China Natural Gas Market

Historically, natural gas has not been a leading component of the total primary energy supply in China, but its share in the country's energy mix has been rapidly increasing. In the first half of 2015, total consumption of natural gas of 90.6 bcm rose 2.1% over the same period in 2014 and represented about 5.5% of the entire energy mix (up from 3% in 2007), compared with the world average of 24%. Production in the same period was up 3.8% year on year to 65.6 bcm.

Development of the natural gas industry is one of China's strategic policies in order to secure energy supplies and to achieve environmental targets. Part of this strategy is to encourage the transportation of gas from west China and other countries around China, including Russia and the Central Asian countries, where there are significant resources, to east China where demand is highest and the energy shortage is most apparent.

China's first major West to East Gas Pipeline, built by CNPC, the parent company of Petrochina Ltd. (NYSE:PTR, www.petrochina.com.cn), was completed on October 1, 2004 and now carries approximately 17 bcm of gas per annum from the Tarim Basin along a 4,000 km pipeline which terminates at Shanghai.

In order to respond to future demand expectations, there are now three new long distance gas pipelines from west China to east China, two of which are to supply gas to Zhejiang Province. One is being developed by CNPC and one by Sinopec. Additionally, the fourth and fifth West to East pipelines have been planned with their first phase expected to be completed by 2017.

In August 2007, CNPC announced proposals for a Second West to East pipeline with a capacity of 30 bcm per annum. The pipeline, with length over 8,000 km, runs from Turkmenistan through Xinjiang to Guangzhou in southern China, branching at Nanchang to run east to Shanghai and passing through western and northern Zhejiang Province. Construction was commenced in February 2008 and the main line was completed in June 2011. CNPC signed agreements in July 2007 to import 30 bcm of natural gas per annum over 30 years from Turkmenistan to supply this pipeline. Although the aggregate design capacity for First and Second West to East pipeline is 47 bcm per annum, CNPC triggered the construction of the Third West to East Pipeline in October 2012 in order to fulfil the booming natural gas requirement in East China.

In March 2010, Sinopec announced completion of a natural gas pipeline running from south west Sichuan Province to Shanghai. This pipeline, with a total pipeline capacity of 17 bcm, currently supplies 12 bcm per annum to cities along the pipeline, including northern Zhejiang Province.

In the past, the Chinese Government has held state-set gas prices based on local costs and thus below international LNG market levels. However, strong demand for gas, coupled with pollution targets, has meant that China has obtained supplies from foreign sources at market prices and up until 2014 the market saw significant upward pressure on prices as the NDRC adjusted prices to reflect China’s purchases on the LNG spot market and CNPC and CNOOC reported signing long term LNG supply contracts at prices close to oil equivalent.

In May 2014, China and Russia signed a large scale natural gas deal worth US$400 billion with a contractual period over 30 years. The pipeline for this supply is scheduled to start providing China with 38 billion cubic meters of natural gas annually from 2018.

These developments are clearly indicative of a maturing gas market with a more market-driven pricing system which should benefit the development of Primeline’s Blocks in the long term. It is also apparent that a nation-wide gas grid is in the process of being established in China and the east China region, as the most industrialised region, will be the frontrunner for this improved gas infrastructure.

Natural Gas Market in Zhejiang Province

The Gas Sales Contract was signed on October 29, 2014 between CNOOC China Limited ("CCL"), a subsidiary CNOOC, and Zhejiang Gas for the sale of gas from LS36-1 on the basis of the fixed price, take or pay gas sale agreements with Zhejiang Gas originally dating back to 2008. The parties to the Gas Sales Contract, which has a 15 year term, are CCL (acting for itself and as agent for Primeline) and Zhejiang Gas.

