20.3% 19.6% Net cash

Oilfield Service provider

Anton Oil 3337.HK HK$ NR 1.16 - 317 0.61 10.8 7.2 4.7 3.5 1.21 7.3% 12.9% Net cash

SPT Energy 1251.HK HK$ NR 1.34 - 231 0.79 5.4 4.0 2.9 2.3 1.69 23.9% 24.1% Net cash

Hilong 1623.HK HK$ NR 1.85 - 349 5.5 4.7 3.5 3.1 1.19 17.5% 17.9% 21%

COSL 2883.HK HK$ O 11.08 14.00 6,419 12.9 8.7 7.9 6.8 6.2 1.44 15.1% 14.8% 76%

Schlumberger SLB US$ NR 62.56 - 83,427 186 14.7 12.0 7.8 6.7 2.67 18.0% 20.2% 16%

Haliburton HAL US$ NR 28.35 - 26,167 116 8.6 7.7 4.4 3.9 1.98 20.7% 20.3% 16%

Lang rig manufacturer

Honghua 0196.HK HK$ NR 1.25 - 519 0.46 7.6 5.5 3.4 2.7 0.81 8.6% 10.5% Net cash

Pressure pump manufacturer

Yantai Jereh 002353.SZ RMB NR 45.87 - 3,310 12.9 35.1 25.1 26.0 18.3 8.18 20.2% 22.6% Net cash

Proppants supplier

Carbo CRR US$ NR 75.70 - 1,748 71 13.9 11.2 7.2 5.7 2.77 17.0% 17.9% Net cash

St. Gobain SGOB.PA € O 27.73 37.00 11,842 61 8.6 7.6 4.6 4.3 0.82 9.0% 9.8% 44%

Note: O = OUTPERFORM, N = NEUTRAL, U = UNDERPERFORM, NR = NOT RATED

Source: I/B/E/S, company data, Credit Suisse estimates


25 June 2012


Government drivers Energy security is at the heart of China’s push into shale: China faces a hard future with oil supply—potentially having to import 10 mn barrels per day by 2020, 10% of estimated global production. While gas only plays a minor role in primary energy use (currently at 4%), China wants to increase gas’ share in the total mix, for both environmental reasons and overall growth factors. What China does not want to do is end up with a gas supply as dependent on foreign sources as it is for oil.

Figure 10: China / US—exploitable shale gas reserve estimates

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China may have twice the shale gas reserves in the US: At the start of 2012, the EIA significantly reduced its estimate of technically recoverable shale gas reserves to 482 Tcf (13.6 Tcm). In March this year the Chinese Ministry of Land & Resources estimated that China has 25.1 Tcm of exploitable onshore shale gas reserves (lower than the previous EIA estimate of 36 Tcm).

Figure 11: China—potential import scenario without domestic shale production

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25 June 2012


Without shale production China could be 50% dependent on imported gas by 2020: Assuming conventional domestic production attains a 9% CAGR, CBM hits 30 Bcm/year by 2020 and demand sees a 15% CAGR, the call on import gas (LNG and pipeline) would be 180 Bcm/year—around 50% of total gas demand at that time. Currently, China has long-term LNG contracts for 51 Bcm/year (including options for projects not yet sanctioned i.e., APLNG) and 52-87 Bcm/year of pipeline contracts with Turkmenistan, Kazakhstan and Myanmar (the range reflects a further 35 Bcm/year rumoured to have been committed to by China with Turkmenistan) —leaving a shortfall of 42 to 77 Bcm/year.

Figure 12: Effect of shale gas on China’s gas production balance—60 Bcm case by 2020

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Import dependency would reduce to 20-30% if shale ‘succeeds’: The government has a quoted target of shale gas production between 60 Bcm and 100 Bcm/year by 2020 (and 6.5 Bcm in 2015)—if this is achievable, it significantly reduces the need for further gas imports beyond those already committed to. If the higher 100 Bcm target was hit 79 Bcm/year of gas imports would be required, which would be more than met by existing import contracts and the additional 35 Bcm/year Turkmenistan supply.

Figure 13: Effect of shale gas on China’s gas production balance—100 Bcm case by 2020

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25 June 2012


China would need to contract for further gas from 2017, without W-E III: With no shale production and without the additional 35 Bcm/year speculated to have been agreed from Turkmenistan (‘W-E III’), China would be short gas by 2017, in our scenario (demand sees a 15% CAGR going forward), the 60 Bcm target by 2020 would extend that need to 2019, and the 100 Bcm target by 2020 would mean China not having to contract for any further import gas in this decade.

Figure 14: China un-contracted gas import requirements—three scenarios

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With W-E III and shale production the door is firmly shut for further gas imports: Under the same demand scenario, but bringing W-E III into the base case (20 Bcm in 2016, 35 Bcm/year thereafter) would mean that ‘even’ 60 Bcm/year by 2020 would leave China long gas to the end of the decade; if it hits the 100 Bcm/year upper target, it would be 60 Bcm/year long gas in 2020.

