LNG has all of the properties of an explosive theme; there’s virulent skepticism and pervasive prognostications about an eternal supply glut as confirmed by models that plug arbitrary supply/demand projections into a spreadsheet, and there’s the contradictory reality of almost unquenchable incremental demand over the medium to long-term that is only constrained by the quantity of economical supply that can come on-stream.
I find it peculiar that in an anticipated glut scenario, for example, Cnooc Ltd., the third largest National Oil Company in China, “is set to sign ‘about three’ term contracts to purchase liquefied natural gas this year as demand increases, Chairman Fu Chengyu said. The company also aims to get government approval this year to build three additional terminals to receive the fuel.” ( http://www.bloomberg.com/apps/news?pid=conewsstory&tkr=CEO%3AUS&sid=aTTWU1Q8ORqQ ) I also find it peculiar that in the midst of an anticipated LNG glut, Shell and PetroChina are currently pursuing a multi-billion dollar unsolicited bid for Arrow Energy (AOE), a currently unprofitable Australian energy company with extensive high cost CSG acreage.
So what are the skeptics missing? Despite the current LNG surplus, Bank of America anticipates a deficit to emerge in 2015 and to grow to a 74Mtpa shortfall in 2020. Their analysis includes an estimate of 35Mtpa of Chinese LNG demand by 2020, approximately 10Mtpa higher than the supply currently contracted for. This estimate, however, may be extremely conservative as regas capacity in China is set to grow to 40Mtpa by 2020, and incremental announcements like the one mentioned in the previous paragraph from companies like Cnooc and PetroChina could provide even further upside. Just as investors underestimated the ability of China’s insatiable appetite to transform basic materials industries like iron ore, investors seem to be discounting China, India, and South America’s ability to do the same in the more nascent LNG industry. The consumption side of the LNG equation is beginning to transform, with shipments to India up ~23% and those to China up ~53% yoy in 2009, new regions like Brazil and Argentina taking deliveries for the first time ever, and long-term substitution of gas and LNG for fuel oil as a power source occurring across Europe and Asia. Natural gas consumption comprises less than 4% of China’s primary energy demand, substantially less than coal at 68% and crude oil at 19%. ( http://www.dowjones.de/site/2010/03/prospects-for-chinas-naturalgas-industry-grow.html ). The country just started to import natural gas in 2006, and imports already approached 7% of the nation’s total gas supply last year. This implies that only ~.3% of China’s primary energy consumption was comprised of natural gas imports in 2009; a theoretical shift towards just 3% of the country’s energy consumption consisting of natural gas imports implies a tenfold increase in imports from current levels. The following recent article highlights the impending explosion in Chinese gas demand, as “much as China's blistering car sales spur gasoline demand, its frenzied property boom bolsters demand for gas.” (http://www.reuters.com/article/idUSTRE62G0UM20100317)The most compelling way to play the emerging LNG theme is to buy shares of InterOil (NYSE:IOC), an integrated energy company in PNG with in excess of 8.2 tcf of certified 2C natural gas resources and 156.5 million barrels of condensate, a total of 1.52 billion barrels of oil equivalent. Australian investors seem to recognize the value of natural gas resources, as coal seam gas companies have displayed parabolic uptrends over the past several years. Origin Energy Limited (ASX:ORG) has appreciated >1200% in the past decade and now sports a $13.5 billion market cap, Arrow Energy Limited (ASX:AOE) has appreciated 3400%, and Pure Energy and Queensland Gas were acquired by BG Group for substantial premiums. I surmise that if InterOil were listed on the Australian Stock Exchange, the stock would currently trade at >$200 per share (and it would still be too cheap!), as Australian investors have a much better grasp than US investors of the value of concentrations of economical natural gas resources in remote locations that could be devoted to exports.InterOil’s cost advantage over competing CSG resources is in the vicinity of $4/mcf. Liquid Niugini’s proposed 2 train liquefaction facility will produce approximately 1200 mmcfgpd. With this level of production, a conservative $3/mcf cost differential (including F&D, production, etc…), a 20 year project life, and a 10% discount rate on future cash flows implies that the NPV of InterOil’s gas exceeds that of CSG (assuming 8.18 tcf) by $11.19bn or ~$1.37/mcf. Hence if average CSG transactions are being consummated at >$1.50/mcf, InterOil’s gas in Elk/Antelope should be worth >$2.87/mcf or $300/share (this excludes the value of the condensates and nets out Interoil’s 57.5% stake in the resource) to a strategic partner or acquirer of the assets.
Since InterOil’s liquefaction terminal will not begin to export gas until 2015, the current excess supply of LNG is irrelevant to its project’s appeal to buyers. Offtake agreements are being struck today in order to fill in the progressively increasing supply deficit beginning in 2015, and current demand trends are moving in the right direction in the most important regions for future consumption growth. InterOil has the lowest cost gas production in the world, government approval for its project, and a straightforward and economical liquefaction project plan. I understand the difficulty investors have in grasping the concept that such a small energy company can undertake such a monumental endeavor, but all of the difficult obstacles are behind it, and I find it unfathomable that deals won’t be struck with all of the critical criteria having now been fulfilled (government approval, discovery of adequate resources, third party certification, and Pacific LNG’s hiring of Henry Aldorf). There are many companies around the world that have sufficient excess capital to fund the equity portion of InterOil’s project themselves, so InterOil’s assets have tremendous market value even if you arbitrarily assume that management won’t be able to execute. As I mentioned in my prior post, however, I strongly believe that InterOil’s management team is one of the most diligent, honest, and competent of any that I have encountered in my career, and they are highly motivated to close deals with the vertical section of Antelope 2 and government approval now behind them. Some skeptics thoughtlessly extrapolate upon a lack of deals and hence conclude that no deals will be struck in the future. Others witnessed the Elk 2 dry hole and hastily lost confidence in management. But if you just open your eyes and exert some objectivity, you’ll be forced to acknowledge that InterOil’s discovery of 1.52 billion barrels of oil equivalent comprising gas and condensate resources in just a few years has been a heroic achievement, and its government project approval and certification update, which fulfill the final criteria necessary to complete deals, only just occurred in the past several months. This is a very unique investment opportunity with a massive value discrepancy and a slew of upcoming catalysts to close the gap.
Disclosure: Long IOC common stock, Long IOC call options