Liquefied Natural Gas — Moving towards FID in 2018

Company description: Mid-scale LNG development

LNGL is developing LNG export terminals in the US and Canada. Its main asset is the 8mtpa (or greater) Magnolia LNG project on Lake Charles, while Bear Head LNG is an 8-12mtpa development in Nova Scotia. LNGL’s proprietary OSMR (optimised single mixed refrigerant) technology is a patented, mid-scale liquefaction technology, promising lower capital and operating costs. The company is currently working hard to get the Magnolia LNG project to financial close and FID by the end of CY18, with start-up in CY23.

Financials: Magnolia should be funded

LNGL has an agreement with KBR (leading a joint venture with SK E&C) for a lump sum turnkey contract for the 8mtpa Magnolia project for US$4.354bn. We expect this to be 70% debt funded, with the remaining 30% or so coming from its equity partner, Stonepeak Infrastructure Partners. Funding of the Bear Head project is less certain, although we expect similar debt structuring capacity. The ability of LNGL (and partners) to attract suitably priced debt funding is key to the value the projects will generate for shareholders. The move by BNP Paribas (former debt co-ordinator) to exit all oil and gas investments in 2017 was a set-back, but not a major one in our view. The company will likely need to raise equity in the next 12 months to fund project development costs and marketing costs.

Valuation: Current US$3.23/ADR should grow

Although we refer to other techniques, our primary methodology continues to be using risked DCF analysis. The predictable and consistent cash flows from the project (once up and running) should enable high debt funding levels and healthy dividend distributions, allowing comparisons with utility-type peers in time. The current share valuation is contingent on various factors, not least LNGL’s ability to reach financial close for its projects and, around four years later, start and operate them successfully. Unfortunately it has taken a number of years longer than originally anticipated to progress the project, as regulatory timetables coincided with a depressed LNG pricing and supply/demand environment. This picture looks to be brightening of late.

We currently value LNGL at US$3.23/ADR, applying a 60% risk to Magnolia and 15% to Bear Head. Even assuming just Magnolia, this could rise significantly once the project starts based on P/E, EV/EBITDA and dividend yield.

Sensitivities: Predictable cash flows once started

The overriding consideration for investment in LNGL is its ability to get the projects to sanction – despite a marked change in oil prices and dawning realisation by industry players that LNG supply/demand will shift in four to five years, the shares have not picked up materially. Investors are waiting for binding tolling agreements to be signed which we think will happen in 2018.

The structuring of the financing is also key as investors could see large swings in valuation depending on the amount of debt it can attract, while the prices negotiated for the tolling fees (or SPAs) will also have an impact. The larger the debt facility (and lower the costs), the higher the equity returns for the partners. Our modelling indicates an unlevered project IRR in 2018 of 11% (and levered equity cash flow IRR of 17%, assuming 70% debt).

Liquefied Natural Gas Ltd (LNGL) is focused on efficient, mid-scale LNG developments, which are expected to have significantly lower capex/opex costs than existing technologies. The company is currently developing two LNG liquefaction plants in North America, the 8mtpa capacity (or greater) Magnolia LNG plant (Louisiana) and 8-12mtpa Bear Head project (Nova Scotia). The company has shares listed on the ASX and ADRs in New York. A full US listing is currently on hold.

LNGL’s OSMR liquefaction technology is patented in all major markets and promises to deliver lower capex and opex costs than comparative technologies. Although commercially new as a full application, it is a novel combination of a number of existing solutions reducing risks.

OSMR is the integration of three proven technologies/processes: single mixed refrigerant process (the oldest LNG liquefaction technology), combined heat and power (which is used extensively in the power industry) and ammonia refrigeration (which is one of the most used refrigeration technologies in industrial applications). Furthermore, a number of studies have been executed by third parties, including by CH-IV (2008), Foster Wheeler (developer of multiple LNG systems globally), Arrow-WorleyParsons (2009 and 2010), and HQC and Consultants (2010). A report was also issued by SK E&C in June 2009, and updated in 2013. This concluded that OSMR should be highly reliable and provide good utilisation.

Furthermore, the involvement of KBR (in a JV with SK E&C) as the contractor should be a considerable comfort. It is putting its own balance sheet behind the project and has guaranteed minimum production. The JV will be responsible for the execution of the turnkey projects at Magnolia and be responsible for the timing and budget (and open to liquidated damages).

