Shell community liaison officer Bill Quanbai (right) with a farmer near a fracking drill site in Sichuan province
Photo: Stefen Chow

With help from Shell and other western energy giants, Beijing hopes to turn vast shale gas assets into a new source of clean(er) energy through fracking. The trick is to avoid an environmental disaster.

By Brian Dumaine
April 11, 2013

As the white Toyota SUV bounces over the rutted dirt roads of Sichuan province in western China, Shell’s Bill Quanbai Li points to a drilling site with a derrick rising on the horizon. Nearby, a farmer tills a canola field with a wooden plow pulled by an ox. Li is a community liaison officer for Shell, and his job is to smooth over relations between the energy giant and the villagers as the company explores for shale gas in this rural area about two hours northeast of Chengdu, a city of some 14 million. He says he spends a lot of time explaining to the locals — many of whom make only $150 a year — how hydraulic fracturing, or “fracking,” will affect their land and their lives. “You can’t believe what comes up,” he says with a smile.

One time, he recalls, a man who raises cobras in his living room worried that the vibrations from the drilling process used to extract gas from underground rock formations would disorient his snakes — including a prized albino cobra. In another instance, a farmer complained that his chickens stopped laying eggs once the fracking started. (Li explained to both that the process lasts only one to two hours a day over a couple of weeks and is unlikely to create tremors strong enough to upset the animals.) Then there was the old woman who sat in a chair in the middle of the road, blocking a convoy of trucks headed to a drilling site. It turned out that she wanted Shell to hire her son.

To win hearts and minds, Shell has helped build new roads in the area, funded an addition to the local elementary school, and created an old-age home for widows. Why would an oil major go to such lengths to curry favor in this rural farming community? Simple: If China contains as much shale gas as Shell thinks, the company could be in the early stages of developing one of the biggest energy discoveries in history. Shell says it is investing $1 billion a year to tap into China’s vast basins of shale gas, including here in Sichuan province. And the company doesn’t want that investment endangered by any public-relations blunders. Granted exclusive access to Shell’s fracking sites in Sichuan earlier this year, Fortune got to see firsthand the challenge and opportunity the company is tackling.

How much shale gas does China have? The short answer is that no one exactly knows yet. Exploratory drilling is still in the very early stages; Shell first broke ground in Sichuan in 2010. But most in the industry agree that China’s shale potential is vast. The U.S. Energy Information Administration estimates that the country has total reserves of 1,275 trillion cubic feet of shale gas — more than Canada and the U.S. combined. (The U.S. alone is now estimated to have a 100-year supply.)

Shell is not the only Western energy company hoping to capitalize on China’s shale potential. Chevron recently formed a joint venture with the China National Petroleum Corp. and has begun drilling exploratory wells in Sichuan. And Conoco Phillips — in a joint venture with Sinopec — announced in December that it plans to drill wells in Sichuan later this year. The gold rush has begun.

If shale gas lives up to its promise, it could be a game changer for China. The nation’s thirst for energy continues to surge. Over the next 20 years the country is expected to double its demand for power. For perspective, Daniel Yergin, in his book The Quest: Energy, Security, and the Remaking of the Modern World, writes that in some recent years China has added the power equivalent of a France or a Great Britain. To meet its voracious demand, the country is currently building 29 nuclear plants and adding vast amounts of wind, solar, and hydro power.

But coal remains king for now. China generates 80% of its electricity from coal and consumes almost as much of the fossil fuel as the rest of the world combined. What’s more, the country is opening new coal-powered plants at a rate of about one a week. Given that coal plants are the largest generators of greenhouse gas, China’s love affair with anthracite has serious implications for climate change. The sooner China can begin producing a significant portion of its electricity from shale gas — which emits only half the CO2 of coal — the better off the world will be.

But perhaps more compelling to China’s party leaders is that cleaner-burning shale gas could also help address the country’s increasingly dire air-pollution problem. In Beijing in late January the pollution darkened the air so badly at times that some flights had to be canceled. The atmosphere was heavy with what’s called PM 2.5 — for particulate matter that’s 2.5 micrometers in diameter. These small particles of black carbon — the same substance that gives coal miners black lung — are fouling the air. The EPA considers PM 2.5 concentrations of over 35 parts per million to be hazardous. In Beijing the level in January at times approached 1,000 parts per million. A recent report in the British medical journal The Lancet concluded that 1.2 million Chinese died prematurely in 2010 because of air pollution. Environmental protests are on the rise across the country. And even state-owned newspapers have begun running lengthy articles on air pollution.

