As opposed to oil or other carbon-based energy sources, natural gas, in its basic form, is not easily transportable. This is problematic as the largest producing countries of oil and gas historically tend not to be the major users of these products. This is especially true for Europe, most of Asian countries, and up until recently, the United States.
the challenges of Transporting natural gas
Moving natural gas from the production site to where it is consumed traditionally requires very costly pipeline networks such as the recently famous Nord Stream II that runs from Russia to Western Europe. The alternative way to transport natural gas is to pressurize and cool it down to about -163°C at which point it liquifies: this is LNG or liquified natural gas. It is then loaded onto cooled and pressurized ships and shipped to anywhere on the planet. Once the ship carrying the supercooled fuel reaches its destination, the LNG needs to go through a regasification process so that it can be vaporized and used in powerplants, industrial processes and domestic consumption. On top of being very economical for long distances as opposed to gas pipelines, it is highly practical because liquified natural gas takes 600 times less space than its gaseous form. Unfortunately, moving LNG overland by pipeline is impractical because it needs to be kept super-cooled.
an expanding industry
While the first experimental LNG was shipped in 1959 from the US to the UK, the first actual large scale production site was built in Algeria in 1964. Since then, the industry has been in continued expansion.
For a number of years, the LNG sector has been growing thanks to demand from countries such as Japan, Korea and China. The sector saw a significant acceleration driven by Japan when the country decided to decommission its nuclear power plants following the Fukushima incident. This was followed by the mid-2010s US shale revolution which turned the US from a major oil and gas importer to one of the leading exporters. With access to until-then untapped oil (and the gas that comes with it), the oil market became oversupplied. This led to a massive drop in global oil prices, along with US gas prices. A few years later, the US LNG export industry flourished, as several companies built LNG export terminals to benefit from exporting the abundant and cheap US-produced natural gas. The country soon joined Qatar, Australia and Algeria as a top LNG exporter.
Ending dependence on Russia
With the Russian invasion of Ukraine and the subsequent sanctions imposed on Russia, the world, and most notably Europe, is looking to discontinue its reliance on Russian imported gas. Europe imports about 40% of its gas, or 155 bcm (billion cubic meters) from Russia every year. This up-for-grabs market is the next leg of growth for the LNG industry. However, there are some limiting factors, most notably the lack of regasification capacity in countries that are most reliant on Russian gas like Germany and Italy and a lack of shipping capacity. This means that fully replacing this piped gas by LNG will not be possible over the short term, notwithstanding the fact that it would represent close to a quarter of all the LNG produced worldwide, most of which is already sold on a long-term basis. Consequently, this has led to an excessively tight LNG market with prices skyrocketing.
increased Pressure on the whole supply chain
Prices of ancillary services are also up, with day rates for LNG tankers trading at a decade high, USD 120,000/day, up 50% on last year. It is now very difficult to find ships with long charters, which will significantly impact LNG traders. On top of that, new emissions standards for tankers coming into force next year will limit the number of ships in the market. Rates for floating storage and regasification units are also up and supply is short.
In mid-June 2022, the LNG market became even more stressed as a fire occurred at the Freeport LNG production facility in Texas. The company does not expect the production site to be fully up and running before at least the end of the year. This had two consequences:
- the US gas prices are sharply down as gas which would have been exported will have to be consumed locally and
- the LNG prices into Europe and Asia have risen even higher, as the super chilled fuel supply is now scarce.
The LNG industry is characterised by large upfront capital costs of several billion USD and long investment cycles. Therefore, the industry mainly works with 15–20-year contracts that enable LNG producers to have a reasonably high certainty with regards to the returns they can expect. Additionally, as it takes 4 to 5 years to build a liquefaction export terminal, the industry – and investors– have a great visibility on the capacity additions over that timeframe.
As very few projects were sanctioned in the 2015-2018 timeframe and considering the 5 years required to build a new liquefaction plant, the market will remain tight until 2023 at the very least, if not 2024. This is even more true due to the new demand coming from Europe.
Taking advantage of the LNG investment opportunity
Based on that thesis, we invested in Cheniere, the largest US LNG exporter, at the end of 2021. The rationale for it was simple: the company should benefit from the massive capex they invested over the past few years to expand their liquefaction capacities and will therefore be able to reap the benefits of the tight market. On top of that, as the situation in Ukraine was deteriorating, it was a good – and fairly cheap – way of hedging against a then unlikely war. There are only very few alternatives for investing in public companies in the LNG sector such as Sempra Energy, Energy Transfer, Tellurian or NextDecade, although the last two will not have producing capacity for the next few years and will therefore remain loss-making. Additionally there are other, more diversified oil and gas groups that have significant shareholdings in several LNG plants across the world, such as TotalEnergies, ExxonMobil, Shell and Chevron.
As the current situation unfolded, our investment in Cheniere has significantly paid off. We remain optimistic even if the stock is up more that 30% YTD. Incremental news of struggling US LNG peers and reduced Russian gas flow to Europe favour Cheniere. The increasing difference between US gas prices and the price at which LNG companies can sell this gas abroad are leading to greater profit per unit sold.
The European energy crunch will appear this autumn. LNG prices will remain elevated and in short supply, LNG stores have not been replenished, there is a squeeze on ships and floating regasification vessels, Germany’s nuclear fleet is to be shut down in a matter of months, environmentalists are moving to block construction of onshore regasification terminals, renewable energy permissioning is no faster than this time last year despite the REPowerEU initiative, and renewable energy construction is delayed due to supply chain disruption. It may be a cold, expensive winter. Those companies capable of easing the pain stand to gain.