LNGL’s technology is believed to be very competitive with other techniques, producing a much lower NPV10 breakeven than other projects. The very low risk to gas supply and low prices for delivered LNG mean that Magnolia should be very attractive to offtake partners.

According to the company, capex for conventional technologies (which we interpret as single, double and propane-precooled mixed refrigerant systems) are around US$1,000/tpa, while the OSMR for trains 1 and 2 is significantly lower (US$549-628/tpa). Plant efficiency should compare well with other technologies, with lower fuel usage leading to a material improvement over a single mix refrigerant process. The smaller train sizes (vs those typically used by Shell/BG for example) allow a modular development and enable a company such as LNGL to be a credible developer.

Patent protection and licensing

LNGL’s patents could lead to valuable future licensing fees. These pale in significance compared to the returns from project equity ownership but could provide useful, cost free, revenues. The management continues to market the project (and technology) globally and is very open to licensing the technology to the right partners.

Magnolia and Bear Head are well placed to take advantage of the shale gas boom in the US and Canada, where fracking has utterly changed the gas supply picture. Massive existing infrastructure, increasing technological progress and available capital has seen a huge surge of gas production, substantially reducing and stabilising prices.

In this environment, the US has the potential to provide gas to LNG export schemes without risking major price increases. We anticipate that Magnolia could be fed by the Haynesville and Eagle Ford shale gas plays via Kinder Morgan’s Louisiana pipeline (with which LNGL has executed a binding capacity precedent agreement), with areas further afield also possible.

Bear Head will likely be supplied via the company’s Bear Paw pipeline, which offers a path for gas to flow to the site. It would connect Bear Head to Goldboro (where the Maritimes and Northeast pipeline terminates, meeting the Sable Island pipeline). The 62.5km pipeline is fully permitted.

LNG supply, demand and pricing

We do not forecast LNG supply/demand, but note that many independent sources point to a rebalancing of supply/demand by 2022-23, after which time new supply will be needed. Given LNGL’s low-cost approach, it should be well placed to have economic returns from development.

The recent increase in Brent pricing has seen LNG increase in concert. The forward gas curve has continued to lower and flatten, implying increased arbitrage opportunities for shale gas-based LNG.

For a tolling partner, Magnolia(n) LNG would cost approximately $7/mcf, (made up of source gas (US$2.9/mcf in 2023-24 forward prices), tolling fee of c US$2.5/mcf and transport costs of US$1-2/mcf). Given the current LNG prices of c $10/mcf, this would make trading very attractive, giving us comfort that LNGL will be able to negotiate long-term contracts in 2018.

LNGL continues to progress its marketing efforts, as can be seen in Exhibit 3.

The Magnolia project is a four-train, 8mtpa LNG plant planned to be built on a 115 acre plot in the Port of Lake Charles, Louisiana (adjacent to the existing LNG channel). The plant will use LNGL’s proprietary OSMR process liquefaction technology. A binding 20-year pipeline capacity precedent agreement was signed in 2014 with Kinder Morgan Louisiana Pipeline (KMLP). The site itself has a lease for 30 years (potentially extendable to 70 years) and the project is construction ready.

A binding lump sum turnkey (LSTK) with KBR (& SK E&C) has been executed, fixing capex at $4.354bn for the first four fully operational trains (excluding other costs of 13.5-15.5%) – this is currently valid until mid-2018, although we would not be surprised if it was extended again.

LNGL is partnering with Stonepeak Infrastructure Partners on Magnolia. Stonepeak will provide the equity required (US$1.5bn) to develop the project, while debt funding will need to be sourced. An agreement with BNP Paribas fell through after the bank declared in 2017 that it would no longer fund any oil/gas developments. The management is confident that it will be able to secure funding through other sources.

Project timing

The project development timing has continued to slip. We now model financial close – originally scheduled for mid-2015 – in late-2018. The next steps are:

LNGL bought the Bear Head site from Anadarko in August 2014 for US$11m. Under Anadarko, the site was originally developed as an LNG import terminal but was mothballed in 2007. All permitting and approvals had been granted and civil works had reached an advanced stage – for example, roads, utilities and foundations for two 180,000m3 LNG tanks are complete.

The site is large (327 acres vs 115 at Magnolia) and the company has ample space for 8mtpa (two phases). Indeed, it has filed applications with the Canadian authorities for up to 12mtpa of capacity. We assume that first gas is in mid-2027, which is later than management guidance of 2024-2025, as we assume FID after Magnolia first gas.

