The four squabbling fiefdoms in China's shale-led political transition

By Sophie Lu

The writer is a consultant with Regester Larkin Energy

For those tracking China's factional politics in this year of momentous transition, a telling indicator will be a coming brawl over its apparently gargantuan shale gas resources. In the arena of political power, where China's shale goes, so shall China.

Shale gas -- locked into barely porous rock deep within the Earth, and released through a method called hydraulic fracturing, or fracking for short -- has fundamentally disrupted the global energy balance, and changed geopolitics: American shale gas has undermined Moscow's political influence in Europe by reducing the dominance of Russian natural gas, and reverberations in the Middle East and elsewhere are likely in coming years.

The shakeup appears especially likely to strike China, which has the world's largest estimated reserves of shale gas. In August, the government will hold its second auction of shale reserves, and already we can make out the shape of a titanic struggle for them.

The shale brawl mirrors China's larger political currents. In the Fall, China will undergo a once-in-a-decade transition of power in which seven out of nine members of the country's top decision-making body, the Standing Committee, will be replaced. The struggle for who ends up on top pits two competing factions -- the reformists against the statists. Who are they, and what makes them tick? And how will their destiny be reflected on China's shale gas patch?

First, take a look at these two charts. The first juxtaposes the recent trajectory of U.S. shale gas production with China's own plans -- Beijing, as you see, hopes by 2020 to reach what the U.S. was producing four years ago.

 

This second chart details China's year-by-year plans.

 

Go to the Jump for the rest of China's shale brawl.

Just months after an enormous discovery of natural gas off the coast of Israel, a local company has reported another potentially big strike -- an estimated 1.4 billion barrels of oil, in addition to more natural gas. The company, Israel Opportunity Energy Resources, says it will start drilling by the end of the year. All of a sudden, Israel has found itself a focus of the world's hydrocarbon interest.

Energy experts are tittering about a prodigious new golden age of oil and gas in the Eastern Mediterranean, where Israel and Cyprus could become substantial oil and natural gas exporters, in addition to some other surprising places including French Guiana, Kenya, North Dakota, and Somalia. All in all, say increasingly mainstream projections, the world is moving into a period of petroleum abundance, and not the scarcity that most industry hands embraced just months ago. Plus, the United States, or at least North America, may be on the cusp of energy independence while OPEC's days of über-influence are numbered.

What these experts have not said, however, is that while this new golden age may indeed shake up the currently rich and powerful and create new regional forces, it could also accelerate the swamping of the planet in melted Arctic ice. So much new oil may flood the market that crude and gasoline prices might moderate and lessen consumer incentives to economize. "In the absence of U.S. leadership, I tend to agree with NASA's James Hansen that it is 'game over for the planet,'" Peter Rutland, a professor at Wesleyan University, told me in an email exchange.

This unspoken flaw in the golden-age scenario suggests it might not unfold so smoothly. The projected turnaround of oil's sagging fortunes may indeed herald economic salvation for the U.S. and global economies. But the environmental consequences could also trip up its full realization.

One of the most consequential energy decisions on the Obama Administration's plate isn't one typically discussed in the election-year hot house -- whether to expand drilling, allow the expansion of a pipeline for Canadian oil sands, or to throw clean-tech entrepreneurs to the sharks.

It is whether to more fully open the floodgates of the U.S. natural gas boom on the world by permitting greater exports of shale gas. The appearance of large volumes of U.S. shale gas on the global market could rattle geostrategy and markets from Russia, to Europe, China and the Middle East.

Shale gas drillers -- saddled with a glut of gas, and fire-sale prices -- are pushing hard for permission to build liquefied natural as terminals and export some of their supply, perhaps 60 billion cubic meters a year, especially to Asia.

