Legal reforms opening doors to foreign investment in China's oil, gas sector

China's energy challenge—2

Portions of this article first appeared in China Law & Practice, February 2004, 18(1), pp. 19-27 and is reproduced with the permission of Euromoney (Jersey) Publications (Jersey) Ltd.

The China energy challenge creates both risks and opportunities for foreign investors.

Opening China's oil and gas sector to foreign investment is seen as one way to raise production capacity and stimulate output, but this inevitably leads to a dilemma as the government seeks to keep its state companies competitive.

To meet its World Trade Organization accession commitments, China amended regulations governing foreign investment in both its onshore and offshore oil and gas sectors in 2001. The requirement of Chinese majority ownership in certain midstream and downstream enterprises also has been removed. Foreign parties are no longer required to sell their share of production to their Chinese partner, and the preference for using Chinese personnel, goods, and supplies has been diluted.

Over the next 2 years, China also will allow foreign ownership in its retail and wholesale oil and gas markets. Tariffs on imported crude oil have been eliminated, and those on gasoline and lube oil have been reduced. Import quotas and license requirements for "refined or processed oil" (gasoline, kerosine, diesel, lubricants, and the like) were recently relaxed, allowing foreign investors to apply for a direct import license. Remaining quotas and license requirements are to be eliminated by Jan. 1, 2006. The doors to foreign investment are open wider than ever.

Management of foreign investment activities

Foreign investment in oil and gas exploration and production is encouraged as a matter of Chinese national policy, in response to soaring domestic oil and gas demand (OGJ, Sept. 6, 2004, p. 20).

However, it is essential that foreign participants understand the infrastructure of government entities and regulations governing foreign investment in the energy sector.

The Foreign Investment Industrial Guidance Catalog (FIIGC), effective Apr. 1, 2002, lists the industries or activities in which foreign investment is encouraged, restricted, or prohibited. Some activities are prohibited outright, others require a Chinese partner, and still others are encouraged and may be eligible for beneficial tax rates or exemptions. If an activity is not mentioned, it is implicitly permitted, subject to applicable laws and regulations.

The FIIGC's classification system reflects China's commitment to certain WTO accession principles tempered by a desire to keep its national oil companies competitive when the country's energy markets are fully opened.

Upstream

The foreign investment regime for upstream activities is rather elaborate. Foreign investors are required to partner and execute production-sharing contracts (PSCs) with one of the national oil companies and to obtain approval from a number of state and provincial institutions, depending on the level of investment.

Foreign investment in the upstream oil and gas sector so far has been more significant in China's offshore areas than onshore. The key measure of the greater foreign participation offshore vs. onshore is the fact that China National Offshore Oil Corp. (CNOOC) had more than 30 PSCs with foreign partners at the close of 2003, compared with about half that for China National Petroleum Corp.'s PetroChina and just a handful for China Petrochemical Corp.'s Sinopec. The numbers have increased since then in all areas, but offshore is still, by far, the most active area for foreign partners. One reason may be that the Chinese offshore industry has been open to foreign investment since 1982, but the onshore sector has been open only since 1993.

Under regulations that established the legal and operational framework for offshore development with foreign investors, CNOOC was formed in 1982 and was given exclusive right to work with foreign interests in China's offshore sector. Similar onshore regulations gave CNPC and, since 2001, Sinopec responsibility for working with foreign interests in onshore exploration and production. Each was to occur in the form of cooperative joint ventures.

PSCs

The PSC is the cooperative joint venture document that governs the operational and financial life of a project with a foreign partner from exploration through development to production. It includes the formula by which the foreign investor will recover its exploration costs, share in production, and obtain a return on investment.

The PSC embodies basic provisions of onshore and offshore regulations, mineral development laws and regulations, and exploration and production licenses, but it also includes numerous standard PSC provisions to reimburse exploration expenses and share production.

The Chinese party to the PSC must be a state company (e.g., CNPC, Sinopec, CNOOC), but it may allow representatives of its publicly listed affiliate to participate in PSC negotiations.