Figure 15: China—un-contracted gas import requirements (incl. Turkmenistan II gas)—

three scenarios

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Gas cost also drives the focus on shale: CS is not a believer in global LNG price convergence, and expects APAC LNG prices to continue to be significantly correlated to crude oil through the remainder of the decade and into the next (please see our recent


25 June 2012


Global LNG Sector update report, Tighter then looser, 8 June 2012). We estimate a 40% correlation to crude for the Turkmenistan gas, at the country border, with a further US$2.3/mcf as the transportation fee through Kazakhstan/Uzbekistan—hence at US$100/bbl this suggests a price at China’s western boundary of US$9/mcf—and a provincial gate cost to supply of US$13-13.5/mcf for eastern seaboard provinces.

For LNG, we expect landed prices in North Asia to sit in the US$18-19/mmbtu range until the mid of the decade, then fall back to circa US$14/mmbtu as crude moves back into an ‘equilibrium’ pricing range (we would add US$1/mmbtu as a placeholder for re-gas cost to convert DES LNG prices to a provincial gate price). If shale is produced in Sichuan and it follows a broadly similar scale/unit cost to produce reduction as the US shale gas could be produced at circa US$4/mcf (well-head), hence a Provincial gate supply cost (including a return to the upstream) of circa US$6/mcf in the Eastern Seaboard provinces.

Figure 16: China—shale gas supply cost vs LNG/Central Asia imported gas

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25 June 2012


The target Figure 17: China NDRC’s shale gas production target range

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6.5 Bcm by 2015, 60 to 100 Bcm by 2020: The current five-year plan is primarily dedicated to China accelerating through the exploration and appraisal phase for domestic shale gas production, with the hope that this pre-work translates into an aggressive production ramp-up in the 2016–20 plan period—hence, the target of 6.5 Bcm/year by 2015 and a broad target range of 60 to 100 Bcm/year by 2020.

Figure 18: US actual vs CS China shale gas production scenarios (time sequenced)

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China—purely for comparison purposes

Source: US EIA, NDRC, Credit Suisse estimates

Is China hoping that 2015 is ‘US 2006’? The US recorded a very pedestrian rate of shale production growth during 2000–05, but really accelerated on both percentage and absolute production growth terms in and after 2006, going from 15 Bcm in 2005 to 31 Bcm in 2006 (+107% YoY), then adding 40-50% annually thereafter.


25 June 2012


Figure 19: US actual versus China drill up scenarios

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The 60 Bcm target is not completely unrealistic—though 100 Bcm looks unrealistic: In our scenarios, we assume China achieves its 6.5 Bcm shale gas production target in 2015, and ramps up from that level to achieve the lower and upper ends of the announced target. To reach 60 Bcm by 2020 requires production to attain a CAGR of 56% over 2016-20, while the 100 Bcm target would require a production CAGR of 72%. Figure 19 shows the percentage ramp-up required vs the US actual experience—which recorded a production CAGR of 42% during the 2006-11 period.

Figure 20: China—shale gas production following a US growth trajectory

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10-17 Bcm in 2015 would be a much better ramping point in China: Just for the analysis’ sake we apply the US production ramp during 2007–11 to the 6.5 Bcm that China targets by 2015 which would suggest 38 Bcm production by 2020. However, if China was producing 10 Bcm in 2015, applying the US production ramp would see China achieving the 60 Bcm target by 2020, and the 100 Bcm target would be achieved if 2015 production was 17 Bcm.


25 June 2012


Figure 21: China—extrapolated US growth to 2023

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Is 2021–23 a more realistic target? Again, starting with the 6.5 Bcm production target in 2015, if we use the average 42% US production CAGR (2006-11) China would hit the 60 Bcm target in 2022 and 100 Bcm in 2023.


25 June 2012


China—the story so far Prospectivity—twice as large as in the US: The Sichuan and Tarim basins are deemed to be the most prospective at this point, with deposits also in the Ordos, Junggar, Tuha and Bohai basins. The most recent forecast of recoverable shale resources in China is 25 Tcm (EIA – 2012 estimate)—similar to the US. Chinese estimates vary for in-place and recoverable resources, but conclude that some 70% of the total shale gas in-place is in three marine shale areas, namely South China, North China and the Tarim basin.

Two shale gas blocks formally awarded thus far: The MLR (Ministry of Land and Resources) offered four shale gas blocks in 2011 to six qualified bidders, of which two were eventually taken up—one by Sinopec (Nanchuan block) and the other by Henan Provincial Coal Gas Dev’t & Utilisation Co (Henan CBM – the Xuishan block); both blocks are in Chongqing. The bid requires a minimum US$3,000 spend/km p.a.

Figure 22: China—current view of shale gas deposits distribution

Source: US EIA

20 further blocks to be bid in 2012: The second round of bidding has been delayed since late 2011, likely due to the disappointing response in the first round, and a focus on which type of entities should be eligible to bid. Initially, the plan was for only Chinese SOEs to be involved in the bids—but this appears to have since been extended to both Chinese independents and foreign companies in a JV with a suitable local partner. Apparently 17 companies have pre-qualified for the second round (source OGP – 15 May 2012).


25 June 2012


63 test wells drilled up to April 2012: Of these 63 wells, 58 are shale gas and five shale oil wells, with 15 of these being horizontal. In 2011, 18 shale wells were drilled in China, of which 16 were vertical and two horizontal. Industry sources suggest vertical frac wells cost an average of US$250,000 per well, while horizontal fracs cost an average US$600,000/well.

