VE China upstream oil and gas

(Rel. 17–2009)Reprinted from Doing Business in China, pgs. V-3.1 – V-3.33, copyright 2009 © Juris Publishing, Inc., V. INDUSTRY SECTOR REPORTSChapter 3Upstream Oil and Gas in ChinaDavid Blumental, Tju Liang Chua and Ashleigh Au ∗____________SYNOPSIS§ 3.01 Introduction[1] Growth in Energy Consumption and Production[2] Securing Energy Supply[a] Coal[b] Oil[c] Natural Gas & Liquefied Natural Gas[d] Coal-Bed Methane[3] Demand-Side Reduction[4] Environmental Situation[5] The Chinese Energy Industry∗ David Blumental is the Chief Representative and Managing Partner of the Vinson & Elkins Shanghai office. His principal areas of practice are business law, international business transactions, cross-border mergers, acquisitions and divestitures as well as corporate and project finance and oil and gas. He is a member of the firm’s Energy Transactions & Projects Practice Group, Project Finance and Development Group and the China Practice Group.Tju Liang Chua is an Associate at the Vinson & Elkins Shanghai office and a member of the firm’s Energy Transactions & Projects Practice Group, and China Practice Group. His principal areas of practice are international business transactions and cross-border mergers and acquisitions with a particular focus on the energy sector. Prior to joining Vinson & Elkins in 2006, Tju Liang had been based in London, Jakarta, and Singapore.Ashleigh Au is a paralegal at the Vinson & Elkins, LLP Shanghai office.DOING BUSINESS IN CHINA V-3.2(Rel. 17–2009)[a] China National Petroleum Company (CNPC) & PetroChina[b] Sinopec[c] China National Offshore Oil Corporation (CNOOC)[d] Sinochem[e] Other players[6] Foreign participation in China's energy industry[a] Early 1980s[b] 1990s to Present[c] Recent trends§ 3.02 Regulation of the Upstream Oil & Gas Industry[1] Regulatory Authorities[a] National Energy Administration (NEA)[b] Ministry of Land and Natural Resources[c] Ministry of Commerce (MOFCOM)[d] Ministry of Environmental Protection[e] State Maritime Administration[f] China Offshore Oil Operation Safety Office[g] State Administration of Work Safety[h] State Energy Committee[2] Laws & Regulations[a] Onshore Regulations[b] Offshore Regulations[c] Royalties[3] Taxes[a] Windfall Tax[b] Crude Oil Export Tax§ 3.03 Oil & Gas Contracts[1] Overview[2] Crude Oil Production Sharing Contracts[a] Contract Term[b] Operator[c] JMC[d] Exploration[e] Minimum Work/Expenditure Commitments[f] Discovery; Determination of CommercialityV-3.3 UPSTREAM OIL AND GAS IN CHINA § 3.01[1](Rel. 17–2009)[g] Natural Gas Discoveries[h] Relinquishment[i] Development: ODP and Work Programs[j] Payments, Financing and Cost Recovery[k] Taxes[l] Quality, Quantity and Price of Crude Oil[m] Ownership of Assets and Data[n] Marketing[o] Local Content Requirements[p] Governing Law and Language[q] Consultation and Arbitration[3] Coal-Bed Methane Production Sharing Contracts[a] Contract Term[b] Operator[c] Minimum Work/Expenditure Commitments[d] Relinquishment[e] Price of CBM[f] Local Employment[g] Destination of CBM and Marketing[4] Joint Study Agreements and Geophysical Survey Agreements § 3.04 Conclusion§ 3.01 IntroductionWith the recent drastic changes in global crude oil prices first rising to record levels of around US$147 a barrel in July 2008, and then crashing to around US$35.98 (US$35) a barrel in December 2008, the energy industry, media, governments, international agencies, and even consumers are paying special attention to China’s impact on demand in the world’s energy markets.[1] Growth in Energy Consumption and ProductionDuring the Mao era and its immediate aftermath (from 1949 until the late 1970s), China had always been a net exporter of oil. The Daqing oil fields in Heilongjiang province, discovered in 1959, are China’s§ 3.01[2]DOING BUSINESS IN CHINA V-3.4 largest oil fields and the fourth largest producing oil fields in the world. Sales of Daqing crude oil to Japan and other countries provided significant contributions of valuable foreign exchange to China. However, after the government-led liberalization of the economy in 1978, China’s demand for energy surged. To meet this rising demand, China began to consume a considerably greater amount of domestically produced oil. In 1993, China became a net importer of crude oil and since then, China has been responsible for approximately 40 percent of the growth of the world’s oil demand.Since 2000, China’s energy demand has rapidly increased as the economy has grown between nine and ten percent each year. In late 2003, China surpassed Japan to become the world’s second largest consumer of petroleum after the United States. The following year, China