In addition, thirsty nations are on America's doorstep. Japan is most insistently lobbying the White House to open up U.S. gas exports, reports the Wall Street Journal's Tennille Tracy. The reason is the need to compensate for its loss of nuclear-power production since last year's Fukushima nuclear reactor meltdown. Others wanting U.S. gas include India and South Korea.

But a Japanese Trade Ministry official told Tracy that he expects no decision until after the November election. The reason is politics -- a number of economists are calling cheap gas a savior for a U.S. manufacturing revival, perhaps even the harbinger of a new industrial revolution. So if you start exporting the gas, and spark higher domestic prices, you may jeopardize this potential opportunity to revitalize American industry. President Obama would be accused by his critics of another job-squandering demonstration of economic incompetence.

Yet the chances are that the U.S. will end up with higher prices whatever the case. This is because drillers will not forever produce at high rates for $2.50 per 1,000 cubic feet; they will slow or shut down production from some fields, and the resulting drop in supply will send the price higher.

This is at it should be. To the degree that the frackers get their act together environmentally as suggested by the International Energy Agency, the global availability of shale gas could assist the resolution of numerous global conundra -- the problem of carbon buildup in the atmosphere; of Europe's over-reliance on Russian gas; of increasing Chinese restiveness with coal pollution; not to mention of Western manufacturing competitiveness. If there is a large, long-term shift to hybrid electric cars, oil demand could drop, and shake up the economic calculus in the Middle East.

Charles Ebinger of the Brookings Institution told me that U.S. exports will send up domestic gas prices at the margin -- "The anticipation of more export projects would lead to people lining up reserves to support them," he said.

But ultimately, the big impact will come with an industrial embrace of more natural gas, and a greater shift by U.S. utilities to the conversion of large coal-fired power plants to natural gas. Michael Levi of the Council on Foreign Relations agrees. The volume suggested for export is "less than 10 percent of current U.S. production," Levi told me.

Apart from the entertainment value, what is the big deal about the saga of Aubrey McClendon, the CEO of Chesapeake Energy, and his use of the company as a piggy bank? The big deal is that, more than any single individual apart from the innovator George Mitchell, McClendon is responsible for the shale gas boom that is shaking up geopolitics. Of course, McClendon's hijinx do not change the geopolitical shakeup, but they are a window into the type of personalities who make up the wildcat boom (pictured above, McClendon, left, owns the Oklahoma City Thunder professional basketball team along with Clayton Bennett, right). As with most such revelations, the kernels and sometimes the whole kit-and-kaboodle are detailed in the fine print of a company's annual 10-K filing with the Securities and Exchange Commission. The thing is, few people bother to read such material -- apart that is from the folks over at footnoted.org, whose whole business is to do so. The footnoted folks have been talking about McClendon for awhile now (such as here, here and -- from today's Website -- here). I asked footnoted's Theo Francis for some insight into Chesapeake. His reply follows.

 

O&G: What could and should a Chesapeake investor, given an ordinary read of the company's 10-K annual reports, have known about Aubrey McClendon's compensation package, perks and financial dealings in recent years? As a followup, if that same investor elected to dig deeper and follow the trail of citations, what would he or she have been able to know?

Theo Francis: Piecing it together can take some work and patience, but it's there, mostly in the annual proxy filing, with updates scattered across other filings over the course of a year.

A snapshot of McClendon's compensation in 2011 (primarily from an April 30 amendment to the company's 10-K filing) illustrates what's available: Salary of $975,000; a $1.95 million discretionary bonus -- meaning it isn't based on any kind of performance measures, but just on the board's general sense of how well he's done; $13.6 million in stock awards; and $1.3 million in perks and retirement-plan contributions. Those perks are telling too: $500,000 in free personal trips on company aircraft (on top of another $650,000 in jet rides for which he reimbursed the company), $250,000 in personal accounting services provided by company employees (about which more in a moment), and $121,570 in personal security benefits. Total for 2011: $17.9 million. Over the last three years, McClendon's compensation has added up to more than $57 million. Plus, Chesapeake doesn't even count some perks, because there's ostensibly no incremental cost to the company, including for an unknown number of tickets to sporting events. McClendon has also built up $7.5 million in a deferred-compensation plan, a kind of IOU from the company.