The government says it is working hard to crack down on industrial polluters and limit the number of cars on the road. It has some of the strictest environmental laws of any nation, yet enforcement often proves elusive. Long term, one of the most effective ways to reduce pollution will be to switch to cleaner fuels. That’s why, two years ago in its 12th five-year plan, Beijing set highly ambitious targets for shale gas production. The National Energy Administration announced the goals of producing 230 billion cubic feet of shale gas annually by 2015 and at least 2.2 trillion cubic feet per year by 2020 — the equivalent of about a quarter of America’s current production.

For all the excitement over shale gas in China, however, the country stands at an important crossroads. Much could go wrong. The shale gas boom in the U.S. happened after years of development of new drilling techniques. China, by contrast, is playing catch-up on fracking technology and trying to do it virtually overnight. Fracking — if done improperly — has the potential to pollute water tables and release methane, a potent greenhouse gas. (More on safety issues later.) Unlike in the U.S., where “frack” is practically a four-letter word to environmentalists, in China the risks of shale gas development are not yet widely known. But even here, where the will of the state is not usually swayed by the wants of the public, an environmental disaster could derail the fracking revolution before it really gets started.

Not everyone in the oil and gas industry believes that China will hit its 2015 target. The numbers for 2020 are even more ambitious. In a recent report, BP said it thinks it will be at least 2030 before China reaches those levels of production. But Martin Stauble, Shell’s VP of Gas China, is optimistic: “The 2020 number is a huge number. It all hinges on the geology being conducive and the regulators providing the right framework. There are still huge hurdles, and I don’t want to be naive about it, but Beijing is very clear about what it wants, and it wants to make it happen.”

One big challenge is that no one knows for certain where the shale gas sweet spots are or how much of it can be extracted economically. Geologists have concluded that China’s most promising shale gas deposits lie in three giant basins: the Tarim Basin in the northwest, the Ordos Basin in north-central China (including Inner Mongolia), and the Sichuan Basin in the southwest. Millions of years ago these areas were the bottoms of oceans and lakes. Plant and animal matter buried there was covered by sediment, and the heat and pressure from the rock turned the organic sludge into oil and gas. This band of hydrocarbons — now two miles beneath the surface of the earth — is often referred to as “nature’s kitchen.”

Over millions of years some of the oil and gas seeped upward through pores in the rock and sand and was trapped in reservoirs. Those reservoirs have provided most of the hydrocarbon production over the past century. But in the Sichuan Basin — as in large shale formations in the U.S., such as the Barnett and the Marcellus — much of the gas became trapped in sedimentary rock. Oil and gas present in such formations are called unconventional because they do not flow into wells by themselves — the rocks first need to be split open to release the hydrocarbons. In the U.S. drillers have perfected this process by fracking wells, or injecting a mixture of water and chemicals at high pressure to create pores in the shale rock. This technique, combined with advances in horizontal drilling, is what has unlocked unconventional gas.

Of the three basins in China, Shell picked the Sichuan and Ordos basins to develop first. Both have promising geology. (The Tarim Basin in the northwest is in a desert, and fracking requires vast amounts of water — as much as 4 million gallons per well.) The company is currently developing one block in the Ordos and three in Sichuan. Shell is working on these shale assets as part of a joint venture with PetroChina, the massive state-owned oil company, which has 1.7 million employees. So far the partners have drilled 40 exploratory wells in China, or two-thirds of the 60 total fracking wells drilled in the nation so far. That compares with the roughly 35,000 wells that are fracked each year in the U.S.

At Shell’s Jinqiu block, in the rural area outside Chengdu, Shell has drilled 19 wells, all in different stages of development. The company won’t say yet that this area will be a winner, but one completed well was producing significant amounts of gas during a visit in late January. Says Tony Cortis, the general manager at Jinqiu and a 25-year veteran of Shell with extensive fracking experience in Canada: “All I can say is that we’re pleased with the results so far.”

Visiting these drill sites, one comes away with the realization that fracking isn’t easy. For starters, not all unconventional gas deposits are created equal. In some the gas is trapped in sandstone, which is trickier than shale to drill through. Reaching gas trapped in shale isn’t much easier, because every shale is different and the types of formations in China are largely new to drillers. So far Shell has found that the shale is harder and therefore more difficult to drill and frack than the deposits in the U.S.

