You are on page 1of 34

V.

INDUSTRY SECTOR REPORTS Chapter 3

Upstream Oil and Gas in China


David Blumental, Tju Liang Chua and Ashleigh Au
____________
SYNOPSIS 3.01 Introduction [1] Growth in Energy Consumption and Production [2] Securing Energy Supply [a] Coal [b] Oil [c] Natural Gas & Liquefied Natural Gas [d] Coal-Bed Methane [3] Demand-Side Reduction [4] Environmental Situation [5] The Chinese Energy Industry

David Blumental is the Chief Representative and Managing Partner of the Vinson & Elkins Shanghai office. His principal areas of practice are business law, international business transactions, cross-border mergers, acquisitions and divestitures as well as corporate and project finance and oil and gas. He is a member of the firms Energy Transactions & Projects Practice Group, Project Finance and Development Group and the China Practice Group. Tju Liang Chua is an Associate at the Vinson & Elkins Shanghai office and a member of the firms Energy Transactions & Projects Practice Group, and China Practice Group. His principal areas of practice are international business transactions and cross-border mergers and acquisitions with a particular focus on the energy sector. Prior to joining Vinson & Elkins in 2006, Tju Liang had been based in London, Jakarta, and Singapore. Ashleigh Au is a paralegal at the Vinson & Elkins, LLP Shanghai office.
(Rel. 172009)

Reprinted from Doing Business in China, pgs. V-3.1 V-3.33, copyright 2009 Juris Publishing, Inc., www.jurispub.com

DOING BUSINESS IN CHINA


[a]

V-3.2

3.02

3.03

China National Petroleum Company (CNPC) & PetroChina [b] Sinopec [c] China National Offshore Oil Corporation (CNOOC) [d] Sinochem [e] Other players [6] Foreign participation in China's energy industry [a] Early 1980s [b] 1990s to Present [c] Recent trends Regulation of the Upstream Oil & Gas Industry [1] Regulatory Authorities [a] National Energy Administration (NEA) [b] Ministry of Land and Natural Resources [c] Ministry of Commerce (MOFCOM) [d] Ministry of Environmental Protection [e] State Maritime Administration [f] China Offshore Oil Operation Safety Office [g] State Administration of Work Safety [h] State Energy Committee [2] Laws & Regulations [a] Onshore Regulations [b] Offshore Regulations [c] Royalties [3] Taxes [a] Windfall Tax [b] Crude Oil Export Tax Oil & Gas Contracts [1] Overview [2] Crude Oil Production Sharing Contracts [a] Contract Term [b] Operator [c] JMC [d] Exploration [e] Minimum Work/Expenditure Commitments [f] Discovery; Determination of Commerciality

(Rel. 172009)

V-3.3

UPSTREAM OIL AND GAS IN CHINA

3.01[1]

3.04

[g] Natural Gas Discoveries [h] Relinquishment [i] Development: ODP and Work Programs [j] Payments, Financing and Cost Recovery [k] Taxes [l] Quality, Quantity and Price of Crude Oil [m] Ownership of Assets and Data [n] Marketing [o] Local Content Requirements [p] Governing Law and Language [q] Consultation and Arbitration [3] Coal-Bed Methane Production Sharing Contracts [a] Contract Term [b] Operator [c] Minimum Work/Expenditure Commitments [d] Relinquishment [e] Price of CBM [f] Local Employment [g] Destination of CBM and Marketing [4] Joint Study Agreements and Geophysical Survey Agreements Conclusion

3.01

Introduction

With the recent drastic changes in global crude oil prices first rising to record levels of around US$147 a barrel in July 2008, and then crashing to around US$35.98 (US$35) a barrel in December 2008, the energy industry, media, governments, international agencies, and even consumers are paying special attention to Chinas impact on demand in the worlds energy markets. [1] Growth in Energy Consumption and Production

During the Mao era and its immediate aftermath (from 1949 until the late 1970s), China had always been a net exporter of oil. The Daqing oil fields in Heilongjiang province, discovered in 1959, are Chinas

(Rel. 172009)

3.01[2]

DOING BUSINESS IN CHINA

V-3.4

largest oil fields and the fourth largest producing oil fields in the world. Sales of Daqing crude oil to Japan and other countries provided significant contributions of valuable foreign exchange to China. However, after the government-led liberalization of the economy in 1978, Chinas demand for energy surged. To meet this rising demand, China began to consume a considerably greater amount of domestically produced oil. In 1993, China became a net importer of crude oil and since then, China has been responsible for approximately 40 percent of the growth of the worlds oil demand. Since 2000, Chinas energy demand has rapidly increased as the economy has grown between nine and ten percent each year. In late 2003, China surpassed Japan to become the worlds second largest consumer of petroleum after the United States. The following year, China ceased all oil exports to Japan. By the end of 2007, China imported nearly half of its crude demand, and had to cut crude exports by nearly 40 percent. Although demand has risen steadily in recent years, the growth of Chinese domestic crude oil production has not kept up to pace with its energy needs. Total imports of crude oil have increased nearly 140 percent from 1.38 million barrels per day in 2002 to roughly 3.8 million barrels per day in 2008. The International Energy Agency (IEA) predicted in 2007 that by 2012 Chinese demand would grow to 9.96 million barrels per day. However, since the 2008 economic crisis, IEA forecasts have been repeatedly revised in response to the precarious state of world markets as Chinas demand has been subject to speculation. Nonetheless, as the future of Chinas economic development and stability relies on energy supply, the issue of satisfying energy demand remains at the forefront. [2] Securing Energy Supply

The rapid increase in domestic energy demand means that securing stable sources of energy for the near-, medium- and long-term has been the most challenging issue facing Chinas leadership and industry players. The Chinese government has approached this issue with a multi-pronged plan: demand-side reductions through conservation and

(Rel. 172009)

V-3.5

UPSTREAM OIL AND GAS IN CHINA

3.01[2]

efficiency improvements, as well as an expanded focus on renewable energy and overseas oil and gas acquisitions. [a] Coal Coal is Chinas main source of energy, accounting for nearly 70 percent of domestic energy supply, and China possesses the worlds largest coal reserves. However, Chinas coal mining industry is hampered by weak organization and supervision, poor safety procedures (mine explosions and collapses are frequent occurrences), and significant bottlenecks in the transportation of coal from mining regions to large end-users in coastal areas. The environmental cost of inefficient coal mining combined with the combustion of coal and fuel oil has proven significantChina is the worlds largest producer of carbon dioxide emissions and often suffers from severe air and water pollution. Furthermore, Chinas energy consumption is noticeably less efficient than that of the U.S., Japan, and other industrialized countries. In other words, China consumes more energy to produce the same economic value. [b] Oil Chinese policymakers and state-owned oil companies have embarked on a multi-pronged approach to improve oil security by purchasing equity oil stakes abroad, diversifying suppliers, enacting new policies to lower demand, investing in energy substitutes, building strategic oil reserves, and maximizing domestic production. Accordingly, Chinas emerging oil companies are being recognized as significant players in international exploration and production (E&P), oilfield services, and liquefied natural gas (LNG) projects worldwide. In pursuit of this multi-pronged strategy, China has endorsed overseas equity investment and entered a range of contracts from the most basic to the most complex with various foreign nations. Importing up to 45 percent of its energy needs, Chinas interests lie in supply diversification. As such, Chinese oil companies have actively pursued projects in the Middle East and Africa, as well as in North and South America in more recent years. China has also joined many Western nations in establishing strategic petroleum reserves to provide a buffer against disruptions in the supply of imported crude oil. China desires to maximize domestic production,

