Docuent of The World Bank FOR OFFICIAL USE ONLY Report No. P-4237-CHA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$30.0 MILLION TO THE PEOPLE'S REPUBLIC OF CHINA FOR THE LIAODONG BAY PETROLEUM APPRAISAL AND TECHNICAL ASSISTANCE PROJECT May 5, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency Unit = Renminbi (RMB) $1.00 = Yuan (Y) 3.2 Y1.00 = $0.31 WEIGHTS AND MEASURES 1 cubic meter (CM) = 35.3 cubic feet (CF) 1 thousand cubic meters (MCM) = 35.3 thousand cubic feet (MCF) 1 million cubic meters (MMCM) = 35.3 million cubic feet (MMCF) 1 billion cubic meters (BCM) = 35.3 billion cubic feet (BCF) 1 thousand cubic meters of natural gas = 9.31 million kilocalories 1 ton oil equivalent (TOE) = 10.2 million kilocalories = 1000 kilograms oil equivalent (kgoe) 1 barrel (bbl) of 0.85 specific gravity crude oil = 0.135 ton 1 barrel (bbl) = 42 US gallons = 0.159 cubic meter 1 Megawatt (MW) 1 million watts 1 Terawatt hour (TWh) = 1 trillion watts/hour 1 meter (m) = 3.28 feet 1 kiLometer (km) a 0.62 mile 1 square kilometer (m2) = 0.39 square mile ABBREVIATIONS AND ACRONYMS BOC - Bohai Oil Corporation CNODC - China National Oil Development Corporation CNOOC - China National Offshore Oil Corporation CODC - Chengbei Oil Development Corporation Elf - Societe Nationale Elf Aquitaine GOC - Government of China ICB - International Competitive Bidding IOC - International Oil Company JCODC - Japan-China Oil Development Corporation LIB - Limited International Bidding MCI - Ministry of Chemical Industry MOPI - Ministry of Petroleum Industry SOE - Statement of Expenditure FISCAL YEAR January 1 to December 31 FOR OMCIAL USE ONLY CHINA LIAODONC BAY PETROLEUM APPRAISAL AND TECHNICAL ASSISTANCE PROJECT Loan and Project Sumnary Borrower: The People's Republic of China Beneficiary: Bohai Oil Corporation (BOC) Amount: $30.0 million equivalent Terms: 20 years, including 5 years grace, at standard variable interest rate. Relending Terms: Loan will he relent to BOC on the same terms and conditions as the Bark loan; BOC will bear the foreign exchange risk. Project Description: The primary objectives of the project are: to assist in the appraisal of BOC's oil and gas condensate discovery in Liaodong Bay in northeast China and in the planning and financing of an optimum program for its development; to help develop local capabilities in all aspects of offshore petroleum operations; and to strengthen China's position as a joint venture partner in these activities. The project comprises: (a) processing and interpretation of some 5,000 km of 3-D seismic data recently acquired in the project area; (b) drilling and testing of five appraisal wells and installation of offshore facilities to enable long-term production testing; (c) provision of equipment to strengthen BOC's data processing facilities, well testing and core analysis capabilities; (d) carrying out special tests, Laboratory work and a series of six studies to assist in the evaluation and future development of the discovery; and (e) training of BOC geologists and engineers in offshore operations among other special petroleum industry topics. Project Benefits and Risks: The appraisal program under the project will bring the level of knowledge about BOC's discovery to the point where a development decision can be made, and at the same time, will upgrade the level of information about the overall prospectiveness of the Liaodong Bay area. The project will further serve to develop a framework within which BOC could mobilize new equity participation by the international oil companies or other financial partners in the development of the present prospect and/or future exploration activities ThS document has a restricted distribution and may be used by recipients only in the performance of their official duties Its contents may not otherwise be disclosed without World Bank authorizaon. in Liaodong Bay where HOC has so far been operating on its own. Given that the four wells drilled on the structure to date have each tested oil and gas, the risk of not finding any reserves is considered small. The main risk is whether the discovery will prove to be commercial, particularly in light of today's declining oil prices. The project has been designed to minimize all potential technical risks by, for example, using modern seismic technology, drilling a sufficient number of appropriateLy tested wells, introducing qualified service companies and consultants, and cLosely monitoring all project activities. Despite the preliminary nature of the data available and apparent complexity of the reservoir, it is judged that there is a reasonable chance of recovering about 7 million tons of oil and nearly 6 billion cubic meters of gas (5 million TOE) in the event of development, which wouLd give an acceptable return under a reasonable range of long-run oil price scenarios. With the appraisal program under the project constituting less than 20% of the full development cost, the investment risk is considered warranted and, in fact, essential in deciding whether to proceed with development. - iii- Estimated Cost: Local Foreign Total ($ million) - 3-D seismic processing 0.3 1.4 1.7 Data processing equipment 0.3 5.5 5.8 Appraisal well drilling 25.5 17.6 43.1 Well testing/lab equipment 0.3 2.8 3.1 Studies and consultancy 1.4 7.5 8.9 Training - 0.8 0.8 Base Cost /a 27.8 35.6 63.4 Physical contingencies 2.7 3.4 6.1 Price contingencies 3.1 4.8 7.9 Total Project Cost 33.6 43.8 77.4 Interest during construction - 6.4 6.4 Total Financing Required 33.6 50.2 83.8 Financing Plan: Local Foreign Total _- (S million) World Bank loan 30.0 30.0 Untied bilateral credit /b (1.2) (13.8) 15.0 BOC /b (32.4) (6.4) 38.8 Total 33.6 50.2 83.8 Estimated Disburse- ments: Bank FY 1987 1988 1989 1990 ($ Tmillion) - Annual 5.0 10.5 12.0 2.5 Cumulative 5.0 15.5 27.5 30.0 Economic Rate of Return: Not applicable. Staff Appraisal Report: No separate report. Map: IBRD No. 19497R IBRD No. 19503 /a Includes duties and taxes of $3.6 million on imported equipment and materials not financed by the Bank. /b Breakdown of bilateral credit between foreign and local currency is tentative; BOC will finance the balances. REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE PEOPLE'S REPUBLIC OF CHINA FOR A LIAODONC BAY PETROLEUM APPRAISAL AND TECHNICAL ASSISTANCE PROJECT 1. I submit the following report and recommendation on a proposed loan to the People's Republic of China to help finance a Liaodong Bay Petroleum Appraisal and Technical Assistance Project. The loan for $30.0 million equivalent would have a term of 20 years, including five years of grace, with standard variable interest rate. The proceeds of the loan would be onlent to the Bohai Oil Corporation (BOC) on the same terms and conditions as the Bank loan; BOC would bear the foreign exchange risk. Cofinancing of $15 million equivalent (untied credit) has been agreed in principle by-the Export Import Bank of Japan. PART I - THE ECONOMY 2. A country economic report entitled, "China: Long-Term Issues and Options" (No. 5206-CHA) was distributed to the Executive Directors on May 22, 1985. Basic data on the economy are given in Annex I. Background 3. Since 1978, China has initiated economic reforms in both rural and urban areas and in the external sector. Reforms have been greatest in rural areas. Following some experiments with the abolition of collective farming in impoverished areas, the Covernment implemented a comprehensive restructuring of rural institutions based on various forms of the "production responsibility system". By 1983 the farm household had become the fundamental unit of management and production in agriculture, within a framework of collective or state ownership of land and major fixed assets. Reforms have not yet proceed- ed as far in the urban economy, but there have been significant changes in enterprise management and finance. The scope for collective and individual economic activities has been enlarged and state enterprises have been allowed greater freedom in production, pricing and marketing above their mandatory plan targets. State enterprises have also been allowed to retain some profits and investment projects have increasingly been financed on a loan rather than a grant basis. 4. In international trade and investment, China has promoted opening up to the rest of the world in recent years. Between 1978 and 1984, the share of exports to GDP nearly doubled to about 10%, a ratio similar to other large economies such as the U.S. and Brazil. Foreign investment has been encour- aged, first through establishment of four Special Economic Zones and signing of joint venture contracts for off-shore oil exploration, and more recently through cpening of several coastal cities to foreign investment. -2- Growth and Stabilization 5. Reforms have helped stimulate rapid development of the whole economy. Real GDP growth averaged 5% p.a. between 1978 and 1981 and 1OZ p.a. between 1981 and 1984. During these six years, per capita incomes in real terms more than doubled in rural areas and increased by more than 502 in urban areas. Agriculture has continued its remarkably strong performance, with gross agricultural output value (excluding rural industry and commerce) rising at nearly 11% p.a. between 1981 and 1984 and grain output at 8Z p.a. (reaching over 400 million tons in 1984). Cash crops and animal husbandry, stimulated by rising demand and attractive prices, have also grown rapidly. Gross indus- trial output value grew at over 10% p.a. over the same period, with heavy industry growing somewhat faster than light industry (12% p.a. vs. 9Z p.a.). If rural industrial output is included, total industrial output value grew at close to 12% p.a. in real terms between 1981 and 1984. The energy constraint on industrial growth was eased by rising coal output (8% p.a. between 1981 and 1984), renewed increases in crude oil production (4% p.a. between 1981 and 1984) and improvements in the efficiency of energy utilization (primary commercial energy consumption grew only 60% as fast as GDP between 1981 and 1984). Manufactured exports growth at 8Z p.a. between 1981 and 1984 was slower than during the 1978-81 period but it started from a much higher base and in the face of worsening world market conditions. 6. The Government continues to face difficulties in combining system reform and rapid overall growth with maintenance of economic stability. During 1979 and 1980, China experienced large budget and current account deficits combined with excessive investment and inflationary pressures. In response, a strict stabilization program was introduced in 1981 relying mainly on administrative controls on investment spending. The program slowed growth but also helped lower the budget deficit from about 5% of GDP in 1979 to less than 1% in 1981, reduce inflation to around 2Z p.a., and change China's external position to one of current account surpluses averaging nearly $4 billion during 1982-84. As a result, foreign debt and debt service ratios remained at low levels ($6.4 billion and 5.5% respectively in 1983) and China's foreign currency reserves (excluding gold) rose to $17 billion (over 7 months' imports) by mid-1984. 7. This comfortable balance oi payments position, achieved at the cost of drastic reductions in investment sp2nding and some recentralization of investment decisionmaking, disappeared rapidly during the course of 1984 and early 1985. Partly as a result of decentralization of decisionmaking and the lack of effective indirect levers, there was a rapid acceleration of invest- ment and consumption during 1984 and the first half of 1985 causing the economy to overheat. Real GDP grew by 142 during 1984, while average wages in state-owned enterprises rose by 20% and domestic credit grew by 36%. The retail price index rose by only 3% in 1984, but inflation is expected to be higher in 1985. Imports of capital goods increased from e4 billion in 1983 to over $7 billion in 1984, with most of the increase occurring in the second half of the year. There was also a rapid expansion in consumer goods imports. These trends continued during early 1985. As a result, foreign exchange reserves (excluding gold) had fallen to about $10 billion by July 1985 (equivalent to 3.1 months of exports), and the current account 3- deficit for the year is likely to be in the range of $10 billion. The Govern- ment has responded quickly by launching a strict stabilization program that includes further increases in interest rates as well as a series of adminis- trative directives governing bsnk credit and project approval. As a result, aggregate credit and demand as well as new import orders have begun to slow, though total imports will continue to rise as past orders are filled. Recent Reforms 8. The Central Committee of the Chinese Communist Party issued a major document on "reform of the economic structure" in October 1984. Recent reform developments have been fully in accordance with the directions indicated in the October decision: (a) state enterprises should be made fully independent units which pursue profits and are responsible for losses; (b) the scope of mandatory planning should be reduced and replaced by indicative planning while the focus of planning should shift from annual to medium- and long-term guidance planning; (c) a more rational price system should be introduced by reducing the role of state-controlled prices and increasing the role of "floating" and free market prices; and (d) the tax system should be improved, finance and banking should be reformed and a larger role should be given to indirect macroeconomic regulation through instruments such as tax, credit and pricing poLicy. 