We expect the development of Bear Head to cost a similar amount to Magnolia. While much of the civil works are complete, the harsher climate may require greater protection against the cold winters. To balance this, the yield of LNG could well be greater, increasing efficiency and reducing overall costs.

Bear Head will likely be supplied via the company’s Bear Paw pipeline, which offers a path for gas to flow to the site. It would connect Bear Head to Goldboro (where the Maritimes and Northeast pipeline terminates, meeting the Sable Island pipeline). The 62.5km pipeline is fully permitted. We note that Bear Head LNG continues “to market capacity to all three potential gas paths: US, offshore Nova Scotia; and Western and Central Canada.”

The source of equity funding for Bear Head is unclear at the moment. We assume a similar structure of funding as Magnolia, although there is currently no equity partner. Magnolia cash flows are not likely to come through until 2023, which would mean that using these to fund development at Bear Head would necessarily require an FID after this date.

Commodity risk: Should binding tolling agreements be signed, the company should have no direct exposure to commodity risk, while operating costs movements should be largely mitigated by tolling fees. However, if SPAs are used at Magnolia, the company would be more exposed to movements of Henry Hub (HH). As we note elsewhere in the note, the futures curves of HH has lowered and flattened over the years since fracking was introduced.

Financing risks: LNGL needs to secure the funding for the development of the projects. For the 8mtpa Magnolia project, this is US$4.4bn (gross excluding other costs, $5bn including other costs, but excluding capitalised interest). Of this, we assume $1.5bn is funded by Stonepeak, with the rest funded through debt. Without this funding, the Magnolia project’s (and hence LNGL’s) value could be uneconomic or severely compromised. We assume that the project is 70% debt funded at an interest rate of 6.5%. If debt cannot be found at this level then the NPV of LNGL’s stake could fall materially.

Technological risk: the OSMR process has received the technological approval of KBR and SK E&C and has the tacit confidence of a range of companies. The contractors will provide performance liquidated damages for capacity should the technology not deliver the modelled efficiencies and KBR has guaranteed 92% efficiency (implying 8% fuel used in process). The tolling term sheets also require that Magnolia provides minimum production – if this is not achieved, the plant could suffer financial penalties.

Cost escalation risk: cost escalation risk is well mitigated if tolling agreements can be signed quickly. LNGL has a turnkey contract with KBR that is valid until 30 June 2018. Although we are optimistic that the contract will be renewed, there is no guarantee that the cost will be the same and there is therefore a risk of escalation.

Protection risk: LNGL has patent protection for OSMR in 16 countries including the US and Canada (countries where its projects are currently located), and the majority (if not all) of consumer countries (including Japan).

Partner risk: the success of the LNGL projects is reliant on many parties, whether for providing equity finance, arranging debt finance or signing binding tolling agreements, constructing the plants (KBR and SK E&C) and transporting the gas (Kinder Morgan). Partners involved so far (Stonepeak, Meridian and KBR) have been happy to renew contracts and agreements as required.

Tax risks: Magnolia is subject to federal and state taxes, which we assume to be 25% over the life of the project (including tax holidays and breaks), with a 2% land tax (2% of asset value, with a five-year tax break extendable for a second five-year period). For Bear Head, we apply the 31% corporate tax rate (including state tax).

LNG pricing risks: our base case assumption is that all LNG is sold to FTA-approved countries but it does have non-FTA approval, enabling to sell worldwide (widening its reach and hopefully revenues).

We think the board is strong, particularly the experience of Greg Vesey (CEO), Paul Cavicchi (chairman) and Phil Moeller (non-executive director).

LNGL key personnel

Paul Cavicchi (chairman) has over 25 years’ experience across a range of gas and power projects, including development and construction of LNG infrastructure. Paul’s most recent executive position was as executive VP of GDF SUEZ Energy North America where he supervised and directed all business development efforts for the company in North America. Previous roles include president and CEO of SUEZ Renewable Energy.

Greg Vesey (CEO) joined as MD and CEO in April 2016, based in Houston. Greg has held senior executive roles in the international energy sector through a distinguished career of 35 years with Chevron and Texaco. Most recently, he was president of Chevron Natural Gas and VP, gas supply and trading, from 2011 to 2015. In this role he was responsible for Chevron’s global LNG, natural gas and natural gas liquid marketing and trading activity and was based in Houston. Other roles include president of Chevron Global Power and at Chevron Technology Ventures. Greg holds a bachelor of business degree from Northwestern State University of Louisiana.

