Politics & Markets

Coal bed methane -- Panacea to China's energy woes (Issue: 10)

As China continues its development exploits, the need to develop energy sources has gained more eloquence. Environmental concerns have prompted China to look for other avenues to replace coal based energy in the energy equation. Coal Bed Methane (CBM) is fast emerging as an attractive alternative, thus strengthening the investment case of China based CBM companies.

Economic development is never without victims. In the case of China it is the environment. Along with its impressive 10% GDP growth the Chinese energy consumption has been rising at 11% per annum over the last five years. China?s insatiable demand for energy is indicated by its fuel consumption. During the last five years, the Chinese annual oil consumption has increased by 8% to reach 7.2 mmbbl per day. More imposing is the staggering 15% annual growth in gas consumption. Natural gas continues to assume a greater role in the Chinese energy equation and in 2006 China consumed 2 billion cubic feet of natural gas.

  

By the end of 2005, China had an installed generation capacity of 500 million kW with an annual electricity generation of 2.4 trillion kWh, making China the world?s second largest power generator. A further 100 million kW were added to its power generating capacity in 2006. Despite new additions, China?s projected long run electricity demand growth of 9-10% falls short of the projected generation capacity growth of 4-5% per annum. China certainly is keen to develop its energy sources to meet the rising demand.

Much of China?s energy comes from coal power plants. China currently produces 1 billion tonnes of coal per annum to generate 75% of its energy needs. In view of high emissions and environmental pollution, China plans to reduce the proportion of coal based energy to 63% by 2010. Against this backdrop, the increased use of other sources in the energy equation has now become a priority. This includes power generation through unconventional sources such as Coal Ben Methane (CBM).

CBM is methane found in coal seams produced either by biogenic (by microbes) or thermogenic (by heat) routes. It is a more environmentally friendly power generation alternative as it does not produce sulfur dioxide (SO2) and produces only 50% of the carbon dioxide (CO2) emitted through coal combustion. The US has the most developed CBM industry due to the presence of large coal basins. CBM now accounts for 8% of the US natural gas production.

According to China United Coal Bed Methane (CUCBM) China has CBM resources of 36.8 trillion cubic metres (Tcm) within its extensive coal deposits spanning across the country. China has the third largest CBM resources after Russia and Canada and twice as much as the US resources, the CBM industry leader. CUCBM expects CBM production to reach 10 billion cubic feet (Bcf) and account for 20-25% of China?s gas energy by 2010. CUCBM is a state agency with exclusive right to explore and develop CBM resources in joint venture with foreign companies. 

Attempts are currently underway to realize such lofty targets. Since 1998, CUCBM has signed over thirty production-sharing contracts (PSCs) with several renowned energy companies to develop its CBM riches. CBM PSCs started with energy majors such as Texaco, Arco, ConocoPhillips, Greka and Australia?s Lowell oil. Having realized the role more focused companies can play in the CBM space, CUCBM subsequently invited several smaller but specialized firms such as Pacific Asia China Energy (TSX: PCE.V), Far Eastern Energy (FEEC.OB), Verona Development Corp. (VDC.V), Green Dragon Gas (London AIM: DI), etc to participate in the development of Chinese CBM resources. These firms have made considerable progress in their respective projects.

The development of CBM industry is also expected to reduce China?s notorious coal mining accidents. China has the dubious honour of recording the highest number of coal mine accidents in the world with most of them caused by methane explosions. CBM drainage is expected to reduce the risk of methane explosions and sudden outbursts of coal and gas, leading to considerably improved safety conditions. Reduced down time due to accidents and improved reputation provide additional incentives for China to develop its CBM industry.

However it is the quest to establish secure energy sources locally, preferably the cleaner variety, is what is driving the Chinese CBM market. China is a signatory to the UN Framework Convention on Climate Change (FCCC) and the Kyoto Protocol, both of which seek the reduction of greenhouse gas emissions. China is also aware of pollution related environmental damage and health costs which the World Bank estimates to be as high as US$54bn/year. CBM clearly is high on China?s energy agenda.