One party is designated as the operator, which can be either the foreign or Chinese partner. The operator is responsible for managing all the day-to-day activities of the joint venture and has responsibility for preparing and carrying out work programs and budgets, procuring equipment, funding operations via cash calls, hiring crews, maintaining records, and overseeing associated operations. A joint committee of the parties' representatives supervises the operator.

Where the foreign investor (referred to as the "contractor") is the operator, the Chinese partner has the right to take over operations once the contractor has recovered its share of exploration and development costs. Whether the operator or not, the Chinese partner is responsible for obtaining all approvals before development operations may begin.

The PSC contractor bears all exploration costs and expenses, relinquishing acreage following each phase of exploration until a Development Area or Production Area is delineated.

Once a discovery is made, the Chinese partner has the right to take up to a 51% participating interest in the block.

Once the block is in production, a cost-recovery and production-sharing formula comes into play. Out of first production, taxes and royalties are payable to the government. Royalties are payable on a sliding scale based on production volume: 0-12.5% for oil and 0-3% for gas. Thereafter, the parties are allowed to recover their current operating costs out of cost-recovery oil, followed by a recoupment of exploration and development costs. The volume of cost-recovery oil is less before payout than after payout in order to allow the contractor and Chinese partner to recover their development costs more rapidly. Following payout, and after reimbursement of monthly operating expenses, the PSC parties receive remainder oil in proportion to their participating interests.The contractor may export its share of production or sell its remainder oil to the Chinese partner and repatriate the income abroad.

Public tenders are required for offshore PSCs, while those onshore may be entered into either through negotiation or public tender. PSCs must be approved by the Ministry of Commerce.

Midstream, downstream

Foreign investment in China's midstream and downstream sectors here is less structured and regulated than in the upstream sector, but there is also more commercial uncertainty (e.g., fiscal stability, market-based pricing, and regulatory transparency). There are no formal substantive laws or regulations along the lines of the onshore and offshore regulations that govern foreign investment in these sectors:

Pipelines. Construction and operation of pipelines are encouraged by the FIIGC. The Chinese party no longer must be the majority partner, although no foreign investor appears to have taken advantage of this change to date. Gas distribution, once prohibited from foreign investment, is now merely restricted and requires majority Chinese ownership. This change reflects a recognition that this segment of the industry is in need of improvement if natural gas utilization is to be increased, one of the tenets of China's current 5 year energy plan.

LNG. Despite major facilities under construction and the proliferation of planned terminals along the eastern coast of China, LNG activities (terminals and regasification facilities) are not mentioned in the 2002 FIIGC per se (although LNG terminals are encouraged). With no mention in the catalog, these are considered areas in which foreign investment is permitted (and has seen significant foreign investment).

Refining and petrochemical manufacturing. The construction and operation of refineries is restricted and subject to the central government's approval based on an "overall state balancing." In contrast, manufacturing of many types of petrochemicals, from ethylene to synthetic rubber to agrichemicals, is encouraged under the 2002 catalog. However, facilities with an ethylene production capacity greater than 600,000 tonnes/year require Chinese majority ownership.

Marketing. Foreign participation in petroleum marketing is technically restricted but effectively prohibited in the wholesale sector until Dec. 11, 2006, when foreign investment will be "permitted to deal" in both crude oil and refined products (called "processed oil"). In the meantime, only state-controlled companies have licenses to import or export crude oil and refined products. On the retail side, foreign investors will be permitted to establish wholly owned enterprises and are "permitted to deal" in processed oil by Dec. 11, 2004. However, foreign investors may not hold a controlling interest in "chain stores" that have more than 30 outlets.

The future

China's need to facilitate energy production will require an investment environment that attracts foreign capital, particularly in areas such as natural gas pipelines and distribution.

With the market liberalization required by the WTO, Chinese national companies will have to face foreign companies competing with them to supply the Chinese market with badly needed energy.

On the other side of the coin, Chinese national oil companies are in the hunt for oil and gas resources abroad and are taking on the role of an international oil company, backed by significant financial resources to "bring home the energy."

As the Chinese national oil companies compete more actively around the world for scarce energy resources, they will have to perform at international standards. However, there is no doubt that their presence in an increasingly competitive environment for the world's energy resources will be felt by international participants everywhere.

This is the second of two parts.

The authors