Which brings us to the related-party transactions, the ones that the company did disclose: Buying McClendon's map collection for $12.1 million in 2008 (a transaction that was ultimately unwound after a lawsuit); paying the Oklahoma City Thunder basketball team, in which McClendon personally owns a 19.2% stake; $2.9 million to $4.1 million a year for more than a decade for stadium naming rights, plus another $36 million over 12 years for sponsorship and advertising costs; and $4.6 million on tickets and games in 2011-12. There's also the board's decision in 2009 to ease the stock-ownership requirement and front McClendon $75 million toward his investments in the company's drilling operations, after he had to sell pretty much all his Chesapeake shares in a margin call the year before.

And then, of course, there's the long-standing "Founder Well Participation Program," which allowed McClendon to invest alongside Chesapeake in its drilling operations, and which is what's at the heart of the current series of embarrassments for the company. The disclosure about the program in last year's proxy was 1,500 words, which sounds like a lot, and there is a fair amount of detail: How the program works (very generally), why the board does it (with extra business clichés) and so on, as well as an estimate of the present value of McClendon's interests in the wells ($308 million at the time) and a table showing annual revenues, capital and operating expenditures, along with cash-flow from the program for McClendon. But there was an awful lot that wasn't disclosed. Since the original Reuters report, the news of an informal SEC inquiry, the company's decision to wind down the well participation program, and so on, the company has produced a lot more information about the program, McClendon's borrowing and other details, in a series of filings and statements.

The bottom line, I think, for any reasonable outside observer -- and I'm talking about before the Reuters bombshell  -- is that Chesapeake feels like a company run by McClendon, for McClendon and his buddies. As long as the company delivered for shareholders, there was a good chance that things could proceed with only minimal reforms for quite a while. But there's very little sense here that these people ever stopped and thought, ‘You know what, we're playing with other people's money; maybe we should rein it in a little.'

And as we've seen time and again over the years, that certainly sets the stage for a revelation like the one we got from Reuters.

 

Same framework -- what went undisclosed that we've learned about in recent weeks?

Quite a bit, and that's why you've seen shareholders react so badly.

For me, Chesapeake had the feel of an insouciant bad boy: It seemed like it was being pretty brash and up-front about its extremes, and that shareholders were for the most part shrugging it off. We always worry about what's not disclosed, and on one level, when a company flouts conventions to the degree that Chesapeake has, you have more to worry about (with Enron being perhaps the ultimate modern-day example). But after a while, it's easy to think, ‘OK, look, they almost got away with the map thing, and although they had to unwind the sale, there wasn't too much of a fall-out; if I were they, I'd just lay it all out and shrug when the good-governance types whine.' Maybe that's what they're doing -- you don't want to count on it, but heck, I don't own the stock, so I can let it lie.

Instead, the new revelations suggest there was, and is, a lot more lurking below the surface. There's a single line in last year's proxy that suggests McClendon might be borrowing under the Founder Well Participation Program, saying the program "does not restrict sales, other dispositions or financing transactions" involving his interests in it. What's missing is any indication that he might have more than $1 billion in borrowing backing the program, that his lenders might also do business with Chesapeake (putting him in a potentially awkward situation, to say the least), or that -- as the original Reuters article suggests -- his personal loans might require him to take certain actions that put him in conflict with Chesapeake's shareholders. That's a lot.

Now there's a suggestion, in an article by The Wall Street Journal's excellent Russell Gold, that Chesapeake may not have fully disclosed some $1.4 billion in off-balance-sheet arrangements of its own. That would seriously ratchet up the disclosure failures, in my view.

Go to the Jump for more of Theo Francis and the rest of the Wrap.

