- Cheniere Energy is trading at record highs following a multi-year run based on optimistic future expectations.
- Investment in the company is simply a highly leveraged and dangerous arbitrage bet on natural gas prices that can easily go the other way.
- Even if the bet works out and everything goes exactly as planned by the company, the valuation still isn't anywhere close to justified.
I started watching Cheniere Energy (NYSEMKT:LNG) in 2008 when it fell from $40 to $2. Since that time, it has rebounded over the past 4 years to a new high of over $76, where I decided to finally get short. Although I've followed the LNG story unfold for the past several years, I have admittedly never made a move on it and missed out riding the wave of hype in to the stratosphere.
LNG refers to liquified natural gas. Exactly as its name suggests, it is natural gas that has been converted to liquid form for transport. It is cost efficient to transport over long distances due to its reduction in volume. Therefore in countries like Japan, where natural gas trades at a sharp premium to domestic prices, the market expects there to be an opportunity to reap huge profits through export. That is pretty much the only use for LNG however, as it is not efficient for use in natural gas vehicles as the cryogenic storage requirements are too costly. Vehicles instead use compressed natural gas [CNG]. So there is no domestic market for LNG.
While the LNG export business could very easily be on the cusp of becoming a reality after being theorized for the past decade, I believe that the expectations for Cheniere Energy's stake in it are far too optimistic and have actually crossed the threshold to hysteria. That is, even if a series of perfect situational events play out in Cheniere's favor, there is no possible way that the company can sustain anywhere near the current valuation of over $15B. If there are headwinds in any one of the number of moving variables required for Cheniere to be successful, the highly leveraged company can easily fail and return to its former penny stock pricing.
So many things can go wrong that investors are not considering, starting from the domestic cost of natural gas itself which has been on a steady rise the past few years. It can certainly rise further. Perhaps as a result of EPA fracking restrictions, increased operating costs or simply because many of the country's largest drillers have shifted production to oil in recent years. The once massive supply gut is shrinking rapidly. This is the major risk considering that Cheniere's bet will only pay off if the price gap between domestic and Japanese gas does not close. And once the transportation is factored in, the margin becomes razor thin.
If there is indeed a long-term secular shift upwards in domestic natural gas prices, then the LNG export business is finished before it even gets off the ground. This is a best case scenario for a short position, as it would render Cheniere Energy worthless because, as mentioned, there is no domestic use for LNG. It is also a realistic possibility. There is virtually unlimited amounts of natural gas in Russia for instance, as evidenced by the 30-year supply deal at $10.50-$11.00 per million BTUs. Russia can also supply Japan and any other country. So there is plenty of competition out there against the U.S. providers like Cheniere.
In fact Frank Harris, the global head of LNG at Wood Mackenzie says that:
Returns are already getting squeezed. By the end of the decade, the LNG market looks better supplied and spot cargoes from the U.S. won't look so attractive.
Bloomberg's calculations based on data from Rice University in Houston show that the price differential between U.S. and Asian gas is poised to drop by more than 60% by 2020. As a result, exporters will face a drop of as much as $6M per tanker. With the U.S. Department of Energy considering dozens of applications for export projects across the country, it is already a crowded market, and that will pressure margins even further.
So Cheniere, which has taken on nearly $9B in debt to invest in LNG facilities, is a making a highly leveraged arbitrage bet that both the current price of domestic natural gas remains low and that the record high Japanese prices remain high. If either of these two variables shift against Cheniere, the bet will fail, and the company will become worthless. Again, this would mark a best case scenario for the short position, but as you can see, it is entirely possible, given all of the moving parts. To put it in to context for baseball fans, if Cheniere pitches anything less than a perfect game, it will lose.
Although even a loss won't likely stop Cheniere CEO Charif Souki from continuing to collect incredible pay that topped $142M last year, making him the highest paid executive at any U.S. publicly-traded company. All this while the company is burning cash at unprecedented rates. Cheniere reported a not-so-modest Q2 loss of $215M on Friday, well exceeding analyst consensus of $70M.
Now even in a best case scenario, if everything goes as planned, Richard Berger makes a compelling argument based on FCF projections that the company is still grossly overvalued to the point of potentially being an Enron style fraud. His article was published when the price of Cheniere's stock was a little over half of where it is right now. Berger's arguments are still entirely valid, as there is no evidence to disprove them even after the share price has doubled. He was early on his call to short, but I have no doubt even at the entry he suggested, it will be in the money sooner rather than later.
So given the recent blow off top in the share price over the past year, I feel that this is as good of a time as any to get short. Although it is impossible to pick a top when dealing with an irrational frenzy like this, I'm comfortable initiating my short right now at historic highs. I've scaled in to my short with a $75 average and continued to add as recently as Friday at just over $70. I will continue to add as this plays out, as I expect the rug to be pulled out from beneath the feet of the overly optimistic Cheniere investors who will undoubtedly one day be tripping over each other to the exit.
Disclosure: The author is short LNG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.