Natural Gas: The bridge fuel to nowhere?
With the push towards renewable energy globally, are companies investing in natural gas infrastructure ending up with the short straw?
Natural gas extracted from two miles under the earth in West Texas is helping power homes in Pakistan. Large-scale liquefied natural gas (“LNG”) liquefaction companies, like Cheniere Energy, are on the forefront of making this would-be dream a reality. The global energy sector is more inter-connected than ever before, and natural gas has come to the forefront as a relatively clean “bridge” fuel [1]. While this has helped reduce the cost of energy worldwide, the global focus on combating climate change and the regulatory changes to address climate change pose a real threat to energy infrastructure project developers like Cheniere Energy.
In a simplistic sense, LNG liquefaction companies compress and liquefy natural gas, which is then exported to energy-starved markets globally. Like most energy infrastructure projects, LNG liquefaction projects require a large upfront investment to the tune of $10 – $30 billion and take roughly 7-10 years from initial inception to commercial reality [2]. In the energy world, this time-frame is equivalent to ions of years and a lot can change in the marketplace between when projects are incepted and when they become a commercial reality.
To mitigate the extended time horizon and changing market landscape, large scale LNG projects have long-term, fixed-priced, take-or-pay off-take contracts in place with credit-worthy counterparties before they begin spending the big dollars on the construction of the projects. However, these contracts are usually for roughly 80% of the project’s overall capacity and for about 15-20 years – the combination of which is expected to generate a modest return on the capital invested in the project.
But a significant portion of the value for companies like Cheniere Energy is expected to come from the ability to sell the uncontracted volumes at attractive margins in the near-term and re-contracting with customers beyond the initial contract period in the long-term. This is where the rubber meets the road.
While near-term demand in energy-starved markets has and will fluctuate from season to season, longer-term demand prospects seem glim, or rather lower than expected as compared to that at the time of project inception. This is mainly due to the importance placed on renewable energy sources by the regulatory regimes in most demand-pull markets such as India. The reason for this is two-fold:
- Actions to meet goals related to renewable energy standards – Most countries that have been forecasted to increase their dependence on natural gas have instead chosen to invest, or rather, subsidize renewable energy investments [3][4]
- Although natural gas via LNG might be cheaper as a delivered ex ship (“DES”) commodity today, significant infrastructure investment is needed in terms of pipelines, power plants and transmission channels to convert that into tangible electricity in power, especially across a large geography.
To address these challenges in the short-term and the long-term, Cheniere’s management is taking a few key steps:
- Short-term – For its excess uncontracted merchant / spot volumes, Cheniere is looking to enter into short-term contracts with credit-worthy counterparties to mitigate seasonal and annual demand fluctuations due to weather. An example of this being their deal with Engie in Europe [5]
- Long-term – In demand-pull markets lacking infrastructure as it relates to regasification of LNG or power plants, Cheniere is teaming up with local developers and investing in such infrastructure projects to ensure a sustainable market for its LNG in the long-term. A classic example of this being the Andes project in Chile [6].
Given the contractual nature of the business, the short-term prospects of the business are fairly certain and measurable. However, in addition to the measure taken by management to address potential threats, I would recommend the following strategic actions to ensure the business is viable in the long-run.
- For the newer development projects, the key would be to focus on smaller-scale, more modular LNG projects. While it would be slightly more expensive on a per unit of energy metric given lower fixed cost synergies, it would help Cheniere better cater to changing market needs and demands [7].
- Developing floating LNG projects will also be key in the long-run. Given the uncertain regulatory climate both in the US and abroad, floating LNG projects will help mitigate binary regulatory risk and help Cheniere be nimbler in an ever-changing global market.
Key fundamental questions do arise about the industry and the company. Given the enormous upfront capital investment and the long lag time to bring these projects to fruition, trust in the US regulatory regime to export natural gas to both FTA and non-FTA countries has been a fundamental tenant and value driver of this business. Can this trust last forever? In addition, with most nations doubling down on renewable energy with subsidies, how much longer will natural gas be the bridge fuel of choice?
