Striking black gold: Going underground to maximise oil potential

While Mongolia is rapidly becoming world famous for the large deposits of gold, copper and coal at its mines, a less well-known investment story is that of the country’s hydrocarbons sector. Recent surges in exploration promise significant expansion of the sector, and the government is also looking at developing its own downstream operations. The hope is that Mongolia will be able to supply a significant amount of its own petroleum needs, while ending dependency on its neighbours for its refined products.

GAUGING POTENTIAL: The sector first started being developed in Soviet times, when some exploration work was undertaken. Yet, given the abundance of oil and gas reserves in the USSR, with which Mongolia was closely allied, the search was considered somewhat secondary, with little ground covered. Where the Soviet teams did look was in the areas of south-eastern Mongolia where oil naturally seeps to the surface. A rig was brought in and a small refinery built, which worked off the limited output of these deposits throughout the 1940s and 1950s. Then, in the late 1950s, the refinery was destroyed by fire. The Soviets subsequently abandoned the field.

There then followed a long hiatus until the birth of modern Mongolia in 1990. Conscious of the fact that this long break in operations had left the country with little in the way of experienced oil and gas companies or personnel, the new government invited in major players, such as Shell and BP, to evaluate the country and see where potential might lie.

GOING UNDERGROUND: BP’s conclusion was that the country had similar potential to that of the neighbouring Chinese provinces, where oil production in particular was already under way. Indeed, the nearby Erlian basin over the border in China had produced a total of 550m barrels by the start of 2011.

Oil production, but not gas, that is. This is due to the region’s geological nature. A series of cretaceous basins extend under the Chinese-Mongolian border, with a series of faults. This kind of structure typically has two characteristics – the oil is waxy, due to the high presence of water, and there is either no, or very little, gas. The basins tend to contain small deposits, often requiring some kind of lift. This is made additionally complicated by the climate, which in winter can fall to -40°C. At those temperatures, pipes freeze and well heads seize up. Anti-coagulants are thus a vital part of any extraction process, with supply of these a major part of the financial numbers game.

Given the difficulties, it was some time before any new production got under way. A new petroleum law was drawn up in the meantime, modelled after Kuwait’s. The law dictates that all underground resources remain the property of the state, with production-sharing contracts (PSCs) to be signed between the Petroleum Authority (PA) and its private sector partners. The terms of the PSCs can vary from contract to contract, but in broad terms, there is a five-year exploration period, with a minimum level of investment required in this period. The initial contract can be extended for another five years, although this has yet to be done.

COST RECOVERY: If exploration is successful and production commences, the PSC goes into its cost-recovery phase. During this phase, the cost of exploration – along with certain administration and legal costs – can be deducted from the government’s share of the PSC, although there is a maximum of 40% of production allowed for cost recovery. The government’s share of the PSC also varies according to the terms negotiated in each case, but generally, the government gets a share of 40-60% of the oil recovered, with the amount also increasing as more oil is produced.

Investors in oil exploration also get a number of benefits under the law. They are exempt from value-added tax and Customs duties on machinery imported for exploration purposes, which when can add up to a saving of 15%. The extraction contract typically runs for 20 years, with two five-year extensions possible.

As the blocks are usually very large – Block 20, for example, started out at 18,926 sq km – companies are required to relinquish approximately 25% of their territory after two years, although more can be relinquished after the payment of a fee per sq km.

The Petroleum Law of Mongolia is considered amongst one of the more favourable globally, and ranked within the top 10 back in 1995, just four years after it was drafted and approved by the parliament.

IN OPERATION: Under these terms, more than half of Mongolia’s entire territory has now been put into blocks for PSCs, although only three blocks are currently active. These are Blocks 19 and 21, and PSC 1997– the latter named after the year of its initiation and also referred to as PSC 97. Production from Block 19 began in 1998 and from Block 21 in 2010.

Block 19, in the Tamsag basin of far-eastern Mongolia, is currently the main, commercially producing resource, with 85 wells active as of September 2011. Block 19 produces an average of 6000 barrels per day (bpd) between its wells. The block was first explored by London-headquartered SOCO and found exactly what BP had said it would. The crude was light and sweet, but given its waxiness, the company decided to sell their interest to the Chinese National Petroleum Corporation (CNPC, or PetroChina). CNPC bought a 94.4% stake in Blocks 19, 21 and 22, and in November 2006 started selling commercially from Block 19. Block 21 was producing around 200 bpd from four wells in September 2011, according to the PA.

The south-eastern PSC 1997, a Soviet-era exploration site, was initially developed by Rock Oil, which subsequently sold on to Sinopec. The block was producing 1700-1800 bpd by September 2011.

Other companies have also begun taking stakes in other blocks, such as Petro Matad, which was awarded the far-eastern Block 20 in 2006, and south-western Blocks Four and Five in 2009. Canada’s Ivanhoe is located in Block 16 in the central-western Nyalga basin, while Swiss-headquartered Manas Petroleum is in Blocks 13 and 14, adjacent to PSC 1997.

In September 2011, a total of 30 blocks were made available for PSCs, with 18 of them under contract, six in the process of making an agreement, five open for bidding and one block under relinquishment, according to the PA. Of the 18 that were under contract, two were under development plans, while the rest were in the exploration phase.

CHALLENGES: In terms of carrying out the work on these blocks, some local companies offer basic seismic services, but there is a preponderance of foreign companies and staff, as Mongolia currently lacks domestic expertise. The human resources challenge is thus a major one, with some companies trying to train as many local staff as they can, while others largely bring in ready-made foreign crews.

The lack of transport infrastructure in rural areas also creates difficulties, with off-road vehicles and heavy trucks used to transport most materials. Crude oil, is shipped by road tankers, as there is currently no pipeline to the blocks in production. As there remains no in-country refining capacity, with output goes either to China or Russia for processing.

A further challenge may be legislative. Several proposed petroleum laws are being touted, mainly with a focus on increasing the government’s share of the sector, but also with an eye to strengthen environmental regulations. It is likely there will be a new legislative package proposed after the 2012 elections.

The government is aware of the challenges, however, and is trying to increase training while also investing in the transport infrastructure. There are also plans for a pipeline to inner Mongolia, along with schemes for a domestic refinery – a large central one, or a small one closer to the existing fields in production.

EXPECTATIONS: Indeed, in the next few years, the widespread expectation is that the current exploration phase is going to produce significant results, with production then rapidly accelerating. Most of the companies who are currently exploring are in step with each other as well, likely producing a deluge of new development phase fields in a few years’ time.

Given the success of the Chinese oil developers over the border, Mongolia could thus be looking at a significant oil bonanza by the end of the decade.