may 9, 2012 unconventional natural gas (shale g as ) c ... · our top picks are jereh oilfield,...

Sector Research | China Unconventional Natural Gas (Shale Gas)

THIS IS THE TRANSLATION OF A REPORT ORIGINALLY PUBLISHED IN CHINESE BY GUOSEN SECURITIES CO., LTD ON Feb 14, 2012

For ratings definitions and other important disclosures, refer to the Information Disclosures at the end of this report. Bespoke translation by Guosen Securities (HK) Brokerage Co., Ltd. strictly for use by its clients only.

1

May 9, 2012

Unconventional Natural Gas (Shale Gas) Cautious Buy

Right direction, but it’s still a pipe dream for now

Investment highlights

Shale gas development enjoys huge growth potential in China. Shale

gas production reached 180 billion cubic metres in the US in 2011, accounting

for 34% of its total natural gas production, which enabled it to become a net

natural gas exporter, and revolutionised the energy landscape. We believe

China can replicate the success in the US, as technically recoverable shale

gas reserves in China amount to about 31 trillion cubic metres, equivalent to

about 10 times the conventional gas reserves, according to the government.

The time is not ripe yet for mass production of shale gas. The unique

confluence of economic, political and industry conditions that support the

shale gas boom in the US, such as government subsidies, preferential tax

policies, liberalised natural gas pricing mechanism, advanced technologies,

etc, do not exist in China so far. China launched a pilot programme in

Guangdong and Guangxi in 2011 to reform the natural gas pricing

mechanism, but the effect has yet to be felt.

To focus on gas exploration before 2015 and extraction afterwards. We

expect China to start producing shale gas in 2015, when a solid foundation for

shale gas extraction should have been laid. Chinese enterprises will focus on

shale gas exploration before 2015, and start commercial extraction

afterwards in our view, as blocks awarded to enterprises in the 1st and 2nd

rounds of shale gas tenders are expected to enter the extraction phase then.

Shale gas development will benefit different companies along the

supply chain at different stages. Exploration companies stand to be the first

to benefit, equipment manufacturers with technological advantages or

producing specialised exploration & drilling equipment stand to benefit at the

equipment-purchasing stage, gas field service companies taking the initiative

to accumulate technological capabilities set to benefit at the drilling stage,

while oil & gas companies will be the last to benefit.

Our top picks are Jereh Oilfield, Shenkai, Anton Oilfield Services and

Honghua Group, as we believe the core products Jereh and SK provide are

indispensable equipment used in shale gas development, while Anton enjoys

strong technological advantages as it has introduced advanced technologies

from the US, and Honghua is on course to excel as a vertically integrated

company engaged in drilling, oilfield services and drilling rig manufacturing.

Exhibit 1: Valuation of major A-share listed companies

Ticker Company

name Last price Market cap EPS PE (x) PB

(x) (RMB) (RMB bn) 2011E 2012E 2013E 2011E 2012E 2013E

002353 Jereh Oilfield 67.95 15.604 1.85 2.73 3.78 36.71 24.90 17.95 6.48

002278 SK Petroleum & Chemical

9.51 2.487 0.33 0.39 0.45 28.41 24.18 21.33 2.29

Source: WIND, Guosen Securities Economic Research Institute

Analyst

Liu Xuming +86-010-66025272 [email protected] S0980511070001

Sales Contact

Dan Weil Global Head of Institutional Sales and Trading Managing Director +852 2248 3588 [email protected]

Chris Berney Managing Director +852 2248 3568 [email protected]

Joe Chan Director +852 2248 3578 [email protected]

Cancy Kong Vice President +852 2248 3538 [email protected]

Jiafeng Li Vice President +852 2899 7281 [email protected]

Shunei Kin Vice President +852 2248 3536 [email protected]

Unconventional Natural Gas (Shale Gas) May 9, 2012 | China THIS IS THE TRANSLATION OF A REPORT ORIGINALLY PUBLISHED IN CHINESE BY GUOSEN SECURITIES CO., LTD ON Feb 14, 2012

Guosen Securities (HK) Brokerage Co., Ltd. Bespoke translation by Guosen Securities (HK) Brokerage Co., Ltd. strictly for use by its clients only

2

1. Shale gas: an important complement to conventional natural gas ............................................................................................... 3

1.1 Shale gas: unconventional natural gas ...................................................................................................................... 3

1.2 Shale gas production surged in the US due to development of extraction technologies ...................................................................... 3

1.3 China’s shale gas reserves equal to 12 times conventional natural gas reserves ................................................................................ 5

1.4 Shale gas on course to be an important gas source as demand surges in China ................................................................................ 5

1.5 Shale gas extraction expected to change China’s energy supply pattern ............................................................................................ 6

2. Several hurdles still need to be overcome ...................................................................................................................................... 6

2.1 Policy support is a must ...................................................................................................................... 6

2.2 Natural gas pricing mechanism need to be liberalised ...................................................................................................................... 7

2.3 Technological challenges to be resolved ...................................................................................................................... 9

2.4 Several considerations when investing in shale gas development..................................................................................................... 10

3. China’s shale gas development schedule ..................................................................................................................................... 11

3.1 China’s shale gas development is still in a nascent state .................................................................................................................. 11

3.2 Only large state-owned companies participated in China’s first shale gas block tender..................................................................... 11

3.3 Large SOEs enjoy advantages as huge amounts of capital investment and shale-specific experience are needed .......................... 12

3.4 Shale gas development schedule: to focus on gas exploration before 2015 and extraction afterwards ............................................. 13

4. Major beneficiaries at different stages .......................................................................................................................................... 15

4.1 Shale gas development will benefit different companies at different stages ...................................................................................... 15

4.2 Domestic shale gas exploration basically monoplised by the two oil giants ....................................................................................... 16

4.3 Equipment manufactures enjoying technological advantages / producing specialised exploration & drilling equipment stand to benefit

at the equipment purchasing stage .................................................................................................................... 16

4.4 Gas field service companies taking the initiative to accumulate technological capabilities stand to benefit at the drilling stage ........ 17

4.5 Oil & gas companies will be the last to benefit .................................................................................................................... 18

5. Jereh Oilfield: a leading fracturing equipment manufacturer on course to benefit from shale gas extraction ....................... 19

5.1 Substantial growth potential for the fracturing equipment market ...................................................................................................... 19

5.2 Facing less intense competition given the high barrier to entry ......................................................................................................... 19

5.3 On course to win recognition after participating in the fracturing process of China’s first test shale gas well ..................................... 20

5.4 How much benefit can Jereh get? .................................................................................................................... 20

6. SK Petroleum & Chemical: MWD business on course to benefit from growing volume of drilling operations ....................... 20

6.1 Capturing large market share in the high-end drilling product market ................................................................................................ 20

6.2 MWD business on course to benefit from shale gas horizontal well drilling ....................................................................................... 21

6.3 The sales volume of surface equipment is expected to grow as the number of wells need to be drilled increases ............................ 21

6.4 How much benefit can SK get? .................................................................................................................... 21

7. Anton Oilfield Services: a local market leader enjoying strong technological advantages ...................................................... 22

7.1 Core advantage: advanced unconventional energy extraction technologies...................................................................................... 22

7.2 An eye to the future .................................................................................................................... 22

7.3 Successfully participated in the fracturing operations for China’s first shale gas well ........................................................................ 23

7.4 How much benefit can Anton get? .................................................................................................................... 23

8. Honghua Group: a vertically integrated company engaged in drilling, oilfield services and drilling rig manufacturing ........ 24

8.1 Staying cautious in bidding for exploration right .................................................................................................................... 24

8.2 Well positioned to provide one-stop shale gas extraction solution ..................................................................................................... 24

8.3 A leading drilling rig manufacturer attaching importance to technology innovation ............................................................................ 24

8.4 Stepped into the fracturing equipment market .................................................................................................................... 25

8.5 How much benefit can Honghua get? .................................................................................................................... 25

Appendix ................................................................................................................................................................................................ 27



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1. Shale gas: an important complement to

conventional natural gas

1.1 Shale gas: unconventional natural gas

Shale gas is a type of unconventional natural gas that exists in some shale formations. It

mainly consists of methane trapped in small fractures thousands of feet below the earth’s

surface. Shale gas has grown in importance as a complement to conventional natural

gas as energy demand continues to increase.

Conditions for the formation of conventional natural gas include “reservoir”, where gas

reserves are held, “seal”, a unit with low permeability that impedes the escape of gas

from the reservoir rock, and “trap”, the stratigraphic or structural feature that ensures the

juxtaposition of reservoir and seal so that gas remains trapped in the subsurface, rather

than escaping and being lost. Shale gas resource differs from conventional gas in that

the shale acts as not only the “reservoir”, but also the “seal” and the “trap”. The reservoir

systems have gas-bearing strata that are not density-stratified, and distributed over a

very large geographic area. As such, shale gas can be several times more abundant than

the proven reserves of conventional natural gas.

Conventional natural gas, being lighter than air, usually flows freely through cracks, and

can naturally rise to the surface of a gas well. Because of this, in many natural gas wells,

lifting equipment and well treatment are not necessary. However, for shale gas, initial gas

in place (IGIP) is primarily in the form of adsorbed gas, while far less of it is in the pore

space, implying that mass production of shale gas will be impossible unless some

specialised treatments and technologies, such as horizontal drilling and hydraulic

fracturing technologies are adopted. Shale gas was discovered a very long time ago, but

it was not commercially produced until recent years, as special techniques are required

for shale gas extraction, which makes it more expensive than conventional gas to extract.

Exhibit 2: Differences between shale gas and conventional natural gas

Shale gas Conventional natural gas

Origin Thermal evolution, biogenic origin Thermal evolution, biogenic origin, and crude oil cracking

Key component Largest component is methane; small amounts of ethane and propane

Largest component is methane; certain amounts of ethane and propane

Formation Acting as reservoir, seal and trap itself Needs combination of reservoir, seal and trap

Distribution Widespread Combination of reservoir, seal and trap

Form of storage Adsorbed gas and free gas Free gas

Depth 200 to 4,000 metres below the surface >500 metres below the surface

Reserves in China Technically recoverable reserves estimated at 36.1 trillion cu m Proven recoverable reserves of 3.0 trillion cu m

Dominant well design Horizontal well Vertical well

Extraction Unable to naturally rise to the surface, specialised technologies is needed

Able to naturally rise to the surface

Source: Shale Gas Outlook to 2020, Guosen Securities Economic Research Institute

1.2 Shale gas production surged in the US due to development of

extraction technologies

The extraction technologies of shale gas are also “unconventional” compared with that of

conventional gas. With over 30-year experience in shale gas development, the US has

developed a set of mature and advanced extraction technologies. After Barnett Shale,

the first recognised major shale gas field in the US, went into operation in 1982, the US

Shale gas can be several times

more abundant than the proven

reserves of conventional natural

gas.