9. Rural reforms have continued to progress more rapidly than reforms elsewhere in the economy. There has been a remarkable spread of nonagri- cultural activities like processing, transport, and commerce. "Specialized households" (which concentrate on cash crops, animal husbandry, or nonagri- cultural activities) and pooling of capital by small groups of househoLds in various types of ventures are becoming increasingly common forms of economic organization in China's rural areas. Wholesale markets for some agricultural products have emerged. To encourage investment in land improvement and devel- opment, farming contracts between collective and peasant households for the use of land (which typically had been fixed for no more than 3-5 years) can now be extended to as long as 15-20 years. In early 1985, the system of agricultural procurement was changed. Previously the Government purchased quota output of grain and other crops at relatively low prices and stood ready to purchase all above-quota output at a higher price. Under the new system, procurement up to a certain amount (below former quota procurement) is based on contracts concluded voluntarily between peasants and procurement agen- cies. Prices for these purchases are based on the relatively high average price of past years. Output above the contracted amount must be sold by peasants directly on the free market, but the Government will intervene to purchase grain if the price falls to the original low quota procurement price. Thus a considerably larger portion of basic crop production will be produced for and traded on markets with flexible prices. 10. The momentum of urban reforms has revived, with significant progress on several fronts. In enterprise management, the focus has been on broadening and delineating the decisionmaking authority of urban enterprises. Profit retention now extends to virtually all state-owned industrial enterprises and to nonindustrial sectors like transport, commerce, construction, and other services. Urban collectives and individual enterprises, as well as a variety -4- of joint ventures between them and state enterprises, have grown rapidly (the number employed in urban individual enterprises rose from 150,000 in 1978 to 2.31 million in 1983). 11. In financial reforms, the most important new development has been the implementation of a profit tax system to replace profit remittances by state enterprises to the government budget. Though most enterprises have switched to this system, the benefits have been limited because of the application of a different effective tax rate for each enterprise, to offset the impact of distorted relative prices and other factors. Similar problems have resulted in the abandonment of an attempt to impose a fee or charge on the fixed capital provided to state enterprises by the Covernment, and they have hindered the shift from grant to loan financing of new fixed invest- ment. Financial discipline at the enterprise level remains weak, in spite of efforts to strengthen accounting and auditing systems and more strictly enforce existing financial regulations. 12. Some progress has been made with price reform. The majority of agriculture commodity prices were decontrolled even before the recent change in pricing and procurement of grain. Prices of many minor consumer goods are also set by negotiations between producers and conmnercial units. "Floating prices" (up to 20Z above or below official prices) are now allowed for many industrial producer goods (either for all output or for output above the mandatory plan target). Price adjustments for key energy products and raw materials (which in many cases are severely underpriced) and for subsidized basic consumer goods like grain and edible oil have proven more difficult to implement, hindered by th. potential impact of price changes on urban living standards and on the finances of energy-using enterprises. Nevertheless, some price rises have occurred (e.g., for coal and petroleum), and moreover the share of free market transactions, at largely uncontrolled prices, has increased in recent years. Gradually over time, and onLy partly as a result of conscious policy, a two-tier system is emerging; a large but shrinking share of the total supply of most important goods is subject to mandatory plan allocation and administratively set prices, while at the margin a substantial and 1,rowing share is allocated by the market mechanism, largely at flexible prices. This pattern may permit China to "grow out of the plan" in a rela- tively smooth transition, though there are obvious threats to this strategy arising from the strong incentive for arbitrage between planned and unplanned realms. 13. The Covernment recognizes the need to develop new tools of indirect macroeconomic management and has taken some steps to do so. The People's Bank of China was established as a separate central bank at the beginning of 1984, with its commercial banking functions taken on by the newly created Industrial and Commercial Bank of China. In 1985, new methods of credit planning and control were introduced and lower-level and specialized banks were given significant redeposit requirements. Interest rates (including deposit rates) were also raised in 1985, with some move toward unification of rates and development of a term structure resembling that in other countries. Technical transformation loans with a maturity less than one year and loans for working capital now carry the same 7.9% interest rate while loans of longer maturity carry higher rates, up to 10.8% for 10-year loans. However, interest rates on budgetary capital construction loans (formerly grants) remain low and there are a variety of directed credit schemes. On the external side greater use is now being made of the exchange rate. The old internal settlement rate was abolished at the beginning of 1985 and between January and end-October 1985 the rate against the U.S. dollar declined by over 13%. Despite these changes progress in developing new indirect levers of control has been slow. Recent difficulties in securing macroeconomic balance highlight the need to strengthen institutions and macroeconomic management tools (including monetary, fiscal, and exchange rate instruments) for a decentralized and more market-oriented economy. Long-Term Issues and Prospects 14. In September 1985 a national party conference adopted a proposal which will be the basis for drafting a new Seventh Five Year Plan covering the period 1986-90. The proposal reaffirms a political commitment to economic reform and provides guidelines for future reform and development. One of the main objectives of the plan will be to create a favorable environment for reform which, in turn, will set the stage for future development. Target growth rates (7% p.a. for industry, 6% for agriculture, a little over 7% for CNP) are below rates of growth achieved with the Sixth Five Year Plan, invest- ment is to be restrained in the next few years, and emphasis is to be placed upon quality rather than quantity of output. It is felt that slower growth will facilitate reform. 15. The plan proposal identifies three main areas of reform. First, enterprise management and incentives are to be improved by: giving enterprises greater autonomy in production, pricing, and employment decisions; lowering and equalizing taxes; increasing competition; increasing accountability for performance; and reforming personnel procedures. In addition, some small state enterprises will be turned over to collective or individual management through contract or lease. Second, the role of the market is to be extended and market networks strengthened. The scope of mandatory planning will be further reduced and markets for capital, technology, and labor will gradually be developed. Third, the emphasis of planning will shift from detailed admin- istrative control to indirect macroeconomic control through economic policy. To this end a series of mutually reinforcing reforms in the planning, pricing, fiscal, banking, and labor and wage systems will be introduced during the plan period. 16. Implementation of the plan proposal will help foster an environment in which fundamental reforms can be gradually implemented in a coordinated way. But specific policy measures will take time to design and then to imr'- ment. Many of the reforms required will be difficult, particularly since reforms in different areas are closely interrelated, and thus appropriate sequencing and coordination are essential. For example, price reform in the absence of improvements in enterprise financial discipline will have limited benefits, yet the more profit-oriented behavior that would result from tighter financial discipline would exacerbate the adverse impact of distorted prices. Similarly, reform of the labor allocation system will be incomplete without eliminating many of the "social responsibilities" of enterprises (which now provide housing, medical care, and pensions for their workers and -6- in many cases education and jobs for workers' children) and replacing them with Government-supported social service programs. The plan proposal suggests moving in this direction by commercializing housing. 17. China's objective of quadrupling the gross output value of industry and agriculture between 1980 and 2000 (which means GDP growth of well over 6Z p.a.) will require significant improvements in efficiency as well as continued high saving and investment rates. The plan proposal recognizes there must be major structural changes in the economy over the next two decades, including a reduction in the share of agriculture, a rise in the share of industry and services (which at present is unusually low), and substantial urbanization. There will also be a shift within agriculture, away from grain and basic crops and into cash crops and animal husbandry. The new plan will emphasize development of the service sector, mainly through removing restrictions on collective and individual activity. Urban development will focus on small and medium sized cities and towns while restrictions on growth of large urban areas will continue. 18. Certain physical/technical constraints will hinder the attempt to achieve China's targets for the year 2000 and its longer-term goal of catching up with developed countries. Despite rapid growth and substantial improve- ments in efficiency in recent years, agriculture may again become a constraint on overall growth, since land in China is severely limited. In energy, short- ages of fuel (primarily coal) and electricity may continue to constrain growth in transport and com-ercial infrastructure. Without large new investments and improved efficiency, economic growth will lag. In mobilizing resources in all these areas, China could profitably make use of foreign borrowing. Finally, the rising share of the elderly in China's population (related to the slowdown in population growth) means that more resources will have to be devoted to maintaining their consumption levels, especially in the decades after 2000. 19. Poo motivation and inefficient utilization of labor in the state sector of the economy are major problems which can be solved only by coor- dinated reforms in labor allocation, the wage system, enterprise management, and social services, among other things. Reforms in the system of education and training to develop China's "human capital" potential also are crucial. Backward technology and inefficient use of existing technology must be addressed by a combination of reforms, appropriately directed investment, and transfer of advanced foreign technology. Irrational location of factories, suboptimal scale of many plants, and poor utilization of physical capital in general are related problems. 20. If reforms successfully transform the economic system, with a bene- ficial impact on growth and efficiency, a new set of issues will come to the fore, as the plan proposal recognizes. Management of a reformed economy with indirect fiscal, monetary, and other instruments is a major issue (see para. 13 above). In this context, maintaining an adequate saving rate (if the Government no longer accounts for the bulk of aggregate saving) and avoiding inflation (as well as deep cyclical downturns) will be major goals. Assuring an adequate minimum standard of living for the population and an appropriate level of social services will become a major challenge as enterprise and rural communal responsibilities in these areas are reduced. The problem of poor, backward rural areas in various parts of the country will continue to require attention. Redistributing financial resources to these areas through the fiscal system, easing restrictions on migration out of the poorest areas, and lowering nonagricultural wages to make investment in them more attractive are some options for alleviating poverty. 21. In order to mobilize the external resources needed for rapid, sustained growth the plan proposal calls for export growth of 40-50Z over the next five years, greater efforts to attract foreign investment, and increased commercial borrowing. If exports grow at 8Z p.a. between 1984 and 1990 an: imports grow at 9% p.a., China would have a relatively modest current account deficit of around $4-5 billion p.a. during the remainder of this decade, equivalent to about 1Z of GNP. This implies that the present debt service ratio would increase only moderately by 1990. If China's exports grow more slowly, imports will probably have to be cut back because a higher borrowing target, though feasible in terms of debt service indicators, would probably run into supply constraints as China would become one of the largest developing country borrowers. This highlights the need for continued export growth in order to meet other plan objectives and service greater comxercial borrowing. The plan proposal recognizes that greater use of exchange rate and pricing policies will be needed to encourage export growth. 