Pacific Asia China Energy Drilling Subsidiary Signs Multi-Million Dollar Contract

| About: Pacific Asia (PCEEF)

Often overlooked in finding the lower risk coalbed methane [CBM] company is the fact it can take years before a company can generate cash flow from gas sales. While the CBM blocks awarded by Chinese United Coalbed Methane [CUCBM] to its foreign partners are quite generous, and should become increasingly valuable later this decade, investors remain less well-informed as to the realistic time frame these CBM projects might take. The upfront development costs could burden many companies during the first two to five years. The elusive jackpot, which could be enormous, might not materialize until circa 2009 or 2010, or take longer.

Not so for Pacific Asia China Energy (OTC:PCEEF). When we began coverage of the CBM sector, it was done with a jaundiced eye. The appeal was not pure CBM although China’s red-hot growth and ravenous energy appetite demanded we focus on China’s CBM plays, instead of those in North America.

What attracted us to this tiny and very speculative CBM play was the joint venture relationship PACE had begun, at the time we began writing about PACE, with Mitchell Drilling Corp, Australia’s largest private drilling company. After interviewing Nathan Mitchell this past May, it became evident PACE’s CBM extraction story would play second fiddle to the coal degasification in China until the company achieves commercial production.

At the time, we were concerned about what Sprott Asset Management’s CBM analyst Eric Nuttall had told us, “CBM exploration and development can get pricey.” This sounded like CBM explorations were best left to the oil giants, such as BP Plc, which recently announced it was spending $2.4 billion in the San Juan Basin over the next decade to expand its CBM development in Colorado and New Mexico.

By contrast, Nathan Mitchell argued the latest drilling technology his firm has used for the past six years was regularly getting gas out of the ground for under $1.50/mcf. His drilling company had proven it with more than 250 wells in Australia using the Dymaxion® horizontal/vertical drilling technology. The company had drilled about 50 wells in India with another 70 wells coming. Corporately, the company had taken acreage in southern Kansas in the United States where it had just finished its first CBM well. His company's website boasts of ‘Finding the Needle in the Haystack’ and having had a 100-percent success rate intersecting the surface-to-inseam wells with the main vertical wells.

What married Mitchell Drilling to PACE was the inroads the CBM company’s president Tunaye Sai has made, as well as his personal connections, within CUCBM in China. Mitchell wanted to expand into China’s explosive CBM sector, hence the partnership with PACE. We first discussed the potential of this relationship after Mitchell and Sai unveiled the Dymaxion drilling technology at a Chinese coal symposium in spring 2006. Both were unabashedly excited about being swamped by Chinese coal executives asking when they could start using this innovative drilling technique to degasify their coal mines. Shortly thereafter, PACE paid the upfront costs to build two drill rigs.

Last week, the PACE Mitchell joint venture inked its first drilling contract to degasify a Chinese coal mine, valued at about US$7.5 million, with a unit of the Shenhua Group. In an email from PACE President Tunaye Sai, we were told:

“This is a turnkey operation, which includes 44,000 meters of drilling – both SIS and UIS. For surface-to-inseam [SIS], it includes the supply of well head CBM production equipment, test production for three months and the training of local operators.”

Buried at the bottom of the company’s news release was a paragraph describing a signed Memorandum of Understanding for a second degasification – in Yunnan Province – with a different coal mining company, noting that contract terms are now being negotiated. Curious about this, we emailed Mr. Sai, who is also a mining engineer living in China, as to how many coal mining companies were in the pipeline. In his curt response, Sai said, “We can get another ten companies to sign up soon, but we have three which are very close now.”

Hypothetically, if all ten coal mining companies materialized, this could represent upwards of US$75 million in revenues for an obscure TSX Venture-listed company whose main assets, until now, were exploration-stage production-sharing CBM contracts in China. Where’s the profit? We asked about the cost of building each drill rig.

“The cost of building the drill rig was US$1.5 million,” Sai wrote. “But we have to add in other accessories.”