Shale gas was not commercially

produced until recent years, as

special techniques are required for

shale gas extraction, which makes it

more expensive than conventional

gas to extract.



4

has achieved three key milestones in shale gas development, as it developed the

hydraulic fracturing technology in 1997, introduced repeated fracturing treatments in

1999, and then adopted horizontal drilling technology in 2003 (for details, please refer to

the Appendix). At present, the US is the only country where mass production of shale gas

has been achieved.

Given the positive outlook for shale gas, production surged in the US, as a large number

of oil producers and oilfield service companies entered this burgeoning market. Shale

gas production in the US reached 180 billion cubic metres in 2011, accounting for 34% of

its total natural gas production, which enabled it to become a net natural gas exporter,

and revolutionised the energy landscape in the US and even around the world. Given the

huge progress in shale gas development, the price of natural gas slumped 41% in the US

over the past 12 months, while power prices fell by 50%, as a number of natural gas-fired

power stations came into operation, while the construction of some wind farms, nuclear

power plants and thermal power stations came to a halt. According to the US Energy

Information Administration (EIA)’s forecasts, shale gas will become the most important

energy source in the US, as it’s on course to account for 46% of US energy consumption

by 2035.

Exhibit 3: Shale gas production in the US over 2000-10

Source: EIA, Annual Energy Outlook 2011, Guosen Securities Economic Research

Institute

Exhibit 4: Forecasts of the share shale gas makes up in US energy consumption

Source: EIA, Annual Energy Outlook 2011, Guosen Securities Economic Research

Institute

0

300

600

900

1,200

1,500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

1 bn cu m 150

120

90

60

30

Shale gas will become the most

important energy source in the US,

as it’s on course to account for 46%

of US energy consumption by 2035,

based on the forecasts of the US

Energy Information Administration.



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1.3 China’s shale gas reserves equal to 12 times its conventional

natural gas reserves

According to the gas reserve data for 32 countries (Russia, Central Asian and

Mid-Eastern countries are not included) released by the EIA, technically recoverable

shale gas reserves in these countries reached a combined 187.5 trillion cubic metres,

much higher than their combined conventional natural gas reserves of 36.1 trillion cubic

metres. China ranks first in the world in terms of technically recoverable shale gas

reserves, with an estimated 36.1 trillion cubic metres, which is more than 12 times its

proven conventional natural gas reserves of 3.0 trillion cubic metres.

According to the calculations of the Oil & Gas Strategic Research Centre under the

Ministry of Land and Resource, China’s technically recoverable shale gas reserves

reached about 31 trillion cubic metres, slightly less than the EIA’s estimate. Given China’s

huge reserves, shale gas is on course to become an important part of the country’s

energy mix, in our view.

Exhibit 5: Comparison of shale gas reserves and conventional gas reserves in 32

countries (100 million cu m)

Country

Conventional natural gas Shale gas

Ranking Production Consumption

Balance of trade

Proven recoverable

reserves

Technically recoverable

reserves

China 830 872 14 30299 361039 1

US 5833 6456 28 77163 244091 2

Argentina 1,46 430 11 3794 219172

Mexico 501 609 51 3398 192837 4

South Africa 20 54 178 - 137336 5

Australia 473 309 -147 31148 112135 6

Canada 1594 852 -246 17556 109869 7

Libya 159 59 -467 15489 82119 8

Algeria 816 289 -518 45024 65412 9

Brazil 102 187 127 3653 63996 10

Poland 59 164 181 1642 52952 11

France 8 490 278 57 50970 12

Other countries

4250 4800 -5256 131421 183210 -

Total 14645 15571 -5765 360646 1875138 -

Source: EIA，World Shale Gas Resources, Guosen Securities Economic Research

Institute

1.4 Shale gas on course to become an important energy source as

power demand surges in China

China’s natural gas consumption grew 14% per annum on average over 2000-10. As at

the end of 2010, China’s apparent consumption1 of natural gas grew 23% y-o-y to 109.6

billion cubic metres, among which primary energy accounts for about 4%, much lower

than the developed countries’ average of 23%. According to the 12th Five-Year Plan,

China’s natural gas consumption is on track to reach 260 billion cubic metres by 2015,

which will increase its share in China’s overall energy mix to 8%. Under such scenario,

we believe China is on course to witness a gas consumption boom in the next few years,

with the consumption expected to enjoy a CAGR of 19%.

1 Apparent Consumption = Production + Imports - Exports ± (Stock Change)

Shale gas will become an important

part of China’s energy mix as it has

the most technically recoverable

shale gas reserves in the world

(excluding Russia, Central Asian

and Mid-Eastern countries).

Gas consumption in China is

expected to surge over the next five

years, expanding by a forecast

CAGR of 19% over the period.



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Natural gas supply will be very tight in China, indicating strong demand for new gas

sources. Out of the total gas supply in China for 2010, 95.2 billion cubic metres were

domestically produced gas, 13.6 billion cubic metres were LNG imported from abroad,

and 5 billion cubic metres were natural gas imported through pipelines, which means

China’s main gas supply sources consist of domestically produced natural gas, LNG

imported through LNG terminals located in the south-eastern coast, and natural gas

imported from Central Asian countries and Russia through pipelines.

China’s proven natural gas reserves of 3 trillion cubic metres is only 32 times its annual

natural gas production, implying the outlook for natural gas development will be dim if it

cannot find new gas sources or reserves. Besides, China’s high dependence on foreign

natural gas represents a risk to national security and economic stability, as natural gas

imports are extremely sensitive to geopolitical factors as well as commodity prices in

global markets. In this case, we believe the expansion of domestic shale gas production

can provide an important gas supply source, and help China to strengthen its voice in the

global energy market.

1.5 Shale gas extraction expected to change China’s energy supply

pattern

As mentioned, according to calculations of the Ministry of Land and Resource, technically

recoverable shale gas reserves in China reached about 31 trillion cubic metres, with

southern China, northern China, northwestern China and the Qinghai-Tibet area

accounting for 46.8%, 8.9%, 43% and 1.3% of the total reserves respectively. Besides

Sichuan Basin and Tarim Basin, the Yangtze River valley also enjoys huge potential in

terms of shale gas extraction, according to the ministry.

Given western regions contribute most to China’s natural gas production, while eastern

regions account for most of its gas consumption, two phases of West-East gas pipeline

projects have been constructed across the country, and the third phase is on course to be

constructed. Under such circumstances, increase in natural gas production capacity in

eastern China can help reduce gas transport costs and change China’s energy

landscape, in our view.

2. Several hurdles still need to be overcome

2.1 Policy support is a must

According to the 12th Five-Year Plan for shale gas, China targets to complete the

evaluation work of domestic shale gas reserves by 2015, increase its proven geological

reserves of shale gas to 1 trillion cubic metres, out of which 200 billion cubic metres are

recoverable gas reserves, and expand its annual shale gas production to 6.5 billion cubic

metres. However, some hurdles still need to be overcome in order to achieve these

ambitious goals.

Shale gas development needs policy support as costs associated with the development

of shale resources are significantly higher than for conventional natural gas. After the US

federal government released the Section 29 tax credit for unconventional gas to

incentivise shale gas drilling, state governments launched tax incentives, and shale gas

drilling companies in some states could even be exempt from the production tax. What’s

more, some unconventional oil and gas energy research funds have been established in

China’s proven natural gas reserves

of 3 trillion cubic metres represent

only 32 times its annual production,

meaning supply is limited and

expansion of shale gas production

is critical to securing China’s

energy requirements going forward.

Sichuan Basin, Tarim Basin and

Yangtze River valley enjoy huge

potential in terms of shale gas

extraction.

Under the 12th Five-Year Plan,

China targets to increase its annual

shale gas production to 6.5 billion

cubic metres.



7

the US to encourage SMEs to invest in shale gas exploration and extraction. With

vigorous support from the government, the US shale gas boom has begun to take off.

However, in contrast with the US, very few efforts have been made by the Chinese

government to encourage shale gas development in terms of laws and regulations, tax

incentives, government subsidies, R&D, technology import, etc. Shale gas exploration

and extraction companies cannot find support from the government, and could face huge

losses due to policy risks. Exhibit 6 shows relevant policies and regulations that we

believe can give a boost to shale gas development. However, there is a limited chance

these policies and regulations can be clarified and implemented in the short term, as

multiple interest parties are involved, including the State Administration of Taxation, the

Ministry of Finance, the Ministry of Land and Resource, the National Development and

Reform Commission (NDRC), the State-owned Assets Supervision and Administration

Commission, local governments, CNPC, Sinopec, etc. The central government as well as

local governments have to negotiate with PetroChina and Sinopec before making

changes to shale gas policies, as the two oil majors monopolise the mining rights of 66%

of domestic shale gas reserves.

Exhibit 6: Policies and regulations that we think would be supportive for shale gas development

Category Detailed policies and regulations

Extraction tax Tax reduction & exemption

Subsidy Government subsidies

Natural gas price Pricing mechanism needs to be liberalised

Reform of the natural gas pricing mechanism (pilot programmes have been launched in Guangdong and Guangxi)

R&D Tariff reduction and exemption on imported equipment

Encouraging governments, enterprises and universities to establish R&D bases

Encourage enterprises to increase investment in R&D

Encourage cooperation with foreign enterprises via joint ventures and overseas acquisitions

Regulations Clarifying the bidding mechanism for shale gas projects

Increasing government investment in shale gas exploration

Clarifying mining rights in overlapping areas

Encouraging the central government, provincial governments and SOEs to reach agreements on shale gas development and solve related problems.

Source: The Ministry of Land and Resource, Sinopec, PetroChina, Guosen Securities Economic Research Institute

2.2 Natural gas pricing mechanism needs to be liberalised

China’s domestic natural gas pricing mechanism also discourages enterprises from

operating in shale gas. China adopts a complicated natural gas pricing mechanism,

under which the NDRC determines the wellhead prices and pipeline transport prices,

while provincial and municipal governments have a say in retail prices. Given the strict

policy regulations, China’s natural gas wellhead prices are much lower than prices of

LNG and natural gas imported through pipelines.

The aforementioned pricing mechanism leads to two major problems. On one hand, the

development of natural gas exploration and extraction in China lacks momentum due to

the limited investment, and on the other hand, natural gas importers face huge losses

given high import prices. If the government maintains the cost-plus pricing mechanism2,

enterprises’ interest in developing shale gas resources will continue to wane, as they can

make more money from conventional natural gas and oil.