The success of CBM projects heavily depends on the availability of coal resources and China has them in abundance. China is currently the largest coal producer and has the third largest coal resources in the world after Russia and the UK. China?s vast coal resources virtually guarantee CBM resources and augur well for China?s CBM aspirations.

Offering further comfort is the role played by the Chinese government in the development of CBM resources. In May 1996, the State Council established CUCBM as a state agency to oversee the CBM sector with the mandate to commercialise the exploration, development, marketing, transportation and utilization of CBM. CUCBM is jointly owned by PetroChina Company Ltd and China National Coal Group and enters into PSCs with foreign companies. CBM companies also benefit from generous government incentives such as a two-year income tax holiday and reduced value-added tax and royalty. CUCBM has not been a greedy government authority keen on milking CBM ventures. Country risk it appears is minimal for CBM companies in China.

This makes companies that provide exposure to the Chinese CBM industry distinctly attractive investments. The industry however requires focused, technologically savvy operators thus making pure CBM players equally appealing due to their focused approach and greater commitment. Thus companies such as Pacific Asia China Energy, Far East Energy, Verona Development Corp., Green Dragon Gas and Ivana Ventures (ANA.V) warrant a closer look.

The greatest positive about pure CBM players is the direct exposure it provides to the China CBM story. Most of them extensively use a local workforce which usually leads to strong relationships with authorities. More importantly, they are still not on the radar screen of larger institutional investors and appear to be relatively under valued. While they are yet to reach the production stage, they have made considerable progress in their respective projects and are well poised to benefit from the expected growth of the Chinese CBM sector.

For instance, London listed Green Dragon Gas is developing CBM resources in Shanxi, Jiangxi and Anhui provinces with a plan to drill 80 wells by February 2008. Cumulative production from pilot wells drilled on the Chengzhuang section has exceeded 5.5 mmcf so far. Pacific Asia China Energy has two projects in Guizhou and Hubei provinces. According to an independent technical report by Sproule International, the Guizhou project has an estimated potential gas resource of 11.2 Tcf. Ivana Ventures has two projects in Xinjiang and Anhui with several exploration wells. Verona Development Corp has two projects in Shanxi (Shanxi project) and Henan provinces (Zhenzhou project) at varying stages of exploration. Meanwhile, Far East Energy has two PSCs with CUCBM and farm-out agreements with a subsidiary of ConocoPhillips in China.

In an attempt to foster greater co-operation in the Chinese CBM sector, the Chinese government passed a ruling to permit CBM companies to forge alliances amongst themselves. Prior to this ruling all CBM projects were to be developed in joint venture with CUCBM. The ruling effectively ends CUCBM dominance and is a giant step towards industry deregulation. Industry participants, particularly foreign companies, have greeted the news with much optimism. CBM companies are likely to use the ruling to form joint ventures among themselves to accelerate their development programmes. This ruling further confirms that China recognises the important role foreign participants can play in the CBM industry seriously.

It is important to note that China?s natural gas pipeline infrastructure is also showing considerable development. The main the West to East Gas Pipeline is expected to rectify the imbalances in the allocation of gas resources. The 4,000-km-long West-East pipeline commenced operation in October 2004, with the supply of some 12bcm of natural gas to 10 provinces. China expects to increase the pipeline capacity to 17bcm by end 2007. In addition, China plans to spend US$375mn to build two pipelines with a total length of 1,390km for CBM gas transmission. Improving pipeline infrastructure augurs well for the CBM industry.

Despite their ongoing projects and the exposure they provide to the burgeoning Chinese CBM sector, they have attracted little investor interest. Strong fundamentals surrounding the Chinese natural gas sector underpin the fortunes of alternative gas sources such as CBM. With the regulatory environment providing an equally strong support for CBM players, the sector appears to be well set to take off.

We have highlighted below few companies with CBM projects in China. These are focused CBM players and are not engaged in the development of conventional hydrocarbon resources.

