Strategic impetus of investing in LNG projects

Kiran Somanchi's picture
Kiran Somanchi, Senior Exploitation Engineer, Birchcliff Energy Ltd
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We know there’s money to be made in LNG. Take the abundant levels of gas from North America and sell it to the key importing regions, like Asia or Europe, looking for more supply. Pretty simple stuff, but how do independent natural gas producers partake in the upcoming LNG boom?

To answer that question, let’s investigate the cash flow profile and economics of an LNG project. Suncor published the funds flow from operations (FFO) profiles for various North American plays ranging from mining to light oil. Cash flows from mining projects tend to be like that of utilities: large upfront initial investment (indicated by the trough) followed by long, stable, dividend-like payouts increasing over time. Project life ranges from 20-50 years and requires lower sustaining capital as there is virtually no decline.


Source: Suncor, Investor Relations, July 2018

LNG projects have a similar FFO profile to utilities and mining. Both projects require billions of upfront investments; decline rates are virtually zero as supply contracts are typically locked in for 20 years; there is no recovery factor or reservoir risk; and once the project is paid out, the owners receive steady payouts just like dividends. The table below tracks the estimated RORs of various international LNG projects, most of which are under 15%. Essentially, E&Ps are foregoing high returns of upstream for the long, stable cashflows of a utility, albeit at a lower rate of return.


Source: Structuring LNG Tolling Agreements, King & Spalding, May 2017

That presents an interesting conundrum: why forego the double-digit returns of upstream to invest into lower return projects like LNG? The traditional answer was to monetise stranded upstream gas assets. Gas assets in North America are not stranded in a strict sense, but rather represent a long-term arbitrage opportunity for future growth. The 2x2 matrix below plots Market Growth vs. Market Share.


Now imagine you run an energy company with a strong geographic concentration in a specific play like the Montney or Permian. You possess a strong competitive position with a large market share. Offsetting land has been primarily locked up by competitors who can operate at a lower cost. The prospects for future organic growth, apart from M&A, are limited. You are cashflow positive and do not have many options apart from paying down debt, buying back shares or increasing dividends. The low commodity prices don’t really justify production growth. Funds generated by cash cows is better invested in long-term projects like LNG which earn a lower return but provide scope for future, stable growth over the next 40 years. This, in a nutshell, is LNG.


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