James A.

Baker III Institute for Public Policy

ENERGYforum
Rice University

THEI TS ENERGYOF CHINA RISE IMPLICATIONS AND

Quantitative Analysis of Scenarios for Chinese Domestic Unconventional Natural Gas Resources and Their Role in Global LNG Markets
Kenneth B. Medlock III, Ph.D. Peter R. Hartley, Ph.D.

JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY RICE UNIVERSITY

Quantitative Analysis of Scenarios for Chinese Domestic Unconventional Natural Gas Resources and Their Role in Global LNG Markets
By

Kenneth B. Medlock III, Ph.D.

JAMES A. BAKER, III, AND SUSAN G. BAKER FELLOW IN ENERGY AND RESOURCE ECONOMICS, JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY, RICE UNIVERSITY
AND

Peter R. Hartley, Ph.D.

RICE SCHOLAR, JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY, AND GEORGE AND CYNTHIA MITCHELL CHAIR OF ECONOMICS, RICE UNIVERSITY

PREPARED BY THE ENERGY FORUM OF THE JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY
AS PART OF THE STUDY

THE RISE OF CHINA AND ITS ENERGY IMPLICATIONS

DECEMBER 2, 2011

Scenarios for Chinese Domestic Unconventional Natural Gas Resources

THIS PAPER WAS WRITTEN BY A RESEARCHER (OR RESEARCHERS) WHO PARTICIPATED IN THE JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY STUDY. THE RESEARCH AND THE VIEWS EXPRESSED WITHIN ARE THOSE OF THE INDIVIDUAL RESEARCHER(S) AND DO NOT NECESSARILY REPRESENT THE VIEWS OF THE JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY OR THE STUDY SPONSORS.

2011 BY THE JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY OF RICE UNIVERSITY THIS MATERIAL MAY BE QUOTED OR REPRODUCED WITHOUT PRIOR PERMISSION,
PROVIDED APPROPRIATE CREDIT IS GIVEN TO THE AUTHOR AND THE JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY.

Scenarios for Chinese Domestic Unconventional Natural Gas Resources

ACKNOWLEDGMENTS
The Energy Forum of the James A. Baker III Institute for Public Policy would like to thank The Institute of Energy Economics, Japan, and the sponsors of the Baker Institute Energy Forum for their generous support of this program. The James A. Baker III Institute for Public Policy would also like to thank Deloitte MarketPoint LLC for its continued support of the Energy Forums natural gas modeling efforts. The Energy Forum further acknowledges contributions by study researchers and writers.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources

ABOUT THE STUDY

The Rise of China and Its Energy Implications is a major research initiative to investigate the

implications of Chinas oil and natural gas policies and domestic energy market development on global energy markets. This study focuses on the influence of Chinas energy development on U.S. and Japanese energy security and global geopolitics. Utilizing geopolitical and economic modeling and scenario analysis, the study analyzes various possible outcomes for Chinas domestic energy production and its future import levels. The study considers how trends in Chinas energy use will influence U.S.-China relations and the level of involvement of the U.S. oil industry in Chinas domestic energy sector.

STUDY AUTHORS
JOE BARNES JAMES D. COAN JAREER ELASS MAHMOUD A. ELGAMAL PETER R. HARTLEY AMY MYERS JAFFE STEVEN W. LEWIS DAVID R. MARES KENNETH B. MEDLOCK III RONALD SOLIGO RICHARD J. STOLL ALAN TRONER

Scenarios for Chinese Domestic Unconventional Natural Gas Resources

ABOUT THE ENERGY FORUM AT THE JAMES A. BAKER III INSTITUTE FOR PUBLIC POLICY
The Baker Institute Energy Forum is a multifaceted center that promotes original, forward-looking discussion and research on the energy-related challenges facing our society in the 21st century. The mission of the Energy Forum is to promote the development of informed and realistic public policy choices in the energy area by educating policymakers and the public about important trendsboth regional and globalthat shape the nature of global energy markets and influence the quantity and security of vital supplies needed to fuel world economic growth and prosperity. The forum is one of several major foreign policy programs at the James A. Baker III Institute for Public Policy of Rice University. The mission of the Baker Institute is to help bridge the gap between the theory and practice of public policy by drawing together experts from academia, government, the media, business, and nongovernmental organizations. By involving both policymakers and scholars, the institute seeks to improve the debate on selected public policy issues and make a difference in the formulation, implementation, and evaluation of public policy.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources

ABOUT THE INSTITUTE OF ENERGY ECONOMICS, JAPAN

The Institute of Energy Economics, Japan (IEEJ), was established in June 1966 and specializes in research activities in the area of energy from the viewpoint of Japans national economy in a bid to contribute to sound development of Japanese energy supply and consumption industries and to the improvement of domestic welfare by objectively analyzing energy problems and providing basic data, information and the reports necessary for policy formulation. With the diversification of social needs during the three and a half decades of its operation, IEEJ has expanded its scope of research activities to include such topics as environmental problems and international cooperation closely related to energy. The Energy Data and Modeling Center (EDMC), which merged with the IEEJ in July 1999, was established in October 1984 as an IEEJ-affiliated organization to carry out such tasks as the development of energy data bases, the building of various energy models, and the econometric analyses of energy.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources

ABOUT THE AUTHORS

KENNETH B. MEDLOCK III, PH.D.
James A. Baker, III, and Susan G. Baker Fellow in Energy and Resource Economics James A. Baker III Institute for Public Policy, Rice University