2 Related companies first calculate the cost of the product, and then add a proportion of it as

markup.

But before the production target for

shale gas can be reached, strong

policy support by the Chinese

government is critical, similar to the

experience in the US.

China’s cost-plus natural gas

pricing mechanism is complicated

and it discourages operators from

developing shale gas given the

huge losses already suffered by

natural gas importers.

http://en.wikipedia.org/wiki/Markup_(business)



8

China launched a pilot programme in Guangdong and Guangxi at the end of 2011 to

reform the natural gas pricing mechanism. The government uses prices of imported fuel

oil and LPG in Shanghai as a starting point to derive the city gate prices3 for Guangdong

and Guangxi, where the city-gate ceiling price was set at RMB2.7 per cubic metre. The

programme aims to liberalise well-head price for natural gas, and link domestic natural

gas pricing to imported gas. However, as the pilot programme was only recently launched,

the effect has yet to be felt, and we believe it will take some time for the pilot programme

to be smoothed out, and even more time to expand it nationwide. The government also

noted that it intends to liberalise well-head prices for shale gas, coal-bed methane and

coal gas, which will all be determined through negotiations between the buyers and

vendors, but apparently it still has a long way to go before taking actual actions.

We believe China’s shale gas development won’t gain momentum if costs associated are

too high, which means the outlook for shale gas will be highly dependent on natural gas

prices. Although it’s still very difficult to calculate the costs associated with shale gas

exploration and extraction, given the lack of relevant data so far, we tried to make the

calculation based on the assumption that the geologic conditions for shale gas extraction

in China are similar to that in the US, and China has overcome technological challenges

and developed mature extraction technologies just like the US.

Based on Honghua Group’s calculation on single-well drilling costs, we assume it

typically costs RMB32.88 million in the US to drill a shale gas well, compared with

RMB28 million in Sichuan, China.

Exhibit 7: Comparison of single-well drilling costs in China and the US

(RMB10,000)

Cost item US China Note: basic assumptions US China

Installment and disassembly 68 48 Total vertical depth (metre) 2100 3500

Field construction 143 100 Total horizontal depth (metre) 1050 1500

Vertical drilling 136 245 Frac interval spacing (metre) 120 150

Horizontal drilling 205 290 Number of intervals 8 10

Well completion 341 425 Drilling cost of vertical wells (RMB/metre)

648 700

Measurement while drilling 171 266 Drilling cost of horizontal wells (RMB/metre)

1952 1933

Consumptive materials/rent/transport 682 341 Fracturing cost per interval (RMB10,000/ interval)

85 65

Transport cost 123 85 Cost of casing pipes (RMB/metre)

759 300

Fracturing 682 650

Flow control 314 100

Casing 239 150

Wellhead equipment and production equipment

184 100

Total cost 3288 2800

Source: Expert interviews, Honghua Group, Guosen Securities Economic Research

Institute

The calculation goes like this: we assume the single-well drilling cost is RMB28 million,

other capital expenditures, including costs associated with field construction, pipeline

network construction, etc, amounts to RMB7 million, and the fixed assets are depreciated

over 30 years on average. Besides, we assume the annual production capacity of a

single well reaches 2.8 million cubic metres (which is equal to that of Barnett Shale in

3 City gate price are equal to wellhead price plus transport price

The pilot programme to reform the

natural gas pricing mechanism in

China was launched only recently so

nationwide implementation of the

scheme will not be imminent given

the need to fine-tune the system.



9

2011), operating fee and management fee amount to about RMB1.165 per cubic metre

(equivalent to about US$0.9 per MCF), and other costs, including tax charges and

financial costs account for 20% of the total cost.

We conducted sensitivity analysis to the two key factors, namely production per well and

well drilling cost.

Exhibit 8: Sensitivity analysis of single well production capacity and drilling cost

(RMB/ cu m)

Single well production capacity (10,000 cu m/ year)

Drilling cost (RMB10,000)

1600 2000 2400 2800 3200 3600 4000

120 0.865 1.031 1.198 1.365 1.531 1.698 1.865

160 0.698 0.823 0.948 1.073 1.198 1.323 1.448

200 0.598 0.698 0.798 0.898 0.998 1.098 1.198

240 0.531 0.615 0.698 0.781 0.865 0.948 1.031

280 0.484 0.555 0.627 0.698 0.769 0.841 0.912

320 0.448 0.511 0.573 0.636 0.698 0.761 0.823

360 0.420 0.476 0.531 0.587 0.642 0.698 0.754

400 0.398 0.448 0.498 0.548 0.598 0.648 0.698

440 0.380 0.425 0.471 0.516 0.562 0.607 0.653

Source: Expert interviews, Honghua Group, Guosen Securities Economic Research

Institute

If the production capacity of shale gas wells in Sichuan province could reach the level in

Barnett Shale, the average well-head shale gas cost would be RMB0.70 per square

metre (before tax). However, given China lags well behind the US in terms of shale gas

extraction, the average well drilling cost in China is actually much higher than that in the

US. At present, drilling costs for test wells operated by CNPC and Sinopec exceed

RMB40 million, which means the average drilling costs should be more than RMB0.91

per cubic metre, indicating that shale gas extraction has no advantage over conventional

gas extraction in terms of costs. What’s more, shale gas extraction could lead to

economic losses if natural gas prices fluctuate.

Exhibit 9: Shale gas drilling costs vs. conventional gas extraction costs

Gas field Average extraction cost based on our calculations (RMB/cu b)

Sichuan shale gas field (at the early stage) 0.91

Sichuan shale gas field (in the mature stage) 0.70

Gas field in Chuanyu 0.63

Gas field in Changqi 0.65

Gas fields in Qinghai 0.60

Gas fields in Xinjiang (fields where gas produced are transported to the eastern areas are not included) 0.51

Other gas fields (Dagang filed, Liaohe field, Zhongyuan field, etc) 0.60

Source: Chem99, Guosen Securities Economic Research Institute

2.3 Technological challenges to be resolved

In our opinion, China can gradually master natural gas extraction technologies through

cooperation with foreign enterprises, but the entire process will take some time. The

shale gas extraction boom in the US was led by a number of creative small oilfield

service companies that jointly promoted the prosperous development and growing

adoption of technical know-how for shale gas exploration, with no company being able to

monopolise key technologies. It is not difficult to buy technologies from these companies

Based on our analysis, the average

well drilling cost in China is still

much higher than that in the US.



10

or cooperate with them, and the advantage of being a late starter will enable China to

accelerate its adoption of shale gas extraction, in our view, although it will take some time

and practice for domestic companies to master relevant new technologies, given the

nascent state of China’s shale gas industry. We believe China won’t be able to replicate

the success of shale gas in the US without the participation of domestic oil & gas

companies and gas field service companies.

Cooperation with US oil companies or oilfield service companies will be the main channel

for China to explore and extract shale gas in the short term, in our view. For example,

CNOOC purchased 33% of US-based Cheaspeak’s shale interests, while Sinopec

agreed to pay Devon US$900 million for the 33% stake in five fields, and PetroChina

bought 20% stake in Shell’s shale gas asset in Canada. China’s three oil giants aim to

acquire advanced technologies through these acquisitions to prepare for a shale gas

boom in China. Besides, PetroChina has signed an agreement with BP to jointly extract

shale gas, signed a shale gas fracturing technology training agreement with RPC, Inc.,

and achieved cooperation with Halliburton Company in shale gas exploration, etc, while

Sinopec is also seeking for possible cooperation opportunities in shale gas exploration

with leading companies, including Chevron and BP.

Main difficulties Chinese companies need to overcome when developing shale gas

technologies include: 1) to learn and master technical know-how for shale gas

exploration and extraction efficiently, and combine advanced technologies with

shale-specific experience. 2) To improve and innovate shale gas extraction technologies

based on specific geological conditions in China. 3) To integrate different shale gas

technologies, and combine different procedures, including data collection, geological

analysis, drilling, logging, well completion, gas extraction, etc, into one.

2.4 Several considerations when investing in shale gas development

Enterprises usually won’t make huge investment in shale gas extraction, if they are

uncertain whether the development projects offer good prospects. Several factors need

to be considered when assessing the economic potential of a shale gas project. First of

all, although geologists can estimate geographic locations rich in gas reserves, investors

still face huge risks without early-stage exploration, test-hole drilling and geological

evaluation. According to experiences in the US, enterprises can’t accurately forecast the

recoverable reserves and investment prospect of a gas field, nor provide a development

solution accordingly, until relevant data and information are effectively collected.

Secondly, given the high costs and substantial risk associated with shale gas

development, an effective and detailed development plan needs to be made to ensure

maximum investment returns. In contrast with conventional natural gas, investors of

shale gas projects might face huge losses unless exploration and extraction activities are

carried out in core areas, although shale gas reserves could be more abundant than

conventional natural gas. (For details, kindly refer to the Appendix).

Thirdly, there is a need to build supporting facilities, including gas gathering stations,

pigging stations, and especially transport facilities, such as pipeline networks, highway &

railway networks, etc, if large amounts of shale gas is produced. The construction of

these facilities won’t be carried out unless investors see huge economic potential in the

shale gas extraction projects.

We believe China won’t be able to

replicate the success of shale gas in

the US without the participation of

domestic oil & gas companies and

gas field service companies.

Several factors need to be

considered when assessing the

economic potential of a shale gas

project, such as field data and

construction costs.



11

3. China’s shale gas development schedule

3.1 China’s shale gas development is still at a nascent state

Although China has made some progress in shale gas exploration in recent years, its

shale gas development is still in a nascent state, as no proven shale gas reserves have

been officially announced, the evaluation work of domestic shale gas resource potential

has not been completed, and the industry standards for shale gas has not yet been set.

Shale gas was not approved as an independent mineral source until several months ago.

China basically has not mastered any specialised shale gas exploration technology so far,

and domestic enterprises still lack project specific experience. What’s more, although

PetroChina, Sinopec and Shaanxi Yanchang have exploratory projects underway, China

does not yet have any shale gas wells producing commercially.

Exhibit 10: Milestones in China’s development of shale gas

Time Milestones

2009-2010 The Ministry of Land and Resources launched a nationwide project to assess the shale gas development potential in key areas, (mainly Sichuan, Chongqing, Guizhou, Hubei, and the middle and downstream Yangtze River areas) and expanded the project to Northern China one year later.

Oct, 2010 CNOOC paid US$1.08 billion for a one-third stake in Chesapeake Energy Corp.’s Eagle Ford shale project in Texas, in the biggest acquisition of a US oil and gas asset by a Chinese company.

