Drilling for Profits in China’s New Energy Frontier

North American shale isn’t the only high-stakes energy game around. China is sitting on vast shale reserves of its own and it’s determined to up the ante against other oil and gas producing countries. The Middle Kingdom also is drilling farther and deeper offshore.

To fulfill these ambitions, the world’s second-largest economy will need the expertise of experienced oilfield service companies—and that spells huge opportunity for Schlumberger (NYSE: SLB), the world’s largest oilfield services provider.

With main offices in Houston and Paris, Schlumberger’s services include offshore drilling and hydraulic fracturing, or “fracking,” a process whereby water, sand and chemicals are injected underground to loosen trapped hydrocarbons.

With a market cap of $120 billion and more than 23,000 employees around the world, Schlumberger is leveraging the growing prevalence of fracking, which has exponentially boosted energy production in North America. Now China wants to reap the benefits of fracking and Schlumberger is at the head of the line to help.

To be sure, an index of Chinese manufacturing growth released on January 23 registered an unexpected contraction, triggering a sharp drop the next day in global equity markets. But China’s demand for energy will remain strong into the foreseeable future, regardless of market fluctuations along the way.

Meanwhile, Schlumberger devotes considerable resources every year to research and development, a commitment to new technology that consistently attracts new clients.

On January 17, Schlumberger reported that fourth-quarter 2013 earnings rose 22 percent, as energy companies spent more money to search for unconventional deposits—notably in the “BRIC” nations of Brazil, Russia, India and China. The latter country stands out for its aggressive plans to expand domestic production this year and beyond.

Schlumberger’s earnings reached $1.66 billion, or earnings per share (EPS) of $1.26, up from $1.36 billion, or $1.02 in EPS, from the same period a year ago. Revenue rose 7.4 percent to $11.9 billion. The company hiked its quarterly dividend by 28 percent to $0.40 a share.

Growing revenue from Asia—especially China—helped drive Schlumberger’s stellar fourth-quarter performance. The company generates about two-thirds of its revenue outside of North America, the highest ratio among its top competitors, including Halliburton (NYSE: HAL) and Baker Hughes (NYSE: BHI).

Schlumberger also benefited in the quarter from greater deepwater drilling activity. The global energy boom and innovations in drilling technology are prompting energy companies to push into deeper ocean depths, providing steady demand for deepwater experts such as Schlumberger.

Global deepwater production is expected to reach 10 million barrels per day by the end of this year, accounting for roughly 12 percent of the worldwide total and up from less than 2 percent in 2002.

Meanwhile, fierce competition for contracts in North American oil and gas shale fields threatens the profit margins of the major oilfield service companies. Schlumberger, Halliburton, Baker Hughes and others are scrambling for their piece of the shale action in the US and Canada, making it harder for them to sustain growth. But Schlumberger has found a way around this obstacle, by focusing on new opportunities in emerging markets.

Among Schlumberger’s top priorities is to boost production of shale gas in China. The energy-hungry country holds an estimated technically recoverable reserve of more than 1,200 trillion cubic feet of gas, the largest of any country in the world (see chart below).


China is only one of three countries (the others are the US and Canada) to produce shale gas in commercial quantities. And yet, shale gas currently represents a meager 1 percent of China’s natural gas production.

Natural gas is adopting a starring role in the Middle Kingdom, as pollution there worsens. According to the World Health Organization (WHO), China is now the world’s largest emitter of greenhouse gases.

The WHO reports that the air density of fine particulate matter in many Chinese cities is reading well about 600 micrograms per cubic meter. Some readings have even exceeded 1,000; WHO has pegged the safe reading at 25 micrograms. This spreading health crisis is prompting China’s authorities to seek cleaner alternatives to coal and oil, such as gas.

Enter the Dragon

In China’s 12th Five-Year Plan (2011-15), the central government established the goal of hiking natural gas consumption to about 230 billion cubic meters (bcm) by 2015. That means China must enter more challenging environments to unlock new resources.

In 2012, the state-owned China National Petroleum Corporation (CNPC) and Royal Dutch Shell (NYSE: RDS-B) signed an agreement to jointly explore for gas in Sichuan province. Dubbed the US-China Shale Gas Resource Initiative, this partnership is assessing China’s shale gas potential and facilitating international investment in the country’s shale formations.

In 2013, China’s consumption of natural gas reached an estimated 100 bcm in 2013, representing a year-over-year increase of 15.4 percent. Greater shale exploration and production in China is boosting the country’s rig count as well as the average service activity at each rig.

China’s leaders have expressed the view that domestically available extraction technology is insufficient to fully develop in-country shale strata, paving the way for Schlumberger, which is entrenched in the country and already enjoys close collaboration with the country’s official energy entities.

China’s energy policy has helped lift the company’s stock price, as the chart below shows.


Despite the upward movement of its shares, Schlumberger’s trailing 12-month price-to-earnings (P/E) ratio is only 17.4, a good value compared to the trailing P/E of 22.4 for its industry of oil and gas equipment and services.

Schlumberger’s operations in China are well positioned for substantially higher demand. The company’s track record, combined with its footprint in China, provide it with a competitive edge.

The company currently operates in five major basins in the Central and Western part of China as well the Bohai Bay and the South China Sea. Schlumberger also has boosted productivity from shale gas fields in the Ordos Basin, the second-largest basin in China.

In the Ordos field, Schlumberger is working in collaboration with PetroChina (NYSE: PTR), China’s biggest oil and gas producer. A subsidiary of CNPC, PetroChina recently found a new and gigantic reserve of shale gas in Sinchuan province.

The confluence of these trends has prompted Schlumberger to peg China as the center of its worldwide operations. In 2013, the company opened its “Schlumberger Reservoir Laboratory” in Chengdu, China. The 32,000 sq. ft. facility is home to petrophysical and geomechanical services that are designed to maximize production throughout the life of the company’s China-based energy reservoirs.

Schlumberger also operates reservoir laboratories in Africa, Asia, Australia, Europe, North America and South America. The China lab is the newest and most advanced and is designed as a launching pad for expanded operations throughout Asia.

Schlumberger’s existing infrastructure and partnerships in China are unrivaled by its peers. The company should enjoy substantial multiyear growth in China, as economic development and a rising consumer class increase the country’s thirst for new energy sources.

John Persinos is editorial director of Personal Finance and its parent website Investing Daily.

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