22. Even with continued good export performance, China will have substantial external capital requirements during the remainder of the decade. Under the trade growth assumptions outlined above (exports growing at 82 p.a. and imports at 92 p.a. during 1984-90), the current account deficit would be over $5 billion in 1990 and the gross borrowing requirement would be about $6.5 billion. If export growth fell to 6% p.a. during this period and imports continued to grow at 9% p.a., the current account deficit would reach $14 billion by 1990. Although the plan proposal calls for increased borrowing at commercial rates, access to concessionary capital will play an important role in sustaining China's growth. China also has a claim to concessionary lending because it is still one of the poorer countries of the world. But China's access to concessionary capital for financing development and modernization is limited; apart from Bank Group funds, a significant amount of concessionary capital is likely to come only from Japan and a few other bilateral donors and will probably average no more than $500-600 million p.a. during the rest of the 1980s. PART II - BANK GROUP OPERATIONS 23. To achieve the target growth rates envisioned in the Seventh Five- Year Plan, to increase efficiency, and to maintain equity in distribution, China will need continuing economic reforms. China will need to import more technology, increase trade, and expand investment. In the next few years, therefore, the Bank can best assist China by increasing its access to foreign technology and capital and supporting the implementation of reforms that will help to increase the efficiency of resource use and reduce poverty. -8- 24. To address China's objective of updating technology, the Bank will play the role of an intermediary. In transportation, energy, industry, agriculture and social sectors, the Bank will contribute to technology transfer by bringing the Bank's experience to bear on project design and implementation and by helping China to seek appropriate technical solutions through international competitive bidding, training, and foreigr technical assistance. 25. Bank assistance will be closely linked with the Government's reform efforts. There are five major elements common to both rural and urban reform in China that will be the focus of the Bank's involvemenc. First, institu- tional change, involving both the separation of economic and administrative functions and further decentralization of decisionmaking, will extend to every sector in which the Bank is involved. Second, financial sector reform, primarily development of financial institutions, has become a focus of Bank assistance. Third, improving planning and project analysis will be critical to reform in sectors such as agriculture and industry, where decisions are now being made by households and independent enterprises, as well as in infrastructure where direct government involvement will be required. The Bank will therefore continue its emphasis on introducing appraisal methods and financial planning as well as analysis of intersectoral issues. Fourth, the Bank will be involved in the Government's major program of price reform and development of indirect levers such as control via money, credit and fiscal policies. And finally, the Bank will support reforms in health, education and other social services and measures, in particular, to address the problems of poor regions. Economic and Sector Work 26. The Bank's economic and sector work in China aims at expanding the understanding of the structure and direction of the Chinese economy and introducing to the Government new tools of economic management. This work provides a foundation for Bank Group lending and for the dialogue with the Government on development options and policies. Past work has included two major economic reports, studies on sectoral investment analysis and planning, and collaborative research with Chinese institutions. The Bank has also organized seminars on macroeconomic and sector issues. 27. Over the next two years, the Bank will carry out a large program of studies to follow up on issues identified in the most recent economic report. In this program, the Bank will examine alternatives for developing the financial system, foreign trade and investment. It will also analyze issues of intersectoral investment coordination and development of resource- poor regions. One such study is already under way in Gansu province to formulate programs for increasing interregional resource flows, improving the efficiency of investment and reducing poverty. Research on urban development, transport planning, and regional industriaL development will also be under- taken to form the basis for project preparation. Collaborative studies with Chinese research institutions will continue. An ongoing study of management and guidance of state-ownedi industrial enterprises will be followed by a study of collective enterprises, which are expected to become increasingly important industrial organizations in the reformed system. -9- Lending Operations 28. Since China's change of representation in the Bank Group in May 1980, 37 projects involving lending of $3,709.9 million to China have been apDroved. Of the projects, twelve have been in the agriculture sector, seven in energy, six in transport, four in industry, four in education, two in technical cooperation and one each in health and water supply. In FY85, IFC made its first investment in China of $17.02 million in automobile manufacturing. Annex II contains a summary statement of these loans, credits and IFC investment as of March 31, 1986. 29. In addition to the proposed project and the already approved second rural credit, third industrial credit, second technical cooperation, provin- cial universities, third railway, port development and fisheries projects, we expect to present to the Board this year two power projects and a health project. For FY87 and beyond, we expect the lending program for China to continue to grow from current levels. Infrastructure projects in energy and transport will remain priorities. Technical renovation of enterprises, particularly in industry, will be given greater attention and support as will the regional approach to project development, now being used to assess the needs of Cansu province. 30. In the energy sector, future Bank lending will be aimed at improving efficiency of energy consumption and expanding energy production. For example, in the coal subsector, we will assist in upgrading the facilities and operations of existing mines and in transferring improved technology for mines under construction or in operation. In power, we will assist China in tech- nology transfer, staff training and institution building. Through a power tariff study, we will seek to introduce a tariff system based on marginal cost and to increase the awareness of the need for a nationwide power system devel- opment progre-. In the petroleum subsector, the rationale for project involvement will lie in the identification, packaging and transfer of specialized technologies as well as in the strengthening of investment plan- ning and management capabilities. 31. Future transport projects will both upgrade technology and strengthen institutions. In roads, major changes in organization and financing will be required as a result of administrative decentralization and introduction of the production responsibility system in rural areas. In rail- ways, we will focus on technologies to improve domestic production of railway equipment and materials in addition to our work on line construction and electrification. We also intend to broaden our involvement in ports to include coastal shipping and inland water transport. For all transport subsectors, we will support efforts to improve financial analysis and investment planning. 32. Agriculture lending will focus on developing institutions to provide services to individual farmers and to monitor and stimulate change in the pace and pattern of agricultural development. The shift from grant to loan finance and the increased autonomy of the rural banking system will be supported through rural credit projects. We will continue to assist with the training, research, extension, and other service activities of the ministries concerned - 10 - with agriculture. In addition, we expect to finance programs for specialized agricultural development such as livestock and fisheries, and for irrigation and area development. 33. Bank lending in industry, as in agriculture, will focus on strength- ening of financial intermediaries which provide credit to state and collective enterprises. In addition, we expect that there will be large regional projects in fertilizer, cement and machine tools and other subsector projects concerned with upgrading technology and improving organization and management. 34. Bank lending in education will gradually be broadened beyond the present concentration on higher education. For exampLe, we will finance vocational and technical education which is now being given great emphasis in China. In view of the Government's recent decision to universalize access to primary and lower secondary education, another major aim of education lending will be to assist with basic education, particularly in poor rural areas. In this context, support for teacher education will be given priority. 35. Project preparation in the urban sector is currently concentrated in Shanghai *n efforts to improve services, especiaLly in environmental upgrading and housing, and development of municipal institutions. Future lending is expected to include support for development of medium-size and small urban areas in specific provinces. In addition, we expect to continue lending for rural water supply. Bank lending in health will provide access to new medical technologies for more efficient health care in both the lingering problems of communicable disease, primarily in poor rural areas, and the emerging problems of chronic disease. This will involve further support for medical training and planning and management of service delivery systems. Projects will also support the reform of systems for supplying and financing health services. 36. Cofinancing with multilateral and bilateral agencies has been arranged for projects in coal, power, agriculture and rural water supply and will remain a feature of our assistance program. We will explore further options for cofinancing with export credit agencies. Commercial bank cofinancing and the use of B-loans also appear viable, particularly as China increases the overall volume of its foreign borrowing. In technical assist- ance, we will continue to incorporate into projects components for training, overseas study, and access to foreign expertise. In addition, we will be the executing agency for a second UNDP umbrella project in China. EDI activities remain an important element of the Bank's program and in coming years will provide an extensive program of policy seminars for senior Chinese officials, and economic and financial management courses and sector-specific training for officials from core and line agencies. Implementation 37. Project implementation is generally proceeding well. Most project agencies, as well as the Ministry of Finance and the State Planning Commission, have established and staffed offices to handle Bank projects. Disbursement performance has also been satisfactory. Special accounts have been established for a majority of the approved projects and have helped to speed disbursements. In October 1985, the Bank opened a resident office in - 11 - Beijing to support further expansion of the lending program, accelerate project preparation, improve project implementation and further economic and sector work. PART III - THE ENERGY SECTOR 11 Energy Overview 38. China's commercial energy sector is dominated by coal and oil. While coal is the most important energy source, comprising about 70% of commercial energy consumption today, oil has also become important, accounting for about 18Z of commercial energy use and 20% of export earnings in 1984. China now exports about 20% of its oil production and 1Z of its coal production. Natural gas, hydroelectric power and limited quantities of shale oil and geothermal power supply the balance of domestic demand for commercial energy. Non-commercial resources (biomass) provide-energy equivalent to about 40X of China's domestic supply of commercial energy. 39. China's achievement in developing its energy resources over the last three decades has been remarkable. During the period 1952-84, annual production of coal increased from slightly over 60 million to 760 million tons, oil from 0.1 million to 114 million tons and electricity generation from 1.3 to 377 TWh; total production of primary commercial energy grew at an average annual rate of 9% over this period. If China is to maintain a high rate of economic growth in the future, it will need to continue to increase significantly the production of all types of energy resources although the growth rates will be substantially lower than in the past. For the petroleum industry in particular, this presents a major challenge, since the largest onshore oil fields have either reached or will soon reach their peak production rates, and although there have recently been some encouraging oil discoveries offshore, they have yet to be declared commercial. In addition, serious sectoral constraints which exist in various aspects of technology, logistics, management and financing need to be overcome. 40. Because of these constraints, adequate energy supply may become a serious obstacle to further economic growth for the remainder of the century, unless measures are taken to improve the efficiency of the sector both in terms of discovering and developing new sources of supply and in terms of energy conservation and demand management. This will require improved long- term planning and intersectoral coordination as well as increased reliance on market forces to provide incentives to producers and to control demand. The Government in its Sixth Five-Year Plan (1981-85) accorded high priority to the development of two inter-related sectors, energy and transport, and these 1/ dditional information on the energy sector is given in Chapter 4 (Energy Development) and Annex C (Energy) of the recent economic report China: Long Term Issues and Options, issued May 22, 1985 (Report No. 5206-CHA). - 12 - objectives will continue to be emphasized in the Seventh Five-Year Plan (1986-90). 