AMID high oil and gas prices and falling coal costs, Chinese companies are revisiting the idea of transforming coal into more useful and higher-value derivatives such as chemicals, oil and gas, which could mitigate energy security concerns.

Still, government policy will dictate how fast the coal-conversion industry is developed. Some analysts said they believe it will remain a niche industry in China for some time, given water scarcity and carbon emission issues.

China has the world's third-largest proven coal reserves, at 114.5 billion tons, trailing only the US and Russia, according to BP Plc estimates. High transport costs to eastern markets and the central government's campaign to shift development strategy westward have pushed companies to focus their investment on local projects tapping large coal reserves in underdeveloped western regions of China.

In terms of coal-to-gas capacity, projects involving 15 billion cubic meters have so far secured approval from the National Development and Reform Commission, China's top planning agency.

Projects entailing as much as 55 billion cubic meters are under construction, with a further 115 billion cubic meters on drawing boards, according to estimates by analysts at Sanford C. Bernstein.

These projects could be price competitive with China's gas imports at current prices of liquefied natural gas, their report said.

The large volumes, if realized, could reduce China's demand for additional gas imports beyond currently secured purchase contracts before the end of the decade, analysts said.

Sinopec, for example, has recently announced plans to build two major gas pipelines with combined capacity of 60 billion cubic meters per year, for transporting synthetic gas from coal gasification projects from Xinjiang, the energy-rich region in China's far northwest, to the eastern provinces of Shandong, Zhejiang and Guangdong by 2016.

"Synthetic gas would effectively eliminate the market for additional gas imports before 2020," said Neil Beveridge, senior analyst at Bernstein, referring to piped gas from Russia and liquefied natural gas from elsewhere.

China's domestic gas production, plus currently contracted gas imports of 100 billion cubic meters, will reach 350 billion cubic meters by 2020. Demand is expected to reach 400 billion cubic meters.

Synthetic gas from coal gasification projects could provide 14 percent of China's gas demand by 2020, he said.

Coal-to-olefins projects, which are currently being explored to complement the traditional oil route in China, also appear to be economic at current oil and chemicals prices, analysts said. Olefins, such as ethylene and propylene, are used in the production of petrochemicals and polymers.

Coal-to-olefins could be China's strategic answer to cheap natural gas-based olefins in North America, analysts said.

Warned to consider risks

Consulting and advisory firm Deloitte forecasts China's olefin capacity will reach 56 million tons at minimum by the end of 2015, including 51 million tons of oil-based capacity. That compares with annual demand of 50 million tons.

China's feedstock diversification strategy supports the development of the coal-to-olefins business, said Yann Cohen, Shanghai-based national leader for the chemicals industry at Deloitte China. But he has warned market entrants to consider risks, such as overcapacity, price and quality consistency of coal, and water supply accessibility and costs.

The coal-to-olefins capacity projected by Deloitte is conservative because it doesn't include projects that haven't yet secured final government approval, he said. For example, Dow Chemical Co and top Chinese coal producer Shenhua Group have been waiting for years for approval on a US$10 billion coal-to-chemicals project in Shaanxi Province.

China is actually facing a major controversy in the coal-to-chemical industry, a generic term for coal gasification, coal to olefins, coal liquefaction, coking and calcium carbide.

On the one hand, the country needs to develop the sector to reduce reliance on imported gas, to diversify the feedstock of olefins and to alleviate the shortage of petroleum.

On the other hand, however, these projects consume massive amounts water in mining regions where water is often scarce. This has aroused wide concerns that coal-to-chemicals projects may trigger water crises and put additional pressure on the fragile ecological balance.

Another key risk facing the industry is the carbon tax, which could offset the cost advantages of the carbon-intensive coal conversion projects, both Deloitte's Cohen and Bernstein's Beveridge said.

A carbon tax is likely, given China's desire to reduce emissions.

Since 2004, coal-to-chemical projects have been developed across China and have caused a severe production surplus in the coking and calcium carbide sectors.

That investment boom was mainly triggered by local governments anxious for projects to foster local economic growth and create jobs.

To control the blind rush into the coal-to-chemicals industry and reduce adverse ecological impacts, China has stipulated that only the National Development and Reform Commission has the authority to approve projects from 2010, and that approval process was suspended for almost three years.

Li Ye, a section chief at the National Energy Administration, said in June that the planning commission had received 104 coal-to-chemical project applications from local governments, because the three-year moratorium was close to an end.

Demonstration projects

Total investment would have exceeded 2 trillion yuan (US$320.8 billion) had all the applications been approved, he said.

The planning commission announced 15 large-scale coal-to-chemicals demonstrations projects - mainly coal gasification and coal-to-olefins - in the first half of 2012, which sparked renewed interest in the industry and marked the cautious re-opening of investment plans.

If adopted on a large scale, the trend could be good for the coal industry but negative for oil and gas.

"While the will is there at the local government level, we detect caution from the central government, given the water and emissions challenges," Beveridge said. "We expect coal-to-gas and chemical projects will remain niche industries in China, although government policy in 2013 will be important to watch."

Globally, coal is set to rival oil as the dominant energy source by 2017, the International Energy Agency said in a report last month. It said only a drop in gas prices could curb the use of coal in the absence of carbon tax levies.

The world's coal consumption will rise 2.6 percent annually to 4.32 billion tons of oil equivalent by 2017, compared with 4.4 billion tons for oil, the agency report said.

In the US, a boom in shale gas has cut gas prices paid by utilities by half since 2008. That prompted a switch away from coal.

China is also developing the shale gas sector but so far, no commercial production has been announced, mainly due to technology issues.