Competition between exporters of liquefied natural gas is heating up. In fact, the competition is getting so fierce, that suppliers are actually beginning to see their advantage erode – buyers are finding themselves increasingly comfortable turning to the spot market to meet their energy needs, eschewing long-term contracts so coveted by exporters.
The reason is that more LNG capacity is nearing completion, and that pace will accelerate over the next two to five years. And the shifting dynamics boil down to the developments in two countries – Australia and the United States.
Major gas suppliers invested top dollar in Australia in order to make it the LNG exporter of choice for the Asia-Pacific region. And Australia was well-positioned to do so – several of the world’s largest LNG consumers – Japan and South Korea – are nearby. To top it off, China, often ranked as the largest consumer of an array of other commodities, is finally kicking its imports of LNG into high gear. Australia scrambled to serve the hungry Asian market.
However, investors in Australian LNG did not anticipate one major development: the shale revolution in the United States, which brought a tidal wave of natural gas online and caused prices to plummet.
LNG export facilities are now in the permitting phase or under construction in the United States, with the first terminal expected to come online at the end of 2015. The inauguration of Cheniere Energy’s (NYSE: LNG) Sabine Pass facility will be a milestone for the United States as it ramps up natural gas exports.
The entry of the United States into the LNG market will have two effects, both of which are negatives for Australian LNG developers. First, buyers will have more choice. Already, major Asian energy consumers have signed deals with yet-to-be-built export terminals in the U.S. In fact, an estimated 35 million tonnes of LNG per annum (mpta), which is the equivalent of more than 12% of the entire global market, or almost one-third of annual demand in Japan, are under contract. As Japanese and Korean energy importers turn to the United States, Australia is losing ground.
The U.S. is much further from East Asia than Australia is, especially when considering most of the LNG export terminals will be built in the Gulf of Mexico, not the Pacific. That means that U.S. LNG has much higher transportation costs. Still, Australia is losing some business on price because of the low fuel cost in the United States, as well as the ballooning cost of Australian projects. High labor-costs, a strong currency, and project delays are adding billions of dollars to many Australian energy projects.
The second effect of greater U.S. LNG, which is more or less an extension of the first, is that buyers in Japan and Korea are increasingly shying away from locking themselves in to long-term contracts. Instead, they appear to be comfortable relying on the spot market, knowing that more supply will come online soon.
That trend crystalized with recent news that Chevron (NYSE: CVX) is having difficulty locking in buyers for some of its LNG capacity at its massive Gorgon project in Australia. The facility, one of the world’s largest LNG terminals as well as the world’s most expensive, will have an annual export capacity of 15.6 million tonnes. Construction of the terminal is 83% completed and expected to start operations in 2015, but Chevron is struggling to book customers. It had hoped to get 85% of the facility’s export capacity under long-term contract, and sell the remaining volume into the spot market. But so far the oil and gas major has only 65% of the volume under contract.
This is a worrying trend for Chevron, particularly since the mammoth Gorgon project is vastly over budget. Originally projected to cost just $37 billion, costs skyrocketed to $54 billion because of the aforementioned challenges – high labor costs, currency risk, and project-specific delays.
And failing to lock in the export facility’s capacity will leave Chevron vulnerable to the vagaries of the spot market. That should scare Chevron’s executives because the Japan-Korea-Marker (JKM) price, a benchmark spot price for Asia, has experienced a surprisingly strong decline in 2014. The JKM price for August was only $11.35 per million Btu (MMBtu), more than 40 percent lower than the highs seen in the years following the Fukushima crisis when Japanese demand for LNG spiked. It was not uncommon to see JKM prices for winter delivery exceeding $19/MMBtu as recently as last year.
There are reasons to believe that the tightness seen in LNG trade exhibited between 2011 and 2013 will not return anytime soon. That hinges on two main developments. First, is Japan’s possible return to nuclear power, which looks a bit less likely than it did a few months ago. Japanese Prime Minister Shinzo Abe is supporting a restart of several reactors, but public opinion may push that off until next year at the earliest. Nevertheless, each reactor that comes back online at some point in the future will diminish LNG demand and push down prices.
The other factor, which is much more likely than Japan’s nuclear prospects, is the wave of LNG capacity set to come online between 2015 and 2018. Liquefaction capacity is projected to expand by 100 mtpa by 2018, or a 35% increase. That is a massive volume of new capacity coming online, and basically all at the same time. The effect on global supply and demand is uncertain, but it will surely depress prices and force the cancellation of a slew of projects on the drawing board.
Global LNG trade on the spot market hit a record high in 2013, with short-term sales accounting for one-third of the worldwide total.
Thus, for investors there are two criteria to keep in mind when evaluating investments in LNG exporters.
First is the ability to sign up customers to long-term contracts rather than betting on the spot market to take cargos. As more LNG suppliers (particularly from the United States) enter the market, LNG buyers will be more reluctant to sign long-term contracts. And perhaps more importantly, they will shy away from long-term contracts linked to the price of oil.
Still, if suppliers can succeed in lining up long-term buyers, they will be better off. To be able to survive the potential supply glut coming down the pike, finding companies that have most of their volume signed up to long-term contracts will be key.
The second factor for investors to consider is how far along the projects are in their development. Projects that are set to come online within the next 2-5 years could work out just fine. But investors should forget about projects that are still in the planning phases. They won’t be a part of the 100 mtpa set to come online within the next five years and could struggle to recoup costs. They are too late and investors should steer clear of the companies pursuing them. There could be another wave of profitable LNG projects at some point in the future, but that will not be until sometime in the 2020’s when demand catches up with supply.
Ironically, despite being the new kid on the block, the leading export facilities in the U.S. have succeeded in getting customers to agree to 20-year contracts to take their LNG cargo. Cheniere Energy has sold virtually all of its export capacity under long-term contracts, securing customers for the long haul. Chevron is struggling with its Gorgon LNG facility, but its Wheatstone has most of its volume under contract. Freeport LNG, a project 50% owned by ConocoPhillips (NYSE: COP), has lined up customers for its proposed liquefaction trains. Toshiba Corporation, SK E&S, and BP all agreed to long-term contracts.
Investors should note that the U.S. Department of Energy recently overhauled its regulatory approval process for LNG export facilities, which should benefit first movers to the detriment of projects further behind. The process will now favor projects that have already obtained environmental approval. That means that investors should take a look at the first-movers, such as Cheniere and Freeport LNG, but be more cautious about the next tier of projects.
Santos Ltd. (ASX: STO), an Australian firm, is finishing construction on its Gladstone LNG project. The $18.5 billion project will convert coal seam gas into LNG, and Santos has 7.2 mtpa out of a total 7.8 mtpa under long-term contract with Korea Gas Corporation. Shipments are expected to commence in 2015. With the bulk of Santos’ cargo under contract, it should turn a tidy profit.
These are a few examples of viable LNG export projects. But investors should be careful not to assume that just because there is a rush to export natural gas, all projects will be profitable.