Kenneth B. Medlock III, Ph.D., is the James A. Baker, III, and Susan G. Baker Fellow in Energy and Resource Economics at the Baker Institute and an adjunct professor and lecturer in the Department of Economics at Rice University. Currently, Medlock heads the Baker Institute Energy Forums natural gas program and is a principal in the development of the Rice World Natural Gas Trade Model, which assesses the future of international natural gas trade. He also teaches energy economics courses and supervises students in the energy field. Medlock studies natural gas markets, gasoline markets, energy commodity price relationships, transportation, modeling national oil company behavior, economic development and energy demand, forecasting energy demand, and energy use and the environment. Medlock is a council member of the International Association for Energy Economics (IAEE), and a member of United States Association for Energy Economics (USAEE), The American Economic Association and the Association of Environmental and Resource Economists. In 2001, he won (with Ron Soligo) the IAEE Award for Best Paper of the Year in the Energy Journal. In 2011, he was given the USAEEs Senior Fellow Award. Medlock also served as an adviser to the U.S. Department of Energy and the California Energy Commission in their respective energy modeling efforts. He was the lead modeler of the Modeling Subgroup of the 2003 National Petroleum Council (NPC) study of long-term natural gas markets in North America, and is involved in the ongoing NPC study North American Resource Development. Medlock received his Ph.D. in economics from Rice and held the MD Anderson Fellowship at the Baker Institute from 2000 to 2001.

PETER R. HARTLEY, PH.D.

Rice Scholar, James A. Baker Institute for Public Policy George and Cynthia Mitchell Chair of Economics, Rice University

Peter R. Hartley, Ph.D., is the George and Cynthia Mitchell Chair and a professor of economics at Rice University. He is also a Rice scholar of energy economics for the James A. Baker III Institute for Public Policy. Hartley has worked for more than 25 years on energy economics issues, focusing originally on electricity, but also including work on natural gas, oil, coal, nuclear, and renewable energy. He wrote on reform of the electricity supply industry in Australia throughout the 1980s and early 1990s and advised the government of Victoria when it completed the acclaimed privatization and reform of the electricity industry in that state in 1989. Apart from energy and environmental economics, Hartley has published research on theoretical and applied issues in money and banking,

Scenarios for Chinese Domestic Unconventional Natural Gas Resources

business cycles, and international finance. He worked for the Priorities Review Staff, and later the Economic Division, of the Prime Ministers Department in the Australian government. He came to Rice as an associate professor of economics in 1986 after serving as an assistant professor of economics at Princeton University from 1980 to 1986. Hartley completed an honors degree in mathematics and a masters degree in economics at The Australian National University. He obtained a Ph.D. in economics at The University of Chicago.

Scenarios for Chinese Domestic Unconventional Natural Gas Resources I. Introduction1 The past decade has yielded dramatic change in the natural gas industry. Specifically, there has been rapid development of technology allowing the recovery of natural gas from shale formations. This technology has been applied with much success in North America, and there is much interest in seeing similar developments in other countries around the world. Since 2000, production of natural gas from shale formations in North America has dramatically altered the global natural gas market landscape. In fact, the emergence of shale gas is perhaps the most significant development in global energy markets in the last decade. Knowledge of the shale gas resource is not new as geologists have long known about the existence of shale formations, and accessing those resources was long held in the geology community to be an issue of technology and cost. In the past decade, innovations involving the use of horizontal drilling with hydraulic fracturing have yielded substantial cost reductions, making shale gas production a commercial reality. In fact, shale gas production in the United States has increased from virtually nothing in 2000 to over 10 billion cubic feet per day (bcfd) in 2010, and it is expected to more than quadruple by 2040, reaching over 50 percent of total U.S. natural gas production by the 2030s (see Figure 1). Figure 1. U.S. Natural Gas Production through 2040 (Reference Case)

Scenarios for Chinese Domestic Unconventional Natural Gas Resources To be sure, shale gas developments in North America have had a ripple effect across the globe by displacement of supply in global trade and by fostering a growing interest in shale resource potential in other parts of the world. Thus, North American shale gas developments are having effects far beyond the North American market, and these impacts are likely to expand over time. The state of knowledge regarding the portion of shale gas that is economically recoverable has changed rapidly over the last 10 years. A simple chronology of assessments for North America, where most development activity has occurred to date, is as follows: As recently as 2003, the National Petroleum Council2 estimated that about 38 tcf of technically recoverable resource was spread across multiple basins in the North America. In 2005, the Energy Information Administration (EIA) was using an estimate of 140 tcf in its Annual Energy Outlook as a mean for North American technically recoverable shale gas resource. In 2008, Navigant Consulting, Inc.3 estimated a mean of 280 tcf of technically recoverable resources from reviewable geologic literature, but a survey of producers indicated up to 840 tcf. In 2009, the Potential Gas Committee4 put its mean estimate at just over 680 tcf. In 2011, Advanced Resources International (ARI) reported an estimate of about 1,930 tcf of technically recoverable resource for North America, with over 860 tcf in U.S. gas shales alone.5 Importantly, although each assessment is from an independent source, the estimates are increasing over time as more drilling occurs and technological advances are made. Moreover, the shift in the generally accepted assessment of recoverable shale resource has left producers, consumers, and governments all grappling with the implications for markets as well as the geopolitical repercussions. Shale gas developments stand to exert enormous influence on the structure of the global gas market. Throughout the 1990s, natural gas producers in the Middle East and Africa, anticipating rising demand for LNG from the United States in particular, began investing heavily in expanding LNG export capability, concomitant with investments in regasification being made in

