Natural gas transforms into a liquid when it’s cooled to minus 260 degrees, enabling exporters to load the liquefied commodity onto specialized carriers for shipment to an import terminal.

LNG frees gas from the physical constraints of the global pipeline system. Before the widespread commercialization of LNG technology, natural gas located far offshore or in remote areas was considered stranded and had no economic value because producers couldn’t deliver output to consumers. LNG allows natural gas produced in Australia or offshore West Africa to high-demand markets such as Europe and Asia.

Global consumption of natural gas should grow at a faster pace than any other fossil fuel in coming years, according to projections from the US Energy Information Administration (EIA).

Source: Energy Information Administration

Whereas the EIA expects global demand for natural gas to surge almost 50 percent between 2010 and 2035, oil demand is expected to grow by 30 percent and coal demand is expected to jump by 40 percent.

This forecast appears conservative relative to industry estimates. For example, ExxonMobil Corp (NYSE: XOM) expects global gas demand to increase at an annualized pace of 1.6 percent over the next 30 years, compared to a 0.9 percent annualized growth rate for aggregate energy demand.

In either case, there’s a good chance that natural gas will overtake coal as the world’s second-largest source by the middle of the coming decade. Two factors will fuel this paradigm shift: Natural gas is more plentiful than oil and burns cleaner than oil or coal.

The global LNG trade continues to grow at a faster pace than both overall demand for natural gas and volumes transported by pipeline. In 2005 LNG accounted for about 26 percent of the 722 billion cubic meters of natural gas that exchanged hands in the global market. By 2010, global trade in natural gas had surged to more than 975 billion cubic meters; LNG accounted for about 31 percent of the market.

With a number of liquefaction projects slated for completion over the next few years, the global LNG trade should expand substantially over the next few years. At the end of 2011, global LNG export capacity stood at about 275 million metric tons per annum; plants currently under construction will expand global capacity by about 25 percent, while capacity could surge to 650 million metric tons per annum in 2018 if all the planned or proposed projects come to fruition.

Source: GasLog F-1A Filing

That being said, a number of the proposed LNG export terminals likely won’t be built, while delays should push out the completion date of a number projects that are currently under construction. Even with these inevitable slippages, global liquefaction capacity should increase substantially in the next few years.

Investors must distinguish between the North American market and international markets for natural gas. The frenzied development of the Marcellus Shale in Appalachia, the Haynesville Shale in Louisiana and other unconventional plays has glutted the US market. With production still likely to outpace demand, US natural gas prices should remain depressed for at least the next two to three years. (See Commodity Markets and Energy Stocks: 2011 Review and 2012 Outlook from the Jan. 5, 2012, issue of The Energy Strategist.)

With domestic natural gas prices hovering near record lows, some US-based investors overlook the growth opportunities in international markets for natural gas. Utilities and other major gas consumers in Europe and Asia lack rapidly growing domestic supplies of natural gas and rely heavily on imports to meet supply.

Natural gas has been growing in popularity in China, particularly in power-generation facilities located near major cities. Concerns about air quality mean that many of the high-rise residences constructed during China’s recent housing boom are equipped for piped gas. Further migration to urban areas will only increase demand.

Even after China’s annual consumption of natural gas more than tripled between 2000 and 2009, this extraordinary growth shows no signs of abating. The National Development and Reform Commission (NDRC) estimates that in the first 10 months of 2011, domestic natural gas demand surged to 3,676 billion cubic feet (bcf)–up 20.4 percent from year-ago levels. Meanwhile, energy companies in China produced only 2,916 bcf of natural gas over the same period, an increase of 6.6 percent. To offset this shortfall, the country’s imports soared by 86.5 percent, to 904 billion cubic feet.

LNG accounted for about half China’s imports in the first 10 months of 2011; these volumes are expected to grow substantially in coming years.

Meanwhile, Japan and South Korea, which is cut off from Asia’s pipeline network by North Korea, import the majority of their natural gas via LNG tankers. With many of its nuclear reactors still shuttered for evaluation and maintenance, Japan’s LNG imports remain near record highs.

