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Legal risks for foreign investors in China shale opening

The government is keen to lure foreign investors into the country’s unconventional gas sector. Hopeful developers must be clear about the rules, write Fung Lin Leung, senior associate, and Ben Smith, foreign legal consultant, Norton Rose Fulbright Hong Kong

China has lots of shale gas and its government is keen to see foreign investors help produce it. But before it can repeat some of the success of North America’s unconventional sector, China has much to address, including the regulatory regime for foreign participation, subsidies, access to pipelines, and water usage and protection.

There’s no doubting the government’s enthusiasm. China has carried out two tendering rounds for shale gas exploration rights since 2011 and a third round expected this year. New policies have been introduced since 2011 to spur investment in shale gas, including a number of significant moves, such as the Ministry of Land and Resources’s (Molar) reclassification of the resource as a new type of mineral independent of conventional hydrocarbons. This was important, because until 2011, shale gas was treated simply as natural gas, and state-owned companies controlled all natural gas exploration. The change in definition allowed for the granting of shale gas exploration rights to privately owned companies.

Encouragement

Shale gas exploration was also added to the “encouraged” category in China’s Foreign Investment Industry Guidance Catalogue in 2011. Encouraged categories are generally subject to less strict administrative requirements and are eligible for certain tax and other benefits, all of which should act as a spur to encourage foreign investment. However, the catalogue also specifies that foreign investment in shale gas exploration and production has to be in the form of a Sino-foreign joint venture (JV).

Following the re-classification, there were several policy updates, as well as a five-year plan (2011-15) drafted specifically for shale gas. These will see Molar grant shale gas exploration rights through competitive bidding -- open to both state-owned and private firms. Foreign companies with shale gas technology are being encouraged to join Sino-foreign ventures or other forms of cooperation with Chinese companies. Royalty reductions and even exemptions are also available to explorers. Finally, shale gas producers may apply for a production subsidy -- 0.40 yuan ($0.064) per cubic metre (cm) of shale gas produced -- if a number of requirements are met.  The subsidy will expire in 2015 and is being reviewed.

Another boost came last February, when the government issued new rules forcing pipeline operators to give non-discriminatory pipeline access to other companies. PetroChina, the major pipeline operator, afterwards approved its plan, “Implementation Measures on Opening Up Oil and Gas Pipeline Facilities in a Fair Manner (Trial)”, without giving further details. It is still unclear how the non-discriminatory access will be implemented. 

Meanwhile, Molar has held two tendering rounds for granting shale gas exploration rights. The first saw just six companies invited to bid. The second was a public tender, butonly two Sino-foreign JV companies participated. 

In the second tendering round, both state-owned and private Chinese companies, including Sino-foreign JVs (with Chinese firms typically holding 51% of the venture), were qualified to bid. The key qualification criteria were that the bidder had an independent Chinese legal identity; had registered capital of at least 300 million yuan (about $49m); and possessed oil and gas exploration qualifications or partnered with an entity with did. Consortia were barred from the tender. Molar has not said whether the same criteria will apply to future rounds.

Molar held those rounds. But there are discussions about allow provincial authorities to conduct their own tenders – another effort to speed shale gas development. It might help, but the political sensitivity around environmental issues, planning of infrastructure and ensuring the process is properly and fairly implemented will mean that this issue is approached with caution. As a result, the third tendering round has seen some delays. 

Despite the government’s efforts to lure international developers, it hasn’t published rules on foreign investment in shale gas. So until specific regulations are issued, the general foreign investment law and mineral resources law will apply to shale gas.

Sino-foreign JVs could participate in future tendering rounds for shale gas blocks under China’s general foreign investment regulations. But if the qualification criteria are the same as those that applied in the second round, any foreign firm would need to use a Sino-foreign joint-venture company as the bid vehicle.  

Footstep into China

Establishing a Sino-foreign joint-venture company typically takes six to 12 months to complete.  However, the lead time between the announcement of the tendering round and the deadline for bid submissions will normally be shorter than six months. The second tendering round, for example, was announced in September 2012 and the deadline for bid submission was just a month later. So foreign investors will need to have their Sino-foreign JV companies established in China to be ready to participate in future tendering rounds.   

China’s general mineral resources law allows the transfer of exploration rights from the rights holder to a third party with the approval of the granting authority. Sino-foreign joint-venture companies can accept the transfer of such rights. It is also possible for foreign investors to acquire equity interests in Chinese domestic companies that hold shale gas exploration rights and convert the acquired rights holder into a Sino-foreign joint-venture company. In the absence of specific approval requirements, the general restrictions and approvals for foreign investments and transfers of mining rights will apply.   

When shale gas was previously classified as natural gas, foreign contractors could participate in shale gas projects by entering into production sharing contracts (PSCs) with the national oil companies that had been granted exploration rights. That method was based on the regulations for foreign participation in natural gas exploration (although the rules do not specifically cover shale gas).  According to Molar, only Shell and PetroChina have a valid shale gas PSC, which was approved by the Chinese government in March 2013.

Shale gas no longer falls within the scope of those regulations. There has been no indication from the Chinese government that similar regulations will be promulgated for shale gas projects in order to provide the legal basis for PSCs.

Foreign companies intending to secure market entry may also explore the feasibility of other forms of co-operation. For example, conducting joint study/evaluation with a rights holder, licensing technology to a rights holder, and providing consultancy or technical services to a rights holder.

There are a number of other specific legal issues foreign investors should keep in mind. First, exploration and production rights tend to be granted for shorter terms than is typically found in other countries. This leaves rights holders negotiating extensions once investments have been made, or opting not to make investments because the horizon in which to take a return on investment is too short. 

Investors should also consider pipeline access. Most of the country’s shale-gas reserves are remote. Shale gas producers will have to build pipelines or feed their gas into cross-province pipelines or develop small-scale liquefied natural gas facilities to move the gas to market in road tankers. Pipeline access must be resolved early to ensure that a planned project has an economically viable route to market. Despite the new third-part-access rules for pipelines, the effect of the measures is yet to be seen.

On top of this, companies involved in PSCs trying to sell gas in China’s domestic market have encountered legal issues. Foreign companies intending to sell shale gas directly into China’s domestic market must first obtain a Chinese business licence with a business scope that allows it to do so. The feasibility of obtaining such Chinese business licence must be considered early in the process.

Figure 1 - China's shale oil and gas
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