The Massif Capital Review volume 1, No. 1 for the month of January-February 2017, titled, “LNG.”

Investors are regularly confronted with a challenge when evaluating growth. It is frequently difficult to differentiate between growth that creates value and growth that destroys value. Although conceptually straightforward, any growth that occurs in which the cost of capital exceeds the return on the capital expended to achieve the growth is value destructive, the idea that growth is not always a positive often befuddles investors. When combined with the tendency of the investing community to drift from one growth driven infatuation to another, the fact that markets swing like a pendulum from overzealous buying to despondent selling is unsurprising.

The value of growth is even harder to evaluate when projects have extended timelines, which delays corporate feedback on profitability, increasing management reliance on forecasts. The commodity super cycle from the mid-2000s to 2012-2013 is a clear demonstration of the many issues with a growth at any cost mindset. Chinese-led demand growth for iron ore, coal, zinc, and numerous other industrial commodities resulted in a significant increase in mining profitability. Return on capital employed within the industry rose from around 7.5% at the turn of the century to a 35% in 2005 and remained high throughout much of the decade including in the wake of the financial crisis.

The understandable response by mining management was overconfidence; an assumption that good results were a because of their managerial skill rather than a consequence of uniquely favorable industry conditions. Capital allocation decisions were driven by overly optimistic demand forecasts anchored to recent experience with Chinese demand, and decisions were tainted by what Daniel Kahneman referred to as the inside view, which is when individuals in a group focus on “specific circumstances and search for evidence in their own experiences.” The reflexivity of markets is lost on those taking an inside view.

The result of these corporate actions: projects started, and capital investments made, that would not be operating (providing feedback to the company) until the operating environment changed. The outcome of these decisions well captured by figure one. ROCE for mining firms was high, investment ramped up, the cycle turned and profits dipped. The life of mines is long, so determining whether or not the dollars invested by management from 2005 to 2013 will yield more than a dollar in the marketplace (a core test for any business) over the next decade will not be known for some time, but the failure of management to take into account the industries changing asset base (an outward shift in the supply curve) and put a check on capital expenditures is surely responsible for much of the pain they have experienced over the last three to four years.

Timelines and capital expenses in the Liquid Natural Gas (LNG) industry are similar to the mining sector; and like the mining sector between 2005 to 2013, the LNG industry has also experienced a boom in investment. In Australia, the LNG industry in the last decade have started or is constructing a total of 9 LNG terminals, with an output capacity of 24% of 2015 global liquefaction capacity, the total cost of which is expected to be $152 billion, or roughly $50 billion more than initially budgeted. The cost overruns are likely to extend the payback periods for projects many years, if not decades.

LNG

Meanwhile, throughout the rest of the world, roughly 88 million tons per annum (mtpa) of liquefaction capacity (excluding the 75 mtpa discussed above) is being constructed and expected to come online over the next four years. In total, the projects above will boost global liquefaction capacity by 53%. Since 2011 demand has grown 10% but much of that growth (about 20%) comes from Japan as a result of that countries decision to shut down its fleet of Nuclear reactors following the 2011 Fukushima disaster. In the last two years, Japanese LNG demand has shrunk as nuclear reactors have started to come back online, to date 3 of 54 reactors has restarted with 23 reactors progressing towards restart. The impact on Japanese demand from restarting those reactors is unclear, but unlikely to be positive.

Compounding the problems associated with the global boom in LNG investment has been the rising capital expenditures related to the construction of a ton per annum of liquefaction capacity. In 2003 it cost roughly $300 to construct a ton per annum of liquefaction capacity, the cost is now $1,200 per ton per annum, a fourfold increase. The increase in LNG construction costs, according to the IHS CERA Upstream Capital Costs Index, is roughly double the cost increase associated with other upstream oil and natural gas facilities. Although all the firms in the space will see absolute growth in revenue, the costs related to achieving that growth have increased at rates which will make it difficult to earn a return on.

The ROIC for new LNG projects remains to be seen, but at the current time, the slump in oil prices appears to have significantly dented the potential of most, if not all new projects. LNG pricing remains highly regional with different pricing dynamics, but regardless LNG prices have suffered a downward trend globally over the last few years. LNG out of the US is tied to Henry Hub Natural Gas prices, and as such has been forecasted for many years to be a cheap source of LNG for Asia, where LNG prices have historically been tied to oil prices. Since 2014 the oil-indexed LNG contracts have seen significant price depreciation, and some grumbling by buyers who have long-term contracts that did not respond to the drop in the price of oil as much as may have hope for.

In recent months spot prices for LNG have fallen as low at $5.14/MMBtu in Europe and $6/MMBtu in Asia. Most projects are unlikely to recoup invested capital at those rates let alone turn a healthy profit. In the United States, most final investment decisions were made by management when Japanese LNG prices were north of $12/MMBtu, in 2012 prices peaked at $18.07/MMbtu. According to the Japanese Ministry of Economy, Trade, and Industry, in February of this year, the average price for spot based LNG imported into the country was $8.5/MMbtu. One is hesitant to forecast this trend continuing, but the continuation seems as likely as the reversal, which is the crux of the issue.

Management for many oil and natural gas companies spent billions of shareholder’s dollars on projects with dubious ROIC profiles except in very well defined circumstances. The question now becomes can the winners be separated from the losers, or is the whole category to be written off until the market digests the growth and the pendulum swings from exuberance to despondency?

Golar LNG (GLNG): Midstream Giant or Pipedream?

Golar LNG is one of Wall Street’s favorite LNG plays and what’s not to love: the share count has grown at a CAGR of 6% a year, free cash flow has averaged (-$338) million a year for the last decade and the Altman Z-score (a measure of potential bankruptcy risk) has been signaling distress for all but two of the last twenty years. Despite the distressing financials, of

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