Mike Mott (CFO) joined the company in September 2014. Before joining LNG, Mike held a number of senior finance, strategy and operations roles at BG. He held progressively senior accounting and risk management roles at Dynegy from 1995 and was previously at PwC.

Joseph B’Oris (CDO) began his career at Getty Oil (later acquired by Texaco). While at Texaco, Joe was responsible for all commercial activities on the Sabine pipeline (owner/operator of Henry Hub). He served in leadership roles in various LNG projects across the world for Nexen Energy/CNOOC, Shell, Marathon, and Jordan Cove LNG, where he was responsible for commercial and business development activities.

John Baguley (CTO) joined LNGL in May 2014 as the Magnolia LNG COO based in Houston, moving to CTO in November 2015. John brings over 30 years’ experience in the successful delivery of front-end engineering design and EPC services for major LNG plants and projects worldwide, including serving as a project director, project manager and engineering manager for some of the world’s most challenging facility locations (primarily at KBR for 33 years).

Non-executive director: Phil Moeller is a former commissioner of the Federal Energy Regulatory Commission (FERC). He was the second-longest serving member in the history of FERC and the only person in the federal government in a senate-confirmed position who was nominated by both President George W. Bush and President Barack Obama. He focused on policies that encouraged the construction of additional electric transmission and interstate natural gas infrastructure and policies promoting well-functioning wholesale markets.

Project financing cost

The key to how much of the project’s value current investors will be able to retain is the level of debt that can be raised for development. With 30% already covered by the Stonepeak agreement (see below), we assume debt will cover the rest. However, if this is too optimistic new funding sources may have to be found, diluting current shareholders’ interests.

For simplicity, we model that all debt is provided by a bank facility and that this is paid off as quickly as possible with project free cash flows. This will almost certainly not be the case – Cheniere has raised c 80% of its debt through bonds, with the remaining 20% as a bank facility. As a result, our modelling (with dividends paid only after all bank debt is paid off on a project basis) will likely lead to a later (and higher) dividend stream than will probably take place.

The Stonepeak agreement (originally made in 2013) was renewed and extended in July 2017 and provides that Stonepeak will contribute equity funding of up to US$1.5bn for the project (which should cover all required equity funding). In return, it will receive a redeemable preferred interest in Magnolia with a fixed coupon with pay-in-kind provisions during construction. The tenor is 12 years and it is redeemable at Magnolia’s discretion after three years of operations. There are no conversion features into Magnolia or LNGL shares.

We assume that the rest (70%) of the project financing will be achieved through debt and at an effective interest rate of 6.5%. This is higher than peers are trading on (on a yield-to-maturity basis), including Cheniere. As a result, as long as LNGL delivers the projects as promised, we think 6.5% is a fair/conservative assumption for the moment.

Company financials

At December 2017, LNG had cash resources of A$33m, annualised administration expenses of c A$16m and spends around A$5m every six months on project development (expensing for the moment). At this level of spend the company will require further capital in 2019 assuming no offtake is forward sold; our base case assumes any capital raise is executed at the current share price which would be dilutive for shareholders.

We assume FID is taken on Magnolia at the end of CY18, and this should catalyse a payment from Stonepeak adding short-term capital for LNGL. After sanction/FID, the project should be largely funded by Stonepeak and debt, with little equity required from LNGL. It will need to pay for G&A in this period however until first production and cash flows.

Our DCF approach is one used across our oils coverage and, given the steady predictable expected EBITDA across the LNG projects, should be applicable for the valuation of LNGL. We then apply a risking to account for various factors before the projects’ start-up (such as uncertainty over possible delays and uncertainty over reaching FID/sanction).

Major assumptions

Our modelling assumptions produce an unlevered IRR for Magnolia (gross) of 11% in July 2018 (17% levered), so the value for shareholders depends to a great extent on the inputs we use. Increase in debt facility/lowering of debt rates/increasing tolling fees achieved/decreases in final capex bills and other factors all have a very material effect on this valuation. We also caution that our risking is very subjective and we would urge investors to be comfortable with their own view on project progress.

Historical pricing multiples for peers

With stock markets at historical highs and multiples continuing to expand, we urge investors to look beyond current multiples to ensure that long-term investment retains a margin of safety for returns. LNGL’s peers/comparators have traded on a wide range of multiples in the last 25 years, depending on interest rates and overall investment sentiment. As a result, investors should be aware that current multiples are not consistent over time and are well above historical norms/averages.