(Rel. 172009)

3.01[2]

DOING BUSINESS IN CHINA

V-3.6

and in the past decade has gone to extensive and expensive lengths to do so: building several trans-national pipelines, including the 4000 km West-East pipeline at a cost of more than US$24 billion, and engaging in exploration in remote areas such as Xinjiang. Recent government measures to optimize domestic production include proposals to toughen block exploration and production licensing and raise the minimum investment and exploration obligations of national oil companies. [c] Natural Gas & Liquefied Natural Gas Natural gas has not been a major fuel resource in Chinas past. Several significant hurdles exist for the development of the natural gas market within China: (a) First, natural gas is expensive compared to coal if environmental costs are not included. (b) Second, China is not believed to be endowed with abundant and cheap gas reserves, and known supplies are often located far from the main centers of demand. Recent estimates of Chinas proven domestic natural gas reserves ranged from 1.51 to 2.35 trillion cubic meters. (c) Third, China lacks a well-developed legal and regulatory framework to encourage investment in the gas sector. China does, however, govern such matters as pricing and long-term take or pay contracts. (d) Fourth, there is a lack of knowledge over how to best develop natural gas technology and markets. (e) Finally, Chinas gas supply infrastructure is fragmented and would require substantial investment to finance its expansion. The weakest link in Chinas natural gas chain is the perception that high costs result in a weak demand for gas. While the government is beginning to address this issue, without a stronger market pull for gas, the entire natural gas chain remains weak, irrespective of efforts to develop the market by administrative direction. Notwithstanding the challenges, Chinas government has been pushing for natural gas to take on a larger role in Chinas present and future. As a part of the 2005 11th Five-Year Plan to curb pollution, the

(Rel. 172009)

V-3.7

UPSTREAM OIL AND GAS IN CHINA

3.01[2]

government set a target of making natural gas 5.3 percent of domestic energy consumption by 2010. This marks a consumption increase from the 2.8 percent consumed in 2005, but falls somewhat lower than the 8 percent the government has targeted since 1999. In order to meet these targets, various state-owned oil companies have begun work on many natural gas projects designed to increase the supply of natural gas in China. In recent years, China has made efforts to improve the interconnectivity of its natural gas pipelines. As a result, the distribution network in Sichuan province, where a significant amount of gas reserves lie, has become Chinas most advanced natural gas distribution network. Additionally, the West-East natural gas pipeline that stretches from Xinjiang to Shanghai began operations in January 2005. Currently, the West-East pipeline operates under capacity due to lack of gas. Chinas first liquefied natural gas (LNG) import terminal, with a capacity of 3.3 million metric tons per year, began operations in Guangdong province in May 2006. A second LNG import terminal in Fujian province, with a capacity of 2.41 million metric tonnes per year, received its first shipment in April 2008, well ahead of the 2009 target date for opening production. Many more projects are in the planning and construction stages including a long-term agreement with Shell that will import LNG from Qatar, a China National Petroleum Corporation (CNPC) LNG terminal in Dalian, a Sinopec terminal in Qingdao, and seven more terminals by China National Offshore Oil Corporation (CNOOC) alone. These projects aim to provide the 200bcm of natural gas estimated to be in demand by 2020. [d] Coal-Bed Methane In recent years, China has expanded its domestic energy sources to include coal-bed methane (CBM). Previously, CBM was viewed exclusively as a problem, with the presence of methane in Chinas coal mines causing frequent mine explosions and collapses. The expansion of CBM extraction has dual benefits: improving the safety of coal extraction work, and supplying a cleaner, additional source of fuel to meet energy demands. It is estimated that China has over 37 trillion cubic meters of reserves. China United CoalBed Methane (CUCBM), a joint venture between PetroChina and China National Coal Group, was founded in

(Rel. 172009)

3.01[3]

DOING BUSINESS IN CHINA

V-3.8

1996 to develop CBM with foreign companies and enhance exploration activities. The discovery of 75.4 billion cubic meters of CBM reserves in the Qingshui basin in Shanxi province led to the CUCBMs first commercial CBM project, Shanxi Panhe, which did not produce commercial gas. By 2006, about 1,000 CBM test and pilot wells were completed within more than 30 basins by domestic and foreign companies, none of which led to commercial production. Chinas CBM has remained a largely under-exploited resource. Only 700 million cubic meters of CBM have been produced to date falling short of the 2005 central government energy plan (the 11th Five-Year Plan) target to extract ten billion cubic meters of CBM per year by 2010. Lagging development, however, has paved the way for the reshaping of Chinas regulatory structure and the encouraging foreign investment in the industry. As a result, the State Council took away CUCBMs monopoly on forging alliances with foreign investors in 2007 and in April 2009, the State-Owned Assets Supervision and Administration Commission announced the division of CUCBMs assets between PetroChina and the China National Coal Group. The separation of this joint venture, which was perceived to be unsuccessful, signals Chinas desire to accelerate development and meet the 11th Five-Year Plan production targets. Plans to develop the commercialization of CBM include the construction of ten CBM pipelines, with the first one due for completion by the end of 2009. [3] Demand-Side Reduction

In an effort to reduce the countrys reliance on coal reserves, China is seeking demand-side reductions through more efficient energy production and consumption while actively seeking out energy producing substitutes. The central governments energy plan, the 11th Five-Year Plan promulgated in 2005, calls for accelerated development of oil and natural gas, aggressive development of electricity, and a push to greatly develop renewable energy sources. The Chinese government has made it a national priority to develop diversified, clean, and more efficient energy sources, including oil and natural gas, clean coal technology and, to a growing extent, renewable energy sources such as wind, geothermal and solar power.

