China - Zhongyuan - Wenliu Petroleum Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 4183-CHA STAFF APPRAISAL REPORT CHINA ZHONGYUAN-WENLIU PETROLEUM PROJECT March 10, 1983 Eniergy Department Petroleum Projects, Division I 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 (September 1982) 1 Yuan US$0.53 1.9 Yuan US$1.00 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES 1 British thermal unit (Btu) = 0.252 kilocalories (kcal) 1 barrel (bbl) - 0.159 cubic meters (cu m) 1 kilogram of coal equivalent (kgce) = 0.64 kilogram of oil equivalent 1 kilometer (km) 0.621 miles (mi) 1 kilowatt (kw) = 1,000 watts (w) 1 kWh = Kilowatt hour 1 megawatt (MW) - 1,000 kilowatts (kw) 1 cubic foot (CF) = 0.0283 cubic meter (cu m) ABBREVIATIONS AND ACRONYMS 0API = American Petroleum Institute degrees (API gravity) CNOOC = China National Offshore Oil Corporation CONGEDC = China Oil and Natural Gas Exploration and Development Corporation EOR = Enhanced Oil Recovery GMC Gas Management Company GOC = Government of China LPG = Liquefied Petroleum Gas MCF = Thousand cubic feet MOF = Ministry of Finance MOG = Ministry of Geology MOPI = Ministry of Petroleum Industry PCN1 = Production Company No.1 PCPRC = Petroleum Corporation of the People's Republic of China PVT = Pressure - Volume - Temperature RDI = Research and Design Institute SPC State Planning Commission ZPEB = Zhongyuan Petroleum Exploration Bureau  FOR OFFICIAL USE ONLY CHINA ZHONGYUAN-WENLIU PETROLEUM PROJECT Table of Contents Page No. I. ENERGY SECTOR Introduction ........................................ 1 Energy Balance ...................................... 2 Resource Endowment .. 4 Coal ........................................... 4 Power .......................................... 4 Oil and Gas . ... . ............ . 5 Oil Shale ...................................... 5 Geothermal .................................... . 6 Non-Commercial Energy .......................... 6 Distribution of Energy Resources . . 6 Scale of Development .. 7 Efficiency of Energy Use .. 7 II. OIL AND GAS SECTOR ............................. 9 Background .......................................... 9 Petroleum Geology .. 9 Institutions ........................................ 9 Exploration Policy .. 10 Onshore ........................................ 10 Offshore ....................................... 10 Hydrocarbon Bearing Structures . . 11 Onshore ........................................ 11 Offshore .................................... 13 Current and Anticipated Level of Oil Production . ........... . 13 Quality of Crude Oil ....... . 15 Transportation ............... 15 Refineries .......................................... 15 Consumption Pattern .. 16 Natural Gas ......................................... 17 Prices ............... 18 Planning and Investment .. 20 Role of the Bank ............... 21 III. BENEFICIARY .............................................. 23 Background .......................................... 23 Functions ....... 23 This report is based on the findings of a mission that visited China in September 1982 and was prepared by Messrs. V. Nayyar, A. El-Mekkawy, H. Schober, A. Smit, H. Berilgen and Miss S. Shum of the Energy Department. | 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.  Capital Structure .. 23 Organization and Management ......................... 23 Project Implementation .. 25 (a) Production Company .25 (b) Drilling Company and Other Auxiliary Companies .25 (c) Project Unit .26 Financial/Accounting Practices ..26 Costing osting.................. 27 Internal Control System ..28 External Audit. .......28 Incentive System ..28 Insurance ..29 IV. THE PROJECT ..29 Background ..29 Project Objectives ..29 Geology . . 30 Oil and Gas Production Prospects . .30 Production Plan and Project Design . .30 South Wenliu ..30 East Wenliu . ..31 LPG Recovery ..32 LPG and Natural Gas Market ..32 Project Description ..33 Project Implementation .. 34 Project Implementation Schedule . .35 Drilling and Completion Practices. 36 Reservoir Engineering Study ..36 Computer Facilities . . 37 Training ..38 Laboratories ..38 Project Costs ..38 Project Financing ..40 Procurement and Disbursement ..40 Project Risks ..41 Ecology and Safety ..42 Reporting Requirements ..42 V. FINANCIAL ASPECTS .43 Background ..43 Present Financial Position ..43 Future Finances ..43 Investment and Field Maintenance Program 44 Pricing . .45 Costs ..45 Funds Flow ..45 Financial Position ..46 Sensitivity Analysis ..47 Zhongyuan-Wenliu Petroleum Project . .47 Performance Measurement ..49  - iii - VI. ECONOMIC ANALYSIS ........................................ 50 Background .... 50 Project Benefits .. .................................. 50 Project Costs....................... ......... 50 Economic Rate of Return and Net Present Value ....... 51 Sensitivity Analysis .... 51 Other Benefits .... 51 VII. RECOMMENDATIONS .. 52 ANNEXES 2.01 Organization Chart - Ministry of Petroleum Industry 3.01 Organization Chart - Zhongyuan Petroleum Exploration Bureau (ZPEB) 3.02 Organization Chart - Production Company No.1 3.03 Organization Chart - Drilling Company No. 1 3.04 Organization Chart - Gas Management Company 4.01 Geology 4.02 Performance and Expected Production Profile 4.03 Detailed Project Cost 4.04 Implementation Schedule 4.05 Disbursement Schedule of Bank Loan 4.06 Notes on Training 4.07 List of Imported Equipment 5.01 ZPEB Balance Sheet (1/1/82) 5.02 Notes on Financial Aspects 5.03 ZPEB Projected Income Statement (1982-86) 5.04 ZPEB Projected Balance Sheet (1982-86) 5.05 ZPEB Projected Sources and Uses of Funds (1982-86) 5.06 ZPEB Unit Cost of Production (1982-86) 5.07 ZPEB Drilling Cost 6.01 Economic Analysis 7.01 Related Documents and Data Available in the Project File MAPS IBRD No. 16781 IBRD No. 16782 IBRD No. 16780   - 1- I. ENERGY SECTOR I! Introduction 1.01 China is well endowed in primary energy. It is the fourth largest producer of commercial energy after the United States, the Soviet Union and Saudi Arabia. Output of commercial energy is one-fifth of US and one-third of USSR. Coal and lignite reserves are estimated at over 600 billion tons. Annual hydro potential is estimated at 1,900 billion kWh, against the present hydro generation of 58 billion kWh and overall power generation potential of 300 billion kWh. Official estimates of oil and gas reserves are not available. Unofficial estimates, however, place the recoverable reserves of oil at 1.8-2.5 billion tons, and of natural gas, both associated and non- associated, at about 130 billion cubic meters (equivalent to over 110 million tons of oil). From the review of the sedimentary basins, the ultimate recoverable reserves of oil are estimated to be in the range of 12 to 20 billion tons. In addition, the reserves of oil shales are reported to be of the order of about 400 billion tons. For a number of reasons, including logistics, substantial investment requirements and long gestation period needed for developing coal and hydro potential, the relative share of coal and hydro power in the overall energy balance is not anticipated to increase significantly over the next ten years. 1.02 China's achievement in developing its energy resources over the last three decades has been impressive. Production of coal has increased from little over 60 million tons in 1952 to 620 million tons in 1981. During the same period, power generating capacity increased from a little less than 2000 MW to 67,000 MW. Oil production increased from about 0.1 million tons in 1950 to 106 million tons by 1979. Output of oil fell marginally to about 101 million tons in 1981. This rapid pace of development has pushed China into the rank of the third largest consumer of commercial energy in the world, behind USA and the Soviet Union, but ahead of Japan. 1.03 China's global pre-eminence as a producer and consumer of commercial energy notwithstanding, its consumption pattern is more analogous to a developing country where a large proportion of the population continues to rely upon non-commercial sources (plant residue and animal power) for meeting its energy requirements. Consumption per capita is about 650 kilograms of coal equivalent (kgce), which is slightly above the average for developing countries (620 kgce). In fact, China's energy sector is a curious amalgam of the traditional and the modern and of advanced technologies and inefficient practices. The future prospects remain uncertain, and while the probability for retaining self-sufficiency in energy remains high throughout the eighties, it is doubtful if China would be able to sustain the rate of growth it achieved over the last two decades. Major oilfields have peaked and 1/ For more detailed discussion please see Bank's report No. 3391-CHA - China: Socialist Economic Development - Annex E: The Energy Sector.  -2- entered into a declining phase. No new discoveries have been made in a magnitude to offset this decline. Rapid expansion of coal industry faces intractable problems in terms of investment, location and transportation. Remoteness of major hydro potential sites from the centers of consumption and the long gestation period, precludes hydropower's share from increasing significantly beyond its present level within the first half of the 1980's. Energy Balance 1.04 The table below estimates the commercial energy balance for 1980, 1981 and 1985.  - 3 - Energy Balance (Million Tons of Oil Equivalent) Production 1980 % 1981 % 1985 % Crude oil 105.9 24 101 24 95.0 20 Natural Gas 12.3 3 10.5 2 9.5 2 Coal 303.8 68 303.8 69 342.9 72 Hydroelectricity 20.9 5 23.5 5 27.0 6 Total Availability 442.9 100 438.8 100 474.4 100 Consumption 1. Petroleum products 81.0 19 75.0 18 86.0 18 Industry & commerce 35.5 8 32.9 8 37.1 8 Power 16.5 4 15.3 4 12.1 2 Transport 14.0 3 13.0 3 18.9 4 Agriculture & construction 15.0 4 13.8 3 17.9 4 2. Natural gas 12.3 3 10.5 2 9.5 2 Industry & Commerce: Feed stock 4.9 1 4.2 1 3.8 0.7 Fuel 5.9 1.5 5.0 1.2 4.6 1 Power 1.5 0.5 1.3 0.3 1.1 0.3 3. Coal 303.3 a/ 71 298.4 72 331.1 72 Industry & commerce 182.0 43 179.0 43 185.6 40 Power 57.3 13 56.4 14 74.0 16 Transport 12.0 3 11.8 3 13.7 3 Domestic 52.0 12 51.2 12 60.0 12.7 Interfuel substitution outside power - - - - 1.5 0.3 4. Hydroelectricity 20.9 5 23.5 6 27.0 6 5. Refinery losses 7.0 2 7.0 2 6 2 Total domestic consumption 424.5 100 414.9 100 461.6 100 Exports Crude oil 13.3 64 13.8 57 3.0 23 Petroleum products 4.6 22 5.2 21 - - Coal 3.0 14 5.4 22 9.8 77 Total Exports 20.9 100 24.4 100 12.8 100 a/ Includes stock change of 5 million tons of coal or 2.5 million tons of oil equivalent. Source: China: Socialist Economic Development - Annex E: The Energy Sector and mission estimate.  -4- Resource Endowment 1.05 The major existing and potential sources of primary energy are indicated below: (a) Coal 1.06 Coal is China's traditional source of energy and at present caters to nearly 70% of its demand for commercial energy. The output of raw coal in 1981 was about 620 million tons, a level surpassed only by USA and USSR. The coal and lignite reserves are concentrated largely in the north and northeast, and represent about 70% of the total recoverable reserves in China (600 billion tons). In terms of production also, the north and northeast account for 70% of the total national output and the south, with production level of 15%, remains coal deficient. About 75% of coal production comes from large mines with more than 0.6 million tons annual capacity. The small mines (1000- 100,000 tons annual capacity), over 20,000 in number, are rudimentary underground operations and the productivity is extremely poor. The output of the small mines goes essentially for meeting local commercial and domestic needs. While there are some modern collieries in China, most of the mines are only partly mechanized. Future plans call for increased mechanization in both old end new mines, and for domestic manufacture of underground mining equipment. The Government expects the output to reach 700 million tons by 1985. However, in increasing coal output, transport, essentially railroad capacity, appears to be a major constraint. (b) Power 1.07 China increased its generating capacity from little less than 2000 MW in 1952 to over 67,000 MW by 1981 - an average growth rate of about 14% per annum. Of this, 70% of the generating capacity is thermal (46,200 MW) and 30% is hydro (21,000 MW). In 1980, 309 billion kWh of power was generated, of which about 80% was thermal and the balance 20% hydro. China's hydro power potential is among the largest in the world, and is estimated at 1900 billion kWh per year against the present hydro generation of about 60 billion kWh. The Chang Jiang (Yangtze River), which flows through the southwestern portion of China and eastern Xizang (Tibet), holds the largest hydro potential. On account of the terrain through which it flows, only limited efforts have been made to develop this potential. Major hydropower development has, however, taken place on the Huang He (Yellow River) and the Han Shiu (Han River) which flow through northeastern part of China. Liujiaxia is the largest hydropower station in China and is constructed in Gansu on the Huang He. It has a designed capacity of 1,225 MW and is annually capable of delivering about 5.7 billion kWh. Danjiangkou is the second largest power station in China, is located on HIan Shiu and has a generating capacity of 900 MW. This hydro station meets the power requirements of the province of Hubei. Presently, China has about eleven hydroelectric stations with a capacity of 290 MW or greater. The other Chinese rivers which have major hydroelectric systems are the Songhuajiang (590 MW), the Dadu River (508 MW), the Fuchun River and tributaries (1330 MW) and the Yalu River (1100 MW). 1.08 Over the last decade, the mini hydrostations got a tremendous impetus and grew from about 15,000 to about 90,000 in number. Typically, these stations are about 50 kW in generating capacity, and are designed to meet the needs of the rural areas. Besides providing power to the local communes,  - 5 - reservoirs built for this purpose meet irrigation requirements, prevent floods and are being used for pisciculture. The potential is indeed immense, and it can be harnessed with local materials and the construction period is short. However, seasonality appears to be a major constraint. (c) Oil and Gas 1.09 Growth in the hydrocarbon sector, over the last two decades, has been equally remarkable. While oil was discovered in China in 1897, annual oil production up to 1950 was no more than 120,000 tons of which about 50,000 tons was from oil shale. During the fifties, exploratory effort was confined to northwest China which resulted in small discoveries. However, fromn 1957, exploration was undertaken in the northeast-and northern China, leading to the discovery of the 'super giant' oilfield in Daqing in 1959. This was followed by discoveries in Shengli and Dagang in 1964. In 1965 petroleum production reached 11.3 million tons and with that China became self-sufficient. During the sixties, increase in oil production was relatively moderate; the major spurt came in the seventies with production increasing from 30 millionl tons in 1970 to 106 million tons in 1979. This increase came largely from the development of the Daqing oilfield, and to a lesser extent, from the development of the Shengli and Renqiu oilfields. 1.10 Official estimates of oil and gas reserves are not available. The magnitude of China's proven and probable reserves is the subject of considerable speculation and study outside the country. Varying estimates relating to the proven recoverable reserves have been made by different geologists/bodies; the opinion, however, is now converging to a range which varies from 1.8 to 2.5 billion tons. Estimates regarding possible and probable reserves, both offshore and onshore, are by nature somewhat speculative. The current estimates range from 5-10 billion tons in the onshore region and 4-8 billion tons in the offshore area. 1.11 Currently, the major non-associated gas fields are located in the Sichuan Province and the recoverable reserves are estimated at 70 billion cubic meters. In addition, there are some minor natural gas fields in the northwestern part of China. Over and above this, the recoverable reserves of associated gas are estimated at about 50 billion cubic meters. The cumulative recoverable gas reserves are thus about 130 billion cubic meters, equivalent to over 110 mi1li tons of oil. There is, however, a view that gas reserves have not-been adequately explored and the presently known recoverable reserves are a mere fraction of the full potential. According to some estimates, the ultimate recoverable reserves of natural gas, both offshore and onshore, could be as high as 3,000 billion cubic meters. (d) Oil Shale 1.12 Reserves of oil shale in China are reported unofficially to be of the order of 400 billion tons and may be much larger, since geological environment is favorable for their formation in many of the sedimentary basins. Deposits of 100 billion tons or more, containing 5-10 billion tons of oil, are reported in Heilongjiang and Hebei. The grade of most of oil shales is fairly low (less than 10%), but a few deposits have 10-20% of oil by weight. Before 1958, oil shale accounted for almost half of Chinese oil production, but the proportion declined rapidly as normal crude oil production increased after the  -6 - discovery of the Daqing oilfield. Currently, from the Liaoning and Guangdong mines, about 300,000 tons of shale oil is being produced. (e) Geothermal 1.13 China's geological conditions are such as to give rise to abundant geothermal phenomena, especially in the Tibetan Plateau. Most occurrences seem to be relatively low temperature ground water suitable for space heating; high temperature manifestation suitable for power generation seems to be more frequent in the mountainous southwestern part of the country, such as Yunnan Province and Xizang Autonomous Region (Tibet). The Ministry of Geology, which has the responsibility for developing geothermal resources, has identified and developed two projects. The first is a geothermal power station in the Yangbajain geothermal field of Xizang, some 50 km from Lhasa and the other is an urban heating system developed in the southeastern part of Beijing. Geothermal energy has not been developed to a significant extent in China. Furthermore, its role is likely to be limited to urban heating systems in the colder regions of the country and possibly to power generation in Xizang. (f) Non-commercial Energy 1.14 Although no data base exists for quantifying the extent of non- commercial energy used in China, it is apparent that this form of energy constitutes a significant proportion of the total energy used, especially in the rural areas. Fuel wood from loppings and grass, animal and crop residue, and especially rice straw, are the principal sources of non-commercial energy. Unofficial estimate places the energy extracted from these sources at 250 million tons of coal equivalent or about one-third of the total energy used. If this estimate is correct, then the traditional fuels play a smaller role in China than in most other countries with similar per capita levels. This is partially explained by a high population density and low availability of forest resources. 1.15 For maximizing the benefits from non-commercial sources of energy, China has pioneered and is now the leader in producing biogas. Biogas, which contains methane up to 65%, is produced by the fermentation of animal and human waste, vegetation, household garbage and waste water. Originating in the Province of Sichuan, biogas digesters are now all over China with the exception of the colder regions of the country, and currently exceed 6 million in number. A typical 10 m3 digester, costs about 50 Yuans (US$30), and can meet the composite energy needs of a family of five. In addition to the ecological benefits, through lower deforestation and the saving of fossil fuels, biogas digesters produce organic fertilizer, an essential ingredient for Chinese agriculture. Distribution of Energy Resources 1.16 China's energy resources are not evenly distributed. The northeast and the north, with nearly 30% of China's population and more than 45% of the gross industrial output, have as much as 75% of the known commercial energy in terms of coal and oil. These reserves currently account for the bulk of the counrry's production and are being extracted at a relatively fast pace. The east, with one-fifth of the total population and 30% of the industrial output, is almost devoid of any energy resource. The central south and southwest China, except for hydropower potential, is equally bereft of other forms of  energy. It is the northwest China, with possibly half of China's probable reserves of coal and oil, and with major hydro potential in Xizang, which would need to be developed for meeting China's growing energy needs. Some of these areas, however, have a hostile environment, are inaccessible and very sparsely populated and, therefore, developing energy resources here would neither be cheap nor quick. It is for this reason that China is increasingly considering its oil potential in the offshore area, especially in the southeastern continental shelf. Scale of Development 1.17 One of the basic tenets of Chinese developmental philosophy has been going small on a big scale. This guiding principle has had a significant impact on its energy policy and manifested itself in a large number of small coal mines, about 90,000 mini hydropower plants, and innumerable biogas units. True, the productivity of the small coal mines is low and the working environment is hazardous, and the cost of power generation in mini hydro plants is generally higher than in major hydropower stations. Yet, these units rely on local initiatives, skills, materials and capital, and have been brought onstream with commendable speed. Most of the small coal mines have been developed in the energy deficient southern China and now provide the much needed fuel for local industries and households. Similarly mini hydro stations have a significant impact on the local economy by providing flood control, irrigation, and power, without creating a draft on the major power stations and on the under-developed transmission system. These stations have made rural electrification possible on an extensive scale. 