Liquefied Natural Gas — Higher capacity at 8.8Mtpa, lower SPA pricing

Magnolia LNG currently has DOE approval to expand export capacity to 8.8Mtpa to countries with FTA agreements with the United Sates, a 0.8Mtpa increase from the DOE’s initial FTA approval orders. Management expects FERC approval and non-FTA consent for 8.8Mtpa of export capacity to be received in the coming months.

Magnolia LNG has proposed to construct up to four liquefaction production trains, each with a capacity of 2.2Mtpa or greater using LNGL’s patented OSMR process technology. Further details on plant location and OSMR can be found in the video embedded below.

Based on latest released LNGL quarterly reports and company presentations we have updated our modelling of Magnolia LNG to reflect increased export capacity, plant efficiency of 8% (company guidance range 6–8%) and now base economics on a sale purchase agreement (SPA) rather than a tolling fee arrangement.

The SPA terms that drive our valuation model are outlined below:

Based on the current spot HH price of US$2.50/mmbtu, this equates to a total fee net of gas cost and own use gas consumption of c US$2.50/mmbtu, which is marginally lower than the US$2.75/mmbtu we had previously modelled. Also under the terms of an SPA, LNGL will have the ability to secure favourable basis differentials increasing its net margin. We do not include potential ‘trading’ gains in our valuation.

Key drivers of Edison’s Magnolia LNG valuation are described in the table below:

Changes to Edison’s valuation from our last published note are highlighted below:

We value both the Magnolia and Bear Head LNG projects on a leveraged basis, assuming that project debt financing, in addition to Stonepeak’s US$1.5bn preferred equity commitment, is priced at 6.5%. We discount leveraged free cash flows at a project level using a 10% cost of equity. In order to account for corporate costs not included in our LNG asset models we make deductions for SG&A and project overheads netted against existing cash available to fund pre-FID costs.

As discussed earlier in this note, the positive valuation impact of increasing Magnolia capacity to 8.8Mtpa is offset by our assumption of lower SPA pricing. A key component of negotiated offtake SPAs will be the UFC that LNGL is able to command. Increasing competition from projects within the US LNG pipeline and those receiving FERC approval is likely to put pressure on this price component.

We provide a sensitivity to this key driver in the table below. As would be expected, a small absolute change in UFC has a material impact on Magnolia leveraged NPV and IRR (we use a 10% cost of equity).

US LNG trade is starting to have a marked impact on global gas pricing, with the US share of European LNG imports rising from 0% in 2015 to over 10% in 2019 (12.6% to March 2019). Growth in LNG spot volumes combined with warmer usual temperatures in the Northern Hemisphere led 2019 winter spot LNG prices to fall to multi-year lows. Low prices were also supported by a build in Chinese volumes in storage ahead of winter and strong Norwegian flows as well as a higher than average wind power contribution in to Europe.

Exhibits 6 and 7 illustrates growth in US exports directed to the EU as the Asian spot price premium was insufficient to support the freight cost delta between the EU and Asia, and the impact of a China-imposed 10% tariff on US LNG imports, recently upgraded to 25%. In the longer term, Asian LNG demand growth expectations remain robust with Chinese LNG imports expected to grow from c 54Mtpa in 2018 to over 90Mtpa by 2025 in support of the state’s mandated plan to replace coal power generation with gas in a drive to improve air quality. Uncertainty around the duration and magnitude of Chinese import tariffs remains an uncertainty.

This demand is to be met through a variety of sources, with the Chinese state recognising the value of diversification given the backdrop of lingering US trade talks. In May 2019, two state-owned Chinese companies (CNPC and CNOOC) signed agreements to participate in Artic LNG2, acquiring a 10% stake. Chinese LNG imports by source are shown in Exhibit 8, showing current diversity in the LNG supply mix; in addition to LNG, piped gas supply to China is dominated by Turkmenistan, Uzbekistan and Russia.

