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Interview

with Stephen Lyons, Managing Director, Sino Gas & Energy

21.03.2012 / Energyboardroom

Sino Gas & Energy is a very interesting story. You’ve said in a past interview that you never imagined you would find yourself working in China; you’ve said this company “literally chanced upon” the opportunity to farm in to Chevron blocks in the Ordos Basin. You’ve said you’re almost like an “overnight success five years in the making.” Can you tell our readers the development story behind this very unusual Australian company focused on exploring unconventional gas assets in China?

We came to Beijing in late 2005, and, indeed, quite literally chanced on the opportunity to become involved with some Chevron-Texaco assets. We took that opportunity, which was a bold move for what was a smaller Australian company at the time. The first couple of years were very challenging, but the last couple have been tremendously successful.

When you look at our story from our genesis to where we are now, it’s been an enormous transformation in the span of just five or six years. I believe that it would be very hard to recreate the same circumstances, and the same opportunity that we taken.

We originally came to China with the idea of being a service provider to the unconventional gas sector here—directional steering technology and the related knowhow. I am very happy that we did not go down that line of business as the service sector is quite tight in China—it is also very difficult to find projects onshore as an MNC. Offshore the situation is a bit different, but onshore the Chinese themselves are very, very capable operators. As an E&P company today, we actually do not employ any international service providers on our fields either.

We have invested about $40-50Mn in our blocks to date, while we are probably looking at over $2Bn in potential project value.Australians are quite used to seeing their energy companies exporting resources to China, but to explore assets from within China is quite another story. How did you convince your shareholders to buy into this idea when you listed on the ASX in 2009?

I must say that this is an ongoing challenge for the company: effectively educating the investing public in Australia. And not only in Australia; we now have shareholders from around the world, particularly in Hong Kong and the UK.

In any case, your point is quite right: Australians are very used to selling iron ore and other commodities to China. China appears in Australian newspapers constantly. Things are not quite as obvious when you are a China play; and we are completely a China play.

Our listing in September of 2009 came at the back of the first global financial crisis of late 2008, with the markets continuing to severely slump in early 2009. We were the first energy company to list on the ASX since January 2008. It was not easy, and it was not a large raising at the time. I cannot necessarily say that the IPO has served us well, and the challenge is ongoing to maintain interest in investors. We now have an Executive Chairman in Australia who spends a lot of time in dialogue with Australian investors. We try to do the same from within China down in to places like Hong Kong.

Notwithstanding its challenges with investors, with the rollout of the 12th 5-Year Plan, Sino Gas & Energy seemingly finds itself in a fatefully strong position. Natural gas is now to grow to approximately 8% of the energy mix in China, while unconventional gas is to grow to 1/3 of gas supply. Shanxi Province, home of the Ordos Basin, plans to shift from coal to gas power. Did the company see this coming? How has the ‘12-5’ plan, as you call it, affected your strategy?

When we first came to China, we were well and truly aware that the gas demand was there, and that China was effectively looking to move away from coal and clean up its environment. This drive was already there in 2006. The problem, however, was that the 11th 5-Year Plan simply did not gain enough traction. It was a good plan, and is similar to the 12th 5-Year Plan—but it lacked proper execution.

Our projects are actually listed in the 12th 5-Year Plan and we have been very actively involved with our partners in planning for the next 5-Year Plan from early 2010. What we have seen in 2011—and this is something that we have never seen before—is that PetroChina, in particular, is becoming very interested in CBM production. In previous years, we have seen a bit of a scattered approach to CBM; 2011 was a breakout year. CNOOC, too, is becoming increasingly involved in gas production after they bought into CUCBM.

Chinese companies are driving in this direction in their own right, and they are also becoming tougher on the foreign companies that they operate with. They were always focused in terms of ensuring foreign partners did a certain amount of work, and spent a certain amount of money, etc. Now, however, they are moving more toward an outcome-based approach, wherein instead of looking at well counts, they are requiring that we, say, have a certain portion of the field through the reserves process and into development within a given timeframe. This is another aspect of our work that we haven’t seen in previous years, and find this evolution is in line with our own interests in producing the gas as fast as possible.

