Point of View: Far East Energy pressing big CBM schemes in China

China, where personal incomes have quadrupled in recent years while the country's burgeoning economy has grown fivefold, currently is consuming energy at a pace surpassed only by the US (see related article, p. 20).

Holding the world's largest coal reserves, China burns it in abundance, with the result being that it also has one of the highest rates of pollution in the world. Because the Chinese government wants to clean up its air and increase the use of cleaner natural gas, it has budgeted more than $9 billion to boost gas usage to 8% by 2010 from 2% today. Part of that plan calls for natural gas to replace coal as the major source of electric power generation in Beijing by the 2008 Olympics.

Consequently, one of the fastest-growing sectors of China's energy industry is coalbed methane (CBM) extraction from its vast coal reserves. Among Western companies working with China in this pursuit are supermajors ChevronTexaco Corp., ConocoPhillips, and BP PLC. And then there is the 21/2-year-old Houston-based independent, Far East Energy Corp., that currently holds a major interest in leases totaling more than 250,000 acres, making Far East Energy the third-largest holder of CBM acreage in China. Its holdings in northern and southern China could contain as much as 13 tcf of recoverable CBM.

Infant dragon moves

Despite its fairly new status as a corporation, Far East is governed by personnel having a wealth of experience in the energy industry, particularly in CBM production, said Mike McElwrath, the company's chairman and CEO, and they recognized an opportunity to promptly put that expertise to work in China.

Far East personnel were aware that the Chinese government had created China United Coal Bed Methane Co. (CUCBM), giving it sole rights to develop China's CBM, McElwrath said. "It is also charged with contracting with foreign companies for the joint development of that resource base," he added. "And we were aware, through contacts in China, that CUCBM was actively seeking out American companies and American technology to develop the CUCBM potential, primarily because the United States is way out front in technology in the development of coalbed methane."

Still, how did a start-up company with few assets and no production or cash flow secure such contracts?

"That's a good question," McElwrath said, citing three factors that drove that decision: "First of all, CUCBM was looking for a company in South China that was willing to come in, recognizing that there was not a fully developed pipeline infrastructure incentive. There's an enormous estimated CBM gas in place, but there's not an existing major pipeline in place," he said. "We were willing to go in and take a risk on the basis of what we saw to be a readily expanding demand for gas in the south that was fostered in part by the central government.

"And there was the factor that we were an American company that could bring American technology to bear."

The third factor was Far East's leadership and board of advisors that included a former vice-chairman of Bechtel Group, Don Gunther, and McElwrath himself, a former acting assistant secretary of energy in the administration of President George H.W. Bush, among other experience, all of which lent the company substance and leadership.

"Our senior vice-president [of China operations], Tun Aye Sai, was the one who led the primary negotiations. But Americans such as former [Far East] CEO Bill Jackson were involved in that as well," he said.

McElwrath, who has been on the company's board of advisors since its inception at yearend 2001, became chairman and CEO Oct. 13, 2003.

He said the company "started out [in partnership] with CUCBM in the eastern sector of China's Yunnan Province seeking concessions in South China."

Far East was successful in securing a 30-year production-sharing contract covering three blocks, in which it holds 60% interest while CUCBM holds 40%: Enhong has an estimated 1.1 tcf of recoverable CBM, Laochang has 1.55 tcf, and Zhaotong has 0.55 tcf—all estimates of Yunnan Provincial Coal Geology Bureau.

Drilling is already under way under the program, with the first well having been spudded last October and at least two more wells completed as of mid-April. The program calls for production to start in late 2005 or early 2006, at which time new industrial development slotted for the area may be completed.

"We're not even sure a full-fledged [new transmission] pipeline will end up being necessary" for the South China production, McElwrath said. "Tun Aye Sai and Senior Vice-Pres. Alex Yang have been on the ground recently having discussions with some of the cities. We believe that the landscape is changing. It appears to us that more industry is about to locate in some of the nearby cities, which are within a few kilometers to 50 km of our field. And we also believe that the demand is getting strong enough that we will haveU[those industrial] facilities coming in as well as [other] cities in the area who, for their industries or maybe for their populace, are beginning to look at the utilization of natural gas.

"It appears to us that we may be in a very fortunate convergence of market demand, industry growth, and the proving up of our gas, but all of those things, obviously, are speculative. We first have to prove up the gas...reserves. The plants have yet to be built, and until the reserves are proved up, no one will build a pipeline. But, frankly, we're optimistic on all three points."

