China - Karamay Petroleum Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 4902-CHA FILE !,' STAFF APPRAISAL REPORT C HI NA KARAMAY PETROLEUM PROJECT May 7, 1984 Energy Department Petroleum Proiects, 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 1983) 1 Yuan US$0.51 1.98 Yuan US$1.00 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES 1 British thermal unit (Btu) 0.252 kilocalories (kcal) I 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 API = American Petroleum Institute degrees (API gravity) CNOOC = China National Offshore Oil Corporation CNTIC = China Technical Import Corporation EOR = Enhanced Oil Recovery GOC = Government of China iOC's = International Oil Companies JC Oil = Japan China Oil Development Corporation KOC = Karamay Oil - Gas Exploration and Development Corporation LPG = Liquefied Petroleum Gas MCF = Thousand cubic feet MOF = Ministry of Finance MOG = Ministry of Geology MOPI = Ministry of Petroleum Industry OIP = oil-in-place PCN2 = Production Company No. 2 RASP = Resource Appraisal Simulation for Petroleum SPC = State Planning Commmission XPB = Xinjiang Petroleum Bureau  FOR OFFICIAL USE ONLY CHINA KARAMAY PETROLEUM PROJECT Loan and Project Summary Borrower: The People's Republic of China Beneficiary: Karamay Oil-Gas Exploration and Development Corporation (KOC) and the Ministry of Petroleum Industry (MOPI) Amount: $100.3 million equivalent, including capitalized front- end fee of $0.3 million. Terms: 20 years, including 5 years of grace, at standard variable interest rate. Relending Terms: Same terms and conditions as the Bank loan; GOC bears the foreign exchange risk. Project Description: The proposed project would assist GOC/KOC in exploring and evaluating the potential of the Karamay oilfield; evolving the optimum method of recovering heavy oil and undertaking a study on utilization of gas from South China Sea. It would include high resolution and three dimensional seismic surveys, drilling of about 530 exploration/appraisal wells, and designing and carrying out pilot projects for heavy oil recovery. An important objective of the project is to introduce modern technology and methods to the petroleum industry in China -- expanding the process initiated under the first two Bank-financed petroleum projects in the country to areas of exploration strategy and heavy oil recovery. The project would provide for improvement of techniques and equipment utilized in the evaluation of oil bearing formations, upgrading of the processing center at Urumqi, establishment of a training center and a computer center and technical assistance (including 180 man-months of expatriate consultant services). The major benefits from the project are the prospect of establishing additional light oil reserves and the potential for heavy oil, evaluating the viability of recovering of heavy oil by appropriate thermal processes, a study to optimize gas use, and transfer of technology. The project involves risks which are common in petroleum exploration and development. The project has been designed to minimize these risks, including the provision of seismic surveys and technical assistance. Even though it is not possible at this stage to quantify the rate of return from the project, tlip prospects of the exploration program and ttw ht,,vy oili pilot project proving economic art r-?;*J dh. 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.  Local Foreign Total ($ million) Estimated Costs: Seismic Surveys 20.0 24.0 44.0 Seismic data processing 8.0 8.0 16.0 Exploration and delineation wells 298.0 132.0 430.0 Heavy Oil Pilots 5.5 11.5 17.0 Supporting facilities & Services 2.0 10.5 12.5 Imported Equipment 6.0 27.0 33.0 Training & Technical assistance 2.0 6.0 8.0 Total Base Cost 341.5 219.0 560.5 Physical Contingencies 34.0 21.0 55.0 Price Contingencies 68.5 33.0 101.5 Total Project Cost!' 444.0 273.0 717.0 Front-end fee -- 0.3 0.3 Charge on use of foreign exchange 36.2 -- 36.2 Total Financing Required 480.2 273.3 753.5 Financing Plan. GOC/KOC 480.2 -- 430.2 Suppliers' Credit or GOC -- 173.0 1658.0 IBRD -- 100.3 100.3 Total 480.2 273.3 753.5 Estimated IBRD FY 1985 1986 1987 1988 Disbursements: ($ million) Annual 8.0 32.0 54.0 6.3 Cumulative 8.0 40.0 94.0 100.3 Econaomic Rate of Return: N.A. Maps: IBRD No. 16436 R2 IBRD No. 17771 R 1/ Local costs include taxes and import duties (estimated at 15% of imported goods).  CHINA KARAMAY PETROLEUM PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. I. ENERGY SECTOR ....... . ..................,...... * . A. Introduction ........................................... .1 B. Energy Balance and Resource Endowment .. ...............2 Coal ................................ . . . . .. . . . . . 2 Power ................. .2 Oil Shale.... 2 Non-commercial Energy ...................3 C. Efficiency of Energy Use ........................... .. . .3 I I. OIL AND GAS SECTOR . ...... . .4 A. Background ............................... 4 B. Oil and Gas Reserves..... ........... . .............. ....... . 4 C. Institutions.... 5 D. Exploration .. ..... . ......6 Onshore...... 6 offshore ........................... .... . . . .. .. . . 6 E. Consumption Pattern ................... ...... . . . .. . . . .. . 7 F. Natural Gas . .......... . ............... 8 G. Prices ..........................9 Ht. Investment . ..... 10 I. Sectoral Issues and the Role of the Bank .10 III. BENEFICIARY .................t.... ...o...12 A. Background ............ 12 B. Functions. ...... 13 C. Organization and Management. . ...... 13 D. Companies Responsible for Project Implementation .....14 E. Financial/Accounting Practices . . . .15 F. Planning .............................. . . .. .. t .... . 15 G. Internal Control System .... .......................... . .16 H. External Audit . ....16 I. Incentive System . . . . ......................... 17 J. Insurance . . ..... ....... *17 This report is based on the findings of a mission that visited China in September 1983 and was prepared by Messrs. V. Nayyar, A. El-Mekkawy, J. Schweighauser, A. Smit and Ms. S. Shum of the Energy Department, with the support of P. White, who acted as consultant for the mission.  - ii - IV. THE PROJECT ........................................... 17 A. Background ....... 17 B. Project Objectives . . ........................................ 18 C. Geology and Prospects . . .................................. 19 Karamay Area ................................. . .. 19 Wuerhe-Hungchiba Area . . .................................. 20 Hongshanzui-Chepaizi Area . . .......................... . 20 D. Project Design . ............................................. 20 Exploration Program .... 20 Heavy Oil Pilot ............................................. 22 E. Project Description .......................... ... ..... .............. 23 Exploration and Appraisal Program . . . . 23 Heavy Oil Recovery . . ..................................... 23 Training . . ............................................... 24 Studies ................................. . . , .. . . 24 F. Project Costs . . ............................................. 24 G. Project Implementation . . .................................... 26 H. Project Financing . . ......................................... 26 I. Allocation and Disbursement of Bank Loan .....................2 J. Procurement . . ............................................... 27 K. Technical Studies.......................................... 29 Reservoir Engineering . . . 29 Geological Study ....................................... . . 30 Gas Use Study . . .......................................... 30 Training ...... o . ........................................ 31 L. Computer Center . . ........................................... 31 M. Transportation Requirement . . . 31 N. Ecology . . ................................................... 32 0. Reporting Requirement ....................................... 32 V. FINANCIAL ASPECTS .................................................. 32 A. Introduction ................................................. 32 B. Pricing ..... 33 C. Costing . . ................................................... 33 D. Funding Arrangement . . ....................................... 34 E. Past Finances and Present Financial Position ................ 35 F. Future Finances ....... 36 G. Investment and Field Maintenance Program .... 36 H. Funds Flow . . . ............ 37 I. Financial Position .. .......................... 37 J. Sensitivity Analysis . . . ............. 37 K. Recommendations . . . .............. 38  - iii - VI. PROJECT RISKS AND JUSTIFICATION .......... ............. 38 A. Project Justification .... ... .... .... ***a .... .. . ... .... .38 B. Project Risks . . . . ................................. 38 Petroleum Exploration ..................................... 38 C. Cost-Benefit Analysis ..................................... 39 Heavy Oil Recovery Pilots .......... ..................... 39 D. Conclusion ....... . . . . .......................... . 40 VII. RECOMMENDATIONS ..................................... 40 ANNEXES 1.01 Energy Balance 2.01 Organization Chart, Ministry of Petroleum 2.02 Oil Production by Major Fields and Regions and Oil Balances 2.03 Gas Production and Refinery Yield 3.01 Organization Chart - Karamay Oil - Gas Exploration and Development Corporation 3.02 Organization Chart - Drilling Company 3.03 Orgnization Chart - Production Company No.2 4.01 Petroleum Geology of the Karamay Oil Field and its Extension 4.02 Hydrocarbon Expectations 4.03 Geophysical Exploration 4.04 Allocation of Bank Loan 4.05 Disbursement Schedule of Bank Loan 4.06 Thermal Recovery of Heavy Oil 4.07 Project Implementation Schedule 4.08 List of Equipment 5.01 Notes on Financial Aspects 5.02 KOC Income Statements (1980-82) 5.03 KOC Balance Sheet (1980-82) 5.04 KOC Projected Income Statements (1983-87) 5.05 KOC Projected Balance Sheet (1983-87) 5.06 KOC Projected Sources and Uses of Funds (1983-87) 5.07 Flow of Funds Between KOC and GOC (1980-87) 5.08 KOC Unit Cost of Production 6.01 Assumptions for Cost/Benefit Analysis 7.01 Related Documents and Data Available in the Project File MAPS IBRD No. 17771R IBRD No. 16436 R2   I. ENERGY SECTOR I! A. 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 USA and one-third of USSR. Coal and lignite reserves are estimated at over 600 billion tons. Exploitable annual hydro potential is estimated at 1,900 billion kWh, against the present hydro generation of 74 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 9 to 18 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 the 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 666 million tons in 1982. During the same period, power generating capacity increased from a little less than 2000 MW to 72,360 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 - 102 million tons in 1981 and 1982. Rapid development of its indigenous energy base 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 energy 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. Future prospects of developing domestic sources of energy 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 entered into a declining phase. No new discoveries have been made in a magnitude to offset this decline. With the help of internationl oil companies, China has initiated a major exploratory effort in its offshore areas; and while the prospects are considered to be very good, offshore oil is unlikely to augment China's production significantly before 1990. Rapid expansion of coal industry faces problems in terms of investment, 1/ For more detailed discussion please see Bank's report No. 3391-CHA - China: Socialist Economic Development - Annex E: The Energy Sector.  - 2 - 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 1980's. B. Energy Balance and Resource Endowment 1.04 Estimates of commercial energy balance for 1980, 1982 and 1985 are at Annex 1.01. Oil and gas as a source of primary energy is considered in section II, other sources are discussed below: (1) Coal 1.05 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 1982 was about 666 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. 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 and new mines, and for domestic manufacture of underground mining equipment. The Government expects the output to reach 700 million tons by 1985. To increase coal production beyond this level would require not only a massive increase in investment for opening new mines and modernizing existing ones, but also in rail transport which is the single most important constraint. (2) Power 1.06 China increased its generating capacity from little less than 2000 MW in 1952 to over 72,360 MW by 1982 - an average growth rate of about 14% per annum. Of this, 68% of the generating capacity is thermal (49,400 MW) and 32% is hydro (22,960 MW). In 1982, 328 billion kWh of power was generated, of which about 77% was thermal and the balance 23% 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 74 billion kWh. 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, reservoirs built for this purpose meet irrigation requirements, prevent floods and are being used for pisciculture. (3) Oil Shale 1.07 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 discovery of the Daqing oilfield. Currently, from the Liaoning and Guangdong mines, about 300,000 tons of shale oil is being produced. In view of the anticipated energy shortage, oil shale may once again need to be considered as an important energy resource. (4) Non-commercial Energy 1.08 Unofficial estimates place the energy extracted from non-commercial 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 income levels. This is partially explained by a high population density and low availability of forest resources. For maximizing the benefits from non- commercial sources of energy, China has pioneered and is now the leader in producing biogas. 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. C. Efficiency of Energy Use 1.09 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 the structure of GNP 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 and fertilizer industry, energy consumption per ton of output is approximately double the level achieved in other developing countries using state-of-the-art technology. 1.10 The problem of energy efficiency in China largely results from the use of outdated technology,,ynadequate facilities to capture waste heat, the scale of industrial plants,- and the raw materials used. Many of these problems will require complex studies and take time to resolve. Their solution would require substantial capital investment and considerable 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 1/ This may however have to be compared with savings in transport cost.  - 4 - measures appear to have had some success. In 1980 and 81, primary commercial energy consumption per unit of Gross Domestic Product (GDP) fell by 6.7% and 4.0% respectively. II. OIL AND GAS SECTOR A. Background 2.01 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 relatively modest discoveries including the Karamay oil field. However, from 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 withi that China became self-sufficient. During the sixties, the increase in oil production was relatively moderate; the major spurt came in the seventies withi production increasing from 30 million 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. B. Oil and Gas Reserves 2.02 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 for oil have been made by different geologists/bodies; the opinion, including that of the Bank's missions, is now converging to a range which varies from 1.8 to 2.5 billi.on 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. 