LNG – a ‘natural’ solution to the world’s energy needs
Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
This piece provides a brief discussion about the merits of liquefied natural gas as an energy source and how investors can seek to gain exposure to a theme that we expect only to grow in importance.
Countries logically construct their basket of energy supplies like portfolio managers determining their asset allocation strategies, namely seeking to balance a series of factors. In the case of energy, these include the security of supply, its cost and the environmental impact. March’s unfortunate events in Fukushima, Japan, induced a sense of fear and uncertainty with regard to nuclear. While some of this may have been misplaced or even distorted by media hyperbole, governments’ and investors’ perceptions of relative energy risks have been inevitably distorted and will take time to realign. In our view, nuclear still has a valid role to play in global energy supply, but in both the near- and the longer-term, advocates of alternative sources, and in particular liquefied natural gas (or LNG) can make a strong case for growing provision within energy and investment portfolios.
LNG is natural gas (predominantly methane) that has been converted temporarily to liquid form for ease of storage or transport. Natural gas is a major source of energy, but many towns and cities that need the energy are located far from gas fields.
Transporting gas by pipeline can be costly and impractical. As a consequence, LNG is created by cooling the gas to a liquid at around -160ºC. In this form, it is a clear, colourless, non-toxic fluid that can be transported and stored more easily than natural gas because it occupies up to 600 times less space. When LNG reaches its destination, it is returned to a gas at regasification facilities. It is then piped to homes, businesses and industries.
The LNG industry can trace its history back to 1958 when the first demonstration tanker shipment of LNG was made from Lake Charles, LA, to Canvey Island in the UK. The integrated oil companies helped spur the development of the sector with Shell providing the technology for the world’s first commercial liquefaction plant at Arzew, Algeria, in 1964. The industry has grown significantly since then and according to Chevron, a major US player, there are now 101 import terminals globally designed to receive LNG shipments, 24 LNG liquefaction export terminals and more than 200 storage facilities where LNG is kept until needed.
Global demand for LNG has tripled in the last thirty years, according to the International Energy Agency, which also forecasts a further doubling in LNG over the next twenty years. The growth potential of LNG is corroborated by further sources, with Shell, for example, modelling a 6.7% p.a. CAGR in LNG from 2005 to 2020 and Woodside, an Australian oil and gas business, projecting a 5.0% p.a. CAGR over the next ten years. To gauge the potential of LNG it is interesting to consider that while it provides around 10% of the world’s energy needs today, this is spread broadly around the globe: to return to the earlier asset allocation analogy, Russia and the UK are ‘overweight’ with LNG, with this source accounting for over 50% and around 40% of these countries’ respective energy needs, while at less than 10% (and just 4% in the case of China), India, Brazil and China are currently ‘underweight’.
Several important factors look set to spur the growth of LNG. First, as has been well-documented elsewhere, the world’s population is continuing to expand and emerging markets are industrialising rapidly. Aggreko, a UK-listed provider of temporary power, highlights that there is a logarithmic relationship between power consumption and industrialisation, with non-OECD power consumption growing over four times faster than levels in comparable OECD nations. Against this background, Shell forecasts that global energy demand will grow by two-thirds through to 2050, with increasing power generation demands accounting for the biggest element of this change. The emergence of ‘new’ global centres of industrial power are also borne out in forecasts by Wood Mackenzie, a firm of global energy consultants, which predicts that by 2025 the four leading importers of LNG will be Japan, China, South Korea and India. This compares to the current top four of Japan, the USA, Spain and Germany.
Next, considerations of cost clearly matter. The world’s reserves of natural gas are very large and appear more than adequate to support natural gas exports far into the future, with the caveat that many of these reserves are located in places where economics, technology or geopolitics may raise questions about how quickly they will become commercially available. Nonetheless, according to BP, there currently exists 187 trillion cubic metres of proved reserves, equivalent to a reserves: production ratio of more than 60 years. Natural gas today sells for around $4.30 per mcf (i.e. 1000 cubic feet), making it nearly equivalent in cost to coal. As more supplies become available, the cost of gas should correspondingly fall, especially as economies of scale from increased production, transportation and gasification start to impact.
Furthermore, the cost of coal (and oil) rises considerably relative to natural gas when the social and environmental effects of the former are taken into account. Natural gas contains less than 50% of the carbon content that oil (in the form of gasoline, petrol) has. More importantly, natural gas vehicles emit little to no harmful pollutants such as carbon monoxide, nitrogen oxide, and toxic volatile organic compounds that gasoline and diesel consumption currently produce. In addition, no scalable, affordable technology exists today to make either coal or oil clean. A world with an increasing energy contribution from LNG would not only be healthier, but also less exposed to climate change. Potentially persuasive arguments can also be made for renewable energy sources such as wind or solar. While not the specific topic for discussion here, it is hard not to remain a sceptic, however, with regard to such technologies: these industries will likely grow in importance, but lack scale and are often still heavily dependent on state subsidies.
Politics, however, may play a bigger role than either economic or environmental arguments in determining countries’ energy allocation strategies. Energy security has become an issue of growing importance, reinforced by recent geopolitical instability in the Middle East and North Africa as well as oil currently standing at over $100/ barrel. The oil crises of the 1970s drove developed nations including America, Japan, the UK and France towards increased domestic energy exploration and production and/or alternative energy sources. Nonetheless, the US still imports approximately 60% of the oil it consumes, costing the country $1 billion per day. LNG constitutes just 22% of America’s energy consumption. Western importers of LNG may draw comfort from the fact that with limited new investment in existing facilities in Russia and a moratorium on new projects in Qatar, Australia is set to become the world’s third-biggest supplier of natural gas on a regional basis (after North Africa and West Africa) by 2020.