Green Dragon Oil (London AIM: DI)
Green Dragon, through its subsidiary Greka Energy (International) B.V., has five PSCs with CUCBM covering a total of approximately 6,700 km2 (approximately 1.6 million acres). This represents one of the largest area granted by CUCBM in China operated by a foreign CBM company and was secured alongside US majors including Texaco, Phillips and Arco.

Green Dragon?s projects are in Shanxi, Jiangxi and Anhui provinces, where several CBM projects are currently underway. The Shanxi province hosts the Qinshui basin, the southern part of which has been the focus of CUCBM's exploration and appraisal programmes. Green Dragon?s project areas are located in proximity to potential market in Zhengzhou, Henan. The mineral rich Jiangxi Province with rail and highway links make Green Dragon?s operations in the province equally attractive. Meanwhile, Green Dragon?s operations in the Anhui province is bound to benefit from the West-East gas transportation pipeline running near the block and the potential market in Nanjing, Jiansu Province.

Green Dragon is in an expansion mode. In December 2006, Green Dragon acquired 49% interest in Kesi Hengrun Technology Company Ltd (KHBT), which has 59% interest in Beijing Huayou United Gas Development Company Ltd (BJHY). BJHY is currently developing a gas distribution network in the fast growing Beijing?s Business Development Area. China National Petroleum Company (CNPC) owns the remaining 41% interest in BJHY. The acquisition is expected to help Green Dragon?s aspirations to become a vertically integrated gas producer and distributor in China.

 

Pacific Asia China Energy (TSX-V: PCE)
Pacific Asia China Energy (PACE) has two projects in Guizhou and Hubei provinces through two fully owned subsidiaries. PACE has PSCs with CUCBM with the option to own 60% and 70% interest in Guizhou and Hubei projects respectively. In addition, PACE has 50:50 joint venture with Mitchell Drilling Contractors Pty Ltd of Australia thus securing an exclusive license to use Mitchell's proprietary drilling Dymaxion System in China. PACE Mitchell Dymaxion is a unique and highly effective surface to in-seam drilling technique which the company has deployed since early 2000. To date, over 200 Dymaxion wells have been drilled on CBM projects.

According to an independent technical report by Sproule International, the Guizhou project has an estimated potential gas resource of 11.2 Tcf within its 970 km2 CBM concession. Located in south-central China approximately 700 km northwest of Hong Kong, and known as the "home of coal in South China", the Guizhou Province is a major energy producing province. The province has a regional population of 245 million with a rapidly developing rail and highway infrastructure. PACE is conducting a pilot production test comprising three vertical wells located in the Zhongyi region of the Mayi block, in which Sproule estimates in accordance with Policy NI 51-101 and the COGE Handbook, a "Most Likely Case volume of discovered CBM resources in place" at 5.2 TCF for targeted coal seams 17-1, 17-2, and 19, having an aggregate thickness of 9.2 m distributed over the Guizhou project area. 

The company?s Huangshi CBM concession is located in Hubei province in central China, home to the Huangshi city with some 3 million people. This is a primary coal producing area since 1999 and has a well developed transportation infrastructure. It is also located in close proximity to pipelines. PACE has identified two locations for slim core-hole testing in the Huangshi concession. Pending results, it is expected that one site will be selected for a vertical well fracc stimulation test.

Brisk development activities are expected at both concessions and PACE appears to be well-funded to finance its development programmes. PACE Mitchell is also making steady progress and has signed a drilling services contract for degasification at the Yunnan Weixin Guanyinshan Coal Mine in Kunming, Yunnan Province. An agreement has also been reached with Weixin Yuntou Yuedian Zhaxi Energy Co. Ltd, owner of the coal mine, for the right to negotiate degasification services. The latter marks the second major contract to be signed as a direct result of PACE Mitchell's degasification marketing initiative. PACE Mitchell complements PACE operations in China CBM space and targets to become a leading coal degasification/CBM drilling company

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Far East Energy (OTC BB: FEEC)
FEEC has PSCs with CUCBM and farm-out agreements with a subsidiary of ConocoPhillips in China. Spanning over 1.057 million acres, the Shanxi project has an estimated 13.1 to 19.6 Tcf of total gas-in-place with potentially 6.55 to 9.8 Tcf recoverable CBM resources. The Shanxi project is a farm-out from ConocoPhillips and provides 66.5% interest potential for FEEC (after 3.5% ORRI). The core recovery tests by ConocoPhillips indicate significant levels of cleating (fractures in the coal) and friability (brittle and fragmented coal) suggesting high permeability. The tests also show high gas content of 400-800 cubic feet per ton. Once developed, the project has the potential to become one of the largest CBM projects in the world.