Of the US$4.125 million the PACE subsidiary would gross from the 55-45 split with its marketing partner, this would leave about $US2.6 million. Sai would not offer any guidance on profitability, writing, “We have to operate this first and then calculate the net profit.” Still, there appears to be sufficient profit margins in this contract. In an audio interview with PACE executive vice president Steve Khan on December 14th, he explained the cost of building the drill rig, borne by PACE, would be paid down first and then the profits split by the joint venture.

In all, this appears to be a potentially lucrative arrangement for PACE. Other foreign CBM operators have expressed interested in using the subsidiary’s Dymaxion® drill rigs. How many? “About four,” Sai responded. We independently confirmed at least one competing CBM company has been evaluating the drill rig.

The big boost for this deal was the client, which was subtly noted in the PACE news release. The Shenhua Group is not only China’s largest coal producer, but it is also the world’s third largest coal mining company behind Peabody Energy and Rio Tinto. In June 2005, Shenhua’s initial public offering in Hong Kong – at $3.3 billion – was one of the year’s largest IPOs. Major investors such as Hong Kong billionaires Lee Shau Kee and Cheng Yu-Tung invested, and so did Fidelity.

Shenhua has been on a tear for the past six years. Recently, the company’s deputy general manager announced the company planned to become the world’s largest coal company by 2010, producing 200 million tons per year. In July, Bloomberg reported Royal Dutch Shell Plc and Shenhua Ningxia Coal agreed to study investing up to $6 billion in building a 70,000 barrel/day plant in the Ningxia province for turning coal into fuels and chemicals. British construction giant Amec has been appointed to provide the initial engineering design for this plant.

The Ningxia Hui Autonomous region in northwest China has proven coal reserves of about 31 billion tons; potential reserves could run more than 200 billion tons. The Shenhua Ningxia Coal Group, which awarded the PACE-Mitchell contract, has at least 13 coal mines in the province. This first contract may be viewed as an audition for the Dymaxion® drill rig. For a tiny company, this would be on similar footing for a tech company announcing a new technology contract with Microsoft. Shenhua is the 11th largest company, by market capitalization, trading on the Hong Kong stock exchange, and the world’s second largest publicly traded coal company.

The timing is perfect. As we’ve reported previously, the State Administration of Coal Mine Safety has been beating the drums to improve mine safety. The horrendous publicity of China’s unparalleled level of coal miner deaths is an image the Chinese would like to change. In an article written last March, we reported Chinese Premier Wen Jiabao’s concerns about methane gas explosions in his country’s coal mines. A mining engineer by profession, he said, “The development of coal bed methane exploration and production can not only prevent gas explosions in the collieries, but also help diversity the energy consumption mix, and we should intensify efforts to research, explore and utilize coal bed methane resources.”

The Chinese Premier has been tough on coal miners. Coal-rich Shanxi province, for example, plans to shut down many of its smaller and more dangerous mines this year. By June, the province will have closed nearly 6,000 coal mines, cutting the total number of producing coal mines to 3,200.With China’s quantity of coal mines, and the substantial number of coal miner deaths, mine safety is one of the country’s greatest concerns. Degasifying coal mines is at the top of the mine safety list, and bodes well for drilling technologies, such as the Dymaxion®, for many years into the future.

We asked Steve Khan for his take on this new contract. “Revenues from our drill rig subsidiary offer investors some ‘risk protection’ as the company moves forward toward commercial gas production,” he responded. Meanwhile the company soon plans a vertical drilling program on its Guizhou CBM block. According to Sproule International Resource estimates, which have not been independently reviewed, there might be up to 11.2 trillion cubic feet on the 970 kilometer square concession.

True, the initial drilling contract doesn’t hold the sexy appeal of a major natural gas discovery, but this may also be on the horizon, judging by the world-class gas content found at shallow depths during the early-stage drilling of 2006. Results were comparable to at least two other foreign-owned CBM companies hoping to commercially develop their concessions. Results were similar to gas content found in New Mexico’s San Juan Basin and in Alabama’s Black Warrior Basin – both major CBM producers in the United States.

In the interim, PACE appears to be on a roll of lining up, and hopefully signing more, contracts. If the Dymaxion® drilling technology catches on in China, this could very well result in a steady and increasing stream of revenues to buttress PACE against any possible volatility in natural gas prices. After all, there are more than 800 Chinese coal mining companies with several thousand mines which may need degasification.