2.03 Currently, the major non-associated gas fields are located in the Sichuan Province and the recoverable reserves are estimated at 80 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 million 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. Recent gas discoveries in Zhongyuan and South China Sea lend credence to this view point.  -5- C. 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. The organization chart of MOPI is in Annex 2.01. There are however areas where functions of other ministries overlap with MOPI. The Ministry of Geology (MOG), in addition to being in charge of petroleum related geological work, separately and independently undertakes offshore exploration. Similar fragmentation of responsibility exists in the refining. 2.05 The petroleum sector in China employs over a million workers. MOPI oversees this vast sector through seven onshore petroleum companies, one offshore petroleum company and several institutes and service companies. However, primary responsibility for exploration and production of oil and gas rests with the regional oil companies. Through the process of iterative consultations with each company, MOPI and the State Planning Commission establish various physical targets and agree on investment priorities. Resources for investment financing are allocated by MOPI, while regional companies have a much greater autonomy in the financing of their current expenditures (see Section 5). Once this is done, each company enjoys a fair amount of operational autonomy and is answerable to MOPI essentially for results. In fact, difficult logistics, great distance and the sheer numbers involved make the MOPI intervention on anything but the most basic issues virtually impossible. Such an organizational system has worked effectively so far. However, these large oil companies, self contained as they are, have little or no contact amongst them or with the rest of the world; the resulting insulation makes learning from one another's experience and diffusion of new technology, significantly more difficult. Furthermore, the existing organizational pattern does not encourage innovation, the decision making process is protracted and the areas of responsibility are rigidly defined; these characteristics could becone problems, as interface with the foreign oil industry increases, especially in offshore development. 2.06 The China National Offshore Oil Corporation (CNOOC) was created in February, 1982 to oversee all work relating to offshore exploration and development. CNOOC is 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 facilit:ies, CNOOC has established four regional subsidiary corporations. In addition, CNOOC has set up six specialized companies for logging, geophysical services, navigation, offshore drilling, etc., in joint venture with foreign companies. Further, as of September 1983, Petrochemical Corporation of China has been created and all industries using petroleum products or natural gas as feed stock have been transferred to this Corporation. In addition, all refineries with a capacity of over 1 million tons have come under the management of this Corporation. This Corporation is independent of MOPI and reports directly to the State Council.  -6- D. Exploration (1) Onshore 2.07 Until the late 1970s, China was remarkably successful in implementing a policy of total self-reliance. However, the rate of discovery has been declining and Renqiu was the last major discovery. This stagnation results from a large number of features which characterize China's exploratory efforts. On the one hand, the immense size and geological complexity of the prospective areas impose an enormous requirement in resources which cannot be made available from the system. On the other hand, the policies dictated by central planning and the objective of self reliance has limited cross fertilization, access to new technologies and ideas and has over-emphasized production and short term gains over long term prospecting efforts commensurate with China's geological potential. 2.08 As part of the effort to meet the formidable target it has set to double oil output by the end of the century despite production decline irom existing fields, GOC has recently decided to accelerate the country's exploration program. Over the medium term, the main prospecting efforts will remain in the better understood east and north-eastern basins, including exploratory drilling in deeper geological strata of existing oilfields and seismic surveys in the peripheral of producing areas where even small discoveries could be brought to stream rapidly. Prospecting efforts will also be expanded in the under-explored west and northwest, including the Junggar, Tarim, Qaidam and Ordos basins, which have been neglected despite good prospects for discovery of large reserves. These areas could contribute significantly to China's production in the 1990's. 2.09 Taking account of its technological constraints, China has secured, on a limited scale, assistance of foreign petroleum service companies in undertaking seismic surveys and exploratory drilling in especially difficult areas. In addition, China has tried to attract international oil companies to explore in north-western basins, but the industry has so far appeared to prefer the offshore areas where the infrastructure constraints are considerably less than onshore and where extensive geophysical surveys could be carried out at a lesser cost. More recently, GOC has turned to the Bank to provide technical assistance to enhance the productivity of Chinese oil companies, primarily through the identification of technological problems, appraisal of hydrocarbon prospects and assistance in the selection of tezhnologies which could be disseminated rapidly and would help upgrade the ongoing production and exploration effort. (2) Offshore 2.10 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 basins. These surveys identified six prospective basins and more than 475 prospective hydrocarbon structures therein.  - 7 - 2.11 Initially, China entered into participation agreements with foreign oil companies through bilateral negotiations. On the basis of these negotiations, five agreements were entered into; two with the Japan National Oil Company (JNOC) for the Bohai bay, one with Elf, also in the Bohai bay, one with Total Chine for an area in the Tonkin Gulf and one with Arco in the South China Sea off the Hainan Island. Subsequently, in early 1982, the Government promulgated regulations that would enable foreign oil companies to participate in exploring China's offshore basin. Further, CNOOC was created to invite and evaluate bids and enter into offshore petroleum agreements with foreign oil companies. The new regulations allow petroleum contracts that make foreign oil companies bear the cost of all exploration investment and the accompanying risks. Once a commercial oil and/or gas field is discovered, both the foreign contractor and CNOOC will invest jointly in its development. Initially the foreign contractor will be responsible for developing and operating the field, but CNOOC may take over as the field's operator whenever it deems fit. The rights of the foreign contracting party to recover its investment and expenses and to receive remuneration for the petroleum produced would be specified in the contract. 2.12 The response to the first phase of Chinese offering has been adequate. Eleven production sharing contracts have been negotiated and concluded, of whiich ten relate to the South China Sea and one is for the South Yellow Sea. CNOOC hopes to conclude another four to five contracts by the end of 1984. Of these, for five contracts, the operator is BP, for two Esso, for another two Occidental with JNOC and Idemitsu being operators for one each. E. Consumption Pattern 2.13 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 20% in 1982, with coal (73.5%) and hydro (7%) providing the balance. The major consumer of oil is the industry and commerce sector (45%) followed by transport (17%) 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 6 million tons in 1982, as fuel oil. Non availability of refining facilities close to the producing field, transportation constraints and poor quality of crude, in part explain this otherwise wasteful practice. 2.14 Over the last 17 years consumption has been growing at an annual rate of about 12%. 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 1982 is reported to be about 82 million tons against the peak of 90 million tons attained in 1978. IHowever, it is moot if further reduction in consumption can 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  - 8 - cannot be secured without discarding the investment. A more promising direction is in the choice and design of new investments which should be more energy efficient and flexible in Lerms of fuel use. 2.15 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 reliable forecast. However, the demand for petroleum products in 1985 could reach about 90 million tons. Imiplications of such a scenario are serious. China has so far been able to maintain the export level; in fact stepped it up even in a situation of declining production. In 1982 China's earnings from the export of oil are estimated at $5.4 billion and represented 22% of its total foreign exchange earnings. Consumption level of 90 million tons or above would imply that oil exports would cease to be a significant source of foreign exchange earnings in the not too distant future. The overall growth in production, consumption and exports over the last 15 years is at Annex 2.02. F. Natural Gas 2.16 China produces gas in significant quantities; in 1982 production of gas (associated and non-associated) amounted to 11.9 billion cubic meters, equivalent to about 10 million tons of oil. Of this, gas produced in association with oil amounted to 5.96 billion cubic meters. The balance of 5.95 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. Gas production over the last five years by regions is at A.nnex 2.03. Presently about 30% of the natural gas is used for fertilizers, about 10% for petrochemicals and synthetic fibers and the balance of 60% for fuel, of which about 12% was used for thermal power plants. 2.17 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 oi]fields, production of associated gas would also decline. As a matter of fact, gas production in 1982 in relation to 1980, registered a decline of about 15%, equivalent to 2 million tons of oil. Falling gas production would inevitably stimulate demand for liquid hydrocarbons. However, prospects for developing alternate sources of gas have improved. Recently a major gas discovery has been made in Zhongyuan; preliminary estimates place the reserves at about 3.5 trillion cubic feet (tcf). Separately the oil discovery made in the Bohai bay is reported to have high gas-oil ratio ranging from 800-2800 sef to a barrel of oil. Again, an offshore gas discovery of significant magnitude has been made south of Hainan Island in the South China Sea by Arco. Further, gas discoveries, both associated aad non associated, are likely to be made as offshore exploration gathers momentum. It is, therefore, necessary that China take steps to exploit this potential which would, inter alia, involve the development of the gas fields, put:ing in gathering systems, establishing gas infrastructure and taking such other measures as are necessary for identifying potential demand and building the necessary absorptive capacity for gas. In the ensuing months, the Bank intends to review this aspect in considerable detail with MOPI.  -9- G. Prices 2.18 Prices of petroleum products, like other essential commodities in China, are fixed by the National Price Administrative Bureau. This Bureau 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 relatively higher cost oilfields in northwest China (Karamay oilfield) and new oil fields (Zhongyuan) which sell crude at Y115 ($58) and Y130 ($68) per ton, respectively. 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 Internationallb Domestic Price Y/ton $/ton Y/ton $/ton price $/ton as % world prices Gasoline 590 298 800 404 282 143 Kerosene 420 212 680 343 270 127 Diesel 240 121 420 212 230 92 Fuel oil/ 55 28 134/c 68 160 43 Natural gas/Id - - 2.9 1.5 4.0 38 (Y/MCF) ($/MCF) ($/MCF) 2.19 The average price of reconstituted barrel is about Y53 or $27, which approximates the international price (FOB) net of average transport cost within China. In pricing petroleuma products, like many other countries, China uses the system of cross subsidies; some products (motor gasoline and kerosene) are priced above international levels and others (diesel, fuel oil) below this level. The price of fuel oil is the relevant comparator for the value of natural gas. In China, the price of natural gas approximates the fuel oil price in Btu equivalent. The Government has initiated a series of administrative measures, including quotas, in order to contain the demand for petroleum products and encourage its substitution by coal. The Government is aware that some energy products are underpriced. It is considering the revision of petroleum prices as a part of its overall price readjustment. There is a proposal to increase the price of crude oil from Y100 to (Y115 and Y130 in some cases) to Y175 per ton. This proposal is pending a decision of the State Council. As an interim raeasure, starting from July 1982, a special tax of Y70/ton has been levied on crude and fuel oil which is burnt as fuel. La Weighted average price, 30% of fuel oil consumed as feedstock does not include special tax on petroleum fuel. /b FOB Singapore prices on December 19, 1983. /c Assumes transport cost averaged at Y30/ton. /d In terms of Btu fuel oil equivalent.  - 10 - H. Investment 2.19 The average investment in the petroleum sector over the last six years has been about Y4.5 billion ($2.3 billion) per annum. Of this total, some 70% has gone into development with exploration securing 30%. About 52% of the investment has been funded by the state budget and the balance (48%) by the retained funds of state enterprises. Government funds have covered the entire cost of exploration and 27% of development investment. As offshore exploration has mainly been carried out by foreign oil companies at their risk, China's expenditure for offshore exploration has so far remained modest, cumulatively amounting to about Y80 million ($40 million). On the other hand the exploration expenditure made by foreign oil companies is estimated at Y1 billion ($500 million) by end 1982. 2.21 To offset the anticipated decline in the existing oilfields and secure a net increase over the current production level, China would need to step up its petroleum investment substantially. Exploration investment would also need to be increased. Offshore development would create a further draft on resources since GOC would share the development costs to the extent of 51% under the joint venture agreement. Depending upon the success attending the offshore exploratory efforts, China's share could amount to several billion doLlars. China would not be in a position to finance such an ambitious program from within its own resources. It has accordingly decided to finance al-L offshore development program from commercial/bilateral borrowing and supplier credit. Consequently, for financing its share of the offshore exploration/development in Bohai Bay, GOC has relied largely on loans from the government of Japan, and its Exim Bank. Total borrowing for this development is expected to exceed $1 billion. However, for the time being, GOC wishes to limit commercial and supplier's credit, etc. for the development of its offshore program. Limiting cofinancing to a specific activity, according to the Chinese policy makers, has several advantages: it makes credit monitoring easier; as offshore activities would generate foreign exchange directly, debt servicing would not be an issue; financial requirements are likely to be high and risks relatively low; and this will assist China in not only obtaining the necessary resources but also securiag better terms. I. Sectoral Issues and the Role of the Bank 2.22 From available evidence it is clear that China at least in the medium term, faces the prospect of decliniag oil production. There are also various constraints to the rate at which alternative sources of energy (gas, hydro, coal) can be developed and brought to the consumption centers. China's petroleum exploration strategy over the longer term is to increase exploratory efforts, especially in the northwes: onshore areas, and in the offshore areas where private industry investment is being actively sought. On the energy demand side, various measures to control demand are currently being implemented including quota systems, technical assistance to enterprises, and some industrial restructuring (para. 1.10). 