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources the United States. But the rapid growth in shale gas production has turned such expectations upside down and rendered many of those investments obsolete. Import terminals for liquefied natural gas (LNG) are now scarcely utilized, and the prospects that the United States will become highly dependent on foreign imports in the coming years are receding. Rising shale gas production in the United States is also having an impact on markets in Europe and Asia. In particular, LNG supplies whose development was anchored on the belief that the United States would be a premium market are now being diverted to European and Asian buyers. Not only has this immediately presented consumers in Europe with an alternative to Russian pipeline supplies, it is also exerting pressure on the status quo of indexing gas sales in both Europe and Asia to a premium marker determined by the price of petroleum products. In recent rounds of renegotiations, Russia has had to accept far lower prices from many of its traditional long-term customers and has accepted a partial link to gas on gas pricing. Revelations about the potential for increased shale gas production are also occurring in other regions around the world, with shale gas discoveries being discussed in Europe, China, India, Australia, and elsewhere. To be sure, the enormity of global shale gas potential will have significant geopolitical ramifications and exert a powerful influence on U.S. energy and foreign policy. In this study, we utilize scenario analysis to examine the role that China plays in the future of global gas market developments. In doing so, we consider two cases, which we compare to a reference case, where: 1. Chinas technically recoverable shale resource base is dramatically larger; and 2. Chinas economic growth falters, thus lowering natural gas demand growth. We also expand on the effect of shale gas developments more generally by highlighting a recent paper by Medlock and Jaffe (2011)6 in which no shale is developed anywhere in the world. This highlights the overall importance of the shale gas resource to international gas markets.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Among the geopolitical repercussions of expanding shale gas production are: It virtually eliminates U.S. requirements for imported LNG for at least two decades, reducing U.S. and Chinese dependence on Middle East natural gas supplies, lowering the incentives for geopolitical and commercial competition between the two largest consuming countries, and providing both countries with new opportunities to diversify their energy supply. It substantially reduces Russias market share in both Europe and Asia, depending on the amount of shale resource that is ultimately available in both regions. It lowers prices and stimulates greater use of natural gas, thereby having significant implications for global environmental objectives to the extent it displaces coal. It reduces overall dependence on Iranian natural gas, which limits Irans ability to tap energy diplomacy as a means to strengthen its regional power or to buttress its nuclear aspirations. It should be pointed out that the sustained rapid development of shale gas is not a certainty. In particular, environmental concerns regarding the use and potential contamination of water resources are major issues that will need to be addressed before governments will allow full realization of shales growth potential.7 In China, in particular, water availability for hydraulic fracturing may considerably diminish the potential for domestic shale development. According to a report by Gleick et al. (2008),8 China faces some of the most severe water challenges in the world due to overallocation, inefficient usage, and widespread pollution, as well as a fairly weak regulatory body. Moreover, the response to issues of scarcity from Beijing and central water agencies has typically been one involving proposals for massive new infrastructure to divert water from one region to another rather than new approaches to management. One such massive project is the South-to-North Water Transfer Project, which will funnel 45 billion cubic meters (bcm) of water to the northern part of the country through the Yangtze River basin but will not be completed for several decades at the earliest. There are also plans for investment in water distribution systems and the construction of more than 1,000 water and wastewater treatment facilities. Plans for coastal water desalination are also in their early stages.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Regional conflicts over water allocation have emerged from a national water policy that seems centered around moving water from region to region via large infrastructure projects. This national policy stance is not new. The intensity of the problem in some regions can be witnessed by the fact that periodic clashes have occurred since the 1970s over water from the Zhang River. The North China Plains also face fierce competition over water, as Beijings growing population has led to the citys exploitation of nearly all major rivers flowing through surrounding provinces. Figure 2 highlights the potential water availability issues and their intersection with potential shale gas developments. Notice, with the exception of only a couple of basins, the coincidence of shale gas resources and water stress is very high. Due to potential water constraints, we have substantially reduced the technically recoverable shale gas resource base in China in our Reference Case. However, we do compare this outcome to one in which any potential water issues can be largely overcome, which results in a technically recoverable shale resource base that is substantially larger. We describe all scenarios in more detail below. Figure 2. China Shale Resource and Water Stress Map9

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources II. Study Approach In this study, we utilize the Rice World Gas Trade Model (RWGTM)10 to examine the market implications and geopolitical consequences of potentially important supply and demand side developments in China, namely rising supplies of natural gas from shale and changes in its economic outlook. The RWGTM is a dynamic spatial general equilibrium model where supply and demand is balanced at each location in each time period such that all spatial and temporal arbitrage opportunities are eliminated. The model, therefore, proves and develops reserves, constructs transportation routes and associated infrastructure, and calculates prices to equate demands and supplies while maximizing the present value of producer rents within a competitive framework. Thus, new infrastructures must earn a minimum return to capital in order for its development to occur.11 By developing pipeline transportation routes and LNG delivery infrastructure, the RWGTM provides a framework for examining the effects of critical economic and political influences on the global natural gas market within a framework grounded in geologic data and economic theory. Moreover, it provides insight as to the location and conditions under which resources are competitive in a global market. The RWGTM allows the examination of potential futures for U.S. and global natural gas in a manner that allows quantification of geopolitical influences on resource development and export flows. The RWGTM predicts regional prices, regional supplies and demands, and interregional flows. Since geopolitical influences can alter market outcomes in many different ways, the nonstochastic nature of the RWGTM allows an analysis of many different scenarios and allows the model to characterize the impact of later economic outcomes on earlier investment decisions. In this way, the inter-temporal nature of the RWGTM allows a complete analysis of the impact on investment decision pathways of specific scenarios. This follows from the fact that capacity and reserve expansions are determined by current and future prices along with capital costs of expansion, operating and maintenance costs of new and existing capacity, and revenues resulting from future outputs and prices. The RWGTM is a unique tool because it allows simultaneous analysis of many different outcomes and is not sequence dependent.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources The RWGTM is a highly disaggregated representation of existing and potential resources, demand sinks, and distribution networks. The extent of regional detail in the RWGTM varies based primarily on data availability and the potential influence of particular countries on the global natural gas market. For example, large consuming and producing countries, such as China, the United States, India, Russia, and Japan, to name a few, have extensive sub-regional detail in order to understand the effect that existing or developing intra-country capacity constraints could have on current or likely future patterns of natural gas trade. In general, regions are defined at the country and sub-country level, with extensive representation of transportation infrastructure connecting over 290 regions with more than 135 supply regions. U.S. demand is characterized at the state and sub-state level for the residential, commercial, industrial, and power generation sectors. Demand in all other countries is less detailed at the enduse level, as it is estimated for the power generation sector and all other sectorsa limitation directly related to data availability. Supply costs are present for each region in three primary categories(i) proved reserves, (ii) growth in existing fields, and (iii) undiscovered resourcesand are present for both conventional and unconventional resources. The resource data derives from sources including the Oil and Gas Journal (OGJ), United States Geological Survey (USGS), National Petroleum Council (NPC), Australian Bureau of Agriculture and Resource Economics (ABARE), and Baker Institute research on unconventional resources in North America and globally. North America finding and development (F&D) costs are based on estimates developed by the NPC and have been adjusted using data from the Bureau of Economic Analysis KLEMS data to account for changes in upstream costs since the early 2000s. These costs have been econometrically related to play-level geological characteristics and applied globally to generate costs for all regions of the world. In general, long-run F&D costs increase with depletion, and short-run adjustment costs limit the rush to drill phenomenon. Technological change is allowed to reduce F&D costs over the long run. In a global natural gas market as develops in the RWGTM, events in one region of the world influence all other regions to the extent trade can occur between regions. Thus, political factors affecting relations between Russia and China, for example, will affect flows and prices