41. Resource Endowment. China is well endowed with primary energy. Its coal and lignite reserves, believed to be the largest in the world, are concentrated largely in the north and northeast which have about 70% of the country's total reserves (estimated at over 640 billion tons). Future plans call for still further increases in coal production and pose serious challenges for transportation development as well as for upgrading and modernization of coal production, beneficiation and utilization technology. Biomass fuels, primarily fuelwood and crop by-products, are the second most important source of energy in China and are the dominant source of household fuel in the rural areas. Recoverable reserves of oil are estimated at 6-15 billion tons onshore and another 3-10 billion tons offshore. Recoverable reserves of non-associated gas are currently estimated at about 85 billion cubic meters (BCH), about 90% of which are located in the Sichuan Province; associated gas reserves are additionally estimated at just over 40 BCM. However, the 125 BCM of currently known gas reserves (about 115 million tons of oil equivalent (TOE}) could be only a small fraction of the full potential; recent gas discoveries onshore in the North China Basin (at Zhongyuan) and offshore in the South China Sea and Bohai Gulf, as well as potential future discoveries, are likely to augment significantly the present estimates. Unofficial estimates of oil shale in China place reserves at about 400 billion tons, with current production from two mines amounting to about 300,000 tons per year. 42. China's hydropower potential, among the largest in the world, is estimated at 1900 TWh annually, of which only 87 TWh have been developed to date. A major constraint is that the bulk of the undeveloped potential is in four major basins in the southwest and northwest where large-scale development would require transmission distances of 1200-1500 kilometers to major industrial load centers. The known uranium reserves in China are sufficient to sustain 15,000 MW of nuclear power generation for 30 years. Although potential sources of high temperature geothermal energy are abundant in the mountainous southwestern part of the country, their development has not been extensive and their role is likely to remain limited due to their distance from major load centers. 43. Efficiency of Energy Use. Total commercial energy consumption in China in 1984 reached 485 million TOE or about 470 kilograms oil equivalent (kgoe) per capita, which is somewhat above the average for developing countries (425 kgoe in 1983). China's consumption of energy per unit of GDP is well above that of any major developed or developing country. Several factors contribute to this high intensity of energy use in China, among them the high share of industrial output in GDP, structure of industrial produc- tion, scale of industrial plants, raw materials used, technology employed and current industrial organization and operating practices. 44. In the late 1970s, it became evident that this high rate of energy consumption could not be sustained. To date, the Government has relied principally on a series of administrative measures to promote efforts to improve energy efficiency, including tightening of energy supply quotas, - 13 - provision of energy conservation bonuses, and creation of conservation centers to provide technical assistance to units in adopting energy efficient measures and technology. Coupled with changes in industrial structure, the result to date has been an impressive improvement in the overall level of energy effi- ciency in China: after increasing steadily during 1970-77, primary commercial energy consumption per unit of gross value of industrial and agricultural output (GVIAO) has been dropping since 1978 at an average annual rate of nearly 5%. However, the task of fine tuning the current system to provide suitable economic signals to consumers and incentives for further improvements in efficiency will be increasingly difficult. In order to achieve further energy savings, it will be necessary to move from the current system of administrative controls toward a more flexible allocation system, which provides more autonomy for individual entities and increasingly relies on an energy price structure which reflects the relative scarcity of each source of energy. It will also be necessary to continue to replace outdated energy- intensive technologies and to further improve the use of energy-intensive goods and thereby adjust the structure of industry away from the energy- intensive sectors. Oil and Gas Subsector 45. After declining in 1980-81, China's oil production has climbed to 125 million tons in 1985, with notable increases of 8% in 1984 and a further 9% in 1985, particularly in the Shengli area; China exported an estimated 35 million tons of its domestic production in 1985, making it the largest oil exporter in Asia. These increases in production have been attributed to a combination of: (a) improved field productivity brought about by means of an intensive campaign of infill drilling and well stimulation; and (b) the discovery of new fields in established oil producing provinces through a successful program of drilling on the periphery and continuing exploration in the vicinity of producing fields. While the initial results have certainly been promising and it appears there may be more scope than previously expected for further production increases in some of the newer fields and maintenance of production in others, the investment requirements will be substantial. Moreover, over the longer term and certainly in the 1990s, sustained or increased production will depend on new oil discoveries, which in turn will require stepping up the level of exploration in prospective areas both offshore and onshore. 46. China's production of natural gas has also shown some increase in recent years, about 2% a year since 1982. Although China produced 12.7 BCM of natural gas (about 11.6 million TOE) in 1985, this was some 12% less than its peak production in 1979. About half of the natural gas produced is non- associated gas, 902 of which comes from the Sichuan Basin where production has fallen by nearly 20% over the Last 5 years and rehabilitation measures to arrest the decline are presentLy under evaluation; the recently approved Bank loan for the Weiyuan Gas Field Technical Assistance Project (Loan No. 2580- CHA) is helping to support this effort. While most past exploration has been directed toward the discovery of oil, the Government now recognizes that natural gas could contribute significantly to domestic energy supply and is starting to re-evaluate its policies toward gas exploration and development. In particular, the Government is actively considering the development of a - 14 - domestic market for its recent gas discoveries both onshore and offshore, which suggest a reasonably encouraging long-term prognosis for diversification of gas supplies, provided a number of complex institutional issues, including pricing, can be overcome in the near future. 47. Exploration and Production Strategy. Continuing to increase production of oil and gas will require a very large and sustained effort in exploration and production in China. This calls for a three-pronged approach on the part of the Government: (a) to formulate and promote major new initiatives in exploration both offshore and onshore to identify new reserves which could be brought into production in the next two decades. This would require, in addition to current policies, a more systematic evaluation of China's geological potential and a more aggressive exploration strategy in areas which are difficuLt geographically and geologically; (b) to continue exploration around the presently producing oil and gas fields and undertake a series of well-balanced infill drilling, rehabilitation and enhanced recovery programs in these fields to ensure recovery rates comparable to those obtained in the Western hemisphere; and (c) to better assess the potential of gas prone areas and promote gas market development in those areas where reserves have already been discovered. Difficult as the task may be, the Government has made considerable progress toward establishing an appropriate policy framework and has taken important steps to achieve the first two objectives by opening up the offshore and more recently some onshore areas to foreign oil companies and by introducing advanced technology and modern exploration/production practices and management structures in the regional petroleum bureaus which manage the existing oil and gas fields. Considerable work and policy development nevertheless remain to be done to ensure efficient exploration, development and marketing of natural gas. 48. Since 1979 when China first began to open up its offshore for exploration by international oil companies (IOCs), production sharing contracts have been concluded for 31 areas (as of early 1986); these include 23 contracts from the two rounds of bidding (initiated early 1982 and late 1984), 3 extensions of first round contracts and 5 bilateral contracts negotiated during 1980-82 (for which 2 small oil developments in the Bohai and Beibu Gulfs are now underway). Until the recently announced oil discoveries in the Pearl River Mouth Basin (Phillips/Pecten and Agip/Chevron/Texaco), however, the results of the IOCs' exploration efforts had been generally disappointing, the main encouragement having been the Arco gas discovery in the South China Sea and several tests/shows of oil and gas in wells drilled. Under Governmental regulations established in 1982, the IOCs bear the cost of all exploration investment and accompanying risks, and once a commercial discovery is made, the foreign contractor and China Na onal Offshore Oil Corporation (CNOOC) invest jointly in its development.- An important difference in the contract terms between the two rounds of bidding was the elimination (in the second round) of the 12.5% royalty on fields producing less than one million tons per year. The Chinese have also demonstrated 2/ CNOOC was also created in 1982 to invite/evaluate bids and enter into offshore petroleum agreements with the IOCs. - 15 - flexibility in the extensions of some of the first round contracts whereby the IOCs have apparently been able to shift exploration drilling comitments to prospective areas outside their original blocks. The bids for the second round are currently being evaluated, and although four contracts had been concluded by the end of 1985, continuing flexibility in contract terms/work requirements will be an important factor in the successful conclusion of further contracts during this period of declining oil prices and limited availability of risk capital for exploration in the oil industry. It never- theless seems clear that China is keenly interested in maintaining a high level of activity offshore and that its comitment to an open-door policy is a long-term one; in fact, CNOOC has recently indicated that more rounds of bidding can be expected and that it may also be willing to discuss some areas which have not been formally demarcated. 49. In the interest of accelerating its onshore exploration program as well, but recognizing its own budgetary and technical limitations, China Announced in March 1985 that it intended to make available to foreign oil companies onshore acreage in 136 sedimentary basins covering about 360,000 km2 in 10 southern provinces. The China National Oil Development Corporation (CNODC) has been formed in parallel to CNOOC to handle onshore activities with the IOCs, and data packages have already been made available on some areas within the opened provinces. By end-1985, one onshore contract (Hainan Island) had been concluded and others were under discussion. It appears that, at least initially, the formulation of contractual and operational particulars for the onshore areas will be handled through individual negotiations with interested foreign parties rather than through the more formal bidding rounds used for the offshore. Expediency and flexibility in negotiating terms suited to each particular area are cited as the primary reasons for this decision, although it is also expected that CNODC will deveLop some form of general agreement as a basis for negotiations. While the onshore area opened to date is large, virtually unexplored and geologically interesting, it is the north- western part of China which is considered to be highly prospective and of particular interest to the industry; the Chinese are apparently considering opening parts of the northwest as well but logistics remain a major constraint. Energy Pricing 50. Energy in China continues to be largely allocated administratively, with market forces playing a secondary role. In general, prices for energy allocated under the State plan are not set according to international prices and are low in relation to economic costs, with the exception of certain petroleum products and electricity for residential consumers. It should be noted, however, that comparisons of these prices in China with international prices are extremely complex and must be interpreted with caution, particu- larly because of difficulties in analyzing energy prices in isolation from domestic prices of other commodities and uncertainties about the level of the exchange rate appropriate for such comparisons. Improvements are being made by permitting market-related prices for above-quota fuel supplies which give - 16 - more appropriate signals at the margin to their producers and users.3/ Nevertheless, under the present pricing structure, while significant economic rents are generated from some fuels (e.g., oil), average operating costs are barely covered for others (e.g., coal). The Government is well aware that some energy products are under-priced and significant progress has been made during the past few years in movement toward prices reflecting full ecouomic costs, particularly in the case of coal. Moreover, the Government is planning a general reform of the price system, although the first priority for reform is consumer goods (e.g., agricultural products) and only later industrial products prices. Rationalization of energy prices to increasingly reflect economic costs will continue to be an important aspect of the Bank's ongoing dialogue with the Government. 