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Cablegate: Natural Gas in South China (Part 2 of 2): Chinese Taking

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RR RUEHCN RUEHGH RUEHVC
DE RUEHGZ #0419/01 0930311
ZNR UUUUU ZZH
R 030311Z APR 07
FM AMCONSUL GUANGZHOU
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UNCLAS SECTION 01 OF 05 GUANGZHOU 000419

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E.O. 12958: N/A
TAGS: ENRG EPET EMIN ECON SENV KIPR CH
SUBJECT: Natural Gas in South China (Part 2 of 2): Chinese Taking
Control as Offshore Exploration Looks Promising

REF: Guangzhou 418

GUANGZHOU 00000419 001.2 OF 005


THIS DOCUMENT IS SENSITIVE BUT UNCLASSIFIED AND INCLUDES BUSINESS
SENSITIVE INFORMATION. IT SHOULD NOT BE DISSEMINATED OUTSIDE OF
U.S. GOVERNMENT CHANNELS OR IN ANY PUBLIC FORUM WITHOUT THE WRITTEN
CONCURRENCE OF THE ORIGINATOR. IT SHOULD NOT BE POSTED ON THE
INTERNET.

1. (SBU) SUMMARY: The Chinese government has renewed efforts to
diversify the nation's energy mix and improve the environment by
bringing anticipated large offshore gas reserves in the South China
Sea (which had previously been ignored, vented or flared) to
production. As offshore oil and gas fields in the South China Sea
look more promising, exploration blocks previously operated by
foreign-run joint ventures, are increasingly being consolidated
under China National Offshore Oil Corporation (CNOOC) ownership.
Overall, CNOOC continues to act less like a profit-seeking
corporation and more inline with government desires to secure
resources globally to quench China's growing energy thirst. Despite
healthy financial returns in the past, most Western exploration and
production companies are finding newly offered projects to be higher
risk (the full extent of which will not be known until exploration
begins), technically difficult to complete, in deeper water, and
with operating control solely by CNOOC. This is the second of two
cables on the subject of natural gas in south China. END SUMMARY.

In the Past, Foreign Companies Dominated
----------------------------------------

2. (SBU) CACT is a representative case of what foreign offshore oil
and gas joint ventures are becoming today. Originally started in
1984, CACT was an equal partnership between AGIP (now ENI, the
national oil company of Italy), Chevron, and Texaco to explore two
blocks in the South China Sea. After seven years of exploration and
development, the JV started production with seven offshore platforms
in 1991. After 15 years, CNOOC exercised its option to purchase 51%
of the venture in 1999 and the later merger of Chevron and Texaco
adjusted the financial split to its current level - 51% CNOOC, 32%
Chevron, and 16% ENI. For the past 7 years, operator rights have
rotated among the three partners yearly as has the overall project
manager position.

3. (SBU) Congenoff spoke to Mr. Maurizio Senese, Deputy Project
Manager for CACT and the highest ranking manager from ENI in the JV,
who stated management and engineering positions within the JV are no
longer relinquished by CNOOC employees. The overall management of
the JV has shifted from a mix of American, British, and Italians to
Chinese. With the shift, the remaining Chevron and ENI management
are largely ignored except when information needs to be passed back
to respective company headquarters. The need to use foreign experts
is declining rapidly and CNOOC is currently seeking permanent
operator rights so it can ensure that all production from the fields
is directed to China. Senese said that despite the fact that the
CACT project was ENI's project with the highest rate of return in
the world, the company will likely bow to Chinese pressure and
financial incentives and sell their share in the project within the
next few years.

4. (SBU) Mr. David Lindsay, President of Devon Energy China, one of
the largest U.S. energy companies active in the South China Sea,
told Congenoff that Devon is currently involved in a joint venture
with Husky Energy (a Canadian energy firm majority-owned by Hong
Kong billionaire Li Ka-shing) and CNOOC in the Eastern South China
Sea. Following the trend described above, CNOOC recently purchased
operator rights to the project in the Panyu field and Devon is now
pursuing new exploration projects.


GUANGZHOU 00000419 002.2 OF 005


CNOOC Learns Quickly
--------------------

5. (SBU) Mr. Senese commented that the number of foreign experts
used in CACT projects had declined dramatically in the last few
years. CNOOC Engineers and managers alike are often put on multiple
projects at one time so they can learn a broad range of skills.
CNOOC employees are moved from one CNOOC joint venture to another in
an attempt to gain knowledge of techniques from different foreign
partners. For depths up to 200 meters, Senese said that CNOOC is
now competent and offshore joint ventures in these depths will
continue to be bought out while new projects will be entirely owned
and operated by CNOOC.