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources throughout the world, not just in Northeast Asia. This follows because transportation links connecting markets transmit price signals as well as volumes of physical commodity. It is in this manner that markets become increasingly connected over time, specifically as profitable spatial arbitrage opportunities are exploited until they are eliminated. The costs of constructing new pipelines and LNG facilities in the RWGTM are estimated using data on previous and potential projects available from the EIA, International Energy Agency (IEA), and various industry reports. Within the United States, Federal Energy Regulatory Commission (FERC)-filed tariff rates are used to determine the cost of transporting natural gas via pipeline. For regions outside the United States, a rate-of-return calculation is generally used to construct the tariffs on pipelines, such that the present value of the tariff revenue at 50 percent capacity utilization just recovers the upfront capital cost in 20 years. For LNG, facility throughput tariffs and shipping rates are based on information obtained from various industry reports. We compare results in an analysis based on the following three scenarios. Reference Case: This case posits a scenario in which all known global shale gas resources can be developed given prevailing commercial technologies and open tendering practices. This scenario includes all global shale resources that have been identified as commercially viable in Europe and Asia and thereby present a full picture of the current expectations for changing geopolitical and market implications of a full scale development of known shale gas resources. High China Shale Case: This case assumes the quantity of commercially viable shale resource available for development in China is substantially larger than in the Reference Case. In fact, the estimated technically recoverable shale resource distributed across four basins is 600 tcf, an increase by an order of magnitude over the Reference Case. The dramatically larger resource assessment is still smaller than the resource identified in the recent ARI/EIA study, but other issues related to development, which are outlined herein, make this a reasonable upper bound assessment for this case. Low China Demand Case: This case posits a much slower growth rate of the Chinese economy than the Reference Case. The average annual growth rate of real GDP in China from 2010-2030 is 2.5 percent in this case, which is a reduction from 5.1 percent in the Reference Case. This occurs due to an assortment of potential problems that might affect

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources the Chinese economy in the coming years (high inflation, problems related to infrastructure constraints, etc.).12 III. Defining the Resource Shale gas resources became prominent for its potential to provide large amounts of marketable natural gas in only the last several years, centered primarily on developments in the United States. Beginning with the Barnett shale in northeast Texas, the application of innovative new techniques involving the use of horizontal drilling with hydraulic fracturing has resulted in the rapid growth in production of natural gas from shale. Moreover, the production potential that has been identified since the emergence of the Barnett shalewhich until very recently was the largest single producing natural gas play in North America, having just been surpassed by production from the Haynesville shale in neighboring Louisianahas dramatically altered expectations for global LNG trade. Less than 10 years ago, most predictions were for a dramatic increase in LNG imports to the United States, but shale production has turned this thinking upside down. Today, growth opportunities for LNG developers are seen in primarily in Asia, which could be threatened by a similar emergence of shale in those regions. Knowledge of shale gas resource is not new as geologists have long known about the existence of shale formations. However, the ability to access shale resources in a commercial manner is new. In a study published in 1997, Rogner estimated over 16,000 trillion cubic feet (tcf) of shale gas resource in-place globally with just under 4,000 tcf of that total estimated to be in North America.13 At that time, only a very small fraction (<10 percent) of this was deemed to be technically recoverable and even less so economically. But recent innovations have rendered this resource accessible both by providing the technological capability and by reducing costs, thereby providing economic feasibility. In fact, the IEA recently estimated about 40 percent of the estimated resource in-place by Rogner (1997) will ultimately be technically recoverable. Despite very large assessments of resource in-place, the commercial viability of shale is determined as a subset of resource in-place. In particular, technically recoverable resources define the boundary of those resources that can be recovered with existing technology, but economically