Germany’s decision to close all its nuclear power plants over the next 10 years likewise bodes well for activity in the global LNG market.

My Best Buys List currently includes two stocks with exposure to this growth trend: Growth Portfolio holding BG Group (LSE: BG/; OTC: BRGYY) and Conservative Portfolio holding Teekay LNG Partners LP (NYSE: TGP).

BG Group, formerly British Gas, derives more than one-third of its revenue from LNG-related activities and remains one of the largest players in this business. The company’s operations span every link in the LNG supply chain, from exploration and production to liquefaction and re-gasification and marketing and trading operation. BG Group’s London-traded shares rate a buy under 1,650 pence (GBP16.50).

Teekay LNG Partners LP (NYSE: TGP)

Teekay LNG Partners LP owns a fleet of 20 ships that transport liquefied natural gas (LNG), five vessels that carry liquefied petroleum gas (LPG), and 11 conventional oil tankers. All its existing ships are contracted under long-term time charter arrangements at fixed day-rates; the master limited partnership’s (MLP) LNG carriers have an average of 16 years remaining on their fixtures, while the average outstanding contract for its LPG and conventional oil tankers stands at 15 years and 10 years, respectively.

Day rates for oil tankers continue to languish. Although demand for these vessels remains solid, a glut of newly constructed vessels has led to an oversupply of capacity, depressing day rates to levels that make it difficult for many operators to turn a profit. These headwinds, coupled with declining ship values, have forced General Maritime and a number of tanker owners to declare bankruptcy.

But these headwinds won’t push Teekay LNG Partners on the rocks; conventional oil tankers only account for a small percentage of the firm’s distributable cash flow (DCF), and most of the MLP’s vessels are booked under long-term time charters at fixed day rates. When the contracts on Teekay LNG Partners’ oil tankers roll off five to 10 years from now, the supply-demand balance in this shipping market should have normalized.

Meanwhile, demand for LNG tankers is booming, but most of these specialized vessels are booked under long-term deals associated with a particular export facility. Day rates in the spot market now exceed $140,000, up from about $65,000 in early 2011 and $20,000 in mid-2010.

Teekay LNG Partners’ existing fleet has limited exposure to these skyrocketing day rates, as these vessels are booked under long-term contracts. But the tight supply-demand balance in the market for LNG tankers makes fleet additions worthwhile.

In 2011 the MLP added a 33 percent equity interest in three LNG carriers last year and a 100 percent interest in three LPG carriers. All six vessels are booked under long-term deals that produce steady, reliable cash flows and the total value of those contracts exceeds $200 million.

In the third quarter of 2011, Teekay LNG Partners announced a joint venture with Japan-based Marubeni Corp (Tokyo: 8002) to purchase six LNG tankers from Denmark-based ship owner AP Moller Maersk for USD1.3 billion. This table outlines the current status of these six vessels:

Source: Bloomberg

The majority of these ships are booked under long-term agreements, but Maersk Magellan and Maersk Methane’s fixtures will expire in the next several years, allowing Teekay LNG Partners to take advantage of the tight market. In fact, the Maersk Methane’s charter was slated to expire in early 2012, but the joint-venture partners secured a three-year fixture for the vessel at a day rate of $130,000.

In 2012 Teekay LNG Partners’ interest in these six ships should generate $40 million in distributable cash flow, equivalent to a quarter’s worth of DCF from its legacy operations. Management plans to boost the MLP’s distributions from the current level of $0.63 in the first quarter of this year. If the company were to raiise the quarterly payout to $0.675, the stock will yield more than 6.7 percent–well above the 5.7 percent yield offered by the Alerian MLP Index. Teekay LNG Partners LP rates a buy under 41.

Golar LNG Limited (Oslo: GOL, NSDQ: GLNG)

Golar LNG Limited is 46 percent owned by World Shipholding, a group that’s indirectly controlled by Norwegian billionaire John Fredriksen, who made his name and fortune in the energy transportation and services business and is chairman of Aggressive Portfolio holding SeaDrill (NYSE: SDRL).