1.18 However, this policy has not been an unqualified success. Its indiscriminate application to all facets of industrial activity spawned a large number of small scale refineries, fertilizer units, cement, and iron and steel plants. This led to dissipation of resources where economies of scale were given up in deference to a developmental philosophy. 'Teakettle' refine- ries are inefficient and make product standardization impossible. Backyard fertilizer plants for synthesis of ammonia, besides requiring investment per unit of nutrient output which is two to three times higher than modern plants, produce product which is unstable and relatively ineffective in use. Small scale iron and steel works are equally inefficient in terms of capital use and the quality of product. This is not to suggest that this policy should be abandoned; it is merely to argue for a more rigorous economic scrutiny. Efficiency of Energy UJse 1.19 From the limited data available, it appears that China's level of commercial energy consumption is very high in relation to its economic activity. Although global comparisons of commercial energy consumption per unit of GDP show China with an energy intensity level more than double that of most other developing countries and industrialized market economies, this is a very crude index of energy efficiency, and is subject to considerable variation due to differences in economic structure (China has a relatively larger heavy industrial sector than many other countries) and problems associated with the valuation of output. Nevertheless, micro-level energy intensity comparisons on a physical basis, particularly in industry, indicate substantial potential for improvement in industrial energy efficiency in China. For example, in the steel industry, China's largest industrial energy consumer (12% of total commercial energy), energy consumption per ton of crude  - 8 - steel, even in large integrated plants, is approximately double the level achieved in best international practice, and energy consumption per ton in the small and medium plants is about 25% higher than in the larger plants. In the nitrogenous fertilizer industry, average energy consumption per ton of ammonia is roughly double that of best international practice, due partly to the outmoded technology used in these smaller plants, and to different raw materials. The smaller scale plants, which produce over half the ammonia, have about one-half the energy efficiency of the newer larger plants in China. The problem of small inefficient plants is also true in the brick industry. Smaller brick plants, which produce 2/3 of the country's bricks, consume 50% more energy per ton of bricks than the larger plants. 1.20 The problem of energy efficiency in China is, therefore, due not only to certain managerial/operational inefficiencies, which might be corrected in the relatively short term with little or no investment, but is also related to the use of older-fashioned technology, inadequate facilities to capture waste heat, the scale of industrial plants, and the raw materials used. Many of these problems will take longer to solve, and require substantial capital investment and some industrial restructuring. The Government is well aware of and highly concerned about these problems, and is promulgating a number of policy measures to address them, while according energy conservation equal priority with increasing energy production. These measures include plans to establish a number of energy conservation technical assistance centers to assist industrial enterprises in evaluating and improving their energy efficiency, enterprise-level quota systems with accompanying bonus and pricing systems for energy conservation below or above quota, industrial restructuring (including decreased relative emphasis on heavy industry), and increased taxation on petroleum fuels to encourage both conservation and fuel substitution. These measures appear to have had some success and the Government estimates that about 6 million tons of coal equivalent were saved in 1981. II. OIL AND GAS SECTOR Background 2.01 China is perhaps the oldest user of hydrocarbons; the Zulujing field was developed over 2000 years ago, producing gas through bamboo pipes and oil from dug pits. In the modern times, the first oilfield was discovered in 1897 at Dushanzi in the Junggar basin, followed by another discovery in 1907 at Yanchang in the Shaanxi Province. Over the next forty years, exploratory efforts were minimal, relied largely on the initiative of the private companies and the total number of wells drilled was less than 170. This drilling activity led to the discovery of three oil and two gas fields. The size of the discoveries and the production level was modest and an important constituent of the output was shale oil. Production averaged about 70,000 tons per year and reached 120,000 tons by 1950. Of this, shale oil accounted for 50,000 tons. 2.02 It was only after 1950 that a concerted effort was made to increase oil production. The older oilfields (Jiuquan, Yanchang and Dushanzi) were expanded to increase oil production. Separately, exploratory effort was  stepped up in northwest China leading to the discovery of the Karamay oilfield in the Xinjiang Autonomous Region. The scale and the size of the discoveries were small, and China had to rely on imported oil to meet its requirements. As of 1957, the focus of exploration shifted to the north and northeast China leading to the discovery of the super giant oilfield in the Songliao basin in 1959. Called 'the great celebration', the Daqing oilfield, since its discovery, has accounted for more than 50% of China's total oil production. Petroleum Geology 2.03 The petroleum geology of China is unusual in that most of the known petroleum accumulations are found in the sedimentary rocks of lacustrine rather than marine origin, laid down in ancient lakes or inland seas which occupied depressions in the Chinese landmass. These sediments now underlie large areas of the North China Plain and the Xinjiang Autonomous Region in the northwest. Oil and gas were formed in rocks of Mesozoic and earlier Tertiary age and accumulated in sand beds intercolated with the shaly source rocks. The reservoirs are block faulted quite intensely and their origin tend to be thin and poorly sorted, but so numerous that the aggregate oil bearing thickness in the section is appreciable. Nine petroliferous basins have been identified onshore China; the Songliao and the North China Plain basins in the north and northeast China, Sichuan and Guangxi basins in southern China, Shaanxi and Qin-Chuan basins in central China and the Qaidam, Tarim and Junggar basins in the northwest China. Presently the Songliao and the North China Plain basins are the most prolific producers of oil, accounting for more than 90% of its production; but the basins in the remote and inhospitable northwest are estimated to contain the largest oil potential. Substantial oil accumulations have been proved in China and an aggregate daily production level of 2 million barrels places China among the largest oil producing countries of the world. Institutions 2.04 The Ministry of Petroleum Industry (MOPI) oversees all aspects of oil and natural gas activities which include policy making and overall planning, exploration, production, distribution, transportation, research/design and training. Created as a Bureau in the Ministry of Fuel Industry in October, 1949, it became a full ministry in 1955 and oversaw the opening of the Daqing oilfield in 1959 and the various discoveries thereafter. In 1970 it was merged with the Ministry of Coal and the Ministry of Chemical Industry. In 1978, the ministries were split and MOPI once again became an independent entity. The organization chart of MOPI is in annex 2.01. The petroleum industry in China has been in a state of continuous change; this has blurred the lines of responsibility and created its own anomalies. The Ministry of Geology (MOG), in addition to being in charge of petroleum related geological work, separately and independently undertakes offshore exploration. Export of oil and procurement of foreign technology and equipment relating to the oil industry is the responsibility of several corporations under the charge of the Ministry of Foreign Economic Relations and Trade. Similarly, fragmentation of responsibility exists in refining; some refineries are managed by MOPI while others are managed by the Ministry of Chemical Industry. There is also a considerable overlap in technical training and research; its administrative responsibility is shared/divided betweeen MOPI, Ministry of Education-and the Chinese Academy of Sciences.  - 10 - 2.05 For securing foreign technology and undertaking external liason, the Petroleum Corporation of the People's Republic of China (PCPRC) was created in 1977. The principal objective of PCPRC and its affiliate, the China Oil and Natural Gas Exploration and Development Corporation (CONGEDC), was to enter into agreements with foreign oil companies, especially in regard to offshore geophysical and seismic work. As of February 16, 1982, the China National Offshore Oil Corporation (CNOOC) was created. This Corporation will take over all the offshore functions and contractual rights and obligations of PCPRC and CONGEDC. CNOOC will be responsible for inviting and evaluating bids and entering into offshore petroleum agreements with foreign oil companies. For implementing petroleum contracts and contracts for the construction of offshore installation and facilities, CNOOC will set up regional subsidiary corporations, namely, the Bohai Bay Oil Company, the South Yellow Sea Oil Company, the Eastern South China Sea Oil Company and the Western South China Sea Oil Company. In addition, CNOOC is considering establishing other specialized companies. Exploration Policy (a) Onshore. 