(Rel. 172009)

V-3.9

UPSTREAM OIL AND GAS IN CHINA

3.01[5]

[4]

Environmental Situation

Though government measures have encouraged a shift away from energy-intensive industries such as steel manufacturing, the real demands of economic growth often translate into efficiency taking precedence over conservation. However, while measures implemented to increase energy efficiency and reduce energy demand offer some mitigating effect, the problem of long-term energy supply remains unresolved. Notwithstanding recent reports by the China State Statistics Bureau showing an annual 15 percent increase in total energy production, demand for energy continues to rise on the back of rapid economic growth and the countrys potential energy shortage is becoming increasingly acute. [5] The Chinese Energy Industry

The modern Chinese petroleum industry was created in large part in 1998 when the Chinese government mandated the restructuring of state-owned assets to establish CNPC in the north of the country and China Petrochemical Corporation (Sinopec) in the south. Prior to restructuring, CNPC had been engaged in upstream exploration and production throughout China since 1988 when it replaced the Ministry of Petroleum Industry. Sinopec was engaged in mid/downstream refining and distribution. A third firm, CNOOC, presided over most offshore oil and gas production and has managed to retain its pre-1998 control since restructuring. All three of the Chinese majors have restructured and conducted relatively successful international IPOs. [a] China National Petroleum Company (CNPC) & PetroChina Created from the former Ministry of Petroleum, China National Petroleum Corporation (CNPC) is the largest of the state-owned oil companies. In early 2000, CNPC invested most of its high quality assets into its subsidiary PetroChina Company Limited. PetroChina made an IPO of a minority interest on the New York and Hong Kong stock exchanges in April 2000, with its market capitalization rising over US$3 billion. British Petroleum was the largest purchaser, subscribing for 20 percent of the shares offered. Warren Buffet was another major investor. The IPO, which was originally intended to raise US$7 billion, was scaled back due to labor and human rights groups who objected to CNPCs

(Rel. 172009)

3.01[5]

DOING BUSINESS IN CHINA

V-3.10

involvement in a controversial development project in Sudan. Nonetheless, CNPC investment in Sudan yielded record highs of crude output exceeding 11 million tonnes in 2008. CNPC has also expanded into overseas oil and gas exploration in Iraq where the company aims to increase oil and gas production by 5% annually and reach a capacity of 25,000 barrels per day within six years. Since listing, PetroChina has enjoyed consistent growth, and has solidified its position among the worlds most important companies. In 2008, the Financial Times released its twelfth Global 500 list, which measures the worlds most important companies based on evaluation incorporating stock market listing and market perception. With a market value of US$424 billion, CNPC ranked second on the list between ExxonMobil and General Electric. PetroChinas subsidiaries include Jinzhou Petrochemical Co. Ltd., Liaohe Jinma Oilfield Co. Ltd., and Jinlin Chemical Industry Co. Ltd. [b] Sinopec Sinopec is the second largest of the Chinese state-owned oil companies. In October 2000, Sinopecs IPO in Hong Kong and New York raised approximately US$3.5 billion from the offering and sale of a 15% minority stake. Approximately US$2 billion of the offering was purchased by ExxonMobil, BP, and Shell. However, Sinopecs offering was also scaled back due to weakness in the international equity markets. ExxonMobil, BP and Shell have all since sold off the shares they acquired during Sinopecs IPO. In November 2007, Sinopec issued shares on the Shanghai stock exchange. As a result, Sinopecs market share tripled. While PetroChina enjoys the larger market share, Sinopec has often been the highest earning company in China. It was the only company to earn more than one trillion yuan in 2006. In the 2008 Global 500, released by the Financial Times, Sinopec ranked as the 37th most important company in the world. Sinopecs subsidiaries include Shanghai Petrochemical Co. Ltd., Fujian Petrochemical Co. Ltd., and 17 smaller subsidiaries.

(Rel. 172009)

V-3.11

UPSTREAM OIL AND GAS IN CHINA

3.01[5]

[c]

China National Offshore Oil Corporation (CNOOC)

CNOOC was established in 1982 for the purpose of administering offshore petroleum operations with foreign entities. Today CNOOC maintains exclusive rights to offshore petroleum exploration and production, although in 2002 it spun off oilfield services to China Oilfield Service, Ltd. (COSL). While the spin-off is now listed on the Hong Kong stock exchange, the Chinese government maintains majority control of COSL. Since listing, CNOOC has been a leader in overseas M&A. In 2005 CNOOC attempted to acquire the American Union Oil Company of California. The attempt set off a political storm in the United States amid concerns of a Chinese company gaining control over American energy. This failed attempt aside, CNOOC has fared well in M&A and remains the domestic leader in LNG. [d] Sinochem Sinochem is Chinas petroleum and petrochemical trading company. While trading has traditionally been their main function, they have expanded greatly this decade. In 2002, Sinochem established Sinochem Petroleum Exploration and Production Company, Ltd. to engage in overseas E&P acquisitions. By 2006, they had become fully engaged in a wide range of up-, mid-, and downstream sectors. [e] Other players Shaanxi Yanchang Petroleum Group Company is a state-owned company formed in 2005 through the merger of 21 private exploration and development companies and three refineries. Shaanxi Yanchang is Chinas fourth-largest oil company. China United Coal Bed Methane Company (CUCBM) is a stateowned company formed in 1996 to facilitate the development of coalbed methane projects. From 2001 through 2007, government regulations granted CUCBM the exclusive right to cooperate with foreign partners in the development of coal-bed methane projects. This privilege, however, was expanded to other companies with state council approval in 2007. China Zhenhua Oil, a wholly owned subsidiary of North China Industrial Group (NORINCO), was formed in 2004. Zhenhuas

(Rel. 172009)

3.01[6]

DOING BUSINESS IN CHINA

V-3.12

expansion into overseas investment has led to projects in Kazakhstan, Iraq and Pakistan. Recent developments include the signing of a share purchase agreement in Kazakhstan making Zhenhua the controlling shareholder of the K&B Oilfield with 75% interest. In 2008 Zhenhua also signed a Production Sharing Contract with a CNPC affiliate in the Ahdeb Oil Field in Iraq. The company has also revealed plans to invest over US$30 million drilling in Basca and Bahawapul, Pakistan. In December 2004, private oil companies formed an association under Gongshanglian, the China Chamber of Commerce for the Petroleum Industry (CCCPI), which at that time had about 140 member companies. In June 2006, under CCCPIs coordination, Chinas largest private firms unified to form the Great United Petroleum Holding Co., Ltd. (GUPC). At its establishment, the conglomerate announced its possession of capital at about RMB5 billion (US$603.9 million). GUPC hopes to give private firms a platform from which to compete with large state-owned oil companies in order to develop operations in China and acquire upstream assets overseas. To date, they have yet to achieve much success. [6] [a] Foreign Participation in Chinas Energy Industry Early 1980s

The 1980s marked the beginning of the reformation era for the oil and gas industry. Prior to this time, activity was very limited and legal framework presented a blank slate. Spurred by the need for foreign capital, technology, and know-how, China took the first step in Sinoforeign cooperative exploration by signing five bilateral petroleum contracts in 1979. The bidding procedures for Sino-foreign cooperative exploration followed shortly. In 1982 and 1983, the PRC promulgated very early regulations that would lay the framework for todays oil and gas industry. These laws provided for the most basic production sharing contracts in the form of petroleum contracts. These investment risk contracts were designed to both attract foreign investment and benefit China through provisions that mandated the transfer of technology and industry acumen. In the late 1980s, gradual price reform took place with the development of the market. Chinas twotiered plan to incorporate both a planned economy and a market economy signaled a milestone for foreign investment in the PRC.