2011 The Ministry of Land and Resources began to assess the shale gas development potential in five regions, studying standards for shale gas evaluation and development technologies.

Jan, 2011 CNOOC paid US$1.3 billion for a one-third stake in Chesapeake Energy Corp.’s Wyoming and Colorado fields

Apr, 2011 PetroChina constructed China’s first test well for shale gas in Weiyuan, Sichuan province, and production of this well stablised at 10,000 cu m/ per day in the first three months after it came on line

Jun, 2011 Shaanxi Yanchang drilled the first shale gas well designed to extract gas from shale formed in continental facies4 in China, which successfully went into operation.

Jul 4, 2011 China held the first shale gas tender. Six domestic enterprises participated in the tender, and Sinopec and Henan Provincial Coal Seam Gas Development won the exploration rights.

The mid-Dec 2011 Sinopec did large scale fracturing in Yuanba-9 well, and the production increased to 11,500 cu m/ day.

Dec, 2011 PetroChina’s Changning-Weiyuan block in Sichuan became a country-level shale gas test zone covering an area of 6,567 sq km. The JV of PetroChina and Shell discovered the Fushun-Yongchuan block, and began assessment work on it.

Dec 30, 2011 The Ministry of Land and Resources released a notice to approve shale gas as an independent mineral source.

Jan 4, 2012 Sinopec invested US$2.2 billion for a third of Devon Energy Corp's interest in five developing fields, including Niobrara, Mississippian, Utica Ohio, Utica Michigan and Tuscaloosa fields, as part of a long-term partnership.

Feb 2, 2012 PetroChina paid over US$1 billion for 20% interest in Shell’s Groundbirch shale gas project in Canada

Source: The Ministry of Land and Resources, Sina Finance, PetroChina, Sinopec, CNOOC, Guosen Securities Economic Research

Institute

3.2 Only large SOEs participated in China’s first shale gas block

tender

Winning tenders for shale gas exploration rights is the first step to obtaining mining rights

in China, after the government adopted the open-tender system for shale gas exploration

rights. According to government regulations, companies that win exploration rights for an

oil or gas block can apply for the mining right only if they can complete the exploration

work before the exploration licence expires, and they can apply for trial extraction before

4 Deposits made in the continental domains.

China still lacks the technical

knowledge for shale gas

exploration. Besides, industry

standards have yet to be set and

proven reserves have not been

officially announced in China yet

The government has introduced the

open-tender system for shale gas

exploration rights in China. This will

help attract investment into the

sector and encourage competition

among the Chinese oil companies.



12

the completion of the exploration work. The mining fee will be paid year by year based on

the area the mining zone covers at a rate of RMB1,000 per sq km per year, while the

registration fee is less than RMB500, suggesting that there is a big chance an oil & gas

company that has won the exploration right for a block can obtain the mining right. The

adoption of the open-tender system for shale gas exploration rights will help attract

investment from various channels to promote shale gas exploration and extraction, and it

will also encourage competition among Chinese oil companies, as obtaining exploration

rights is a pre-requisite for obtaining mining rights.

China’s search for natural gas achieved a milestone in June 2011, as the country

launched the first round of tenders for four shale gas blocks, with six groups making bids,

including PetrolChina, Sinopec, CNOOC, Shaanxi Yanchang, China United Coalbed

Methane Co. and Henan Provincial Coal Seam Gas Development and Utilization Co.,

with a total of nine bidding documents submitted to the government.

Exhibit 11: Results of China’s first shale gas tenders (four blocks)

Block Top three bidders Total bid price

(RMB mn) Number of

wells Single well investment

(RMB10,000) Area

(sq km) Result

Yu Qian Nan Chuan Sinopec 591 11 5373 2197.9 win

China United Coalbed Methane

219 5 4380 fail

PetroChina 150 11 1364 fail

Yu Qian Xiang Xiushan

Henan Provincial Coal Seam

248 10 2480 2038.87 win

China United Coalbed Methane

165 6 2750 fail

Shannxi Yanchang 193 5 3860 fail

Guizhou Suiyang <3 bidders participated - - - - Didn’t release results

Guizhou Fenggang <3 bidders participated - - - - Didn’t release results

Source: The Ministry of Land and Resources, Guosen Securities Economic Research Institute

According to the tender results, Sinopec won the Yu Qian Nan Chuan block, while Henan

Coal Gas Development and Utilisation was awarded the Xiushan block. Less than three

companies participated in the auctions for the two blocks in Guizhou province, implying

enterprises still have a cautious view towards shale gas exploration.

The four blocks offered in China’s first auction of shale gas exploration rights in July 2011

cover a combined area of 110 million square kilometres, accounting for 1.3% of the total

area of China’s shale gas blocks, and the figure falls to only 0.5% if the two blocks that

failed to be auctioned off is not included, which is indicative of the substantial room for

shale gas tenders going forward.

3.3 Large SOEs enjoy advantages as huge amounts of capital

investment and shale-specific experience are required

Given the high barriers to entry, only large companies have the capability to win tenders

for shale gas exploration and extraction, as huge amounts of capital investment and

shale-specific experience are needed. A company has to invest at least RMB300 million

to develop 10 shale gas wells, and it could take several years to recoup the initial

investment.

One reason why a number of small companies participated in shale gas development in

the US is because there had long been a mature and open oil & gas exploration and

extraction market in America, whereas in China, onshore oil & gas mining rights are

Barriers to entry into the shale gas

sector are high given the

substantial up-front costs required

and the long period to recoup initial

investments.



13

monopolised by several large SOEs, including PetroChina, Sinopec, Shaanxi Yanchang

and China United Coalbed Methane, etc.

Given all the companies that participated in China’s first round of shale gas tenders are

influential large SOEs, the government will definitely seek feedback from them, which

means these major players are not only leading practitioners in China’s shale gas

development, but they will also participate in helping to establish the regulations and

processes. It remains unclear whether other companies can compete to win shale gas

tenders, but given the aforementioned financial and technological challenges, we believe

the likelihood is small if authorities assign a high weighting to the bid price when

awarding tenders.

3.4 Shale gas development schedule: to focus on gas exploration

before 2015 and extraction afterwards

Below is our forecast of China’s shale gas development schedule, based on our analysis

of related government policies, technological development and geological conditions, etc.

We expect China to start producing shale gas at the beginning of 2015, when a solid

foundation for shale gas extraction should have been laid. According to our forecasts,

regulations regarding management of mining rights and relevant preferential policies are

on track to be issued by 2013. Domestic companies should master mature shale gas

development technologies by the end of 2014, and the ongoing natural gas price reform

is on course to achieve a milestone at the beginning of 2015, three years after the launch

of the reform. Chinese enterprises will focus on shale gas exploration before 2015, and

start commercial extraction afterwards, as blocks awarded to enterprises in the first and

second rounds of shale gas tenders are expected to enter the extraction phase, after the

completion of exploration work.

We believe the smaller companies

will find it difficult to win tenders if

the government places a high

priority to the bid price when

awarding tenders.

We forecast China will be ready to

start producing shale gas by the

start of 2015.



14

Exhibit 12: Guosen’s forecasts of China’s shale gas development schedule

Key factors2011 2012 2013 2014 2015

1st tender 2nd tender

Approved as an

independent

mineral source

To improve tax, subsidy,

and R&D policies, while

study the management

mechanism

Launched pilot

programme in

Guangdong and

Guangxi

To gradually

liberalise natural

gas prices

PetroChina

opened China’s

first shale gas well

Proven technically

recoverable reserves to reach

510 billion cu m

To gradually accumulate

advanced technologies

To cooperate with foreign

companies and learn

advanced technologies

To develop a mature

tendering mechanism

To expand the pilot programme nationwide

To master mature shale gas

development technologies

The number of shale gas wells need

to be drilled gradually increase

China’s first shale

gas well went into

operation

The number of shale gas

wells need to be drilled

rapidly increase

Production capacity rise as the number of wells increase

To release detailed

preferential policies

Events already happened Our forecasts

Production capacity

rapidly increase, as

more and more wells

go into operation.• Extraction

• Shale gas policies

• Exploring &

mining right

• Technological

development

• Gas pricing

mechanism

reform

• Exploration

• Drilling

1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4


Before 2015, China’s shale gas exploration activities will mainly be carried out by

companies that won exploration rights in tenders launched in 2011 and 2012. According

to contract specifications, Sinopec and Henan Coal Seam Gas are on track to complete

the exploration work of two blocks covering a combined area of 4,237 square km by July

2014, while PetrolChina will complete the initial exploration programme of a test block

covering an area of 6,567 square km. According to our calculations, based on the shale

gas reserves in Barnett Shale, the technically recoverable shale gas reserves should

reach 792.8 billion cubic metres in the three blocks, and the figure falls to 510 billion

cubic metres if the calculation is based on the average reserve level of the top seven

shale gas fields in the US. The annual shale gas production capacity of the

aforementioned three blocks can reach 6 billion cubic metres, if we make calculations

based on the smaller number. China could kick off the second round of shale gas tender

in 2012, in our view, although the combined area of blocks to be auctioned is still unclear.

Based on the aforementioned forecasts, about 2,300 wells will be drilled in the three

blocks, and the drilling operations are expected to be carried out step by step after 2015.

We believe China will launch the

second round of shale gas tenders

in 2012.



15

4. Major beneficiaries at different stages

4.1 Shale gas development will benefit different companies at

different stages

The entire shale gas development process can be divided into three stages, including

exploration, drilling and extraction. Oil & gas companies usually organise the entire

process after obtaining exploration licences, and sell the oil and gas being produced from

the wells to make profit. Through all the three stages, exploration licence holders pay

outside suppliers or exploration and oilfield service subsidiaries to complete the

exploration and drilling work, as well as provide field service, while they themselves are

usually in charge of the operation of oil and gas wells and extraction work, after they

come on line.

Shale gas development will benefit different companies in the supply chain at different

stages. Exploration companies stand to be the first to benefit, as exploration is the first

stage in shale gas development. After the ODP (overall development plan) of a shale gas

project is determined, equipment manufacturers are set to benefit, as they can sell drilling

equipment to companies in charge of the drilling work5. After that, gas field service

companies will make money as most upstream work in the gas field is contracted out to

them. As the production of the shale gas blocks gradually stabilise, oil & gas companies

begin to see returns on their initial investments.