Zhejiang Province has a total population of approximately 56 million and a land area of 101,800 sq km. It rates as the 4th largest provincial economy within China and has enjoyed double digit annual growth during the last 30 years. 2014 total GDP was RMB 4.015 billion (US$ 647 billion) or approximately US$ 11,914 per capita. Its import and export size and growth are impressive, reaching US$ 355 billion in 2014. Zhejiang Province has almost no primary energy supply except for its hydro-energy potential and more than 90% of its energy needs have to be imported from outside. Energy consumption in Zhejiang Province relies heavily on coal at approximately 61%, then oil at 22.5%, with hydro and nuclear energy at 7% and natural gas at only 2.8%, far below the national level of 4.6% and miniscule compared with an average international level of 24% of the total energy mix.

Zhejiang Province currently has a natural gas grid of circa 1000 km in the northern part of the Province (330 km in 2012) serving the major cities in the area, including Hangzhou, Huzhou, Jiaxing and Shaoxing, and which is fed by the first and second West to East Gas pipelines, together with gas from Sichuan. This gas grid is owned and operated by Zhejiang Gas. In August 2007, following the announcement of the proposed Second West to East Gas Pipeline, the Zhejiang Provincial government decided that a gas grid should be established in the southern part of Zhejiang Province in order to utilise gas from the proposed pipeline. As a result, the gas distribution strategy of Zhejiang Province was changed and Zhejiang Gas is now constructing a gas grid which will extend throughout the Province linking the existing grid to other major cities within Zhejiang Province, including Wenzhou with approximately 600 km being built over the last year This expanded grid has been connected to the Second West to East Gas Pipeline, the Sichuan Gas to East Pipeline constructed by Sinopec in 2010 and to LNG imports which came on stream in 2013. Zhejiang Province is planning to expand its gas grid to 4,100km by 2020 and that the provincial grid will be connected to Wenzhou at some point.

Total natural gas consumption through the Zhejiang provincial grid in 2014 was 6.6 bcm per annum, and after recent consolidation, is expected to grow over the next 10 years with the expansion of the provincial gas grid.

Following finalisation of the plans for the construction of the provincial gas grid by Zhejiang Gas in 2007, it became possible for gas from LS36-1 could eventually be supplied to the proposed provincial gas grid via a connection at Wenzhou.

The fixed price, take or pay predecessor to the Gas Sales Contract was entered into with Zhejiang Gas in 2008 and this formally started the field development.Wenzhou is the closest major city to LS36-1 and is situated on the coast only 140 km away. LS36-1's natural gas is currently solely supplied to the Longwan Power Station which is a combined circle gas turbine power station. Wenzhou's current gas usage apart from the Longwan Power Point is restricted to LPG and small scale locally sourced LNG.

The development of this provincial grid presents a longer term opportunity for Primeline in that, rather than endeavoring to create a greenfield gas market in Wenzhou alone, it may eventually be possible to supply to a rapidly developing market via the grid which is to be established serving all the major cities in the Province and beyond. It is apparent from other natural gas grids in China that once supply has been established then there is consequent expansion of demand.70% of counties and cities in Zhejiang are not linked to the provincial gas grid, hence, the gas market is still immature. With the progressive development of the provincial gas grid and the drive to improve air quality, Primeline expects growth in gas consumption in the medium to long term.

In the short term, gas consumption growth in Zhejiang has slowed and together with the substantial development of long distance pipeline infrastructure and LNG terminals along the East Coast of China, the general economic slowdown and the dramatic drops in oil prices seen in late 2014 to early 2015, has led to an oversupply of gas.

Since February 2015, Zhejiang Gas has tried to seek a very significant reduction of the basic gas price. Primeline has been working with CNOOC and Zhejiang Gas to try to reach an amicable agreement as to the timing and extent of the possible adjustment to the price. Zhejiang Gas has lowered offtake, and made partial payment or nonpayment of various invoices. On April 15, 2016, the China International Economic and Trade Arbitration Commission ("CIETAC") served formal notice of commencement of arbitration proceedings by Primeline against Zhejiang Gas to recover its receivables.