ceased all oil exports to Japan. By the end of 2007, China imported nearly half of its crude demand, and had to cut crude exports by nearly 40 percent.Although demand has risen steadily in recent years, the growth of Chinese domestic crude oil production has not kept up to pace with its energy needs. Total imports of crude oil have increased nearly 140 percent from 1.38 million barrels per day in 2002 to roughly 3.8 million barrels per day in 2008.The International Energy Agency (IEA) predicted in 2007 that by 2012 Chinese demand would grow to 9.96 million barrels per day. However, since the 2008 economic crisis, IEA forecasts have been repeatedly revised in response to the precarious state of world markets as China’s demand has been subject to speculation. Nonetheless, as the future of China’s economic development and stability relies on energy supply, the issue of satisfying energy demand remains at the forefront.[2] Securing Energy SupplyThe rapid increase in domestic energy demand means that securing stable sources of energy for the near-, medium- and long-term has been the most challenging issue facing China’s leadership and industry players. The Chinese government has approached this issue with a multi-pronged plan: demand-side reductions through conservation and(Rel. 17–2009)V-3.5 UPSTREAM OIL AND GAS IN CHINA § 3.01[2] efficiency improvements, as well as an expanded focus on renewable energy and overseas oil and gas acquisitions.[a] CoalCoal is China’s main source of energy, accounting for nearly 70 percent of domestic energy supply, and China possesses the world’s largest coal reserves. However, China’s coal mining industry is hampered by weak organization and supervision, poor safety procedures (mine explosions and collapses are frequent occurrences), and significant bottlenecks in the transportation of coal from mining regions to large end-users in coastal areas. The environmental cost of inefficient coal mining combined with the combustion of coal and fuel oil has proven significant—China is the world’s largest producer of carbon dioxide emissions and often suffers from severe air and water pollution. Furthermore, China’s energy consumption is noticeably less efficient than that of the U.S., Japan, and other industrialized countries. In other words, China consumes more energy to produce the same economic value.[b] OilChinese policymakers and state-owned oil companies have embarked on a multi-pronged approach to improve oil security by purchasing equity oil stakes abroad, diversifying suppliers, enacting new policies to lower demand, investing in energy substitutes, building strategic oil reserves, and maximizing domestic production. Accordingly, China’s emerging oil companies are being recognized as significant players in international exploration and production (E&P), oilfield services, and liquefied natural gas (LNG) projects worldwide.In pursuit of this multi-pronged strategy, China has endorsed overseas equity investment and entered a range of contracts from the most basic to the most complex with various foreign nations. Importing up to 45 percent of its energy needs, China’s interests lie in supply diversification. As such, Chinese oil companies have actively pursued projects in the Middle East and Africa, as well as in North and South America in more recent years.China has also joined many Western nations in establishing strategic petroleum reserves to provide a buffer against disruptions in the supply of imported crude oil. China desires to maximize domestic production,(Rel. 17–2009)§ 3.01[2]DOING BUSINESS IN CHINA V-3.6 and in the past decade has gone to extensive and expensive lengths to do so: building several trans-national pipelines, including the 4000 km West-East pipeline at a cost of more than US$24 billion, and engaging in exploration in remote areas such as Xinjiang. Recent government measures to optimize domestic production include proposals to toughen block exploration and production licensing and raise the minimum investment and exploration obligations of national oil companies.[c] Natural Gas & Liquefied Natural GasNatural gas has not been a major fuel resource in China’s past. Several significant hurdles exist for the development of the natural gas market within China:(a) First, natural gas is expensive compared to coal ifenvironmental costs are not included.(b) Second, China is not believed to be endowed with abundantand cheap gas reserves, and known supplies are often locatedfar from the main centers of demand. Recent estimates ofChina’s proven domestic natural gas reserves ranged from 1.51to 2.35 trillion cubic meters.