We continue to believe that LNGL’s major shareholder IDC Energy (a 9.9% shareholder in LNGL) should provide LNGL with valuable financing and customer relations in the Chinese market.

Exhibits 8 and 9 show recent evolution in spot LNG pricing; under the SPA terms assumed in our base case valuation, a purchaser would be paying c US$5.3/mcf (free on board) at current spot Henry Hub. This is US$4.8/mcf below the 2018 average Northeast Asian spot price and US$9.6/mcf Brent indexed pricing (13% slope). Current Asian spot pricing is close to the long-run marginal cost of US LNG, suggesting that the market was oversupplied over the 2019 winter.

We recognise that weakness in current spot markets, and a material increase in the US LNG FERC approvals are likely to increase buyer power when negotiating SPA commercial terms.

Industry forecasts of global LNG supply and demand indicate a potential supply shortage in the mid part of the next decade, a gap Magnolia and Bear Head LNG could look to fill. In the short term, oversupply and a pipeline of US LNG projects moving towards sanction are likely to put pressure on LNGL’s negotiating power; investors will need to take a view on the pros and cons of accepting lower SPA pricing or waiting for market conditions to improve. Given the sensitivity of equity returns to SPA terms, we believe a patient approach to SPA negotiation is prudent, but project delays increase the pre-FID overhead burden and potential dilution if equity investors do not participate in equity placings required to cover pre-FID costs.

US-China trade talks have added an element of uncertainty to the signature of offtake agreements for Magnolia. China’s decision to increase import tariffs on US LNG from 10% to 25% will probably have minimal impact in the short term, other than being negative for investor sentiment. We believe that China’s retaliatory increase in LNG import tariff announced in May 2019 is likely to be temporary, as it will ultimately lead to higher gas prices for Chinese domestic consumers as the global LNG market swings towards a supply deficit.

As shown in Exhibit 7, the 10% tariff put in place last year has led to a significant reduction in US LNG trade with China. China received 18 LNG vessels from the US in H118, decreasing to nine vessels in H218 and only two in H119. In the short term, China’s move to further increase tariffs is likely to have little impact on inter-country energy trade.

While the current trade war increases uncertainty around Chinese demand for US LNG, offtakers may use this backdrop as an opportunity to secure long-term SPAs at discounted prices. China is rapidly increasing its LNG imports and will soon become the world’s biggest LNG importer, overtaking Japan. Ultimately, we expect China to source gas from a wide range of sources, including the US once an amicable trade solution is reached. Given that the US is the greatest component of global LNG supply growth and China the greatest component of global LNG demand over the next decade, we feel amicable trade is in the interests of both parties.

As of 31 December 2018, LNGL had A$33.2m of cash, and enough capital to support ongoing SG&A and pre-FID engineering costs for an estimated nine to 12 months. The last 12-month (LTM) cash SG&A expense stood at A$14.5m (including share-based payments) and project development overheads (not included in Edison asset models for Magnolia and Bear Head) stood at A$14.5m. We believe further delays to Magnolia FID could drive LNGL to raise further capital in order to cover pre-construction costs.

In 2015, LNGL secured a binding engineering, procurement and construction (EPC) contract with KBR for Magnolia LNG at a fixed capex of US$4.4bn for the first four operational trains. The EPC contract has a six-month pricing adjustment mechanism, which is due to be re-evaluated in June 2019. We note that recent re-evaluations (last September 2018) have not led to an increase in project capex.

Under the current agreement, Stonepeak is to provide equity funding of up to US$1.5bn for the project in return for a preferred interest in Magnolia with a fixed coupon with pay-in-kind provisions during construction. The tenor is set at 12 years and is redeemable at Magnolia’s discretion after three years of operation (there are no equity conversion features). Debt funding for Magnolia is still to be secured; we currently assume a 70:30 debt to equity funding ratio with debt priced at 6.5%. Our Magnolia funding assumptions remain unchanged from our last publication.