Last month, Chesapeake Energy (NYSE: CHK) agreed to sell half of its undivided interest in a substantial portion of its acreage in the Mississippi Lime formation to Chinese oil giant Sinopec (NYSE: SHI).
The transaction is the latest in a series of asset sales that the struggling natural gas producer has conducted since last year. With its precarious debt situation exacerbated by depressed prices for natural gas, the company continues to face a daunting funding gap for the year.
Though the Sinopec joint venture will bring in $1.02 billion in cash, of which the majority will be received upon closing, many analysts have pointed to the deal's disappointing metrics. One of the biggest letdowns was the fact that Chesapeake received a little less than $2,400 per acre for its Mississippian acreage – a fraction of the value the company said the land was worth in a presentation last year.
But beyond the much lower than expected price, there are two other aspects of the deal that are both interesting and revealing. Let's take a look at both and then conclude with ways to invest around the latter theme.
No drilling carry
As Morningstar analyst Mark Hanson points out, the Chesapeake-Sinopec deal marks the first joint venture transaction that Chesapeake has ever done without a drilling carry. The term "drilling carry" refers to an accounting arrangement often used in oil and gas joint ventures, whereby one company acquires a working interest in another company's oil and gas property and agrees to fund drilling and other expenses related to that property for a predetermined length of time.
Consider Chesapeake's transaction with another major Chinese oil company a few years ago. In that deal, which involved the use of a drilling carry, China's largest energy producer, CNOOC (NYSE: CEO), purchased a one-third undivided interest in a portion of Chesapeake's net leasehold acreage in the Eagle Ford Shale.
Under the terms of the deal, Chesapeake remained the operator of the project and was responsible for all leasing, drilling, completion, operations, and marketing activities related to the project. However, subject to Chesapeake paying CNOOC an agreed upon $1.08 billion in cash at closing, CNOOC agreed to finance 75% of Chesapeake's share of drilling and completion expenses.
Not only is the absence of a drilling carry a departure from typical operating procedure for Chesapeake, but also for Sinopec. In previous transactions, the Chinese state-owned oil giant has often made an initial, upfront cash payment and opted to pay the remainder in the form of a drilling carry.
For instance, last year Sinopec acquired a third of Devon Energy's (NYSE: DVN) equity in shale gas properties located in the Niobrara, Utica, and Tuscaloosa Marine shales, as well as assets located in the Mississippian and the Michigan basin. The acquisition, which cost Sinopec almost $2.5 billion, made use of a drilling carry, allowing Sinopec to fund Devon's drilling expenses over a defined period of time.
Sinopec's motives
The Chesapeake-Sinopec transaction was also revealing in highlighting Chinese oil companies' motives in purchasing North American oil and gas assets. Contrary to what some might expect, Sinopec and other Chinese firms' main objective is not simply to acquire offshore assets to diversify their operations, but rather to gain the expertise and know-how required to efficiently produce gas from shale reservoirs.
There's a good reason for this; China may possess the world's largest shale gas reserves. According to its Ministry of Land and Resources, China could be sitting on a whopping 4700 trillion cubic feet of shale gas, with around 880 trillion cubic feet of that volume expected to be recoverable. By contrast, the latest projections by the U.S. Department of Energy estimate that the U.S. possesses just about 482 trillion cubic feet of recoverable shale gas.
Yet despite China's vast potential reserves of shale gas, Chinese companies have little to no experience in drilling gas wells. Of the sixteen Chinese firms that recently received exploration rights in the country's shale gas fields, not a single one has drilled a gas well before.
Drilling for shale gas is no easy task. It's a complex procedure that requires millions of dollars worth of sophisticated equipment and dozens of highly skilled personnel. Since Chinese firms lack the requisite expertise, one of their only options is to ask oil-field services companies for help, which creates lucrative opportunities for firms like Schlumberger, Halliburton, Weatherford International (NYSE: WFT), and National Oilwell Varco.
Ways to play the China shale gas trend
Executives at National Oilwell Varco have long recognized China's growing demand for shale gas equipment and technology as a major future growth opportunity for the company. In earnings calls going back to at least 2011, CEO Merrill Miller has emphasized the company's desire to gain first-mover advantage in China and other major markets in the years ahead.
Weatherford, which has a long history of presence in China, is also optimistic about future opportunities in China's shale gas market. As CEO Bernard Duroc-Danner explained in the company's most recent conference call, Weatherford's offerings in China will be shaped by two key considerations: developing the appropriate infrastructure to support its business, and offering its Chinese clients services that local and other foreign companies cannot offer.
Some of these companies have already put their chips on the table, having recently invested in Chinese oil-field services firms. For instance, Schlumberger paid about $80 million dollars last year to acquire a roughly 20% stake in Hong Kong-listed Anton Oilfield Services Group, while Halliburton entered into a strategic joint venture with China's SPT Energy Group.
The projected growth in China's shale gas market holds tremendous promise for these firms, especially since services for shale gas operations command higher rates due to higher levels of service intensity. Energy investors would be wise to track these firms' progress as they vie for contracts with Chinese shale gas operators and seek to capitalize on the expansion of China's shale gas industry.
