1. Natural gas is extracted from the ground
2. The natural gas is purified to certain specifications
3. The purified natural gas is shipped via pipeline to a liquefaction facility
4. At the liquefaction facility, the natural gas is cooled and converted to a liquid
5. The LNG is shipped on special tanker ships that keep the LNG in liquid form during transport
6. The LNG is converted back into a gas at the destination and distributed

Because of the shale gas boom in the U.S., we are now the world’s largest producer of natural gas. U.S. production in 2014 was 70.5 billion cubic feet per day (BCF/d), which represents an increase of nearly 40% over the past decade. The U.S. now produces 21% of the world’s natural gas, at a relatively low cost. This has translated into large price discounts on U.S. natural gas relative to prices in Europe and Asia. And those discounts, in turn, have created incentives to move U.S. natural gas into those markets.

A decade ago it appeared that the U.S. was going to have a natural gas shortfall, and there was a widely-perceived need to build LNG import terminals. Charif Souki founded Cheniere to build one at Sabine Pass, on the Texas-Louisiana border. In 2007 Cheniere created the Cheniere Energy Partners (NYSE: CQP) master limited partnership to own assets such as its Sabine Pass LNG terminal.

Today, Cheniere’s corporate structure looks like this:

Companies were so certain of the need for LNG imports that Chevron and Total signed 20-year option agreements to import LNG at a cost of $250 million a year. Then along came the shale gas boom and changed everything. Suddenly the U.S. no longer had a big need for LNG imports, and Cheniere’s $2 billion investment seemed to be a waste of money.

Cheniere nearly went bankrupt as its share price plummeted from $40 to a dollar and change. So Souki decided to instead convert the facility — at a much greater cost, complexity, and construction time — into an LNG export terminal. Construction began in 2012, and the first train should begin shipping LNG within six months.

Companies wishing to export liquefied natural gas (LNG) to countries that lack a free trade agreement (FTA) with the US require approval from both the Federal Energy Regulatory Commission (FERC) and the US Department of Energy (DOE). The non-FTA countries are in many of the most lucrative LNG markets, such as northeast Asia.

The licensing process and the cost of obtaining FERC approval are more onerous than is the DOE approval process, but Cheniere was the first company to receive both permits. Cheniere has to date received FERC approval to ship 2.76 BCF/d from Sabine Pass for the first four trains that are under construction, 2.14 BCF/d from the first three trains under construction at Corpus Christi, and then in April of this year received approval to ship another 1.40 BCF/d from two additional trains at Sabine Pass. All totaled, Cheniere has received approval to export 6.3 BCF/d — an amount equal to nearly 9% of total U.S. natural gas production in 2014. (Cheniere’s competitors have secured FERC approval to export another 4.3 BCF/d of LNG.)   

The latest update from Cheniere was that the first batch of LNG from Train 1 is expected to ship late this year. More likely it will be next year before we see meaningful export volumes.

These will be the first significant LNG exports from the Lower 48. (ConocoPhillips has had a small LNG export facility in Kenai, Alaska for more than 40 years, serving primarily Japan.) Cheniere’s Train 2 is scheduled to begin production during the second half of next year, while Trains 3 and 4 are scheduled to come online in 2017.

Cheniere is projecting ~$2.9B annual fixed fee revenue for 20 years and distributable cash flow (DCF) for CQP of $2.95 per unit for the first 4 trains. This is projected to rise to $3.65 per unit when Trains 5 and 6 come online. CQP has recently been paying $1.74 per year in distributions, for an annualized yield of 5.6%. However, these payments are not yet coming out of cash flow from export volumes, and as a result CQP’s debt has been growing.  

CQP’s projection for late 2017, when the first 4 trains are online, implies DCF growth of nearly 70% from current levels. If it delivers, units should enjoy a significant rise, but the execution risk is high. This is a first of its kind facility in the U.S., and unforeseen events are a greater risk for a project like this.

In any case, it was recently announced that Carl Icahn has purchased an 8.18% stake in Cheniere Energy, the parent company. Icahn’s filing revealing the stake indicated that he believes the company is undervalued, and that he is likely to take an activist role. However, also noteworthy is that Icahn’s energy bets have not panned out recently. For 2014, Icahn Enterprises (NASDAQ: IEP) reported its first annual net loss since 2008, citing oil’s “precipitous decline.” Icahn took major losses in Talisman Energy (Toronto: TLM) and Chesapeake Energy (NYSE: CHK).

My view is that this is a high-risk, high-reward play, only suitable for investors with the appropriate risk tolerance. The company will be in the news a lot over the next year, and it should start to generate DCF. That alone will provide some momentum. However, any missteps, and the fall will be steep because high expectations are already priced in.

A safer long-term bet, in my view, is on the natural gas suppliers that will sell natural gas to Cheniere. Demand for LNG is likely to be significant over the next decade, and is but one of the demand-side drivers that should push natural gas into a higher trading range.    

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