2.23 Demand for petroleum products, while currently contained at a fixed level of about 82 million tons through administrative measures, will pick up over the next few years thus reducing the potential for exports. The period between 1985-1990 could be difficult, seeing a steady erosion in foreign exchange earnings from exports of oil. Thus for China, sustaining production  - 11 - at the current level is of critical importance, and a marginal increase in aggregate production would be of considerable advantage. To achieve this, however, will require a substantial investment in terms of new technology, adoption of enhanced oil recovery methods, infill drilling, exploring for and developing peripheral reservoirs, rapidly developing small discoveries and above all building the necessary infrastructure to utilize associated and natural gas which could replace liquid hydrocarbons. 2.24 China's onshore petroleum operations currently face the prospects of declining production, with regional companies being required to undertake exploration and production under increasingly difficult and complex conditions. In this they are hampered by the lack of both appropriate technology and relevant equipment. To help overcome these constraints, it has sought the collaboration of international oil companies (IOC's). A number of these companies have been invited to visit China's oilfields and have been approached as to whether they would be interested in providing technical assistance for exploration and development. With similar objectives, a large number of Chinese delegations have also visited various IOCs. In these efforts, China has met with little success. While there has been considerable interest in China's petroleum potential, this interest has been confined almost exclusively, at least for the present, to the offshore areas; as for the possibility of providing technical assistance, little interest has been expressed by most of the IOC's who expect higher returns in deploying their scarce technical staff than can be provided by technical assistance contracts. It is in this context that GOC has sought Bank's participation in the onshore petroleum sector. Over the past three years Bank staff have assisted several regional Chinese oil companies in assessing the nature of the problems they were facing, providing state-of-the-art expertise, proposing solutions, diagnosing technological gaps, prevailing upon them to undertake relevant technical studies, assisting them in preparing terms of reference, and securing consultants. The Bank will subsequently assist these organizations in overseeing these studies and designing corrective measures and supervising their implementation. 2.25 The basic rationale for the Bank's participation in China's petroleum sector therefore lies in the packaging of technical assistance programs, monitoring them, and subsequently overseeing their implementation. As conditions are so diverse within the different producing areas of the country and the management problems of each oil company so unique that for each oilfield a separate package of technical assistance has to be evolved, which is achieved through a detailed review by the Bank staff of the entire operations of the company, and an agreement on the area where assistance would be most useful. For example, in the Daqing oilfield, the focus of first Bank- financed petroleum project (Loan 2231-CHA), the technical assistance addressed enhanced oil recovery, infill drilling, reservoir engineering, production techniques, etc. In the Zhongyuan oilfield, the Bank's second petroleum project (Loan 2252-CHA), the technical assistance related to exploration and drilling methods under conditions of high temperature and pressure. In both cases, however, the main objective remained the same, that is, to provide the specific package of technical assistance requirements in priority production areas; assistance which would maximize the chances of increasing production further at an acceptable cost.  - 12 - 2.26 Similarly, the broad objectives of the Bank in the Karamay Petroleum Project are the provision of technical assistance. Specific components have, however, been tailored to meet the needs of KOC not only in oilfield technology but also in designing an exploration and heavy oil recovery program which aim at establishing a higher, longer-term, production base for the Karamay oilfield. The exploration component will assist KOC with up to date tec'hniques and equipment related to exploration and delineation which should improve the chances of discovering additional reserves in the near term. The heavy oil component will assist in studying the feasibility of, and evolving state-of-the-art methods for developing considerable reserves of heavy oil which have already been discovered. Finally the project will focus the attention of the Government of China on natural gas as a source of potential energy. To this end the project would assist the government in undertaking a detailed study regarding the potential demand for natural gas from South China Sea and in determining the viability of supplying natural gas to the potential market. While the exploration component will largely be limited to KOC, it is expeCted that the heavy oil component and the gas related studies will have a cour;trywide impact and contribute to increased oil and gas production. The Bank:'s future lending in this sector would support GOC's efforts to stem the decline in its oil production through the application of enhanced oil recovery methods, and exploring and developing the peripheral areas of existing fields. In addition, the Bank would assist China in diversifying its energy base through a more rapid development of its heavy oil reserves and optimizing the use of natural gas (through rehabilitation of old gas fields, development of new fields and provisions for infrastructure). III. BENEFICIARY A. Background 3.01 Oil exploration commenced in Karamay in 1953 under a venture jointly managed by China and the Soviet Union. In 1955, the management reverted exclusively to the Chinese. The Karamay oilfield was discovered in late 1955. In June 1956 the Karamay Mining Bureau was established to develop the Karamay oilfield. Except for a limited period during the 1970's, the bureau has functioned from its very inception under the overall leadership of the Ministry of Petroleum. However, the Xinjiang Petroleum Bureau (XPB), on behalf of the Xinjiang Autonomous Region supervises issues relating to personnel. In January, 1983, the management of the Karamay oilfield was reorganized and the company was designated as the Karamay Oil-Gas Exploration and Development Corporation (KOC). The other oil companies currently operating in the Xinjiang Autonomous Region are the South Xinjiang Exploration Company, which is currently undertaking exploration in the Tarim Basin and the East Xinjiang Exploration Company which is currently exploring in the eastern and the southeastern part of the Junggar Basin. As in the case of KOC, all operational and financial matters are supervised by MOPI and issues relating to personnel are managed by XPB.  - 13 - B. Functions 3.02 KOC operates as a state owned enterprise and its current functions encompass: - Seismic work - Exploration - Oilfield development - Developing and processing natural gas - Sale of crude oil to authorities/organizations designated by the state - Operation and management of pipelines within Xinjiang 3.03 As in the case of other state owned petroleum entities, there was no formal statute or decree relating to the creation, powers and functions of KOC. As having a distinct juridical personality is a fundamental condition for entering into a project agreement with the Bank, MOPI agreed to issue a statute which clearly sets out the powers and functions of this entity. Accordingly, a charter on KOC's legal status became effective on April 17, 1984. C. Organization and Management 3.04 KOC's management consists of a president who is assisted by one senior vice-president and three vice-presidents who are respectively in charge of production, exploration and scientific research, administration and finance, and coordination. KOC's functions are largely managerial with specialized companies being responsible for various oilfield activities. These companies are sub-units of KOC and not separate legal entities. The oilfield is divided into four administrative units, with a production company being responsible for oil production for each of these units. These companies carry out drilling through the drilling company which in turn secures specialized services i.e. logging, cementation, and other downhole services from KOC's specialized companies established specifically for these purposes. Surface construction is carried out by the surface construction company. All work relating to exploration is the responsibility of the Geological Exploration Department which functions under the chief geologist. This department oversees the work of companies set up for undertaking geophysical/geological surveys, drilling and well testing. The organization chart for KOC is in Annex 3.01. 3.05 Each specialized company, follows the standard organization pattern, namely, it is divided into brigades, and brigades in turn into teams. A brigade consists of 10-15 specialists, who function as staff officers under the brigade leader. The brigade leader is responsible for the teams under its command for fulfilling the stipulated targets. The brigade is staffed with professionals who have managerial responsibilities, and skilled workers man the teams. A team typically consists of 50-100 persons with a team leader who is an experienced skilled worker. 3.06 KOC is amongst the oldest operating oil companies in China, and has in its ranks, some of the most experienced and disciplined petroleum personnel. KOC's organizational structure, more or less, adheres to the standard Chinese pattern; there are a number of companies, each responsible  - 14 - for a specialized function. This permits build up of expertise and, by placing the companies in a client-contractor relationship, ensures a satis- factory performance level and quality control. In many ways this organizational structure is not too dissimilar from the private industry which relies on a host of specialized contractors to perform specific tasks. Thus organizationally KOC is capable of carrying out its preassigned tasks. 3.07 The management is aware of its technical and organizational problems. Like other oilfields in China, technical deficiencies arise on accDunt of outdated equipment and technology. For example, in exploration of especially complex structures, KOC is handicapped by its lack of modern equipment for collecting and processing seismic data. Similarly, for the recovery of heavy oil, it is not privy to the latest methods of thermal recovery. Organizationally, there is a discernable premium on the achievement of physical targets and absence of a similar emphasis on quality control. Further, under the existing organizational pattern, KOC like other oil companies in China, is directly responsible to MOPI. However, contact between various oil companies is minimal and mobility of staff almost non-existent. This insulation retards the transfer of technology from one oil field to another and makes modernization of the oil industry so much more difficult. The project, as designed, takes such limitations into account. Overall, there is little doubt that KOC will be able to carry out the project with competence and speed. D. Companies Responsible for Project Implementation 3.08 KOC will have the overall responsibility for implementing the project, except for the gas use study and heavy oil pilot project at Liaohe which will be the responsibility of MOPI. The seismic work would be carried out by local and expatriate seismic crews. Performance of the Chinese crews has been satisfactory, particularly in mapping shallow horizons. However, for undertaking geophysical work in complex areas, especially for mapping deeper horizons and conducting three dimensional surveys, expatriate crews are needed to supplement local expertise. Expatriate assistance would also be secured for assisting in the processing of geophysical data. In addition, the processing center at Urumqi would be appropriately upgraded to handle the increased data inflow. 3.09 The Drilling Company will be responsible for undertaking all exploratory and delineation drilling. It has a work force of 10,700 workers, of which 865 are technicians and 250 are engineers. It currently operates 57 rigs. It is headed by a director who is assisted by one senior deputy director and three deputy directors in charge of production and operation, administration, and production support. The actual drilling is carried through 5 production brigades which in turn are subdivided into 57 drilling teams. Each drilling team has 4 crews, which operate in shifts, 24 hours a day. A drilling team typically consists of 50-60 skilled workers and is headed by a team leader who is a skilled worker with considerable experience. Support for drilling operations is provided by similarly constituted units which are responsible for mud engineering, installation, transportation, equipment and supply, repair, etc. The organization chart of the drilling company is at Annex 3.02. Performance of the drilling company has been satisfactory; in 1982, it drilled 328 wells to an average depth of 1,800 meters. The total footage was over 600,000 meters and on average 6  - 15 - wells were drilled per rig. Given the age of the equipment (most of the rigs are ten years old) and the outdated technology these rigs incorporate, performance of the drilling company is more than adequate. However, during 1982, 22% of the rig time was spent on maintenance and moving from one location to the next. Furthermore, the supporting services such as coring, testing and cementing were not up to the current petroleum industry standards. Provision has, therefore, been made in the proposed project to provide specialized drilling material and equipment and transport support to KOC; this should considerably improve the operating efficiency of the company. 