Multiple ‘trial’ initiatives between Chinese and foreign entities: PetroChina is working with Shell, and is now in the process of converting its trial agreement with Shell into a Production Sharing Contract (PSC) for the Fushan-Yongchuan shale gas play in Sichuan (awaiting final approval). It has also signed a trial agreement with Henan CBM for the Xuishan block. Apart from PetroChina, CNOOC apparently is also working with Shell in Anhui—the two have signed a joint study agreement (JSA) that will commit Shell to providing technical assistance for CNOOC to explore shale gas.

BP is working with Sinopec while Total also recently signed a pact to work on shale with Sinopec. Chevron has announced it is working in the Qianna basin, and is starting seismic data capture in July. Exxon is also working with Sinopec, in a study signed in mid-2011 in Sichuan. Statoil is reportedly in talks with Shenhua. PetroChina is also reportedly working with Conoco on shale gas exploration.

Shell appears ahead at this point: Converting its trial agreement into a PSC is a major step forward for Shell/CNPC PetroChina. So far, 15 shale wells have reportedly been drilled, with Yang 101 + 102 each producing an average of 100,000m3/day (3.5 mn cubic feet/day) on the 3,500 km2 Fushan block. Shell is talking about a drill-up programme of 500-1,000 wells. It has already purchased three shale gas rigs from Honghua (0196.HK, Not Rated), and stated its plans (Source: Upstream publication) to use 30 frac units in the drill up of the Fushan block. The same article talked about Shell committing to spend US$1 bn/year over the next five years on shale in China. The next phase is the bid and award of a Front End Engineering and Design (FEED) contract for the development of the block. Worley Parsons, Fluor and AMEC are all reportedly interested in participating—although a local partner is thought to be required for these companies to be eligible to bid.


25 June 2012


The math Shale gas production declines rapidly in the first few years of well cycle. Unlike conventional oil and gas production wells, shale wells typically decline rapidly in the early part of a well cycle and then slow down towards the middle and latter part. In our typical shale gas well, we have production declining by 73% by the end of Year 1, 37% by Year 2 and 25% by Year 3. At the start of Year 4, we already have flow rates 90% below the initial production. This mirrors production declines of 75% in the first four years in Marcellus shale area in the US.

We assume an initial production (IP) rate of 4 mmcfd in our base case. We also run scenarios around our base case—in the high case scenario, we assume an IP rate of 8 mmcfd, while in our low case scenario, we assume an IP rate of 2 mmcfd. Under our base case the EUR reaches 2.3 bcf per well, and in our high and low cases the EUR is at 4.6 bcf and 1.2 bcf per well, respectively.

Figure 23: Production curve for a typical shale gas well

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Figure 24: Shale gas production curve—high case Figure 25: Shale gas production curve—low case

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25 June 2012


Figure 26: Number of wells required to get to 60 Bcm/100 Bcm NDRC target 60 Bcm scenario 100 Bcm scenario

Low Base High Low Base High

IP rate (mmcfd) 2.0 4.0 8.0 2.0 4.0 8.0

Cumulative # of wells – by 2015 820 410 205 820 410 205

Cumulative # of wells – by 2020 12,800 6,800 3,400 20,300 10,100 5,100


Under our base case we estimate China needs to drill 6,800 wells by 2020 to get to the bottom-end of the NDRC production target. To reach the NDRC’s 6.5 Bcm target by 2015, we estimate 410 wells to be drilled. As we enter the latter part of the decade we expect drilling activities to ramp up significantly, with the number of wells drilled increasing by 400/year until 2018. In essence, we estimate 6,400 wells to be drilled in the latter part of the decade.

It is worth noting that Figure 27 below is simply an illustrative example of China’s shale gas production profile to achieve the 60 Bcm target. We did not carry on with the drillings post 2020 in our exercise, hence the sharp decline in production once China hits the 2020 target.

Figure 27: China 60 Bcm shale gas production scenario—

CS base case

Figure 28: Number of shale gas wells assumed under CS

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We estimate China needs 10,000 wells by 2020 to achieve the 100 Bcm production target. With this we assume an even more significant ramp-up in drilling activities starting 2016; under this scenario, we expect China to drill 9,000+ wells in the latter part of the decade.


25 June 2012


Figure 29: China 100 Bcm shale gas production

scenario—CS base case

Figure 30: Number of shale gas wells assumed

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25 June 2012


The challenges Costs US horizontals range between US$5 mn and US$10 mn per well. Based on our US E&P Team’s estimates, a horizontal well in the US could cost anywhere from US$5 mn to US$10 mn. In the Eagle Ford, with depths of 3,000-3,600 meters (10-12,000 feet) and laterals roughly 1.6 km long, well costs range from US$6.5-8.5 mn on average. In the Bakken reserve, with comparable depths and longer lateral of 3 km, well costs can be closer to US$10 mn. Vertical wells on average are closer to US$2-3 mn, but obviously depth dependent.

Current drilling costs in China are high… Our understanding from industry players suggests that the first few horizontal wells drilled in China cost 2-3x that of the US. Currently, a single horizontal well could cost somewhere around US$15 mn in China.

…but are expected to come down with higher economies of scale. Upstream players plan to bring costs down to a level comparable to the US as production ramps up in China—for example, Shell JV targets US$4 mn per well in the long run.

