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Is LNG the next energy bubble?

The enormous pivot towards cleaner renewables has resulted in massive liquefied natural gas investment. But is oversupply about to blow away pricing?
January 26, 2017

The future is gas. Actually, that's not true. It's liquid, or liquefied natural gas (LNG), to give the proper term for the easily-transported, supercooled hydrocarbon at the centre of the steep rise in gas consumption forecast for the coming decades. Investors in Royal Dutch Shell (RDSB) will be familiar with this outlook. After all, one of the two big reasons London's largest listed company decided to buy BG in 2015 was to land a prized stake in an LNG portfolio in Australia, a country widely tipped to supplant Qatar as the world's largest exporter of liquefied gas in the next couple of years.

Unfortunately, any optimism for the LNG industry's future is currently darkened by dour predictions of a decade of persistent oversupply. The very factors that have allowed the commodity to flourish - advances in shipping technology and a boom in export terminals - could prove its undoing.

As was the case with the recent fallout in the global oil market, the US is going to be a big contributor to this glut. Analysts at Bloomberg New Energy Finance think 2017 is the year when North American exports of LNG start to surge by more than 250 per cent to 12.3Mtpa (million tonnes per annum), and then to 70.6Mtpa by the end of the decade.

This is set to coincide with the first production from a number of Australian projects, the size of which are quite stunning relative to the total market. The Gorgon LNG development, led by Chevron (US:CVX) and in which Shell and ExxonMobil (US:XOM) both hold a 25 per cent stake, is a prime example. Gorgon shipped its first cargo 10 months ago, but by 2020 the development at Barrow Island, Western Australia, will be producing around 15.6Mtpa. That's equivalent to 6 per cent of last year's entire global LNG demand.

Despite this looming imbalance, it's not hard to see what tempted many energy companies to the prize. While oil faces big long-term questions over carbon pricing, sources of supply, demand and rates of return, consumption of cleaner natural gas is expected to grow by 35 per cent in the next two decades. According to Bloomberg, LNG makes up much of that growth; demand should increase by around 60 per cent by 2030.

 

 

Gold rushes have a habit of creating more losers than winners, however, even if LNG is a wholesale bet by all of the world's largest oil and gas companies. An uncharitable observer might remark that such groupthink is to be expected; after all, the majors adopted uniformly flabby business models when prices were at their highest, following one after the other into ever-riskier drilling ventures with seemingly limited consideration for the inherent volatility of oil and gas markets. But the pivot towards liquids makes sense for two important reasons: to feed the energy needs of the Asian century, and because multibillion energy companies really are the only outfits aside from state-owned enterprises with the balance sheets and market clout to get projects off the ground.

Another issue for investors is the opaque offtake agreements and take-or-pay contracts that dominate the industry. For example, a recently extended contract between Centrica (CNA) and Qatargas will see the British Gas owner buy up to 2Mtpa between 2019 and 2023, but gives away little when it comes to pricing detail. Nevertheless, the ball is more likely to be in the buyers' court for the next few years. Gas researchers at HSBC believe uncontracted volumes - up to 15 per cent of Australian gas, and around half of all US production - could struggle to find a home, and create an impetus for the Asian buyers who make up the majority of global demand to renegotiate prices.

 

Again, this is likely to depend on the structure of individual contracts, although typically many LNG buyers have the option to lower their purchases by up to 10 per cent below contracted levels without invoking ‘take-or-pay’ penalties.

A further set of complicating factors, particularly in Asia, is the impact of demand for other energy sources. For example, the recent rise in Asian LNG prices to around $9/mBtu, from a low of $4 last April, was largely due to the relatively higher cost of coal, and nuclear power station outages in South Korea. By the same token, one of the biggest medium-term threats to LNG prices could be a faster than expected restart of the Japanese nuclear energy sector. At present Japan is the largest single source of global LNG demand, although this position is already receding. Analysis from the Oxford Institute for Energy Studies suggests that a swift ramp-up in nuclear could even reduce the need for already-contracted LNG supply.

 

IC VIEW:

Because of the oversupply and pricing issues facing LNG markets, it is important that investors in both Shell and BP (BP.) pay closer attention to this growing source of earnings. Following the BG acquisition, Shell is on track to produce 45Mtpa from 2018, making it one of the biggest players in the market, while BP recently doubled down on its Tangguh project in Indonesia, in addition to its strategic focuses on gas liquefaction and trading. With spot prices hovering close to or above costs, we are slightly more bullish on Australian production than burgeoning US sales to Europe.

 

Favourites

Ophir Energy (OPHR) makes its money from sales of oil in Thailand, but the greatest asset in its stable is its stake in the Fortuna LNG development in Equatorial Guinea. The block - which is expected to produce between 2.2m and 2.5m metric tonnes of gas a year - is now ready for a final investment decision that would lead to first gas in the first half of 2020.

In November, Ophir gave a strong indication that the project will go ahead after it signed an agreement to develop the project with joint venture partners Golar LNG (US:GLNG) and Schlumberger (US:SLB). And, while the three-year project is likely to cost $2bn, Ophir suggested that excluding interest payments, and assuming a gas price of $6/mmbtu, Fortuna will generate $560m in gross cash flow every year for 15 to 20 years.

 

Outsiders

Although Aim-traded Falcon Oil & Gas (FOG) only looks at energy projects in "politically and economically stable countries", its main asset in Australia's Northern Territory has big environmental concerns to contend with. Specifically, a moratorium on fracking introduced by the territory's new government has cast doubt over the likelihood that the Beetaloo Basin, where Falcon holds a 30 per cent interest in several drilling permits, will become a source of gas to Total (Fr:FP) and Inpex's (JP:1605) enormous Darwin LNG plant, some 600km to the north.

Fortunately, for Falcon, its farm-out agreement with partners Origin Energy and Sasol means it is carried for its entire drilling programme, buying the company some time to demonstrate that Beetaloo's geology compares with North American gas shale formations.