3.10 Production Company Number 2 (PCN2) will be responsible for implementing the heavy oil pilot project in Karamay. It currently operates in one subdivision of the Karamay oilfield and its production in 1982 was 2.1 million tons; which was produced from about 1,100 production wells. The company is headed by a director who is assisted by three deputy directors in charge of operations, welfare and administration, and has a workforce of 5,300 workers of which 204 are technicians and 43 engineers. Drilling and completing the shallow heavy oil pilot wells and installing the surface facilities will be carried out by PCN2 through various specialized companies of the KOC. The design and monitoring of the steam injection and in-situ combustion process will be accomplished by specialized consultants under the overall supervision of PCN2. The organization chart of the company is at Annex 3.03. E. Financial/Accounting Practices 3.11 KOC follows the "Accounting System for State Enterprises" enacted by GOC in 1953 and subsequently revised in 1960 and 1981. While the accounting and financial arrangements of KOC are satisfactory in the context of China, there are fundamental differences between some of KOC's practices and those of commercially oriented petroleum enterprises (Annex 5.01). KOC 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, KOC's balance sheet for production does not include construction work-in-progress. In order to provide an overall view of KOC's financial performance and position, KOC's balance sheets for production and capital construction have been consolidated for purposes of financial appraisal. F. Planning 3.12 Production and net income targets are established annually for KOC by MOPI. KOC works out the detailed implementation plan and the annual budget for operation and investment is usually finalized and approved by MOPI after several iterations. While heavy emphasis is placed on the budget as a controlling tool, KOC generally does not undertake financial planning beyond one year. However, in the light of the rising cost trend at Karamay, it would seem prudent for KOC to extend the horizon of financial planning beyond one year. The financial plan would form a critical basis for KOC to evaluate investment, control cost and make pricing recommendations to MOPI. It is, therefore, recommended that KOC 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. During  - 16 - negotiations, an assurance was obtained from KOC that the financial statements based on a rolling five year plan would be submitted to the Bank and discussed annually with the Bank as part of the review of KOC's finances (para. 5.19). 3.1.3 Insofar as investment planning is concerned, the investment evaluation criteria as applied by KOC are inadequate. Under the present system, only payback period is taken into account for project evaluation and there is no provision for analysis based on net present value and internal rate of return. In addition, investment evaluation is based on financial cost to the oilfield but not the economic cost to the country. In fact, the costing system at KOC does not provide for the calculation of economic cost (para. 5.05). With the view towards strengthening the financial management system at KOC, the training component provided under the project would include short courses on economic and financial analysis (para. 4.36). In addition, the costing system at KOC would be strengthened to provide for the calculation of economic costs (para. 5.05). G. Internal Control System 3.14 Internal control procedures at KOC are generally adequate. However, KOC does not have at present an independent, comprehensive and systematic cenl:ralized 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 KOC are in linE! with the prescribed system of GOC. Such reviews are, however, achieved on aLn 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 KOC's internal control system. The need for setting up a centralized and comprehensive internal audit system was discussed with KOC. It would, however, take time for KOC to fill its internal audit function with qualified and experienced staff. Under the proposed project, training in internal auditing would be provided to the financial staff at KOC (para. 4.36). H. External Audit 3.15 Until recently, financial/accounting practices in China did not provide for external auditing whose scope and depth were in conformity with internationally accepted auditing standards. The responsibility of reviewing the accounts of state enterprises in China was divided among the line ministry (MOPI), Ministry of Finance, the People's Construction Bank and the People's Bank of China. However, such reviews did not constitute an independent audit of KOC's financial statements. In June 1983, an independent audit agency was set up and the Auditor-General appointed. The State Audit Agency is at par with a national ministry, reports directly to the State Council and is charged with auditing the accounts of government departments and state-owned enterprises. The State Audit Agency is in the process of formulating auditing regulations as well as recruiting/training of the audit staff. The Bank has assisted this process by conducting a seminar in China on the requirements and  - 17 - guidelines for audit of Bank projects. In addition, technical assistance is provided by bilateral and UN sources and the recently approved Technical Cooperation Credit (No. 1412-CHA). Under this project, US$1 million has been allocated to assist the State Audit Agency in training staff to audit Bank- financed projects. In the context of this project, during negotiations, KOC agreed to maintain separate accounts for the project. In addition, the project accounts and KOC'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. KOC would consolidate its accounts for oilfield capital construction and production in submitting its financial statements to the Bank in order to provide an overall view of KOC's financial performance and position. I. Incentive System 3.16 Bonuses are distributed only when the targets for both production and net income are reached. This differs from the incentive system in some other oilfields in China whereby bonuses are distributed if at least one of the various targets is met and the bonus amount simply varies with the number of targets reached. Under the two tier pricing system (para. 5.03), MOPI has set KOC's production target to slightly below the level it is expected to achieve (para. 5.14). As a result, the production target appears to be more of a mechanism to help maintain KOC's profitability than as a performance yardstick. The net income target, on the other hand, is used by MOPI to measure KOC's performance in regard to production and cost control. The present incentive system, which was instituted recently as part of China's economic readjustment program, represents the first step towards the right direction. The maximum annual bonus for overall KOC is set by MOPI at 2 months of KOC's average worker salary. For purposes of bonus distribution, KOC'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. J. Insurance 3.17 KOC presently insures a portion of its assets with the People's Insurance Company of China. During negotiations, an assurance was obtained from KOC that it would make satisfactory arrangement for the insurance of the project works, including coverage for equipment and materials in transit. IV. TILE PROJECT A. Background 4.01 The Junggar Basin lies about 3,000 km west of Beijing in a sparsely populated desert area. It covers an area of 130,000 km2 and is part of the Xinjiang Autonomous Region. The search for oil commenced in the late 19th century. The first discovery was made at Dushanzi in 1897. Systematic exploration started only in 1953, under the Sino-Soviet Technical Cooperation Agreement. Initial operations included drilling of some deep wells in the vicinity of Dushanzi and Urumqi. Thereafter, the focus shifted to the northwestern part of the basin (Karamay), an area well known for its extensive surface oil shows.  - 18 - 4.02 The first commercial oil discovery was made in 1955. Since then, in the area of Karamay, over 20 oilfields have been discovered and developed. The fields are aligned along a narrow structural zone about 100 km long, which trends northeastward from Karamay. Current annual production is about 4 million tons of oil; only a minor amount of gas is produced. Of the existing proven reserves, recoverable reserves of light oil are estimated at 30-40 million tons. Additional reserves likely to be established by the proposed exploration and delineation program are 300 million tons of light oil, and about one billion tons of heavy oil-in-place. Heavy oil could possibly yield significant volumes of commercial oil despite the expected low productivity of the fields. B. Project Objectives 4.0:3 The project has three broad objectives. Firstly, it will support an expanded exploration program in the Karamay oil belt and its southern extension which will include seismic surveys with six parties for two years and drilling some 370 exploration and appraisal wells. This massive exploration program is expected to add some 150 million tons of light oil--in- place in the Wuerhe-Hungchiba area, in addition to another 200 million tons of oil-*in-place in the Karamay area. It is an essential component of the plan to increase production to 7 million tons by 1990 as projected by KOC. 4.04 Secondly, this project aims at evaluating the potential of heavy oil in the Karamay and Liaohe oilfields. This would be achieved by drilling exploration and delineation wells for firming up the extent and charac- teristics of the various reservoirs. In addition, pilot projects would be designed to test alternate methods for thermal recovery and select the best for fieldwide application. While this component is not expected to add significantly to oil production during the 80's, it should provide a sound basis on which thermal recovery projects could be developed during the 90's. It should also provide a framework in which the feasibility of similar projects can be evaluated. 4.05 Thirdly, and most importantly, the object of the Bank's participation is to provide technical assistance. The project provides for critically needed technical inputs for KOC's overall exploration and development program, including modern equipment for logging, cementing, fracturing, etc.; several studies to improve the understanding of the oil habitat to better manage and deve:Lop light reservoirs; upgrading of the seismic data processing center; establishing a training center for skilled workers and a computer center to improve oilfield management; and above all, maintaining through supervision, the implementation and dissemination of new technologies. In addition, with the view towards focusing GOC's attention on the optimization of gas usage<, the project provides for the undertaking of a detailed study regarding potential demand for the gas from South China Sea and the viability of supplying natural gas to the potential market. 4.06 As a part of the overall program to stem the anticipated decline of onshore oil production in China, it is planned to increase the output from the Karamay area to 7 million tons by 1990. The mission believes that this is a reasonable objective. The KOC area can be divided into three regions (IBRD Map No. 17771R):  - 19 - (a) the Karamay area proper where oil production has been established and no major difficulty is anticipated in securing additional production; (b) the Wuerhe-Hungchiba area where no production has been established so far, but exploration has delineated 15 areas which KOC considers highly prospective for oil, and in five of these areas oil was found by test wells; and (c) the southern portion of the Karamay producing area (the Hongshanzui-Chepaizi area) for which no meaningful oil and gas expectations can yet be quantified, however eventual hydrocarbon resources could be a multiple larger than those at Karamay proper. C. Geology and Prospects 4.07 The Junggar Basin is a structurally depressed area filled with sediments of Carboniferous to Tertiary age which reach thicknesses in excess of 10,000 m. The Tien Shan Mountain system in the south separates the Junggar Basin from the much larger Tarim Basin. Mountainous areas of lesser importance fringe the basin in the northwest, northeast and east. Geological exploration has shown that the Junggar Basin consists of several structural units; all are prospective for oil and gas. Each unit has its own hydrocarbon habitat, so different methods and techniques need to be applied for systematic basinwide exploration. (For a brief review of the geology of Junggar basin, see Annex 4.01). (1) Karamay Area 4.08 The Karamay trend is about 300 km long and 20-30 km wide. So far exploration has been restricted to a narrow belt, mainly northeast of Karamay, some 100 km long and 20 km wide. This zone which is severely folded and faulted faces a major depression toward the east. Hydrocarbons generated in this basin migrated toward its edges where they were trapped in suitable geological structures. In the Karamay area oil has been retained in various geological horizons and in a multitude of trapping structures. Two types of trapping domains are of particular importance: (a) Carboniferous to Triassic rocks, being severely folded and faulted; reservoirs are mainly sandstones and conglomerates; carbonate reservoirs are subordinate and occur mostly in the Carboniferous. Oil which occur in this trapping domain have specific gravities between 0.8 and 0.9; mostly they can be recovered by means of conventional production techniques; (b) in contrast, the overlying Jurassic and Cretaceous sediments are practically unstructured. They cover the older formations in a sheet-like manner. Both horizons contain large volumes of heavy oil (over 1 billion tons oil-in-place). This heavy oil has probably originated from light oil by transformation caused by bacterial action after it had migrated from deeper horizons into the shallow Jurassic/Cretaceous reservoirs.  - 20 - 4.09 Twenty fields have been discovered and put into production with a yearly output of 4 million tons of light oil. At first it was thought that the oilfields were controlled by a single fault system; in the late 70's with the introduction of digital seismic acquisition methods and advanced processing, it became clear that the fault trend in fact consisted of a series of parallel fault systems. Exploration in this producing area now focuses on evaluating the significance of the additional geological trapping conditions so identified. Oil-in-place is believed to be in the order of about 200 million tons of light oil and additional exploration is expected to add perhaps 200 million tons. It should be possible to recover 25% of this oil. (2) Wuerhe-Hungchiba Area 4.10 In the Wuerhe-Hungchiba region, recent seismic data have defined the continuation of the Karamay fault trends. In this area, however, compressional forces forming the Halalaar Mountains (see IBRD Map No. 17771R) have been much stronger than in the Karamay area. This has resulted in a much greater structural deformation of the potential reservoirs in this area, making prospect appraisal much more difficult than at Karamay. To cope with these special problems, KOC needs to introduce new exploration techniques with which its technicians are not yet familiar, such as three dimensional seismic acquisition and processing. Also, in order to overcome drilling problems which are caused by geological conditions, special equipment and completion techniques are required. KOC expects to find 400 million tons of oil-in- place; however, stochastic analysis based on examination of parameters governing origination, migration and trapping of the oil in this area indicates that it is better to assume a probability of finding 100-150 milliorn tonIs oil-in-place. (3) Hongshanzui-Chepaizi Area 4.11 The Hongshanzui-Chepaizi area is practically unexplored. Shallow core holes have encountered indications of oil in several geological horizons. Regional seismic lines and sparse gravity data suggest that important oil trapping structures could be present. Furthermore, some 100 km south of Karamay a new, potentially prospective basin has been identified. Preliminary investigation based on data obtained from exploration in the Urumqi-Dushanzi area would indicate that large scale oil and gas generation could have taken place here. D. Project Design (1) Exploration Program 4.12 The project has been designed to optimize the next steps in each of the prospective areas, which are in varying stages of exploration maturity. In the Karamay producing area KOC will continue exploration with conventional means. Trapping mechanisms are well known and can be recognized on the seismic data by the currently operational crews. The available seismic grid will be narrowed under this project and many pre-1980 lines will be reshot in order to get better control over the deeper structures which were found in some wells to be potential producers. During negotiations, an assurance was obtained from KOC that it would review with the Bank its exploration program under the project.  - 21 - 4.13 In the Wuerhe-Hungchiba area KOC faces much more serious geological and technical difficulties. Objective horizons vary strongly in composition; hence, zones of good porosities and permeabilities show an irregular distribution. Trapping structures are plentiful but due to the severe geological disturbances, adequate mapping of their location and extent has in many cases been beyond the current capabilities of KOC's technicians. Permian and Carboniferous targets are mostly deep; and require high level of expertise in mapping the structures, drilling and completing such deep holes. In addition, most prospective horizons need fracturing to stimulate production; stimulation techniques require equipment of superior quality to that available at present with KOC. 4.14 The exploration/delineation program of the Wuerhe-Hungchiba area would follow a stepwise approach and will include the following major elements: (a) Execution of high resolution seismic survey to better map the deeper horizons where the bulk of light oil occurs. Agreement was reached with KOC that two foreign crews will be contracted for this work and that the focus will be on appropriate acquisition parameters and seismic processing. A total of 2100 line kilometers will be needed. An assurance was obtained during negotiations that KOC will review and agree with the Bank on the seismic program, including location, shooting parameters and processing methodology. (b) In parallel with seismic work, KOC will initiate and carry out a stratigraphic and structural study which will focus on composition and distribution of reservoir bodies as identified in previously drilled wells. Use will be made of all well logs, core data and seismic data. Al additional component will be an investigation of the extent and nature of fracture patterns affecting the various formations. It will be demonstrated that in several instances fractures can contribute substantially to well productivities. (c) In a separate evaluation to be undertaken with Bank staff, KOC will extend its information base regarding the main oil geological parameters like source rocks, their quality and regional occurrence, migration of oil and gas, development of geological trapping structures and presence or absence of cap rocks. Information on these parameters 1Yill be used as an input to an evaluation procedure (RASP model)- as adapted by the Bank for rapid assessment of oil expectations. The output of this model will have a dual use: (i) it will highlight the main exploration risks; and (ii) will allow comparison of various prospective areas. (For a comprehensive discussion of the RASP approach, see Annex 4.02). 1/ Resource Appraisal Simulation for Petroleum: a computer program to assess an area's hydrocarbon endowment based on available geological data.  - 22 - (d) After integration of the presently available data and the future seismic interpretation and geological studies, KOC will drill some 80-100 exploration/delineation wells. The first series of wells will be drilled preferably where reservoir development can be reasonably well predicted and where structures can be mapped with confidence. With increased acquisition and processing experience and the benefit of the studies as outlined above, KOC will attempt drilling more complex and deeper structures for a full evaluation of the prospectiveness of the project area. (e) This first drilling phase will be followed whenever necessary by additional detailed seismic, most likely three dimensional (3-D;) surveys, to define the extent of oil and gas discoveries. KOC has agreed to present to the Bank each quarter the outcome of seismic work and the results of the drilling operations in addition to their proposal for future exploration work and/tor development plan for any discoveries. 4.1.5 In the Hongshanzui-Chepaizi area, covering some 6000 km2, exploration would first focus on the delineation of Karamay-type oil traps in the north. These would be small and of irregular occurrence. Thereafter, exploration will proceed toward the southern area where traps may be larger and arranged in a structural style different from Karamay. 4.16 Geophysical acquisition and processing need thus to focus on shallow complex structures and deep features where subtle trapping conditions may become increasingly important. One expatriate high resolution seismic crew will be contracted for this area. If this seismic survey reveals structures with potential for hydrocarbon trapping, up to 10 wells may be drilled here. The application of an evaluation procedures as outlined in Annex 4.02 assist in arriving at a judicious selection of such structures. As in the Wuerhe- Hungchiba Area, exploration would be carried out in a step-like manner. (2) Heavy Oil Pilot 4.17 The oil-in-place reserves of heavy oil in the Karamay area are estimated at about one billion tons. The extent and characteristics of the various deposits have yet to be ascertained through drilling of some 160 exploration and delineation wells. Heavy oil is present at depths ranging froml few meters to 500 meters, its specific gravity ranges from 0.97 to 0.92, and its viscosity ranges from 250,000 centipoise (almost immobile) to about a thousand centipoise at reservoir temperature. Pilot projects conducted so far, using both steam flooding and in-situ combustion have not been successful. Similarly, the Liaohe oilfield has large reserves of heavy oil at depths ranging from 1000 to 3,000 meters. Some pilots have been conducted but they have not as yet resulted in commercial applications. The lack of success attending some of these projects was due to a variety of reasons; (a) inappropriate selection of the type of oil reservoir to be tested; (b) poor monitoring practice; (c) inadequacy of equipment; and (d) non-availability of the appropriate technology. Considerable advances have been made in the technology of thermal recovery which could with advantage be used for exploiting heavy oil reserves in China (see Annex 4.06).  - 23 - 4.18 Competent designing, selection of appropriate reservoirs, use of state-of-art technology and careful monitoring are essential for undertaking a successful pilot project. At the same time, methods of refining heavy oil would need to be studied, the value of fractions it would yield assessed and means of transporting it out of Karamay and Liaohe evaluated. The results of such a techno-economic study would need to be integrated with the results of pilot projects prior to selecting method(s) and heavy oil reserves for a full scale development. There are a few oil companies (Getty, Occidental, Chevron, Shell, etc.) which have extensive experience and access to the latest technology in heavy oil. Efforts will be made to secure technical assistance from one of these companies. In the event such a tie-up does not materialize, KOC will be asked to appoint consultants, acceptable to the Bank, for assisting it in the aforementioned tasks. Further, if the results of the techno-economic study and the pilot project are positive, consultant (or the oil company) would assist MOPI and/or KOC in designing a project for fieldwide application. MOPI and KOC have agreed that the study would be completed by December 31, 1986 and the design of pilots by March 31, 1985. The results of the study/design and the consequent action plan would be agreed upon with the Bank. E. Project Description 4.19 The proposed project will consist of the following components: (1) Exploration and Appraisal Program (a) conducting conventional, high resolution and three dimensional seismic surveys with three local and three foreign crews for a period of two years; (b) drilling about 100 exploration/appraisal wells in the Wuerhe- Hungchiba area, about 10 exploration wells in the Hongshanzui- Chepaizi area and about 260 appraisal/development wells in the rest of Karamay area to establish light oil potential; (c) improving oil field logistics by providing transport and oilfield equipment (cementing, fracturing, workover, coring, testing, laboratory, formation and production logging) necessary to support the exploration and delineation program; (d) improving KOC's processing capability by upgrading Urumqi seismic processing computer center to accommodate future load of high resolution and three-dimensional seismic surveys; and (e) establishing a computer center at Karamay for storing and processing of oilfield technical, administrative and financial data. (2) Heavy Oil Recovery (a) designing of pilot projects for thermal recovery of heavy oil in (i) Karamay and (ii) Liaohe oilfield;  - 24 - (b) undertaking techno-economic studies to evaluate the refining methods of heavy oil, the value of fractions it would yield and the means of transporting it out of Karamay and Liaohe; (c) drilling and completion of the necessary injection-cum- production and observation wells, installation of surface/subsurface facilities including steam generators, air compressors and instrumentation and provision of equipment and material for heavy oil laboratory; (d) drilling of exploration/delineation wells in Karamay (160) and Liaohe to firm-up the extent and characteristics of the various reservoirs; and (e) monitoring the performance of the pilot projects and designing optimum processes for field wide application. (3) Training establishing a training center for skilled workers and equipping it with necessary audio-visual materials, training equipment and library. In addition, training of professionals through short local courses or foreign study tours to appropriate institutions; (4) Studies provision of experts and services to perform studies in the following field of activities: (a) a stratigraphic and structural study in Karamay with the purpose of outlining the most prospective areas; (b) reservoir engineering study for tight conglomerate reservoir (Wuerhe); (c) devising training curricula and training methods for skilled workers and professionals; (d) a study on KOC's costing (for details see para. 5.06); and (e) a study for utilization of gas from South China Sea. F. Project Costs 4.20 The proposed project is estimated to cost an equivalent of US$753.5 million, including physical and price contingencies, of which US$273.3 million or 36% represent the foreign exchange component. A physical contingency of 10% was applied to the local and foreign costs. The basic cost estimate is derived from past costs in the Karamay area and from budget quotations and prizes of material and equipment imported in early 1984. Price contingencies botlh for local and foreign costs have been assumed at 7.5% for 1984, 7% for 1985 and 6% for 1986 and 1987, amounting to 17% of the base cost plus physical contingencies. No price contingencies have been added to the 3-D seismic survey costs, since a fixed price contract for this work is already in effect. 4.21 It is noted that the overall project cost is much lower than similar projects in other developing countries due to : (a) the extremely low level of salaries in China compared to the international industry standard; and (b) extensive experience in planning and implementing similar projects in Karamay. In estimating the cost of consultant services for special studies and technical assistance, 180 man-months have been assumed.  - 25 - 4.22 The estimated project cost, including taxes and import duties of 15%, is shown in the following table: Summary of Project Cost Yuan Million US$ Million Foreign 1. Exploration Local F.E. Total Local F.E. Total as % of total Seismic surveys 39.6 47.5 87.1 20.0 24.0 44.0 55 Seismic data processing 15.8 15.8 31.6 8.0 8.0 16.0 50 Exploration/ 590.0 261.4 851.4 298.0 132.0 430.0 31 Delineation wells 645.4 324.7 970.1 326.0 164.0 490.0 33 2. Heavy Oil Feasibility studies & pilots 5.0 16.8 21.8 2.5 8.5 11.0 77 Production/injection & observation wells 5.9 5.9 11.8 3.0 3.0 6.0 50 10.9 22.7 33.6 5.5 11.5 17.0 68 3. Supporting Facilities & Services Transport equipment 1.4 9.9 11.3 0.7 5.0 5.7 88 Laboratories 0.6 2.0 2.6 0.3 1.0 1.3 77 Computer center 2.0 8.9 10.9 1.0 4.5 5.5 82 4.0 20.8 24.8 2.0 10.5 12.5 83 4. Imported Equipment 12.0 53.4 65.4 6.0 27.0 33.0 82 5. Training & Technical Assistance Training 2.0 4.0 6.0 1.0 2.0 3.0 67 Studies 2.0 5.9 7.9 1.0 4.0 5.0 80 Total Base Cost 676.3 431.5 1107.8 341.5 219.0 560.5 39 Physical contingencies 67.4 42.2 109.6 34.0 21.0 55.0 38 Price congingencies 135.6 65.4 201.0 68.5 33.0 101.5 39 Total Project Cost 879.3 539.1 1418.4 444.0 273.0 717.0 38 Front end fee - 0.6 0.6 - 0.3 0.3 100 Charge on Use of Foreign Exchange! 71.7 - 71.7 36.2 - 36.2 - Total financing required 951.0 539.7 1490.7 480.2 273.3 753.5 36 1/ Based on an internal settlement rate of US$1.0 = Y2.8, KOC would have to pay a premium equivalent to 41% of the Bank loan.  - 26 - G. Project Implementation 4,.23 KOC will have the overall responsibility for implementing the project, except for the gas use study and the heavy oil pilot project at: Liaohe which will be the responsibility of MOPI. The exploration and the delineation drilling and the drilling for heavy oil will be carried out by the Drilling Company. The Production Company No. 2 will be responsible for implementing the heavy oil pilot component. Other services required will be provided by the construction, material and transportation, and other companies. The seismic program will be designed by the geological and exploration department which will subsequently supervise it. The field acquisition will be carried out by Chinese and foreign crews. In addition expatriate assistance will be needed in the processing and interpretation of geophysical data, designing and monitoring the heavy oil pilots and conducting geological, reservoir and gas use studies. Paras. 