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources recoverable resource defines the boundary of what is commercially accessible. Thus, large resource in-place estimates do not necessarily imply large-scale production is forthcoming because technical innovations and cost reductions are critical to commercial viability. As noted above, the application of horizontal drilling with hydraulic fracturing to create a reservoir in virtually impermeable shale formations propelled the Barnett shale to becoming the largest single producing natural gas play in North America. This subsequently altered producers' expectations about the viability of shale resources in other locations, and triggered a virtual rush to the shale resource. Innovations aimed at lowering costs continue, with longer laterals, increased frac stages, and better proppants. For example, Schlumberger recently reported very promising results in test wells from the use of its innovative new HiWAY fracing technique, yielding up to double the daily production and greater expected ultimate recovery when compared to standard slickwater fracs. Currently in North America, break-even prices for some of the more prolific shales are estimated to be as low as $3 per thousand cubic feet (mcf), with a large majority of the resource accessible at below $6/mcf. Ten years ago, costs were significantly higher. As firms continue to make cost reducing innovations, greater quantities of the shale resource will become both technically and economically viable. Given the magnitudes of the assessments of shale resources reported in just the past couple of years, modeling done at the James A. Baker III Institute for Public Policy (BIPP) at Rice University indicates a relatively conservative estimate of North American technically recoverable shale resource of 686 tcf. A detailed account is provided in Table 1. The break-even price indicated in Table 1 is the average price needed for development of the average type well for the associated technically recoverable resource. Shale gas resources are not limited to only North America. In-depth studies are currently underway to fully assess shale resource potential in Europe, Asia, and Australia, but a dearth of commercial activity renders the current assessments in those regions highly uncertain. In Europe, while some estimates exist, there is active research into assessing shale potential in Austria, Sweden, Poland, Romania, Germany, Croatia, Denmark, France, Hungary, Netherlands, Ukraine, and the United Kingdom, to name a few locations.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Table 1. North American Shale Gas Assessments in the RWGTM
Mean%Technically% Recoverable% Resource%(tcf) Breakeven%Price Antrim Devonian/Ohio Utica Marcellus Marcellus%Tier%1 Marcellus%Tier%2 Marcellus%Tier%3 NW%Ohio Devonian%Siltstone%and%Shale Catskill%Sandstones Berea%Sandstones Big%Sandy Nora/Haysi New%Albany Floyd/Chattanooga Haynesville Haynesville%Tier%1 Haynesville%Tier%2 Haynesville%Tier%3 Fayetteville Woodford%Arkoma Woodford%Ardmore Barnett Barnett%Tier%1 Barnett%Tier%2 Barnett%and%Woodford Eagle%Ford Palo%Duro Lewis Bakken Niobrara Hilliard/Baxter/Mancos Paradox/Uinta Mowry Horn%River Horn%River%T1 Horn%River%T2 Montney Montney%T1 Montney%T2 Utica Total%US%Shale Total%Canadian%Shale Total%North%America 8.0 4.2 54.0 32.2 21.8 35.4 35.0 4.7 10.2 1.8 1.3 11.8 13.5 8.5 90.0 50.0 40.0 65.0 25.0 40.0 10.0 521.5 165.0 686.5 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.75 $%%%%%%%%%%%%%%%%%%%%%%%%%%5.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%5.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%5.75 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.50 2.7 1.3 11.7 6.8 6.3 1.2 3.8 4.3 105.0 42.0 36.8 26.3 36.0 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%5.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%5.75 13.2 170.8 5.4 135.4 47.4 43.3 44.7 $%%%%%%%%%%%%%%%%%%%%%%%%%%4.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%5.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.50 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.75 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.75 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.75 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.75 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.25 $%%%%%%%%%%%%%%%%%%%%%%%%%%7.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.00 $%%%%%%%%%%%%%%%%%%%%%%%%%%6.25 $%%%%%%%%%%%%%%%%%%%%%%%%%% 5.50

Currently, our work at BIPP indicates a technically recoverable assessment in Europe of roughly 220 tcf split between Sweden, Poland, Austria, and Germany, with the largest proportion (about 55 percent) in Poland, and entry costs in the $6-8/mcf range. Data for Asia and the Pacific is generally even more preliminary, but potential has been identified in China (75 tcf of recoverable resource) and Australia (50 tcf of recoverable resource), to name two. These estimates are very

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources preliminary and are thus full of uncertainty, but it is possible that estimates of commercially accessible resources in these regions will grow over time, particularly as technologies are developed to increase production rates and lower costs. In fact, the shale resource is by most accounts very large. The previously mentioned studies by Rogner (1997) and ARI (2011) are summarized in Table 2, where technically recoverable resources from Rogners study have been inferred using the IEAs recent assessment of a reasonable recovery factor. Notice that the resources are quite substantial, especially when compared to the assessments in the Reference Case, which are also included in Table 2. Ongoing research will likely result in an increased assessment to be used in our own modeling, but that is preliminary at the time this research was completed. Nevertheless, in order to understand the implications of larger recoverable resources, we have constructed the High China Shale Case for comparison. Table 2. A Summary of Global Shale Gas Assessments**
North America Latin America Europe FSU China India Australasia Middle East North Africa Other Total Rogner (1997)* 1537 847 220 251 1411 925 1019 235 6445 ARI (2011) 1931 1225 639 --1275 63 396 --558 538 6625 RWGTM 686 --220 --75 --50 ------1031

*- applies a 40% recovery factor to the estimated gas in place. **- The assessments in the RWGTM incorporate an assessment of economic viability as well as a discount factor applied to reflect other constraints.

