Natural gas will be the world’s fastest-growing fuel for at least the next 20 years. Meanwhile, once-abundant reserves of natural gas near key markets such as the US and Europe are depleting.

The likely consequence: A massive increase in the global natural gas trade.

Fortunately, a technology exists to facilitate the movement–and the trade–of natural gas over great distances. Natural gas, when cooled to minus 260 degrees Fahrenheit, turns into a liquid known as liquefied natural gas (LNG). Even better, by converting gas to LNG, the gas shrinks about 610 times. That’s roughly equivalent to shrinking a full-sized beach ball to the size of a ping-pong ball. That convenient liquid can be transported in tanker ships in a similar fashion to crude oil and then regasified–converted back to a gas–near its end markets.  

For years, natural gas was burned off as a useless byproduct of oil drilling, especially for fields located some distance away from major markets. There was no pipeline infrastructure near these fields to transport the gas. But LNG changes all that. Those isolated fields, known in the industry as stranded fields, are now valuable assets.

To play the trend, I’m adding Teekay LNG Partners (NYSE: TGP) to the Proven Reserves Portfolio. Teekay owns several LNG tanker ships on long-term contracts to major integrated energy companies. These contracts are for fixed charter fees independent of gas prices; Teekay LNG is insulated from commodity price risk. Even better, I expect the company to pay out more than $1.50 in distributions this year and more than $2 in 2007. That equates to yields of 5.1 and 6.9 percent, respectively.

Before analyzing Teekay LNG in more detail, let’s dig a little deeper into the LNG market.

The Importers

According to estimates by BP (NYSE: BP), global consumption of natural gas totaled nearly 95 trillion cubic feet (tcf) in 2004; Energy Information Administration (EIA) estimates peg total 2005 global gas demand at more than 151 tcf. That’s an increase of approximately 60 percent, considerably higher than the 49 percent jump in oil consumption projected over the same period. Demand from some key markets is likely to grow far faster than that. Consumption by India and China, the world’s two most populous nations, will grow close to three times as fast as the rest of the world.

A quick glance at global world gas reserve figures suggests this isn’t much of a problem. After all, BP estimates proven global reserves of gas totaling 6337 tcf. Based on demand of 150 tcf annually (approximately the amount the globe will consume in 2025), there’s enough gas in the world to satisfy demand for 150 years.

That sure seems like a long time when you consider that current proven global oil reserves are only sufficient to cover demand for about 40 years (if global oil demand stays constant at around 80 million barrels per day).

But there’s a problem with the world’s gas supplies. Like oil, gas reserves are concentrated in a few key places around the world–close to 60 percent of the globe’s proven gas reserves are located in three countries: Russia, Qatar and Iran. Meanwhile, the big consumers of gas will be in developing Asia, the US and Europe, markets located a considerable distance from key gas production centers.

Traditionally, most gas has been moved by pipeline. But this is impractical for a large chunk of the world’s gas reserves. These reserves–in many cases located thousands of miles from their end markets–are known as stranded reserves. LNG allows such reserves to be efficiently exploited.

Let’s consider the world’s largest single consumer of natural gas, the US. The US currently consumes over 23 tcf of gas, close to 25 percent of the world’s total gas consumption, a figure expected to grow to about 40 tcf by 2025. A slew of natural-gas-fired power plants were built in the 1990s and those plants will need fueling.  

Fortunately, the US does have considerable reserves of gas, some 187 tcf. Unfortunately, traditional, conventional sources of gas have already been exploited and the nation will increasingly have to rely on what’s known as unconventional gas in coming years. (This market is explored in detail here.)

While unconventional natural gas will help prevent US gas production from declining, it will not be enough to keep pace with domestic demand. As the chart below demonstrates, the US is already importing gas to meet demand and the EIA projects the situation is only going to get worse over the next 20 years.

Source: BP, Energy Information Administration

Note how quickly domestic consumption is outstripping US gas production. According to the EIA, production from conventional reserves has already peaked; unconventional reserves will delay the peak in US gas production for a few more years until 2012. After 2012, US gas production will gradually tail off.

