Can BP Finally Trigger The Chinese Shale Boom?

Chinese President Xi Jingping wrapped up a productive week in the United Kingdom this week, inking major deals that tie the two countries closer together. The trip made more news than Xi's visit to the U.S. a few weeks earlier, where he wasn't treated with nearly as much deference.

The red carpet rollout produced a series of major trade deals, but one of the most important developments of the trip was an announcement of deeper cooperation between BP (NYSE: BP) and China's state-owned China National Petroleum Corp (CNPC). The agreement called for strategic cooperation in "shale gas exploration and production in the Sichuan Basin and future fuel retailing ventures in China and other international partnerships." British Prime Minister and China's Xi Jingping were on hand for the signing, a deal that will form the backbone of a "global comprehensive strategic partnership" between the two countries in the 21st century.

BP and CNPC

BP and CNPC already cooperate on a crucial oil project in Iraq. The Rumaila field, Iraq's largest, produces 1.3 million barrels per day (mb/d). The successful cooperation between the two oil companies in Iraq convinced them that they should expand their partnership, BP's CEO Bob Dudley said in a statement.

In addition to the shale partnership, BP also secured a deal to supply state-owned China Huadian Corp. with 1 million tonnes of LNG per year for the next two decades, a deal that the company says is worth $10 billion.

But the real excitement is over China's shale sector. China holds the largest reserves of shale gas in the world at 1,115 trillion cubic feet. It also holds 32 billion barrels of oil trapped in shale, putting it behind only Russia and the U.S. In other words, the shale potential is truly massive.

And the Sichuan Basin is the most sought after shale region in China. The area in south-central China encompasses over 74,500 square miles. The area already produces more than 1.5 billion cubic feet of natural gas each day (bcf/d). But according to the EIA, only the southwestern quadrant of the Sichuan Basin is believed to be attractive enough for shale development, due to its "suitable shale thickness and depth, dry to wet gas thermal maturity, and absence of extreme structural complexity."

The southwest section of the Sichuan has a good combination of attractive below and above ground features: favorable geology, flat surfaces, existing pipelines, water availability, and proximity and access to urban gas markets. If shale is going to be developed in China, it will be here.

There are other shale basins that have potential, but are much less attractive. For example, the Yangtze Platform is structurally much more complex than the Sichuan. The shales do not hold continuous deposits, and data is sparse. Chevron (NYSE: CVX) and BP have looked at the area in years past when prices were high, but it is not the top priority for the industry. Then there is the Jianghan Basin to the east of Sichuan. Jianghan is home to some conventional drilling, but its geological complexity also makes shale development less appealing relative to the Sichuan.

With this context in mind, BP's partnership with CNPC to target the Sichuan makes sense, and holds out the potential for future success in both oil and gas development.

Disappointing Results Thus Far

Despite the potential of the Sichuan Basin, international companies trying to tap China's shale resources have been frustrated by a litany of obstacles. The geology is complex. Infrastructure is lacking. Water resources are scarce. Data needed to find and develop the best resources is also scarce. Put more simply, China's shale remains underdeveloped, which makes production costs a lot higher compared to North American shale. The government also regulates prices, which complicates the return on investment.

China has seen more than 200 wells drilled thus far, and China's state-owned companies, including CNPC and PetroChina, are expected to produce 600 million cubic feet per day (MMcf/d) of shale gas by the end of the year. CNPC has done the bulk of the work, accounting for 125 wells drilled (74 of which have gone into production) and could produce 250 MMcf/d by the end of 2015. Still, this is a paltry sum - the U.S. produces a few orders of magnitude more than this from its shale basins. The Marcellus Shale, for example, produces nearly 16,000 MMcf/d.

China Investments Cut

The collapse in oil prices has forced the oil majors to prioritize. Since there is not enough money to throw around the way there was a few years ago, high-cost areas are getting cut from exploration portfolios. And despite BP's deal with CNPC, the oil majors have sent mixed signals on their dealings in China.

For example, in 2014 BP pulled out of joint ventures in the South China Sea, writing off $112 million. The British oil giant is probably pleased with that move, considering the simmering tension in the region.

But shale regions in China are also on the chopping block. Royal Dutch Shell (NYSE: RDS.A) signed a production-sharing contract with another Chinese state-owned giant, PetroChina, in 2012. But earlier this year, Shell reduced its exposure to China's shale industry, and also sold a 75 percent stake in an oil-lubricants business based in China. It also pulled out of an LNG export project in Australia with PetroChina.

Other companies followed in Shell's footsteps. Anadarko Petroleum (NYSE: APC) and Noble Energy (NYSE: NBL) sold off their Chinese assets. Hess (NYSE: HES) scrapped a venture with PetroChina in China's shale patch.

Another Chinese oil giant, Cnooc, scrapped a shale gas project in Anhui province earlier this year because of high costs and disappointing results.

Conclusion

All of this makes the announcement between BP and CNPC a curious one. Low oil prices will likely prevent any significant investment in Chinese shale in the near-term. China's shale patch is simply too expensive right now. That will change once the industry starts to scale up, but for now, that remains a little ways off.

The above ground factors are also not insignificant. Roads, rigs, pipelines, processing facilities, deep capital markets, friendly regulation, mineral rights, risk incentives - these are all essential ingredients necessary for a shale boom, elements that are uniquely abundant in the United States but are largely in short supply in China.

This will change for the better when oil prices rise. But for the latest BP-CNPC announcement, investors should remain skeptical until actual dollars are committed to an exploration program. For now, the partnership could remain on paper.