The firm owns 26 LNG carriers, including those already sailing the seas and several slated for delivery over the next three years. This fleet makes the company the largest independent owner of LNG vessels in terms of total capacity. Golar LNG Limited has also entered the market for floating storage and re-gasification units (FSRU), or seaborne LNG import terminals that can deliver natural gas to countries that lack sufficient onshore re-gasification capacity.

Unlike Teekay LNG Partners, Golar LNG Limited tends to emphasize near-term growth over sustainable cash flow. Rather than securing long-term contracts for its fleet, Golar LNG Limited leases most of its vessels in the spot market, where ships are available on demand, and under short-term charters.

With day-rates on LNG carriers approaching record highs in the spot market, Golar LNG Limited should find itself flush with cash flow over the next few years. Of course, the firm’s earnings would plummet if day-rates were to weaken or if the market for LNG carriers were to become oversupplied.

Golar LNG Limited’s enviable order book includes five vessels scheduled for delivery in 2013, seven ships in 2014 and one LNG carrier in early 2015. Not only do these newly built LNG tankers provide ample exposure to elevated prices in the spot market, but backlogs at the world’s major shipyards also mean that any new orders won’t be delivered until at least mid-2015. 

With the supply of new LNG carriers expected to grow at a three percent annualized rate through 2014, Golar LNG Limited is in prime position to take advantage of a tight spot market.

Source: GasLog F-1A Filing

Although supply-demand conditions in the LNG tanker market remain tight, fleet additions begn to accelerate in 2014. Demand should be sufficient to snap up these newly delivered vessels, but pricing in the spot market should moderate slightly. Meanwhile, the next two years represent a golden opportunity for Golar LNG Limited and other ship owners with unattached LNG carriers.

Shares of Golar LNG Limited currently yield 3.4 percent, though this payout should climb as the company books its newly built vessels in the spot market.

Meanwhile, the outlook for the company’s FSRU business also appears sanguine, as these vessels don’t require importers to take on the considerable time and expense needed to build onshore re-gasification terminals.

Shares of Golar LNG Limited have returned about 62 percent over the past year, while units of Teekay LNG Partners are up only 2 percent. This outperformance reflects Golar LNG Limited’s superior exposure to elevated day-rates in the spot market.

At the same time, Golar LNG Limited’s stock price can fluctuate dramatically in response to shifting sentiment regarding global economic growth and the outlook for natural gas consumption.

We prefer Teekay LNG Partners as a long-term holding, but the recent pullback in shares of Golar LNG Limited has prompted us to consider the stock as a potential Aggressive Portfolio holding. Until the valuation reaches favorable levels, we will track Golar LNG Limited as a Hold in the Energy Watch List.

Golar LNG Partners LP (NSDQ: GMLP)

We rated the Golar LNG Partners LP a Buy shortly after the MLP went public in April 2011. (See the April 21, 2011, issue of The Energy Strategist, International Opportunities in Coal and Natural Gas). Golar LNG Limited acts as Golar LNG Partners’ general partner.

Whereas Golar LNG Limited tends to focus on opportunities in the spot market, Golar LNG Partners pursues a similar strategy to Teekay LNG Partners and books its vessels under longer-term fixtures that generate reliable cash flow.

The MLP’s fleet comprises three FSRUs and two LNG carriers, all of which are booked well into the future: The Golar Spirit FSRU is under contract until 2018; the Golar Freeze FSRU’s fixture won’t expire until 2020; the Golar Winter FSRU is booked until 2024; the Golar Mazo LNG carrier comes off contract in 2018; and the Methane Princess LNG tanker’s contract is up in 2024.

These fixed-rate time charters mean that Golar LNG Partners’ current asset base offers little exposure to the elevated day-rates available in the spot market.

Drop-down transactions from the MLP’s general partner will likely drive cash flow and distribution growth in the near term. Golar LNG Partners has already taken advantage of these opportunities, purchasing the Golar Freeze FSRU from Golar LNG Limited at a price that enabled the MLP to increase its distribution by 11.7 percent from its initial payout.