Notable differences in the assessments in Table 2 center largely on the level of detail. For example, the RWGTM has no shale gas assessment in Latin America, FSU, India, Middle East, North Africa, and Other. This accounts for a difference in the total technically recoverable

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources assessment relative to the ARI assessment of over 2,300 tcf. It is important to point out, however, that the economic viability of much of the resource identified in the Rogner and ARI studies can be called into question due to the rock properties and other factors related to the geophysical properties of the shale. Work is currently ongoing to assess the extent to which this is the case. In addition, factors such as market structure and mineral property rights also will play a role in the economic viability of shale around the world, a point that cannot be understated. Arguably, if the current market structure in the United States did not exist, the shale gas boom would not have occurred. This is due to the fact that the small producers who initiated the proof of concept had little to no risk of accessing markets from very small production projects. A market in which capacity rights are not unbundled from facility ownership does not foster entry by small producers. IV. Scenario AnalysisReference Case The repercussions of expanding shale gas production potential are profound. In the Reference Case scenario, LNG exports originate from a wide diversity of sources instead of being concentrated in any one geographical region, and no single supplier gains significant market leverage (see Figure 3). Qatar remains the largest LNG exporter while Australia emerges as a close second. Nigeria, Iran, and Venezuela eventually each grow to positions of prominence, and they collectively account for about 35 percent of global LNG exports by 2040. Importantly, it has been shown by Medlock and Jaffe (2011) that shale gas, by displacement, has both spatial and temporal impacts on the global gas market. More specifically, they show that shale gas delays for well over a decade the worlds reliance on regions that have historically been volatile and greatly reduces the chances of decisive monopoly power being exercised by any individual or grouping of producers. In the United States, in particular, growth in LNG imports is put off by at least two decades.14 Nevertheless, global LNG trade grows, largely due to growth in Asia. In fact, the Reference Case reveals very different reliance on LNG across regions, ranging from very low in North America to very high in Asia (see Figure 4).

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 3. Reference Case LNG Exports (by country) to 2040

We can see that Asia accounts for a massive 59 percent of global LNG demand, with China leading the way at 24 percent of all global LNG imports. This compares to a European import share of 22 percent and a North American import share of 16 percent.15 In sum, growth in supplies of natural gas from shale is a catalyst for deepening of the global natural gas market, and strong demand growth in Asia triggers significant growth in global LNG trade. The deepening of the global gas market has distinct benefits. In particular, as shown in Hartley and Medlock,16 growth in LNG trade implies growth in physical liquidity, which increases arbitrage allowing for shocks in one region to be transmitted to others. While this may seem undesirable, it actually mitigates the impact of any single shock. For example, greater ability to import LNG provides European consumers a means of dealing with future disruptions in Russian supplies, or U.S. consumers a means of coping with unexpected hurricane damage. Thus, the impact of the shock on any one region is reduced through arbitrage.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 4. Reference Case LNG Imports (by country) to 2040

Brito and Hartley17 show that growth in physical liquidity also limits the ability of a single supplier to price above marginal cost. The relative abundance of LNG, prompted by the dramatic growth in shale, also puts downward pressure on demand for pipeline supplies, meaning Europe and Asia see increased competition. Importantly, this has implications for the terms at which existing and future supplies are negotiated. In fact, as the natural gas supply curve becomes more elastic, as is the case with shale gas developments, it will become increasingly difficult to price above marginal cost, meaning oil indexation is likely to lose some of its prominence. Absent storage and physical liquidity, oil indexation provides an element of price certainty. But, to be sure, oil indexation is a form of price discrimination. Figure 5 provides an illustration of price discrimination. Note that oil indexation does not preclude the existence of spot transactions, but market structures that do not easily allow resale can severely limit them. In Figure 5, about 15 percent of the marketed volumes are sold on a spot basis, with the remaining 85 percent contracted above marginal cost. In general, for a firm to be able to price discriminate (1) it must be able to distinguish consumers and prevent resale, and (2) its consumers must have different elasticities of demand. Both of these conditions are met in Europe and Asia. However, an increased ability to trade between

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources suppliers and consumers (i.e., increased physical liquidity) leads to a violation of condition (1). This is more likely to happen as the supply curve in Figure 5 becomes more elastic (flatter).18 Even now, evidence of diminished ability to price discriminate is emerging in Europe as there have been multiple announcements of changes in contractual terms, with a propensity to index at least a portion of sales to spot prices. Thus, by displacement, the increase in shale production in North America has begun to have impacts on traditional pricing mechanisms in other markets. If shale resources are proven to be commercially viable in Europe and Asia, this will accelerate, and the new normal could very well be characterized by more intense competition and increased pressure for departure from the traditional oil-indexed pricing paradigm. Figure 5. Oil Indexation and Price Discrimination
P

Rent earned from pricing supply above marginal cost

S
POIL INDEX

P@ P=MC
Marginal price

Oil Indexed Contract Volume

Spot Volume

D Q

Total Volume

As demonstrated in Medlock and Jaffe (2011), if the increased competition from shale had not emerged, two producing countries in particular would be left with a dominant position in the global gas market: Russia and Iran. Before the shale discoveries, these nations were expected to account for more than half of the worlds known conventional gas resources. Notably, both Russia and Iran have been more than just casual observers in the Gas Exporting Countries Forum (GECF). The emergence of shale limits the near term possibility of a successful natural gas cartel being formed by those countries involved in the GECF by increasing the elasticity of supply of

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources natural gas in countries outside GECF, which reduces the potential for a small group of producers to exercise monopoly power. In fact, in the Reference Case, as can be seen in Figure 6, world dependence on Middle East natural gas remains below 20 percent until the late 2030s as rising demand from Asia finally makes its mark. But, as argued in Medlock and Jaffe (2011), reliance on Middle East natural gas is significantly higher in a world without shale gas. Moreover, the Middle East country that is disadvantaged the most as a result of rising shale gas production is Iran, whose exports are effectively delayed by over a decade. Figure 6. World Supply by Region, 1990-2040 (Reference Case)

In the Reference Case, China becomes a major importer of natural gas both via pipeline and LNG. In fact, it is the largest driver of growth in LNG trade going forward. Figure 7 indicates both the growth in demand for natural gas and the manner in which demand is metvia domestic production (conventional and unconventional gas), LNG imports, and pipeline imports. Among the domestic options, shale gas becomes an increasingly important source of supply, but it largely acts to offset declines in conventional gas production. Almost all of the growth in demand is balanced by imports of pipeline gas from Russia, Turkmenistan, and Myanmar (with Russia being the largest supplier long term) and by LNG imports. In fact, LNG imports account for over 50 percent of Chinas gas supply longer term. 25

Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 7. China Natural Gas Balance, 2010-2040 (Reference Case)

Strong growth in LNG imports to China has implications for pricing in Asia, as might be expected. In Figure 8, we see the prices for Asia, National Balancing Point (NBP), and Henry Hub. Note that the Asian price remains strong relative to other global markers, being at parity with NBP and well above the price at Henry Hub. Interestingly, demand growth in China ultimately drives a strengthening of energy ties between Russia and China, a result that may, if it eventuates, influence the balance of power in Northeast Asia. Figure 8. Select Natural Gas Prices, 2010-2040 (Reference Case)19

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources V. Scenario AnalysisHigh China Shale Case As noted above, the recent assessment by ARI (2011) places Chinas technically recoverable shale gas resource at over 1,200 tcf, which is a stark contrast to the resource assessment used in the Reference Case (75 tcf). However, there is tremendous uncertainty around the economically recoverable assessment of shale in China. Challenges related to water access and availability, infrastructure, resource ownership and market incentive, and market structure are all very relevant issues that must be considered when formulating the amount of shale resource that may ultimately be recovered. Given the tremendous uncertainty associated with resolution of these types of issues, we consider a case in which the resource assessment in China is raised to 600 tcf. Table 3 indicates the distribution of the shale resources in both the Reference Case and the High China Shale Case. Notably, the resource is spread across multiple basins, where the distribution is informed by the ARI study and historical gas production. Note that the largest concentration of shale is in western (Tarim) and north central China (Ordos), which coincide with the regions with the largest technically recoverable assessments for conventional natural gas (85 and 19 tcf, respectively) and, in the case of the Ordos basin, coal bed methane (100 tcf). Table 3. Shale Assessment Across Cases (Units: tcf)
Reference Tarim Basin West Junggar Basin Tuja Basin Central North Central Northeast Sichuan Basin Jianghan Basin Ordos Basin Songliao Basin Bohai Bay Basin Total 45 30 --75 120 150 80 600 --250 High China Shale

Figure 9 indicates demand and the manner in which demand is met in the High China Shale Case. As in Figure 7 above, sinks (demand and exports) are represented as negative values and sources of supply are represented as positive values. A few things are of substantial note. First,

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources even though shale gas production is substantially higher, resulting in lower import dependence, China still imports natural gas via pipeline and as LNG. Second, China begins to export gas (to South Korea) beginning in 2016, rising to almost a billion cubic feet per day. The overall impact of lower import dependence and exports to South Korea substantially reduces demand for LNG imports in Asia (see Figure 12). Figure 9. China Natural Gas Balance, 2010-2040 (High China Shale Case)

Figure 10 indicates the changes relative to the Reference Case associated with the assumptions regarding the technically recoverable shale resource base indicated in Table 3. The top panel in Figure 10 indicates a very large increase in shale gas production, which results in a decline in both LNG and pipeline imports. We also see that demand is higher due to lower prices (see Figure 11), and that China begins to export gas (by pipeline to South Korea). Higher shale gas production in China leaves it less exposed to potentially disruptive events in the Middle East and Russia. This follows because in the Reference Case, China becomes increasingly dependent on both the Middle East and Russia for both LNG and pipeline imports. Thus, to the extent that natural gas supplies can instead be sourced from domestic production, China is better off.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 10. Changes in Supply Sources and Disposition Relative to Reference Case Sources of Supply

Demand

Exports

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources The benefits extend beyond Chinas borders as well. This is evidenced in Figure 11 through the impact that greater Chinese shale production has on prices. Asian prices are reduced by the greatest amount, but prices at both NBP and the Henry Hub are also reduced. This occurs as a result of the large reduction in LNG demand in Asia, which reduces competition for LNG imports. In fact, LNG imports to the U.S. and European nations increase (see Figure 13) in the High China Shale Case. Figure 11. Decadal Average Changes in Price Relative to Reference Case

Figure 12. Changes in LNG Exports by Country Relative to Reference Case

We also see that global LNG exports are generally lower as a result of greater shale production in China, a result that reinforces the point that Asian demand is the driver of LNG growth in the Reference Case. Figure 12 indicates that in 2040 about 85 percent of the reduction in LNG 30

Scenarios for Chinese Domestic Unconventional Natural Gas Resources exports falls on Iran, Qatar, Russia, and Venezuela. This is analogous to the point made in Medlock and Jaffe (2011) that shale resources tend to reduce the long-run market influence of Iran, Russia, and Venezuela. Figure 13. Changes in LNG Imports by Country Relative to Reference Case

VI. Scenario AnalysisLow China Demand The recent experience of the Chinese economy has led many to predict very robust long-term average annual growth rates of the economy. This, in turn, yields very robust outlooks for Chinese energy demand, and more specifically, natural gas demand. Given the impact that such strong growth has on global natural gas flows in the Reference Case, we examine a scenario in which demand growth in China is much less robust. We affect this change by assuming much slower economic growth. In the Reference Case, the average annual growth rate in GDP from 2010 through 2030 is 5.6 percent, but in the Low China Demand Case the average annual growth rate in GDP is 2.9 percent.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 14. China Natural Gas Balance, 2010-2040 (Low China Demand Case)

Figure 14 indicates demand and the manner in which demand is met in the Low China Demand Case. As above, sinks (demand and exports) are represented as negative values and sources of supply are represented as positive values. Of note is the fact that the reduction in demand (see Figure 15) results in lower import dependence, where the majority of the reduction occurs as a result of lower LNG imports. The overall impact of lower import dependence and exports to South Korea substantially reduces demand for LNG imports in China (see Figure 15). Lower LNG demand in China, as in the analysis above, leads to higher LNG imports in the United States and Europe (see Figure 18). As in the High China Shale Case, China exports natural gas to South Korea in this case as well, which reduces Korean demand for LNG in addition to the reduction in China (see Figure 18). However, the source of supply for exports from China is different. In particular, Russian natural gas is imported via pipeline and re-exported, meaning China is more likely to be a transit country when demand growth is lower.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 15. Changes in Supply Sources and Disposition Relative to Reference Case Sources of Supply