(Rel. 172009)

V-3.13

UPSTREAM OIL AND GAS IN CHINA

3.01[6]

[b]

1990s to Present

In the 1990s China took continued interest in foreign investment. As more companies became interested in China, production sharing contracts gradually became more sophisticated. With the opening of the midstream, foreign enterprises showed only limited interest in this sector. Domestic companies continued to carry out most midstream operations. In 2002, government regulations encouraged the construction and operation of oil (gas) pipelines by foreign enterprises. Initially few investors were eager to take advantage of the opportunity. To date, foreign firms are involved in pipelines and pipeline construction, but they have generally been run by Chinese companies. GE Oil & Gas will be providing eight centrifugal compressors for the Sichuan-Shanghai pipeline, while Sinopec will have oversight. The West-East pipeline was originally supposed to be a joint venture between a subsidiary of Sinopec and three foreign companies, but PetroChina terminated the arrangement two years after operations began. Domestic companies continue to dominate many other aspects of midstream operation. In 2006, in order to comply with its WTO (World Trade Organization) commitments, China opened the wholesale market to foreign competition and in 2007, 25 foreign private companies were granted the right to store and sell crude and processed oil in China. However, strict technical requirements provide great barriers to entering the market. As a result, most wholesale and retail operations are wholly or mostly run by Sinopec or CNPC. [c] Recent Trends Since China joined the World Trade Organization In December 2001, newly promulgated amendments to the principal regulations governing foreign participation in onshore and offshore upstream petroleum projects have brought regulations in line with Chinas WTO commitments. One of the most significant steps towards WTO accession was the revision of the Regulation of the Peoples Republic of China on SinoForeign Cooperation of both Continental and Offshore Petroleum Resources 2003. These revisions expanded opportunities for foreign companies in China, yet entering China for exploration still required a partnership with a Chinese SOE. These regulations were amended

(Rel. 172009)

3.02[1]

DOING BUSINESS IN CHINA

V-3.14

again in 2007, but with few changes. In general, as expressed by the Secretariat of the WTO, recently there have been no major changes in policies concerning Chinas energy sector, which continues to be characterized by a high level of state ownership, regulation and limited competition. While this outlook seems generally true with regards to downstream activities, China has indicated great interest in foreign cooperation in production and exploration. China began a strategic oil reserve system in 2004 in order to provide increased energy security to accommodate growing demand. The 11th Five-Year Energy Plan also outlines aims to increase oil reserves. In addition, investments in risk exploration, development and production of petroleum and natural gas, as well as investments relating to new technologies for petroleum exploration and development are listed as encouraged industries in the 2007 Catalogue of Foreign Investment Industries ( (2007 Catalogue). The 2007 Catalogue sets out detailed lists of industries and specific activities according to whether foreign investment is encouraged, restricted, or prohibited. It should be noted that the 2007 Catalogue expressly requires that foreign investment in such petroleum activities be pursued in cooperation with Chinese partners. 3.02 [1] Regulation of the Upstream Oil & Gas Industry Regulatory Authorities

One of the biggest problems faced by the Chinese government in formulating and implementing a national energy policy and administering the countrys energy industry has been the lack of a single regulatory body with sufficient authority to carry out regulatory functions. Since 1993, when the Ministry of Energy ( ) was dismantled, regulatory oversight has been fragmented among different regulatory bodies. Authority has shifted with each subsequent restructuring of the government. In 1998, China carried out an aggressive bureaucratic restructuring plan that slashed the number of ministries from 40 to 29. As part of this plan, the regulation of the petroleum industry was transferred away

(Rel. 172009)

V-3.15

UPSTREAM OIL AND GAS IN CHINA

3.02[1]

from CNPC, Sinopec, and the disbanded Ministry of Geology and Mineral Resources (), and passed on to the Administration of the Petroleum and Chemical Industry under the State Economic and Trade Commission. With the elimination of the State Economic and Trade Commission ( ) in 2003, most of the functions of its Administration of Petroleum and Chemical Industry were usurped by the National Development and Reform Commissions Energy Bureau (). In an effort to manage the problem of fragmented authority over the energy industry, the NEA (National Energy Administration) ( ) was established in 2008 to facilitate communication between practitioners and government bodies. The broad mandate of the NEA includes the drafting of energy strategies, proposing reform advice and implementing the management of energy sectors. However, its power and autonomy have been met with scepticism as authority continues to lie with the NDRC, more senior leadership, and Chinese industry leaders. Consequently, although the formation of the NEA may have temporarily stifled proposals for a single energy ministry, the realization of such an entity will depend on the performance of the NEA in coming years. The authorities that currently have oversight over the upstream oil and gas industry in China include the following: [a] National Energy Administration (NEA) The NEA is responsible for the assignment and approval of blocks, the examination and approval of Overall Development Programs, the management and approval of budgets, and the management appointments for the three Chinese majors. [b] Ministry of Land and Natural Resources The Ministry of Land and Natural Resources plays a role in the examination and approval of blocks open to foreign investment. [c] Ministry of Commerce (MOFCOM) MOFCOM is responsible for the review and approval of all contracts for foreign investment.

(Rel. 172009)

3.02[2]

DOING BUSINESS IN CHINA

V-3.16

[d]

Ministry of Environmental Protection

The Ministry of Environmental Protections role is to prevent and control environmental pollution, and to protect the environment and public health. [e] State Maritime Administration This body ensures compliance with maritime safety and also regulates pollution control. [f] [g] China Offshore Oil Operation Safety Office State Administration of Work Safety COOSO was formed under CNOOC to regulate safety. The State Administration of Work Safety is in charge of overall supervision and regulation of work safety. [h] State Energy Committee The State Energy Committee ( ) is the highest deliberating and coordinating organ. It is responsible for formulating state energy development strategies, and deliberating energy security and key problems arising out of the energy development. [2] Laws & Regulations

Chinas legal framework for the oil and gas industry does not provide an overarching Petroleum Law governing exploration, development, production and sales. There is also a question of the role of private companies in upstream E&P, though private companies are already active in downstream trading and sales. Foreign investment in E&P is governed by two sets of State Council regulations, one for offshore activities, first promulgated in 1982; the other governing onshore activities, first promulgated in 1993. Both were amended and reissued in 2001. However, major Chinese players have reportedly been urging Chinas National Peoples Congress to consider adopting more legislation to govern this industry. A draft of Chinas first Energy Law was been released in 2007 to solicit public opinion but has not yet been approved by the central government.

