In this week’s Energy Letter, I reviewed how the US went from a near-certain liquefied natural gas (LNG) importer to the cusp of becoming a major LNG exporter. Today I want to discuss the economics of LNG, the permitting process, the possibility that US natural gas supply may be overstated and the companies poised to profit from LNG exports.

But first, a short primer on the differences between LNG, CNG, and NGLs.

Natural gas is predominantly methane, which is the simplest hydrocarbon. At typical temperatures and pressures, methane is a gas. Compressed natural gas (CNG) is methane that has been pressurized and put in a tank. Most of the world’s natural gas vehicles are CNG vehicles.

Natural gas liquids (NGLs), on the other hand, are longer-chain hydrocarbons like ethane, propane and butane that are typically condensed out of natural gas during processing and sold separately. So LNG and CNG are forms of natural gas, but NGLs are not.

To make LNG, natural gas has to be cooled to below -261°F, at which point it becomes a liquid. The advantage of LNG over CNG is that the liquid form takes up much less space, hence more can be transported in a given volume. CNG allows a given volume of natural gas to be compressed to perhaps 0.4 percent of its original volume, while LNG can reduce that initial volume down to less than 0.2 percent. Another way to think of it is that a container of given size could transport 1 unit of natural gas, 250 units of CNG, or 600 units of LNG.

Thus, to produce natural gas in the US and ship it across the ocean requires purification (removal of NGLs and impurities like sulfur and carbon dioxide), cooling and conversion to a liquid, shipment on special ships that keep the LNG in liquid form during transport, and then conversion back into a gas at the destination.
The budding US LNG export market will be driven by the differentials between the cost of producing natural gas in the US and the price of LNG in Asia and Europe. As long as the costs to produce and ship LNG are lower than this differential the export market should continue to grow.

LNG Transport Ship. Source: http://www.marineinsight.com

So what are those costs? In a report called Macroeconomic Impacts of LNG Exports from the United States, prepared by NERA Economic Consulting for the US Department of Energy, costs were estimated for moving gas from a wellhead in the US to the city gate of several destinations. The costs to China/India, Europe, and Korea/Japan were respectively estimated at $8.39/MMBtu, $6.30/MMBtu, and $7.14/MMBtu (excluding the cost of the gas). However this is on the high side of various estimates.  Others have estimated the costs to ship to Korea/Japan at $3.17/MMBtu, and several other independent estimates put these costs in the $2-$4/MMBtu range.

The spot price of Henry Hub natural gas averaged $3.72/MMBtu from 2010-2012. The price of LNG in Japan over the same time period averaged $14.13/MMBtu, a differential of  $10.41/MMBtu. In Europe, prices averaged $9.84/MMBtu for a differential of  $6.12/MMBtu.

Despite the NERA estimate that was done for the DOE, I have seen enough independent estimates to convince me that total LNG costs from US wellhead to foreign city gate are less than $5/MMBtu, plus the price of the natural gas. If we take $5/MMBtu as a rough ballpark estimate (which I believe to be conservative), we can see why the LNG export market is developing. If we add the average 2010-2012 price of US natural gas to the cost to liquefy and ship, natural gas producers could have put gas into Japan at a cost of $8.72/MMBtu, $5.41/MMBtu less than the average $14.13/MMBtu price of LNG in Japan during that timeframe. The European market wasn’t nearly as lucrative, but LNG could have still been landed in Europe for $1.12/MMBtu less than the going rate.

Of course we would expect a big uptick in LNG exports to put upward pressure on US natural gas prices. This would benefit natural gas producers like Aggressive Portfolio Best Buy Chesapeake Energy (NYSE: CHK), which is up over 30 percent since we added it to the portfolio in May. Potential losers in a higher natural gas price scenario are industries like fertilizer and chemical manufacturers that rely heavily on natural gas inputs in their production.

How much might increased exports impact natural gas prices? The Energy Information Administration (EIA) attempted to quantify the impact of increased exports in a 2012 report. Under the scenarios it modeled, 12 billion cubic feet per day of natural gas exports would increase domestic natural gas prices by $1.58/thousand cubic feet (Mcf; there is roughly 1 MMBtu/Mcf) to $3.23/Mcf (36 to 54 percent from their baseline).

Of course higher gas prices should help encourage drilling rigs to shift back to natural gas production. After 2010, natural gas prices plunged and there was a huge shift in rigs from drilling for gas to drilling for oil. The natural gas rig count remains near all time lows, but if gas prices rise to $5/MMBtu there should be a noticeable shift from oil back to gas.  

