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Playing Devil's Advocate with Golar LNG ?3


Preface

Although almost all of my liquid investments are still in individual stocks and their derivatives, my return on capital didn't really take off until I put a significant portion of my analytical effort into macro analysis - factors that are non-specific to a specific company.  Over the last decade as a full-time investor, this focus has proven to be of tremendous value both for identifying new opportunities and risks that would otherwise go unnoticed.  Golar LNG is one of the many stocks I cover in my long service as part of my belief that the the reshaping of energy markets presents perhaps the greatest investing opportunity of this generation.  Although I am bullish on GLNG for the near-term, this article will focus on why I think the market may be under-appreciating the long-term risk it embodies.  Furthermore, I will assume that readers are already familiar with bull case, though one update distributed via my service earlier today may be worthwhile:

Two pieces of news this morning make it look increasingly likely that Golar will get the go-ahead on the Tortue project.  The first is BP's earnings call, where we heard the following at 19 and 22 minutes into the Q & A, respectively:

in terms of LNG and FIDs, I wonder if you could give an update on Tortue LNG. What's still missing? Will BP be the sole off-taker has the development plan be approved and what when exactly do expect to take FID?

In terms of the Tortue project, the project entered its feed in April 2018. And we're still targeting FID by the end of '18 and first gas in 2022. The project was targeting first phase of about 2.5 million tonnes per annum. And then we've got a further 2 phase to test it up to a further 10 million tonnes per annum. We've got nothing left to update on that. We still expect FID this year. And I'm sure Bernard will have some more to talk about that in December at the Investor Day in Oman.

Furthermore, a Chinese firm has just confirmed a contract for a platform at the site.  This makes it seem quite likely that the Final Investment Decision from BP will go Golar's way.

As I see it, risks associated with Golar LNG fall into 4 main categories: Geopolitical, Shipping, LNG-specific, and Stock Market.

Geopolitical

Geopolitical risk is highlighted by the fact that the field developer, Perenco, still has not made a decision to start operation of additional trains despite mounting demand for natural gas.  This is almost certainly related to finances, politics and infrastructure in Cameroon, whose credit history was stable and gradually improving until a recent downgrade in outlook from Moody's.  If we were to (somewhat improperly) translate that to a risk of corporate default, it would nominally equate to over 30%.  While I think that overstates the risk, it does have relevance as a quantified measure that might impress would-be investors, and get them to remember retroactive tax troubles that Vodafone has faced in India, or the summary cancellation of AES business in Bulgaria.  Golar's incarnations would be much less able to withstand such events than either of these companies.

Similarly, the Tortue project referenced above relies on agreement between Mauritania and Senegal.  Plans for the completion and commencement of operations of the Sergipe power plant, in Brazil, will have to survive the electoral upheaval that has just taken place there.  While I have no particular reason to believe that either of these projects will not proceed, the fact remains that developing in such environments represents a significantly elevated level of risk.

Shipping

When it comes to energy my outlook for the long-term is guided by estimations on ERoEI.  Though the concept it simple, its implementation is complex and unstandardized.  Normally such effects would translate directly into pricing, but by contrast to Europe, and increasingly, much of the rest of the developing world, the Americas have long avoided pricing pollution appropriately.  This has lead to a fragmented global natural gas market, which LNG seeks to overcome.  The recent result is a frothy and reactionary shipping market.  Much of the bull case relies on extrapolating current pricing, even though the length of that dynamic is debatable as new ship supply and fuel issues are set to intensify in 2020.

Over the long-term, though studies by the University of Texas at Austin put natural gas as the cheapest form of generation, with simple turbine generation coming in at $820/kW, and combined cycle at $1020, that cost more than doubles to $2080 when adding carbon capture capabilities.  By comparison, utility solar is always competitive at $1100 and wind not so far behind at $1520.  No other solutions even come close.  In America, this gives natural gas a potentially bright future, depending on local and federal policy, but that won't help Golar.  Asia is more likely to take a holistic approach, especially if Trump's solar tariffs continue to dampen external panel demand.  Schlumberger's most recent report also indicates potential for Asian development.  Even to the extent that external sources are used, Russia and Australia would be the logically preferred sources.  

They will be followed by Canada, where Shell recently approved the LNG Canada project.  The facility will be Canada's largest infrastructure investment in recent memory and use a modular LNG train design with proven technology built in Asian yards which have recent experience delivering LNG modules on budget and on schedule.  The cost to deliver LNG into Asia is expected to be structurally advantaged compared to a greenfield development on the US Gulf coast.  My guess is that applies to the west coast of Africa as well. Construction should begin immediately, but that still means initial LNG shipments won't start until the middle of the next decade.

