Cheniere - What Can Go Wrong

| About: Cheniere Energy, (LNG)


Cheniere's long-term contracts are reassuring, but not a certainty.

Competition is not disappearing fast enough in a very soft global LNG market.

Included in some of Cheniere's contracts are other types of risk.

Cheniere (NYSEMKT:LNG) is one of those complex businesses with many moving parts, so it's best to identify first how you could lose money before how you'll make money. The value proposition of Cheniere is the same as it's always been, and that is to leverage the cheap and abundant U.S. shale gas as feedstock for liquefied natural gas to be sent abroad where prices had been much higher. In fact, the natural gas in the U.S. has gotten cheaper and more abundant since the concept was hatched many years ago, but global LNG prices have since fallen sharply as a glut of the product is flooding into the market.

What makes Cheniere unlike most commodity energy companies are its 20-year contracts with customers that guarantee a fixed fee for liquefying the gas. The typical arrangement with its customers includes a fee of 115% of the Henry Hub natural gas price, plus the shipping cost (if Cheniere is delivering the LNG) plus a fixed rate per million BTUs of LNG. Cheniere conversely pays its natural gas suppliers a discount to Henry Hub largely because it can, as it's such a massive and soon-to-be-perpetual buyer in the market.

The risks in Cheniere are many. The most devastating would be a sharp rise in natural gas pricing. This could be for any number of reasons including reduced funding for the industry, strong demand for natural gas from other industries, and other costly situations including earthquakes arising from wastewater injection (which can be remedied by wastewater treatment). The reality is natural gas is a commodity and is subject to the swings. While it seemingly has only swung downward, it will surely bounce back up, and how Cheniere's customers respond to these surging costs will be critical. As a side note, Seth Klarman's Baupost Group is one of the largest investors in Cheniere and his fund also holds a sizable stake in Antero Resources (NYSE:AR) and Bellatrix Exploration (NYSE:BXE); both natural gas producers. While both are likely cheap in themselves, they're probably also a good natural hedge against rising natural gas prices.

In theory, Cheniere's long-term contracts with their customers should be ironclad and, barring extraordinary situations such as a shortage of LNG carriers or a catastrophe, there is no wiggle room for Cheniere's LNG buyers. But bankruptcy risk is a reality and this annuity-like income is just as dependent on the creditworthiness of these buyers much as any annuity is dependent on the financial health of the insurance company.

A case in point is French utility EDF, which Cheniere counts as a customer. The company has been in the spotlight with its proposed nuclear power plant for the UK, and the uproar about it potentially compromising the company's solvency. However, EDF is only one of many of Cheniere's buyers and the likelihood many of its buyers will become stressed is doubtful.

Cheniere has also partnered with a Chilean utility to build an LNG plant in Chile while guaranteeing a long-term supply of LNG. While Rockefeller may have approved of this downstream investment, Cheniere is still taking on unique risks unrelated to its core value proposition (cheap U.S. gas).

Jim Chanos who has been the most prominent bear on the company has said these long-term contracts could be scraped as LNG spot pricing remains subdued on the back of a supply glut. But even in this current weak LNG market, we've heard little noise about customers walking away from contracts. Most long-term Cheniere investors would probably prefer a weak LNG market today to keep competition at bay and also to bring new buyers into the market. While a few LNG plants have been axed, many of the LNG sites are just seeing their final investment decisions being punted into the future.

Cheniere has also signed contracts with European buyers that instead of linking the gas price to Henry Hub link it to a domestic European spot price. In this situation, Cheniere is going head to head with Russia and other producers in Europe as it would take on the pricing risk instead of passing it on to its customers.

Another more glaring risk is a continual fall in renewables technology. While a proliferation of renewables in the U.S. would help Cheniere as there would be less competition for natural gas, should places like Europe and China continue to adopt the technology that will weigh on demand for LNG. I think the trend toward LNG and natural gas should continue as places like China that employ coal for some 70% of their power move toward cleaner technology and LNG is certainly included in that bucket. Renewables such as solar might also see prices increases. A glut of solar panels has weighed on producers in both China and the U.S., bringing many producers to their knees. Should solar operators take capacity out (that should happen in free market economies, but in China that may not be the case), this will put pressure on pricing.

Another risk that has been less obvious in the case of Cheniere, but more so with the Australian LNG operators such as Chevron (NYSE:CVX), is that of engineering risk. So far Bechtel has delivered the 1st train relatively on time and without major cost overruns unlike its Australian counterparts. Many more trains need to be completed and there will probably be hiccups along the way, but if costs remain as expected and perhaps lower now that the roughnecks from the oil patch are looking for work, then bondholders will get paid and everyone will be happy.

In sum, the downside is extensive for Cheniere, but unless the abundance of shale gas in the U.S. is challenged, these other risks are not too big to swallow.

Disclosure: I am/we are long LNG.

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.