(Rel. 172009)

V-3.17

UPSTREAM OIL AND GAS IN CHINA

3.02[3]

[a]

Onshore Regulations

All petroleum resources within the Peoples Republic of China are property of the state. Foreign enterprises seeking to invest in onshore exploration and development in the PRC must, by law, partner with one of the state-owned Chinese Majors. In these partnerships, the rights and responsibilities of each party are not equal. For the right to enter the Chinese market, the foreign party must assume much greater risks, as well as the initial investment costs. The Regulations of the Peoples Republic of China on Sino-Foreign Cooperation in the Exploitation of Continental Petroleum Resources () (Onshore Regulations) is the primary regulatory structure governing foreign parties exploration and development of onshore oil reserves in China. Originally promulgated by the State Council in October 1993, the Regulation was amended in September 2001 and again in September 2007. The primary objective of the Onshore Regulations, in addition to safeguarding the development of the petroleum industry, is to promote international economic cooperation and technical exchange. It is the Onshore Regulations that require foreign enterprises to partner with Chinese petroleum companies in order to explore and develop onshore oil reserves in China. Furthermore, the Onshore Regulations provide an outline for the nature of the partnership as well as the rights and responsibilities of both the foreign and local parties. [b] Offshore Regulations In general, the regulatory framework governing foreign cooperation in offshore oil exploration and exploitation is substantially similar to that governing onshore operations. The Regulations of the PRC on the Exploitation of Offshore Petroleum Resources in Cooperation with Foreign Parties were first promulgated by the State Council in January 1982 and amended in September 2001() (Offshore Regulations). [3] Taxes

(Rel. 172009)

3.02[3]

DOING BUSINESS IN CHINA

V-3.18

There is a continuing effort by the Chinese government to manage Chinas energy shortage by discouraging the export of crude oil by imposing new tariffs and encouraging the import of crude oil products by lowering applicable tariffs. [a] Windfall Tax In March 2006 the PRC State Council levied a special revenue charge, or windfall tax, upon both oil producers selling crude oil to subsidize purchases by certain weak groups, including peasants and certain public interest industries against the negative impact of such price increases. The windfall tax is calculated on a monthly basis and paid on a quarterly basis. It is levied on all oil production enterprises (both domestic and foreign) selling crude oil produced in China whenever the weighted average price of crude oil sold in any month exceeds US$40 per barrel. In the case of Sino-foreign joint ventures producing crude oil in the PRC, the Chinese partner is responsible for withholding this charge. [b] Crude Oil Export Tax The Crude Oil Export Tax was levied from November 1, 2006 by a circular aiming to adjust the tariffs applicable to the import or export of a range of natural resources and other products derived from natural resources. At this time a new five percent (5%) tariff on the export of crude oil applies to both multinational Chinese oil and gas companies and traders exporting crude oil from China. A more recent announcement issued on July 4, 2007 exempts crude oil produced offshore by foreign companies from qualifying for Petroleum Contracts until July 30, 2012. Any foreign company that paid the export tariff prior to August 1, 2007 is entitled to reimbursement for the tariff paid. [c] Royalties Chinese and foreign enterprises engaged in the cooperative exploitation of onshore and offshore oil resources must pay royalties according to relevant regulations. Payment of royalties is stipulated in (i) the Provisional Regulations on the Payment by Sino-Foreign

(Rel. 172009)

V-3.19

UPSTREAM OIL AND GAS IN CHINA

3.03[2]

Cooperative Joint Ventures of Royalties for the Exploitation of Onshore Oil Resources ( ) (Onshore Royalties Regulations), promulgated by the Ministry of Finance in 1990 and amended in 1995; and (ii) the Regulations on the Payment by Sino-Foreign Cooperative Joint Ventures of Royalties for the Exploitation of Offshore Oil Resources (Offshore Royalties Regulations), promulgated by Ministry of Finance in 1989. Royalties are calculated based on annual gross production and are payable in kind by installments to the PRC tax authorities. The 1995 amendment of Onshore Royalties Regulations raised the minimum amount of annual production under which enterprises are exempt from royalties from 50,000 to 500,000 or 1,000,000 tonnes, as an added incentive to foreign cooperation in oil exploitation. 3.03 [1] Oil & Gas Contracts Overview

Foreign enterprises seeking to invest in upstream exploration and production (E&P) activities in China will have to partner with one of the Chinese state-owned petroleum companies (the Chinese Petroleum Companies). This restriction is required by legislation including the Onshore Regulations, Offshore Regulations, and the other legislation governing coal-bed methane development, which grants the Chinese Petroleum Companies exclusive rights to petroleum prospecting, exploitation, and production in cooperation with foreign enterprises. Contractually, a foreign enterprise will participate in E&P activities in China by entering into a production sharing contract (PSC) for a defined geographic area referred to as a block. PSCs are won by the foreign enterprise either through negotiation or with an invitation to bid from one of the Chinese Petroleum Companies, followed by approval from the Ministry of Commerce (MOFCOM). [2] Crude Oil Production Sharing Contracts

(Rel. 172009)

3.03[2]

DOING BUSINESS IN CHINA

V-3.20

Under a PSC (referred to in China as a Petroleum Contract), the state oil company, on behalf of the government, grants the foreign enterprise (referred to in the PSC as the Contractor) exclusive rights, subject to supervision, to explore for oil in a defined contract area. The Contractor has no ownership rights of minerals in the ground, which leaves the Contractor vulnerable to political instability. For many years offshore PSCs in China were based on a model form, the CNOOC Model 1992 offshore contract. Though revisions were discussed intermittently, there were no forthcoming changes until the end of 2008 when CNOOC undertook to revise this contract. This 5th round Model Contract reflects increased flexibility on certain provisions including commerciality and relinquishment and tightens provisions in the areas of environmental concern and assignment provision in response to market pressures and high prices. For onshore deals, PSCs are based on CNPCs model onshore contract. In both offshore and onshore contracts, the main sensitivity centers on provisions concerning assignment, stabilization, the determination of commerciality and relinquishment. We have set out various typical provisions below: [a] Contract Term The contract term is generally divisible into three separate periods: (i) exploration, (ii) development, and (iii) production, with the parties obligations differing during each period. Where operations are focused on an undeveloped contract area, the exploration period is generally divided into 3 phases, usually lasting 7 years in aggregate. If there is no commercial discovery by the expiry of the first or second phase of the exploration period, the PSC may be terminated by the Contractor. The development period typically begins when Chinese government authorities and the Joint Management Committee (JMC) (discussed below) approve the overall development program. This is prepared upon presentation of seismic evidence proving that the oil field is commercial. The production period commences on the date of commercial operations. The date of commercial operations is the date on which the extraction and delivery of a certain quantity of crude oil or gas, as confirmed by the JMC, occurs. Large complex constructions of

(Rel. 172009)

