China continues to face a massive pollution issue due to a heavy reliance on coal for energy production. The promise of natural gas could solve this problem, but the company is so far reliant on expensive imports. One major solution could be the development of domestic Chinese natural gas supplies with shale gas quickly turning into a real possibility. Unfortunately, the country continues to struggle with making this a reality despite increasing signs of massive supplies trapped in rocks under the ground. Whether due to infrastructure issues or the lack of technical expertise, limited success has occurred to date in extracting shale gas.
While one solution is to work with international oil service firms to drill horizontal wells, another solution is to hire a local firm such as Recon Technology (RCON) that continues to make progress in developing the fracturing technology for the specific shale in China. Part of the success comes from the recent introduction of fracturing technology from Baker Hughes (BHI) on a China Petroleum and Chemical Corporation, or Sinopec (SNP), oilfield.
Recon Technology is an extremely small oilfield services firm, but some recent success with a Sinopec contract suggests that it might have the expertise to succeed in this sector. Recon is a non-state-owned oil filed service company have has been providing software, equipment and services to the oil and gas exploration segment in China for more than 10 years.
Clear And Present Opportunity
Very few opportunities exist that are as clear and present as the drilling for shale gas in China. The country is literally choking on the pollutants from burning coal for energy production and must find an alternative energy source. The country is now flush with shale gas reserves if only the country could get the gas out of the ground and transport it to the cities needed.
Due to high import costs of natural gas and low domestic production, coal naturally became a cheap supply of electricity. Not to mention, the country had abundant supplies of coal so natural gas wasn't initially needed. Now though, the pollutants of coal are becoming a national health issue especially in the mega-cities along the coast.
The below graph showcases the 67% of power generation in 2012 from coal and only 3% from natural gas. Under the predicted scenario by Bloomberg New Energy Finance, the energy mix will only shift to 8% maximum natural gas by 2030. Naturally a lot of that shift likely depends on the ability to exploit domestic shale gas.
Figure 1 - China's power generation capacity mix, 2012 vs 2030 (%, GW)
Shale Potential
Over the last decade the shale revolution has helped grow production of natural gas and oil in the U.S. The advancement of horizontal drilling and hydraulic fracturing technologies has made previously unproved and uneconomic resources into technically recoverable resources of vast amounts. Now the U.S. Energy Information Administration (EIA) estimates that China actually has the largest amount of recoverable shale gas. An amount so vast that it could dramatically shift the balance of electricity production in China and make the country less reliant on external fuel sources.
Back in 2011, the EIA produced a report suggesting that China had the vast shale resource and updated it recently in June. The updates were based on recent well tests around the world and better technologies. These improvements have made some shales more technically recoverable, while others, such as those in Norway, were completely wiped off the list due to failed wells. According to the updated projections, China is undisputed leader of potential shale resources.
Figure 2 - Top 10 countries with technically recoverable shale gas resources
As the table shows, China's technically recoverable shale gas resources are enormous. Not only in its pure size, but also compared to other countries. China has 1,115 trillion cubic feet (TCF) while the U.S. sits at 665 TCF or almost half of the supplies as China. Even more interesting is the size of Argentina and Algeria with shale gas resources exceeding those of the U.S. and vastly above the amount needed for domestic demand in those relatively small populations.
The question really becomes whether these technically recoverable resources can actually be economically recoverable. Natural gas typically needs pipelines to be economically feasible especially in far from population areas. The question remains whether China and these other countries have the infrastructure to make these vast shale resources feasible to recover for a long time. Remember how the U.S. has struggled to get domestic oil supplies from the Bakken region in North Dakota to the areas where refineries can utilize the product. At times discounts of up to $20 per barrel existed that greatly reduced oil-derived profits while natural gas for the most part is still flared in the area due to a lack of pipelines.
The shale oil potential in China only follows the totals in Russia and the U.S. It could become as important of a resource in the future, but for now the need for cleaner electricity options outshines the demand for oil.