Land access Land access the remit of the Ministry of Land and Resources (MLR): The MLR controls the allocation of land use rights, both on and below the ground in China. Hence, there is a clear pathway to land access for shale gas developers in China, for future blocks to be awarded. Shale is almost certainly also on blocks of land currently allocated for another primary exploitation (i.e., coal bed methane or coal). The principle to be applied in these cases is that the holder of land for the initial purpose has the ‘right of first approval’ to re-apply to the MLR to extract shale. Given the infancy of the shale gas story in China, what is not yet clear is whether there will be a significant issue between above ground land users (primarily agricultural) and shale exploitation.

Rigs China is ‘rig rich’ but will still need considerable additional rigs to drill up its shale production target. From our interactions with industry consultants and operators we understand that there is no official land rig count in China. Based on our knowledge, we estimate China has around 1,500 land rigs on the ground. However, almost all of the fleet are not tailored for shale gas drillings. Honghua last year sold three land rigs to Shell’s JV in China with shale drilling specifications.

We estimate China needs 280 additional rigs in our base case scenario for producing 60 Bcm by 2020. This is based on the assumption that it takes 1.5 months to drill one well, and all the rigs operate at a 70% utilisation rate. Should China produce 100 Bcm by 2020 (the high-end of the target), it will need 540 additional rigs, based on our analysis. The additional 280 rigs represent 19% of the current rig fleet—or looking at it another way, China needs to buy 40 rigs every year from 2013 onwards.

Should China get to the 100 Bcm target the additional rigs would represent 36% of the current fleet, implying China would need to buy 75 rigs every year from 2013 onwards.

China will need over 40% additional rigs on top of the current fleet, under a bearish scenario, in which we use our low case IP rate assumption to get to the 60 Bcm target. Under this scenario, China will need to buy an additional 640 rigs for shale drillings by 2020.

On the other hand, only 10% additional rigs are required if we use our high case IP rate for producing 60 Bcm by 2020. Under this scenario, China will only need an additional 140 rigs.


25 June 2012


Figure 31: Number of additional land rigs required in China by 2020 under our production

scenarios

-

200

400

600

800

1,000

1,200

Low Case Base Case High Case

60bcm scenario 100bcm scenario

(No. of rigs)


If we then assume that 10% of the current rig fleet (i.e., 150 rigs out of the 1,500) can be converted into shale drillings, China will need only 10% additional rigs under our base case, as shown in Figure 33.

Figure 32: Number of additional land rigs required as a %

of current rig fleet

Figure 33: Number of additional land rigs required as a %

of current rig fleet (assuming 10% conversion from

existing fleet)

0%

10%

20%

30%

40%

50%

60%

70%

80%



0%

10%

20%

30%

40%

50%

60%

70%

80%




Horizontal wells We understand that China had drilled 63 wells up to April 2012. Of that, 58 were shale gas and five shale oil wells, with 15 of these being horizontal wells. In 2011, 18 shale wells were drilled in China—of which 16 were vertical and two horizontal. This compares to 16,100 horizontal wells drilled in the US in 2011, according to Spears & Associates.


25 June 2012


Figure 34: US—number of horizontal wells drilled

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

2009 2010 2011 2012E

(wells)

Source: Spears & Associates

Pressure pumps An estimate of 1 mn HP currently in China, compared to 14 mn in the US. Given the early stage of frac technology, there is no official estimate in terms of fracturing horsepower (HP) in China. Our understanding from industry experts suggests that there is around 1,000,000 HP of pressure pump in China. This compares to about 14,000,000 HP in the US currently, according to Spears & Associates. In China, to drill one horizontal frac well, one would roughly need 1,000 horsepower of pressure pump equipment, according to industry experts.

We estimate China will need 4.2 mn additional HP to reach the low-end of the target. By using data in the US, we calculate that roughly 12,000 cm (340 cf) of shale gas is produced per horsepower. Applying this to China’s production target in 2020, and assume that the current 1 mn HP capacity is taken up for other unconventional gas drillings, we estimate China will need 4.2 mn additional HP to achieve 60 Bcm, and 7.1 mn HP to achieve 100 Bcm.

Figure 35: US—fracturing horsepower (HP) capacity Figure 36: Fracturing horsepower (HP) capacity in China

vs US 2011 frac capacity

-

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

18,000,000

2006 2007 2008 2009 2010 2011 2012E

(Frac HP)

-

2

4

6

8

10

12

14

16

China - low shale China - high shale US - 2011

(million frac HP)

Source: Spears & Associates Source: Spears & Associates, Credit Suisse estimates


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Water A multi-stage horizontal well requires 4-5 mn gallons of water. This water consumption amount is consistent between China and the US, based on our conversation with industry experts and our US E&P team.

Figure 37: China—water usage by segment Figure 38: Total water consumption under our production

scenarios, as a % of 2010 China industrial water supply

-

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

2003 2004 2005 2006 2007 2008 2009 2010

Residential Industrial Others

(mn gallons)

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%



Source: CEIC, Credit Suisse estimates Source: CEIC, Credit Suisse estimates

It appears that water consumption from fracing takes up only a small portion of China water supply. We compare estimated water consumption by 2020, by applying a 5 mn gallons per well assumption—it appears that by then, shale will only take up less than 1% of industrial water supply.

