23rd March 2023
LNG
Dear Investor,
Today we want to talk about a sector related to the energy theme, which we believe will benefit from our broader bullish outlook. As covered in previous letters, we like energy in various different forms. As part of this, we also like certain companies involved in the transportation of energy and energy products.
This includes the LNG transportation industry, a sector which has been starved of capital, and which benefits from the new world order and from the price rises in energy commodities caused by inflation. As a matter of definition, we believe prices rises are the symptom of inflation not the inflation itself. Inflation, to us is an increase in the quantity of money and it manifests itself in the reduction of purchasing power of that money, i.e., price rises in goods, services and assets.
So why are we interested in this sector?
First a look at LNG, which stands for Liquefied Natural Gas. LNG is the cleanest fossil fuel but it is still a fossil fuel. Its benefit is that it has approximately only 50% of the carbon emissions of coal, and 70% of oil and so is much less polluting (although this is of course relative). On land, gas is usually transported via pipelines. To cross seas, the gas is first converted into liquid by cooling it to -162 degrees Celsius in a process known as liquefication, which reduces the volume by a factor of 600 making it much easier to transport. LNG can be transported over land by insulated pipelines or by sea in specialised ships called LNG tankers. At the destination, It then gets turned back into gas by a process called regasification, which does what it says on the tin! (Stats from justenergy.com)
Gas has been in the news a lot over the last year as the cutting off of Russia’s gas to Europe was one of the consequences of the Russia/Ukraine war.
As per the below chart, 76% of Europe’s energy use came from fossil fuels in 2021 of which the lion’s share at 34% came from gas.
Source: WEF/BP’s statistical review of world energy
It is estimated that between 45-50% of that gas came from Russia prior to the Ukraine war. After the war started and related sanctions imposed, one obvious impact was on the price of EU Natural gas. Below is a chart of the Dutch TTF Natural gas price over the last 2 years (The European benchmark). In August 2021 it was trading at around 50, peaking at 339 in August 22 and now is back around 50.
Source: Yahoo Finance
While there is an element of financial speculation involved in pushing up prices, it is a basic economic tenet that if you take supply out of the market and the demand doesn’t change then prices will rise until demand and supply are back in equilibrium. Prices rose dramatically as Europe scrambled to fill its gas storage facilities to enable enough energy for winter, and demand fell just as dramatically as prices made many industries unprofitable and forced closures.
New York Times Sept. 19, 2022
Makers of metal, paper, fertilizer and other products that depend on gas and electricity to transform raw materials into products from car doors to cardboard boxes have announced belt-tightening. Half of Europe’s aluminum and zinc production has been taken offline, according to Eurometaux, Europe’s metals trade association.
Among them is Arcelor Mittal, Europe’s largest steel maker, which is idling blast furnaces in Germany. Alcoa, a global aluminum products producer, is cutting a third of production at its smelter in Norway. In the Netherlands, Nyrstar, the world’s biggest zinc producer, is pausing output until further notice.
Even toilet paper is not immune: In Germany, Hakle, one of the largest manufacturers, announced that it had tumbled into insolvency because of a “historic energy crisis.”
LONDON, Nov 2 2022 (Reuters) – Europe needs its industrial companies to save energy amid soaring costs and shrinking supplies, and they are delivering – demand for natural gas and electricity both fell in the past quarter.
It is far too early to rejoice, though. The drop is not just because industrial companies are turning down thermostats, they are also shutting down plants that may never reopen.
And while lower energy use helps Europe weather the crisis sparked by Russia’s war in Ukraine and Moscow’s supply cuts, executives, economists and industry groups warn its industrial base may end up severely weakened if high energy costs persist.
Energy-intensive industries, such as aluminium, fertilisers, and chemicals are at risk of companies permanently shifting production to locations where cheap energy abounds, such as the United States.
There was lots of doom and gloom in the press about how Europeans would freeze over winter and really it could have been a lot worse, but a few things happened to save the day.
Firstly, as stated above, demand collapsed from industry. Secondly, as China was still in lockdown, Europe did not have to compete for gas from that large buyer and so were able to fill up their storage facilities. Thirdly, there was an unseasonably warm winter in Europe and fourthly, America rode to the rescue by transporting cheap US Natural gas to Europe.
Source: St Louis Fed
You can see that European Natural Gas prices diverged widely from US prices post invasion and while gas is not as easily transportable as oil, the huge difference in prices meant it became economical to do so.
As an (important) aside, in September 2022, the Nordsea pipelines which transport Natural Gas from Russia to Europe were sabotaged with explosions and rendered unusable. The immediate outcry from the West and Western media was that this was a Russian act of sabotage, blowing up a pipeline that they themselves had spent billions of dollars building. Now a question I always ask myself when something like this happens, is “Cui Bono?” or in English “Who benefits?”.
With the destruction of the pipelines, Russia has no leverage over Europe by threatening to turn off and on the gas supply. That option simply no longer exists. They just cannot transport gas to Europe that way anymore. On the other hand, you now have Europe very reliant on US gas and you have the US benefiting by selling gas to Europe and drawing them closer to the US sphere of influence. Both Germany and Italy, major European players were not wholly hostile to Russia prior to and during this war. What you now have is a Germany willing to re-arm itself and build up its army (just as Japan is doing), and contribute more to Nato. I have already mentioned above the benefit to the US from Europe buying US gas plus the movement of gas heavy industry to the US. Something to think about…
So where were we? NG, being a cleaner fossil fuel and also due to economic considerations is being considered in a different light now that it is more widely understood that a lack of affordable energy impacts consumers and businesses. So we see headlines like the below:
Source: The Hill 6th July 2022
The European Parliament voted Wednesday to classify liquefied natural gas (LNG) and nuclear power as “sustainable” fuels, making them eligible for subsidies reserved for renewable energy. The decision was quickly blasted by environmental groups and activists as setting back the cause of fighting climate change
All of the above events meant that it became extremely profitable to transport Natural Gas and oil after the invasion of Ukraine. Supply contracted as the sanctions took a bunch of Russian ships off the market, the loss of the pipelines meant more gas had to be transported by sea, and the increased prices of the commodities themselves meant they could be transported much further distances and so day rates boomed.