The yawning gap between consumption and production is currently being met by imports and that will continue. The fact that the US imports gas is nothing new; the change will be where that gas comes from.

Right now most imported natural gas in the US comes from Canada. Gas in Canada can be easily moved and sold into the US via the existing pipeline grid. Unfortunately, Canada faces a similar problem to the US. Canada is producing about 9 bcf of gas per day more than it needs to meet domestic consumption. That adds up to over 3.2 tcf per year of surplus gas available for export. But Canada’s own consumption of gas is rising rapidly, the nation’s reserves are depleting and production growth is likely to slow. The result: Canada will not be able to meet all of America’s gas needs. To see where the gas will come from, check out the chart below.

Source: BP, Energy Information Administration

This chart shows the EIA’s projections for natural gas imports into the US over the next 20 years. It’s clear what’s satisfying US demand–US imports of LNG have already started to climb and will soar over the next few years. LNG will supplant Canada as the US’ primary source of gas imports by around 2010.

It would be wrong to assume that the problem of rapid growth in gas consumption is limited to the US. Japan already imports almost 100 percent of its natural gas in the form of LNG; the country accounted for more than half the global LNG market up until 2003. Rapidly growing Asian economies–India and China–will need to dramatically increase their LNG imports in coming years. To get an idea of the problem, check out the chart below of the Indian natural gas market.

 

Source: BP, Energy Information Administration

India’s natural gas production has roughly kept pace with demand since the early 1970s. But over the past couple of years, production growth has slowed–take a look at the beginnings of a consumption gap on this chart. Note just how fast India’s oil consumption is projected to rise between now and 2025. It will be very tough for the country to grow production quickly enough to meet all that demand. Imports and, increasingly, LNG will fill the gap.

LNG requires considerable infrastructure. Once gas in remote stranded fields is produced, it must be liquefied at a gas liquefication plant. That gas must then be loaded into highly specialized LNG tanker ships such as (NYSE: RD) , pictured below.

Source: Royal Dutch Shell 

The Royal Dutch Shell Gemmata loads cargo at an LNG terminal.

Once the LNG is transported to its end market, it’s loaded into a pipeline near a regasification facility. There it’s converted back into gas form and pushed into the pipeline system, just like domestically produced natural gas.

On the production end, several countries will likely emerge as key players. In the Asia Pacific region, Australia, Indonesia and Malaysia have all been major LNG exporters. Most of that LNG shipped to date has been destined for the Japanese market, but more and more is likely headed for China or even the US.

Australia’s Northwest Shelf facility, owned by a consortium of energy companies, has greatly expanded its LNG infrastructure and negotiated long-term supply agreements with India and China.

Russia, with more than 30 percent of global gas reserves, is already building LNG facilities and is likely to become a significant player in this market in coming years. Russia’s remote Sakhalin Island facility would be difficult to serve by pipeline–the country will export large quantities of LNG from this field starting in 2007.

And Qatar, with the world’s second-largest reserves of gas, is investing heavily in the development of LNG facilities. The nation’s oil production was once over 1 million barrels per day, but peaked and has now started to decline. Qatar’s North Field is the largest single gas field in the world; it’s also very inexpensive to produce and drill. The Qatari government has decided to develop this field in two ways: LNG and gas-to-liquids (GTL) technology. GTL involves converting natural gas directly into liquids through a series of controlled chemical reactions.

Several facilities are being built or are planned for Africa. Africa’s large yet remote gas fields are a perfect fit for LNG technology.

Building out major new LNG liquefaction plants has proven less troublesome than the other side of the LNG trade–the regasification facilities located in the key end-markets. In the US in particular, companies have encountered significant difficulties siting new regasification facilities, particularly in the Northeast and, to some extent, California. Local residents in these markets have raised safety concerns and successfully blocked the construction of several new LNG terminals. To date, the US has only five LNG receiving terminals nationwide in active use. While there are several under consideration, many proposed terminals are encountering significant resistance from local populations.