China’s prospective shale gas basins are in low precipitation areas. By looking at the precipitation map in China, of the three major prospective shale gas basins, only Sichuan is under a mild precipitation area, while Tarim and Ordos basins are in a low rainfall area. Securing water supply for multi-stage fracturing could be a challenge once China’s shale gas production ramps up rapidly towards the latter part of this decade.


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Figure 39: China’s precipitation map and three major prospective shale gas basins

In millimeter In inches

> 1500 > 59.1

1000-1500 39.4-59.1

500-1000 19.7-39.4

100-500 3.9-19.7

0-100 0-3.9

Tarimbasin

Ordosbasin

Sichuanbasin

Source: weather.com.cn

Globally social/environmental concerns on unconventional gas developments are rising: Several US states have banned fracing; in France, the practice has also been banned and in the UK, there has been a major public concern to initial drilling carried out in the North West of the country being linked to increased seismic activity in that area. In Australia, there has been a significant pushback between certain CBM developers and the farming community, both around the use of water as well as commercial terms for land access to place well pads/drill wells. In China, given the lack of shale wells drilled, the degree of public concern is unclear. We would not be surprised that national public concerns regarding water quality and usage, and CO2 emissions are less likely at least in the initial phase of shale gas exploration in China, but local concerns may be real and important.


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Pipeline reach Figure 40: China vs US gas kilometre per million population

-

200

400

600

800

1,000

1,200

1,400

1,600

China - Now China - 2015 China - 2020 US today

(km per mn population)


Pipeline reach will be an issue in China: Currently, China’s gas pipeline reach is approx. 50,000 kilometres, of which 35,000 km is primary distribution.. In contrast, in the US there are some 400,000 kilometres of gas pipeline. The current plan to extend China’s gas pipeline reach is to achieve 100,000 km coverage by 2015 as per the NDRC, and 150,000 km by 2020, in our assumption. At which point China would have only 38% of the current US gas pipeline reach.

Figure 41: China versus US gas pipeline reach

-

50

100

150

200

250

300

350

400

450

China - Now China - 2015 China - 2020 US today

('000 km)


Chinese Bcm per kilometre of pipeline could exceed the US: At the moment the implied amount of shale gas to be carried per 1,000 km in China is very low. Interestingly, if China hits the 60 Bcm target by 2020, it would carry a similar quantity of shale per 1,000 km as the US currently does, but would exceed the US by 50% if the 100 Bcm upper target is achieved that year.


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Figure 42: China vs the US—Bcm carried per 1,000 km pipeline capacity

0%

10%

20%

30%

40%

50%

60%

70%

China - Now China - 2015 China - 2020 (Low) China - 2020 (High) US

(Bcm per '000km pipeline capacity)


Sub surface experience likely the largest challenge currently: With less than 100 shale wells drilled (versus a cumulative 35,000 shale wells in the US over the past three years), Chinese/foreign developers have virtually no experience drilling the Chinese shale resource base.


25 June 2012


The ‘to-buy’ list To summarise, we estimate that in order to achieve the low-end of China’s shale gas production target of 60 Bcm, China will need to drill 6,800 wells in aggregate or 1,600 wells p.a. by 2020. With that China will need to buy 280 rigs under our base case assumption (4 mmcfd IP rate) and 1.6 mn HP of pressure pump. This compares to less than 10 shale-specific rigs and 1,000,000 HP currently.

Figure 43: China’s ‘to-buy’ list under the 60 Bcm scenario 60 Bcm scenario

Low Base High Current

Cumulative no. of wells by 2020 12,800 6,800 3,400 15 No. of additional rigs required 643 286 143 <10 Additional horsepower required - 4,290,000 - ~1,000,000


And if China’s shale gas programme ramps up significantly and hits the 100 bcm target, China will need to drill 10,000 wells in aggregate or 3,000 wells p.a. by 2020. In that scenario, China will need to buy 540 rigs under our base case assumption (4 mmcfd IP rate) and 3 mn HP of pressure pump.

Figure 44: China’s ‘to-buy’ list under the 100 Bcm scenario 100 Bcm scenario

Low Base High Current

Cumulative no. of wells by 2020 20,300 10,100 5,100 15 No. of additional rigs required 1,089 536 250 <10 Additional horsepower required - 7,100,000 - ~1,000,000


If we take our base case assumption under both the target scenarios, we estimate the total shale gas oilfield services spend through to 2020 would be US$58 bn under the 60 bcm case. And it will be up to US$87 bn under the 100 Bcm scenario.