(c) Third, China lacks a well-developed legal and regulatoryframework to encourage investment in the gas sector. Chinadoes, however, govern such matters as pricing and long-termtake or pay contracts.(d) Fourth, there is a lack of knowledge over how to best developnatural gas technology and markets.(e) Finally, China’s gas supply infrastructure is fragmented andwould require substantial investment to finance its expansion. The weakest link in China’s natural gas chain is the perception that high costs result in a weak demand for gas. While the government is beginning to address this issue, without a stronger market pull for gas, the entire natural gas chain remains weak, irrespective of efforts to develop the market by administrative direction.Notwithstanding the challenges, China’s government has been pushing for natural gas to take on a larger role in China’s present and future. As a part of the 2005 11th Five-Year Plan to curb pollution, the(Rel. 17–2009)V-3.7 UPSTREAM OIL AND GAS IN CHINA § 3.01[2] government set a target of making natural gas 5.3 percent of domestic energy consumption by 2010. This marks a consumption increase from the 2.8 percent consumed in 2005, but falls somewhat lower than the 8 percent the government has targeted since 1999. In order to meet these targets, various state-owned oil companies have begun work on many natural gas projects designed to increase the supply of natural gas in China.In recent years, China has made efforts to improve the interconnectivity of its natural gas pipelines. As a result, the distribution network in Sichuan province, where a significant amount of gas reserves lie, has become China’s most advanced natural gas distribution network. Additionally, the West-East natural gas pipeline that stretches from Xinjiang to Shanghai began operations in January 2005. Currently, the West-East pipeline operates under capacity due to lack of gas.China’s first liquefied natural gas (LNG) import terminal, with a capacity of 3.3 million metric tons per year, began operations in Guangdong province in May 2006. A second LNG import terminal in Fujian province, with a capacity of 2.41 million metric tonnes per year, received its first shipment in April 2008, well ahead of the 2009 target date for opening production. Many more projects are in the planning and construction stages including a long-term agreement with Shell that will import LNG from Qatar, a China National Petroleum Corporation (CNPC) LNG terminal in Dalian, a Sinopec terminal in Qingdao, and seven more terminals by China National Offshore Oil Corporation (CNOOC) alone. These projects aim to provide the 200bcm of natural gas estimated to be in demand by 2020.[d] Coal-Bed MethaneIn recent years, China has expanded its domestic energy sources to include coal-bed methane (CBM). Previously, CBM was viewed exclusively as a problem, with the presence of methane in China’s coal mines causing frequent mine explosions and collapses. The expansion of CBM extraction has dual benefits: improving the safety of coal extraction work, and supplying a cleaner, additional source of fuel to meet energy demands. It is estimated that China has over 37 trillion cubic meters of reserves.China United CoalBed Methane (CUCBM), a joint venture between PetroChina and China National Coal Group, was founded in(Rel. 17–2009)§ 3.01[3] DOING BUSINESS IN CHINA V-3.8 (Rel. 17–2009)1996 to develop CBM with foreign companies and enhance exploration activities. The discovery of 75.4 billion cubic meters of CBM reserves in the Qingshui basin in Shanxi province led to the CUCBM’s first commercial CBM project, Shanxi Panhe, which did not produce commercial gas. By 2006, about 1,000 CBM test and pilot wells were completed within more than 30 basins by domestic and foreign companies, none of which led to commercial production. China’s CBM has remained a largely under-exploited resource. Only 700 million cubic meters of CBM have been produced to date falling short of the 2005 central government energy plan (the 11th Five-Year Plan) target to extract ten billion cubic meters of CBM per year by 2010. Lagging development, however, has paved the way for the reshaping of China’s regulatory structure and the encouraging foreign investment in the industry. As a result, the State Council took away CUCBM’s monopoly on forging alliances with foreign investors in 2007 and in April 2009, the State-Owned Assets Supervision and Administration Commission announced the division of CUCBM’s assets between PetroChina and the China National Coal Group. The separation of this joint venture, which was perceived to be unsuccessful, signals China’s desire to accelerate development and meet the 11th Five-Year Plan production targets. Plans to develop the commercialization of CBM include the construction of ten CBM pipelines, with the first one due for completion by the end of 2009.