PetroChina has told you that that in terms of their very significant plans for unconventional gas, yourselves and half a dozen foreign operators are integral partners. How would you describe the evolution of your relationship with your Chinese collaborators at PetroChina and CNOOC? What do you believe you can bring to the table in a country that very much says: ‘provide something unique or we will do it ourselves?’

I will answer the latter question first, as it is a good one. There is no doubt in mind that China has, internally, most of the capability it needs to produce conventional and unconventional oil & gas both onshore and offshore. If you visit CNPC, for example, you see that it is really a world-class oil & gas business. It is no coincidence that they are one of the top three companies in our sector worldwide. They have the skills.

At Sino Gas, we signed two PSCs that have been approved by central government. These contracts have a long life: 30-plus years, with the option to extend. We have the backing, hence, of the authorities. Relationships in China are absolutely key, and we have had various people involved in this project that have, for instance, worked with CUCBM for quite a long time. Our previous Chairman, when he was the Texaco head here in China, led the signing of one the first projects between CUCBM and a foreign company. Our history with CUCBM, in one way or another, goes back over ten years. I have myself been here for about 6 years, and many of our other staff have been involved with our project and our partners for a similarly long time. Our relationship with our partners is very strong.

There is also, by the way, an interesting link between PetroChina and CUCBM, as the latter split out about 12 people into PetroChina in 2008. The current head and one of the vice-heads of PetroChina are the same people that were at CUCBM. Our JMC representative at Sino Gas also used to be the JMC representative for CUCBM. There is commonality and shared history, and we spend a lot of time interacting with our partners—from the top of the organization down.

You mentioned that your partners are becoming increasingly results driven, and, happily, both your Sanjiaobei and Linxing assets are said to be on the brink of production. Can you more specifically elucidate the latest status of these fields, and explain your current plans for production, distribution, and marketing?

Indeed, as I have said, 2011 was a great year for us. Every well we have drilled in 2010 and 2011 was a gas discovery. That is a function of good knowledge of our subsurface and solid implementation. We have been operating these fields for 6 years, with a number of very capable and experienced personnel. We are getting very good at our well picks. 12 gas discoveries in a row is no accident.

What all of this means is that we are well beyond the greenfield exploration stage, and truly into appraisal and commerciality. Both of our blocks—although they are on slightly different timing schedules—will go through the Chinese reserve process. We get our reserves audited by an independent Australian audit company; but in China, you must also go through the local process, which produces a review similar to a Western SPE report, but tuned and compliant with Chinese guidelines. Our partners are also intimately involved in this report.

The reserve report is delivered to the reserve assessment group at the Ministry of Land and Resources. The officials will then take a look, and likely ask for some tweaks, which we will then complete. The report is the first part of the Overall Development Plan (ODP) process.

In 2012, we have some more wells to drill, we have some more seismic assessments and well tests to perform, etc. to effectively fill in the gaps to produce the remaining data for the Chinese reserve reports. This is our current status in terms of formally moving the project out of the exploration phase and into the development period.

We are starting commercial pre-production in the middle of this year. That will come in the form of a pilot program, and by the end of the year we hope to have 8-10 wells producing 24/7 into the pilot. We would like to start getting some gas sales revenue and test the markets.

There are a number of concepts that we are considering alongside our partners. We have had some success with Compressed Natural Gas (CNG), but it soon became apparent that economically, this approach was just not going to work in terms of delivering to our mid-tier cities. Instead, we are looking at mini LNG. The technology now exists in China, and is being used significantly in Shanxi Province.

There are also pipelines that, increasingly, are crisscrossing our blocks. The pipelines are the second stage: we will go to commercial gas using LNG to start, and then we will evacuate the gas via pipeline later.

In terms of the infrastructure and regulation for gas distribution in China, we have heard mixed reviews. Xavier Chen, head of the EUCC Energy Committee, has emphasized that the gas network has really evolved over the last ten years, citing major examples like the west-east pipeline. Mr. Schoentgen of gas giant GDF Suez, however, has concerns that infrastructure is truly still lacking, especially in areas like gas storage, and legislation is not yet mature enough and does not adequately cover areas like the relationships between gas companies. What is your appraisal of the favorability of China’s gas infrastructure and regulation?

