A Rare Opportunity In Natural Gas

Natural Gas has been rallying along with oil, but I have still preferred to stay away from investing in it, as the gluts that plague natural gas are local and less easily rebalanced than the global gluts that currently plague oil. But, there is one opportunity I see in natural gas – and that’s in LNG – Liquid natural gas. And the still best stock in that space remains Cheniere Energy (LNG).

The natural gas market is not like oil, in that it is not a global market – the markets that price natural gas are unique to where it is used, with prices in Europe that hover at a $5 premium to U.S. prices, and in Japan at as much as a $10 premium.

The model at Cheniere has been a very a simple one: Capture the arbitrage between plentiful and cheap natural gas here in the U.S. and extremely strong demand and dear prices in Asia.

But less simple is how to capture that arbitrage: The mechanics of turning gas into a liquid for transport requires frigid temperatures and extreme pressures and specialized tankers to contain it. Building even one LNG plant is a multi-billion dollar endeavor, which Cheniere has done successfully in the Sabine Pass in Louisiana (and soon will finish in Corpus Christi, Texas) –but it required a choking amount of debt in order to accomplish.

In addition, market action could quickly destroy that U.S./Asia premium: We’ve seen U.S. natural gas prices reach upwards of $10 in the early years of the century and I for one have stopped predicting against any extreme in any commodity price after seeing oil fall below $30 this year. Anyone who claims that natural gas won’t see double digits again in this country is playing the fool.

So, how you model long-term customer contracts is the critical component for a company like Cheniere, and they’ve done a fantastic job – writing into contracts an additional $1.50/mcf premium to Henry Hub prices, and locking in 20-year premiums on delivery of $3/mcf that will at the very least provide a cash flow yield of more than 15 percent. There is little commodity risk, at least at the outset of deliveries, and a long-term, bankable cash flow.

There is some competition, most significantly Dominion (D) with their Cove Point plant in Baltimore – but they are at least another year and a half away from completion and are facing new challenges from environmental lobbying groups. Cheniere is very far ahead of everyone else in LNG.

Moving Souki out was tough, but necessary – and his replacement, Neal Shear, was one of the original creators of the Morgan Stanley (MS) commodity desk in the 80’s – this is one guy who knows commodity markets.

Of course, Carl Icahn is a big investor in Cheniere, as is Seth Klarman. Normally I don’t really care which hedge funds own which stocks, but it is telling that Klarman, who usually has no problem holding cash, has accumulated such a large percentage stake in Cheniere and recently strongly added to holdings here in the $30’s. If you buy shares, you’ll have the warmth of knowing you’re in well below the basis price of either of these hedge fund giants.

I’ve waited a long time, trying to gauge when the shares will be done ‘growing into’ their projected cash flow against the massive debt they still need to service. Now that the stock price has flatlined for several months here in the 30’s, I think that time has come. This is not a speculative play as it was in 2013 and 2014. It is a utility play with cash flow that greatly underestimates current share prices.