Right place, right time

The second major contract Far East secured was a farmout of Conoco- Phillips's 1,058,000 acre CBM Dragon project in Shanxi Province in northern China. That transaction came about because Far East personnel were "in the right place at the right time," McElwrath said.

In Beijing, at a gathering of all companies involved in China's CBM projects, a ConocoPhillips employee was overheard mentioning that the company might be interested in divesting the property as a result of the merger of predecessor companies Conoco Inc. and Phillips Petroleum Co.

"ConocoPhillips wanted to focus all their dollars and their intellectual capital in China on [their $2 billion investment in] Bohai Bay, because Bohai Bay has the critical mantra of the majors these days, which is replacement of reserves," commented McElwrath. Former Phillips unit Phillips China Inc. discovered oil and gas in Bohai Bay in 1999.

"We immediately at that signing ceremony approached [the ConocoPhillips representative] with the fact that we would be interested in [the CBM Dragon project]," said McElwrath. Conoco- Phillips farmed out the property to Far East. "We really were very fortunate, because normally that's the kind of project that has probably been farmed out to [companies] much, much more established and bigger than Far East Energy," he added.

"The Dragon project has the potential to become a megaproject of the type normally found only in the portfolio of the majors," the Far East CEO said. "Essentially, the real thing that we're excited about is that the size of these projects is just enormous. They compare favorably to the biggest basins of the US. Although we're farmed out to ConocoPhillips—Far East holds 40%—and certainly they have an interest [30%], and CUCBM has a retained interest [30%], ...it's just us in this enormous concession under our belts; that's what I'm excited about."

The Chinese government in April approved the farmout for Far East, which has placed $1 million in escrow as security to guarantee performance of its initial obligations covering the Dragon development. The company will first perform an evaluation-and-work program to test the two existing wells on the acreage. Fracturing and testing were scheduled for this summer. If the two-well test program is successful, Far East will drill and test a horizontal well in the second phase of the PSC. That well, to be drilled later this year, would be the first horizontal well ever drilled in China for the production of CBM, according to Far East.

Far East utilizes the services of Chinese drilling firm Huabei Petroleum Administration Bureau from North China and well service company Xian Coal Research Institute. CBM wells are drilled much closer to each other than conventional gas wells; they cost less—$250,000 vs. $5-20 million; and they are much shallower than conventional wells—2,000-3,000 ft deep vs. 10,000-15,000 ft. After drilling 18 wells by the end of 2005, Far East will have satisfied its obligations in northern China with CUCBM.

"And then the fun begins," said McElwrath. "We could then drill at our own pace, which would be fast and aggressive.

"If all goes well, we would really push. We'd use four rigs, maybe six or more, with each rig drilling perhaps as many as two wells per month because these would be relatively shallow wells. And we hope that by the end of 2006, we'd have 80-100 wells in the north. You'd be seeing a similar development program in the south. Again, all this presumes that we have favorable test results and favorable pilot production results, and if we do, we intend to develop extremely aggressively," he added.

Business with China

Far East does not anticipate any major challenges in doing business in China.

"We're very confident about doing business in China in the sense that, historically speaking, for many years now—at least 2 decades—China has had an exemplary track record in the energy sector of honoring all its commitments," McElwrath said.

"Some of the reasons behind that are that China is interested in attracting and gaining exposure to overseas technology, particularly American technology, in the development of its resource base. So China wants to be a good partner, particularly with American companies, in these early stages of development.

"As for us, Phillips was one of the earliest overseas companies to operate in China, and we are very, very pleased to be partners with ConocoPhillips because Phillips is well-known to the Chinese government. The Chinese and Phillips have functioned well as partners for more than 2 decades now," he added.

Finally, of course, China is now in the World Trade Organization, and the government is committed to the normal business regime of the WTO and its member countries, he said.

In addition, McElwrath sees China becoming ever more capitalistic, and he is particularly impressed with the energy the country is exhibiting at this time.

"When I was in Beijing a year ago in December, I commented that I've never seen anything as dynamic. You could just feel a sense of entrepreneurship and a bustling economy unlike anything I've ever felt, except in the days of the oil boom in Houston or in Midland in West Texas in the early 1980s. It just was an incredible feeling," he said.

"I think they have a nice combination now, a definite freeing up of private enterprise and at the same time enough state control to marshal resources for some very huge infrastructure projects, like the [3,800 km] West-East pipeline. So you get a combination of the best of both worlds."

Career highlights

Michael R. McElwrath is chairman and CEO of Far East Energy Corp., Houston.

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