Figure 45: CS estimation of the total shale gas OFS spend up to 2020 Shale target

(US$ bn) 60 Bcm 100 Bcm Assumptions

Total horizontal drilling/fracturing spend 47.8 69.4 US$8 mn per horizontal well Total land rig spend 2.3 4.3 US$8 mn (Rmb50 mn) per land rig Total pressure pump spend 4.3 7.1 US$1,000 per horsepower

Grand total 54.4 80.8


Figure 46: China’s total shale OFS spend under the 60

Bcm scenario, using our base case assumption

Figure 47: China’s total shale OFS spend under the 100

Bcm scenario, using our base case assumption

47.8

2.3 4.3

-

10

20

30

40

50

60

Total horizontaldrilling/fracturing spend

Total land rig spend Total pressure pump spend

(US$ bn)

69.4

4.3 7.1

-

10

20

30

40

50

60

70

80

Total horizontaldrilling/fracturing spend

Total land rig spend Total pressure pump spend

(US$ bn)



25 June 2012


Conclusion: Evolution or revolution? It is (far) too early to conclude China will be the next big province—but don’t write off the targets yet: Raw prospectivity remains strong in China, with the recoverable estimate as large as in the US. However, while the US shale gas revolution was driven by free market economics, China is driven by a top-down focus to exploit domestic gas resources from the energy security perspective, as well as improved input economics. Even if the 60-100 Bcm production target by 2020 is a clear stretch target (range), the US experience suggests it is not completely unrealistic; the key challenge appears to be how quickly China can get through the ‘learning’ phase and move to scale production. With exploration and exploitation risk in front of the production ramp, we conclude the early ‘winners’ of the China shale theme will be equipment suppliers and service entities.


25 June 2012


Stock list Figure 48: China’s shale gas value chain

Upstreamplayer

Equipment/materialssupplier

Oilfield Serviceprovider

Mid/downstreamoperator

PetroChina (857 HK)Sinopec (386 HK)CNOOC (883 HK)Shell (RDSa.L)Chevron (CVX)

Land rigs:Honghua (196 HK)BOMCO (not listed)Lanzhou Lanshi (not listed)RG Petro Machinery (not listed)

Pressure pumps:Yantai Jereh (002353 SZ)

Proppants:Carbo (CRR US)Saint-Gobain (SGO FP)Yixing Orient Petroleum Proppant(not listed)ENTI (not listed)

Anton Oil (3337 HK)SPT Energy (1251 HK)Hilong (1623 HK)COSL (2883 HK)Sinopec Engineering(not listed)Orion Energy (not listed)

Water purification:Aegis (not listed)

CNG/LNG transportation:CIMC Enric (3899 HK)

NGV:Weichai-Westport (not listed)Kunlun Energy (135 HK)


Figure 49: China’s shale gas value chain—valuation comps Price TP Mkt cap 6M trading vol P/E (x) EV/EBITDA (x) P/B (x) ROE (%) Net D/E

Company Ticker FX Rat. LC/sh LC/sh US$ mn US$ mn 12E 13E 12E 13E 11A 12E 13E 11A

Upstream players

PetroChina 0857.HK HK$ O 10.46 13.30 246,707 98 10.2 10.9 5.2 5.1 1.57 14.1% 12.2% 26%

Sinopec 0386.HK HK$ N 7.00 7.05 78,213 82 8.1 14.8 4.6 5.6 1.05 12.1% 6.5% 44%

CNOOC 0883.HK HK$ O 14.98 18.30 86,188 119 6.5 6.3 3.4 3.2 2.09 25.7% 22.1% Net cash

Royal Dutch Shell RDSa.L £ N 2,131 2,530 85,395 113 4.5 4.2 2.3 2.1 0.78 15.4% 15.1% 15%

Chevron CVX US$ O 100.0 130.0 198,265 209 7.0 6.2 2.9 2.7 1.62 20.3% 19.6% Net cash

Oilfield Service provider

Anton Oil 3337.HK HK$ NR 1.16 - 317 0.61 10.8 7.2 4.7 3.5 1.21 7.3% 12.9% Net cash

SPT Energy 1251.HK HK$ NR 1.34 - 231 0.79 5.4 4.0 2.9 2.3 1.69 23.9% 24.1% Net cash

Hilong 1623.HK HK$ NR 1.85 - 349 5.5 4.7 3.5 3.1 1.19 17.5% 17.9% 21%

COSL 2883.HK HK$ O 11.08 14.00 6,419 12.9 8.7 7.9 6.8 6.2 1.44 15.1% 14.8% 76%

Schlumberger SLB US$ NR 62.56 - 83,427 186 14.7 12.0 7.8 6.7 2.67 18.0% 20.2% 16%

Haliburton HAL US$ NR 28.35 - 26,167 116 8.6 7.7 4.4 3.9 1.98 20.7% 20.3% 16%

Lang rig manufacturer

Honghua 0196.HK HK$ NR 1.25 - 519 0.46 7.6 5.5 3.4 2.7 0.81 8.6% 10.5% Net cash

Pressure pump manufacturer

Yantai Jereh 002353.SZ RMB NR 45.87 - 3,310 12.9 35.1 25.1 26.0 18.3 8.18 20.2% 22.6% Net cash

Proppants supplier

Carbo CRR US$ NR 75.70 - 1,748 71 13.9 11.2 7.2 5.7 2.77 17.0% 17.9% Net cash

St. Gobain SGOB.PA € O 27.73 37.00 11,842 61 8.6 7.6 4.6 4.3 0.82 9.0% 9.8% 44%

Note: O = OUTPERFORM, N = NEUTRAL, U = UNDERPERFORM, NR = NOT RATED

Source: I/B/E/S, company data, Credit Suisse estimates


25 June 2012


China’s oilfield services industry is dominated by the non-listed arms of large SOEs (CNPC, Sinopec Group and CNOOC parent), which in aggregate constitute over 80% of the market share. The rest of the market is made up of 1,000+ independent oilfield service providers, and only a handful of them are listed, with each player taking up less than 1% of the market share.