V-3.21

UPSTREAM OIL AND GAS IN CHINA

3.03[2]

facilities with multiple producing zones are generally conducive to long production periods. Subject to negotiation, options to renew or extend each period may be incorporated in the PSC. [b] Operator In a typical PSC, the foreign contractor will initially be the operator. However, the state oil company may subsequently succeed as operator either prior to the full recovery of development costs with the approval of the JMC or at anytime after the full recovery of development costs by giving written notice to the Contractor. The Onshore Regulations require foreign partners to provide timely reports to the Chinese Partner on the progress of exploration, development, and production activities. These reports include current samples as well as associated technical, economic, financial, and administrative materials. Once submitted, all of these materials become the property of the Chinese Partner and their subsequent use, transfer or grant, are subject to strict governmental regulation. [c] JMC In a typical PSC, the parties will establish a JMC to govern petroleum operations in the contract area. The JMC has a multi-faceted role in reviewing and adopting the overall development program for each oil field within the contract area and the work programs as proposed by the operator, determining commerciality of each petroleum discovery according to the operators appraisal reports, and approving expenditure and budgets. Usually, each party appoints an equal number of representatives to the JMC; the state oil company appoints the chairperson and the Contractor appoints the vice chairperson so that both parties are involved in the decision making process. In the main, decisions of the JMC are made unanimously at a meeting through consultation and, where approved, in conjunction with an expert committee, nominated by the parties. Where an agreement cannot be reached by the JMC and the expert committee (if any), a further meeting is convened to find a new solution based upon the mutual benefits of the parties. However, during the appraisal period, the Contractors proposal will prevail with a caveat that such proposal does not conflict with the

(Rel. 172009)

3.03[2]

DOING BUSINESS IN CHINA

V-3.22

contract term, the terms relating to relinquishment, minimum work commitments, and minimum appraisal expenditures of the Contractor. [d] Exploration Once the partnership contract is approved, and the Sino-foreign cooperative blocks are made public, the partnership will have exclusive rights to the block. Any enterprises occupying an aforesaid block for petroleum prospecting before the cooperative block was made public must withdraw. Furthermore, any prospecting data acquired by enterprises occupying the cooperative block before it was made public, shall be sold to the Chinese Petroleum Companies. During the beginning phases of the exploration process, the majority of risk is borne by the foreign enterprise. The Onshore Regulations require that the foreign enterprise alone provide the investment for prospecting, be responsible for prospecting operations and bear all prospecting risk. Additionally, in the Cooperative Exploration Agreement, the foreign party and the Chinese Petroleum Companies must negotiate exploration and exploitation fees to be paid to the Chinese Partner. The agreement also establishes the distribution percentages between the two parties. Only after an oil field of commercial value is discovered do the Chinese Petroleum Companies become involved. The Onshore Regulations do, however, provide a safety net for foreign contractors. The Chinese government will protect the exploitation activities, investments, profits, and other legitimate rights and interests of the foreign contractor. In the event that the state must expropriate petroleum due to the needs of public interest, the state shall award the foreign enterprise with appropriate compensation. [e] Minimum Work/Expenditure Commitments Exploration work commitments for undeveloped sites, both onshore and offshore, are typically split into phases with an accompanying minimum work expenditure (i.e. the minimum monetary amount expected to be spent as a result of exploration) for each phase. Common appraisal work commitments include: (i) acquisition/ reprocessing of seismic images over certain areas; (ii) drilling of wildcat and appraisal wells of specified depths; and (iii) evaluation of geological data. The minimum work commitments must be completed within certain timeframes and are enforceable by means of penalty

(Rel. 172009)

V-3.23

UPSTREAM OIL AND GAS IN CHINA

3.03[2]

clauses coupled with the state oil companys right of termination if the Contractor fails to fulfil such work commitments. The state oil company and the Chinese government closely supervise all exploration activities. Approval from relevant government authorities may be required for the drilling of wells or for the adoption of the overall development plan by the JMC. Additionally, the Contractor may not substitute wildcat wells with appraisal wells without the state oil companys consent. Upon expiry of any phase of the exploration period, if any minimum work commitments are unfulfilled and the Contractor elects to continue to the next phase, the unfulfilled works shall be added to the minimum work commitment for the next phase, subject to consent of the state oil company. Alternatively, if the Contractor elects to terminate the PSC, regardless of whether the minimum work expenditure is fulfilled, the outstanding work commitments are accumulated, converted into a cash equivalent and paid by the Contractor to the Chinese government. On the other hand, the Contractor shall not be obliged to reimburse the government for the balance of the minimum work expenditure if the minimum work commitments are fulfilled. [f] Discovery; Determination of Commerciality Upon discovery of an oil field during exploration, the parties will, through the JMC, agree upon a determination of whether the discovery is commercial and merits further development. If it is agreed that a discovery is commercial, an Overall Development Program (ODP) (discussed further below) is then prepared and implemented for the development of the oil field. The PSC also provides for sole risk operations where the parties do not agree on the commerciality of an oil field. [g] Natural Gas Discoveries Any natural gas associated with the lifting of crude oil is generally first used for petroleum operations and subsequently assessed to determine commercial value. If no commercial value can be attributed, the operator will dispose of the gas, provided there is no impediment to the production of oil. If the excess gas is deemed valuable, parties may agree on further investment or more typically, the state oil company has the right to unilaterally market the gas. For natural gas that is not

(Rel. 172009)

3.03[2]

DOING BUSINESS IN CHINA

V-3.24

associated with the lifting of crude oil, parties may negotiate its development, production, and marketing. If such gas is deemed commercially valuable, either a supplementary contract is negotiated between the parties or the state oil company will issue an invitation to bid for the right to explore and exploit the gas resources. [h] Relinquishment The contract area is typically defined by its geographical location, boundary coordinates, and maximum depths. In onshore PSCs, at the conclusion of the appraisal period, the Contractor will determine which parts of the contract area it wishes to retain for further appraisal and development. Following approval of the overall development program, any part of the contract area not included in the development areas is relinquished by the Contractor. In offshore PSCs, the relinquishment obligation, following completion of phases 1 and 2 of the appraisal period, is usually tied to a fixed percentage, typically 25% of the contract area. Upon expiry of phase 3 of the appraisal period, or any extension thereof, the Contractor must relinquish the remainder of the contract area, less the proposed development area. For both onshore and offshore PSCs, upon expiry of the development period, the Contractor must relinquish the remainder of the contract area, less the proposed production area. At the expiration of the production period of the last producing oil field, the Contractor will relinquish all rights to the entire contract area. [i] Development: ODP and Work Programs An Overall Development Program (ODP) is an extensive overview providing all relevant aspects of the proposed development, presenting the program from the economical, environmental, geological, geophysical, legal, and technological angles. In the main, the operator for the PSC prepares and implements, inter alia, annual work programs and budgets, procures supplies and insurances, enters into all service contracts and generally obtains approvals from, and reports to, the JMC. For the ease of operations, the operator has a certain degree of flexibility in its expenditure in connection with the performance of its duties under the PSC. In

(Rel. 172009)