Exhibit 13: Companies expected to benefit at different stages

2

Ge

olo

gic

al

ev

alu

ati

on

Exploration

Sta

rt o

ve

r a

ga

in

Seismic survey/data

collection

Data processing/

interpretation

Gas reserve evaluation

Ec

on

om

icp

ote

nti

al

Succeed

Design of development

plan

Evaluation of economic

potential

Initial exploration/ trialmining

Fail

Feasible

Overall gas field

development solution

Equipment

design/purchasing/installment

Construction of development

project

Installing the drill pad

Drilling, wire line logging,mud logging

Hydraulic fracturing and well

completion

Dri

llin

g

Extraction

Construction of pipeline network

Separation/compressing/storage &

transport

De

sig

n

Ex

tra

cti

on

Fail

Put into operation

Stage where exploration

companies stand to benefit

Stage where equipment vendors

stand to benefit

Stage where gas field service


1

Stage where extraction


Drilling & Planning Extraction

3 4

Sta

rt o

ve

r a

ga

in


5 Some gas field service companies purchase equipment in advance to strengthen their

competitive edges.

Shale gas exploration can be mainly

divided into three stages, including

exploration, drilling and extraction.



16

4.2 Domestic shale gas exploration basically monoplised by the two

oil majors

As mentioned, domestic exploration companies are set to benefit from growing shale gas

exploration demand. Generally speaking, shale gas exploration technologies are similar

to that of conventional natural gas, with seismic exploration data analysis and evaluation

technology being the key technology exploration companies need to master. As such,

domestic companies can basically satisfy the technological requirements despite the lack

of project-specific experience, and they can also hire or cooperate with foreign

companies to do this job when necessary.

Assuming an investment of RMB20,000 is needed per square km at the exploration stage,

oil & gas companies have to invest a total of RMB16.7 billion, as prospective shale gas

blocks in China are expected to cover an area of 870,000 square km. Besides, additional

costs associated with 3D seismic survey and initial exploration will further increase the

investment amount.

There are only a small handful of companies engaged in shale gas exploration in China,

most of which are subsidiaries of PetroChina and Sinopec, as the two companies adopt a

vertically integrated business model. Under such circumstances, we can hardly find other

stock picks besides the two oil majors.

4.3 Equipment manufactures enjoying technological advantages /

producing specialised exploration & drilling equipment stand to

benefit at the equipment purchasing stage

Once the ODP has been formulated, oil & gas companies will begin to purchase

necessary equipment. In contrast with oil & gas companies, which have to wait for a long

time to recoup their huge investment in shale gas development, equipment

manufacturers can benefit as long as the exploration stage is over, and they can make

profit in a relatively short time. Chinese equipment manufacturers will begin to get a

boost in 2H 2014, when exploration activities are expected to be completed, due to

growing demand from drilling contractors.

Competition among Chinese gas extraction equipment vendors has intensified in recent

years as China’s oil and gas industry gradually matured, and has seen stable production

for years. The profit margins in the industry have come under pressure as there are more

than 1,800 oil and gas equipment manufactures in China offering homogeneous products.

These companies are expected to benefit from the anticipated shale gas boom in the

long run, but the growth upside should be limited in the short term due to the large

inventory of conventional equipment in domestic oil & gas companies.

Whether equipment manufacturers can ride the wave of China’s shale gas boom mainly

depends on the appeal of their products and their relationship with clients, and only

technologically advanced products that are irreplaceable and unique can bring stable

profits. As long as the products and services win recognition from customers, equipment

manufacturers could have the opportunity to sign long-term cooperation agreements with

them, which will generate huge amounts of profits, as these customers are usually not

price-conscious.

Chinese equipment manufacturers

will begin to get a boost in 2H 2014,

when exploration activities are

expected to be completed.

There are only a small handful of

companies engaged in shale gas

exploration in China, most of which

are subsidiaries of PetroChina and

Sinopec

Only technologically advanced

products that are irreplaceable and

unique can bring stable profits.



17

We suggest paying attention to vendors providing specialised equipment used in shale

gas development. Exhibit 14 shows the main specialised equipment used in horizontal

drilling and hydraulic fracturing processes.

Exhibit 14: Specialised equipment used in shale gas development

Category Specialised equipment

MWD6 Wireless MWD, wireline SST7, LWD8, Single/multi-shot inclinometer

Specialised drilling equipment

Specialised drilling rigs used in horizontal wells, deviation bit, power drill、single bent bolt、directional connector, non magnetic drill collar, and heavy weight drill pipe

Well completion High-intensity casing pipes, foamed cement, casing perforating equipment blow-out preventer, Christmas tree

Hydraulic fracturing Fracturing truck, instrument van, sand blender, manifold truck, fracturing fluid, chemical agent

Source: Exploration and Extraction of Unconventional Oil and Natural Gas, Guosen

Securities Economic Research Institute

The aforementioned equipment are technologically advanced specialised oil extraction

equipment adopted by a small handful of domestic oil & gas companies and oilfield

service companies. However, the adoption of these equipment will gradually increase

going forward, as China accelerates shale gas development. According to our forecasts,

domestic equipment manufacturers will begin to benefit over 2013-2014. Given the low

costs associated with equipment manufacturing in China, manufacturers can also

develop their export business to secure a share of the booming global shale gas market.

For example, fracturing trucks manufactured by Jereh Oilfield Services have been

successfully exported to the North American market.

Jereh Oilfield and Shenkai Petroleum & Chemical Equipment will be principal

beneficiaries among equipment manufacturers, in our view.

4.4 Gas field service companies taking the initiative to accumulate

technological capabilities in advance stand to benefit at the

drilling stage

As mentioned, given the nascent state of China’s shale gas drilling and extraction

technologies, most domestic gas field service companies have to cooperate with foreign

companies in the short term to accumulate technologies. Based on our estimates,

domestic companies will begin to benefit from shale gas development starting from 2015,

and gas field service companies that take the initiative to accumulate technological

capabilities are set to excel.

Our top picks for the oilfield service industry include Anton Oilfield Services and Honghua

Group, which we believe have accumulated considerable technological capabilities in

recent years. Anton Oilfield Services began to develop shale gas extraction technologies

in 2006, and participated in the construction of PetroChina’s first shale gas test well,

while Honghua Group is a leading shale gas development plan provider in China, which

also made efforts to develop extraction equipment based on the specific geological

conditions in China.

6 MWD stands for Measurement While Drilling

7 SST stands for Survey Steering Tool

8 LWD stands for Logging While Drilling

Our top picks for the oilfield service

industry include Anton Oilfield

Services and Honghua Group.

According to our forecasts,

domestic equipment manufacturers

will begin to benefit over 2013-2014.

Jereh Oilfield and Shenkai

Petroleum & Chemical Equipment

will be principal beneficiaries.



18

As for other gas field service companies, we believe oilfield service companies that are

on track to make huge progress in technology development might also benefit, although

they can’t be primary beneficiaries in the short term. For example, Tong Oil Tools has

successfully developed compound perforating technology, although the effectiveness of

this technology are still unclear given the lack of practical applications and the small

share it makes up in total spending on oilfield service.

Some other companies primarily engaged in coal bed methane development, e.g.

Zhundong Petroleum Technology, Landocean Energy, Tianyi Science&Technology, Tong

Oil Tools, can also find opportunities in the shale gas market, if relevant technologies can

be applied to shale gas development, although it will take some time to complete

technology transfers, given shale gas development is even more difficult than coal bed

methane development. Downstream vendors, such as natural gas transport and storage

companies will receive a boost due to growing natural gas consumption, but support from

shale gas will be limited, as shale gas still accounts for a small share of China’s natural

gas production.

4.5 Oil & gas companies will be the last to benefit

Oil & gas companies that face significant risks of losing substantial amounts of money

invested since they won the shale gas tenders are usually the first to invest but the last to

benefit, and it’s very difficult to predict how much benefit shale gas investment will bring

to these companies. We believe key factors affecting the investment prospect for shale

gas projects include natural gas price, gas reserves in designated blocks, actual gas

production and capital expenditure, which will be highly dependent on China’s reform on

natural gas pricing, subsidy policies for shale gas, results of tenders to be launched by

the government, technological development, etc.

Shale gas mining companies9 can’t make profit from investment in shale gas projects in

the next few years, in our view. As mentioned, the recoupment period of shale gas

investments is relatively long. Based on our forecasts, several oil & gas companies,

including PetroChina, CNOOC, Shaanxi Yanchang, China United Coalbed Methane Co.

and Henan Provincial Coal Seam Gas, Guanghui Industry, Sinopec, Zhenhua Oil, CITIC

Resources, etc, stand a chance to win exploration rights in tenders to be held in the

future. It’s still very hard to forecast how much they can benefit from shale gas

investment, given uncertainty over government policy, extraction technology

development, etc.

To sum up, two equipment manufacturers, including Jereh Oilfield and Shenkai

Petroleum & Chemical Equipment, as well as Anton Oilfield Services and Honghua

Group, which we believe have accumulated technological capabilities, will be the first to

benefit from China’s shale gas development.

9 Shale gas mining companies are basically companies wining shale gas exploration rights

in tenders, as they can easily obtain the mining rights after the completion of exploration work

Shale gas mining companies can’t

make profit from investment in

shale gas projects in the next few

years, in our view.

Oilfield service companies that are

on track to make huge progress in

technology development might also

benefit.



19

5. Jereh Oilfield: a leading fracturing

equipment manufacturer on course to

benefit from shale gas extraction

5.6 Substantial growth potential for the fracturing equipment market

Jereh Oilfield is mainly engaged in the production of fracturing equipment, including

fracturing trucks, metre trucks, etc, and is on course to benefit from China’s shale gas

development. High-end fracturing trucks that can be operated safely at pressures of over

100 Mpa are usually used in the fracturing process. Although estimates vary, the

combined hydraulic fracturing of fracturing trucks amount to only 1 million HHP in China,

compared with around 15 million HHP currently in the US. What’s more, China’s

fracturing truck supply is mainly made up of low-end truck models, out of which only a

few can be used for shale gas development. Based on our forecasts, China’s total

hydraulic fracturing capacity is on track to increase by 2 million HHP by 2015.

A complete hydraulic fracturing fleet should consist of various equipment, including

fracturing pumper, sand blender, instrument van, manifold truck, etc. Assuming most of

the fracturing trucks are HQ2000 Fracturing trucks, a fleet has to be equipped with at

least 10-20 trucks to handle a project.