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(1) “As Natural Gas Replaces Coal it’s More than Just a Bridge Fuel”, Oil & Gas Journal, https://www.oilandgas360.com/natural-gas-replaces-coal-just-bridge-fuel/, accessed November 2017
(2) Mike Corkhill, “LNG project costs and the luck of the draw”, http://www.lngworldshipping.com/news/view,lng-project-costs-and-the-luck-of-the-draw_41276.htm, accessed November 2017
(3) Anjali Jaiswal, “India Leads on Climate Action as Trump Exits Paris Agreement”, https://www.nrdc.org/experts/india-leads-climate-action-trump-withdraws-paris, accessed November 2017
(4) Michael Safi, “India plans nearly 60% of electricity capacity from non-fossil fuels by 2027”, https://www.theguardian.com/world/2016/dec/21/india-renewable-energy-paris-climate-summit-target, accessed November 2017
(5) Engie Press Release, “ENGIE and Cheniere enter into an LNG Sales and Purchase Agreement”, https://www.engie.com/en/journalists/press-releases/engie-cheniere-lng-sales-purchase-agreement/, accessed November 2017
(6) Naureen Malik, “Chile Just Gave Cheniere a Big Reason to Build Another LNG Plant”, https://www.bloomberg.com/news/articles/2016-06-30/chile-just-gave-cheniere-a-big-reason-to-build-another-lng-plant, accessed November 2017
(7) Giorgio Biscardini, “Small going big”, https://www.strategyand.pwc.com/media/file/Small-going-big.pdf, accessed November 2017
Given the current shortfalls of renewables (intermittency/storage/costs(depending on region)), I believe gas has at a minimum a couple of decades of assured growth. Its prospects are a lot brighter than its liquid cousin. The reason for this is due to the current energy mix and future energy demand. As it stands coal, oil, and gas each constitute approximately 1/3 of the energy consumption worldwide, while nuclear and renewables provide the rest. Coal’s share of the pie will keep shrinking and gas will offset this growth as it is cheaper and a base-load (reliable) form of energy. Most agencies (EIA, IEA, New Energy Finance, BP Outlook 2040) all seem to agree that by 2040 gas will likely have the largest share of energy production worldwide.
I agree that the investment in renewables energy will continue to outpace convention energy; however, even with fast-paced growth rates, it will be a few decades before they can provide even 50% of the energy needed (assuming batteries or intermittency is solved).
I wholeheartedly agree with both of your long-term suggestions for Cheniere. These two strategies should provide them the flexibility needed to provide gas to countries/regions in need.
Great read! I have to agree with Danny that LNG inevitably has decades of room to run as it is seen as accessible and is viewed the cleanest of the conventional. I agree with you that renewables will provide formidable headwinds to the growth of LNG. However, I would argue the greatest threat to LNG is the pressure being placed on the spread. LNG essentially makes money on the difference between market prices across the world. As more of these projects come on line to increase supply globally, this spread diminishes. See the article below:
https://www.bloomberg.com/professional/blog/global-lng-supply-demand-monitor-2/
It will be interesting to see how economic and geopolitical forces play out to determine the future of the energy mix.
Thanks for your thoughts, it’s certainly a complex situation. I agree with you the long-term economic feasibility of LNG is in question. In addition to decreased demand due to renewable energy projects being pushed into the energy mix, the global LNG market is projected to be oversupplied well into the 2020’s.
I see smaller-scale, modular LNG projects as being part of the solution for companies like Cheniere. I don’t think FLNG is a viable solution however, mainly due to the incredibly high capital costs and complex engineering required to make it a success. Shell has completed Prelude, but I don’t think they’d do it again.
Energy Analyst – thanks for the great energy analysis!
I do agree that the long-term viability of natural gas as a competitive fuel source is under great threat, but perhaps not to the extent that your analysis suggests. Renewable energy has historically remained uncompetitive vis-a-vis natural gas for a host of reasons: cost-prohibitively high transmission and distribution costs to the central power grid, fairly limited regulatory support, and tremendously cheap cost of coal and nuclear as a domestic and international fuel source. As these factors become further heightened, natural gas will become further entrenched as the preferred choice of electricity generation over other forms of fuel. With greater interest in curtailing and/or reversing the effects of climate change comes a greater interest in cleaner sources of fuel. As a result, coal as a fuel source for power generation has increasingly come under attack with the enactment of the Cross-State Air Pollution Rule (CSAPR), Mercury and Air Toxic Standards (MATS), and renewable portfolio standard rules across U.S. states. In the U.S. power markets, natural gas remains competitive as the cleanest form of power available to meet both baseload as well as peak power demand on the dispatch curve. Renewable energy will never be able to accomplish due to structural challenges. In practical terms, it will take a wind or solar farm situated on miles of land tracts to generate the same amount of a power as one combined cycle gas plant with an installed capacity of 500 megawatts. See EIA link below:
https://www.eia.gov/todayinenergy/detail.php?id=7590
With the Paris Climate Agreement, developing markets shifting to cleaner energy sources (China recently introduced GHG cap and trade programs that favors natural gas), and deeper support in the U.S., natural gas is here to stay at least for the next 50 years.
This is a good look at what is perhaps the most complex ecological and political issues of our time: how do we wean the world off carbon fuels as fast as possible without starving developing economies of vital resources at affordable prices. At the same time, we have to face the reality that companies like Cheniere are indeed pushing an agenda of a “bridge” fuel that ultimately contributes to long-term dependence on carbon. That is to say, once a country’s economy is nursing at the bosom of cheap fossil fuels, it’s incredibly difficult to transition to sustainable energy sources–even for developed economies with massive investment capital reserves. To that end, there may be a significant impediment for Cheniere to ever walk away from the LNG trade as it stands. The author points out that many of the developing nations who rely on LNG are investing in renewables, but as the case of the developed world shows, the gulf between investment and widespread adoption is huge.
In the end, it’s likely that the challenges the author mentions will erode but not impede the revenue streams of Cheniere and its cohort. Rather, as the world’s population explodes over the next generation, it may be well be that we will look back on this time as the beachhead of a long-term dependence on LNG that we neither wanted nor intended.