Encouraging Gas Development in China—A Work In Progress | Davis Wright Tremaine LLP – JDSupra

Encouraging Gas Development in China—A Work In Progress | Davis Wright Tremaine LLP – JDSupra.

 

The Chinese government recently issued several reform measures intended to open up its gas industry to foreign oil and gas developers. An inflow of foreign capital and technology, it is hoped, will spur construction of the midstream infrastructure needed to jump-start growth in domestic gas production.

Replacing coal with natural gas has long been a government priority due to ever worsening air pollution caused by China’s heavy reliance on coal for electric generation, heating, and daily cooking, etc. The Chinese government is also under international pressure to take more aggressive measures to limit and reduce carbon emissions because China is today the world’s largest producer of carbon dioxide.

However, as the New York Times recently reported, China’s ability to extract sufficient domestic natural gas supplies to reduce its reliance on coal is in serious doubt. In fact, despite heavy investment and strong government support, China’s natural gas production is growing at a slower pace than its decelerating economy, in large part because shale gas production has fallen far short of expectations.

Part of the production problem appears to be structural. Virtually all gas production and exploration, gas pipeline, and other gas assets in China are held by just a handful of state-owned or state-supported enterprises (SOEs) that are, to varying extent, vertically integrated. For example, China National Offshore Oil Corporation (CNOOC), which is also the largest offshore oil and gas producer in China, owns LNG receiving terminals, regasification, liquefaction and distribution facilities, gas pipelines, and gas-fired electric generators. PetroChina, one of the largest companies in the world, is not only a gas exploration and production company but is also a gas marketer and the owner of the majority of the gas pipeline networks in China.

SOE control of virtually all of China’s gas assets and infrastructure in the value chain—from gas exploration to burner-tip—discourages entry by foreign companies who have the requisite gas sector expertise to bring shale gas and other nonconventional gas sources to market. Although there have been rumors of plans to break up or privatize CNOOC, it is unclear as to the timing of such action.

Recent developments, however, suggest that the Chinese government is willing to implement regulatory changes to reduce SOE gas industry control with the goal of facilitating the commercialization of gas reserves from unconventional sources, such as coal bed methane and shale gas.

For example, in December 2013, the National Energy Administration (NEA) said it would “remove policy obstacles for private capital to participate in energy development” and endeavor to provide a fair competitive environment. Under the current Foreign Direct Investment Industries Guidance Catalogue, the Chinese government announced that foreign investment in LNG exploration and exploitation is officially encouraged for joint venture investment with Chinese investors and the operation and construction of LNG infrastructure is officially permitted.

To move to such a “fair competitive environment,” on Feb. 13, 2014, the NEA released the “Measures for Supervision of Opening Up Oil and Gas Pipeline Facilities in a Fair Manner.” In these measures, pipelines (operators) are instructed to open their pipeline networks and related facilities (such as compression and storage) “in a fair manner” for use by third parties (users) where they have surplus capacity. Such third party access “shall be on a fair and nondiscriminatory basis, according to the signing sequence of contracts.” These purchase and sale or transportation contracts shall specify, among other things, the sale or service period, quantity of gas purchased or transported, receipt and delivery points, price, measurement, and gas quality.

Foreign investors that are registered as either the operators or the users are eligible to enter into such contracts to obtain access to such pipeline networks. Where access is requested for pipeline transportation of production by an upstream user, the user must first provide details to the operator on the gas production to be shipped, including a forecast of reserves, gas quality specification, amount and length of term. Downstream users are required to provide similar details on their projected gas demand. The operator then has 30 business days to determine whether or not to grant access, and, if it denies access, it must report its reasons to the NEA, which can overturn this finding. The rule provides that the price for transportation services will be determined by Chinese government pricing authorities. The authority for gas is the National Development and Reform Commission (NDRC). Rulings from the NDRC are to be enforced by the NEA.

Operators are required to post access, pricing, and other terms and conditions electronically through their own website or through another platform recognized by the NEA. To date, only China National Petroleum Corporation has published rules for gas facility access and offered service to third party applicants. However, the operators (who will also be competitors to the users as they are vertically integrated) appear to have substantial discretion under these measures to provide or not provide access. Importantly, there is no way to challenge a finding that an operator does or does not have surplus capacity.

These access rules seem insufficient from the perspective of American companies used to open access where the transporter/operator is obligated to provide open access on a non-discriminatory basis. Additional NEA measures limiting an operator’s discretion to favor its own affiliates in the allocation of surplus capacity, as well as NEA demonstrated willingness to enforce this “fair and equitable” access requirement, is likely needed to entice commercial participation by FOEs with the requisite gas expertise.

Another significant problem is that these NEA measures have been issued on an interim basis with a validity of five years only (through Feb. 12, 2019). A five-year window does not provide sufficient time to permit the new midstream project development that these measures are otherwise designed to encourage.

Continuing a focus on encouraging gas sector development, the NDRC in February 2014 also released “Measures for the Administration of Natural Gas Infrastructure Construction and Operation.” The purpose of these measures is to encourage gas infrastructure development and investment by standardizing the regulation of infrastructure construction and operation, and encouraging “a natural gas market featured by equal participation, fair competition and orderly development.” Although the measures state at the outset that they are to be administered by the NDRC and the NEA, the extent of such agencies’ control is unclear because planning and construction approval authority is delegated under these measures to “competent departments of natural gas of local people’s governments at or above the county level” in “all provinces, autonomous regions, and municipalities directly under the Central Government.” Notwithstanding, and somewhat confusingly, the penultimate measure specifies that the “power to interpret these Measures shall remain with the NDRC.”

The pricing and terms and conditions for access to gas infrastructure, under the NDRC measures, as is the case with the NEA measures, are also vague on critical matters. For example, the NDRC measures require gas infrastructure operators to independently account for the costs and revenues associated with pipeline transportation, gas storage, gasification, liquefaction and compression. This requirement suggests that open access gas services are to be priced on a cost-of-service basis. However, the measures never address pricing directly, only stating that the “State shall establish the trading platforms for natural gas infrastructure services.” What is intended for the operation of these trading platforms, or how such services are to be priced, is left unaddressed.

In sum, these recent NEA and NDRC measures are but a first step in establishing a regulatory regime that will encourage FOE investment in midstream gas infrastructure by private investors. More attention needs to be paid in the near future to not only refining and expanding these measures but also to reform of the SOEs to establish a platform that not only offers fair access to gas facilities but also fair rules of play for private businesses seeking to compete with these more powerful state-owned monopoly players.