California and the Northeast are the regions of the country with the most acute LNG need. Cold winters in the Northeast spell high gas demand, and California uses gas to run a sizeable chunk of the state’s power plants.

One possible solution is deepwater offshore LNG terminals. At such terminals, LNG tankers unload cargo sometimes hundreds of miles offshore, where it’s regasified and injected into subsea pipelines. The first such terminal–the Gulf Gateway Energy Bridge in the Gulf of Mexico–went online earlier this year. An additional six such terminals are proposed along both coasts of the US.

Outside the US, siting facilities has been less of a problem. Both China and India are moving forward with massive LNG receiving terminal projects.

Bottom line: The world is gearing up for an explosion in LNG trade. A few companies are well positioned to benefit from these trends.

The Players

On the production side, the world leader in LNG is Proven Reserves Portfolio holding Royal Dutch Shell (NYSE: RD).  The company owns, either wholly or in part, six active LNG liquefication facilities. The list includes a facility in Nigeria and a stake in the massive Sakhalin LNG project in Russia, that nation’s first LNG facility. When Sakhalin comes fully online in 2007 it will be capable of supplying as much as 8 percent of the world’s total demand for LNG. Shell is also building new facilities in Qatar and Australia.   

On the receiving end, Shell owns two facilities, one in India and one in Mexico. Three more facilities are in the works, including one floating platform off the coast of New York. Royal Dutch remains a buy.

Fellow Proven Reserves denizen BG Group (NYSE: BRG) is another key player in this market. BG (formerly known as British Gas) has one of the highest reserve-replacement ratios in the energy business. That means for every cubic foot of natural gas BG produces, it’s finding and adding more than 1 cubic foot of gas to its proven reserves.

BG has a giant LNG facility in Egypt that handles a good deal of the gas the company produces in North Africa. BG also remains a buy.

I’m adding Teekay LNG Partners (NYSE: TGP), an even more direct play on LNG, to the Proven Reserves portfolio this issue. The company is a master limited partnership (MLP) like Portfolio holdings Penn-Virginia Resource Partners (NYSE: PVR) and Enterprise Products Partners (NYSE: EPD). (For more on MLPs, check out the June 8 issue of The Energy Strategist.)

Teekay LNG was spun off from Teekay Shipping (NYSE: TK), the largest operator of mid-sized crude tankers in the world, via an initial public offering in May. It’s backed up by one of the most respected names in the shipping business.

Teekay Shipping decided to offer the MLP separately to raise cash to further finance the company’s expansion into the LNG tanker shipping market. Because LNG tanker shipping and crude oil tanker shipping are two very different markets, it makes sense to house the MLP separately. Teekay Shipping is now Teekay LNG’s general partner.

Teekay LNG owns or holds a majority interest in a total of four LNG tanker ships and five mid-sized Suezmax crude tanker ships. Teekay Shipping has an additional three LNG tankers scheduled to be delivered over the next year-and-a-half.  This will bring Teekay LNG’s total fleet to seven LNG ships.

LNG tanker ships are much more difficult and expensive to build than crude tankers. The shipyards where LNG tankers are constructed are operating at full capacity and are booked out years in advance; the current lead-time for new LNG tankers is more than three years. I suspect that the global market for LNG tankers will remain far tighter than the market for crude oil carriers. There will simply be more demand for LNG shipping than available supply. There are approximately 175 LNG ships currently in operation–in 2015 there should be close to 400, but that’s not a huge increase given the projected growth in LNG trade. This makes Teekay LNG’s and Teekay Shpping’s combined fleet of seven ships a valuable commodity.

Unlike many of the crude oil tanker shipping companies, Teekay LNG’s ships operate under very long-term contracts. All seven of the ships currently in service or scheduled for delivery have already been chartered by major energy firms on contracts ranging in length from 15 to 20 years. The company’s main customers under these contracts include Repsol (NYSE: REP), a Spanish integrated oil giant, and Ras Laffan Liquified Natural Gas Company, a joint venture between ExxonMobil (NYSE: XOM) and Qatar Petroleum.