FEEC has two PSCs with CUCBM in the Yunnan province (Enhong & Laochang projects) with an estimated 5.3 Tcf of total gas-in-place with potentially 2.65 Tcf of recoverable CBM resources. The company has 70% interest in the two projects with CUCBM accounting for the remaining 30%. Tests on these two blocks show estimated gas in place of 200 to 500 cubic feet per ton of coal.

FEEC also has an accelerated development programme and has commenced the drilling of its HZ08V well, in its Shouyang Block in Shanxi. Based upon these results, FEEC intends to enter into a contract with Beijing China Coal Dadi Technology Development Company (Dadi) to drill additional seven wells. In addition, FEEC confirmed plans to drill five exploratory wells in the Block to expand its database of geologic information about the multiple prospective coal seams.

In addition to its promising assets, FEEC finances received a shot in the arm, with the completion of the recent investment in the Company by the International Finance Corporation (IFC), the private sector arm of the World Bank Group. The IFC investment in FEEC further reiterates the potential for CBM ventures in China.

Verona Development Corporation (TSX-V: VDC)
VDC has two projects in Shanxi (Shanxi project) and Henan provinces (Zhenzhou project) with 60% and 40% interest respectively. These two projects contain numerous high rank gassy coal sequences with an in-situ resource that could exceeds16 Tcf (KAM Energy Consulting). The Shiloubei CBM Project is located in the Hedong Basin, east of the Yellow river in western Shanxi Province, about 600 km to the southwest of Beijing. VDC is developing the project in a 60/40 JV with CUCBM. The project area covers approximately 1015 square kilometres underlain by Carboniferous and Permian coal measures. The project has market access to several large towns in the province and is approximately 50 km from large inter-connector pipelines that supply Beijing.

 

The Zhengzhou energy project is a unique 60/40 joint venture between VDC and the Zhengzhou Coal Company. The exploration block is located on the outskirts of Zhengzhou City in Henan Province, about 700 km to the southwest of Beijing, covers an area of 2,500 square kilometres and is underlain by four coal fields of Carboniferous and Permian ages.

Following the recent completion of regional exploration studies over its 1,015 square kilometre concession, VDC has begun drilling two wells in the Shiloubei Block. On going studies will entail comprehensive desorption and petrograpaphic studies, detailed sedimentological studies, and permeability testing of key intervals.

Arrow Energy (ASX: AOE)
AOE has a portfolio of CBM resources in Australia and throughout Asia including China. The Company however is more focused on its Australian assets and is a major participant in the Bowen Basin, Surat Basin, Clarence Moreton Basin and Nagoorin Graben coal seam gas provinces. Following China?s ruling to permit alliance with companies other than AUCBM, AOE has signed an agreement with PetroChina to develop CBM resources in China.

Asian American Gas Inc. (AAGI, Unlisted)
AAGI has signed two PSCs with CUCBM for Panzhuang and Mabi concessions in southern Qinshui Basin of Shanxi Province. The proven reserve for Panzhuang block is 20.4 billion cubic meters (bcm), and it is one of only three blocks in China that has obtained government CBM reserve certification. The Mabi block holds a total gas in-place reserve of 3.5 Tcf based on a preliminary evaluation.

The company?s Multi-Lateral Drilling production wells in Panzhuang have demonstrated commerciality by their record production rates. With a daily production of 40,000 cubic meters, PZP01-2 well has sparked enormous enthusiasm. AAGI is planning to speed up the development, and is expecting to realize commercial start-up in 2008.

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