Exhibit 15: Hydraulic fracturing equipment used in shale gas development

Hydraulic fracturing equipment Function

Fracturing truck Injecting frac fluids into wells, fracturing strata, and injecting proppants into fractures

Sand blender Blending frac fluids, and provide the fluid for fracturing truck

Sand transport trucks Transporting raw materials to sand blenders

Instrument van Operating fracturing trucks and sand blenders through remote control

Manifold truck Pumping through the low and high pressure manifold frac fluids mixed by the blender unit to the fracturing pumpers

Fracturing fluid Used for gas shale stimulations; consisting primarily of water but also a variety of additives, including proppant

Water tank Storing water

Source: Exploration and Extraction of Unconventional Oil and Natural Gas, Guosen Securities Economic Research Institute

Generally speaking, the “useful life” of fracturing equipment can last for only five years,

given they are frequently used in the multiple-interval fracturing and multilayer fracturing

processes. Massive workload and long operating hours significantly shorten the useful

life of fracturing equipment.

5.7 Facing less intense competition given the high barriers to entry

New entrants have to overcome significant technical barriers to enter the fracturing

equipment market. Plunger pump, the key component of fracturing equipment, has been

attached great importance by the Chinese government in the State High-Tech

Development Plan. Almost all the fracturing equipment used in China were imported from

foreign countries before 2008, but China’s dependence on imported fracturing equipment

has declined significantly in recent years, as more and more domestic companies

introduced related technologies and entered this growing market, although some key

components, especially plunger pumps, still need to be imported. Jereh Oilfield

introduced the plunger pump production technology from OFM Company in July 2011,

becoming one of a handful of companies capable of producing plunger pumps in China.

Jereh Oilfield’s major competitors

include SJ Petroleum Machinery,

SJS, Lanzhou General Machinery

Manufacture, and ZYT Petroleum

Equipment.



20

Jereh Oilfield’s major competitors include SJ Petroleum Machinery, SJS Limited,

Lanzhou General Machinery Manufacture Co., Ltd, and ZYT Petroleum Equipment Co.,

Ltd, although the latter two are only capable of producing low-end fracturing units.

China’s fracture equipment market is not 100% open to foreign players, with tariff barriers

being major obstacle foreign vendors have to overcome when entering the Chinese

market. According to government regulations, the three oil majors have to purchase

domestically-made fracturing equipment to provide support for the domestic vendors,

and as such, foreign vendors can only tap into the burgeoning Chinese market via

components exports. Besides, the Chinese government levies very high tariffs on

imported vehicles. Only when the specified equipment can’t be produced by domestic

vendors or those made domestically can’t meet requirements, can imported equipment

be exempted from import tariff.

5.8 On course to win recognition after participating in fracturing

operations of China’s first test shale gas well

As one of the first shale gas equipment vendors in China, Jereh Oilfield provided three

fracturing trucks and participated in the fracturing operations of Wei 201-H1 Well, the first

test well for shale gas in China, where the company excelled its peers in terms of the fuel

efficiency and gas emission. After that, Jereh Oilfield participated in the fracturing

projects in PetroChina’s test well.

5.9 How much benefit can Jereh get?

Assuming China’s shale gas production capacity can reach 6.5 billion cubic metres by

2015, 2,300 wells are on track to be drilled over 2011-15, indicating there’ll be demand

for 50 fracturing truck fleets with a combined service capacity of 2 million HHP.

Given its technical advantage and good relationship with oil & gas companies, including

PetroChina and Antonoil, we expect Jereh Oilfield to capture 40% market share in the

hydraulic fracturing equipment market, suggesting its fracturing equipment business can

generate sales revenue of RMB4 billion over 2011-15.

6. SK Petroleum & Chemical: MWD business

on course to benefit from growing volume

of drilling operations

6.1 Capturing large market share in the high-end drilling product

market

SK Petroleum & Chemical’s core business is the production of oil equipment, including

measurement-while-drilling parts, mud logging unit, blow-out preventer, Christmas tree,

etc, most of which are high-end technologically advanced products. The company has

been awarded 102 patents and 20 software copyrights, 90% of which are patents for

inventions and utility models. SK’s major competitor is China Petroleum Shanghai

Instrument.

SK Petroleum & Chemical produces

high-end technologically advanced

oil equipment. The company has

become PetroChina’s tier-1 vendor ,

and a key supplier for Sinopec and

CNOOC.

We expect Jereh Oilfield to capture

40% market share in the hydraulic

fracturing equipment market.



21

As mentioned, most of SK’s products are high-end technologically advanced products or

products in short supply, which give it obvious competitive advantages. The company has

become PetroChina’s tier 1 vendor , and a key supplier for Sinopec and CNOOC.

SK is a leading company in China in terms of market share, capturing a 60% share in the

MWD market, a 53% share in the mud logging unit market, and a 25% share in the

blow-out preventer market.

6.2 MWD business on course to benefit from shale gas horizontal

well drilling

WMD equipment, one of SK’s core products, is essential and indispensable equipment

used in the drilling process of horizontal shale gas wells. In recent years, the use of

horizontal drilling has increased significantly, which calls for accurate measurement of

basic trajectory parameters. Single-shot inclinometer are commonly used in traditional

gas wells, but if the direction of the borehole is not in line with the pre-planned paths,

there’ll be a need for redirection, suggesting waste of time and money.

Various down-hole survey equipment, including wireless WMD, SST, LWD, are needed to

ensure faster, more accurate and safer drilling. WMD systems can be installed in the drill

string to provide real time measurements of basic trajectory parameters such as

inclination, direction, tool-face and temperature, which can help improve drilling efficiency

and minimise drilling costs.

Given China’s horizontal drilling technology is still at a starting phase, the adoption of

WMD systems, which are mainly used in the drilling process of oil wells, is not so

common, and the supply can basically meet demand so far. However, given shale gas

has become an increasingly important source of natural gas, both domestic well drilling

companies and gas field service companies will gradually increase their adoption of

WMD systems, in our view, as they gradually master and develop mature technologies.

6.3 The sales volume of surface equipment is expected to grow as

the number of wells need to be drilled increases

Blowout preventers and Christmas trees are surface equipment used after the

completion of the well. A blowout preventer is a large and specialised valve used to seal

oil and gas wells, and cope with extreme erratic pressures and uncontrolled flow

emanating from a well reservoir during drilling. A Christmas tree is mainly used to control

the flow, usually oil or gas, out of the well, and the injection of gas or water into a

non-producing well in order to enhance production rates, etc.

Although Blowout preventers and Christmas trees are not categorised as specialised

equipment used in shale gas development, we expect the two businesses to give a boost

to SK’s results going forward, given the company’s dominating position in the two

markets.

6.4 How much benefit can SK get?

We believe all drilling teams for horizontal shale gas wells will be equipped with MWD

systems in the future. There are altogether about 2,500 drilling teams in China, indicating

substantial growth potential for the MWD market. According to the targets outlined in the

SK has a large market share. For

instance, it has 60% share of the

MWD market and it controls 53% of

the mud logging unit market.

We forecast SK’s sales revenue is

on course to increase by RMB117

million.

The potential for MWD systems is

substantial as there are 2,500

drilling teams in China and each

team will be equipped with MWD

systems.



22

12th Five-Year Plan, at least 130 units of MWD systems will be equipped by domestic

well drilling teams. Assuming SK captures a market share of 30%, and the ASP of MWD

systems is RMB3 million per unit, the company’s sales revenue is on course to increase

RMB117 million. Given the blowout preventer and Christmas tree businesses are closely

correlated to the number of wells drilled in China, we expect SK to see the sales revenue

from surface equipment to increase by RMB184 million over 2011-15, boosted by the

growing number of shale gas wells to be drilled in China.

7. Anton Oilfield Services: a local market

leader enjoying strong technological

advantages

7.1 Core advantage: advanced unconventional energy extraction

technologies

Anton Oilfield Services is a leading oilfield service company mainly engaged in onshore

businesses, including onshore well drilling, well completion, down hole operation, oil

extraction, etc, with 70% of its revenue coming from natural gas well-related businesses.

The company’s principal competitors include some large international oilfield service

companies, such as Schlumberger, Baker Hughes, Halliburto, etc.

Anton Oilfield Services began to import unconventional energy extraction technologies in

2006, when it started to cooperate with small foreign oilfield service companies, and has

become one of a small handful of companies mastering the hydraulic fracturing

technology in China. Foreign technologies may not be fully applicable in China’s shale

gas formation, so revamping these technologies is a major roadblock that stands in front

of domestic companies. Multiple-interval fracturing technology, directional well drilling

technology and coiled tubing technology introduced in 2010 have become a major driving

force for the company’s growth.

Leveraging on the competitive advantages in shale gas extraction technology, Anton

Oilfield Services focuses to establish a high-end brand image. The company has

developed a set of core technologies, which enables it to keep its service prices and

gross margin at the same level as foreign peers. Anton successfully won the

multiple-interval fracturing operation contracts for 77 out of the 102 wells in PetroChina’s

tight gas development project in Erdos Basin in 2010, which gave a boost to the

company’s results in 2010, with its revenues from multiple-interval fracturing business

surging 255.4% from 2009 to RMB220 million that year.

7.2 An eye to the future

Anton has decided to make a full-scale entry to China’s burgeoning pressure pumping

market, according to a notice released by the company at the end of November 2011.

Anton has ordered ten Model 2000 fracturing trucks and supporting equipments from

Jereh Oilfield, which are expected to increase its service capacity to 20,000 HHP after

going into operation in 3Q 2012. The company plans to build a large-scale fracturing fleet

with a combined capacity of 40,000 HHP in order to expand its market share. At the same

time, it’s making efforts to tap into new marekts, including the production of fracturing

fluids, proppant as well as other chemicals to meet the growing demand and provide

one-stop service.

Anton Oilfield has become one of a

small handful of companies

mastering the hydraulic fracturing

technology in China.



23

Anton has established four construction bases in China’s major oil producing areas,

which enables the company to provide quick responses to client needs at relatively low

costs, while its foreign peers usually need to deploy personnel and equipment from

overseas, which implies high costs and long response time. Besides, as a local company,

Anton enjoys some obvious advantages compared with foreign companies, as it’s much

easier for it to get its bids shortlisted in tenders launched by the three oil majors.

7.3 Successfully participated in the fracturing operations for China’s

first shale gas well

Anton participated in the fracturing operations for China’s first shale gas well in June

2011, namely the Wei 201-H1 Well of the Southwest Oil and Gas Field Company, a

subsidiary of PetroChina. PetroChina launched tenders for the fracturing operations for

six wells then, noting that the qualified contractor has to meet all the three major

requirements set by the company, including technology, price, and service time

requirements. PetroChina noted that, given Wei 201-H1 Well marks the first horizontal

shale gas well in China and even in Asia, and the project will have far-reaching impact on

the whole industry.