On the shale gas patch, the twain decidedly do not meet: Shale gas drillers, on the receiving end of two years of withering attacks by anti-fracking elements, have launched a counter-offensive. A special-purposed group of 11 big industry players including ExxonMobil, Shell, Chevron and Anadarko issued an eight-page code of conduct for hydraulic fracturing in Pennsylvania and New York (pictured above, outside the town of Waynesburg, Pa.). I spoke with Anadarko CEO James Hackett, a leader of the group, before the Obama administration's release today of somewhat stiff rules governing fracking on federal land. As I wrote at EnergyWire, Hackett said the group wished to "set a good example" -- a high bar for all operators on the patch in order to reassure public opinion. But Hackett's vituperative description of critics suggests little room for conciliation between the sides. In a nutshell, Hackett sees himself as a patriot, and his critics as anti-science extremists, and worse.

The industry embarked on the standards as part of studies requested by the Department of Energy and a diverse group called the National Petroleum Council. But it was all against the backdrop of hyper-critical media like "Gasland," Josh Fox's much-watched 2010 documentary on fracking. The companies felt that shale gas "can be developed responsibly, but you had a slew of articles coming out from the New York Times. Whether they were fact-based or not didn't seem to matter," Hackett told me. "The Cornell study, the Duke study, the hysteria that people were trying to create around hydraulic fracturing, which was scientifically misplaced."

So there was industry interest in counter-attacking, Hackett said. But once they were into the process, the CEOs started thinking more broadly that they had something to gain by conceding to regulation. Hackett:

There was a feeling that this could be a useful way for us to proceed long term, because the truth is that the technology does keep changing and the practices keep changing. And we have every bit or more a stake of how the regulatory process evolves and society's acceptances of our industry. We have a bigger stake than I'd say than anyone else but the citizenry that we want to make sure is educated about what the benefits of this are so that they don't just say, ‘You lose your license to operate,' without understanding what it means when they say that.

Read on for more of James Hackett, and the rest of the Wrap.

Chris Nelder, a San Francisco-based writer-investor on energy, is the author of Profit from the Peak and Investing in Renewable Energy. He blogs at getrealist.com.

Shale gas fever has overtaken America, but we have seen this sort of mania before.

In 2003 and 2004, a "hydrogen economy" was touted as the Next Big Thing. The United States was poised to run its 240 million cars and trucks on it some day, and wean itself off of oil. California would lead the way, putting half a million hydrogen vehicles on the road and building 200 fueling stations by 2010. Today, after the expenditure of around $2 billion of public funds, the U.S. has just two-dozen fueling stations and 500 hydrogen vehicles, plus only modest progress in fuels cells. There is no longer mainstream discussion of a hydrogen economy.

Then Americans became drunk on ethanol. More than $20 billion in subsidies was spent over a three-decade period ending Dec. 31 that ultimately turned nearly 40 percent of the U.S. corn crop into less than 10 percent of the country's fuel needs by volume, and less than 7 percent by energy content. In 2009, the U.S. taxpayer subsidized 75 percent of the price of each gallon of gasoline replaced with ethanol.

Now the U.S. has gone batty for natural gas. President Barack Obama and key members of Congress have cited a humongous estimate for the natural gas supply supposedly possessed by the United States -- nearly 2,200 trillion cubic feet of the fuel, the equivalent of 379 billion barrels of oil, which if accurate would exceed the crude oil reserves of Saudi Arabia, and satisfy U.S. gas demand at current levels for around a century. Only, that widely published figure represents what are called "possible" reserves, not the more certain categories known as "proved" and "probable" -- gas that is more likely to be producible under current technological and market conditions. When discussing proved reserves, the U.S. Energy Information Administration says the U.S. possesses just one-twelfth of that volume, or 273 trillion cubic feet of gas, the equivalent of 47 billion barrels of oil. That is still a lot but, at the country's 2010 rate of consumption of 24 trillion cubic feet a year, it's just an 11-year supply. Even if we assume a very optimistic 50 percent recovery factor for the estimated 550 trillion cubic feet of probable gas, we would still have just a 31-year supply.