The below chart shows a benchmark daily rate for chartering an LNG tanker over the last 12 months. They were at $45,000/day in August 2022, peaking at US$325,000/day in October/November and now around $75,000/day.
Source : Fearnleys
The equivalent day rate for a 1 year time charter went from $75,000/day to $155,000 a day
Right now, I believe we are in the eye of the storm. The initial fear over winter has gone, storage facilities in Europe are full and Natural Gas prices have come down a lot as this fear has subsided.
See below chart of Natural gas prices in the US over the last 2 years:
Looking forward, what do I see?
- China coming out of its Covid slump and, even if there is not a resurgence in growth, you will see an increase in demand for NG from China and its trading partners after 3 years of lockdowns and subdued economic activity.
- European industries starting up again as prices come down (and if they don’t restart and Europe deindustrialises on the margins, that creates another whole problem as the supply of many items contracts, increasing overall inflationary pressures).
- A continued focus on energy security as actually getting energy will be more important than the price of that energy.
- A very low Natural Gas price which has much more upside than downside from here.
- A continuation of constrained supply routes due to the geopolitical situation.
To me this implies that businesses involved in the production and transportation of NG and LNG are likely going to do very well.
Generally speaking, shipping is a very cyclical business with high operating leverage. And, when things are going well, companies make a lot of money and usually decide to expand by ordering a bunch of new ships, which all come onstream at similar times, meaning supply expands, causing a peak in shipping rates, prices drop and they start losing money. So operating Leverage on the up and downside. Shipping related equities always look cheap on an earnings basis at the top. Now am I really going to say it is different this time? Well yes and no! There are ships on order but the deliveries do not start until the latter half of the decade. In addition, the article below outlines the difficulties in delivering those ships, so we believe there is another big upcycle to come before then.
Source: FT January 2023
Shipbuilders enjoyed a record year for liquefied natural gas tanker contracts in 2022 — and they expect the boom to continue for some time as demand for the fuel rises.
Global orders for the specialist vessels reached 163 in 2022, data from Refinitiv show, more than double the previous year’s figure and the highest since 2011, the earliest data available.
As prices surge, big South Korean shipbuilders responsible for the bulk of the existing LNG tanker fleets told the Financial Times they expected a boost to their earnings despite high material costs weighing on margins. But industry observers have warned that elevated steel prices, labour shortages and limits on construction capacity will constrain shipbuilders’ ability to capitalise on the rush to secure the tankers.
The majority of 2022’s LNG tanker orders are expected to be delivered by the end of 2026.
“LNG carriers are some of the biggest ships in the world by nature. And they are highly specialised ships and they need specialised personnel. There are just not enough people, experts and space to build this volume of ships.”
These ships are also very expensive.
Source: maritime-executive.com
The price of the average large LNG carrier has risen to approximately $240 million, twice that of a tanker or containership.
As an example of a stock in this space, let’s look at Golar LNG which, in its own words, from its website:
We design, build, own, and operate marine infrastructure that turns natural gas into LNG and LNG back into natural gas.
Golar LNG Limited designs, builds, owns and operates marine infrastructure for the liquefaction and regasification of liquefied natural gas (LNG). The Company’s segments include Shipping and FLNG. The Shipping segment operates and charters out LNG carriers on fixed terms to customers and it owns one LNG carrier and one FSRU, the Golar Tundra. The FLNG segment converts LNG carriers into FLNG vessels and charters them out to customers. It operates FLNG Hilli, FLNG Gimi the Gandria. It also has ready-to-implement designs for FLNGs of varying sizes. It operates in Bermuda, the United Kingdom, Norway, Malaysia, Cameroon and Croatia. The Company through its wholly owned subsidiary, Golar Management provides commercial, operational and technical support, crew management services and supervision and accounting and treasury services.
Source: Eikon
How has this fared recently? The two year chart below shows that it doubled from $15 to $30 after the invasion of Ukraine last year and now sits around $22, down 27% from its peak.
Now let’s look at the last energy bull market, where the stock peaked at over $70
There are several stocks involved in this business and this is representative of their price action over the past decade. I chose this one for the thematic portfolio because it has been around for over 80 years, has no debt on a net basis and the chairman who owns 5% of the company is a seasoned shipping executive. In addition we added a position in UNG (a fund owning Natural Gas futures) in the thematic portfolio at the beginning of March.
Source: Nikkei Asia January 24 2023
China tightens grip as dominant LNG buyer with long-term deals
China is quickly becoming the dominant force in liquefied natural gas, with Chinese buyers accounting for 40% of recent long-term LNG contracts among global players.
Source: Reuters
LNG interest from Asia’s emerging gas markets rises as prices ease
Energy companies in Asian emerging markets are returning to the market for liquefied natural gas (LNG) cargoes as prices have fallen to their lowest in more than a year.
Buyers in Thailand, India and Bangladesh have been on the sidelines for months as prices soared following Russia’s invasion of Ukraine, while European buyers paid top dollar for supplies to make up for the shortfall in Russian supplies.
Until next time,