The company also has stated it will contract to build new tankers to meet demand when it has firm commitments for charters. In other words, Teekay plans to wait until it can secure 15- or 20-year contracts before it shells out the cash to build new LNG ships. The partnership therefore takes on little or no risk.

And Teekay LNG has little or no commodity-price risk under its long-term contracts. The company does not take title of the natural gas shipped on its LNG tankers, nor is it responsible for voyage costs, including canal tolls, fuel, port fees or buyer/seller commissions. The companies that own the LNG being shipped bear these costs.

Teekay’s long-term charter contracts are struck at a fixed rate. It does not matter how far the ships travel, if they’re idle or what the price of natural gas is: Teekay LNG earns a fixed fee. For some of the company’s contracts there is a small variable adjustment factor that takes inflation, major down time resulting from damage to the tankers or prevailing market shipping rates into account. But this provision is minor compared to the pricing volatility inherent in most spot rate contracts. (Spot rate contracts are charters made for shorter periods–rates can vary wildly based on current tanker shipping rates.)
 
The company’s main costs are associated with crewing the ships and keeping the tankers in good repair. These costs can be considerable, but tend to be less volatile than commodity prices.

The bottom line is that I expect Teekay LNG to offer stable, reliable cash flows that are insulated from swings in natural gas prices and demand. However, if LNG shipping grows as fast as projected, the MLP has an opportunity to grow by building new vessels for lease on long-term contracts or simply buying tankers from smaller competitors. At any rate, Teekay LNG will be a major participant in the growth of the LNG market.

Best of all, Teekay LNG should prove a solid income play with the potential for major growth in its dividend payouts over time. Current estimates are for distributable cash flow per unit (a measure of cash available for paying unitholders) of about $1.60 this year, $1.75 next year and over $2.15 in 2007. Based on a current price of $31, that payout equates to a yield of a little over 5 percent this year, 5.5 percent in 2006 and close to 7 percent in 2007. And that’s assuming the company makes no accretive acquisitions.

Portfolio Update

Please note that our recommended short position in BJ Services (NYSE: BJS) was stopped out at a price of $55. Based on the initial entry price of $53.02, that equates to a loss of roughly 4 percent.

I still am concerned that that BJ’s domestic pressure pumping business is vulnerable to any pullback in energy prices, as I outlined in the last issue of The Energy Strategist. But the stock is simply getting pulled higher with the rest of the oil services sector. It has, however, underperformed many of the other oil services names on the recent rally, including Wildcatters Portfolio holding Weatherford (NYSE: WFT).

If you’re not already out of BJ, cover your shorts now. I will follow the stock as a hold in the new How They Rate table and look to re-enter it as a short later this year.

I also continue to recommend shallow-water driller Todco (NYSE: THE) as a shorter-term trade on strength in the drillers this summer. As I explained in a June 10 Flash Alert, the stock has tremendous leverage to strength in the offshore Gulf of Mexico market. It is already up considerably since I recommended it in June. I will track Todco as a buy in the How They Rate table.

Finally, a word on the crude oil tanker stocks. I believe the recent rally in the group is the market discounting the normal seasonal upturn in day-rates–for more on this phenomenon, check out my report here. I continue to recommend a pair trade to play the tanker space: Buy General Maritime (NYSE: GMR) and short OMI Corporation (NYSE: OMM) in equal dollar amounts.

I will also now follow tanker operator Frontline (NYSE: FRO) as a buy in the How They Rate table and Overseas Shipholding Group (NYSE: OSG) as a sell.

Enhancements

As indicated throughout this issue, I’ve added a new feature to The Energy Strategist. I’m happy to announce the addition of the How They Rate table. This table, located on the “Portfolios” tab of the Web site, includes a number of companies that I cover but do not recommend in the Portfolios. This table will allow subscribers to get my most recent take on these companies. I will be adding to this portfolio gradually over the next several weeks.