51. A summary comparison of domestic petroleum prices with international prices is given in Annex rv. Since the 1983 increase in domestic product prices, gasoline prices have generally been at or above international prices, and the prices of kerosene 1ad diesel oil have been in the range of 80-90% of international price levels.- With the recent sharp decline in international oil prices, domestic prices of all three fuels are presently well above inter- national levels. The prices of crude oil and fuel oil, on the other hand, have remained considerably below the international level, although since 1982 a special tax of Y70/ton has been levied on both when used as fuel; moreover, above-quota crude/products production and consumption are priced at inter- national levels. As for natural gas prices, the wellhead price of both associated and non-associated gas was standardized at Y50 per thousand cubic meters (MCM) until 1982 when the price of non-associated gas in Sichuan was raised, first to Y80/MCM and then in 1984 to Y130/MCM (about $41/NCM or $1.15/MCF). Because of the Government's interest in accelerating gas develop- ment, it appears that consideration will now be given to such increases for new gas projects on a case-by-case basis until broader adjustments can be made within the loqger term price reform. In equivalent calorific terms, the end- users price .' of gas in Sichuan is about 20% higher than that of fuel oil and 2-3 times the price of coal, the main alternative sources of fuel for indus- trial use, but is significantly below prevailing prices of light petroleum chemical feedstocks. This is consistent with the Government's policy to accord priority to feedstock over fuel uaage in rationing the presently scarce supply of natural gas. 3/ That is, the producer receives a higher, market-related price for goods he produces above his production target, and the consumer must pay a higher, market-related price for goods he consumes over and above his allotted consumption. 4/ Although the Yuar has been devalued since the 1983 increase in domestic product prices, this has been offset to some extent by the gradual decline in oil prices on the international market in recent years. 5/ Including a gas distribution fee of about Y40/MCM. - 17 - Institutional Framework 52. The Ministry of Petroleum Industry (MOPI) generally oversees all activities in the oil and gas subsector, including policy making and overall planning, exploration, development, production, transportation, distribution, research and design, and training. Responsibility for the country's onshore oil and gas fields is divided regionally among several administrative bureaus under MOPI, while CNOOC and CNODC have been created as corporations attached tc the Ministry with responsibility for entering into petroleum agreements with the IOCs for the offshore and onshore concession areas, respectively. The organization of the petroleum industry has been in a state of nearly continuous change since the 1970s which has resulted in some blurring of lines of responsibility and considerable overlapping of functions among MOPI, the Ministry of Geology and the Ministry of Chemical Industry (MCI). To address some of these problems, the Petrochemical Corporation of China (SINOPEC) was created in September 1983 with responsibility for most petroleum refining (plants -with capacities of 1 million tons or more a year) and petrochemicals production based on liquid petroleum feedstocks; MCI handles those petro- chemical plants using natural gas and coal as feedstocks and the remaining small-scale petroleum r.pfineries. As a further step toward strengthening the planning and management of the gas subsector, the Natural Gas Corporation was created under MOPI in 1984 but has so far directed most of its attentiou toward gas supply issues; integrated planning of gas supply and use remains an area where greater intersectoral coordination is needed. 53. CNOOC, formed on February 15, 1982, has been given the exclusive right to explore, develop, produce and market offshore oil and gas resources in cooperation with foreign enterprises; in addition to signing contracts with IOCs and directing/organizing its regional branches and specialized affiliates in implementing these contracts, CNOOC's rights include making plans/organi- zing projects for downstream utilization of offshore petroleum, assisting its subsidiaries/affiliates in arranging contracts with foreign partners for supplying oil field equipment and services, and raising financing for offshore petroleum exploitation for which present government policy is to provide only limited budgetary resources. Although CNOOC comes under the leadership of MOPI, it holds the rank of a bureau directly under the State Council. It has a registered capital of Y6 billion, of which Y1.8 billion had been paid in by end-1984, and pays income taxes like any foreign oil company in China. In addition to its rour regional corporations (Bohai, South Huanghai, Nanhai East and Nanhai West Oil Corporations), CNOOC has numerous specialized corporations and joint venture companies (with foreign/Chinese partners) providing services (e.g., drilling, geophysical, well logging, offshore positioning, mud logging, vesseL services) to the offshore industry. The Bohai and Nanhai West Oil Corporations existed before CNOOC was created and carry out a limited amount of exploration on their own in the Bohai and Beibu Gulfs, respectively, in addition to their joint venture operations with the IOCs. The Bank has found the overall institutional arrangements for offshore petroleum exploration &nd development activities in China to be generally satisfactory, and CNOOC's own organization and involvement in the o'fshore in particular to have worked well to date. - 18 - Sectoral Lending Strategy and Role of the Bank 54. China's petroleum industry is in transition. It has depended so far on a limited number of large fields onshore which have been exploited success- fully in spite of some harsh climatic and geographical conditions and the technological constraints of the Chinese. While the prospect for significant new discoveries outside of established oil producing provinces is still good, they are likely to be located in more remote areas (northwestern China) and will take a long time to explore and develop. It is, therefore, unlikely that discoveries of this kind onshore will contribute significantly to China's oil supply in the next 5 to 10 years. Moreover, offshore exploration, which has been very active over the past four years in China, has not yet produced any sizeabLe discoveries although two consortiums have recently announced what could be commercial oil finds. The contribution of the offshore to China's oil production will also not be of significance until the 1990s. 55. In the near to medium term, therefore, China has to rely on already discovered reserves to meet its internal requirements and to generate an export surplus which wouLd continue to provide a sizeable source of foreign exchange. At the same time, it has to encourage exploration by both private and public sector companies to ensure that new discoveries will replace existing reserves when they are depleted. The policy followed by the Government is responsive to these needs: (a) Over the past 5 years, China has encouraged, and plans to continue to encourage, offshore exploration by international oil companies through innovative contract arrangements and a flexible approach to contract terms; (b) China has recently opened onshore areas, on a limited scale, to foreign exploration and is considering opening up the large unexplored basins in the northwestern part of the country; (c) MOPI, over the last several years, has undertaken a program of modernization of the petroleum bureaus and has promoted the introduction of modern concepts and technology in oil exploration and production to ensure that already producing basins are fully explored and recovery from existing reserves is maximized. These efforts have already yielded results, and oil production has increased from about 101 million tons in 1981 to 125 million tons in 1985; and (dj More recently, MOPI has started to place increased emphasis on the development of natural gas, which has played only a minor role in energy supply in the past, but whose potential as a domestic source of energy appears promising. The Government's strategy in the sector has been pragmatic and, despite some operational problems, largely successful. 56. Over the past four years, the Bank has supported the Government's petroleum strategy, primarily in the modernization of onshore production, by - 19 - assisting several bureaus in their efforts to introduce modern technology and management techniques and to develop new exploration concepts. The main objective of the Bank in four successive operations (Loan Nos. 2231, 2252, 2426, 2580-CIA) was to review development plans, suggest alternative approaches to both exploration and production methods and develop technical assistance packages which would address the main conceptual, managerial and technological gaps and expose the Chinese oil industry staff to state-of-the- art techniques. To the extent possible, the technical assistance packages were designed to be replicable under similar circumstances in order to encourage cross fertilization. In addition, the Bank's involvement in project identification, preparation and implementation has helped to introduce China's oil field entities and MOPI to improved methods of project analysis, invest- ment programming and monitoring of project implementation. 57. In parallel, through informal discussions, seminars and one project, the Bank has also increased the awareness of the Government to the potential of natural gas outside the present main producing area (Sichuan). Increased attention is now being directed toward more fully utilizing the associated gas and exploring for and developing non-associated gas resources in several of China's onshore oil fields. In the case of natural gas, the main objectives of the Bank are not only technical but also institutional, particularly in such areas as gas market development, rationalization of pricing and regional planning of development (since it is much too early for gas to be considered on a national scale). The Bank has been instrumental, for example, in convincing CNOOC that the offshore gas discovery in the South China Sea could be developed to serve the domestic requirements of southern China. 58. Over the past two years, the Bank has maintained an active dialogue with CNOOC, although no project was financed offshore. The main areas of discussion were gas utilization and the need for CNOOC to plan for the large financial requirements which would be needed to meet its obligations in the development of offshore resources. The presently proposed technical assistance and appraisal project for CNOOC's regional corporation, the Bohai Oil Corporation (BOC), will be the Bank's first operation with CNOOC. BOC has discovered what appears to be an oil and gas condensate field in the northern part of the Bohai Culf (Liaodong Bay) in northeast China and has requested Bank assistance in its appraisal. If coumerciality is confirmed, other similar structures aLong a roughly north-south axis in Liaodong Bay would also need to be tested. In addition to providing needed services and technical assistance to help establish BOC/CNOOC as fully competent operators and enhance their effectiveness as joint venture partners with the IOCs, the project will provide an opportunity: (a) to develop a framework for mobilizing new equity participation in BOC's future exploration/development program in Liaodong Bay where BOC has so far been operating on its own; and (b) if the appraisal program under the project is successful, to mobilize financing for its development which would minimize the debt burden of the Government. 59. As for our experience with past lending in the subsector, tnis can be summarized as follows in the case of the four projects financed by the Bank to date. While there have been some start-up delays particularly in the first two projects (Loan Nos. 2231, 2252-CHA), physical implementation of all four - 20 - projects has generally been on schedule and within budget, and project objectives are being met. The main difficulty, which has shown considerable improvement in the last two years, has been slow procurement because of lack of experience with Bank procedures, insufficient coordination among the various entities concerned and delays in starting studies due to rather protracted discussions over the terms of reference, etc. This should be less of a problem in the case of the proposed project because CNOOC/BOC have greater autonomy in procurement than the petroleum bureaus, a special project implementation team has been set up to coordinate the project, and project preparation is well advanced. PART IV - THE PROJECT 60. The project was identified in September 1985 and prepared by the Bohai Oil Corporation with assistance from Bank staff. It was appraised in December 1985. Negotiations were held in Washington in April 1986 with a delegation consisting of representatives of the Government of China, CNOOC and BOC and led by Mr. Luo Qing, Deputy Director, External Finance Department, Ministry of Finance. No separate Staff Appraisal Report has been prepared. Supplementary project data are contained in Annex III. Background and Project Origin 61. The Bohai Gulf covers an area of approximately 73,000 square kilometers (kn2) off the northeast coast of China. The western part of the Gulf covers the northern extension of the North China Basin which contains a number of major oil fields in its onshore portion. About 40% of China's current oil production comes from these onshore fields; however, no major discovery has yet been made in the offshore area. Exploratory efforts in the Bohai Gulf date from 1959. The initial surveys and studies were carried out by the Ministry of Geology. In 1965 the Bohai O'} Corporation was formed to undertake offshore exploration and exploitation.