[3] Demand-Side ReductionIn an effort to reduce the country’s reliance on coal reserves, China is seeking demand-side reductions through more efficient energy production and consumption while actively seeking out energy producing substitutes. The central government’s energy plan, the 11th Five-Year Plan promulgated in 2005, calls for “accelerated development” of oil and natural gas, “aggressive development” of electricity, and a push to “greatly” develop renewable energy sources. The Chinese government has made it a national priority to develop diversified, clean, and more efficient energy sources, including oil and natural gas, clean coal technology and, to a growing extent, renewable energy sources such as wind, geothermal and solar power.V-3.9 UPSTREAM OIL AND GAS IN CHINA § 3.01[5](Rel. 17–2009)[4] Environmental SituationThough government measures have encouraged a shift away from energy-intensive industries such as steel manufacturing, the real demands of economic growth often translate into efficiency taking precedence over conservation. However, while measures implemented to increase energy efficiency and reduce energy demand offer some mitigating effect, the problem of long-term energy supply remains unresolved. Notwithstanding recent reports by the China State Statistics Bureau showing an annual 15 percent increase in total energy production, demand for energy continues to rise on the back of rapid economic growth and the country’s potential energy shortage is becoming increasingly acute.[5] The Chinese Energy IndustryThe modern Chinese petroleum industry was created in large part in 1998 when the Chinese government mandated the restructuring of state-owned assets to establish CNPC in the north of the country and China Petrochemical Corporation (Sinopec) in the south. Prior to restructuring, CNPC had been engaged in upstream exploration and production throughout China since 1988 when it replaced the Ministry of Petroleum Industry. Sinopec was engaged in mid/downstream refining and distribution. A third firm, CNOOC, presided over most offshore oil and gas production and has managed to retain its pre-1998 control since restructuring. All three of the Chinese majors have restructured and conducted relatively successful international IPOs.[a] China National Petroleum Company (CNPC) & PetroChina Created from the former Ministry of Petroleum, China National Petroleum Corporation (CNPC) is the largest of the state-owned oil companies. In early 2000, CNPC invested most of its high quality assets into its subsidiary PetroChina Company Limited. PetroChina made an IPO of a minority interest on the New York and Hong Kong stock exchanges in April 2000, with its market capitalization rising over US$3 billion. British Petroleum was the largest purchaser, subscribing for 20 percent of the shares offered. Warren Buffet was another major investor. The IPO, which was originally intended to raise US$7 billion, was scaled back due to labor and human rights groups who objected to CNPC’s§ 3.01[5]DOING BUSINESS IN CHINA V-3.10 involvement in a controversial development project in Sudan. Nonetheless, CNPC investment in Sudan yielded record highs of crude output exceeding 11 million tonnes in 2008. CNPC has also expanded into overseas oil and gas exploration in Iraq where the company aims to increase oil and gas production by 5% annually and reach a capacity of 25,000 barrels per day within six years.Since listing, PetroChina has enjoyed consistent growth, and has solidified its position among the world’s most important companies. In 2008, the Financial Times released its twelfth Global 500 list, which measures the world’s most important companies based on evaluation incorporating stock market listing and market perception. With a market value of US$424 billion, CNPC ranked second on the list between ExxonMobil and General Electric.PetroChina’s subsidiaries include Jinzhou Petrochemical Co. Ltd., Liaohe Jinma Oilfield Co. Ltd., and Jinlin Chemical Industry Co. Ltd. [b] SinopecSinopec is the second largest of the Chinese state-owned oil companies. In October 2000, Sinopec’s IPO in Hong Kong and New York raised approximately US$3.5 billion from the offering and sale of a 15% minority stake. Approximately US$2 billion of the offering was purchased by ExxonMobil, BP, and Shell. However, Sinopec’s offering was also scaled back due to weakness in the international equity markets. ExxonMobil, BP and Shell have all since sold off the shares they acquired during Sinopec’s IPO.In November 2007, Sinopec issued shares on the Shanghai stock exchange. As a result, Sinopec’s market share tripled. While PetroChina enjoys the larger market share, Sinopec has often been the highest earning company in China. It was the only company to earn more than one trillion yuan in 2006. In the 2008 Global 500, released by the Financial Times, Sinopec ranked as the 37th most important company in the world.Sinopec’s subsidiaries include Shanghai Petrochemical Co. Ltd., Fujian Petrochemical Co. Ltd., and 17 smaller subsidiaries.