V-3.25

UPSTREAM OIL AND GAS IN CHINA

3.03[2]

carrying out an item under the budget, the operator may incur expenditure in excess of the amount approved if the excess amount is within a certain percentage, typically 10% of the approved budgeted amount. To regulate such expenditure, if the aggregate annual excess expenditure will exceed 5% of the annual budget typically, prior approval by the JMC is required. [j] Payments, Financing and Cost Recovery Generally the Contractor will pay a signature bonus to the state oil company upon signing the PSC and within a certain time period thereafter. In addition to the payment of the signature bonus, the Contractor is responsible for all of the appraisal costs and bears the risk of failure if the appraisal wells are found dry. Effectively, the Contractor is required to carry the state oil company through the appraisal period. If the Contractor fails to enter into the development period after incurring appraisal costs, such costs shall be deemed its loss and shall not be reimbursed. The development costs shall be paid by the parties in proportion to their respective participating interests (51% by the state oil company and 49% by the Contractor), unless the state oil company decides not to participate in the development or decides to participate to an extent less than its participating interest (the Opt Out Entitlement). In such circumstances, the Contractor will be liable for any shortfall in the development costs. The Contractor is permitted to use its participating interest in the PSC as security, subject to prior notification to the state oil company and provided that the security over the participating interest does not adversely affect the interests of the state oil company. Following the commencement of commercial production (i.e. the beginning of the production phase), various deductibles including Value Added Tax (VAT), Consolidated Industrial and Commercial Tax, royalties (if any) and unrecovered costs are subtracted from the gross annual production of the oil field. After VAT and royalties are paid to the state oil company and/or the relevant Chinese government authorities, a fixed percentage, of the remaining production is deemed cost recovery oil and prioritized for the reimbursement of operating costs for the production period. The

(Rel. 172009)

3.03[2]

DOING BUSINESS IN CHINA

V-3.26

remainder of the cost recovery oil is classed as investment recovery oil and is used for the recovery of appraisal and development costs, fully payable to the account of the Contractor for the appraisal costs and, payable to the account of the Contractor and the state oil company in proportion to their respective participating interests. This is usually 51% by the state oil company and 49% by the Contractor, as adjusted by the Opt Out Entitlement for the development costs. In some PSCs, the balance of gross production after the above allocations is deemed remainder oil and is divided into share oil for Chinese government account, and allocable remainder oil which is shared by the parties in accordance with their participating interests as adjusted by the Opt Out Entitlement. Accordingly, in the event that the state oil company did not participate in the development of an oil field within the contract area, the Contractor will obtain 100% of the allocable remainder oil of that field. The allocable remainder oil is equal to the remainder oil multiplied by the X factor. Depending upon the value of X, which is in turn dependent upon the level of production, the sharing percentages of the remainder oil between the state oil company and the Contractor will fluctuate. A high X factor implies a small amount of share oil received by the Chinese government. As such, the value of the X factor is highly negotiated. An example of the interaction between remainder oil, allocable remainder oil, share oil and the X factor is as follows: Assume: (i) the annual gross production is 1,000,000 metric tons; (ii) the remainder oil is 300,000 metric tons; and (iii) the following profile exists in the PSC: Annual gross production (thousands of metric tons) 400 400 to 900 900 to 1500 X X factor 95% 91% 85%

= (400,000 x 95%) + (500,000 x 91) (100,000 x 85) 1,000,000

(Rel. 172009)

V-3.27

UPSTREAM OIL AND GAS IN CHINA

3.03[2]

= 380,000 + 455,000 + 85,000 1,000,000 = 92% Note that the 1,000,000 metric tons is made up of 400,000 metric tons, 500,000 metric tons and 100,000 metric tons. It has been divided in such a manner due to the annual gross production profile. Allocable remainder oil = = = = = = X x remainder oil 92% x 300,000 276,000 metric tons Remainder oil allocable remainder oil 300,000 276,000 24,000 metric tons

Share oil

[k]

Taxes

Chinese and foreign enterprises engaged in cooperative exploitation of onshore oil resources must pay business and income taxes, VAT and royalties, etc. to the PRC government according to relevant regulations. [l] Quality, Quantity and Price of Crude Oil Although separately negotiated for each PSC, price is often determined by reference to the prevailing price in arms length transactions of long-term contract sales of a similar quality of crude oil in the main world markets. In the absence of agreement, the PSC usually states that the crude oil price will be determined based on the weighted average sale price of crude oil of the same or similar quality sold by any of the parties to a third party within a certain time period, adjusted for quality, delivery, transportation, payment, and other terms. The quality analysis of crude oil produced from oil fields will be undertaken at the delivery point specified in the PSC. [m] Ownership of Assets and Data Typically, PSCs provide that assets purchased and constructed in accordance with the work program and the budget shall be owned by the state oil company from: (i) the expiry of the production period; (ii) the expiry of the appraisal period if the Contractor terminates the PSC

(Rel. 172009)

3.03[2]

DOING BUSINESS IN CHINA

V-3.28

early; or (iii) the date on which all development costs incurred by the Contractor have been recovered, whichever is earlier. The ownership of all data, records and samples obtained during the course of petroleum operations will vest in the state oil company, subject to the Contractors entitlement to use such data, records, and samples for the duration of the PSC. [n] Marketing Parties typically have an obligation to lift, take and separately dispose of their share of crude oil, subject to an operational lifting tolerance. Commonly, the Contractor and the state oil company will set up a crude oil lifting coordination group for the purpose of lifting each partys entitlement. In some PSCs, crude oil may only be marketed to entities within the PRC (Domestic Marketing Obligations) following market identification studies and consultation with government authorities. Subject to any Domestic Marketing Obligations, if a wider market is agreed, the Contractor will be notified of any prohibited export destinations that infringe upon Chinese political interests. If a Chinese export license cannot be obtained, the parties will agree to consult to maintain the Contractors economic benefits under the PSC. [o] Local Content Requirements Throughout the term of the PSC, the Contractor is obliged to give preference to the use of Chinese goods, equipment, and services. Such use is often subject to the caveat that the Chinese goods, equipment and services must be competitive in price, quality and/or performance as compared to their international counterparts. The Contractor is also under an obligation to employ and train Chinese personnel and, to transfer petroleum technology (including patents, know how and confidential technology) to the state oil company. Prior to the commencement of each phase, the Contractor will submit to the JMC for its approval, a training program aimed at training Chinese personnel and a technology transfer program to transfer petroleum technology and managerial experience to the state oil company. Such programs must be in accordance with the agreed budgets. The relevant expenditure will be charged as appraisal, development or operating costs, depending on when such costs are incurred. With respect to the number of Chinese personnel employed, the Contractor must increase the percentage of Chinese personnel

(Rel. 172009)