A lack of good data, in addition to an apparent bias toward optimistic data, underlies this perception gap. Consider a new, well-by-well analysis by Houston-based petroleum geologist Arthur Berman. Berman, a long-time doubter of mainstream gas estimates, writes that, contrary to popular belief, gas production is not growing under current conditions; instead, 80 percent of the country's shale gas production (pictured above, shale gas operation in Springville, Pa.) has flattened out or declined over the past year. Total U.S. gas production has been on an "undulating plateau" since the beginning of 2009, Berman says, as new shale gas output struggles to compensate for a 32 percent-per-year decline in conventional gas production. This picture is missing from the EIA's data because the U.S. agency bases its reporting on shale gas data only for 2008 and 2009, and does not do well-by-well sampling.

Texas, the deliriously pro-oil birthplace of modern hydraulic fracturing -- the method used to crack open shale and extract its gas and oil -- is about to force all drillers by law to do what many opposed: mandatorily disclose many of the chemicals that they inject into the Earth. As of Feb. 1, drillers must also reveal how much water they use, writes Kate Galbraith in the Texas Tribune. The question is to what degree Texas' move - six other U.S. states also require disclosure, writes NPR's Scott Detrow -- will defuse critics who portray the fracking industry only a bit less demonically than Salem did its witches.

Of all the ways devised to provide energy to the world, none today seems to excite greater passions than hydraulic fracturing, known for short as fracking. The practice has generated a frenzied gas rush in the United States, reports Bloomberg, creating both great wealth and geopolitical turbulence as an unexpected bonanza has shifted the global energy balance. At once, the U.S. has shifted from a gas deficit to a huge surplus, cutting electricity prices last year in half, according to Bloomberg, and China may go the same way. Russia's powerful gas primacy in Europe has been undermined.

Against this, fracking has sparked a robust protest movement that accuses drillers of poisoning drinking water, triggering earthquakes, and ruining roads and landscapes. Bulgaria last week, for instance, issued a moratorium on fracking (Sofia protest pictured above), joining France and Quebec as places stopping the practice. Such resistance has been egged on by intense industry secrecy, along with the traditional fierce independence of the oil patch.

In Texas, the shale gas industry has banded together to try to halt the terrible PR that threatens it in the United States and elsewhere globally -- last Friday, Gov. Rick Perry signed a law requiring industry disclosure of many of the chemicals used to extract the gas. "We have seen the light," Aubrey McClendon, CEO of Chesapeake Energy and probably the loudest critic of shale gas critics, said earlier this month. Coming in the birthplace and home of modern-day fracking, the move ought to quiet shale gas doubters. Right?

From China to eastern Europe to the United States, shale gas has seemed poised to shake up the economic and geopolitical status quo. It's seemed clear that this hitherto out-of-reach, relatively clean fuel could help reduce China's future reliance on choking coal. It could break Russia's monopoly hold on the natural gas market in some parts of Eastern Europe. As for the United States, a shale gas glut has already much-bettered the prospect of lowering projected emissions of heat-trapping CO2.

Yet there has been popular concern regarding how the gas is extracted. Called hydraulic fracturing, or fracking, the method sends intense jets of a water, sand and chemical mixture into underground shale, thus breaking it up and allowing encased gas to be drawn out. Residents of some communities where the process has been carried out have complained of possible groundwater contamination, air pollution and general disruption.

In response, France has outlawed fracking. So has the city of Pittsburgh. Quebec and the state of New York have issued moratoria. Over the weekend, a group of protesters concluded a month-long march to Montreal seeking to extend Quebec's moratorium to 20 years. Meanwhile the U.S. Environmental Protection Agency is studying whether fracking should be regulated from Washington.