Figure 3 - Top 10 countries with technically recoverable shale oil resources
Successful Fracturing Project
All of these details bring the discussion back to Recon Technology that is working on becoming a leading provider in the oilfield services section in China. Whether good or bad, China along with the majority of the world outside of the U.S. is still struggling to reach material commercial success in drilling shale wells.
At the end of October, Recon announced the completion of a successful fracturing project at the Sinopec Zhongyuan oilfield. During fiscal year 2013, the company completed several fracturing service contracts with a total value of $4.8 million. Recon applied horizontal well fracturing in 12 wells with 8 natural gas focused wells achieving 100% success.
Q114 Details
The Q1 results for the period ended September 30 showed continued progress with revenue growing 27% and gross margin improvements as highlighted below:
- Total revenues increased by RMB 2.4 million or 27.2% in Q1FY2014 to RMB 11.51 million ($1.9 million), due to sales of furnaces and automation SCADA systems.
- Gross profits increased 116.4% in Q1FY2014 to RMB 5.29 million ($0.9 million). Gross margin improved to 46% as compared to 27% for Q1FY2013.
- Income (loss) before income taxes showed strong improvement from a loss of RMB 2.31 million to income of RMB 414 thousand ($67 thousand).
- Comprehensive net income (loss) attributable to Recon in Q1FY 2014 was approximately RMB 46 thousand ($8 thousand), an improvement of 102% compared to net loss attributable to Recon of RMB 2.34 million ($382 thousand) for Q1FY 2013.
- Adjust EBITDA in FY 2013 was RMB 1.48 million ($0.2 million), showing an improvement of 186.3% over Q1FY 2013.
The amounts still remain very small for Recon Technology, but the potential is enormous.
Recent Developments
A lot of the recent excitement over the stock was the October announcement of the successful drilling of 12 wells where Recon applied horizontal well fracturing utilizing the Baker Hughes Frac-Point technology. The ability to achieve 100% success on wells drilled for Sinopec in the Zhongyuan oilfield has led to additional contracts. The company recently announced another contract win with CNPC Jidong Oilfield and Sinopec Southwest Branch Company. The new contract might only have a value of $1.2 million, but it is a significant sign of the success of its services.
The fracturing service order follows a previous contract for providing 9 vacuum heating furnaces and 6 phase-change heating furnaces. These furnaces are mainly used to facilitate petroleum transportation by raising oil temperature to decrease viscosity or flow resistance and maintain liquidity before the oil is transported from the oilfield.
The company sits at an interesting position using the technology of the U.S. oil service giant Baker Hughes and working for CNPC or Sinopec. Recon Technology is very small firm to be working with giants in the industry.
Investment In U.S. Oil Company
Recon made an interesting investment in Avalon Oil & Gas (OTC:AOGN) back in July. The company bought a 32% position in Avalon in order to gain knowledge of oilfield services and to provide access to the U.S. market for international expansion.
Avalon is an independent oil and natural gas producer focused on using efficient reservoir maintenance and innovative technologies to rework previously producing wells to generate strong cash flow. Unfortunately the deal doesn't provide the access to the hydraulic fracturing wells that would be ideal to provide experience that could be translated back into success in China.
Stock Chart
The stock set dormant for roughly 18 months until early October when the company started announcing progress with shale gas systems and projects. The below chart showcases how investors appear to be catching on to the potential for oil service firms in developing shale gas in China:
(click to enlarge)
Conclusion
Recon Technology remains a high risk, high reward stock. The company continues to develop as an oil services play in China that has a huge demand for the services it provides. Though China has vast technically recoverable reserves, it is very possible that the reserves could become economically unrecoverable or Sinopec decides to utilize an international oil services firm instead of Recon.
The recent contract wins are very encouraging that Recon Technology could be a major winner in the growth of shale gas and even oil in China. Investors need to be cognizant that any delays in infrastructure or well failures could destroy the valuation proposition in this stock, but all signs point towards Recon becoming a major winner in the development of shale gas in China.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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