The story below ran a couple of weeks ago in the MLP Investing Insider; we’re reprising it here because it provides important color on a project crucial for two of our Best Buy recommendations. And also because it’s time for an update now that BG Group (London: BG, OTC: BGRYY), Energy Transfer Equity’s (NYSE: ETE) sole partner for LNG exports from its Lake Charles terminal, has agreed to be bought out by Royal Dutch Shell (NYSE: RDS-A).

On the one hand, Shell likely didn’t agree to pay a 50% takeover premium for BG Group with the idea of stifling its growth or canceling one of its cheapest remaining LNG development opportunities. As such, its status as the new final decision-maker on Lake Charles is a clear positive.

“We view BG’s LNG growth as a primary motivator for Shell, with Lake Charles standing as the self-proclaimed lowest cost option in the portfolio. Deal a net positive with Shell’s existing platform and balance sheet helping project reach” final investment decision, wrote the analyst at Tudor, Pickering and Holt.

But Shell isn’t much likelier than BG to greenlight the project without lining up offtake commitments for its expected LNG output, and its ability to do that will depend on a recovery in LNG prices that tumbled this past winter alongside crude.

In a presentation following the BG Group acquisition announcement, Shell chief financial officer Simon Henry called Lake Charles one of the “key opportunities” for the company. “Clearly the cost inflation of recent years and the recent oil price fall has led to the reassessment of all of those projects in one way or the other, [and] I can’t actually tell you where all of that will come out. But the key drivers will be brownfield to the extent we can, operative opportunities because they’re under our control, and getting the capital cost down to a level that is robust through cycles.”

Lake Charles is certainly both a brownfield opportunity as a former LNG import facility and one that would give Shell full operational control, But “getting the capital cost down” will require tough negotiations with Energy Transfer on a project the latter has promoted to its own investors as a virtually risk-free font of big profits over multiple decades.

The good news is that Shell has entered this game because of a fundamentally bullish view on global LNG prospects. But it is paying a high price to play, and will only give the go-ahead to Lake Charles if it can make money selling its LNG output.

Lake Charles did reach a lesser milestone last week when the Federal Energy Regulatory Commission’s draft environmental review cleared the project. Now it just needs to find takers for its LNG at a sufficiently high price to warrant building the liquefaction trains.

Energy Transfer’s LNG Score Recedes

There’s no doubting the long-term attractions of liquefied natural gas (LNG). Not only are the lowest-cost projects competitive with crude even at current depressed oil prices, but gas remains a much cleaner fuel than coal, in many ways the best option for meeting the developing world’s ever growing demand for heat and electricity.

Hence the dramatic estimates of LNG supply growth over the next two decades, such as those published last month by BP as part of its updated Energy Outlook. The report projects the LNG trade to grow 7.8% annually through 2020 and 4.3% annually through 2035.


Source: BP Energy Outlook

But in the meantime, in the here and now, there’s a definite chill setting in as low crude prices force a reappraisal of long-held assumptions. And those reservations are already starting to thin out the LNG supply pipeline.

Source: GasLog Partners March 4 investor presentation

Our primary concern here at MLP Profits is with the delay, flagged on the lower left of the chart above, of the big Lake Charles LNG project, on which the final investment decision (FID) has now been pushed out from mid-2015 until sometime in 2016. That’s because Lake Charles is owned by Energy Transfer Equity (NYSE: ETE) and Energy Transfer Partners (NYSE: ETP), two master limited partnerships we recommend and rank highly.

When Energy Transfer detailed the preliminary terms of its Lake Charles joint venture in November 2013, it gave a major upward impetus to ETE’s unit price, which jumped 10% in two days on the news and has risen 79% in the 16 months since.

What initially got investors so excited was the fact that joint venture partner BG Group (London: BG), one of the world’s largest LNG traders, seemed to be assuming most of the risk. Not only would BG be committing to purchasing the facility’s entire output for 25 years (albeit at a price yet to be set), but it would also be responsible for any construction cost overruns as well as facility operations.

The trouble is that this was an agreement negotiated while crude was priced above $100 a barrel and LNG landed in Japan went for around $16 per million British thermal units (mmBtu).

Now Asian spot LNG prices are below $8/mmBtu and BG Group is coming off a very rough year. It share price is down 33% in 10 months and its last CEO was ushered out “for personal reasons” after just 16 months on the job last April. His replacement, the well-regarded Helge Lund, who left the CEO’s post at Statoil (NYSE: STO) for a payday so rich it’s already had to be scaled back under fire, only started last month.