(Rel. 17–2009)V-3.11 UPSTREAM OIL AND GAS IN CHINA § 3.01[5][c] China National Offshore Oil Corporation (CNOOC) CNOOC was established in 1982 for the purpose of administering offshore petroleum operations with foreign entities. Today CNOOC maintains exclusive rights to offshore petroleum exploration and production, although in 2002 it spun off oilfield services to China Oilfield Service, Ltd. (COSL). While the spin-off is now listed on the Hong Kong stock exchange, the Chinese government maintains majority control of COSL.Since listing, CNOOC has been a leader in overseas M&A. In 2005 CNOOC attempted to acquire the American Union Oil Company of California. The attempt set off a political storm in the United States amid concerns of a Chinese company gaining control over American energy. This failed attempt aside, CNOOC has fared well in M&A and remains the domestic leader in LNG.[d] SinochemSinochem is China’s petroleum and petrochemical trading company. While trading has traditionally been their main function, they have expanded greatly this decade. In 2002, Sinochem established Sinochem Petroleum Exploration and Production Company, Ltd. to engage in overseas E&P acquisitions. By 2006, they had become fully engaged in a wide range of up-, mid-, and downstream sectors.[e] Other playersShaanxi Yanchang Petroleum Group Company is a state-owned company formed in 2005 through the merger of 21 private exploration and development companies and three refineries. Shaanxi Yanchang is China’s fourth-largest oil company.China United Coal Bed Methane Company (CUCBM) is a state-owned company formed in 1996 to facilitate the development of coal-bed methane projects. From 2001 through 2007, government regulations granted CUCBM the exclusive right to cooperate with foreign partners in the development of coal-bed methane projects. This privilege, however, was expanded to other companies with state council approval in 2007.China Zhenhua Oil, a wholly owned subsidiary of North China Industrial Group (NORINCO), was formed in 2004. Zhenhua’s(Rel. 17–2009)§ 3.01[6]DOING BUSINESS IN CHINA V-3.12 expansion into overseas investment has led to projects in Kazakhstan, Iraq and Pakistan. Recent developments include the signing of a share purchase agreement in Kazakhstan making Zhenhua the controlling shareholder of the K&B Oilfield with 75% interest. In 2008 Zhenhua also signed a Production Sharing Contract with a CNPC affiliate in the Ahdeb Oil Field in Iraq. The company has also revealed plans to invest over US$30 million drilling in Basca and Bahawapul, Pakistan.In December 2004, private oil companies formed an association under Gongshanglian, the China Chamber of Commerce for the Petroleum Industry (CCCPI), which at that time had about 140 member companies. In June 2006, under CCCPI’s coordination, China’s largest private firms unified to form the Great United Petroleum Holding Co., Ltd. (GUPC). At its establishment, the conglomerate announced its possession of capital at about RMB5 billion (US$603.9 million). GUPC hopes to give private firms a platform from which to compete with large state-owned oil companies in order to develop operations in China and acquire upstream assets overseas. To date, they have yet to achieve much success.[6] Foreign Participation in China’s Energy Industry[a] Early 1980sThe 1980s marked the beginning of the reformation era for the oil and gas industry. Prior to this time, activity was very limited and legal framework presented a blank slate. Spurred by the need for foreign capital, technology, and know-how, China took the first step in Sino-foreign cooperative exploration by signing five bilateral petroleum contracts in 1979. The bidding procedures for Sino-foreign cooperative exploration followed shortly. In 1982 and 1983, the PRC promulgated very early regulations that would lay the framework for today’s oil and gas industry. These laws provided for the most basic production sharing contracts in the form of petroleum contracts. These investment risk contracts were designed to both attract foreign investment and benefit China through provisions that mandated the transfer of technology and industry acumen. In the late 1980s, gradual price reform took place with the development of the market. China’s two-tiered plan to incorporate both a planned economy and a market economy signaled a milestone for foreign investment in the PRC.