Japan's Interest In Access To North American Natural Gas Should Further Recent Price Strength

Includes: BP, CEO, D, ETE, KMI, LNG
by: Zvi Bar

On March 15, Japan, the biggest global importer of liquefied natural gas ("LNG") indicated an interest in joining negotiations regarding the Trans-Pacific Partnership Trade Agreement. The free-trade agreement is expected to involve a substantially growing amount of LNG that, provided shale fracking continues, appears poised for export from the U.S. in the coming years. The agreement is part of President Obama's initiative to dramatically increase exports, and the U.S. government will likely fully welcome and appreciate the addition of Japan to the agreement, as it shall make Japan a consumer of U.S. natural gas.

Though Japan has been a long-time adopter of natural gas and various other alternative energy sources, Japanese demand for LNG significantly increased in the past few years. The cause of this increase is largely due to the nation's temporary suspension of nuclear power after the meltdowns at Tokyo Electric Power's Fukushima station in March of 2011.

Last summer, Japan indicated it would slowly reopen most of the nuclear plants that formerly provided almost one-third of the nation's energy. Despite that decision, the nuclear power restart is still unpopular with many Japanese people, and newly elected leadership may choose to pursue other energy policies. Nonetheless, the current reduced energy production capacity has forced Japan to become more reliant on imported gas.

Most of Japan's natural gas suppliers are relatively close neighbors, such as Australia, Malaysia and Russia, but Japan would likely appreciate expanding and further diversifying its suppliers to include the United States and Canada. Other nations involved in the Trans-Pacific talks include Australia, Canada, Malaysia, Mexico, Singapore and Vietnam.

Japan's energy demand requires it to look everywhere it can for cheaper energy. Last year, when U.S. prices hit a decade low in April of 2012 at $1.902 for one million British thermal units, natural gas prices in Asia remained four to seven times more expensive. Japan's average 2012 natural gas prices were roughly three dollars higher than the United States' 2008 natural gas peak price of at $13.69. Meanwhile, U.S. prices for natural gas in 2012 averaged below three dollars.

These extreme price differences, and the dramatic increase in natural gas production and reserves, have instigated many recent global energy deals. For example last month, Petroliam Nasional Bhd. (OTC:PNADF), Malaysia's state-owned energy company, bid to fully acquire MISC Bhd. in a deal worth about $2.8 billion. Petroliam Nasional (or Petronas, as it is generally called) already owned 62.67 percent of MISC, which operates the world's second-largest fleet of LNG ships.

Most of the global shipping business has had significant overcapacity for years, keeping cargo-box costs and margins low, but LNG shipping's anticipated growth is likely to eventually strain current LNG shipping capacity. This demand for LNG ships will be fueled by the expected continued low price for natural gas in North America, and the expected higher price for gas in Japan, China and other key markets.

Petronas was not only interested in securing control of natural gas ships, but also wished to further increase and diversify its portfolio of energy producing assets. In 2012 Petronas acquired Progress Energy Resources, a Canadian exploration and production company, for $5.2 billion. Canada also simultaneously approved a larger deal by CNOOC (NYSE:CEO), China's state-owned oil company, for Nexen Energy, which itself owned a globally diverse energy portfolio.

LNG terminals are not yet that easy to find in the United States, and the Keystone pipeline development derailment last year forced the industry to consider alternatives to its near-term plans. There is still only one approved export terminal in the U.S., which is still under construction, while several others are awaiting approval. The only presently approved terminal is an 18 million metric ton facility in Sabine Pass, Louisiana, that is being built by Cheniere Energy (NYSEMKT:LNG).

The Sabine Pass facility is not expected to be able to facilitate shipments until 2015. The vast majority of its capacity is already contracted to entities in countries both with and without free trade agreements with the United States. Other approved terminals would also likely quickly build large books of multi-year orders for a substantial portion of their capacity. Many such global energy consumers are now eager to lock in large multi-year contracts while U.S. natural gas prices remain historically depressed. Though U.S. natural gas prices have gone up by 25 percent within 2012 and have essentially doubled from their 2012 bottom, these prices are still considered low.

The Department of Energy indicated that it cannot decide on any further approvals for LNG terminals until the completion and publication of certain natural gas production related research later this year. Therefore, no new terminal approvals should be expected until late in 2013 at the earliest. Other liquefaction terminal applications include one in Hackberry, Louisiana, proposed by Sempra Energy (NYSE:SRE) and a Dominion Resources (NYSE:D) plan for one in Cove Point, Maryland.

In addition to plans to build terminals in the Gulf of Mexico and on the east coast, terminals on the west coast would be ideal for servicing Asian consumers. Beyond potential terminal development within the United States, it appears of ever-growing likelihood that a liquefaction terminal will soon pop up on Canada's west coast. Petronas is a strong proponent of such a plan, and has been working on a project to develop a pipeline to British Columbia and a LNG terminal there that could ship LNG to Asia. Continued delays to the development of the Keystone pipeline would likely expand support for and expedite the construction of such a Canadian Pacific pipeline and LNG terminal.

If such a Canadian pipeline were to soon occur, potential Canadian energy acquisition targets include companies like Enerplus (NYSE:ERF) and Pengrowth (NYSE:PGH), where both hold North American energy assets with about a 50/50 mix of oil to gas. Both companies were formerly Canadian Royalty Trusts, or Canroys, which were substantially similar to MLPs in the United States, and which Canada eliminated a few years ago. In 2010, Korea's state owned energy company acquired Harvest Energy Trust, another substantially similar former Canroy. The development of a Canadian LNG terminal to the Pacific would increase the attractiveness of these assets to Asia.

Beyond North American and Asian energy producers like Malaysia and Indonesia, Australia will also compete for Asian natural gas demand. China and several other Asian nations already rely on Australia for many natural resources, and Australia's resources are substantial. Another likely significant future supplier of LNG and other basic materials to Asia would be Russia. One advantage that Russia may have regarding distribution to China is that it would not require shipping in order to deliver LNG there, and could instead develop a more efficient pipeline system. OAO Rosneft, an integrated oil and gas company that is majority owned by the Russian government, and 20 percent owned by BP (NYSE:BP), appears a strong candidate for becoming a major supplier of LNG to China. Alternatively, the company may be able to leverage the potential for such a deal to enter better long-term contracts with Europe and other markets.

Within the United States, before LNG terminals are operational and the extend of their development is still unclear, capitalizing on the growth in natural gas consumption is probably best attempted through the domestic transportation system that will move gas to port, or to domestic consumers in the event that export demand does not grow as anticipated. The American midstream business has become dominated by publicly traded MLPs. The last several years of MLP growth were primarily predicated on natural gas infrastructure development, but a shift occurred to service increasing crude demand and prices.

Though a still reasonably young asset class, MLPs received validation through high-profile deals in the last few years, including the Kinder Morgan (NYSE:KMI) acquisition of El Paso Corporation (EP) for $38 billion and the Energy Transfer Equity LP (NYSE:ETE) acquisition of Southern Union for $7.9 billion. These deals highlighted the versatility of MLPs and the growing industry preference for working under a MLP model.

2013 could continue to be a strong year for natural gas pricing and the values of natural gas producing companies. After apparently reaching a long-term bottom in 2012, price appreciation has been strong. Additionally, many mergers and acquisitions have occurred and additional ones will likely soon come to market. Such further deals, the future approval of any additional LNG liquefaction terminals and the potential approval of the Keystone pipeline, or portions of it, should all act as catalysts to the continued growth through 2013 and beyond.

Disclosure: I am long ERF, PGH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.