Also last month, just before Lund started, BG Group took a $4.1 billion non-cash impairment charge on its brand new Queensland Curtis LNG Australian export complex in recognition of its reduced long-term profitability given the drop in crude prices. The company is scaling back capital spending by 24% to 36% this year.

On the Feb. 3 conference call following the release of annual results, BG Group’s acting executive chairman, Andrew Gould, was asked what forward curve LNG prices would cause the company to give a green light to Lake Charles construction.

“So Lake Charles, obviously in the current market, which is extremely volatile, it’s not appropriate for us to be looking at any form of investment decision,” he said. “We have good news on the FERC consent, which will be towards the end of 2015, but I suspect that any debate on an eventual project approval is going to be pushed out into 2016, because we still have both sides to work on. We have the eventual agreements for off-take from customers and we also have to work on the cost of Lake Charles going forward. So I don’t think today we’re in a position to give you any guidance on reference conditions that will be necessary, we have too many unknowns in both the selling and the construction side of the equation to do so. I think you could safely assume that it will be pushed way back into 2016.”

Later on the call, Gould indicated the project is unlikely to proceed unless and until BG Group is able secure off-take contracts for its output.

Sixteen days later on Energy Transfer’s post-earnings conference call, group chief financial officer Jamie Welch said final investment decision was being pushed off into 2016 as a result of the timetable for final approval from the Federal Energy Regulatory Commission. “…Both BG and Energy Transfer remain fully committed to the project and the timetable, as Lake Charles remains one of the lowest cost and most flexible LNG supply options in BG’s global portfolio,” he said.

This prompted one analyst on the call to ask “to help me kind of reconcile” Energy Transfer’s optimism with the fact that “BG’s management was significantly less constructive than you all are being on this call.” He didn’t get a convincing answer.


Source: Energy Transfer November 2014 investor presentation

Because Lake Charles was built in 1982 as an LNG import terminal (only to be closed as uneconomical the next year), it already offers some of the infrastructure LNG exports require, including storage tanks and deepwater berths for LNG carriers. As a result, Energy Transfer’s claim that the cost of LNG exports from Lake Charles would be highly competitive with that for competing projects has some merit.


Source: Energy Transfer November 2014 investor presentation

It’s also more than a little disingenuous, because while projects like Queensland Curtis and Gorgon have proven massively expensive, they’re also already built, so that for the purposes of limiting the supply of LNG their construction costs are sunk and irrelevant.

What matters now is at what price global demand will balance the supply, which is set to increase significantly over the next two years as projects like Gorgon and Sabine come on stream.

As BG’s Gould noted, Lake Charles is unlikely to proceed without offtake commitments. And current LNG prices wouldn’t justify the project’s cost based on Energy Transfer’s own estimates as of late last year. (The LCL on the lower right in the graphic below refers to Lake Charles LNG.)


Source: Energy Transfer November 2014 investor presentation

This is a big looming problem for Energy Transfer. Over the last two quarters, proceeds from preliminary work on the project accounted for a little more than 15% of ETE’s distributable cash flow. The partnership once estimated that Lake Charles would generate $1.16 billion of distributable cash flow annually once exports began in 2021.

The only good news here is that today’s low LNG prices might rebound by the time a final decision on Lake Charles is made, whether that’s next year or at some later point. Also, Energy Transfer is large enough that BG Group is likely not its only long-term option for a partner, though it’s so far been the one most willing to shoulder long-term market risks.

Until both parties give the project final go-ahead, it’s safest to assume that all the terms of the arrangement agreed so far are subject to renegotiation, and one that on recent trends would not go in Energy Transfer’s favor.

It’s also likely that ETE’s unit price and, to a lesser extent, ETP’s as well, would suffer significant downside if the project were to be shelved.

For now, that looks like a hazard for 2016 more than 2015, and the concerns voiced by analysts on Energy Transfer’s most recent conference call suggest the market is aware of the risk.

For those reasons, and because we see current oil (and by extension LNG) prices as unsustainably low in the long run, we haven’t downgraded ETE and ETP.

But this is an issue worth tracking as the year and the crude slump progress. If LNG prices are no higher in early 2016, we’ll almost certainly re-evaluate our investment thesis. For now, just realize that Energy Transfer needs higher crude prices much more than its direct exposure to them might suggest.