3.08 to 3.10 provide details of the organization and competence of the various executing companies of KOC. 4.24 Project Implementation Schedule. KOC's specialized sub-units will be undertaking implementation of the respective project components, the Drilling Company for the drilling operations, the Production Company No. 2 for the heavy oil component (para. 3.10) and the other service companies (construction, materials, transport-ation, logging, etc.) for providing the necessary support services. The project implementation schedule is at Annex 4.07. All project components are scheduled to be completed by June 30, 1939. Seismic surveys are expected to start around mid-1984 and continue till mid-1986. Likewise the upgrading of the seismic computer processing center will be effected during that period. Drilling in the Wuerhe-Hungchiba area could start as early as the end of 1984 pending the acquisition, processing and interpretation of seismic work. Drilling in the Hongshanzui-Chepaizi may nor start before the beginning of 1986 and only after seismic surveys and geological studies have been completed. It is expected that the total drilling program under the project (about 530 exploratory and delineation wells) will take about four years to complete, (i.e.) by 1988. Initiation of the heavy oil thermal recovery pilots is expected in the first quarter of 1985, after the necessary consultancy services and the required material and equipment have been procured. Though some useful data will become available from the pilot operations within three years from its initiation, the full evaluation of the heavy oil recovery pilot would not be complete before mid- 1989. H. Project Financing 4.25 It is proposed that Bank finances foreign exchange cost to the extent of $100.3 million (including $0.3 million front-end fee), which will represent 37% of the foreign exchange cost and 13% of the project cost. The Bank loan would finance seismic work, upgrading of seismic processing center, modern oilfield equipment, pilot projects for heavy oil recovery and technical assistance. The foreign exchange expenditure not covered by Bank loan relates largely to tubulars and other such equipment for which suppliers' credit could be available. This category of equipment is secured at a national level for all state oil companies. In the event GOC cannot or chooses not to secure suppliers' credit (para. 2.21), it will finance it out of its own resources. The loan will be for a period of 20 years, inclusive of a grace period of five  - 27 - years. The loan will be made to GOC and funds other than those required for undertaking the gas use study and the pilot project at Liaohe ($4.1 million) will be onlent to KOC on the same terms and conditions. State Council approval of the loan agreement and conclusion of a subsidiary loan agreement between GOC and KOC, satisfactory to the Bank, would be a condition of loan effectiveness. While the foreign exchange risk would be borne by GOC, KOC would be required to pay a substantial premium (41%) for securing a foreign exchange loan. In addition to a loan agreement which will be entered into with GOC, it is proposed to enter into a separate project agreement with KOC. All local costs equivalent to $480 million (Y951 million) will be provided by GOC/KOC. I. Allocation and Disbursement of Bank Loan 4.26 The detailed breakdown for the allocation of the Bank loan is at Annex 4.04. Disbursement of the Bank loan would be made against 100% of the foreign exchange cost of consultants' services and training programs; 100% of the foreign exchange cost of the imported materials and equipment; and 100% of the ex-factory cost of materials and equipment supplied from local sources under ICB. 4.27 Disbursements of the Bank loan is expected as follows: Disbursement Schedule (US$Million) IBRD Fiscal Year 1985 1986 1987 1988 Incremental 8 32 54 6.3 Cumulative 8 40 94 100.3 4.28 A detailed breakdown of the disbursement schedule is set out in Annex 4.05. The loan is expected to be fully disbursed by March 31, 1988. In the absence of a standard disbursement profile applicable to this type of project, the disbursement schedule is based on a three-month time lag between the time the expenditure is estimated to have incurred and the time the equivalent funds are disbursed from the loan. A high rate of disbursement is expected in FY86 since most of the equipment and services will be procured in that year. J. Procurement 4.29 Drilling and construction work would be carried out by force account (KOC's own force). This practice has shown to be cost effective because KOC's personnel are experienced and competent to carry out the work and because salaries in China are extremely low compared with international levels. Seismic surveys will be conducted by three foreign crews financed by the Bank and three local crews financed by KOC. Goods financed under the proposed Bank loan would be procured by international competitive bidding (ICB) in accordance with Bank procurement guidelines, except in cases where limited international bidding (LIB) or direct purchase are more appropriate. For seismic survey and associated computer services, LIB procedures were followed by inviting proposals from a large field of reputable and experienced firms  - 28 - who had eithner prior experience or some exposure to the working conditions in China. Under !CB, local manufacturers would be permitted to participate where appropriate and be eligible for a 15% margin of preference or the prevailing custom duties, whichevrer is lower, in the evaluation of bids. A limited number of items will be procured through direct purchase. Consultants/ Specialists will be selected pursuant to the guidelines for the use of consultants by the Bank's borrowers. In view of the long mobilization time required for seismic crews, the long lead time required for the approval of export license for seismic processing computer, and the need to initiate geophysical work by the spring of 1984 to assist in the location of exploration wells, advance contracting for seismic surveys ($18.4 million) and seismic processing computer ($7.7 million) was arranged and retroactive financing under the loan would be permitted for up to $3.0 million (3% of Bank loan) for expenditures incurred between the date of end of appraisal (10/1/83) and date of loan signing. It is foreseen that total disbursement under LIB would be about $35 million (35% of the Bank loan). In addition, direct purchase will be agreed for spares, equipment and instrumentation costing less than US$150,000 up to an aggregate of US$3.5 million (3.5% of the Bank loan). All bia packages having a value of US$500,000 and above would be subject to Bank review prior to contract award; other packages would be reviewed subsequently. In view of the difficulties and delays faced in the processing of the procurement documents for the first two petroleum projects, there is the need to improve interagency coordination for efficient procurement under this project. Towards this end, a detailed procurement schedule would be prepared and sent to the Bank by the end of May 1984. This schedule and the consequent steps for initiating project implementation would be reviewed between the Bank and representatives from the concerned agencies (MOPI, KOC and CNTIC) by the end of June 1984. The outline of the terms of reference for the studies was discussed and agreed at negotiations.  - 29 - 4.30 The procurement arrangements are summarized in the table below: (US$ Million) Project Element Procurement Method Total ICB LCB Other N.A. Cost Civil works - - 16.6 - 16.6 Seismic survey & upgrading of processing facilities - - 66.0 - 66.0 _ - (26.1) - (26.1) Well drilling & completion - - 545.1 - 545.1 Drilling Equipment Workover rigs 11.1 - 2.7 - 13.8 (11.1) - - _ (11.1) Fracturing cementation & 24.9 - - - 24.9 logging units (24.9) - - - (24.9) Specialized drilling tools, 4.6 - - - 4.6 coring & testing equip. (4.6) - _ _ (4.6) Transport equipment 6.9 - 0.6 - 7.5 (6.9) - - _ (6.9) Laboratory equipment 1.7 - - - 1.7 (1.7) - _ _ (1.7) Computers 5.0 - 1.0 - 6.0 (5.0) - - - (5.0) Heavy oil pilots including equipment & materials 10.7 - 6.4 - 17.1 (10.7) - - - (10.7) Technical assistance Heavy oil feasibility study & technical support - - 5.2 - 5.2 - - (4.0) - (4.0) Other studies & training - - 8.5 8.5 - - (5.0) - (5.0) Total 64.9 - 652.1 - 717.0 (64.9) _ (35.1) - (100.0) Note: Figures in parenthesis are the respective amounts financed by the Bank. K. Technical Studies (1) Reservoir Engineering 4.31 The Wuerhe area in the Karamay field contains an estimated probable and possible oil-in-place of about 85 million tons. The producing formations are extremely tight sandstones. Several wells have been drilled in a small development pilot and they encountered a host of production problems. In order to efficiently develop these reserves, it would be necessary to study (a) log interpretation, correlation between and delineation of tight (about one millidarcy) conglomeratic sand; (b) well spacing, optimum production rates, water injection along with development and monitoring program thereof; and (c) wells completion and production stimulation techniques. Reservoir engineering  - 30 - study will be financed under the project, the results of which will be useful not only for the Wuerhe area but for the development of other prospective reservoirs having similar tight sands. KOC has agreed that a study for this purpose, will be carried out with the assistance of qualified expatriate consultants. The study would be completed by December 31, 1985 and the results of the study would be reviewed with the Bank and an action plan agreed upon. Efforts will be made to disemminate the results of the study and recommendations to the extent they are replicable. (2) Geological Study 4.32 In order to give greater focus and direction to its exploration program, KOC would need to carry out a stratigraphic and structural study which will investigate the composition and distribution of reservoir and bodies. The basis for the study will be well logging, core data and seismic data. An additional component will be the examination of reservoir structure pattern, as these have a significant bearing on well productivities. KOC agreed to carry out this study with the assistance of expatriate consultants, on terms and conditions satisfactory to the Bank. It is expected that the study will be completed by December 31, 1986 and the results of the study and the consequent course of action reviewed and agreed upon by the Bank. (3) Gas Use Study 4.3:3 Recent offshore exploration has resulted in significant gas discoveries in China. The oil discovery made by Japan China Oil Development Corporation (JC Oil) in the southwestern part of the Bohai Bay was reported to have a fairly high gas oil ratio. A gas discovery of significant magnitude had been made south of Hainan Island by ARCO. Oil development plans considered by JC Oil had no provision for the use of associated gas, except for possible reinjection. It appeared that China had not considered associated gas as a significant potential source of primary energy and may have underestimated the potential importance of gas as a domestic source of energy. This situation coexisted with a rapidly increasing level of liquid hydrocarbon consumption. With the view towards optimizing gas usage, the proposed project would provide for a study for utilization of gas from South China Sea. This gas utilization study would, inter alia, undertake a market survey, identify potential demand for natural gas, rank gas uses in terms of priority, relate end users with sources of supply and compare the economic advantage of utilizing gas domestically over exporting it as liquefied natural gas. It is critical to commission such a study early, for potential sources of gas supply have been identified, and the possibility of oil discoveries (and therefore of additional availability of associated gas) is considered to be high. Further, unlike oil, in order to build the necessary absorptive capacity for gas use within the economy not only requires substantial investment but also relatively longer lead time. MOPI agreed to carry out this study with the assistance of consultants, on terms and conditions satisfactory to the Bank. It is expected that the study will be completed by December 31, 1985 and the results of the study and the consequent course of action agreed with the Bank. Separately, GOC has commissioned a gas use study in Bohai area.  - 31 - L. Training 4.34 Training facilities currently available in the Karamay oilfield (a few courses of junior trade school level) are clearly inadequate. It is therefore proposed to finance a training center under this project. It will be equipped with the necessary audiovisual training aids, laboratories, teaching materials and other facilities necessary for imparting training envisaged under the program. It is anticipated, that every year over 1000 skilled workers will be trained and the training center will provide: (a) basic training for skilled workers including courses in drilling, production, well logging, cementing, mud chemistry, instrumentation, pipe fitting, welding, etc., (b) periodic refresher courses to ensure that the workers keep abreast of latest technology and techniques, and (c) language training especially for specialists selected for foreign training. In addition, short courses on financial and economic analysis, as well as internal auditing, would be provided to the planning and financial staff (paras. 3.13 and 3.14). 4.35 In addition to the formal training in the center, on-the-job training will be provided for both skilled and professional workers through (i) professionals working closely with consultants engaged in the various studies and the technical assistance program included in the proposed project; and (ii) professionals/skilled workers functioning under the supervision of expatriates hired through the service contract to operate and maintain the equipment supplied under the project. Further, KOC has agreed to appoint consultants to design training curricula and assist the training center in evolving appropriate teaching materials and methods. KOC expects to appoint these consultants no later than March 31, 1985, on terms and conditions satisfactory to the Bank, review its finding with the Bank and agree upon a course of action. M. Computer Center 4.36 The existing computer facilities at Karamay are inadequate. The proposed project would provide for the establishment of a computer center at Karamay for storing and processing of oilfield technical, administrative and financial data. A Bank consultant would assist in the design of the computer system and prepare a requirement sheet to be used as a basis for soliciting bids for hard and software. N. Transportation Requirement 4.37 Current local consumption at Xinjiang is about 2.5 million tons p.a. The surplus, some 1.5 million tons, is transported out of Urumqi by train to the refinery at Lanzhou (Gansu Province). As local consumption is not likely to grow significantly, most of the incremental production from the Karamay would need to be transported out of Urumqi by train, at least over the medium term. In the event the surplus oil to Lanzhou exceeds the refinery capacity which at present is about 3 million tons p.a., the refinery would need to be expanded and/or a portion of the oil would have to be transported further to other refineries which have idle capacity. During negotiations, GOC stated its intention to carry out the necessary study for transporting oil from Karamay out of Xinjiang taking account of KOC's exploration results and development strategy.  - 32 - 0. Ecology 4.38 The Karamay field is located in a desolate, hilly terrain on the northern edge of the Gobi Desert. With the exception of few oasis and valleys situated away from the oil belt, the area is very sparsely populated by some nomadic tribes. Oil exploration and production activities have been carried out throughout the last thirty years with no adverse effect on the environment. The exploration and development component under this project would follow the same previous practices. It is difficult to assess the amotunt and toxicity of gases arising from applying in-situ combustion in the heavy oil pilot. However this element will be properly monitored during the pilot operation. Experience from the heavy oil pilot operations will be incorporated in the eventual fieldwide applications. P. Reporting Requirement 4.39 KOC agreed to forward to the Bank quarterly reports summarizing: (a) kilometers of seismic line shot in the Wuerhe-Hungchiba and the Hongshanzui- Chepaizi areas; (b) drilling progress and test results for exploratory and appraisal wells in the Wuerhe-Hungchiba or the Hongshanzui-Chepaizi area; (c) the progress made in various technical and financial studies provided under the project; (d) progress on the design, implementation and the results of the pilot project for heavy oil; (e) progress on procurement and disbursement matters and (f) update on project cost. 4.40 In addition, KOC will make a report every six months on: (a) the amount, quality and interpretation of the seismic data recorded in the project area; (b) results and interpretation thereof from exploratory or appraisal wells in the project area; this should include information on stratigraphy, lithology, reservoir permeability and porosity as well as results from production tests; (c) results and interpretation thereof from heavy oil pilot tests; and (d) plans for further seismic acquisition, drilling and testing for the next six months. The exact contents and format of these reports were disctussed and agreed at negotiations. Furthermore, KOC agreed to prepare a Project Completion Report and submit the report to the Bank no later than six months after the loan closing date. V. FINANCIAL ASPECTS A. Introduction 5.01 As a state-owned enterprise, KOC is bound by the financial regulations established by GOC. While the company enjoys considerable operational autonomy, it is far more constrained in financial autonomy. Specifically: (a) KOC's output is marketed as directed and at prices set by the Government; (b) GOC sets KOC's annual production and net income targets, and (c) KOC's operational and investment budget is approved by the Government. A financial appraisal of KOC has been concentrated on costs, internal cash generation, investment and related financing arrangements, internal control (para. 3.14) and incentive system (para. 3.16). KOC has performed in a financially responsible manner within the Chinese system; its finances have been satisfactory thus far and are expected to remain so in the  - 33 - future. However, with the view towards optimizing operational efficiency and management decision-making, the financial management sytem at KOC would need to be strengthened. Under the proposed project, the Bank would seek to initiate significant steps towards achieving this financial objective, including a costing study by consultants, extension of the financial planning horizon (para. 3.12) as well as provisions for training in financial and economic analysis, and internal auditing (paras. 