Demand

Lower demand also results in lower prices in Asia as well as in Europe and the United States. This result owes itself to the reduction in competition for LNG from Asia, which allows supplies to be redistributed at lower cost to other regions.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 16. Changes in Selected Prices Relative to Reference Case

Lower demand for LNG from China, and Asia more generally, results in lower global LNG exports. From Figure 17, we see that the majority of the reduction in exports by 2040 falls to Qatar, Iran, Russia, and Venezuela. In fact, about 85 percent of the reduction in LNG exports falls to these four countries collectively. Figure 17. Changes in LNG Exports by Country Relative to Reference Case

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Figure 18. Changes in LNG Imports by Country Relative to Reference Case

VII. Conclusion This Baker Institute study on the role of China in the future of global gas markets has examined some of the consequences of rising supplies of natural gas from shale in China and lower than expected demand for natural gas in China. The study finds that development of shale gas resources in China will have multiple beneficial effects for energy security in China, and in Asia more generally. In addition, a reduction in import dependence in China has a ripple effect that results in lower prices in Europe and the United States as well as in Asia. Natural gas stands to play a positive role in the global energy mix, making it easier to shift away from more polluting, higher carbon intensity fuels and increasing the near term options to improve energy security and handle the challenge of climate change. Greater shale gas production will lower the cost of improving local air quality in China by encouraging a switch to natural gas in place of coal. In fact, the increase in demand that results in the High China Shale Case is indicative of this occurring when the relative abundance of natural gas is greater. The ample geologic endowment of shale gas in North America and around the globe means that natural gas prices will likely remain affordable even in the face of rising oil prices, and that the high level of supply insecurity currently facing world oil supplies could be eased by a shift to

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources greater use of natural gas without fear of increasing the power of large natural gas resource holders such as Russia, Iran, and Venezuela. To tap this benefit, initiatives such as the U.S.-China Shale Gas Resource Initiative could serve to ensure that Chinese development of its resources is done in a responsible and commercial manner.20 But shale gas development, for reasons highlighted herein, are not certain. So it is imperative that impediments to development be addressed in a timely manner in order for Chinese shale gas production to grow in a robust manner.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources Notes 1. We would like to thank Energy Forum research associate Keily Miller for her invaluable help gathering information on water resources in China. 2. National Petroleum Council, Balancing Natural Gas Policy: Fueling the Demands of a Growing Economy, September 2003. 3. Navigant Consulting, North American Natural Gas Supply Assessment, July 4, 2008. 4. The Potential Gas Committee, Potential Gas Committee Biennial Assessment, June 18, 2009. 5. World Shale Gas Resources: An Initial Assessment of 14 Regions outside the United States (report prepared by Advanced Resources International for the Energy Information Administration, April 2011). 6. Kenneth B. Medlock III and Amy Myers Jaffe, Shale Gas and U.S. National Security (working paper, James A Baker III Institute for Public Policy, Rice University, May 2011). 7. See Time Magazine cover story, The Gas Dilemma, April 11, 2011. 8. See China and Water in Gleick, Cooley and Morikawa, The Worlds Water 2008:2009: The Biennial Report on Freshwater Resources, Island Press, 2008. Available at http://www.worldwater.org/data20082009/ch05.pdf. 9. Map replicated from Natural Gas Weekly Kaliedoscope, Barclays Capital Commodities Research, November 16, 2010. 10. The RWGTM has been developed by Kenneth B. Medlock III and Peter Hartley at Rice University using the Marketbuilder software provided through a research license with Deloitte Marketpoint, Inc. More details regarding the model is available upon request. 11. Note, the debt-equity ratio is allowed to differ across different categories of investment (proving resources, developing wellhead delivery capability, constructing pipelines, and developing LNG infrastructure). 12. We do not address these issues at length in this paper. Rather, we simply assume a lower growth rate to provide an outcome that yields substantially lower Chinese demand for natural gas. Note that we could also assume China, for a policy reason, chooses not to aggressively pursue natural gas. In either case, the result is lower demand.

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Scenarios for Chinese Domestic Unconventional Natural Gas Resources 13. H-H. Rogner, An Assessment of World Hydrocarbon Resources, Annual Review of Energy and the Environment 22 (1997): 217-62. 14. Ultimately, LNG imports rise as declines in conventional resources continue and domestic production growth begins to taper. More information on the model is available upon request. 15. Note that North America includes Mexico. 16. Political and Economic Influences on the Future World Market for Natural Gas, in Natural Gas and Geopolitics: 1970-2040, ed. D. Victor, A. Jaffe, and M. Hayes, Cambridge University Press (2006). 17. Dagobert L. Brito and Peter R. Hartley, Expectations and the Evolving World Gas Market, Energy Journal 28, no. 1 (2007). 18. This will also happen in a liberalized market where trading of capacity rights is allowed, insomuch as the arbitrage allows price signals to clearly transmit. This promotes entry and, to the extent that hubs develop, financial liquidity. Once that occurs, the means to use capital markets to underwrite physical transactions increases and liquidity grows, thus making it difficult to price discriminate. 19. Note the prices depicted in Figure 7 are spot prices, and do not reflect volumes sold on a contractual basis at an oil-indexed premium. 20. Statement on U.S.-China Shale Gas Resource Initiative, The White House Office of the Press Secretary, November 17, 2009, http://www.uspolicy.be/headline/statement-us-chinashale-gas-resource-initiative.

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