Developments like this are being driven by a global push to reduce pollution.  Only America is purposefully going in the opposite direction.  In Europe, the IEA predicts wind will become the dominant energy source by 2027.  Estimates on the energy used to liquefy natural gas come in around 25% of the energy being harvested.  That means that even in Europe and Africa pipelines seem likely remain the preferred modus operandi, with LNG remaining a niche market that will mostly be relegated to spot balancing of supply.

To its credit, management has said that its priorities are first FLNG, then FSRU, and only then shipping.  My best-case hope is that the GMLP Partnership will follow those same priorities by monetizing much of the fleet through asset sales.  Long-term contracts would be second-best, but they would not be long enough to fully sustain Golar LNG's multi-decade development plans and expenditures.  In this way, GMLP may turn out to be a better investment than GLNG through a flattening of the equity structure just as happened with my coverage of CQH.

LNG-specific

Another risk is natural gas' ties to oil production.  The ERoEI on natural gas is even more poorly established than the figures for other sources because of these ties.  It is generally placed in the 5-7 to 1 range, whereas oil is more like 20:1, though both are declining as easy sources are sucked dry.  This creates something of a Catch 22 for natural gas, and LNG in particular.

On one hand, oil will remain a major part of the global economy until widespread alternatives to plastics and other petrochemicals and its supply will reduce the demand for alternatives.  Even the recent U.N. report may underestimate how much that needs to change, but to the extent that fossil fuels become even more out of favor, natural gas will see lack of demand.  If the shift is one-sided against oil, natural gas production would still become more expensive.  While this doesn't impact Golar's current projects it does have relevance to its power generation and upstream aspirations. 

Let's say I'm wrong, though, and LNG does become a dominant source of global supply.  The more widespread its use, the greater the risk of incidents of either terrorist or accidental origin.  Although most comparisons of LNG tanks to atomic bombs are inappropriate, there is no getting around the fact the amount of energy in question is immense and does have catastrophic potential.  A major disaster is a possibility that increases over time and with broader use, and the effects would be likely to ripple through the entire industry.

Stock Market

That would be reflected in the market most of all, and particularly in Golar stocks.  Both are thinly traded, with GMLP managing less than a half million shares per day, and GLNG doing well under 2M.  The usual warnings about volatility and reasonable position sizes definitely apply.  A relevant factor is that Golar's contract brings in $3M per year, recognized monthly, for every dollar that Brent is above $60, up to a cap of $102 per barrel, but the recent rally in oil has been fizzling faster than many expected.  The contract is smart, but quarterly comparisons may prove challenging and produce dramatic volatility in an equity with very limited volume.

Furthermore, Golar's development plans are long-term and very capital intensive at a time when rates are rising, making funding progressively more difficult.  Despite this Golar LNG has just invested $24.75M in Avenir LNG Ltd., which is a startup focusing on delivery and storage to pockets of stranded demand.  The investment is part of a larger $182M initial funding round and Avenir "contemplates a public listing on the Oslo Over-The-Counter market during 2018."  Mention of the OTC market listing alone is enough to make me cringe, and the nicest thing I can say about this is that Golar has always been aggressive in its development, and that it is in a market where that may be appropriate, though the timing less so.  In an economic downturn, not only will energy demand decline, but  the companies that I've covered which have access to much better funding and can grow more reliably will be more in favor. 

Conclusion

GLNG has some excellent short-term catalysts in store, but the bull case may be ignoring some very significant risks.  The LNG market is benefiting from a transition in energy markets that is being temporarily focused by shifting international politics.  By definition, though, transitions are transitory.  As such, it would be wrong to read to much into current events, especially with all the bad information out there.  The extent to which GLNG is appropriately pricing short-term catalysts against long-term risks remains to be seen, and in a turbulent market where investors are right to become increasingly defensive, overly aggressive investing from both management and shareholders could still lead to calamity.  My opinion is that GMLP, with its revised and now sustainable double-digit yield, may prove to be the better investment for the medium term.  That goes doubly for the other similarly yielding options that I've identified in less volatile sectors.  Thus, even though the majority of my GLNG coverage has been bullish, I would still take 5-1 odds on Mr. Mintzmeyer's terms, should he wish to make a public wager.