3.13 and 3.14). B. Pricing 5.02 KOC's revenues are primarily derived from the sale of crude to the refineries. Until recently, all the crude from the Karamay oilfield was priced at Y115/ton. MOPI has proposed an increase in the price of crude to Y175/ton throughout China. The proposed price increase is especially significant for ensuring the financial viability of oilfields with rising costs. However, as long as KOC is in a positive net income position, the major impact of a price increase would be only to increase KOC's fiscal contributions to the Government. Under the present financial arrangement whereby essentially all of KOC's net income is taxed and remitted to the Government (para 5.07), increased profitability would not increase the retention of funds by KOC or its autonomy in the usage of funds. 5.03 The proposed price increase is pending a decision of the State Council. As a pragmatic interim measure to provide for the financial viability of the oilfields, a two-tier pricing system was introduced in 1981 whereby above quota production is being sold at the international price levels (Y400/ton). The additional net income derived from the differential between the domestic and international prices from all the oilfields in China is pooled together by MOPI which allocates the funds back to the various oilfields commensurate with individual needs for investment funds. C. Costing 5.04 Financial accountability at KOC is organized under three levels of cost centers: the corporation, the company and the brigade. Based on the production and net income targets set by MOPI, KOC works out the annual operational and investment budget. The budget is prepared in detail down to the level of brigade and is reviewed and consolidated at the company and in turn the corporation level. For purposes of budgeting, standard costing is applied. Standard costs are based on the prevailing prices except in the case of imported casing and tubing which are subsidized by MOPI. 5.05 Under the existing system in China, cost is the major financial factor over which KOC has discretionary control. Budgeted cost is a major yardstick against which the performance of the cost centers is measured. Review of actual cost against the budgeted cost is regularly undertaken by KOC management and a detailed variance analysis is performed. As noted earlier (para. 3.16), performance in cost control is tied in with the incentive system whereby employee bonuses are distributed only when the net income target is met. Budgetary control at KOC has proved to be effective and actual cost has remained close to the budget. While the present budget and control system at KOC is effective in monitoring its relative operational efficiency over time, it appears doubtful whether the budget basis -- especially in regard to quantity inputs -- is conducive to operational efficiency. To ensure that the  - 34 - budget is a reliable performance yardstick, an evaluation and revision of the present budget basis at KOC are all the more essential to reflect the infusion of modern technology provided under the project which should result in improvement of KOC's operational efficiency (para. 3.09). Insofar as investment decision-making is concerned, the present costing system does ntot provide for the calculation of economic costs of finding and extracting oil which are critical basis for optimizing oilfield investment decisions. An anomaly of KOC's costing is that its operating cost does not include any amortization or write-off of exploration expenses since the investment for exploration has thus far been funded entirely by the Government (Annex 5.01). 5.06 With the view towards strengthening the financial management system, an assurance was obtained from KOC that a study of its costing would be undertaken by March 31, 1986 with the assistance of consultants. The proposed costing study is directed at the optimization of operational efficiency and management decision-making through the upgrading of cost information which would be useful to KOC management in performance evaluation, investment decision-making and pricing recommendations to MOPI. The study would include: (a) review of KOC's present costing procedures and techniques in general, as well as specific budget basis in detail; (b) identification of areas of inadequacies; (c) recommendations for improvement in cost management, including improvement of the costing procedures and techniques, as well as revision of the budget basis for performance evaluation, and (d) derivation of the economic costs for investment decision-making. D. Funding Arrangement 5.07 Until recently, KOC was required to remit all net income and 50% of its annual depreciation fund to the Government. Starting from 1983, KOC's net income is taxed at a rate of 55%. The balance of the net income is to be distributed between KOC and the Government at a proportion set by MOPI and MOF, with the major portion being remitted to GOC. The portion of net income retained by KOC will mainly be applied towards employee bonus and benefits. While the new tax system is introduced to provide state enterprises with increased autonomy and benefits, it is but the first step towards such a direction. Indeed, KOC's remittances to the Government under the recently instituted tax system are not expected to differ substantially from those under the past system. As in the case of other oilfields, KOC is allowed to retain a portion of its internally generated funds, entitled the "Special Fund", to cover the cost of field maintenance. The Special Fund is derived from three sources: (a) 50% of annual depreciation; (b) provision for overhaul; and (c) oilfield upholding provision (Annex 5.01). These provisions are classified as expenses for purposes of calculation of net income to be remitted to the Government. 5.08 KOC's exploration and development investment has so far been financed exclusively by allocations from the state budget. Investment priority in the petroleum sector is determined by MOPI in accordance with the Government's sector strategy. As Karamay is one of the higher cost oilfields in China, Government funding of investment at KOC currently exceeds the company's contributions to the Government. The deficit position of Government take from KOC is, however, more than offset by the surplus from other oilfields such as Daqing. In fact, the petroleum sector is one of the major surplus sectors in China. In 1982 the surplus from oil extraction alone amounted to over Y3  - 35 - billion. At the proposed price increase to Y175/ton, KOC's operations would contribute a surplus to the Government (para. 5.16). 5.09 Government funding to KOC has been on a grant basis, with the exception of 1981 and 82. As part of China's economic readjustment program, KOC was required to borrow, on a trial basis, a portion of its development requirement from the People's Construction Bank of China at an interest rate of 3.6% p.a. In 1983, KOC once again received Government contributions for funding the entire development investment on a grant basis, largely due to MOPI's effort to improve the company's revenue position (para. 5.14). Working capital is funded by borrowing from the People's Bank of China. E. Past Finances and Present Financial Position 5.10 KOC's income statements and balance sheets for the three-year period 1980-82 are set out in Annexes 5.02 and 5.03 and summarized as follows: 1980 1981 1982 Sales Crude (million tons) 3.48 3.50 3.83 Average Sales Price (Y/ton) 115 115 115 Revenues (in million Yuan) 380 387 423 Operating Expenses 289 293 325 Net Income 91 94 98 Net Fixed Assets 951 1091 1323 Total Assets 1310 1608 1837 Total Networth 955 1168 1312 Long-term Liabilities -- 25 92 Operating Ratio 0.73 0.72 0.73 5.11 KOC's finances have remained stable over the last three years, with net income increasing slightly from Y91 million to Y98 million on revenues of Y380 million and Y423 million, respectively. During the same period, the unit cost of production increased slightly from Y77 to Y78 per ton.  - 36 - F. Future Finances 5.12 Financial projections for the period 1983-87 are set out in Annexes 5.04, 5.05 and 5.06. Salient features highlighting KOC's operating results are summarized below: 1983 1984 1985 1986 1987 SaLes Crude (000 tons) 4.03 4.13 4.32 4.80 5.28 Average Sales Price (Y/ton) 129 135 147 175 175 Revenues (million Tyan) 503 545 619 784 858 Operating Expenses- 391 426 461 522 579 Net Income 52 58 76 117 119 Operating Ratio 0.81 0.82 0.77 0.68 0.69 5.1.3 KOC is charged with the task of not only maintaining production but to increase it from the present level of some 4 million tons to 5.5 million tons annually by 1987. The Karamay oilfield has been producing for about thirty years and the productivity per well has entered a declining phase. Increased production at the Karamay is expected to be achieved only at increased unit cost. This is because of the need for investment in more wells, both by infill drilling at the existing fields and the development of new finds which are likely to be at greater depth and/or subject to more complex and difficult reservoir conditions. Over the next five years, KOC estimates that its total operating cost would increase at an average of 10% p.a., outpacing the production growth which is estimated at 7% p.a. As a result, the unit cost of production is projected to rise from Y78/ton in 1982 to Y83/ton in 1983, amounting to Y97/ton by 1987 (Annex 5.08). 5.14 In order to allow KOC to continue to cover costs by internally generated funds, MOPI has set the production quota at 4 million tons p.a. whiczh is slightly below the production projected by KOC over the period 1983- 85. Under the two tier pricing system (para. 5.03), the average price to be received by KOC is estimated to increase from Y129/ton in 1983 to Y147/ton in 1985. The revenues from the anticipated above quota production, which is to be priced at the international level, would more than offset the increase in production cost. As a result, KOC's net income is forecast to increase steadily from Y52 million in 1983 to Y76 million in 1985. Based on the assumption that the price of crude would be raised to Y175/ton from 1986 onward, KOC's net income is projected to increase significantly, amounting to Y119 million in 1987. As production from KOC's existing fields has peaked, its future production and finances over the longer term would increasingly depend on the success of its exploratory efforts. Based on the present expectation, the proposed exploration project could help to arrest decline and/'or augment production at Karamay over the medium and longer term. G. Investment and Field Maintenance Program 5.15 In an effort to increase production, which is targeted to reach 5.5 million tons by 1987, KOC has projected an investment and field maintenance ,/ In constant price terms.  - 37 - program which would amount to Y3.1 billion over the five-year period 1983-87. The average annual outlay of some Y628 million represents a 33% increase over that of the last three years. The major increase in expenditure is to be directed towards field maintenance and exploration (Annex 5.01). The investment and field maintenance program calls for the drilling of about 1,563 wells, of which 1,033 (66%) are production wells, the balance, 530 wells, are for exploration and delineation of both heavy and light oil. As KOC's entire exploration program is being financed by MOPI, the oil company essentially acts as a contractor to undertake exploration for the Government and the exploration program would have to be approved by GOC. The exploration program is a major component of the proposed project and it would be reviewed between the Bank and KOC (para 4.12). H. Funds Flow 5.16 Investment and field maintenance would, repectively, represent some 58% and 35% of KOC's total financing requirement of Y3.4 million over the next five years. KOC's internal cash retained after remittances to the Government is projected to meet about 42% of the financing needs, covering the entire expenditure on field maintenance as well as debt service. Internal funds retained are forceast to cover at least 7 times the debt service requirement throughout the forecast period. The proposed IBRD loan would finance 8% of the total financing requirement. The balance, some 50%, would be covered by Government contributions. Over the period 1983-87, Government funds to KOC are forecast to total Y1.70 billion. During the same period, KOC's total contributions to the Government (taxes, remittances of net income, depreciation) is projected to total Y1.67 billion, which is roughly in balance with the inflow of Government funds (Annex 5.07). The annual Government take is forecast to improve from a deficit position of Y130 million in 1983 to a surplus position from 1986 onward when the proposed crude price increase is assumed to become effective, amounting to an estimated Y86 million in 1987. I. Financial Position 5.17 KOC's financial position is expected to be satisfactory throughout the forecast period. Its debt position is projected to remain low, and the debt/equity ratio is estimated at 5/95 in 1983 and 13/87 in 1987. KOC's liquidity position is expected to remain sound and its current ratio is estimated at about 2.0 over the next five years. J. Sensitivity Analysis 5.18 The results of sensitivity analysis (Annex 5.01) indicate that even under less favorable conditions, KOC's finances are forecast to remain satisfactory. KOC is expected to generate revenues which would more than cover its costs under all of the cases considered, including production decreased by 10%, costs increased by 10% and the price of crude increased to Y140/ton only after 1985. Annual Government take is also expected to be in a surplus position by 1987 for all the cases which assumed a price increase to Y175/ton, but would remain in deficit for the case where the price of crude is only increased to Y140/ton after 1985. This highlights the fact that the major impact of crude price increase is enhancing KOC's fiscal contributions to GOC.  - 38 - K. Recommendations 5.19 KOC's finances have been satisfactory and are expected to remain so in the future. However, since KOC is not operated on a typical commercial basis, its financial performance especially in regard to operating efficiency, cannot be measured in the same manner as a commercially oriented enterprise, and the application of the Bank's normal financial covenants would be of limited significance. During negotiations, an assurance was obtained from KOC that it would review with the Bank by October 1 of each year its current and projected finances, focusing in particular on its trend of production costs and budget variance analysis, as well as its future investment program and related financing arrangements. As noted above, a major financial objective of the Bank is the strengthening of KOC's financial managment system. KOC would undertake a costing study with the assistance of consultants (para. 5.06) and the horizon of financial planning would be extended to no less than five years (para. 3.12). VI. PROJECT RISKS AND JUSTIFICATION A. Project Justification 6.01 In line with GOC's sector strategy to augment oil production over the next decade, the proposed project is of high priority to China. The exploration and heavy oil recovery components included under the project have good prospects of firming up significant petroleum reserves which could, over the medium and longer term, be recovered economically. In addition, the proposed project is an adequate vehicle for promoting the use of state-of-the- art: technology which should ultimately increase the efficiency of operations in the sector. For this purpose, the training and technical assistance components provided under the project have been designed to provide the critically needed technical inputs for KOC's exploration and development program. B. Project Risks 6.02 The project, however, carries the risks inherent in petroleum projects. The major uncertainty relating to the exploration program pertains to (i) the quantity of hydrocarbons accumulation and (ii) the economics of their production; while the risks of heavy oil recovery are mainly related to the economic feasibility of proven technology. (1) Petroleum Exploration 6.03 The principal geological risk involves the size as well as quality of the reservoir. The risk of KOC's exploration program covers three areas at different stages of exploration maturity and carries different levels of geological risks (para. 4.12). The proposed exploration program has been designed to balance low risk, low reward activities and high risk, high reward ones. This has been achieved by focusing a large portion of its exploration activities on the short-term objective of proving additional reserves from conventional prospects, while diverting some resources on evaluating less explored areas and deeper realms. Furthermore, in order to attenuate the  - 39 - geological risks, a stratigraphic and structural study will be carried out to determine the composition and distribution of reservoir bodies, high resolution and 3-D seismic surveys to better map the deeper horizons and a continuous review in order to ensure that exploratory drilling is confined to areas which have high geological ranking (Chapter IV). 6.04 The technical risk is that the project may not be implemented efficiently. Such a risk, however, is low because KOC has a long history of drilling in the Junggar Basin and the project has also been designed to minimize the risk by the provision of critical technical inputs for the evaluation of formations and better transport support for the extensive drilling operations in difficult terrain. The economic risk is that even if hydrocarbons are found, the recoverable quantity would be inadequate to provide an acceptable return on the investment for exploration and development. Such a risk, however, is also considered low. C. Cost-Benefit Analysis 6.05 As in the case of other petroleum exploration projects, the possibilities of a wide range of outcomes render it impossible to quantify with any precision the potential benefits of the proposed exploration program. Instead, the cost-benefit analysis has been focused on the minimum size of discovery that is required to yield an acceptable economic rate of return on the investment for exploration and development. Exploration cost to establish the potential of light oil is estimated at $500 million (early 1984 price terms). The development cost has been estimated on the basis that the field development cost of the new finds would be similar to that of Karamay's existing fields. In addition, freight cost to transport surplus oil out of Xinjiang has been estimated under conservative assumptions. On the basis of the assumptions set out in Annex 6.01, the discovery of fields resulting in an incremental annual production of about 1.5 million tons would be adequate to provide a 15% rate of return to the proposed exploration program. Assuming a 25% recovery factor which is the ultimate recovery expected from the existing Karamay producing area, the present expectation is that there is a high probability that the recovered reserves under the proposed exploration program would exceed the minimum quantity required to yield an acceptable economic rate of return. (1) Heavy Oil Recovery Pilots 6.06 The project provides for thermal recovery pilots which, if successful, would be applied on a large scale at Karamay and/or Liaohe to enhance the recovery of heavy oil. Notwithstanding the proven technique of the various methods of thermal recovery, it is not possible to determine at this stage the optimum method and the precise economics of thermal recovery at Karamay and Liaohe. The major uncertainty arises from: (a) the lack of knowledge of the reservoir characteristics; (b) the degree of response of the specific reservoir to thermal recovery processes (Annex 4.06); (c) the amount of energy used to recover a certain volume of oil; and (d) the utilization and transport of heavy oil. In order to minimize the above uncertainty, the pilots as provided under the project are to be located in a representative area of the reservoirs and their operations would be closely monitored and interpreted with the assistance of consultants. In addition, assurance was obtained from KOC that tests would be undertaken to work out the method of  - 40 - refining the heavy oil and transporting it out of Karamay. The proposed pilots would not only provide for a better understanding of the reservoir and indicate an optimum method of thermal recovery technique, but they are also expected to pay for themselves by the heavy oil thus recovered. Furthermore,, should the thermal recovery be subsequently applied on a large scale and working on a conservative assumption (that is, all the heavy oil is burnt directly as a low grade residual fuel), the thermal recovery of heavy oil is still expected to yield a satisfactory return. There is, in addition, the possibility of extracting high grade lubricating oil from the recovered crude. D. Conclusion 6.07 In conclusion, the proposed project is justified because of the large potential benefits. Even though the project carries risks, such risks are considered relatively low and the project has been designed to attenuate these riLsks. VII. AGREEMENT REACHED AND RECOMMENDATIONS 7.01 During negotiations, assurances were obtained from GOC that it would undertake through qualified consultants the following studies/pilots; review the findings and agree upon the consequent action plan with the Bank: (i) by December 31, 1986, a techno-economic study and by March 31, 1985 design of pilot projects for heavy oil recovery at Liaohe (para. 4.18); and (ii) by December 31, 1985, a gas utilization study (para. 4.33). 7.02 Assurances were obtained from KOC that it would: (a) undertake financial planning for no less than five years on a rolling basis and the financial statements based on such plans would be forwarded annually to the Bank for review (para. 3.12); (b) maintain a separate project account; have the project account and KOC's accounts audited; and submit the audited financial statements to the Bank within six months after the end of each fiscal year (para. 3.15); (c) review with the Bank the exploration program under the project; (d) review and agree with the Bank the seismic program at (i) Wuerhe- Hungchiba area, and (ii) Hongshanzui-Chepaizi area; review the findings and agree on the consequent changes in the design of the exploration program (paras. 4.14 (a) and 4.16); (e) undertake through qualified consultants the following studies/p'ilots; review the findings of the studies/pilots and agree with the Bank on the consequent action plan:  - 41 - (i) by December 31, 1986 with respect to the techno-economic study and by March 31, 1985 design of pilot projects for heavy oil recovery (para 4.18); (ii) by December 31, 1986 with respect to the reservoir engineering study (para. 4.31); and (iii) by December 31, 1986 with respect to the stratigraphic and structural study (para. 4.32); (f) undertake through qualified consultants the design of training curricula and teaching methods for skilled workers and professionals on the basis to be agreed with the Bank; the consultant would be appointed by March 31, 1985 (para. 4.35); (g) submit to the Bank a project progress report in an agreed format at agreed intervals (paras. 4.39 and 4.40); (h) undertake through qualified consultants a study of KOC's costing by March 31, 1986 (para. 5.06); and (i) review its current and future finances with the Bank by October 1 of each year (para. 5.19). 7.03 A condition of effectiveness would be the execution of a satisfactory subsidiary loan agreement between GOC and KOC and the approval of the Loan and Project Agreements by the State Council (para. 4.26). 7.04 With satisfactory resolution of the items outlined above, the project constitutes a suitable basis for a Bank loan of US$100.3 million (including capitalized front-end fee) to the People's Republic of China. The loan would be for a term of 20 years including a 5-year grace period, and would be at the standard variable interest rate.  ANNEX 1.01 -42 - CHINA KARAMAY PETROLEUM PROJECT Energy Balance (Million Tons of Oil Equivalent) Production 1980 % 1982 % 1985 % Crude oil 105.9 24 102.1 22 100 21 Natural Gas 12.3 3 10.0 2 9.5 2 Coal 303.8 68 325.3 70 342.9 71 Hydroelectricity 20.9 5 26.7 6 27.0 6 Total Availability 442.9 100 464.1 100 479.4 100 Consumption 1,. Petroleum products 81.0 19 76.0 17 82.0 18 Industry & commerce 35.5 8 33.9 8 37.1 8 Power 16.5 4 15.3 3 12.1 3 Transport 14.0 3 13.0 3 18.9 4 Agriculture & construction 15.0 4 13.8 3 13.9 3 2., Natural gas 12.3 3 10.0 2 9.5 2 Industry & Commerce: Feed stock 4.9 1 4.0 1 3.8 0.7 Fuel 5.9 1.5 5.0 1.2 4.6 1 Power 1.5 0.5 1.0 0.3 1.1 0.3 3. Coal 303.3 71 322.0 73 333.1 73 Industry & commerce 182.0 43 192.3 44 185.6 41 Power 57.3 13 62.6 14 74.0 16 Transport 12.0 3 13.4 3 13.7 3 Domestic 52.0 12 53.7 12 58.3 12.7 Interfuel substitution outside power - - - - 1.5 0.3 4. Hydroelectricity 20.9 5 26.7 7 27.0 6 5. Refinery losses 7.0 2 5.9 1 7 2 Total domestic consumption 424.5 100 440.6 100 457.6 100 Exports Crude oil 13.3 64 14.7 63 12.0 55 Petroleum products 4.6 22 5.5 23 - - Coal 3.0 14 3.3 14 9.8 45 Total Exports 20.9 100 23.5 100 21.8 100  - 43 - ANNEX 2.01 CHINA KARAMAY PETROLEUM PROJECT Ministry of Petroleum Industry Organization Chart | etrl Idsy Of Equipmen l co ior || DeveJOOmeft EYPisto Drill ng Ponneg gnne | Pesonel & | Coopesotions -dier Scientific Reseo-rh -9Dp | | ptm | |Deporlrnont Depo0nenl| Deoortnent | |epoitn'ernt |n| Depreft | l DEductioc | t Pnder 1vIOPI Diction Dv_S1COrp-t- & Tfh-lg-l 2 Ch-N tonPrIl sit"'te |AdmnstrDtMe I t~~~ogging Mud CoptO 50 Psoidri on Payrol PeoFrgeeurPlpE 1 Dsvisron 1 ~~~~Division | Division |Construction Division | Division Ca.porotion ProduCtion | jFoseignA 01h-oo t Dulvon { | Duislon | | ~~~~~~~~DrOnon Divlon l | Dsio Eotect on ivisiD Southwens IS chnuO NoithivestCrioro Noth Chnoo EsChni Natheost CoLlee s& Ilnielst00 Dos Field | Olea OEe d Oiitieid Oisie dunsdeiMSOE _ lne _itii loic _ubi Shiri OSnd DggPto at C nhino Petroieumr E-1 Chm ~ ~ AONihn500550 Cole VCPIerigi Admu -|Rrinistrt |r! Prop nhenotion | | Dp irPearotm 3 N Doson- Petru _| lKsotmu0 D on & DosgodOlfeld | ZhrongYwin lClg(lhn DeveioPmienr Prororrimsnotion P |Enpoeolourro5 a |tCofege n |Colelge2ES3 C.14.g. (Hub.,W) Boy-SOD  ANNEX 2.C2 - 44 - CHINA KARAMAY PETROLEUM PROJECT /a Crude Oil Production by Region and Major Fields'- (Million Tons) 1970 1975 1977 1979 1980 1981 -1982 Northeast 22.37 50.68 54.87 57.36 58.59 58.63 59.19 Daqing 21.18 46.26 50.31 50.75 51.50 51.75 51.94 Liaohe & others 1.19 4.42 4.56 6.61 7.09 6.88 7.25 North 1.02 4.68 15.55 20.40 19.11 15.26 14.33 Renqiu - - 12.30 17.33 16.03 12.22 11.31 Dagang 1.02 4.68 3.15 2.90 2.91 2.88 2.80 Others - - 0.10 0.17 0.17 0.16 0.16 East 4.67 16.72 17.66 19.21 17.92 16.41 16.70 Shengli 4.67 16.72 17.52 18.88 17.59 16.11 16.35 Others - - 0.14 0.33 0.33 0.30 0.35 Central-South 0.27 0.87 1.26 3.39 4.16 4.80 5.6 Northwest 2.29 4.02 4.21 5.69 6.06 5.99 6.2 Southwest 0.03 0.09 1.09 0.10 0.10 0.09 0.1 Total 30.65 77.06 93.64 106.15 105.94 101.18 102.12 Oil Balances (1965-1985) (Million Tons) Annual Actual Projected Growth 1965 1970 1975 1977 1979 1980 1981 1982 1985 1965--1982 Productioni Crude 11.3 30.65 77.06 93.64 106.15 105.94 101.00 102.12 100.0 142 Export - N.A. 12.28 11.46 17.15 18.29 19.09 20.18 11.0 N.A. Domestic Consumption 11.3 N.A. 64.78 82.18 89.00 87.65 81.91 81.94 89.0 12% a/ Source: Ministry of Petroleum Industry  ANNEX 2.03 - 45 - CHINA KARAMAY PETROLEUM PROJEC,T Natural Gas Production/- (Billion m3) 1978 1979 1980 1981 1982 Northeast 5.00 5.17 5.27 4.30 4.13 Daqing 3.20 3.31 3.39 2.80 2.78 Others 1.80 1.86 1.88 1.50 1.35 North 0.82 0.93 0.80 0.70 0.78 Renqiu - - - - 0.15 Dagang 0.82 0.93 0.80 0.70 0.63 Others - - - - - East 1.44 1.55 1.44 1.20 0.99 Shengli 1.44 1.55 1.42 1.18 0.97 Others - - 0.02 0.02 0.02 Central-South 0.02 0.02 0.05 0.05 0.3 Northwest 0.30 0.33 0.38 0.45 0.46 Sichuan 6.15 6.51 6.33 5.80 5.25 Total 13.73 14.51 14.27 12.50 11.91 Associated 5.95 6.53 7.23 6.20 5.96 Non-associated 7.78 7.98 7.04 6.30 5.95 Product Yield of Refineries (1000 Tons) Product 1979 1980 1981 1982 % of total Gasoline 10,698.6 10,790 11,010 11,001 17 Kerosene 4,093.2 3,980 3,640 3,810 6 Diesel oil 18,728.2 18,280 17,530 17,113 26 Lubricating oil 1,914.8 1,970 1,500 1,399 2 Fuel oil 28,161.2 31,420 28,180 26,096 40 Other n.a. n.a n.a 9 a/ Source: Ministry of Petroleum Industry.  ANNEX 3.01 -46 - Page 1 of 3 CHINA KARAMAY PETROLEUM PROJECT Karamay Oil-Gas Exploration and Development Corporation (KOC) Orgonization Chart President Senior r Of ce of Vice President te Compann 'Ace President] ~ ~ ~ ~ ~ ~ ~ reid _Cm~n Coordination L r | Chief l l Chief l 1 ! T Cie_ _hiefChie LS > | ~~~~~Geologist | Mechanist | t Eonornist | |Accountant| Oilfield Capital D Science & |lannir Finance Construction tec Technology a|iery Department nDepartent |Lcholoza l DprmnDepartment D e eprmn eprmn Department epartentortso WeAfare _i_fielo Geological ng Administration Technology Exploration Dprmn Department Department Department C:ivil Engineering| Ase LDepartment Magent Safety & Geophysical & Quality Control Geological Department Survey Company [ Dispatch | | Drilling |Well Testing O Company )li Production Scientific qesearch Companies (4) Institute Down-hole Production Servce Support Company Company Technical Karamay SerAce Technical Company School Wortd Bankr-256,38  _ 47 - ANNEX 3.02 Page 2 of 3 CHINA KARAMAY PETROLEUM PROJECT KOC - Ddlling Company Organization Chart ProCthen Company S {r55 Deput OriBingo |nln |lln Doputy Drlleco | |p Tran porty Wreiztlon Re| AdministreB B er Broducteon | |roduc Bio e Suppor Crw Crew Crew Crew Crw Crw (er Crews Crw Crew Crw rw 1 rw ( Economist (44 (52 (riB) (Si (B) (32) (12 (12 (12 (12) ()ii I Payrdl | | Asset l _ Sceence & G DepaW | I J