Below, we identify a few listed leading private oilfield service and equipment providers, who are already involved in/are ready to participate in the shale gas theme. We also summarise the shale exposure of the big three Chinese oils so far.

Anton Oil (3337.HK) ■ Provided multi-stage fracturing service to CNPC’s shale gas horizontal well in Sichuan

in 2011.

■ Secured one horizontal well fracturing contract for Sinopec in 2012.

Anton Oil is a leading independent oilfield service provider in China. The company is one of the first independent oilfield service providers that went public, having been listed in Hong Kong since 2007. Anton Oil provides multi-stage fracturing services to its customers, along with other services like well completion and drilling technology. In 2011, Anton Oil completed one multi-stage fracturing service to CNPC’s shale gas horizontal well in Sichuan which was one of the two shale gas horizontal wells drilled in China last year.

SPT Energy (1251.HK) ■ Provided multi-stage fracturing service to Shell JV’s shale gas horizontal well in

Sichuan in 2011.

■ Completed one horizontal well fracturing operation for CNPC in April 2012.

SPT Energy is another leading independent oilfield service provider in China which went public in December 2011. Similar to Anton Oil, SPT Energy provides multi-stage fracturing services to its customers, along with other services like well completion and downhole operations. In 2011, SPT Energy completed one multi-stage fracturing service to CNPC’s shale gas horizontal well in Sichuan—it being the other shale gas horizontal wells drilled in China last year.

Figure 50: The two leading OFS players in shale so far—Anton Oil & SPT Energy Anton Oil SPT Energy

(3337 HK) (1251 HK)

Market Cap US$ mn 317 231

Trading value US$ mn 0.61 0.79

Trading volume mn 4.20 4.53

Revenue – 2011 Rmb mn 1,258.9 1,321.3

EBIT – 2011 Rmb mn 174.9 275.6

Net profit – 2011 Rmb mn *109.3 181.8

Shale exposure in 2011 Provided fracking service to CNPC’s shale gas horizontal well in Sichuan

Provided fracking service to Shell’s shale gas horizontal well in Sichuan

Shale exposure in 2012 YTD 1 fracking horizontal well contract for Sinopec YTD

Completed 1 horizontal well fracking operation for CNPC in April 2012

*Note: added back one-off impairment loss in 2011

Source: Company data

Honghua (0196.HK) ■ Sold three shale rigs to Shell JV in 2011—for shale exploration in Sichuan

Honghua is the largest listed land rig manufacturer in China and one of the largest globally in terms of capacity—120 rigs per year. A majority of Honghua’s land rig production is made for conventional oil and gas drillings, but the company commented that it has the


25 June 2012


technology and expertise to produce rigs that are for shale gas exploration/drilling. In 2011, Honghua sold three rigs with shale gas specifications to Shell JV’s exploration programme in Sichuan.

Yantai Jereh (002353.SZ) ■ Sold three shale rigs to Shell JV in 2011—for shale exploration in Sichuan

Yantai Jereh is one of the leading oilfield service equipment provider listed in the A-share market. The company is an advanced pressure pump manufacturer domestically. Our understanding from industry players suggests that Jereh’s pressure pumps are 15-30% cheaper than international majors’ (Schlumberger, Halliburton) with comparable specs and quality, and also has a comparative advantage of after-sales service locally in China.

COSL (2883.HK) ■ Moved onshore after 30+ years of operating in offshore; currently with CBM exposure

but also looking into shale opportunities

Over COSL’s 30+ years of history, the company has been solely focused on providing rig leasing and oilfield services in offshore regions. Since 2011, the company has started to set foot onshore, eyeing the domestic unconventional gas opportunity in the next decade.

Within unconventional gas, COSL has exposure in CBM but not shale—the company provided well services to a number of CBM projects in China and Australia last year. Our understanding is that CNOOC’s parent is likely to utilise COSL to provide oilfield service to its subsidiary CUCBM, which CNOOC’s parent acquired in 2010. According to management, COSL will also look into shale gas oilfield service going forward given the focus by the government. One of the key advantages for COSL vs other independent OFS player, we believe, is its relationship with CNOOC’s parent—whereby when CNOOC’s parent starts accelerating shale gas exploration/development in the next three to five years, COSL is well positioned for this.

Hilong (1623.HK) ■ Manufacturer of high-strength drill pipes for shale gas exploration

Hilong is more of an oilfield service equipment provider, with its drill pipes and coating materials business contributing close to 80% of total revenue in 2011. One of Hilong’s products are specific high-strength drill pipes for shale gas exploration. The company also provides oilfield services to upstream players, with its focus mainly on overseas markets such as West Africa, the Middle East and Ecuador.

PetroChina (0857.HK) PetroChina is currently working with Shell in the Fushan-Yongchuan block in Sichuan, where the two are in the process of establishing a PSC for the shale development. While it appears that PetroChina is having an early start in CBM exploration and production among unconventional gas, it is anticipated that the company will bid in the MLR’s second shale block auction later this year, and will leverage on its conventional oil and gas infrastructure and expertise to excel shale exploration.