The other effect of higher natural gas prices will be to push some gas resources back into the reserves category. Whether a resource is categorized as a reserve is a function of technology and economics. If gas prices are at $5/MMBtu, then gas that can be economically produced at that price will be shifted into the proved reserves category. But if gas prices are $3/MMBtu, those reserves may have to be written down.

That was exactly what happened with some companies in 2012, and it led some to conclude that there was less shale gas than advertised. According to the SEC that’s technically true; at $3 there is less gas than at $5 under the definition of proved reserves as economically recoverable at current prices. But rising natural gas prices will reverse those write-downs and allow companies to put more proved reserves back on their books. This is why US natural gas reserves continued to rise from the late 1990s through 2011 — despite record production in the latter years — but fell in 2012 when gas prices bottomed out.

So what does this all mean? I think we can identify some likely winners, probable winners, and risks on the road ahead.

The most likely winners under this scenario will be the domestic natural gas producers. It is hard to envision a scenario in which natural gas prices won’t rise to the $5/MMBtu range over the next three to five years. While ExxonMobil (NYSE: XOM) is the nation’s leading gas producer, natural gas won’t move the earnings needle much for this diversified, integrated oil and gas giant. Look rather to drillers that produce a lot of gas as a percentage of total production. Chesapeake, Devon Energy (NYSE: DVN), and Anadarko Petroleum (NYSE: APC) should all do well as natural gas prices increase. (The proposed EPA regulations that would effectively preclude new coal-fired power plants are just icing on the cake).

Probable winners will be LNG tanker companies. One of the companies in this space is Aggressive Portfolio holding GasLog (NYSE: GLOG), which owns six LNG ships currently on the water, with eight more due to be delivered between 2013 and 2016. GLOG is up 32 percent over the past 12 months. Conservative Portfolio Best Buy Teekay LNG Partners (NYSE: TGP) has 29 LNG carriers, and has already agreed to lease two of its ships to the first US LNG export venture. Golar LNG (Nasdaq: GLNG) is a competitor with 13 ships, four of which are floating storage and regasification ships.

Other probable winners will be the backers of the LNG export terminals built early. Ventures signing up customers in the Asia Pacific region should benefit more than those with a high percentage of European customers.

As discussed in this week’s Energy Letter, Cheniere Energy (NYSE: LNG) is the first of the first movers. In 2012 Cheniere obtained approval from the Federal Energy Regulatory Commission (FERC) to export LNG to countries that lack a Free Trade Agreement (FTA) with the US. The non-FTA designation is important, because it covers many of the most lucrative LNG markets.

In 2007 Cheniere created the Cheniere Energy Partners (NYSE: CQP) master limited partnership to own assets such as its Sabine Pass LNG export terminal under construction on the Louisiana/Texas border, as well as another LNG terminal in Corpus Christi. Cheniere has signed up a number of customers in Asia and in Europe.

The permitting process requires approvals from the Department of Energy (DOE) and FERC. Cheniere is the only company to have received both. Freeport LNG, 50 percent owned by ConocoPhillips (NYSE: COP), received approval from the DOE in May and expects FERC to follow suit in early 2014. The project would ship LNG from the Freeport LNG Terminal in Quintana Island, Texas.

In August, the DOE approved the third permit for an LNG export facility. The Lake Charles. Louisiana terminal is backed by UK-based BG Group (NYSE: BG) and Houston-based Southern Union, a joint venture between Energy Transfer Equity (NYSE: ETE) and Energy Transfer Partners (NYSE: ETP).

This month, Dominion Resources (NYSE: D) became the fourth company to win approval from the DOE for a non-FTA LNG export license for its Dominion Cove Point terminal on Maryland’s Chesapeake Bay.

In addition to the four applications already approved by the DOE another 16 are under review. Approving all would give the US a total export capacity of  33 billion cubic feet per day (equivalent to just over half the natural gas production in the US in 2012).

In addition to the single project FERC has approved, it has received applications for approval from another six, including two in Oregon (the only two US West Coast export terminals being considered). In total, 13 LNG export projects have been proposed to FERC, and another eight sites identified by project sponsors.

Cheniere is in the driver’s seat at this point. There is a risk in the longer term that as more LNG export capacity comes online around the globe the large price differentials that have made the LNG trade seem so profitable will inevitably shrink. Likewise, major pipeline projects on the drawing board could pose formidable competition for some of the LNG proposals. This will especially affect latecomers to the process, whereas Cheniere’s head start should give it  probably a few years with limited competition and strong profitability.

The low risk play would appear to be the natural gas producers, followed by LNG tanker companies and a gas infrastructure builder such as Growth Portfolio holding Chicago Bridge and Iron (NYSE: CBI), with the LNG export backers representing more aggressive and riskier options.