2.06 In exploration, as in other sectors, China, till the late seventies, followed the policy of total self reliance and met with remarkable success. Exploration is done by about 300 seismic crews and 500 drilling rigs, which annually drill 2000 to 3000 wells. The rate of discovery has, however, been declining (Renqiu was the last major discovery) and, faced with the prospect of falling oil production, China has modulated its exploration policy. Firstly, it proposes to undertake detailed seismic survey around existing oilfields. This will help identify peripheral sands which could partially offset the anticipated decline. Secondly, it proposes to shift the focus of exploration from north and northeast to Tarim, Qaidam, Junggar and Ordos basins in the north and northwest. This shift will not be easy; all these basins are located in the remote northwestern China, are only tenuously linked with the rest of the country, have extremely hostile weather and difficult drilling conditions. Pay zones are at considerable depths (5,000 to 9,000 meters) and the formation pressure and temperature is high. Developing this area would therefore require a quantum jump both in investment and technology. Thirdly, and recognizing the above, China has secured, on a limited scale, assistance of foreign companies for undertaking seismic surveys and exploratory drilling in specially difficult areas. As these basins are estimated to hold about 50% of China's onshore recoverable reserves, GOC intends, over the next five years, to concentrate its exploratory efforts in this area. Finally, China is seriously considering inviting foreign oil companies to participate in exploration and production, especially in these difficult areas. (b) Offshore 2.07 Prior to 1979, China had on its own undertaken seismic work and developed offshore structures in the Bohai area, and in doing so recognized the limitation of its offshore technology. Thereafter, in a major policy change, China sought the active cooperation of foreign oil companies in identifying and developing its offshore structures. Forty-eight foreign oil companies, from 12 countries, were invited to undertake geophysical and seismic work over 420,000 square kilometers of China's offshore sedimentary  - 11 - basins. These surveys identified six prospective basins, namely, the Bohai, the South Yellow Sea, the East China Sea, the Pearl River, the Southwest Hainan Islands, and the Tonkin Bay basins. More than 475 prospective oil structures have been identified in these basins. Present evidence indicates that the Zhujiang (Pearl River) estuary is the most prospective. 2.08 In order to enable the participation of foreign oil companies in exploring its offshore basins, GOC on January 30, 1982, promulgated "Regulations on the Exploitation of Offshore Petroleum Resources in Cooperation with Foreign Enterprises." These regulations enable GOC to enter into petroleum contract with foreign oil companies whereunder and in terms of the contract, these companies will bear the cost of all exploration investment and accompanying risks. Once a commercial oil and/or gas field is discovered, both the foreign contractor and the CNOOC will invest jointly in its development. Whereas initially the foreign contractor will be the operator responsible for developing and operating the field, under these regulations, CNOOC has the right to take over as the operator whenever it deems fit. The foreign contracting party may recover its investment and expenses and receive remunerations out of the petroleum produced according to the provisions of the petroleum contract. Further, the foreign contracting parties are at liberty to deliver abroad their share of petroleum which is produced under this agreement. The first round of bidding will take place in two phases. The first phase relates to the northern part of the South Yellow Sea, and the Zhujiang estuary in the South China Sea; the second phase concerns the southern part of the South Yellow Sea, the Beibu Wan basin in the South China Sea and the Yinggehai basin. The total area offered is about 150,000 square kilometers. Bids for the first round were invited from foreign oil companies on February 16, 1982, and for the second phase in April 1982. Considerable interest has been evinced by foreign oil companies to these offerings. Hydrocarbon Bearing Structures Onshore 2.09 The oil and gas bearing structures are spread out over the entire China land mass and can be split up geographically into six regions. Oil production from each region along with the salient features of important oilfields are discussed. Northeast China 2.10 This region contains the prolific Songliao basin with the oilfields of Daqing, Liaohe, Banshan and Fuyu. These oilfields account for about 60% of China's current oil production. 2.11 Daging Oilfield. This oilfield is situated in the central portion of the Songliao basin, which is a large Mesozoic/Cenozoic inland sedimentary basin covering approximately 25,000 square km. The Daqing oilfield measures 140 km in the north-south direction and about 15-30 km in the east-west direction. The oil reservoir lies at 700-1200 meters below the surface. Throughout its history, oil has been produced using water flood methods, the field has now reached its maturity, oil production is declining while water injected in the reservoirs is increasing. Infill drilling, producing new reservoirs and enhanced oil recovery methods can be used to partially offset the decline.  - 12 - North China 2.12 This region contains Dagang oilfield in the Bohai basin and the Renqiu oilfield in the Baoding basin. In addition, recent discoveries have been made in Nei-Monggol, which is considered to be an extension of the Songliao basin. 2.13 Renqiu Oilfield. Located in Hebei Province, Renqiu is the first discovery of a Precambrian reservoir in China. Rock characteristics make for irregular porosity and varying oil output. Over the last two years the output from this field has declined sharply (30%), from 16 million tons to about 12 million tons. However, new wells are being drilled at Renqiu; they tend to be prolific and may, therefore, offset the decline partially and add to the output. 2.14 Dagang Oilfield. This field is entirely Tertiary and consists of about 13 oil sands, totalling 37 meters of net pay. It is again a highly faulted and a fractured structure, making the development and the production from the field complex and unpredictable. The pay zones are between 2000 - 3000 meters in depth. The oil bearing strata appears and disappears irregularly and the output at producing wells often fluctuates widely. The oil is relatively light (34o API) and is reported to be sulphur free. Eastern China 2.15 Shengli is the only major oilfield in this region. This field, which comprises about 40 small fields, totalling about 600 km2, is scattered on both sides of the Huang He near the Bohai basin. This oilfield was discovered in 1962, production is from Miocene-Pliocene and Upper Tertiary strata, where a wide variety of stratigraphic traps are situated. Oil sands are found in small reservoirs, spread out in unpredictable patterns over a widely scattered area. Underground permeability and pressure conditions vary, warranting water injection in most of the cases. The quality of oil produced from this field is of poor quality, having a gravity of 22o API, with fuel oil and other heavy ends accounting for 75% of the product yield. Recently another discovery has been made in Chezhen in the Shandong province. Size of this discovery is to be determined. Central-South China 2.16 Major production from this region comes from two new discoveries, namely, the Nanyang field and the Zhongyuan field, both located in the province of Henan. The Nanyang field is reported to be producing about one million tons of oil per annum. The Zhongyuan oil basin lies about 500 km south of Beijing in the basin of the Huang He. Exploration in this area started in 1977 and has led to the discovery of six small oilfields, namely, Wenliu, Pucheng, Wenmingzhai, Weicheng, Guoyunji and Qiaokou. Since its discovery, 1900 line kilometers of seismic survey have been done and 280 wells have been drilled. The current production level-in these oilfields is 2.1 million tons per annum.  - 13 - Northwest China 2.17 This area was the scene of the country's first commercial discovery at Dushanzi in 1897, an oilfield which still produces 0.5 million tons. In the same basin (Junggar), the Karamay oilfield was developed in the early fifties and continues to produce about 3.5 million tons per annum. The Lenghu oilfield in the Qinghai Province and the Yumen and Jiuquan oilfield in the Gansu province are the other oilfields in this region. While cumulatively the northwest region produces about 6 million tons of oil, it has basins which are considered to hold the largest petroleum potential. Of special significance is the Tarim basin where three important discoveries are reported to have been made. Similarly, the Qaidam basin in northwestern Qinghai and the Ordos basin in the Shaanxi Province are considered extremely prospective. Taking into account the potential of this area and the difficulties involved in drilling, MOPI has entered into service contracts with a number of foreign companies to undertake seismic work, data processing and exploratory drilling. Southwest China 2.18 The Sichuan basin is the only hydrocarbon bearing structure discovered in this region. Natural gas has been produced from gas fields in this structure for over a hundred years. The oil production is nominal and does not exceed 0.1 million tons. Offshore 2.19 Currently the Bohai gulf is the only source of offshore oil in China. This gulf is relatively sheltered with a maximum water depth of 60 meters; it has two producing oilfields; namely, Heise and Chengbei. These structures were discovered in 1970 and 1973. Over 130 wells have been drilled in the Heise, but only six are currently producing. Eighteen wells are producing in the Chengbei oilfield and cumulative oil production from the offshore areas is less than half million tons per annum. Current and Anticipated Level of Oil Production 2.20 The table below indicates the crude oil production by region and major fields.  - 14 - Crude Oil Production by Region and Major Fields/a (Million Tons) 1970 1975 1977 1978 1979 1980 1981 Northeast 22.37 50.68 54.87 56.04 57.36 58.59 58.63 Daqing 21.18 46.26 50.31 50.38 50.75 51.50 51.75 Liaohe & others 1.19 4.42 4.56 5.66 6.61 7.09 6.88 North 1.02 4.68 15.55 20.40 20.40 19.11 15.26 Renqiu - - 12.30 17.23 17.33 16.03 12.22 Dagang 1.02 4.68 3.15 3.00 2.90 2.91 2.88 Others - - 0.10 0.17 0.17 0.17 0.16 East 4.67 16.72 17.66 19.75 19.21 17.92 16.41 Shengli 4.67 16.72 17.52 19.47 18.88 17.59 16.11 Others - - 0.14 0.28 0.33 0.33 0.30 Central-South 0.27 0.87 1.26 2.83 3.39 4.16 4.80 Northwest 2.29 4.02 4.21 4.94 5.69 6.06 5.99 Southwest 0.03 0.09 1.09 1.09 0.10 0.10 0.09 Total 30.65 77.06 93.64 105.05 106.15 105.94 101.18 2.21 Over the last one year oil output has fallen by about 5%. However, of greater significance is the fact that the major oilfields, which together account for 90% of China's oil production, have peaked; water cut (proportion of water to oil produced) is increasing exponentially; and consequently decline production has set in. With no major discovery to offset this fall, China would need to rely increasingly on infill drilling, enhanced oil recovery (EOR) methods, exploring for and developing peripheral reservoirs and rapidly developing small discoveries. MOPI has initiated action in these areas and efforts are under way for expanding oilfields such as Fuyu, Liaohe, Karamay, Zhongyuan, Daqing (Gaotaizi reservoir) etc. In view of these efforts, it is estimated that China will be able to temporarily stem the decline and oil output up to 1985 may be in the range of 100-95 million tons. 2.22 The prognosis between 1985 and 1990 is less encouraging. By this time, oil output from Daqing, Shengli, Renqiu and Dagang would be declining at a rapid pace. Furthermore, while prospects for offshore discoveries are rated as very good, oil from the offshore areas is unlikely to augment China's oil /a Source: Ministry of Petroleum Industry.  - 15 - production significantly prior to 1990. Similarly, even if major discoveries are made in the northwest, intractable logistics make the field development and oil transportation an extremely complex and time consuming proposition. Thus, between 1985 and 1990 there is a distinct possibility of oil production falling to 90 million tons. Prospects beyond 1990 depend upon the success attending the current initiative to develop offshore structure with the assistance of foreign oil companies. Quality of Crude Oil 2.23 Almost all Chinese crude oil has a high wax content and a high pour point, so that it is solid at ambient temperatures most of the year. These characteristics lead to severe problems in transportation and refining. Transportation 2.24 Oil and petroleum products are transported by a variety of modes, including pipelines, waterways, railways and road transport. The first crude oil pipeline was built in 1970. Two major pipelines link the Daqing oilfield with the Qinhuangdao refinery and the Dalian port. From this port the oil is either exported or transported to other provinces. Another major pipeline network links Dagang, Shengli, Renqiu and the Zhongyuan oilfields with the Nanjing city. Currently, the crude oil pipeline network extends over 70,000 kilometers and the natural gas pipeline over 2,500 kilometers. Some 64% of the crude oil is transported by pipelines, 26% by waterways and the balance by railways. Presently there are no product pipelines and the petroleum products are moved largely by roads, water ways and railways. MOPI is, however, considering plans to build multiproduct pipelines. All pipeline networks, outside the oil/gas fields, are built, operated and maintained by the Pipeline Administrative Bureau which is answerable to MOPI. Refineries 2.25 The total refining capacity in China is 94 million tons, although throughput in 1981 was limited to 73 million tons. Refining capacities vary significantly - from 6 million tons per annum (MTPA) in Daqing and Beijing, to 5 MTPA in Nanjing, Shanghai, Shengli, Maoming and to a host of teakettle refineries of less than 0.5 MTPA capacity. The main refinery products are fuel oil (41%) diesel oil (27%), gasoline (16%) and kerosene (6%). In addition, they produce industrial solvents and chemical feedstocks. The refineries located in the oilfields or those undertaking only the refining of crude oil are under the admininstrative control of MOPI. However, refineries which also produce petrochemicals or undertake catalytic or hydro cracking are under the Ministry of Chemical Industry. Overall refinery product yield is indicated below:  - 16 - Product Yield of Refineries (1000 Tons) Product 1978 1979 1980 1981 % of total Gasoline 9,913.9 10,698.6 10,790 11,010 16.0 Kerosene 3,560.4 4,093.2 3,980 3,640 6.0 .Diesel oil 18,256.6 18,728.2 18,280 17,530 27.0 Lubricating oil 1,806.2 1,914.8 1,970 1,500 3.0 Fuel oil 28,142.9 28,161.2 31,420 28,180 41.0 LPG - - 1,160 1,033 1.5 Other n.a n.a. n.a n.a 5.0 Consumption Pattern 2.26 Rising oil production led to an increased role of hydrocarbons in the Chinese economy. Coal has been the traditional source of commercial energy supplying 90% of total energy as recently as 1965. The relative share of oil and natural gas increased from about 2% in 1965 to 22.5% in 1981, with coal (72.5%) and hydro (5%) providing the balance. The major consumer of oil is the industry and commerce sector (43%) followed by transport (25%) and power (20%). Similarly, natural gas is used by industry to the extent of 88% and the balance by power. Household consumption for illumination, heating and transportation is minimal and accounts for less than 2%. An unusual feature in the consumption pattern is the direct use of crude, to the extent of 8 million tons, as fuel oil. Non availability of refining facilities close to the producing field, transportation constraints and poor quality of crude, in part explain this wasteful practice. 2.27 While oil production during the last 16 years grew at about 15% per annum, consumption has kept pace. The table below indicates the overall production, consumption and export levels. Oil Balances (1965-1985) (Million Tons) Annual Actual Projected % Growth 1965 1970 1975 1977 1978 1979 1980 1981 1985 1965-1981 Production Crude 11.3 30.65 77.06 93.64 105.05 106.15 105.94 101 95.0 14.7 Export - N.A. 12.28 11.46 13.94 17.15 18.29 19.09 3.0 N.A. Domestic Consumption 11.3 N.A. 64.78 82.18 91.11 89.0 87.65 81.91 92.0 13.2 2.28 Consumption has been growing at an annual rate of about 13%. However, faced with a situation of falling oil and gas production, efforts are being made to decelerate the growth; as a matter of fact consumption in 1981 is reported to be about 82 million tons against the peak of 90 million tons attained in 1978. However, it is moot if further reduction in consumption can  - 17 - be secured without adversely affecting the rate of growth. True there is considerable wastage of energy and the scope for replacing oil by coal is substantial. However, bringing this about is not going to be easy or quick. Replacement of oil by coal would require substantial investment in terms of transportation and extensive retrofitting. Similarly, once a production mode has been determined, the energy efficiency factor is locked in and major improvement in energy use cannot be secured without discarding the investment. 2.29 Forecasts relating to future demand of petroleum products are not available. Further, in the absence of detailed macroeconomic and sectoral data, it is not possible to make any scientific forecast. However, working on the growth rates assumed by the Bank's 1980 Economic Mission under the scenario of moderate growth and moderate saving,1/ but applying them to the reduced consumption base for 1981, the demand for petroleum products in 1985 is estimated to be about 92 million tons. Implications of such a scenario are fairly grave. China has so far been able to maintain the export level; in fact stepped it up even in a situation of declining production. In 1980 China's earnings from the export of oil are estimated at $4.75 billion and represented 26.5% of its total foreign exchange earnings. Consumption level of 92 million tons would imply that as of 1985 oil would cease to be a significant source of foreign exchange earnings. Natural Gas 2.30 China produces gas in significant quantities; in 1981 production of gas (associated and non-associated) amounted to 12.5 billion cubic meters, equivalent to about 10.5 million tons of oil. Of this, gas produced in association with oil amounted to 6.2 billion cubic meters. The balance of 6.3 billion cubic meters, is non-associated gas, which is produced essentially in the Sichuan Province, although marginal quantities are also being produced in the Qaidam basin in the northwest. The gas industry is not new to Sichuan as the current gas fields were discovered and developed over hundred years ago. There are more than 200 gas bearing structures in the Sichuan Province and the current production is around 5.6 billion cubic meters per annum. Weiyuan is the largest gas field in Sichuan, producing about a billion cubic meters a year, followed by Wulonghou, Shiyougou, Zigong, etc. The table below indicates the production of gas by region. L/ For greater details, please see Bank's report No. 3391-CHA - China: Socialist Economic Development - Annex E: The Energy Sector.  - 18 - Natural Gas Production/a (Billion m3) 1977 1978 1979 1980 1981 Northeast 4.62 5.00 5.17 5.27 4.30 Daqing 3.00 3.20 3.31 3.39 2.80 Others 1.62 1.80 1.86 1.88 1.50 North 0.78 0.82 0.93 0.80 0.70 Renqiu - - - - Dagang 0.78 0.82 0.93 0.80 0.70 Others - - - _ East 1.18 1.44 1.55 1.44 1.20 Shengli 1.18 1.44 1.55 1.42 1.18 Others - - - 0.02 0.02 Central-South 0.02 0.02 0.02 0.05 0.05 Northwest 0.26 0.30 0.33 0.38 0.45 Sichuan 5.26 6.15 6.51 6.33 5.80 Total 12.12 13.73 14.51 14.27 12.50 Associated 5.37 5.95 6.53 7.23 6.20 Non-associated 6.75 7.78 7.98 7.04 6.30 2.31 Presently about 30% of the natural gas is used for fertilizers, about 10% for petrochemicals and synthetic fibers and the balance of 60% is used as fuel, of which about 12% was used for thermal power plants. Non-associated gas fields in the Sichuan Province, which have been producing for over 100 years, have now entered a declining phase. Similarly, with the decline in oil production in the Daqing, Shengli and Dagang oilfields, production of associated gas would also decline. As a matter of fact, gas production in 1981 in relation to 1980, registered a decline of about 13%, equivalent to 1.8 million tons of oil. Fall in gas production would inevitably stimulate demand for liquid hydrocarbons. It is, therefore, necessary that efforts are initiated to explore for and develop non-associated gas prospects. Prices 2.32 Prices of petroleum products, like other essential commodities in China, are fixed by the National Price Administrative Bureau. This Bureau a/ Source: Ministry of Petroleum Industry.  - 19 - functions as an independent entity, and works under the supervision and guidance of the State Council. The oilfields sell crude oil to the refineries at a well-head price of Y100 ($53) per ton, with the exception of northwest China and Zhongyuan oilfield (a new field discovered in 1977) which sell crude at Y130 ($68) per ton. Refineries in turn sell petroleum products to the Ministry of Commerce which is responsible for marketing the products. There is a price differential at every point, with the oilfields, the refineries, and the Ministry of Commerce, acting as profit centers for the State. The table below indicates the price of various petroleum products, ex-refinery and at the pump head. Petroleum Product Prices Ex-refinery prices Retail Price/a International/b Domestic Price Y/ton $/ton Y/ton $/ton price $/ton as % world prices Gasoline 590 310 800 420 310 135 Kerosene 420 220 680 358 300 119 Diesel 240 126 420 220 260 85 Fuel oil 55 29 134xc 71 165 43 LPG 230 120 300 158 225 70 Crude oil/d - - 170 89 240 37 Natural gas - - 2.9 1.6 4.0 40 (Y/MCF) ($/MCF) ($/MCF)/e 2.33 The average price of the reconstituted barrel works out to Y55 ($29), which is in line with the international price. Currently, the Pricing Bureau is increasing the price of crude oil sold to the refineries from Y100 (and Y130 in some cases) per ton to Y175 per ton, it is not clear that this increase would be reflected in the end prices. The maximum it may, therefore, achieve is redistribute surplus from the refineries/Commerce Ministry to MOPI. Until recently, there did not appear to be financial incentives in China to switch from oil to coal, since fuel oil in terms of calorific value, is cheaper than coal. During the past two years, the Government has sought to encourage energy conservation and substitution of coal for oil through various administrative means and financial incentives (see para. 1.20). Starting from September 1982, a special tax of Y70/ton is levied on crude and fuel oil which is being burnt as fuel. In effect, the retail prices of petroleum fuel to end consumers would amount to Y170 and Y155 per ton of crude and fuel oil respectively. This is a significant step in the direction towards ensuring that price incentives reinforce rather than contradict administrative regulations, which will be increasingly important as decision-making is decentralized. This aspect would be taken up in the Bank's overall economic dialogue with MOPI. /a Weighted average price, 30% of fuel oil consumed as feedstock does not include special tax on petroleum fuel. /b FOB Singapore prices on March 1, 1983. /c Assumes transport cost averaged at Y30/ton. /d Used directly as fuel. /e In terms of Btu fuel oil equivalent.  - 20 - Planning and Investment 2.34 The major economic instrument is the annual plan, which consists of several parts, including a production plan, a material allocation plan, a labour plan, etc. The core of this document is a set of interlocking material balance matrices, specifying sources (production, import, drawdown on inventory, etc.) and uses (intermediate input, investment, consumption, exports, etc.). The State Planning Commission (SPC) prepares the plan, with overall responsibility for supervision resting primarily with the State Economic Commission. MOPI, like other line ministries, operates under the overall supervision of these commisions. While SPC is the final arbiter for the annual plan, its finalization is a result of a series of iterative consultations between SPC, MOPI and its constituent units. In the absence of long term planning, there is an understandable preoccupation with the current instead of the future, a preference for short-run expedients over measures which aim at fostering productivity over the long run. This has at times led to uneconomic extraction, rapidly rising production reserve ratio and relatively inadequate investment in exploration or new technology. 2.35 The average investment in the oil and gas sector over the last five years has been about Y2.8 billion ($1.5 billion). In the absence of a long term plan, the future investment program for the sector is uncertain. The annual plan for 1982 is being assumed to remain at the same level as 1981. Even during the past, investment has varied from year to year and the investment in 1978 was 50% higher than 1981 or what is programmed for the current year. The major share of investment (50%) has gone into exploration, with oilfield development securing only 30%. The present investment development works out to $0.6 per barrel - a figure which is not only indicative of relatively low cost levels obtaining in China, but more importantly, could be symptomatic of inadequate investment being made in the oil industry. So as to stem the anticipated decline in oil production, China would need to step up investment substantially; for producing oil from peaking fields, development of peripheral sands and exploration in the northwestern part, would require outlays which are quantitatively and qualitatively higher. Offshore development would create a further draft on resources, as under the proposed participation agreement; even though the cost of exploration is to be borne by the foreign oil companies, GOC would share the development costs to the extent of 51%. The table below indicates the investment made in exploration, development and refining during the last five years.  - 21 - Investment for Exploration, Development and Refineries (Y Million) Exploration Development Refinery Total Crude Gas 1977 967 479 30 493 1,969 1978 2,093 1,009 44 646 3,792 1979 1,286 888 80 470 2,724 1980 1,455 948 132 524 3,059 1981 1,266 840 61 351 2,518 Average for period 1,413 833 69 497 2,812 % of total 50 30 2 18 100 Role of the Bank 2.36 China has so far been extremely successful in developing its oil resources. However, its major oilfields, which together account for 90% of its oil production, have peaked. Inspite of relatively high outlays for exploration, Renqiu was the last major oil discovery. From available evidence it is clear that China at least in the medium term faces the prospect of declining oil production. There are also various constraints, including transportation bottlenecks, to the rate at which coal supply can be expanded. The Government's energy strategy involves addressing the problem of moderating energy demand as well as expanding supply. Various measures to control demand are being implemented in the short term, including quota systems, technical assistance to enterprises, and some industrial restructuring (para. 1.20). Sector strategy over the longer term would require China taking steps to increase its exploratory efforts, especially in the offshore areas where private industry investment is being actively sought, and the northwest onshore areas, undertaking fuller development of coal and hydro potential and making structural adjustment in industry to improve the efficiency of energy use and permit the replacement of oil by coal. Coal mines would have to be modernized and transportation constraint resolved; while prospects of offshore oil discoveries are rated as high, oil in significant amounts would be secured only after an extensive period of exploration and development; similarly projects for developing hydro potential have a long lead time. In industry, which consumes over 70% of total commercial energy, major investments to improve and alter processes and modernize older facilities will also take a few years to have substantial impact, although significant savings should be achievable with little or no investment in the shorter term. Investment in many of these areas, however, is unlikely to yield significant results during the eighties. It is, therefore, critical that steps be taken to stem the anticipated decline in oil production and to obtain maximum impact from energy conservation. In the petroleum sector, China would need to develop rapidly the small oilfields which have already been discovered, undertake seismic surveys around existing oilfields in order to discover and identify peripheral sands, initiate a program for EOR, etc.  - 22 - 2.37 China is now facing problems typical to all oil producers, that is, being required to undertake exploration and production under increasingly difficult and complex conditions. Achievement of the above mentioned medium term objectives would thus require, not only increased investment in the oil and gas sector, but also a major infusion of modern technology and equipment. Bank lending in the petroleum sector will have three basic objectives: Firstly to develop known hydrocarbon bearing structures in order to partially offset the anticipated decline; secondly to provide a vehicle for the induction of modern technology to the Chinese oil industry; thirdly to assist in training and upgrading the skills of China's oil industry personnel in current oilfield practices. 2.38 On account of an extended period of technological isolation during the development of oil industry, China has not been successful in discovering petroleum in complex geological environments nor has it developed the technological capability to increase the recovery of oil from existing fields. GOC is seeking the assistance of foreign oil companies in exploring and developing its offshore areas. This would, over a period of time, also result in the transfer of offshore technology. In the onshore area, especially in regard to the discovered and developed oilfields, the GOC expects the Bank to act as a similar conduit for transferring technology. During project preparation, substantial staff input was required for iKdentifying areas where technology needed to be upgraded. Much of the equipment used in the fields such as Daqing and Zhongyuan is obsolescent; there is relatively limited familiarity in the techniques relating to deep drilling and field practices such as drilling, cementing, casing, and formation logging require an indepth evaluation. The attention of the Chinese authorities has been drawn to the need to upgrade field practices; the current project would address itself directly to these issues by helping finance the import of modern equipment and technology. Further work will be needed in preparing terms of reference for technical studies, selection of consultants, supervision of studies, evaluation of findings, and finalizing and implementing a plan of action based on these results, etc. GOC has sought the Bank's assistance in this area which would be provided during the implementation of the proposed project--and this is the primary rationale for the Bank's participation. 2.39 Just like the Daqing Oilfield - Gaotaizi Reservoir Development Project, an important objective under the proposed loan is the training of Chinese technical staff and strengthening of their capabilities. Not only would engineers and technicians be trained in the use of new equipment and in modern petroleum engineering practices, but a well equipped training center would be established together with operational laboratories to supplement the operational work in the field. The loan will also assist in shaping the future investment program by helping finance important pre-investment studies. In the medium term the Bank's involvement in the sector would be aimed at developing rapidly the small oilfields which have already been discovered, undertaking seismic surveys in the vicinity of existing producing fields, and identifying and initiating enhanced oil recovery programs. Bank assistance would, therefore, be directed to further consolidate China's production capabilities and subsequently assisting its exploration investment program.  - 23 - III. THE BENEFICIARY Background 3.01 Seismic work in the Zhongyuan oil fields commenced in 1974 and the first discovery was made in 1977. The initial task relating to exploration and development was undertaken by the Shengli Oilfield Administration. In September 1981, Dongpu Oilfield Administration was created to undertake exploration and development in the counties of Dongming and Puyang covering an area of 5,300 square kilometers. In April 1982, the jurisdiction of this organization was extended to the northwest portion of Shandong and Henan Provinces, and its area of activity was expanded to 20,000 square kilometers. The oilfield management entity was renamed as the Zhongyuan Petroleum Exploration Bureau (ZPEB). Functions 3.02 ZPEB functions as a state-owned commercial enterprise, falls under the jurisdiction of MOPI, and operates as a distinct juridical personality. Its current functions encompass: - Seismic work - Exploration - Oilfield development - Developing and processing natural gas - Sale of crude oil and natural gas to authorities/organizations designated by the state - Undertaking related downstream activities. Capital Structure 3.03 The development of the Zhongyuan oilfield has been financed exclusively by contributions from the Government and ZPEB's internally generated funds. Government contribution is allocated annually to ZPEB according to the investment plan and is channelled through the Construction Bank. ZPEB has recently been permitted by the Government to secure loans for undertaking oilfield investment from the Construction Bank. However, its current outstanding long term debt is nominal. Its total networth as of January 1, 1982, was $453 million. Organization and Management 3.04 ZPEB management vests in a president, who is assisted by eight vice- presidents in charge of production, drilling, capital construction, administration, geology, research and design, personnel and logistics respectively. ZPEB's functions are largely managerial, with specialized companies being responsible for various oilfield activities. These companies are sub-units of ZPEB and are not separate legal entities. Currently there  - 24 - are three production companies, each company being responsible for developing the three discovered oilfields, namely, Wenliu, Pucheng, and Wenmingzhai. These companies carry out drilling through the Drilling Company No. 1. Drilling Company No. 1 in turn secures specialized services like logging, cementation, and other downhole services from ZPEB's specialized companies, established specifically for this purpose. Service construction is carried out by the Service Construction Company and all material is secured and provided to various companies by the Material Supply Company. The responsibility for research, design and provision of scientific, geological and engineering support rests with the Geological Institute and the Research and Design Institute. All tasks relating to exploration are currently being undertaken directly by ZPEB. Exploratory drilling is carried out by the Drilling Company No. 2. An organization chart for ZPEB is in Annex 3.01. 3.05. The companies follow the standard Chinese organizational pattern, namely, they are divided into brigades, and brigades in turn into teams. A brigade consists of 10-15 specialists, who function as staff officers to the brigade leader. The brigade leader is responsible for the fulfillment of stipulated targets by the teams under its command. The brigade leader and the staff are usually professionals with managerial responsibilities, while skilled workers man the teams. A team typically consists of between 50-100 persons with the team leader who is an experienced skilled worker. 3.06 Exploration and production targets are established annually for ZPEB by MOPI. These targets are derived from the annual planned targets fixed for the petroleum sector by the State Planning Commission. These targets, initially framed in broad outline, are passed down to ZPEB, which fleshes out the details, evaluates feasibility and works out the financial implications. The annual plan is usually agreed upon and finalized after several iterations. Following a similar process, ZPEB in turn evolves a work program for various companies, their respective brigades and teams. Once this exercise has been completed, ZPEB enjoys considerable operational autonomy and is answerable to MOPI only for results. Its financial autonomy is, however, more constrained; ZPEB must secure inputs from designated sources at pre- determined prices; similarly it must sell its output to specified agencies at prices which are set by the Government. Its investment plan must conform to the national priorities and even within the framework of the approved plan, it must seek the clearance of the Central Government for any foreign exchange expenditure or material inputs designated as essential. 3.07 ZPEB's personnel is hardworking, disciplined and competent, which makes it an effective organization capable of carrying out its pre-assigned tasks. Its managers appear perceptive about their organizational and technical problems, both in research and production. Its technical deficiencies arise on account of outdated equipment, obsolescent technology and a general lack of familiarity with deep drilling and its concomitant problems. Organizationally, there is a discernable premium on the achievement of physical targets and absence of a similar emphasis on quality control. The project, as designed, takes these limitations into account. The major emphasis is on securing new technology, refurbishing research facilities, modifying and improving field facilities, upgrading the level of training and organizationally inducting modern management practices (see para. 4.13). Overall, there is little doubt that ZPEB will be able to carry out this project with competence and speed.  - 25 - Project Implementation (a) Production Company 3.08 Production Company No. 1 (PCN1), which operates the Wenliu oilfield, will be responsible for developing the southern extension. Production has commenced recently in this oilfield and for the current year it is expected to be 300,000 tons. PCNI has a work force of about 1800 workers including 67 technicians and 28 engineers. The company is headed by a director who is assisted by five vice directors responsible for production, administration, technical management, personnel, and capital construction and logistics. The company operates through oil production brigades (four), each of which oversees oil production teams (66), which have direct responsibility for operating and maintaining oil and water injection wells. The oil production brigades/teams are supported by similarly organized brigades/teams which are responsible for well servicing, gas production, maintenance and repairs, geological and technical services, transportation, etc. An organization chart of PCN1 is in Annex 3.02. PCN1 is a recently established company, it currently operates 82 oil and water injection wells; production from another 49 wells is expected to commence as soon as the composite station and the necessary surface construction facilities are completed. Until recently, it had been acted more or less as a division of ZPEB, but as of January 1983, it enters into direct contractual relationships with the relevant companies. It will, among other things, need to augment its supervisory and quality control capabilities and activities to ensure that drilling and completion of wells conform to acceptable standards. (b) Drilling Company and Other Auxiliary Companies 3.09 ZPEB's Drilling Company No. 1 will be responsible for drilling the oil and injection wells for the proposed project. It has a work force of 6,300 workers, of which 294 are technicians and 62 are engineers. It currently operates 70 rigs and 27 additional rigs are in the process of being secured. It is headed by a director who is assisted by five deputy directors, each in charge of production, equipment, administration, engineering and general services. The actual drilling is carried out through four production brigades which in turn are subdivided into 16 drilling teams. Each drilling team has between 50-60 skilled workers, is headed by a team leader, and operates in shifts, twenty-four hours a day. Support for drilling operations is provided by similarly constituted units, which are responsible for cementation, mud engineering, installation, transportation equipment and supply, etc. An organizational chart of the Drilling Company No. 1 is in Annex 3.03. The performance of the company is adequate; in 1981 each rig on an average logged 5,100 operating hours, of which drilling activity accounted for 2,540 hours. On average each rig drilled about 10,000 meters. 3.10 Auxiliary companies provide specialized services to the Drilling Company. The logging company undertakes formation logging and perforation tasks. The downhole well servicing company is responsible for fracturing and other downhole services. For the proposed project, PCNI will enter into agreement with the Drilling Company No. 1 for undertaking all works relating to development drilling, and the Drilling Company No. 1 in turn will enter into similar agreements with the auxiliary companies for providing various well services. For surface construction, a separate agreement will be entered  - 26 - into between PCN1 and the Surface Construction Company. Besides these main service companies, the services of a number of companies (materials, communication, transportation, repairs, etc.) will be secured as needed. 3.11 Work relating to exploration in the eastern extension of Wenliu oilfield will be directly supervised by ZPEB through its specialized technical departments. Until recently, drilling had been carried out by the Drilling Company No.1. However, in view of the increasing workload, ZPEB has set up another drilling company in end-1982, the Drilling Company No. 2, which is exclusively in charge of exploratory drilling. 3.12 Expatriate consultants would be appointed for designing and preparing the tender bids for the LPG extraction plant. The contract is proposed to be awarded on a turnkey basis to an expatriate contractor, who will be responsible for fabricating and commissioning the plant. The Gas Management Company, which was established in end-1982, will be responsible for operating this unit. An organization chart of this company is in Annex 3.04. (c) Project Unit 3.13 ZPEB, PCN1, the Drilling Company No. 1 and other auxiliary companies are capable of implementing the project. However, for coordinating and monitoring the development program relating to the project, a special section is proposed to be established in the office of the president of ZPEB. In addition, a special project team headed by a deputy director would be established in PCN1 and in the Gas Management Company. These teams will be responsible for implementing the relevant components of the project. During negotiations, assurance was obtained from ZPEB to establish such units by September 30, 1983. Financial/Accounting Practices 3.14 ZPEB follows the "Accounting System for State Run Enterprises" enacted by GOC in 1953 and subsequently revised in 1960 and 1981. While the accounting and financial arrangements of ZPEB (Annex 5.02) are satisfactory in the context of China, there are fundamental differences between some of ZPEB?s practices of commercially oriented petroleum enterprises. Special features of ZPEB's financial and accounting arrangements are: (a) ZPEB maintains two separate sets of accounts for its oilfield activities--one set for capital construction and the other for production. Since these two sets of accounts are not being consolidated, ZPEB's balance sheet for production does not include construction work-in-progress. (b) MOPI finances the approved costs for exploration, and also makes specific contribution to development. From mid 1982 on, ZPEB is required to borrow from the Construction Bank for a portion_ of the Government allocation for development at an interest of 2.1% p.a. 1/ Estimated at about 20% of the total investment and field maintenance program over the period 1982-86.  - 27 - (c) ZPEB's level of working capital is set by MOPI who until recently allocated the entire amount to ZPEB free of charge. Under procedures initiated in mid-1982, ZPEB has been required to borrow to supplement MOPI's allocation by borrowing from the People's Bank for a portion of the approved amount at 3.6% p.a. In the event such borrowing requirements exceed the approved levels, interest rate for the additional funds would be doubled, i.e. 7.2% p.a. (d) ZPEB is permitted to charge as expenses sums up to approved yearly budget limits to provide for overhaul and oilfield upholding before computing net income. Funds retained under these provisions are the major sources of ZPEB's self-financing for field maintenance, renewal and development. (e) ZPEB is required to transfer all net income and 50% of annual depreciation to GOC. The balance of depreciation (50%) is retained by ZPEB for field maintenance and renewal. Of the total contributions to the Government, net incomel/ derived from investment funded by the Construction Bank and 20% of annual depreciation are considered debt service on the Construction Bank loan. (f) While heavy emphasis is placed on the budget as a controlling tool, ZPEB generally does not undertake financial planning beyond one year. 3.15 Given the uncertain range of recovery from the reservoirs and the related costs of oil extraction, it would seem prudent for MOPI to extend the horizon of financial planning in the industry as a tool for management decision-making. It is recommended that ZPEB should reformulate its financial planning based either within the existing financial set-up or on the development of a new financial planning unit, with the objective of producing financial plans for five years for its oilfield investment and operations. The financial statements based on the five year plans would be discussed annually with the Bank (para. 5.18). In addition, ZPEB is expected to consolidate its accounts for oilfield capital construction and production [see sub para. (a) above] in submitting its financial statements to the Bank in order to provide an overall view of ZPEB's financial performance and position. Costing 3.16 Financial accountability at ZPEB is organized under three levels of cost center - the bureau, the company and the brigade. For budgeting purposes, standard costing is applied. Standard unit costs for ZPEB are based on the prevailing prices except in the case of imported casing and tubing which are subsidized by MOPI. Budgeted cost is a major yardstick against which the performance of the cost centers is being measured, and achievement of cost targets is one of the bases for bonus reward (para. 3.19). However, while management control relies heavily on the budget, it appears doubtful whether the budget basis - especially in regard to standard quantities - 1/ Averaged at about 30% of the net income remitted to GOC over the next five years.  - 28 provides for adequate monitoring of the efficiency of operations. With the view towards strengthening the monitoring and control function, it is recommended that an evaluation of ZPEB's costing techniques be undertaken by consultants as part of the study for devising a management information system (para. 4.16). During negotiations ZPEB agreed that separate project accounts would be maintained for the proposed project, whereby all the expenditures actually incurred for the project are consolidated at the bureau level. Internal Control System 3.17 Internal control procedures at ZPEB are generally adequate. However, ZPEB does not have at present an independent, comprehensive and systematic centralized internal audit function. Control of fixed assets is performed by the fixed assets section in the finance department; physical inventory of material is carried out by the materials company in its various warehouses. A financial discipline group, within the finance department at the bureau level, is in charge of checking that the financial/accounting practices at ZPEB are in line with the prescribed system of GOC. Such reviews are, however, achieved on an ad-hoc basis, without a predetermined program and systematic audit procedures. The financial discipline group is in part constrained by the limited number of staff (presently only about three in total) and, for large reviews, the group has to be supplemented by drawing upon the financial staff from other units. Under the existing system, there is no provision for an independent assessment of the effectiveness of ZPEB's internal control system. The need for setting up a centralized and comprehensive internal audit system was discussed both with ZPEB and MOF and MOF will review the internal audit process in the context of the overall audit policies of GOC (para. 3.18). This will be followed up during the supervision of the proposed project. External Audit 3.18 The GOC's present financial practice does not provide for external auditing whose scope and depth are in conformity with internationally accepted auditing standards. The responsibility of reviewing the accounts of state enterprises in China is currently divided among the line ministry (MOPI), MOF, the Construction Bank and the People's Bank. However, such reviews do not constitute an independent audit of ZPEB's financial statements. MOF is currently addressing this issue and is setting up an independent audit group within the Ministry to review and certify the financial statements of state enterprises. Regulations on auditing will be formulated and the independent audit group may, within two years, be transferred to the jurisdiction of the State Council. Technical assistance will be provided for this purpose by several organizations, including UN and specific bilateral assistance. In the context of this project, during negotiations GOC and ZPEB agreed to have the project accounts and ZPEB's accounts independently audited and the financial statements thereof be transmitted to the Bank within six months after the end of each fiscal year. Incentive System 3.19 Bonus is distributed monthly when the monthly targets for production, cost, quality and safety, etc. are reached. Bonus amount varies with the number of targets reached by individual sub-units, the lowest level of which  - 29 - is a team. The maximum annual bonus for overall ZPEB is set by MOPI at 2.7 months of ZPEB's average worker salary. For purposes of bonus distribution, ZPEB's staff is divided into three categories: (i) production workers; (ii) service workers and (iii) office staff. Workers directly involved with production receive the largest amount of bonus while the office staff are at the lowest end of the bonus scale. Insurance 3.20 ZPEB insures all its assets with the People's Insurance Company of China. Insurance covers all major risks, including explosion and blowouts. The People's Insurance Company is in turn reinsured with international insurance companies. These arrangements are satisfactory. IV. THE PROJECT Background 4.01 The Zhongyuan basin lies about 500 km south of Beijing in a densely populated agricultural area. It covers an area of 5,300 sq km, most of which lies in Henan Province with a small part in Shandong Province. The Yellow River traverses its southeastern portion. Seismic surveys of the basin started in 1974, and in 1977 the first commercial oil discovery was made. Since then 17 structures have been shown to be hydrocarbon-bearing. Four of these, Wenmingzhai, Weicheng, Pucheng and Central Wenliu, have been brought into production with a current annual yield of 2.10 million tons oil and 291 million cu m of associated gas per year. In addition, four other fields, including South and East Wenliu, have been determined to contain commercial quantities of hydrocarbons. Reserve estimates of these fields are 200 million tons of oil-in-place, 19.7 billion cu m of associated gas and 15.6 billion cu m of free gas. 4.02 The project was defined during a Bank mission to China in September 1981. Its major components are the development of the South Wenliu field, the exploration of the eastern extension of South Wenliu (East Wenliu), and LPG plant, the import of modern and high technology oilfield equipment and operational and technical assistance, including laboratories, a training center, and a computer center. Project Objectives 4.03 The immediate objectives of the proposed project are to: (i) develop the oil production potential of the South Wenliu field; (ii) explore and evaluate the oil production potential of the East Wenliu discovery presently estimated to have about 80-100 million tons of oil-in-place; and (iii) recover LPG from associated gas which, during 1982, is expected to be flared at the rate of 0.45 million cu m per day. Important elements in developing the South Wenliu field will be the optimization of oil recovery and production rates through appropriate secondary recovery techniques (para. 4.19) and improved completion practices (para. 4.18). For the longer term, a more important objective is to continue the process initiated under the Daqing Oilfield -- Gaotaizi Reservoir Development Project of introducing modern technology and  - 30 - methods into the Chinese petroleum industry. To this end, the proposed project provides through Bank financing imported modern oilfield equipment, computer and training centers, laboratories and technical assistance. Geology 4.04 The Zhongyuan basin is a structurally depressed trough filled with sediments, mostly of Tertiary age, reaching a thickness of 9,000 m. It is bordered by northwest-southeast striking faults. In this direction the basin measures 120 km, and its width expands from 20 km in the north to 70 km in the south. The main structural trapping mechanism is formed by a horstl/ type ridge running centrally along its longitudinal axis. All the oil and gas found so far has been located in the lower Tertiary sands on the flanks of this ridge. These sands are separated by gypsum/salt and shale intervals; the latter is believed to be the source rock for the accumulated hydrocarbons. Faulting of the sands is intensive in the longitudinal direction, and transverse faulting across the structure divides the fields into rectangular blocks. A further description of the basin's geology may be found in Annex 4.01. Oil and Gas Production Prospects 4.05 The South Wenliu oilfield, to be developed under the proposed project, is situated on the eastern flank of the basin's central ridge at about 50 km from the northern limit of the basin. The productive lower Tertiary sands have been penetrated by 35 wells, of which 19 have been tested so far and 15 found productive. Bank-financed reservoir consultants (Core Lab -- USA) evaluated the field's reserves and production potential in 1981 (see Annex 4.02). Their findings were essentially in agreement with the Chinese estimates, but the productive area of the field has now been extended, as a result of additional drilling, to include 5 blocks, and estimated oil reserves have substantially increased. The hydrocarbons in place on the basis of current test results are estimated to be 47.8 million tons of oil and 1.84 billion (109) cu m of free gas (para. 4.07). During the initial stages of production, associated gas is expected to be produced at the average rate of 178 cu m per ton of oil (equivalent to about 830 cu ft per barrel). Peak production from the field is expected to be about 1.0 million tons of oil and 178 million cu m of associated gas per year. Most sands will produce oil having 0.81 to 0.84 specific gravity, a sulfur content of 0.1 - 0.35%, a pour point 2/ of 29-35