- BOC initiated exploratory drilling in 1967, and by the end of 1980 about 100 exploration wells had been drilled and both oil and gas had been discovered in commercial quantities. 62. In 1980 the Government opened the Bohai Gulf to international oil companies in order to bring in foreign investment and technical expertise. BOC subsequently concLuded cooperation agreements with the Japan-China Oil Development Corporation (JCODC) and the Societe Nationale Elf Aquitaine (Elf) for exploration in the southern part of the Gulf and with Chengbei Oil Development Corporation (CODC, a subsidiary of JCODC) for development of the Chengbei oil field discovered by BOC in 1972. Due to disappointing results in three deep exploratory wells, Elf relinquished its participation in 1984, although BOGC continues to look for a new partner(s). JCODC is carrying out an active exploration program in its 25,500 km2 concession area with some 6/ BOC became a regional corporation of CNOOC when CNOOC was formed in 1982 and BOC's area of operation was limited to the Bohai Gulf. - 21 - positive results, and Chengbei field commenced production late in 1985 with CODC as operator. 63. At the time of opening the Bohai Gulf to the industry, the Govern- ment decided to allow BOC to retain opera orship in the smaller northern part of the Gulf - an area of about 12,000 km in Liaodong Bay - so that (a) BOC could gain direct operating experience in offshore technology in an area where the expLoration risk is relatively limited, and could develop the requisite level of technical and managerial skills to maintain continuity in China's offshore activities, but aLso because (b) the Chinese consider this to be a strategic area where foreign participation would be limited to a non-operating financial participation with full access to all data instead of the more usual situation of the IOC assuming responsibility as the operator. BOC has since been carrying out a small expLoration seismic and drilling program on its own in Liaodong Bay. In May 1985, BOC requested a Bank loan to help finance the combined appraisal and development of its first discovery in the Bay, the Jinzhou 20-2 (JZ 20-2) structure discovered in 1984. Two ridges of buried hills known from the onshore Liaohe field extend some 160 km into Liaodong Bay, and the JZ 20-2 structure is located at the northern end of the western ridge close to established production onshore (see Annex V for details on the petroleum geology and potential of the area). The JZ 20-2 structure is a complex faulted anticline having a closed area of approximately 30 km over three separate highs. Four wells have been drilled to date (three on the southern high and one on the central high), and each has tested oil, gas and condensate at various depths ranging from 1,615 to 2,227 meters subsea. 64. The JZ 20-2 structure is located about 45 km from shore where the sea is relatively shallow (about 20m). The drilling of wells presents no major difficulties, although there are some overpressured zones in the Tertiary and pre-Tertiary sections; also weather conditions can be severe and the sea freezes during the January-March period necessitating the suspension of drilling operations for three months in the winter. Based on the results of the first wells, the reservoir conditions of the JZ 20-2 structure appear to be relatively complicated. Both the structural and stratigraphic conditions appear to govern oil accumulation at different levels; the reservoirs are difficult to correlate because of the complex geology; the petrophysical characteristics of the reservoirs show considerable variation from one well to another; and different oil/water contacts have been deteripined in the same producing formation on. different highs indicating separate accumulations. Because of these complications, the oil and gas reserves of the JZ 20-2 structure can presently be only roughly estimated by statistical methods. An analysis based on the Monte Carlo simulation technique -/ indicates the most likely in-place reserves to be on the order of 7/ A statistical technique whereby a set of possible volumes of oil and gas with the attendant probabilities of their occurrence is derived based on quantitative judgments of the explorationists involved as to the chance of occurrence of certain main parameters governing the occurrence of hydrocarbons (e.g., presence and characteristics of source rocks, reser- voirs, structures). - 22 - 33 million tons of oil and condensate (7.0 million tons recoverable) and 9.2 BCH of gas (5.7 BCM recoverable). If proven, these reserves would justify developing the JZ 20-2 structure for annual plateau production rates of about 750,000 tons of oil and condensate (15,000 barrels daily) and 600 million cubic meters (MMCM) of gas (58 MMCF daily). 65. Taking into consideration that BOC has already borne a substantial portion of the exploration risk itself and the limited nature of the informa- tion presently available on reserve and reservoir conditions of the JZ 20-2 structure, the Bank proposed a two-stage approach for the appraisal/develop- ment of the discovery: that is, the Bank would provide immediate assistance for the assessment of the resource, the design of its development and use and related studies and training, to be followed by full-scale development of the field if justified by the results of the first stage. While the chances of BOC reaching a mutually satisfactory agreement on a non-operating equity participation with a private oil compan-y would not be promising at this stage, the chances would substantially improve upon completion of a rOroperly executed appraisal/delineation of the discovery, which is well within BOC's implementa- tion capability and will be carried out under the proposed project. BOC accepted the Bank's two-stage approach and also indicated that it is prepared to consider a minority financial participation from a foreign partner(s) in the development stage. The Bank's further involvement in the development of the field would depend upon the results of the appraisal program as well as the financial and participation arrangements for its development. In the event of additional discoveries in its own ongoing exploration program in Liaodong Bay, BOC has also indicated that it is interested in finding IOCs to farm-in as non-operators to participate in further e-ploration/appraisal and development. Project Objectives and Scope 66. The specific objective of the proposed project is to assist BOC in the appraisal of the JZ 20-2 structure and in the planning and financing of an optimum resource development and utilization program. In view of the possibility of a series of similar structures in Liaodong Bay, the project would also provide an initial assessment of the overall potential of the area and could serve as a model for the appraisal and development of the other structures. By thus upgrading the quality of the prospect and level of information about the overall prospectiveness of the area, the project would provide BOC with a stronger basis for consideration of equity participation by international oil companies or other financial partners in the development of the JZ 20-2 structure and/or further exploration in Liaodong Bay and various other financing schemes, including limited recourse financing, which may be applicable in BOC's future developments as well as those of CNOOC with Arco in the South China Sea and other possible joint ventures. Finally, the project would help BOC/CNOOC to develop improved local capabilities - technical, financial and managerial - in all aspects of offshore petroleum operations and to strengthen China's capabilities as a joint venture partner in these activities. Provided the appraisal program proves sufficient reserves in the JZ 20-2 structure to make it a viable production venture, the proposed technical assistance project would facilitate the rapid implementation of the full-scale development of this structure and the associated facilities for production, transportation and utilization of the resource. - 23 - Project Description 67. The proposed project would comprise the following components: - 3-D Seismic Data Processing. The processing and interpreting of approximately 5,000 km of 3-D seismic data acquired by BOC over the JZ 20-2 structure in 1985; - Strengthening of BOC's Data Processing Facilities. The provision of computer hardware and software needed for seismic data processing and interpretation and reservoir engineering applications; - Appraisal Well Drilling. The drilling and testing of three deviated and two vertical appraisal wells, approximately 2,600-3,200 m deep, and the construction and installation of two subsea templates and one -ellhead platform to enable long-term production testing; - Improvement of BOC's Well Testing and Core Analysis Capabilities. The provision of down-hole test tools and surface test equipment (separators, meters, controls, etc.) and of special core analysis equipment (to measure capillary pressure, wettability, relative permeability, etc.); - Special Tests and Studies. Conducting with the assistance of foreign experts, specialized tests (crushing strength, bending failure, etc.) on ice samples to be taken from the Liaodong Bay and petrophysical and reservoir fluid analyses on core and fluid samples to be obtained from appraisal wells; and preparing with the assistance of consultants, six studies related to the evaluation and future development of the JZ 20-2 structure including Regional Petroleum Geological, Reservoir, Gas Utilization, Field Development Engineering, Feasibility and Financing of Development and Computerization Studies; - Training. The trainirg of approximately 80 BOC engineers and geologists outside of ehina on special petroleum geological, geophysical and engineering subjects, offshore oil industry practices and managerial and economic aspects of petroleum operations (details of proposed training appear in Annex VI). 68. The appraisal program under the project, comprising seismic, wells and studies, will bring the level of knowledge about the JZ 20-2 structure, particularly its potential reserves, to the point where a development decision can be made. If the commercial soundness of the development is proven, an optimum plan to develop the field and produce and use the reserves, including alternative schemes for financing the development, will also be produced under the project. In the event of noncommerciality, which is not considered likely, the appraisal program will serve to minimize outlays for development, and in fact, certain studies included in the project (e.g., Field Development Engineering and Feasibility and Financing of Development Studies) will be reduced in scope or eliminated as appropriate and the loan reduced by a corresponding amount. The Regional Petroleum Geological and Gas Utilization - 24 - Studies, as well as parts of the other studies, will additionally go beyond the confiues of the JZ 20-2 structure with a view toward formulating a strategy and investment program for future exploration/development in Liaodong Bay and assessing the potential market/distribution network for utilization of natural gas in the surrounding onshore area. Finally, there is a substantial component of institution building and technology transfer in the form of technical assistance, training and equipment to strengthen BOC's capabilities in offshore petroleum operations. Project Cost and Financing 69. The total financing required for the project is estimated at $83.8 million, of which $50.2 million or 60% would be in foreign exchange. Detailed estimates of project costs appear in Annex VII. The costs include physical and price contingencies ($14.0 million), interest during construction ($6.4 million) and import duties and taxes ($3.6 million). The estimates are based on detailed lists of equipment, materials and services prepared by BOC and using end-1985 prices. A physical contingency of 10% was applied to the base costs. For local engineering and consultancy services, the average cost to BOC of such services was used. *For the various-foreign consultancy and engineering services, it is estimated that about 400 man-months of services will be required. The average cost of training outside of China (about 41 man-years) is $19,500 per man-year. Price contingencies were calculated on the basis of a three year implementation schedule and expected annual inflation rates of 7.2% in 1986 and 6.8% in 1987-88 for both local and foreign expenditures. No contingencies were applied to the base cost of 3-D seismic data processing for which a fixed-price contract was awarded in January 1986. 