Sinopec (0386.HK) Sinopec announced in June 2012 that it has kick-started development of its shale gas project in the Peiling block in Sichuan, aiming to produce 0.3-0.5 Bcm of shale gas by the end of 2012 and 1 Bcm by 2013. Sinopec has budgeted Rmb78 bn for upstream capex spend in 2012, an increase of 33% YoY and commented that a bulk of that will be towards unconventional gas development. The company is also reportedly working with BP and Total on other shale development blocks. Moreover, Sinopec Group has an investment in


25 June 2012


Repsol Brazil, of which it has a stake in Argentina shale; it is believed that Sinopec will leverage off this relationship for domestic shale development.

CNOOC (0883.HK) CNOOC is working with Shell in Anhui—the two have signed a joint study agreement (JSA) that will commit Shell to providing technical assistance for CNOOC to explore shale gas in the province. On top of that CNOOC has foreign exposure in shale, having made acquisitions in Eagle Ford and Niobrara’s assets in the US over the past two years. We believe CNOOC is likely to utilise the expertise it learnt in the US and leverage it on to its exploration and development domestically.


25 June 2012


Companies Mentioned (Price as of 22 Jun 12) Anton Oilfield Services Group (3337.HK, HK$1.16, NOT RATED) BP (BP.L, 412.0 p, OUTPERFORM, TP 540.0 p) Carbo Ceramics (CRR, $75.70, NOT RATED) Chevron Corp. (CVX, $100.02, OUTPERFORM, TP $130.00) China Oilfield Services Ltd (2883.HK, HK$11.08, OUTPERFORM, TP HK$14.00) China Petroleum & Chemical Corporation - H (0386.HK, HK$7.00, NEUTRAL, TP HK$7.05) CIMC Enric (3899.HK, HK$4.11, NOT RATED) CNOOC Ltd (0883.HK, HK$14.98, OUTPERFORM, TP HK$18.30) ConocoPhillips (COP, $52.76, NEUTRAL, TP $67.00) ExxonMobil Corporation (XOM, $82.09, NEUTRAL, TP $91.00) Halliburton (HAL, $28.35, NOT RATED) Hilong Holdings (1623.HK, HK$1.85, NOT RATED) Honghua Group Ltd (0196.HK, HK$1.25, NOT RATED) Kunlun Energy (0135.HK, HK$12.66, NOT RATED) PetroChina (0857.HK, HK$10.46, OUTPERFORM, TP HK$13.30) Royal Dutch Shell plc (RDSa.L, 2,131 p, NEUTRAL, TP 2,530 p) Saint-Gobain (SGOB.PA, Eu27.73, OUTPERFORM, TP Eu37.00) Schlumberger (SLB, $62.56, NOT RATED) SPT Energy (1251.HK, HK$1.34, NOT RATED) Statoil (STL.OL, NKr137.50, UNDERPERFORM, TP NKr165.00) Total (TOTF.PA, Eu34.84, NEUTRAL, TP Eu43.50) Yantai Jereh (002353.SZ, Rmb45.87, NOT RATED)

Disclosure Appendix Important Global Disclosures David Hewitt & Horace Tse each certify, with respect to the companies or securities that he or she analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. The analyst(s) responsible for preparing this research report received compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities. Analysts’ stock ratings are defined as follows: Outperform (O): The stock’s total return is expected to outperform the relevant benchmark* by at least 10-15% (or more, depending on perceived risk) over the next 12 months. Neutral (N): The stock’s total return is expected to be in line with the relevant benchmark* (range of ±10-15%) over the next 12 months. Underperform (U): The stock’s total return is expected to underperform the relevant benchmark* by 10-15% or more over the next 12 months. *Relevant benchmark by region: As of 29th May 2009, Australia, New Zealand, U.S. and Canadian ratings are based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe**, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. Some U.S. and Canadian ratings may fall outside the absolute total return ranges defined above, depending on market conditions and industry factors. For Latin American, Japanese, and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; for European stocks, ratings are based on a stock’s total return relative to the analyst's coverage universe**. For Australian and New Zealand stocks, 12-month rolling yield is incorporated in the absolute total return calculation and a 15% and a 7.5% threshold replace the 10-15% level in the Outperform and Underperform stock rating definitions, respectively. The 15% and 7.5% thresholds replace the +10-15% and -10-15% levels in the Neutral stock rating definition, respectively. **An analyst's coverage universe consists of all companies covered by the analyst within the relevant sector. Restricted (R): In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Volatility Indicator [V]: A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.

Analysts’ coverage universe weightings are distinct from analysts’ stock ratings and are based on the expected performance of an analyst’s coverage universe* versus the relevant broad market benchmark**: Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months. Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months. Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months. *An analyst’s coverage universe consists of all companies covered by the analyst within the relevant sector. **The broad market benchmark is based on the expected return of the local market index (e.g., the S&P 500 in the U.S.) over the next 12 months.


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Credit Suisse’s distribution of stock ratings (and banking clients) is: Global Ratings Distribution

Outperform/Buy* 48% (59% banking clients) Neutral/Hold* 41% (56% banking clients) Underperform/Sell* 9% (51% banking clients) Restricted 2%

*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock ratings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other individual factors.

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25 June 2012 Asia Pacific/China Equity Research

OG0437.doc

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