V-3.29

UPSTREAM OIL AND GAS IN CHINA

3.03[3]

employed until the minimum percentage threshold required by the PSC is reached. [p] Governing Law and Language Typically the laws of the PRC govern petroleum operations in China. However, there are caveats. If there is no relevant PRC law governing a disputed matter, the applicable laws widely used in petroleum resources countries will apply. If a material change alters the Contractors economic benefits due to the adoption of new laws, the parties will make necessary revisions to the PSC to maintain the benefits entitled by the Contractor prior to the change in law; such a clause is commonly known as a stabilization clause. In China, PSCs are usually drawn up in both Chinese and English, with both versions having equal force and effect. [q] Consultation and Arbitration In PSCs, an obligation for the parties to consult for a fixed period of time prior to commencing arbitration is usually included to promote an amicable and flexible relationship. If the parties cannot amicably resolve the dispute, they may agree to refer the arbitration to the China International Economic and Trade Arbitration Commission in accordance with its arbitration rules or to an arbitration tribunal in a mutually agreed location and in accordance with the UNCITRAL rules. Typically, each party may appoint an arbitrator and the arbitrators so appointed will appoint a third arbitrator who must be a citizen of a country with formal diplomatic relations with China. [3] Coal-Bed Methane Production Sharing Contracts

Owing to the inherent similarities of exploration, development and production processes of natural resources, a Coal-Bed Methane Production Sharing Contract (CBMC) in China is largely similar to an oil & gas PSC. Generally, only slight differences exist in the provisions governing contract term, relinquishment, minimum exploration commitments, operator, employment, price of CBM, ownership of assets and data and CBM destination and marketing.

(Rel. 172009)

3.03[3]

DOING BUSINESS IN CHINA

V-3.30

As with a PSC, a CBMC will provide for a division of production between the state company (in this case China United Coal Bed Methane Corporation Ltd (CUCBM)) and the foreign coal-bed methane Contractor (the CBM Contractor), and granting the CBM Contractor the exclusive right to explore for, develop and produce coal-bed methane (CBM) in a defined contract area, subject to supervision. We have set out various typical provisions below, focusing on the differences between a typical CBMC and a typical PSC. [a] Contract Term The contract term of a CBMC is divisible into three periods: (i) exploration, (ii) development, and (iii) production. Of the three periods, only the exploration period in a CBMC is different to the exploration period in a PSC. The exploration period for a CBMC usually begins within a certain time period after the CBMC is approved by the Ministry of Commerce. The exploration period is divided into two phases. The first phase of 1.5 years is for core testing and the second phase of 1.5 years is for pilot development. If an extension for any phase is required, the CBM Contractor must seek the approval of CUCBM. If CUCBM approves the extension, the extension will be for a reasonable time period in accordance with international CBM practice. The exploration period for a CBMC is generally shorter than the appraisal period for a PSC. [b] Operator Initially, the CBM Contractor will be the operator. If the CBM Contractor decides to change the operator, written consent from CUCBM is required. Effective no later than the date of the full recovery of development costs and interests accrued thereon by the CBM Contractor, CUCBM will become the operator. [c] Minimum Work/Expenditure Commitments For a PSC, if minimum work commitments are not completed within certain timeframes, the CBM contractor may be penalized and the state oil company may have the right to terminate the PSC. Typically, such penalties and termination rights do not exist for a CBMC.

(Rel. 172009)

V-3.31

UPSTREAM OIL AND GAS IN CHINA

3.03[3]

All assets purchased, installed and constructed under the work program and budget will be owned by CUCBM from the date on which all the development costs incurred by the CBM Contractor in the development period have been fully recovered, or from the date on which the production period expires, even though the development costs have not been fully recovered. In the production period, the operator may use the above CUCBMowned assets free of charge for performing CBM operations. Such assets must not be used in any operations other than CBM operations by third parties without the consent of the parties. The ownership of all data, records, samples and other original data obtained in the course of performing CBM operations will vest in CUCBM. However, the CBM Contractor will have the right to use and keep such data, records, and samples for the purpose of CBM operations, subject to necessary approvals and confidentiality obligations. [d] Relinquishment In a PSC, the relevant contractor is usually required to relinquish parts of the contract area at the end of the appraisal and development periods and the remaining contract area at the end of the production period. However in a CBMC, the CBM Contractor is only required to relinquish parts of the contract area at the end of the appraisal period and the remaining contract area at the end of the production period. [e] Price of CBM The price of various grades of CBM is expressed as a FOB price at the delivery point. Determination of the CBM price is determined each calendar quarter and is based on the actual free market price received by the parties. Such price will be the volumetric weighted average of the following components: (i) in arms length transactions, the actual price received; and (ii) for other arms length transactions, the fair market price, accounting for prevailing market conditions. Transportation costs used in determining the FOB price at the delivery point shall be determined in accordance with international petroleum and CBM industry practice.

(Rel. 172009)

3.03[4]

DOING BUSINESS IN CHINA

V-3.32

[f]

Local Employment

Unlike a typical PSC, the CBM Contractor is not required to increase the percentage of Chinese personnel employed throughout the term of its operations. Also there is no minimum percentage threshold required to be maintained by the CBM Contractor with respect to the Chinese personnel workforce. Nevertheless, the CBM Contractor must give preference to the employment of Chinese personnel in the performance of CBM operations. The total Chinese personnel employment level must always be consistent with conducting CBM operations in an efficient and economic manner in accordance with generally accepted good international oil field practices. [g] Destination of CBM and Marketing The CBM Contractor will have discretion as to the destination of its CBM. The CBM Contractor will have the following non-exclusive options: (i) to join with CUCBM to market a part or all of their respective shares of CBM and to sell such CBM jointly to prospective purchasers; (ii) to sell directly its share of the CBM to Chinese users subject to the approval of the relevant government departments; (iii) to sell its share of the CBM to CUCBM and/or its affiliates; or (iv) to sell to other buyers in other lawful destinations. [4] Joint Study Agreements and Geophysical Survey Agreements

Sometimes, rather than directly pursuing a PSC, parties will enter into preliminary agreements, often either Joint Study Agreements or Geophysical Survey Agreements (GSAs). These preliminary agreements are generally for relatively short terms, and are intended as precursors to full PSCs. In a Joint Study Agreement, the foreign party will work together with the Chinese state oil company for a specified timeframe, to evaluate the block and decide if there is enough reasonable evidence to pursue a PSC. In a GSA, the foreign party will conduct specified seismic survey for a short period (typically one year). A GSA is similar to a Joint Study Agreement in that after the completion of the term, the foreign investor has the option of entering into a PSC. However, a

(Rel. 172009)

V-3.33

UPSTREAM OIL AND GAS IN CHINA

3.04

GSA is distinct in that if the parties enter into a PSC, the one-year GSA contract counts toward the PSC work commitment, and likewise, there is a one-year reduction in the PSC expiration date. 3.04 Conclusion

No doubt the energy industry has and will continue to change especially as prices have become so volatile. Chinese companies have changed drastically over the past twenty years as the result of increased capital and technological know-how. This combined with increased foreign investment will only be encouraged in the oil and gas industry. Cooperation with foreign companies will be especially sought out in risk intensive and technologically intensive projects such as CBM type gas onshore E&R, the exploitation of aging oil fields, deep water, gas and LNG.

(Rel. 172009)