70. The proposed Bank loan of $30.0 million would finance about 38% of the total cost (net of duties and taxes) and 60% of the foreign exchange re- quirements of the project. BOC expects to finance $15.0 million of the project costs through the untied credit from the Export-Import Bank of Japan. Should this cofinancing fail to materialize, however, BOC would bear the cost. The balance of the foreign exchange and local cost requirements and any cost overruns incurred in project execution would be financed by BOC's internal cash. The Bank loan would be made to the Government for a period of 20 years (including 5 years of grace) at the standard variable interest rate. The Government would in turn onlend the loan proceeds to BOC on the same terms and conditions as the Bank loan; BOC would. beqr the foreign exchange risk. In addition to the Loan Agreement with the Government, a Project Agreement would be entered into with BOC. Conclusion of a satis- factory Subsidiary Loan Agreement between the Government and BOC and approval of the Loan Agreement by the State Council would be conditions of loan effectiveness. Project Implementation 71. The project would be implemented by the BOC, and BOC's Deputy General Manager for Exploration and Development would be responsible for overall project management. In the day-to-day management of project activities, he would be supported by two assistants, one responsible for the technical aspects of the project and the other for the financial and economic - 25 - aspects. These assistants in turn wouLd oversee and coordinate the project- related work of the BOC managers (or deputy managers) responsibLe for exploration, drilling, evaluation and research, engineering design, procure- ment, and cost control operations. The Deputy General Manager, his two assistants for the project and six managers along with their staff assigned to work on the project would make up the project implementation team. BOC's staff numbers about 15,000 in total, of which some 1,100 are engineers, geologists and other specialists and 1,600 are managerial staff; the profes- sional staff are well quaLified and familiar with oil industry practices. In its 20 years of operation, BOC has developed capabilities, on its own and through joint venture arrangements with foreign contractors/suppliers, in most routine offshore operations including geophysical surveys, drilling and well services, prefabrication and installation of offshore structures and requisite support services and supply base; these services have been used in BOC's own operations and contracted out on a competitive basis to other oil companies in the Bohai, Yellow and South China Seas. BOC has also gained valuable experience through its more recent cooperation agreements with foreign oil companies, particularly in the development of the Chengbei oil field with CODC. An organization chart for BOC is provided in Annex VIII. Assurances have been obtained from BOC that it would maintain the project implementation team under the direction of the Deputy General Manager for Exploration and Development with competent staff in adequate numbers throughout the project. 72. The appraisal wells under the project will be drilled by the Drilling Company of BOC which has nine active offshore drilling units and undertakes contract drilling on a competitive basis for foreign oil companies operating in China; in fact, the company has successfully drilled about 100 wells since 1980 for BOC's joint venture activities and various other IOCs. The templates and welihead platform will be designed, fabricated and installed by the BOC subsidiaries specializing in these areas (Design Company, Platform Fabrication Plant, Offshore Engineering Company and Shipping and Towing Service). These groups have close to 20 years of experience and more than 20 offshore platforms to their credit. Offshore logistics and well services will be supplied by BOC's specialized subsidiaries (towing, supply boats, helicop- ters, drilling including directional drilling, drilling mud services and cemen_ing), by joint venture companies established in cooperation with reputable international service companies (soil survey, rig positioning and tie-back, mud logging and logging of three project wells), and by interna- tional service companies (well testing and logging of two project wells). Assurances have been obtained from BOC that it would: (a) consult with the Bank on the location of each well under the project before commencing drilling operations for the particular well; and (b) review with the Bank the findings and test results of each well upon its completion. 73. Of the 5,000 km of 3-D seismic data, about 3,800 km will be processed by an international geophysical service company and the balance (about 1,700 km to allow sufficient overlap) will be processed in house by the BOC Data Processing Center for the purpose of training and developing its own capabilities in processing. The results will then be integrated and inter- preted by the foreign contractor together with BOC geophysicists. Ice sampling will be done by BOC operating departments with the assistance of foreign consultants, while the ice tests and special core and reservoir fluid - 26 - analyses will be entrusted to foreign companies speciaLizi.ag in these areas. The purpose of the ice tests is to provide data needed to design offshore platforms and related facilities to withstand winter conditions in Liaodong Bay where the ice can reach one meter in thickness. The Regional Petroleum Geological, Feasibility and Financing of Development and Compu- terization Studies will be prepared by BOC's Engineering aud Financial Departments with assistance from foreign consultants; the Reservoir, Gas Utilization and Field Development Engineering Studies will be entrusted to international consultants/engineering companies. The primary objectives of each of these studies, with target start/finish dates, are briefly as follows: - The Regional Petroleum Geological Study will be a synthesis of che geological, geophysical and geochemical data and will aim at clari- fying the petroleum geology of Liaodong Bay including distribution of source and reservoir rocks and structural relationships (January 1, 1986/December 31, 1987). - The Reservoir Study will determine the reserves and optimum pro- duction characteristics of individual reservoirs, study the feasi- bility of recycling of gas condensate reservoirs, recommend optimum field development and well completion schemes taking into considera- tion the relative importance of different reservoirs, expected pro- duction profiles and secondary recovery/pressure maintenance requirements (January 1, 1987/October 31, 1987). - The Gas Utilization Study will analyze alternative uses of natural gas produced from Liaodong Bay under various scenarios of potential supply and demand (April 1, 1987/September 30, 1987). - The Field Development Engineering Study will comprise the optimiza- tion of offshore installations taking into consideration predicted production performance, ecological conditions, existing infrastruc- ture, etc., and the basic design of the installations including the preparation bf bidding documents (July 1, 1987/August 31, 1988). - The Feasibility and Financing of Development Study will assess the economic feasibility of various phased development scenarios and optimum financing arrangements available to BOC (November 1, 1987/ March 31, 1988). - The Computerization Study will investigate the optimum configuration for the data processing facilities which are already available or will be available to BOC (June 1, 1986/August 31, 1986). Draft terms of reference for the major studies have been discussed and substantially agreed with BOC along with a detailed schedule for inviting proposals and carrying out the studies (see the project implementation schedule in Annex IX). Assurances have been obtained from BOC that it would carry out the studies in accordance with the terms of reference agreed with the Bank and the overall schedule above and would appoint qualified consultants to carry out/assist BOC in these various studies in time to initiate work in accordance with the agreed schedule. Finally, assurances - 27 - have been obtained from BOC that it would: (a) keep the Bank informed as to the progress of each study at appropriate intervals and review with the Bank upon completion of each study its overall findings and consequent action plan; and (b) in the particular case of the Reservoir Study and conceptual design phase of the Field Development Engineering Study, review with the Bank the preliminary findings of both at least one month before the scheduled start of the basic engineering phase of the Field Development Engineering Study in order to decide whether to proceed with the study as planned. 74. Technology transfer, both in the form of training and introduction of state-of-the-art materials, methods and equipment for offshore petroleum operations, will be an important outcome of this project. Counterpart BOC staff will be associated with all project activities for on-the-job training. Some training outside of China will also be provided by suppliers of equipment and materials (special core analysis), by consultants and engineering companies (seismic stratigraphy, reservoir engineering, offshore engineering) and by international service companies (log analysis) in connec- tion with the work undertaken by these groups under the project. A limited amount of training (petroleum economics, structural analysis of offshore structures, etc.) will further be obtained through graduate college courses and internationally organized seminars. An outline of the proposed training as discussed and agreed with BOC is given in Annex VI. The training program for 1986 has been agreed with BOC, and assurances have been obtained that BOC would submit to the Bank by September 1 of each year a proposed training program for the next year and would implement the program as agreed with the Bank. 75. As for the status of project preparation, the location and drilling program of the first appraisal well (JZ 20-2-5), as well as the overall rationale and tentative locations of the other four appraisal wells (JZ 20-2- 6, -7D, -SD, -9D) under the project, were discussed with Bank staff during appraisal. The major portion of materials required for drilling have been procured, and BOC has concluded contracts for three offshore drilling units to be used in its Liaodong Bay program. Appraisal drilLing of well JZ 20-2-5 will start in June 1986. The final locations of the four remaining wells will be determined based on the results of the 3-D seismic data processing which has been underway since early March 1986; preliminary results of the processing are expected to be available by June 1986, in time to locate the remaining wells. Major bidding documents and terms of reference for studies were discussed with BOC during appraisal/negotiations and are now being finalized in accordance with a detailed project implementation schedule agreed with BOC during negotiations (Annex IX). The proposed project is basically a continuation of BOC's ongoing appraisal program for the JZ 20-2 structure (3 wells were drilled in 1985) and has a substantial appraisal drilling component as well as the studies and training components which are more typical of the Bank's oil and gas technical assistance projects. For the reasons outlined above, the three year implementation schedule given in Annex IX is considered to be reaListic and more appropriate for this project than the five year schedule which reflects the Bank's past experience with oil and gas technical projects. - 28 - Procurement 76. Detailed procurement arrangements and items proposed for Bank financing are tabulated in Annex X. Procurement of materials and equipment proposed for Bank financing (S11.5 million) will be through international competitive bidding (ICB) according to Bank guidelines, with the exception of not more than $0.8 million of specialized goods for which there are a limited number of qualified suppliers worldwide and whose quality and timely delivery are critical to project implementation and which will be procured through limited international bidding (LIB). In addition, about $3.7 million of specialized well services will be obtained through LIB because of the rela- tively low value of the individual contracts and the limited number of qualified companies worldwide capable of supplying these services. For items to be procured through LIB, quotations will be solicited from at least three suppliers from at least two different countries. Local manufacturers will be eligible to bid under ICB and would be granted a 15Z margin of preference or the prevailing customs duties, whichever is lower, in the evaluation of bids. Services for experimental logging of two appraisal wells, approximately $2.9 million, will be obtained through direct contracting from one (Schlumberger, U.S.) of only two companies worldwide offering a full line of well logs. BOC has access to the logging technology of the other company (Dresser-Atlas, U.S.) through both a subsidiary of CNOQC and a joinc venture between CNOOC and Dresser-Atlas, and has so far relied exclusively on their services. The purpose of the experimental logging under the project is to provide a basis for comparing the services of the two companies and to help BOC determine an optimum logging program for its future wells. Consultancy, engineering and training services, about $11.9 million, will be obtained according to Bank guidelines for the use of consultants. 77. It is estimated that the number of bid packages for bank financing will approximate 30. Prior Bank review of the bidding and contract documents of all packages costing $500,000 or more will be undertaken. The procurement of the items to be financed by the Bank will be the responsibility of the Procurement Department of BOC. Procurement of 3-D seismic processing services and certain essential well services, materials and ice sampling equipment are on the critical path if BOC is to meet its planned schedule for project imple- mentation. BOC conducted, in consultation with the Bank and in accordance with Bank procedures, an international bidding for the 3-D seismic and awarded a contract ($1.4 million) to Compagnie Generale de Geophysique (France) in January 1986. The total amount of advance contracting under the project is not expected to exceed $7.6 million (25% of proposed Bank loan) and will have been procured in accordance with Bank procedures. 