(Rel. 17–2009)V-3.13 UPSTREAM OIL AND GAS IN CHINA § 3.01[6][b] 1990s to PresentIn the 1990s China took continued interest in foreign investment. As more companies became interested in China, production sharing contracts gradually became more sophisticated. With the opening of the midstream, foreign enterprises showed only limited interest in this sector. Domestic companies continued to carry out most midstream operations.In 2002, government regulations encouraged the “construction and operation of oil (gas) pipelines” by foreign enterprises. Initially few investors were eager to take advantage of the opportunity. To date, foreign firms are involved in pipelines and pipeline construction, but they have generally been run by Chinese companies. GE Oil & Gas will be providing eight centrifugal compressors for the Sichuan-Shanghai pipeline, while Sinopec will have oversight. The West-East pipeline was originally supposed to be a joint venture between a subsidiary of Sinopec and three foreign companies, but PetroChina terminated the arrangement two years after operations began. Domestic companies continue to dominate many other aspects of midstream operation. In 2006, in order to comply with its WTO (World Trade Organization) commitments, China opened the wholesale market to foreign competition and in 2007, 25 foreign private companies were granted the right to store and sell crude and processed oil in China. However, strict technical requirements provide great barriers to entering the market. As a result, most wholesale and retail operations are wholly or mostly run by Sinopec or CNPC.[c] Recent TrendsSince China joined the World Trade Organization In December 2001, newly promulgated amendments to the principal regulations governing foreign participation in onshore and offshore upstream petroleum projects have brought regulations in line with China’s WTO commitments.One of the most significant steps towards WTO accession was the revision of the Regulation of the People’s Republic of China on Sino-Foreign Cooperation of both Continental and Offshore Petroleum Resources 2003. These revisions expanded opportunities for foreign companies in China, yet entering China for exploration still required a partnership with a Chinese SOE. These regulations were amended(Rel. 17–2009)§ 3.02[1] DOING BUSINESS IN CHINA V-3.14 (Rel. 17–2009)again in 2007, but with few changes. In general, as expressed by the Secretariat of the WTO, recently “there have been no major changes in policies concerning China’s energy sector, which continues to be characterized by a high level of state ownership, regulation and limited competition.”While this outlook seems generally true with regards to downstream activities, China has indicated great interest in foreign cooperation in production and exploration. China began a strategic oil reserve system in 2004 in order to provide increased energy security to accommodate growing demand. The 11th Five-Year Energy Plan also outlines aims to increase oil reserves.In addition, investments in risk exploration, development and production of petroleum and natural gas, as well as investments relating to new technologies for petroleum exploration and development are listed as “encouraged” industries in the 2007 Catalogue of Foreign Investment Industries (外商投资产业指导目录 (2007 Catalogue). The 2007 Catalogue sets out detailed lists of industries and specific activities according to whether foreign investment is encouraged, restricted, or prohibited. It should be noted that the 2007 Catalogue expressly requires that foreign investment in such petroleum activities be pursued in cooperation with Chinese partners.§ 3.02 Regulation of the Upstream Oil & Gas Industry[1] Regulatory AuthoritiesOne of the biggest problems faced by the Chinese government in formulating and implementing a national energy policy and administering the country’s energy industry has been the lack of a single regulatory body with sufficient authority to carry out regulatory functions. Since 1993, when the Ministry of Energy (能源部) was dismantled, regulatory oversight has been fragmented among different regulatory bodies. Authority has shifted with each subsequent restructuring of the government.In 1998, China carried out an aggressive bureaucratic restructuring plan that slashed the number of ministries from 40 to 29. As part of this plan, the regulation of the petroleum industry was transferred away。