China's Big Bet on Gas

A new pipeline may wean the country off coal and oil

In the arid reaches of China's northwestern Xinjiang region, the daytime temperatures can reach 48C. In spring, sandstorms swirl in, filling the eyes, ears, and throat with yellow grit. It's easy to see why locals call this desert Taklamakan, meaning "You can enter, but never leave." But despite the extreme heat and intolerable weather, a few kilometers outside the town of Lunnan, hundreds of workers in red overalls and matching hard hats are frantically welding together 10-meter-plus sections of pipe before the next sandstorm blows in and forces a retreat.

Their toil represents the starting point of a controversial Chinese megaproject that's second in scale only to Three Gorges Dam. When completed three years from now, the $18 billion West-East Gas Pipeline will stretch 4,200 kilometers--nearly two-thirds the length of the Great Wall--bringing natural gas from undeveloped Xinjiang to go-go Shanghai and, eventually, to countless villages and towns along the way. Beijing has great hopes for the pipeline. The government plans to double gas usage, to an annual 80 billion cubic meters, by 2005, and eventually use it to cut urban pollution by phasing out coal, wean China off imported oil, and jump-start growth in the Far West. Says Chen Li, a deputy director at the Economic Restructuring Office of the State Council: "Development of gas will be extremely rapid."

Perhaps. But the challenges are as daunting as the Taklamakan itself. The pipeline's main builders--mainland oil and gas giant PetroChina, Royal Dutch Shell, and Russia's Gazprom--are betting that China's hunger for energy will increasingly be fed by natural gas. It won't happen overnight: Coal now meets 68% of energy needs, gas just 2.4%.

Moreover, the project has its share of critics, who are girding for battle. They include environmental groups, which complain that the pipeline will pass through fragile ecosystems, and human-rights activists who fear Xinjiang's Muslims will not share in the pipeline's spoils. "We tell multinationals that investment in China may be important," says Mei Ng, director of Friends of the Earth (Hong Kong). "But we hope they balance this with socially, culturally, and ethnically sensitive projects that truly benefit local people."

For the pipe's builders, the immediate concern is ensuring that the project will pay off as soon as possible. "We're very much in the seed phase of developing the gas market in China," acknowledges Martin Bradshaw, managing director of Shell Exploration China Ltd. But, he adds, "we're here for the long term."

Much depends on whether enough demand for natural gas materializes in time. At current prices, the clean-burning fuel can cost twice as much as average-quality coal in China. Consumers in wealthy cities such as Shanghai and Beijing can probably afford gas. But the bulk of it, if all goes as planned, would go to such large-scale users as power plants and chemical factories. They are already hurting because Beijing has been cutting their subsidies. "If the industrial users can't afford the price, there will be no market for this gas," says a director at Shanghai Natural Gas Pipeline Network Co., the city's largest distributor.

Moreover, consumers ready to pay for gas may find cheaper stocks elsewhere. Already, China National Offshore Oil Corp. (CNOOC) has begun selling gas to cities like Shanghai and Tianjin. The company is charging 11 cents per cubic meter--5 cents less than the expected price for West-East gas. CNOOC has a cost advantage, says chief financial officer Mark Qiu, because much of its gas lies a couple of hundred kilometers offshore.

Even if PetroChina and its partners find enough buyers, they may face higher costs than expected. Indeed, it was the project's price tag that prompted British Petroleum, which holds a 20% stake in PetroChina, to pull out last year. While PetroChina says its transparent bidding and procurement process has already shaved 20% off estimated steel costs, the project faces unpredictable construction challenges. For instance, some 700 km of the pipeline will run through uninhabited areas where the partners will be forced to build access roads for workers and equipment.

Cost is a matter not just for the builders but for the central and local governments, too. To meet its ambitious targets, China will have to spend tens of billions of dollars over the next few years building thousands of kilometers of pipe off the main artery to supply markets all over the country. The government also will have to foot much of the bill to switch over to gas in houses, factories, and power plants--another multibillion-dollar undertaking. "The real costs are downstream, with the marketing and development of distribution networks," says World Bank energy expert Noureddine Berrah, who notes that such outlays usually run three to four times those of construction costs. Ultimately, analysts say, gas conversion expenses could reach more than $100 billion, much of it paid by the central, provincial, and local governments.

Despite all the challenges, PetroChina insists the project will make money after 10 years. The mostly state-owned company, which says it has already signed up 45 big customers, vows a 12% return on investment. In any case, the price of gas will fall as new customers sign up. Says PetroChina President Huang Yan: "We have great confidence in this project." For Gazprom, the pipeline represents a chance to eventually sell China gas from its Siberian fields and, says company spokesman Igor Plotnikov, "gain a hold in the [Chinese] market."

Shell executives express similar enthusiasm, saying that over the long term they expect the project at least to match the 15% returns on other international operations. It doesn't hurt that Shell won a 45-year contract, instead of the 30 years PetroChina originally offered, meaning that Shell has more time to recoup its costs. Moreover, the company is betting that the new pipeline will eventually carry gas from Central Asia and Russia. "The West-East pipeline is a pathfinder for future pipelines and gas from farther afield," says Shell China's Bradshaw. "Shell has interests in Russia and Central Asia. This is a strategic reason why we're interested in the pipeline."

In addition, PetroChina is virtually assured that Beijing will do just about anything to get the pipeline built. A measure of the government's commitment is its willingness to deal with--or at least pay lip service to--the environmental and social concerns swirling around the project. With Beijing's blessing, Shell and the U.N. Development Program will carry out an impact assessment aimed at making sure the pipeline will not harm people living along the route, including the Uighur Muslims of Xinjiang. Says Kerstin Leitner, the UNDP's Beijing rep: "The Chinese government wants to ensure the project really benefits" western China by providing jobs and other spin-offs.

Ultimately, Beijing sees the West-East Gas Pipeline as the backbone of its national energy plan. So the government is certain to offer PetroChina heaps of cheap financing, as well as waive land-use taxes in remote areas and tariffs on imported equipment. The pipeline "has enormous government support," says CNOOC's Qiu. The West-East pipeline is a fact of life--whether it is economically viable or not.

By Dexter Roberts in Lunnan, with Catherine Belton in Moscow

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