In its joint venture with PetroChina, Shell provides the advance technology for finding and analyzing the shale deposits, and the management skills for setting up these wells to be operated profitably. PetroChina, which has been drilling conventional oil and gas wells for decades, provides the equipment, manpower, and local operational know-how. “The geology is complicated,” says Xiong Jianjia, the vice president in charge of PetroChina’s unconventional gas projects in southwestern China. “The most important thing for us is to learn and get up to speed on the technology and management surrounding shale gas production. Shell is helping us here.” When asked why PetroChina is diving headlong into fracking, he replies: “Our new government is calling for a beautiful China. We need clean energy, and shale gas will be one of the sources.”

The drilling teams do not want for resources. At one of the Jinqiu plots, a dozen fire-engine-red Mercedes trucks, with pumps that provide a total of 26,000 horsepower, stand ready to force millions of gallons of water down the well to a depth of more than two miles. “The beauty of partnering with the Chinese,” says Cortis, “is that they built these trucks in China, they built them fast, and the equipment works.” The ability of the government to mobilize rapidly is what makes supporters of Chinese fracking believe that the country will be able to ramp up production faster than skeptics think.

One common criticism of fracking in China is that the country doesn’t have a pipeline system in place to bring the gas to market. Xiong of PetroChina counters that plenty of pipeline capacity already exists to carry the shale gas from the Sichuan Basin to southwest cities such as Chengdu and Chongqing. And the government is moving aggressively to add new kilometers of pipeline in other regions. “Gas pipelines are getting built out rapidly,” says Xizhou Zhou, head of China energy at the consultancy IHS. “In China the companies don’t have to worry about grandmothers gathering 200 signatures and filing a lawsuit.”

The shale gas boom in the U.S. has generated a wave of resistance from the environmental community. Fracking opponents are understandably concerned about the risks of shale development — from gas leaking into the water table to wastewater being dumped into rivers to the disruption that the drilling causes to natural habitats and nearby communities. Unfortunately, those concerns have been validated at times by slipshod drilling practices, often traceable to operators that don’t have the operating experience of the oil and gas majors.

Shell wants to make sure that fracking doesn’t acquire a bad rep in China. At its Jinqiu site, the energy giant — which has drilled thousands of fracking wells in the U.S. and Canada — is trying to create a model for proper unconventional drilling in the country. The fracking water is recycled, the well casings are tested multiple times to make sure gas doesn’t leak into the water table on its way to the surface, and the company says it uses state-of-the-art equipment to avoid surface leaks of methane.

The danger is that, as in the U.S., a flood of non-oil major operators eager to participate in the boom will create problems. Beijing announced in January that 16 companies had won a second round of bidding to explore 19 shale gas blocks in central China. None of the contracts went to large oil and gas companies. Instead, the winning bids were made by domestic Chinese utility, coal, and trading companies with little or no experience in fracking. “If there are any shortcuts, Chinese companies will take them, and our grandkids will pay for it,” says Ming Sung, an environmentalist based in Beijing for the nonprofit Clean Air Task Force.

Shell’s Stauble agrees that the environmental track record of China’s industrial companies is not all that great and that the flood of new operators poses a risk. But he says Shell is doing what it can to be a positive influence. “We are telling newcomers what we believe the operating procedures for shale gas should be,” he says. “And we hope they take up these world standards.”

On one level, at least, that’s already starting to happen. The Chinese are reaching out to the West to learn as much as they can, as fast as they can, about shale gas. In February the Sinopec Group announced a $1 billion deal to buy half of Oklahoma City-based Chesapeake Energy’s oil and gas assets in the Mississippi Lime deposit. PetroChina is buying a stake in a big Canadian shale gas field for $2.2 billion. And a third Chinese oil giant, CNOOC, recently spent $15 billion to acquire the Canadian energy company Nexen, which has huge shale reserves.

Will Chinese shale live up to its promise? It’s in the early days, but back at the Jinqiu site, one of the wells has been giving off a soft hiss for months — a sign that there could be bountiful amounts of gas trapped in the rock beneath the rich Sichuan soil. As Shell’s Cortis walks away from the wellhead, he stops and looks back and says, “This is why I do this — to create energy, to leave something behind after I’m gone.” If his hunch is right and Sichuan holds one of the richest basins in the world, both Shell and China will be reaping the rewards for years to come.

This story is from the April 29, 2013 issue of Fortune.

This month in Laguna Niguel, Calif., Fortune hosts the fifth annual Brainstorm Green conference as part of our continuing coverage of corporate sustainability. These stories explore some of the cutting-edge ideas driving green technology. After you’ve read them, we think you’ll come to the conclusion that today business and environmentalism are vitally intertwined.

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