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While overall well counts in China have remained relatively steady, the share of hydraulically fractured wells has nearly doubled.

China has seen a surge of unconventional oil and gas activity in recent years, resulting in a dramatic increase in hydraulic fracturing capacity. According to PacWest Consulting Partners’ research, China has the second-largest frac capacity in the world as of year-end 2013. Only the US has more capacity.

Much of China’s activity is a result of tight oil and gas – resources with permeabilities in the range of micro-darcys – rather than shale, which has nano-darcy permeability. Shale is in its early stages in China, but several exploratory wells have shown strong output. While Chinese unconventional development faces many challenges, PacWest is optimistic about its potential and expects frac capacity to continue to grow to support increased activity, approximately tripling by 2018.

Chinese context

The Chinese government is attempting to encourage more domestic oil and gas production with a mix of targets, subsidies, and gas price reform to achieve broader goals of minimizing imports and displacing coal with gas in power generation.

In its most recent 12th Five-Year Plan (2011-15), China announced a goal to increase gas consumption from about 4% of China’s energy in 2010 to 8% in 2015. It offers subsidies for shale gas as well as coalbed methane. The government already has held two shale auctions and is planning a third in 2014.

A new gas price policy launched in June 2013 could be the most important change so far. It ties the pricing for most incremental new gas production, which unconventionals will be, to imported fuel oil and LPG prices. Analysis shows that the average wellhead price for incremental gas production will approximately double, given Brent prices of about US $110/bbl, which will provide greater incentive to exploit previously uneconomical resources. With the new gas pricing scheme, PacWest estimates that the average horizontal fractured shale well in Sichuan should become economical during 2014 using US shale well analogues.

However, various policies and challenges limit the pace of development. National oil companies (NOCs), particularly China National Petroleum Co. (CNPC), parent company of PetroChina, and Sinopec dominate the oil and gas landscape. This NOC dominance limits knowledge transfer from international oil companies. Government policy prevents foreign partners from taking majority shares in projects and encourages CNPC and Sinopec to look abroad for opportunities. A lack of information complicates investment decisions.

The Chinese oilfield services (OFS) markets also constrain development. Subsidiaries of CNPC and Sinopec collectively account for 80% to 90% of Chinese OFS spend. These subsidiaries tend to be less profit-driven than independent OFS companies, making it difficult for both private local and international firms to compete, with some exceptions in newer areas such as the basins in far-western Xinjiang Province.

Similarly, a substantial portion of oilfield equipment is supplied by companies with close subsidiary relationships with NOCs. “Guanxi” (relationships) still drive decision-making when NOC subsidiaries make business decisions, and aside from certain segments (such as frac engines and transmissions), these tend to source Chinese equipment exclusively.

Current state of unconventionals in China

Contrary to popular view, frac capacity in China is not limited merely to the development of shale gas. In fact, the largest driver of frac activity is currently tight oil/gas resources in the key areas of Ordos, Daqing, and Shengli, located in the north-central, northeast, and east coast regions of China, respectively (Figure 1).

Chinese E&Ps are increasingly fracturing both horizontal and vertical wells to extract resources from these tight oil and gas reservoirs. Overall well counts in China have remained relatively steady, but the share of wells that are fractured has nearly doubled, from 12% in the first half of 2011 to 23% in the second half of 2013, according to PacWest estimates.

Similarly, an increasing proportion of the wells fractured are horizontal, which have more stages and offer the potential for greater production. In Sulige (Ordos basin), whose overall tight gas production has approached 20 Bcm (706 Bcf) in 2012, horizontal wells have five times the output of vertical wells and account for 30% of total output.

Rapidly increasing frac stages have driven dramatic frac capacity additions. By year-end 2013, China’s frac capacity of 2.6 MMhhp overtook Canada to become the second-largest in the world by frac capacity behind only the US. Capacity in 2013 increased 1.1 MM hhp, a growth rate of 77%, on top of a doubling of capacity in 2012, a phenomenal rate of growth.

Future of fracturing in China: Focus on shale

While tight resources have driven most activity and capacity additions so far, we expect shale to play an increasingly important role in the future. Shale activity, currently concentrated in the Sichuan basin region, remains in an exploratory phase.

While a number of commentators decry the apparent lack of progress, experience in the US demonstrates that it takes approximately five years to fully delineate a play. China only began exploring shale in earnest in the 2011 to 2012 timeframe; it is expected to take several more years until a full-scale development program can realistically begin.

Challenges remain for shale. Shale resources are often deep and geologically complex. Current shale wells cost approximately $15 million, much higher than those in the US. The shale auctions have been largely ineffective, with the most recent awarding blocks to local companies with minimal E&P experience. Local land use and infrastructure concerns remain in Sichuan, and Chinese companies lack shale technology and experience.

Nevertheless, optimism remains. The new gas price reform should incentivize output, and many Western players have partnered with NOCs to investigate or explore for shale. Output from certain shale wells is promising, indicating the government’s 6.5 Bcm (230 Bcf) target may be achievable.

Frac capacity expected to grow

In terms of frac capacity, PacWest expects shale and tight resources to drive dramatic increases in capacity, reaching an estimated 7.6 MMhhp by year-end 2018. PacWest believes there will be two periods of frac capacity additions.

In the near-term, frac capacity is expected to grow more slowly than 2013 due to over-exuberant frac additions that have overwhelmed the market and caused fleet utilization rates to drop significantly from 78% in the second half of 2012 to 63% in the second half of 2013. Afterward, capacity additions should increase rapidly once this overhang of capacity is used and shale exploration reaches full-scale development mode.

If shale reaches full-scale development in China, the effects could be sudden and dramatic. In the US, as a comparison, frac capacity increased by more than 6 MMhhp – more than twice the currently installed capacity based in China – in a span of only two years, from year-end 2009 to year-end 2011. China’s experience could be similar, and PacWest believes it is likely not a question of whether this burst of activity and capacity will occur, but when.