Four companies, including Schlumberger, Halliburton, etc, submitted bidding documents,

and the bid prices they offered were close to each other. In the end, Anton won contracts

for four out of the six wells, as it had established an operation base in Sichuan, while

Halliburton were awarded the contracts for the rest two. In order to ensure high service

quality, Anton outsourced the design work to a foreign company. As at the end of June

2011, Anton completed the fracturing operations for 12 intervals. Some most advanced

technologies and new ideas have been adopted during the fracturing process of the Wei

201-H1 Well, which marks a big milestone in China’s development of shale gas in terms

of number of fracturing equipment used, amount of water used in the fracturing process,

etc.

7.4 How much can Anton benefit?

We believe Anton will be a major beneficiary of shale gas development in the long run,

although as mentioned, gas field service companies can’t benefit enormously until after

2015, when China start large-scale commercial production of shale gas. The company’s

profit margin will be maintained at relatively high levels in our view, given the higher

technical barriers new entrants need to overcome to compete in the hydraulic fracturing

market.

China needs to drill about 2,300 wells by 2015, according to the 12th FYP for shale gas,

which will lead to surging demand for hydraulic fracturing operations. Assuming a well is

fractured into 10 intervals on average, each interval implies revenue of RMB600,000, and

Anton captures a market share of 20%, the hydraulic fracturing operation business is on

track to generate RMB2.76 billion in revenue by 2015.

The hydraulic fracturing operation

business is on track to generate

RMB2.76 billion in revenue by 2015.



24

8. Honghua Group: a vertically integrated

company engaged in drilling, oilfield

services and drilling rig manufacturing

8.1 Staying cautious in bidding for exploration rights

Honghua Group is an equipment manufacturing and drilling engineering service

company engaged in research, design, manufacturing and assembly of digging rigs, as

well as other ocean engineering, oil exploration & extraction equipment. Honghua Group

attaches great importance to shale gas development, and is making efforts to tap into the

potential of shale gas.

Honghua plans to bid for exploration rights in shale gas blocks when the time is ripe, but

still holds a cautious attitude to shale gas development so far. The company won’t

participate in the second round of tenders for shale gas exploration rights, as it believes

the unique confluence of economic, political and industry conditions that support the

shale gas boom don’t exist in China so far. On the other hand, given the lack of

experience in oil & gas extraction, Honghua hopes to accumulate experience and

technologies through cooperation with leading companies from home and abroad, before

it aggressively expands into the shale gas market.

8.2 Well positioned to provide one-stop shale gas extraction solution

Honghua Honghua aimed to become a vertically integrated shale gas extraction solution

provider that continues to design shale gas development plan, offer related drilling

equipment and then provide gas field services, after the completion of exploration work.

Nabors Industries, the second-largest shareholder of Honghua, is the world’s largest

onshore drilling contractor that has invested hundreds of millions of dollars to buy shale

gas blocks in the US and Canada.

Honghua Group is a leading shale gas ODP provider in China. The company has

revamped some shale gas development technologies imported from foreign enterprises.

For example, Honghua Group developed the cluster drilling model to drill multiple wells

from a single pad location, which can help reduce gas development costs. The company

transported gas generator sets and diesel generator sets to well pads for power supply to

achieve efficient energy use. Besides, it designed new products specifically tailored to

the requirements of China’s shale gas projects, most of which are located in hilly regions,

including convertible-frequency fracturing fleets and flexible water tanks designed to

adapt to hilly areas. What’s more, the company made efforts to promote the sale of shale

gas in nearby areas, which can help it save costs given there is no need for pipeline

construction.

8.3 A leading drilling rig manufacturer attaching importance to

technology innovation

Honghua is a leading Chinese drilling rig manufacturer that exports most of the drilling

rigs it produces to foreign markets. So far, the company has exported 90 units of drilling

rigs to the US, most of which are used for shale gas development. There were altogether

1,000 units of drilling rigs in the US in 2010, out of which 400 units are used for shale gas

development.

Honghua has developed a number

of new shale gas extraction

equipment. We expect these new

products will be widely used in

China going forward.



25

Horizontal wells have become the dominant well design choice in the shale gas

development market, but China’s horizontal well drilling capacity lags well behind the US.

According to the 12th FYP, 2,300 wells need to be drilled in China by 2015, implying the

drilling capacity has to increase by 40%.

Honghua has developed a number of new shale gas extraction equipment, given most

shale gas fields are located in hilly regions in China, and it’s very difficult to transport

large equipment. We expect these new products will be widely used in China going

forward.

Exhibit 16: Honghua’s innovation in shale gas drilling and extraction equipment

Newly developed/revamped equipment

Function

30 super single drilling rig Can be used to drill vertical wells and inclined wells via mechanised operation; easy to transport, easy to rig up, safer and more economical.

Hybrid coiled tube drilling rig Combining common rigs with the coiled tubing operation equipment; characterised by high operating efficiency, low labor intensity, and good mobility.

Complete sets of drilling equipment

Consisting of convertible frequency fracturing fleets, sand blenders, sand transport trucks, control systems, etc

6000HP fracturing pump Adopting convertible frequency technology to reduce the number of fracturing trucks used in fracturing operations; two pumps equipped in one truck; easy to rig up, more compact.

Flexible water tank Six sets of flexible tanks can store 3,000 cu m of water, which can help save space; easy to transport.

Source: Exploration and Extraction of Unconventional Oil and Natural Gas, Guosen

Securities Economic Research Institute

8.4 Stepped into the fracturing equipment market

Given the anticipated growing adoption of fracturing equipment in shale gas development,

Honghua Group has stepped into the fracturing equipment manufacturing market through

a joint venture. The company announced on December 6, 2011 that its wholly-owned

subsidiary Sichuan Honghua Petroleum Equipment Corporation Ltd. will form a joint

venture with Gansu Huateng Petroleum Machinery Manufacturing Co, Ltd. Honghua will

make a capital contribution of RMB42 million in cash, and Gansu Huateng will contribute

its remaining assets valued at RMB36 million. The registered capital of the JV company

will be RMB120 million, with Honghua and Gansu Huateng holding 70% and 30% of its

equity interest respectively.

Having mastered key plunger pump production technologies, Honghua will begin to

produce fracturing equipment, and obtain the intellectual property rights of these

products. In this way, Honghua is well-positioned to increase the scope of products it

offers, and add another source of growth besides the traditional drilling rig manufacturing

business.

8.5 How much can Honghua benefit?

Honghua Group will mainly get a boost from the booming specialised drilling rig and

fracturing equipment manufacturing markets, as well as its shale gas ODP design

business. According to the 12th FYP, if the sales volume of Honghua’s drilling rigs can

increase by 30 units, the company will see its sales revenue grow RMB900 million by

Honghua is well-positioned to

increase the scope of products it

offers, and add another source of

growth besides the traditional

drilling rig manufacturing business.



26

2015. The fracturing equipment production and shale gas project design businesses, two

new businesses Honghua attaches importance to, are expected to enjoy sound growth

momentum given the growing demand for shale gas service and fracturing equipment.

Exhibit 17: Valuation of major A-share listed companies

Ticker Company name Last price

(RMB)

Market cap

(RMB bn)

EPS (RMB) PE (x) PB (x)

2011E 2012E 2013E 2011E 2012E 2013E

002353 Jereh Oilfield 67.95 15.604 1.85 2.73 3.78 36.71 24.90 17.95 6.48

002278 SK Petroleum & Chemical 9.51 2.487 0.33 0.39 0.45 28.41 24.18 21.33 2.29

Source: WIND, Guosen Securities Economic Research Institute



27

Appendix

Schematic geology for shale gas

The in-place shale gas resource can be very large, but only a small portion of the world’s

shale gas is theoretically producible and even less likely to be producible in a

commercially viable manner. The total organic content and pore space where shale gas

can be reserved depend on the thickness of shale formations. The thicker the

hydrocarbon bearing rocks are, the more shale gas they can reserve. The thickness of

hydrocarbon bearing rocks in different areas can vary, but that of most rocks containing

shale gas reservoirs ranges from 91 to 183 metres, and at least more than 30 metres.

Exhibit 18: Shale in the earth’s surface Exhibit 19: A shale gas well in drilling operation

Source: EIA, Guosen Securities Economic Research Institute Source: EIA, Guosen Securities Economic Research Institute

The productive section of shale gas field varies widely in depth from 76 to 4,000 metres.

Most of the shale gas reservoirs drilled in the US are located in shallower sections,

usually 762 to 1,372 metres in depth, as it’s more technically difficult and less cost

efficient to extract shale gas from deep reserves, given the high temperature and high

pressure, although for the same reasons the deep sections should be rich in organic

matter and shale gas. However, natural gas from deep shale formations has drawn more

attention in recent years, as extracting technologies gradually improve, and demand for

natural gas grows.

There are two kinds of gases in shale gas reservoirs, namely free gas stored in pores

and fractures, and adsorbed gas attached on organic matter and clays. Typical shale gas

reservoirs exhibit porosity of 4-6%, and permeability of less than 0.001×10-3μ m2.In

contract with conventional natural gas, commercial production of shale gas is highly

dependent on the geometry and intensity of the natural fracture system in shale gas

reservoir. Porosity and permeability could increase significantly to 10% and 1×10-3μ m2

respectively aided by natural fractures, making shale gas extraction much more

cost-efficient.

Shale-gas reservoirs are continuous gas accumulations. These reservoir systems have

gas-bearing strata that are not density-stratified, do not contain a gas/water contact, and

persist over a very large geographic area. The challenge in these accumulations is not to

find the gas, but rather to find those areas that will produce gas commercially. Based on

experiences in the US, where dozens of shale gas fields have been developed, shale gas

fields can be divided into core area, tier 1 area and tier 2 area. To date gas production



28

has concentrated in core areas with rich gas reserves, where the shale formations are

thicker and the uncertainty is reduced. Production in tier 1 areas can be profitable or lead

to slight loss, while that in tier 2 areas usually lead to loss. As a result, the shale gas

development in core areas has a significant impact on the prospect of the entire shale

gas field.

Exhibit 20: Core area, tier 1 area and tier 2 area in a shale gas filed

Source: EIA, Guosen Securities Economic Research Institute

Exhibit 21: Production capacity of Core area, tier 1 area and tier 2 area in Fort

Worth area

Area (sq m) Initial rate (MMcf/d)

Cumulative

rate

(MMcf/d)

Core area 1548 2.5 2.5

Tier 1 area 2254 2.0 1.5

Tier 2 area 4122 1.0 0.8


Studies show that controlling factors for shale gas development potential in core areas

include shale gas reserve, thickness of shale formations, pressure gradient and depth,

total organic content (TOC), thermal mature (Ro), porosity, natural fracture, mineral

content, etc. Other factors that have to be considered include content of

non-hydrocarbon substances, water saturation, etc.