Finances Don't Govern All
-------------------------

6. (SBU) Congenoff spoke with Dr. Ziqiong Zheng, China Area Manager
for Baker Hughes Inteq - a large U.S. oil and gas services firm, who
commented that in offshore exploration and production, intellectual
property rights protection is a large challenge. The Chinese oil
services arms of CNOOC, Sinopec, and PetroChina are quick to copy
drilling and logging technologies but so far the copied technology
has yet to approach the original in quality. Still, for
Chinese-only offshore projects, Baker Hughes is at a disadvantage
due to protectionism and favoritism. Without changes in the
business environment, it will suffer due to the diminishing role of
international oil and gas companies in South China Sea projects.

7. (SBU) Dr. Zheng notes that the China oil majors continue to favor
Chinese-made or controlled equipment, even when it is less
efficient. He cited project examples where Baker Hughes technology
was seemingly more expensive, costing $26000 USD per day compared to
$10000 USD for similar Chinese-made equipment. Since the Baker
Hughes designed drilling system can run for 200 hours before needing
to be changed out, a process that can take multiple days at great
depths, compared to only 40 hours for the Chinese-made equivalent,
the Baker Hughes option actually costs up to $2.5 million USD less
and more importantly, can bring a deep-water well to production a
year sooner. Yet CNOOC and other Chinese oil majors routinely use
their own service companies for drilling and often cite social
stability as the reason.

8. (SBU) The Chinese oil and gas industry currently employs 1.2
million people in China (down from a peak of 2 million) and 85% of
these are in support services as varied as schools, hospitals, and
food preparation. Most Chinese managers are not willing to risk a
few million dollars in savings on a project if the outcome can lead
to large domestic layoffs and civil unrest. Still, Dr. Zheng stated
the future for foreign oil services companies in offshore projects
may be brighter than it appears due to the increased government
emphasis on bringing domestic offshore production of oil and gas to
market quickly.

South China Sea Prospects Look Bright...
----------------------------------------

9. (SBU) Both Mr. Senese and Dr. Zheng commented that the South
China Sea is full of potential. The South China Sea is divided by
CNOOC into the Eastern South China Sea which encompasses the Pearl
River Delta and waters to the south and east and the Western South
China Sea which encompasses the waters west of the Pearl River Delta
including those south and west of Hainan island. So far, the
Eastern South China Sea has primarily produced oil and the Western
South China Sea has produced natural gas. This is slowly changing
as CNOOC is now attempting to send gas from its wells in the Panyu
field in the Eastern South China Sea by pipeline through CACT's

GUANGZHOU 00000419 003.2 OF 005


existing platforms in the Huizhou field and then onward to the city
of Zhuhai. The pipeline from CACT's platforms to Zhuhai has been
completed but a faulty Chinese-engineered jacket for a well (the
largest ever designed by China for offshore use at 213 meters) on
CNOOC's Panyu-30 platform was discovered last year and now is being
replaced. This has delayed the rest of the project by over a year.
Once the project is completed, it will produce over 400,000
tons/year of natural gas to be used to fire power plants in southern
Guangdong province.

10. (SBU) Mr. Senese showed Congenoff a set of maps depicting
potential oil and gas fields in the South China Sea. Based on
current seismic data the finds could be huge as over 90% of expected
fields have yet to be explored or developed. Many of the fields
currently in production are also small compared to the potential
that lies in deeper water.

11. (SBU) In June 2006, Husky Energy announced the discovery of one
of the largest Chinese offshore natural gas deposits in the Liwan
Field of the Western South China Sea. The potential recoverable
resource is estimated at between 4 and 6 trillion cubic feet of
natural gas (77.8 to 116.7 million tons). Mr. Lindsay stated that
Devon owned exploration rights to the adjacent field and seismic
data indicated analogous structures which could mean a similar size
discovery. These fields lie in depths of at least 1500 meters of
water.

Future Work with CNOOC Looks Less So
------------------------------------

12. (SBU) Mr. Senese stated that future foreign JVs with CNOOC would
likely be on projects in depths of 1000 meters or greater. He
continued that CNOOC has the expertise for exploration at these
depths but lacks experience in development and production as
evidenced by CNOOC's faulty attempt at only a 213 meter jacket last
year. The phasing out of tax incentives for foreign firms and a new
oil export tax may also affect international oil and gas firms'
willingness to enter new joint ventures.

13. (SBU) Mr. Lindsay commented that most of the new shallow-water
blocks being offered were unattractive. However he stated that when
blocks do come up for offer relationships are extremely important.
Unlike many other countries where blocks are put up for auction, in
China, CNOOC negotiates individually with partners on each block
based on precedence of expressed interest. These negotiations often
take a long time. Dealing with CNOOC is further complicated by the
company's decentralized structure. CNOOC-Shenzhen handles Eastern
South China Sea fields but CNOOC-Zhanjiang manages Western South
China Sea fields. For companies like Devon with interests in the
East China Sea and Bohai Bay as well, the company must also deal
with CNOOC-Shanghai and CNOOC-Tianjin respectively. This can
stretch a lightly-staffed international oil company thin.

