China has long been a part of the global expansion plans of many oil and gas companies. The sheer size and growth of China’s energy sector over the past few decades demand attention, as do the government’s energy policies in influencing development.

According to a U.S. Energy Information Administration May 2015 report, China is the largest producer and consumer of coal in the world (accounting for approximately half of global coal consumption) and the second largest oil consumer in the world (after the U.S.). In 2012, coal supplied nearly 66% of China’s total energy consumption, followed by petroleum and other liquids at nearly 20%, hydroelectric sources at 8%, natural gas at 4%, nuclear power at nearly 1% and other renewables at about 1%.

While China has long relied on coal to power its economy, the government of the People’s Republic of China (PRC) has announced a number of times in recent years its intention to reduce its reliance on coal. This could bode well for producers (and service and supply providers) of alternative energy sources, including oil and natural gas.

For example, in September 2013, the PRC’s State Council announced its intention to reduce the proportion of coal in the country’s energy consumption mix to less than 65% by 2017, and has since set another goal to reduce the figure to 62% by 2020.

The PRC government has also passed a number of policies in recent years to support the development of alternative sources of energy. According to a September 2014 paper by David Sandalow, Jingchao Wu, Qing Yang, Anders Hove and Junda Lin, titled “Meeting China’s Shale Gas Goals,” the PRC government has in recent years supported shale gas production through a number of policies, including production incentives, accelerated permitting, improved infrastructure and technology innovation.

Service and supply companies appear to be building their businesses in China more successfully than those in the upstream and other sectors.

How foreign firms have fared

In the midst of the growth and transformation of the energy industry in China in recent years, how have foreign oil and gas companies fared in the country, and what are the major challenges and opportunities facing them there in the years ahead? To shed some light on the first question, I reviewed the two most recent annual reports on Form 10-K filed with the SEC for all of the oil and gas companies listed in the Houston Business Journal’s list of the 100 largest Houston-based public companies (based on fiscal-year 2013 revenue), which appeared in the July 25-31, 2014, issue of the paper.

Based on a review of these annual reports, for fiscal-year 2014, 12 of the oil and gas companies in the Houston Top 100 disclosed that in 2014 they had operations in China or generated revenues from sales into China (two of these companies have since sold their China operations). Among these 12 companies, only three disclosed in their annual report the amount of sales from their China operations in recent years. See the table for a summary of revenues derived from China operations for these three companies for each of the last three years.

Among the 12, seven were service and equipment companies (representing approximately one-third of all oil and gas service and equipment companies listed in the Houston Top 100) and five were E&P companies (representing approximately one-fourth of all E&Ps listed). In addition, although they are not the subject of this article, it is worth noting that two Houston Top 100 companies, and one operating segment of a Houston Top 100 company, are chemical companies that have operations in China and/or generate revenues from sales into China.

PRC governmental regulations restricting foreign investment in certain sectors of the oil and gas industry impacted what kind of oil and gas companies have been able to enter and maintain a presence in China. For example, in China, foreign investment in the oil and gas E&P industry generally must take the form of an equity joint venture or cooperative joint venture, with the foreign company’s interest being limited to a minority stake. In addition, according to the EIA May 2015 Report, whereas onshore oil production in China is mostly limited to China’s national oil companies, international oil companies have been granted more access to deepwater offshore projects and more technically challenging gas fields.

Among the five E&P companies from the Houston Top 100 that had business or operations in China in 2013 and 2014, two have sold their China businesses. Specifically, during 2014, Anadarko Petroleum Corp. sold its China subsidiary for $1.075 billion and Noble Energy Inc. sold its China assets for $186 million. According to its SEC filings, Noble Energy’s sale of its China assets was part of a larger noncore asset divestiture program, which allows it to allocate capital and human resources to higher-value and higher-growth areas. Similarly, Anadarko Petroleum chairman, president and CEO Al Walker commented that the sale of Anadarko’s China subsidiary “accelerates the recognition of value from a nonoperated legacy asset and continues to demonstrate our commitment to active portfolio management.”

According to its SEC filings, Newfield Exploration Co. had intended to divest its China business, but in December 2014, after not being able to obtain an acceptable offer due to the considerable decline in commodity prices, the company decided to retain its China holdings. ConocoPhillips and EOG Resources Inc. are the other two Houston Top 100 E&Ps with business or operations in China. Among these five companies, only ConocoPhillips and Newfield disclosed in their annual reports on Form 10-K the revenues generated from their China operations.

Whereas recently some Houston-based E&P companies have refocused resources away from China and back to the U.S., there did not appear to be a similar general shift among the seven oilfield services and equipment companies on the list that were operating in China in 2014. Some of these companies appear to have had satisfactory business and financial results in recent years. For example, from 2012 to 2014, National Oilwell Varco Inc.’s revenues from China increased from about $533 million in 2012 to some $1.905 billion in 2014, rising from 3.1% of the company’s 2012 revenues to 8.9% of its 2014 revenues.

The other six oilfield services and equipment companies from the list that were operating in China in 2014 (i.e., Cameron International Corp., Dril-Quip Inc., Baker Hughes Inc., Halliburton Co., McDermott International Inc. and Schlumberger NV) did not disclose in their annual reports on Form 10-K the revenues generated from their China operations.

One reason why there is a higher percentage of Houston-based service and equipment companies in China relative to their Houston-based peers in the upstream, midstream and downstream sectors is regulatory. There appears to be relatively less PRC regulation restricting service business and investment opportunities in China.

While China has shown openness to work with foreign companies in various sectors of the oil and gas industry, some industry observers believe that services and equipment companies are attractive business partners because China’s national oil companies can obtain various sophisticated equipment and services while retaining a higher degree of autonomy and control over the process of resource development. In addition, the PRC government has encouraged the sale into China of certain oil and gas equipment through various tax incentives.

Weidong Wang, a corporate partner at Grandall Law Firm, a China-based law firm with experience in oil and gas law and cross-border transactions involving Chinese and foreign companies, observes that “in an effort to support the exploration, development and production of crude oil and natural gas in China, the Chinese government has provided tax incentives to companies which are engaged in the oil and gas industry, in the form of customs duty and VAT exemptions. These tax incentives are available for the importing into China of certain equipment and products which either are not produced by local manufacturers or surpass locally produced products according to certain performance/quality measures. To qualify for these tax incentives, the products must be imported for the purpose of developing oil and gas projects in certain geographically designated areas in China.”

Some observers note that, while the PRC government continues to restrict foreign investment in a number of segments of the oil and gas industry in China, some of these restrictions might be relaxed in the future. Seth Williams, CEO of Zhongmen Group, a China-focused transaction advisory firm, observes that “the regulatory environment in China is increasingly supportive of direct foreign participation across the Chinese economy and this increased openness, coupled with China’s large market potential, should attract new entrants from international companies looking to build a long-term market presence in China. The bilateral investment treaty currently being negotiated by the two countries is expected to add additional clarity regarding specific opportunities that might emerge for foreign participants in China’s energy industry.”

Greg Krafka is a corporate attorney at Winstead PC in Houston, and represents clients in cross-border transactional matters.

Any opinions of the author expressed herein do not necessarily reflect the views of Winstead PC, its clients, or Oil and Gas Investor, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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