In recent years, China's shale gas industry has attracted great interest from both domestic investors state-owned or otherwise and major offshore players, thanks to a broad range of initiatives and preferential policies promulgated by the central government with a view to encouraging investment.

Notwithstanding these encouraging developments, the regulatory regime for the shale gas industry is still in its early stages,and development has been slow. The regime also poses unique challenges for foreign investors. This article discusses regulatory developments, potential pitfalls and some structural options.

On 31 December 2011, the State Council approved the change of shale gas from a "natural resource" to an "independent mining resource", which is now subject to the Mineral Resources Law and specific legislation. Until now, the only specific legislation was the Circular on Strengthening the Prospecting, Exploitation, Supervision and Administration of the Shale Gas Resources.

Under the new regime, the Ministry of Land and Resources (MLAR) is in charge of administration of shale gas resources, and exploration licences are granted through public tendering. The significance of these developments is that private and foreign investors, subject to certain conditions, are now permitted to invest in this resource. Prior to this change, foreign investors were only allowed to partner with a handful of Chinese state-owned oil and gas companies.

The circular breaks the previous "monopolised" regime by allowing qualified Chinese companies to participate in the public tendering processes whereby shale gas exploration licences are granted to winning bidders for selected gas blocks. Although foreign investors possessing technical know-how have been "encouraged" to participate in the tendering process, they were only able to do so by partnering with qualified Chinese bidders (at least that was the case in the two previous rounds), and their wholly owned Chinese subsidiaries are not qualified bidders either. It is unclear whether such restrictions will be removed in future tendering rounds.

Exploring the structure matrix

The circular otherwise does not adequately address other key considerations relevant to the development of shale gas, in particular on how the existing common foreign investment structures can be used for the so-called "Sino-foreign co-operation" on the joint development of shale gas, as further discussed below.

If foreign investors do not want to participate in the tendering process, or simply prefer to co-operate with Chinese companies that are already winning bidders granted shale gas exploration licences, three key structures commonly known to foreign investors can be considered: Sino-foreign equity joint ventures (EJVs); Sino-foreign contractual joint ventures (CJVs) and production sharing contracts (PSCs).

Each structure has its own pros and cons, depending on the commercial objectives a foreign investor wants to achieve. Such considerations range from a party's contribution form (cash or in kind), transferability and evaluation issue of the shale gas exploration licence, application and transfer of the shale gas exploitation licence, and future mid-stream or downstream arrangements.

Joint venture structures

While EJV and CJV structures are identical on many aspects, the CJV structure generally allows greater flexibility for the parties to structure their commercial arrangements under Chinese law.

Under the current legal regime, shale gas exploration licences cannot be transferred to a Sino-foreign joint venture (EJV or CJV) until the Chinese partner has adequately delivered on its exploration commitments made to the MLAR.

This means that the Chinese licence holder cannot transfer the licence to an EJV as equity contribution before then. But it may provide "contractual access" to the licensed block as a co-operative condition under a CJV structure  without the need to transfer the licence to the joint venture  while committing to transfer the exploitation licence to the joint venture once it is granted, subject to appropriate evaluation. The downside of this approach is that the foreign party will not have ownership on the licence (hence no proprietary interest), but is arguably no worse than it would end up under an EJV structure.

If an EJV structure is used, the parties will have to use the EJV to engage in exploration business which will then contract with the Chinese licence holder for those exploration works committed to the MLAR. However, such contractual arrangements can be easily accommodated under a CJV structure.

Further complications may arise during the exploitation stage as the current legal regime is not clear on whether the Chinese partner or the Sino-foreign joint venture should be entitled to apply for the exploitation licence. The MLAR and its local counterparts have discretion in this respect. Putting aside those legal uncertainties, the commercial reality is that the Chinese partner will want to control the application process and secure the licence solely under its name, and then request the foreign partner to pay for its equity portion of the licence once it is properly evaluated. It is important to understand that, as with transfer of any state-owned assets, such evaluation result must be approved by the relevant Stateowned Assets Supervision and Administration Commission with jurisdiction, if the Chinese licence holder is state-owned.

PSC structure

Historically, the PSC structure was established by the regulations on Sino-Foreign Co-operative Exploitation of Onshore Petroleum Resources, whereby certain state-owned oil and gas companies were granted exclusive rights to co-operate with foreign Investors. While the circular says that Sino-foreign co-operation on shale gas will be subject to those same regulations by "reference", it is unclear how such references can be made.

A further complication comes from a recent development whereby the Ministry of Commerce (MOFCOM) has abolished the previous requirement that PSCs be approved by the ministry (in Beijing) before they can take legal effect. Under the new regime, PSCs only need to be filed with the ministry through their relevant local counterparts. It remains to be tested if a foreign party can use such a contract structure to get its investment both into and out of China without a MOFCOM approval.

One possible approach is for the foreign investor to establish a Chinese subsidiary that can then co-operate with the Chinese exploration licence holder under a PSC structure. It is arguable that due to the fact that two Chinese companies signed a contract under Chinese law, the contract �in substance a PSC should not be subject to the existing regulations restricting foreign investment into conventional and unconventional gas resources.