78. Among the items not financed by the Bank (see Annex X), oil field equipment and materials ($12.5 million) will be procured under BOC's own procurement practices. Of these, locally procured goods ($4.1 million) will be obtained from Chinese enterprises which are the assigned suppliers to BOC; imported goods will be obtained through China National Machinery Import Corpo- ration which procures such items in bulk through international shopping. Although somewhat slow and inflexible, local procurement procedures are reasonably efficient for the procurement of standardized goods. Well services ($19.2 million), offshore construction ($3.8 million) and local engineering - 29 - ($1.9 million) will be provided by BOC and its subsidiary companies. Addi- tionally $5.7 million of well services will be obtained from joint-venture service companies estaDlished in China. Disbursements 79. Disbursement of the Bank loan would be made against 100% of the foreign exchange cost of imported equipment, materials and well services; 100% of the ex-factory cost of equipment and materials manufactured locally and procured under ICB; 70Z of the cost of imported equipment and materials available through local suppliers and procured under ICB; and 100X of the cost of consultancy and training. in order to assist BOC to meet expenditures in a timely manner, it is proposed that a special account be opened in US dollars in a bank acceptable to the World Bank with an initial deposit of $2.5 million which corresponds to four months' average disbursements; replenishments will be made quarterly or when the special account is drawn down to 50% of the initial deposit, whichever occurs first. Disbursements for training and contracts for goods and services each valued at less than $200,000 equivalent would be made on the basis of Statement of Expenditures (SOEs). Documentation supporting the SOEs need not be sent to the Bank, but would be retained in the project office in Tanggu and made available for review by the Bank's super- vision missions. In line with the proposed advance contracting for Bank financed services, materials and equipment, retroactive financing of up to $3.4 million (11Z of proposed Bank loan) is recommended for qualifying expenditures incurred after appraisal (December 1, 1985). Because of the ongoing nature of the project and scope of work, the disbursement schedule for the Bank loan (Annex XI) is based on the project's three year implementation schedule rather than the Bank's standard profile for oil and gas technical assistance projects. Disbursement of the Bank loan is e-pected to be completed by December 31, 1989. financial Aspects, Accounts and Audits 80. Details on BOC's finances are given in Annex XII. BOC has performed in a financially responsible manner and its finances are expected to remain satisfactory over the medium term. Until 1988, BOC's operating revenues will continue to be derived mainly from the contracting of petroleum services. From 1988 onwards, its revenues are expected to be enhanced significantly by the Chengbei joint venture. Over the longer term, BOC's revenue position will be critically dependent on the results of its exploration/appraisal activities in the Liaodong Bay. Based on the reasonable expectation that there will be commercial discoveries from the Liaodong Bay, BOC's net income is forecast to inc-ease significantly from some Y52 million in 1985 to Y132 million in 1990. Over the next five years, BOC's internal cash is projected to meet almost 30% of its total financing requirements and cover the debt service (excluding interest during construction) at least 1.3 times. Its debt/equity ratio is expected to remain satisfactory even though it is expected to in- crease substantially from 10/90 in 1985 to 52/48 in 1990. 81. In general, BOC is required to follow the "Accounting System for State Enterprises" enacted by the Government, except for joint ventures with foreign companies in which case internationally accepted accounting practices - 30 - are followed. Further discussions of BOC's accounting practices are given in Annex XII. BOC's accounts have thus far been kept satisfactorily. However, while heavy emphasis is placed on the annual budget as a controlling tool, the present financial practice in China does not provide for financial planning beyond one year. With a view to promote prudent financial management, assurances have been obtained from BOC that it would: (a) extend the horizon of its financial planning to no less than five years and furnish the Bank with projected financial statements based on a five-year rolling plan; (b) review annually with the Bank by October 1 of each year its current and future financial plans, focussing in particular on its investment program and related financing arrangements; (c) not incur long-term debt without prior agreement by the Bank unless future debt service coverage (excluding interest during construction) based on a reasonable forecast is at least 1.2 times in 1986 and 1987 and 1.5 times from 1988 onwards; and (d) maintain a debt/equity ratio of no more than 60/40. 82. As in the case of other Bank-financed projects, external auditing of BOC will be undertaken by the Foreign Investment Audit Bureau of the State Audit Agency. Assurances have been obtained from BOC that it would maintain separate accounts for the projec.; in addition, the project accounts and BOC's accounts would be independentLy audited and the audited financiaL statements sent to the Bank within six months after the end of each fiscal year. The content and format of the quarterly project progress report has also been discussed and agreed with BOC. Environnmental Impact and Safety 83. China's Safety Regulations for Offshore Installations of 1984 covering both fixed platforms and mobile drilling units are very strict and impose the same safety measures required for the protection of installations, human life and marine environment in the more advanced areas of the world. BOC, as any other offshore operator, is under the legal obligation of main- taining adequate safety standards and so far has had a good safety record. China's Marine Environmental Protection Law of 1982 holds offshore operators strictly liable for oil spills, blowouts and control of discharges. However, the law is general in nacure and does not stipulate what constitutes allowable waste discharge thresholds for drilling cuttings and other emissions. Although the National Bureau of Oceanography is empowered to issue standards governing waste discharges, so far it has determined only the maximum allow- able oiL discharge (30 ml/l). During appraisal BOC agreed to adhere to envi- ronmental standards acceptable to both the Government and the Bank until such standards are promulgated by the Government. The standards recommended by the Bank have been discussed with '-.C and an assurance has been obtained that BOC would compLy with such standards. Project Benefits and Risks 84. The appraisal program under the proposed project is an essential step in assessing the future production potential of the Liaodong Bay area, and more particularly, in ensuring the technical, economic and financial soundness of BOC's proposed development of the JZ 20-2 structure and potentially opening the door to private equity participation in its later - 31 - development. The appraisal program itself is expected to amount to only 15- 20Z of the full-scale development cost and at least some of the wells could be used for development. In addition, the project contains a substantial element of institution building and technology transfer which would enable BOC/CNOOC to guin direct experience in offshore technology and develop the requisite level of technicaL, financial and managerial skills in order to maintain continuity in offshore activities in China, become more effective joint venture partners with international oil companies and properLy monitor the ongoing and future petroleum activities in offshore China. In the event of a commercial development of the JZ 20-2 structure, the oil and condensate could be exported or refined and used domestically. The natural gas would most likely be used domestically, with the potential market including feedstock for industries in the developed coastal area, household use in cities and fuel for power/industry, depending upon the volume and timing of supply; the Gas Utilization Study under the project would analyze alternative uses for the gas. 85. The project carries risks normally associated with oil and gas field appraisal programs. The first risk is that there is no petroleum to be found; given that each of the four wells drilled on the structure to date has tested oil and gas, however, this risk is considered small. The other main risks are technical and economic: (a) that the appraisal program will be insufficient to delineate fully the details of the structure, and (b) that the discovery wiLl prove to be noncommercial. The project has been designed to minimize these risks. Seismic data acquisition was carried out in the 3-D mode with a data density that is toward the upper limit of economically achievable data density, and the processing/interpretation will be done by an experienced international contractor. In addition to the four wells drilled to date, five more deep wells will be drilled under the projecr which will mean there will be 3-4 wells located so as to test completely the prospectivity of both the southern and central highs and at least one welL testing the smaller northern high. The use of modern seismic technology, appropriate testing and evaluation of well results before spudding the next well and introduction of qualified service companies and consultants, as well as close monitoring of all project activities by the project management and Bank staff, will serve to minimize the number of dry holes and amount of investment required for the appraisal of the structure and to optimize the planned field development. Finally, the structure is close to shore in shallow water and driLling conditions are normal which will further help to minimize implementation difficulties and the cost of getting the hydrocarbons onshore. 86. The main economic risk pertains to the complexity of the reservoir conditions of the JZ 20-2 structure, and hence uncertainty as to the estimate of the in-place reserves and their recoverability with a minimum investment in offshore platforms and wells, particularly in this period of declining oil prices. The structure is located at the northern end of the western ridge of buried hills close to established production onshore in the Liaohe field. Based an a preliminary estimate of reserves made by BOC using the results of its first two wells and a tentative development plan for daily plateau production rates of some 15,000 barrels of oil and 58 million cubic feet of gas, the proposed development would still have a real rate of return of 12% at an oil price of $12/barrel (1985 prices) throughout the life of the field. - 32 - BOC's reserve estimates have been reviewed by the Bank and are considered to be reasonably conservative both because they have already been discounted to take into consideration the preliminary nature of the data available as well as the concerns about reservoir continuity, and because they do not include the results of the third well drilled on the central high which found oil in a new horizon (Dongying sands) which is productive further south in the Chengbei field. It is also likely that some reduction in development costs will be possible if a series of structures along these ridges of buried hills can be developed in succession and some common facilities shared. In this respect, this project could also serve as a practicable model for the exploration, development and financing of the other structures in Liaodong Bay. On balance, the investment risk involved in the appraisal program is judged to be reasonable given the encouraging results to dat4 for an economic development of the JZ 20-2 structure and potential for further discoveries in the Liaodong Bay. PART V - RECOMMENDATION 87. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachment May 5, 1986 Washington, D.C. -33_ ANNEX I Page 1 of 7 CHllA. P0PLrS RP. oF - SOCIAtL IUNICAATO OATA US OIIrA. PEoPLr8 REP. or BEPCCn lOc P C iOUF8 swICE AWACKS) j MOST (MMS REICET STIMAT) lb 17L RDCOI'T W IllCOt lABlLg t10 1L9tfl j97 c 3sta8/h ASIA PACtIrIC ASIA 6 PACIFIC AI cumi SQ. KM TOTAL 9561.0 9561.0 9561.0 AIUCN..URLUL 3257.6 3812.0 3865.9 oW uCGTA (U) .. .. 300.0 278.3 1011.1 CKILOCRMS OF OtL EQUIVALEINT) 202.0 239.0 441.9 285.7 566.6 P8PSATCN MM VITAL muTansI POPrUATflON*ID-TEAR CHSMANDSI 651000.0 615160.0 1019102.0 L1IN POPULATION CE or Taint, 16.4 IA .. 21.0 22.3 35.9 POPULATIOU PROJECTIONS POPUlION IN TEAR 2000 CHILL) 1242.3 STATIONARY POPULATION (HILL) 1571.0 POPULATION HamENTUM 1.6 POPULATION DESITY PE SQ. KR. bl.1 85.3 106.2 173.8 3B6.9 PER Sq. M. AGI. LAIID I".8 210.0 260.8 353.3 1591.2 POPULATUOI ACE STRUCTURE CZ) 0-14 TRS 38.9 31.6 32.0 36.3 36.2 1W-64 YRS 56.2 57.2 63.1 39.4 57.7 bS AND AOV 4.7 5.0 5.0 4.3 3.5 POPULATION GROWTH RATE (Z) TOTAL 1.1 2.2 1.7 2.0 2.3 MN .. .. .. 4.1 4.1 CtUDE RICH IRATE (PE TUNS) 39.2 Id 35.7 18.6 27.5 30.1 CRUDe DCATH RATE (PER TRailS) 23.5 7ir 8.8 7.1 10.2 9.4 CROSS REPRODUCTON RATE 2z. 7l 2.3 1.0 1.7 1.9 FAMILY PLAtISI ACCePTORS. ASDAL (THOUS) USERS CZ or tMrED WHEN) 71.0 9.4 56.5 w AD i m u lNDEX OF OOD PROD. PER CAPITA (1969-71-100) .. 100.0 123.0 116.6 124.4 PER CAPtTA SUPPLY OF CALORIES CZ OF REQUIREKIT) 94.6 Id 101.6 119.6 106.3 t15.7 PROTMIS CCRAS PEM DAM) 53.0 7if 56.2 69.7 60.1 60.3 OF WHICH ALIMAL AND PULSE 12.5 7;i 13.3 15.9 14.4 14.1 CHlLD (ACES L-4) DEATH RATE 13.5 6.5 2.0 7.3 7.2 ,STE LIFE EXPECT. AT BIRTH (EARS) 41.0 /e 60.9 67.1 60.5 60.6 NFANTIr MM. lATE (PER Taws) 165.0 Tdl 69.0 38.0 69.2 64.9 ACCESS TO SAFE WATER (IPOP) TOrAL 0.0 4 .2 46.0 URBAN 8.0 77.2 57.6 RURAL 0.0 34.6 37.1 ACCESS TO EXCRETA DISPOSAL (S OF POPULATION) TOTAL . 7.8 50.1 URBAN .. .. .. 28. 52.9 RURAL .. .. .. 5.5 44.7 POPUATION PER PN StCIL 7940.0 /f 3690.0 If 17o0.0 If 3318.0 7751.7 POP. PER NURSING PERSON 3830.0 2760.0
Groupe de la Banque mondiale · Memorandum & Recommendation of the President
China - Liaodong Bay Petroleum Appraisal and Technical Assistance Project
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Memorandum & Recommendation of the President
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Banque mondiale