14. (SBU) Eni's Senese stressed relationships with CNOOC were also
important in joint ventures. He stated that Chevron's open lobbying
against CNOOC during the company's bid for Unocal turned the company
and its representatives into non-entities at CACT. Devon's Lindsay
also commented on the possible folly of a Conoco-Philips decision to
take China to arbitration over a questionably legal windfall tax
implemented on oil production last year. While all international
oil companies agreed the tax, which amounted to $12/BBL at peak oil
prices, was questionable, the decision to formally fight it could
hurt Conoco-Philips more in the long term.

15. (SBU) Dr. Zheng agreed that the divided structure of CNOOC poses
several challenges but also commented that the biggest obstacles for
foreign companies are the lack of complete geological information on

GUANGZHOU 00000419 004.2 OF 005


blocks. CNOOC often paints a rosy picture but most blocks that are
opened for foreign participation are actually high risk or
technically difficult to complete and the foreign partner often
won't know the full extent of the risk until after a deal is struck.
Lindsay stated that his company looked at some of these
opportunities as high risk but minimal investment, implying a
willingness to cease exploration if early wells don't show results.

Rigs are the Bottleneck
-----------------------

16. (SBU) Mr. Senese, Dr. Zheng, and Mr. Lindsay all agree that the
overall worldwide lack of drilling rigs is a major bottleneck to
quicker exploration and development of the South China Sea. With
CNOOC purchasing a stake in the gas fields of Indonesia to support
the CNOOC's Fujian LNG project, it has moved several of its own
drilling rigs from the South China Sea. Furthermore, when
CNOOC-owned rigs become available, CNOOC wholly-owned projects are
given preference to those of CNOOC JVs. International oil firms are
seeking rigs worldwide but with the major rig yards already at
capacity for new production and high demand and commodity costs
pushing up rig prices, the proven reserve threshold for new projects
is also correspondingly higher. As a result, CNOOC and others
currently seem content to add extended-reach wells to existing
platforms rather than develop entirely new fields in the South China
Sea.

CNOOC and China, Combining Efforts in the Developing World
-------------------------- -------------------------------

17. (SBU) Mr. Lindsay has been in China for only one year,
previously heading up Devon's operations in Equatorial Guinea. He
commented on the extreme difficulty of dealing with the government
there. Both Lindsay and Dr. Zheng mentioned the impact that the
Foreign Corrupt Practices Act (FCPA) can have in the developing
world. The government backing of national oil companies such as
CNOOC compounds the problem. In West Africa, CNOOC is able to link
Chinese government financial and aid projects to preferential
treatment on energy deals.

Comment
-------

18. (SBU) While there are numerous promising fields in both the
Eastern and Western South China Sea, increased ownership and control
of projects by CNOOC will likely slow the rate at which these fields
are explored and developed. In the case of the potentially large
natural gas finds off Hainan Island, billions of dollars worth of
investment will be needed to bring the gas to market. The cities of
Zhuhai and Zhanjiang in Guangdong province will be likely hubs for
offshore natural gas. Current plans to connect Zhuhai to Guangzhou
and Shenzhen via pipeline depend on completion of an LNG terminal
that has yet to receive final approval or begin construction (see
reftel) and completion of this pipeline will be in 2012 at the
earliest. Until then, the natural gas coming from the Eastern South
China Sea will continue to be used almost exclusively for power
generation in Zhuhai.

19. (SBU) CNOOC, and China in general, are handling natural gas and
other offshore exploration with a mercantilist approach. The
overriding goal is control of assets, technology, and resources.
CNOOC is willing to use international oil majors and oil and gas
service companies only when it needs the expertise and in these
cases the company seeks to gain new technologies and skills as
quickly as possible to minimize future dependence. Using lucrative
financial offers is still bringing in foreign partners and CNOOC
continues to build relationships, sometimes with government help,

GUANGZHOU 00000419 005.2 OF 005


worldwide. CNOOC also uses the threat of minimizing these
relationships as a potential retribution for those companies who
cross it as it attempts to gain further control of the offshore
situation in China and other nations. Overall, CNOOC continues to
act less like a profit-seeking corporation and more inline with
government desires to secure resources globally to quench China's
growing energy thirst.

Note of Conversions
------------------

20. (U) In this cable, the following conversion factors were used in
computing equivalents:

1 cubic meter natural gas = 35.3 cubic feet natural gas
1 MMBtu = 27.993 cubic meters of natural gas
51414 cubic feet of natural gas = 1 ton of natural gas

GOLDBERG

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