While a compelling case for LNG can be constructed on several grounds, it is not without its risks. Prime among these is the guarantee of supply and the costs attached to this. While there is no shortage of proved reserves of gas, according to BG Group (a UK-listed integrated natural gas company), around $2 trillion at current average funding and development costs will need to be spent in order to bridge the gap between forecast gas demand and supply over the coming decade. A normal LNG investment cycle is at least four years, with over 80% of the capital expenditure borne in the upstream country of gas origin. A demand: supply imbalance is clearly good news for listed LNG plays (discussed in more detail below), but shortages may lead governments to consider other energy alternatives: just as investors have valuation thresholds for assets in their portfolios, debt-constrained governments may not wish to risk over-paying for gas relative to other energy sources. It is worth bearing in mind though that just 20% of LNG is currently sold on spot markets (although BG Group and others are seeking to develop these more actively), while the majority is negotiated on a longer-term basis.
Other arguments against LNG tend not to be wholly persuasive: the geopolitical risks attached to LNG are no higher (and trending lower given the growing importance of Australia) than for either oil or uranium provision, while LNG’s safety record is impeccable. According to ExxonMobil, LNG vessels have travelled more than 151 million miles during the past 50 years, and more than 119,000 LNG carrier voyages have taken place without major accidents or safety or security problems, either in port or at sea. Moreover, an LNG spill would not damage the ground or leave any residue as it evaporates. In water, LNG is insoluble and so would simply evaporate, making water-spill clean-up unnecessary.
As the case for LNG seems clearly to outweigh the negatives, investors should consider how best to gain exposure to the theme, particularly given the current demand: supply imbalance. An LNG project should be considered as a chain of investments whose ultimate success depends on the integration of several elements, namely: field development, a possible pipeline to deliver the natural gas to a coastal location, a liquefaction plant, cryogenic tankers, and a receipt and regasification terminal in the market country. The industry has seen rapid improvement as it has evolved with better compressor technology improving the efficiency of liquefaction plants and larger tanker sizes permitting for greater shipments. Nonetheless, those companies that own extensive gas assets and can extract value along the whole of the supply chain look best placed in our view.
Unsurprisingly, the major integrated oil companies have staked significant claims to the LNG space. In particular, the positioning of ExxonMobil and Shell stand out. The former acquired XTO Energy in December 2009, a $41bn transaction that made Exxon the largest producer of (liquefied natural) gas in the US. Globally, Exxon has LNG production capacity of c 65m tonnes, equivalent to over 10% of its energy portfolio. Exxon is also currently investing more than $1bn p.a. in LNG, a larger sum than any other integrated oil company. As mentioned earlier, Shell was one of the pioneers of the LNG space and has 18.2m tonnes of capacity at present. This is set to expand rapidly with five new liquefaction plants currently under construction (one in Qatar and four in Australia), which should add a further 7.6m tonnes to its capacity in 2011. Chevron and Conoco Philips are also in the vanguard with regard to developing their LNG strategies.
Several operators within the natural gas space are also in the process of expanding their strategies to take advantage of the nascent LNG market. America benefits from having abundant shale reserves of natural gas. Since these assets are destined for domestic consumption, they do not need liquefying, but many operators are seeking to leverage their skill sets internationally. Apache (America’s second-largest gas player after Exxon) is, for example, involved in the current Wheatsone LNG project in Australia, led by Chevron. Meanwhile, Chesapeake (ranked third in the US) has said that it is evaluating the conversion of its LNG-receiving terminals into exporting terminals to exploit potential international demand.
Another name that offers investors exposure is Woodside Petroleum, an Australian-listed LNG (and oil) production company, capitalised at c US$38bn and 24.7% owned by Shell. In our view, Woodside can benefit from its close proximity to the centres of future demand (from Japan, China, South Korea and India) and supply. Australia has a large number of potential LNG projects, both in the Browse and Carnavon Basins (offshore Western Australia, where the Northwest Shelf project has been in operation for over 25 years), and from the Bonaparte Basin (offshore the Timor Sea, where the Bayu Undan project recently commenced production). Woodside has a reserves: production ratio of 18 years, which rises to 24 years if probable reserves are also factored in. Within the next six months, Woodside’s Pluto LNG facility should be set for commercial launch, with production capabilities of over 4m tonnes a year. Other listed Australian LNG-related plays include Santos and Origin Energy.
Elsewhere in the value chain, investors can gain exposure to the theme via BG Group. Its LNG activities combine liquefaction and regasification facilities with the purchasing, shipping, marketing and sale of LNG. BG forecasts that its contracted volumes will grow from 13m tonnes p.a. to over 30m by 2020. Cargoes are delivered to 19 different countries presently, a figure BG expects to expand going forward. Alternatively, investors seeking to exploit specifically the pipeline segment of the LNG market could seek to own companies such as Enterprise Product Partners or Cheniere Energy Partners, both listed in the US. Finally, it is worth considering the First Trust Natural Gas ETF (FCG US), which allows investors broad exposure to the LNG theme without specific company/ country risk.
The Fukushima nuclear crisis in Japan has forced governments (and investors) globally to reassess their energy strategies. While we would argue that it is too soon to dismiss the case for nuclear, it is certainly fair to contend that the already strong arguments favouring increased allocations towards liquefied natural gas have only gained in importance. To repeat, LNG offers security of supply, is cheap, efficient and environmentally friendly (especially relative to coal and oil). At the least, with global energy demand needs surpassing current supply abilities, LNG provides an effective solution. Investors should correspondingly consider reflecting this trend within their own portfolio strategies.
Alexander Gunz, Fund Manager, Heptagon Capital
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