Monday, February 27, 2012

Reversing the Flow

The Natural Gas Market Flips Cheniere Energy's Plans Upside Down

Today Cheniere Energy (CQP) announced that Blackstone committed to invest $2Bn in inequity in the company's planned project to build natural gas liquefaction facilities on the Louisiana coast where CQP has an export/import terminal for gas.  Handy press release with details here:

This is interesting to anyone who follows the US natural gas market, which must be the only commodity on the planet that hasn't rallied in the past couple of years.  Cheniere is a company with an interesting past.  In the 2000s, CQP quite a lot of money (much of it borrowed) to build out a terminal in Louisiana that would allow the import of natural gas from ships.  At the time, the US was clearly short of natural gas and prices steadily increased, making imports from other parts of the world profitable even with the considerable expense of liquefying the gas at its point of origin, putting it on a ship, sailing it a long distance, and regassifying once it landed in the US.  Unfortunately for CQP, not long after the company was really ready to ramp up its import terminal (these things take lots of time to build) the shale drilling/fracking revolution took place in the US natural gas industry and supply from onshore wells considerably outstripped demand.  Even worse, much of the rest of the world saw demand for natural gas outstrip supply, as Europe, China and more recently Japan ramped up purchases of gas.  The strategy of importing cheap gas from overseas to sell at a premium in the US was suddenly upturned.  Since the infrastructure CQP had developed was only designed to bring gas into the US, the company had a problem.

CQP has since found what the company believes will be a way out of its quandary.  Since Cheniere already has a strategically located terminal that lines up nicely with the US pipeline infrastructure, the company has embarked on a multi-year effort to be able to reverse the flow of gas through its terminal.  With today's announcement that CQB has secured an equity investment of $2Bn to help fund this plan, it appears that Cheniere is on its way pending a few more (non-trivial) steps.  But it is worth noting that there is quite a lot of risk in this effort.  The press release indicates that the first of the new liquefaction/export facilities will not be operational until 2015 or 2016 and operation of all 4 facilities may take until 2018.  Considering how much the US market for natural gas has changed in the past 5 years (from chronic shortage to massive oversupply), it is not at all hard to imagine that by 2018 the US will again be short on natural gas and the economics of this venture will not be attractive.

What does this mean to investors?  I suppose that if you are convinced that the current structural oversupply of natural gas in the US is a "forever" proposition, CQB is probably something you would want to buy.  Given the volatility of the natural gas market, I personally would consider CQB to be highly speculative.  I do not find the risk that CQB gets to 2018 with its expensive new facilities running and having incurred a large amount of new debt only to have the export arbitrage gone to be acceptable.  Instead, I think the Cheniere plan is yet another indicator of the future of the US natural gas market. 

There is a huge amount of pessimism about future natural gas prices which is reflected in the commodity futures market and the prices of natural gas producers.  The bear case is that producers of natural gas have unlocked a massive new supply which will continue overwhelming demand forever and producers will not restrain new supply to the market for a variety of reasons.  I think that there are some credible facts supporting this view, but that we should not ignore three key issues:

1) Suppliers are economically rational actors.  If you lose money by drilling new dry gas wells, you stop doing it.  This is why you see a growing list of drilling curtailments and shut-ins of existing wells by major natural gas producers.  Given the faster fall-off rates in production from fracked wells compared to conventional gas wells, a major slowdown in drilling activity suggests that supply will stop growing in relatively short order.

2) Major users of natural gas are highly incented to find the cheapest sources possible and they will go pretty much anywhere to get it.  This is why you see ammonia plants in Trinidad, methanol plants in far southern Chile and remote areas of New Zealand, etc.  Methanex (MEOH) management has even speculated in the past that the future of their industry may floating methanol plants that can pick up stakes and move from gas deposit to gas deposit just like deepwater drilling rigs.

3) No valuable resource goes unused for long in this world, especially if it is dramatically cheaper than the alternatives.  Everyone and their brother wants energy, cheap.  With oil prices over $100 and refined products considerably in excess of that figure, natural gas at less than half the cost is becoming more and more compelling.  That is why you will continue to see the widespread start-up of chemical plants that use natural gas as a feedstock in the US for the first time in over a decade, serious money being put into setting up a natural gas fuelling network for heavy trucks, and export schemes like CQP's.  All of this suggests that demand will eventually catch up to supply in the US.  Once fully build, CQP's export facilities alone would consume something like 4 or 5% of total US natural gas production.

All of these signs point to higher natural gas prices in the future, but it is extremely difficult to predict the timing of that outcome.  It could happen in a year, or it could take 3, or 5, or...  Since exploration and production companies producing natural gas are currently in the market's penalty box, valuations are quite low.  Patient investors willing to wait it out will probably do well over the next several years with natural gas focused equities.  I like CHK (fascinating to watch and who does not like a show?), but most of the sector is valued about the same, so one could easily pick up a collection of reasonably well run names like DVN, UPL, RRC, BBG and others.  Barring an unexpected acquisition, none of these names will probably be this year's hot stock, but if you have an investing time horizon of a few to several years I suspect that returns will be quite attractive as the US natural gas market turns and brings pricing up with it.

As always, be careful, do you own due diligence, consult your advisor if you have one, and take your own risks.  You can lose money at this stuff and I would hate to think that anyone blindly followed my idle speculations here as if it were actual investment advice (nothing I post here is intended as investment advice).

Disclosure: I am long CHK and MEOH.


  1. I know this probably doesn't mean jack to you as you do your own analysis but this past week Barron's interviewed Jeremy Grantham. He is bullish on "stuff in the ground" and like you he thinks nat gas will come back describting today's entry prices as a "dazzling opportunity." That's coming from a realist and generally bearish guy.

    1. I think that natural gas is attractive on a fundamental basis, so I am happy to hear someone as well respected as Jeremy Grantham agrees. However, one of the reasons I find the return potential of natural gas equities attractive is that the market has become so pessimistic on their prospects that even modest improvement could yield big returns.

  2. Which low cost gas producers will have direct access to LNG exports? In Canada, I believe Encana is one (ECA.TO).

    1. My recollection is that there is a consortium of three producers (majors) working on an export terminal at Kitimat. I don't recall which companies, but if you do a bit of googling the names should come up.