In 2012 the MLP’s general partner will likely drop down the Khannur, an older LNG carrier that’s been converted to an FSRU and is signed under an 11-year charter. After this deal occurs, Golar LNG Partners will likely raise its quarterly payout again. Based on the current unit price, a 10 percent increase to the MLP’s distribution would bump the yield to roughly 5.1 percent.

Units of Golar LNG Partners yield less than Teekay LNG Partners because the former’s near-term growth prospects are superior, thanks to a stream of potential drop-down transactions.

At these levels, we continue to prefer Teekay LNG Partners for its higher yield and solid growth prospects. Golar LNG Partners rates a Hold in the Energy Watch List.

GasLog (NYSE: GLOG)

Investors seeking exposure to near-term upside in spot prices for LNG tankers should also keep an eye out for GasLog, a firm that will complete its initial public offering (IPO) on March 29, 2012.

GasLog’s fleet currently consists of two LNG tankers that were delivered in 2010 and are under contract to BG Group until 2015 and 2016, respectively. More important, shipbuilder Samsung Heavy Industries will deliver eight newly built LNG tankers to GasLog through 2015.

BG Group has already booked the four vessels slated to arrive in 2013 under time charters: Two of these carriers will operate under five-year contracts, while the other pair have fixture terms of six years. Royal Dutch Shell (LSE: RDSA, NYSE: RDS A, RDS B) has locked up two vessels scheduled for delivery in late 2013 and early 2014 under seven-year deals; the final two LNG tankers under construction that will arrive in late 2014 and early 2015 are still available and will likely secure attractive bookings. GasLog also has the option to purchase two additional LNG carriers from Samsung Heavy Industries–if day-rates hold up, expect the company to exercise this option.

In addition to its wholly owned fleet, GasLog manages the 11 ships controlled by BG Group and owns a 25 percent stake in one additional LNG carrier leased under a 20-year time charter. The company’s management activities include supervising the construction of new LNG tankers, maintaining the existing fleet and staffing each vessel with well-trained personnel.

After serving as the sole technical manager for BG Group’s extensive carrier fleet for more than a decade, GasLog boasts one of the most experienced management teams in the business.

In terms of its exposure to the risks and rewards of the spot market for LNG Tankers, GasLog represents a happy medium between Golar LNG Limited and the two MLPs highlighted earlier in this report. The newly listed company boasts some exposure to elevated day-rates by virtue of its two LNG tankers that aren’t under contract and the option to build two additional vessels. At the same time, the company’s fleet is booked under shorter time charters than Teekay LNG Partners and Golar LNG Partners’ LNG carriers.

The locked-in earnings growth from the firm’s order book is impressive. Management estimates that these charters in 2012 will generate almost $56 million in revenue. As new vessels enter the fleet in 2013 and 2014, this revenue stream will surge to about $133 million in 2013 and $214 million in 2014.

GasLog will return some of this capital to shareholders in the form of a regular quarterly dividend–initially $0.11 per share for the fourth quarter of 2012. (In other words, investors who buy the stock shortly after the IPO won’t receive a dividend for close to 12 months.) With an expected offering price of $16 per share to $18 per share, the stock would yield between 2.5 and 2.7 percent. At the same time, the surge in cash flow projected for 2013 and 2014 suggests that GasLog could have the scope to triple its quarterly payout over the next three years.

The underwriters of GasLog’s IPO include several heavy hitters on Wall Street: Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM) and UBS (NYSE: UBS). These investment banks won’t be able to offer research opinions on the stock during the quiet period immediately after the IPO, but you can rest assured that analysts at several of these firms will initiate coverage once the regulatory gag is removed.

We will monitor GasLog closely after its IPO, with an eye toward potentially adding the stock to the model Portfolios. Once the company goes public, we’ll track the stock in the Energy Watch List and issue a Flash Alert if we decide to add it to the model Portfolios.