Core Area

Tier 1 Area

Tier 2 Area



29

Exhibit 22: Geological conditions for the formation of shale gas core area

Thickness >45m

Porosity >4%

Press gradient >10.5MPa

Total organic content (TOC) TOC>2%

Thermal mature (Ro) 1%<Ro<3%

Gas concentration >8.2x10m3/km2

Complexity low complexity

Source: Shale Gas-The Game Changer, Guosen Securities Economic Research

Institute

Quite often, the volume of hydrocarbon stored within the natural fractures is much lower

than that stored in the matrix. The natural fractures have much higher permeability than

the matrix. As a result, compared with adsorbed gas, it’s easier for free gas, which

resides in fractures and pores, to get out. After that, as the geopressure declines,

adsorbed gas will gradually desorb from the surfaces of organic matter and clay, diffuse

into cleats, and then flow to the wellbore, where the shale gas will be extracted, and

transported to the surface. The rapid release of free-gas generally results in higher initial

rates of production, although this high initial flow rates will decline rapidly to a relatively

slow but steady rate as adsorbed gas is slowly released from the shale. As such, the

mechanism of gas desorption from shale formations is also a key factor affecting the gas

production. At present, the production of shale gas wells gradually decrease, by 2% to 3%

per annum (no more than 5%), and the production period can last for about 30 to 50

years. Barnett shale can produce shale gas for over 80 years, according to US

Geological Survey (USGS).

The recovery rate of shale gas is lower than that of conventional natural gas. The

recovery rates of the 5 major shale gas basins in the US range from 5%～60%. The

recovery rate of Antrim shale can reach 60% given the shallow location of gas reserves,

low geopressure, high TOC and rich adsorbed gas content, while the recovery rate of

Barnett shale is only about 25% given the deep location of gas reserves, high

geopressure, and smaller share the adsorbed gas takes up.

Shale gas extraction process: drilling, cementing & completion

Drilling and production of shale gas is very similar to that of conventional natural gas

reservoirs; however, due to a lack of permeability, shale gas almost always requires

fracture stimulation. Horizontal drilling and fracturing technologies are two dominating

shale gas development technologies used worldwide, and the two technologies keep

improving, as more and more countries and enterprises entre the burgeoning shale gas

market.

Horizontal drilling starts with a vertical well that turns horizontal within the reservoir rock

in order to expose more open hole to the reservoir. The longer the exposure length, the

more shale gas can be drained and the faster it can flow. The total vertical depth of a well

in Marcellus shale in the US, for example, is about 15.2 metres, while the horizontal

displacement is 402 metres. But if the horizontal drilling technology is adopted, the

horizontal displacement can be extended to 462 to 1,829 metres.

Generally speaking, the longer the horizontal displacement is, the higher the recovery

rate can be. According to relevant data released by the US government, exposure length



30

that extends 914 to 1,219 metres can deliver the best results. Geological steering

techniques are also used in the drilling process to keeps the wells on target.

Most of the shale gas wells were developed with vertical wells in the US until 2002, when

horizontal wells were introduced by Devon in seven test wells in Barnett Shale.

Horizontal wells have gradually replaced vertical wells as the dominant well design

choice since then, and vertical wells already drilled are mainly used for experiments. A

horizontal well usually cost 0-50% more to drill and complete for production than a

vertical well directed to the same target horizon, but the yield of a horizontal well can

reach three times that of a vertical well, indicating that horizontal drilling is actually a cost

effective drilling method.

Foamed cement is a most widely used material for shale gas well cementing, given the

lower density, stable slurry, and high strength. The average yield of shale gas wells using

foamed cement for well cementing are 23 % higher than that of shale gas wells using

traditional cements.

Exhibit 23: Hydraulic fracturing in a horizontal well Exhibit 24: Production of vertical well and horizontal well


Institute

Source: Modern Shale Gas Development In The United States,

Guosen Securities Economic Research Institute

Well completion is the process of making a well ready for production. This principally

involves preparing the bottom of the hole to the required specifications, running in the

production tubing and its associated down hole tools as well as perforating and

stimulating as required. Sometimes, the process of running in and cementing the casing

is also included. Major well completion methods include open-hole perforated completion,

bridge plug completion, perforated casing completion, among which perforated casing

completion has become the dominating completion method being adopted in the US.

Average production of horizontal wells (1000 ft3·d-1, LHR)

Average production of vertical wells (1000 ft3·d-1, LHR)

Production rate (MMcf/d, RHS)



31

Exhibit 25: Comparison between vertical wells and horizontal

wells in Barnett Shale in term of production and number of

wells drilled

Exhibit 26: Number of wells drilled and technological

development in Barnett Shale

Source: EIA, Guosen Securities Economic Research Institute Source: EIA, Guosen Securities Economic Research Institute

Shale gas development technology: hydraulic fracturing

Shale gas well drilling is actually not difficult, but mass production of shale gas will be

impossible unless hydraulic fracturing operations are adopted.

Hydraulic fracturing is the process of pumping a fluid into a wellbore at an injection rate

that is too high for the formation to accept in a radial flow pattern to mitigate the

resistance to flow in the formation. As a result, hydraulic fracturing can help significantly

increase shale gas production, especially when hydraulic fractures can be connected to

productive strata and natural fractures. Fracturing equipment operates over a range of

pressures and injection rates, and can reach up to 100 Mpa and 265 litres per second.

Fluid that does not contain any proppant, is injected through fracturing pumps to create a

fracture that grows up, out and down, and creates a fracture that is wide enough to

accept a proppant. The purpose of the proppant is to “prop open” the fracture once the

pumping operation ceases, the pressure in the fracture decreases, and the fracture

closes, by which process, man-made fractures can be widened to provide more space for

shale gas reservoirs, and at the same time connects pores and fractures. The

productivity of a shale gas well doesn’t only depend on the amount of natural gas

reserves in it, but also the permeability, well construction work, and man-made fractures.

Fracturing fluid can help create fractures, and then transport proppant into fractures. The

most commonly fluid used in shale gas development are water-based fracturing fluid,

which is approximately 99% water and sand with a small amount of additives (<1%)

included, such as resistance reducing additives, etc. However small the percentage of

these additives may be, they play a key role in increasing shale gas production.

Developed simultaneous

fracturing technology in 2006

Began to adopt horizontal

fracturing technology in 2003

Developed repeated fracturing

technology in 1999

Began to carry out hydraulic

fracturing operations in 1997



32

Exhibit 27: Additives used in shale gas hydraulic fracturing operations

Additive type Main compounds Purpose Proportion

Acid Hydrochloric acid Help dissolve minerals and initiate cracks in the rock 0.123%

Biocide Glutaraldehyde Eliminates bacteria in the water that produce corrosive byproducts 0.001%

Breaker Ammonium persulfate Allows a delayed break down of the gel polymer chains 0.010%

Corrosion Inhibitor N,n-dimethyl formamide Prevents the corrosion of the pipe 0.002%

Crosslinker Borate salts Maintains fluid viscosity as temperature increases 0.088%

Friction Reducer Mineral oil Minimises friction between the fluid and the pipe 0.088%

Gel Guar gum or hydroxyethyl cellulose Thickens the water in order to suspend the sand 0.056%

Iron Control Citric acid Prevents precipitation of metal oxides 0.004%

KCI Potassium chloride Creates a brine carrier fluid 0.060%

PH Adjusting Agent Sodium or potassium carbonate Maintains the effectiveness of other components, such as crosslinkers 0.011%

Scale Inhibitor Ethylene glycol Prevents scale deposits in the pipe 0.043%

Surfactant Isopropanol Used to increase the viscosity of the fracture fluid 0.085%

Proppant Silica, quartz sand Allows the fractures to remain open so the gas can escape 8.950%


Composition of fracturing fluid varies according to specific fracturing requirements, and

there is no unified standard for the proportions of different additives. Table 27 shows 13

compositions for mix waters used in different fracturing situations. The US government

requires related enterprises to disclose the compositions of their fracturing fluid, as they

might lead to pollution.

Other key fracturing technologies include multiple-interval fracturing technology,

multilayer fracturing technology, simultaneous fracturing technology, repeated fracturing

technology, etc. Use of multiple-interval fracturing technology in horizontal wells can

improve operational efficiency, and save cost as it helps create fracture networks.

Horizontal wells can be partitioned to over 10 intervals now, compared to one to two

intervals at the early stage of shale gas development. Production in the Tipton-1H-23 well

in Woodford area around Ardmore Basin of the US surged due to the adoption of

multiple-interval fracturing technology, with its shale gas production reaching as high as

14.16×104m3/d.

The horizontal drilling and multiple-interval fracturing technologies makes it possible for

the commercial production of shale gas, significantly expands the scope of shale gas

development, and thus have become key technologies driving the rapid development of

the shale gas extraction in the US. According to statistics, the average daily single-well

production of the first five shale gas basins in the US grew to 20000 m3 from 8063 m3

after the adoption of horizontal well drilling technology, hydraulic fracturing technology,

and multiple-interval fracturing technology.



33

Information Disclosures

Stock ratings, sector ratings and related definitions

Stock Ratings:

Buy: Indicates that the analyst expects the stock to outperform the Benchmark by 20% or more over the next six months.

Cautious Buy: Indicates that the analyst expects the stock to outperform the Benchmark by 10% or more but less than 20% over the

next six months.

Neutral: Indicates that the analyst expects the stock to either outperform or underperform the Benchmark by less than 10% over the

next six months.

Reduce: Indicates that the analyst expects the stock to underperform the Benchmark by 10% or more over the next six months.

Sector Ratings:

Buy: Indicates that the analyst expects the sector to outperform the Benchmark by 10% or more over the next six months.

Cautious Buy: Indicates that the analyst expects the sector to outperform the Benchmark by 5% or more but less than 10% over the

next six months.

Neutral: Indicates that the analyst expects the sector to either outperform or underperform the Benchmark by less than 5% over the next

six months.

Reduce: Indicates that the analyst expects the sector to underperform the Benchmark by 5% or more over the next six months

Disclaimers

This report is based on public data. Guosen does not warrant the accuracy and completeness of the information contained herein. This

report is published solely for reference purposes and shall in no way be construed as a solicitation or an offer to buy or sell securities or

related financial instruments stated herein. Guosen and its employees do not accept responsibility for any direct or indirect losses arising

from the use of this report. Guosen or its affiliates may hold or trade securities issued by the companies mentioned in this report, and

provide or seek to provide investment banking services for these companies. All rights of this report are reserved by Guosen. Without the

prior written consent of Guosen, no one may copy, reproduce or publish part or whole of this report.

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