Our company is personally in a relatively favorable position. The first, second, and third Beijing pipelines either go directly through our blocks or north of our blocks. There is also a brand new, dedicated CBM pipeline built in the area.

So the pipeline network is there, and is expanding. We understand that there are also plans for yet a fourth Beijing pipeline—the government is dedicated to supplying gas to places like Beijing and the coast. It is quite amazing to see the speed with which the Chinese can construct these pipelines, through what is really some quite difficult terrain.

Are we satisfied with the infrastructure? I would say that it is getting there. There is definitely some in place, and more coming. I cannot speak to gas storage, but in terms of our slice of this pie, which is upstream, we are satisfied that the pipelines are being put in place. We have not yet finalized our commercial arrangements for using those pipelines, but there are models, and companies like Shell are obviously using pipelines for their own China gas.

In terms of regulation: gas pricing, in particular, is quite interesting. Our projects are profitable when gas is at about $3. The reference gas price in China today is between $7-$7.50. Profits therefore are strong; IRR on our project is, as a result, very, very strong.

And that is before you look at the pricing reform. The pricing reform has a small affordability aspect to it, but basically it takes 90% of the referenced imported oil and imported LPG into account in informing the gas price—rather than using coal, or using production costs in some arbitrary fashion. The NDRC pointed to the fact that this should help the market turn itself into a gas-pricing regime that is market driven. I think regulation is starting to move in a favorable direction—at least for us. What we particularly like with this gas price mechanism is the transparency. Gas price directly linked to oil price is a concept that is straightforward and easy to grasp.

Is transparency typical in China?

China has its idiosyncrasies, and its own ways of dealing with things. Some areas are very transparent—the 12th 5-Year Plan, for instance—while other areas have less clarity. You need to work with your partners, and the central government bodies, to ensure that you are delivering into the grander China plan.

We know that plans are in place for the development of gas and we are part of those plans. Do we know what the whole plan looks like? No. I would suggest that no foreign business does in China.

What kind of returns are you expecting from your assets here?

We plan to develop our field in phases. We can have upwards of 5-6 phases over the life of the project—it depends how quickly we want to go. Our first phase might be upwards of 70-80 wells. That could produce 30-40Mn standard cubic feet of gas per day, which is a reasonable amount of production.

Payback on the field will depend on how the phases are staged, but could be within 4-5 years. Then we will find ourselves very much in the realm of net free cash flow.

In terms of returns per annum, we have not yet released that sort of information to the market.

Is the acquisition of further assets interesting for you?

These blocks are very valuable in their own right. Furthermore, there isn’t a lot of block trading that goes on in China. That is not to say that we do not have our radar out for further assets—we do.

It is for example possible that, in our work with our partners at CNOOC and PetroChina, we can establish some further cooperation on additional blocks. There are shale gas auctions that have been held in 2011 and there is one upcoming in H1 2012. What you will see is that some of the Chinese companies that missed out the first time will receive shale gas concessions this time. So, there is an opportunity to collaborate with our partners should they receive those assets.

In any case, we have two large blocks to start with and what we need to do is take them into production. We are quite happy with what we have.

Let’s again return to your comment that you never imagined that your career would take you to China. What has kept you here so long?

What we have done here with Sino Gas is, essentially, to start with little to nothing, and generate some quite large projects that we have not yet monetized. It has been very rewarding to do what we’ve done.

What keeps me here is to monetize them. I have been here this long, and I have every intention of seeing it through—and the return is imminent. There were dark days during the first financial crisis, so the work has been challenging at times. But, again: it has been very rewarding. On the cusp of your return on investment, what is your final message to your shareholders, and the international and Chinese community reading Oil & Gas Financial Journal?

We have world-class assets here in China, and we have the knowhow to develop them. We have every opportunity to commercialize these fields. Once we do, you will really see the company meeting its equity price on the markets, and we will really take off and get some real value behind the assets that we have here.

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