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July 15, 2005

Energy's Liquid Future
by Dan Denning

In late 2004, The Japan Times reported that Beijing gave several Chinese companies permission to conduct natural gas exploration in the East China Sea, an area the Japanese have long considered an exclusive economic zone. The Chinese also put pressure on Russian president Vladimir Putin in October to proceed with an $18 billion, 3,000-mile gas pipeline project from Russia's Kovykta Field in eastern Siberia to China's refiners to the south.

The Chinese also pushed on a 1,500-mile link from western Siberia. Japan, meanwhile, is pushing for a pipeline from Vladivostok over the Sea of Japan. Unmentioned was the big prize, the 18 trillion cubic feet of natural gas reserves that sit off the shore of Russia's Sakhalin Island. The island was a brutal and remote prison during the reign of Czar Alexander II. In fact, Russian poet and writer Anton Chekhov visited the island in 1890.

After his visit, he wrote in a letter, "God's world is good. It is only we who are bad...One must work, and to hell with everything else. The important thing is that we must be just and all the rest will come as matter of course..."

The rest is coming to Sakhalin Island now, just God or no. The island is the energy mother lode of the region - a find rivaling Alaska's North Slope - and the kind of resource, if properly harnessed, that could power the region's energy needs for decades. It matters a great deal because the countries of northeast Asia are already vulnerable to disruptions in the flow of oil from the Persian Gulf.

China, South Korea, and Japan are already some of the world's largest oil importers. It's a precious energy lifeline that could easily be cut, either at the Strait of Hormuz or at another chokepoint, the Strait of Malacca.

How will a country like South Korea keep its powerhouse export driven economy going without getting sucker punched by high oil prices? The answer is unknown. But continued development of its energy infrastructure - with companies like KEPCO - will help. Another answer may lie in liquid natural gas (LNG).

This is a golden age for oil and energy investments. Either that, or a fiery sunset that ends with oil and resource wars. But I prefer to look on the bright side. At the moment, however, the bright side of the oil and gas market is dimly lit. Continuous supply disruptions - whether by acts of terrorists or acts of God have altered traditional relationships between supply and demand, while also obliterating America's long-standing complacency about oil and gas supplies. Uncertainty reigns.

But amid the uncertain conditions of our changing petro-political world, liquid natural gas will certainly assume a prominent role. As I see it, there are two major opportunities in LNG: terminal construction and tanker construction. With LNG demand likely to rise from 120 million tonnes in 2003 to 200 million tonnes by 2010, and then 315 million tonnes by 2020 (according to estimates from the International Energy Agency), it's a question of getting the right mix of investments. But first a little background on the LNG market. The excellent Plunkett's Energy Industry Almanac for 2005 offers the following insights:

"One development as a result of higher [energy] price levels and increased demand is serious interest in supplying America's gas needs through LNG (liquefied natural gas). However, due to the necessity of special handling, bringing that supply online in a major quantity will take huge capital outlays and require considerable time. LNG requires special processing and transportation. First, the natural gas must be chilled to minus 260 degrees Fahrenheit, in order for it to change into a liquid state. Next, the LNG is put on specially designed ships where extensive insulation and refrigeration maintain the cold temperature. Finally, it is offloaded at special receiving facilities where it is converted into a state suitable for distribution via pipelines."

Specially designed ships indeed! According to LNG Shipping Solutions, there were only 151 LNG tankers in operation in October 2003. And no wonder. Because of the rigorous specifications, the average cost of a 138,000-cubic-meter LNG tanker is about $160 million. According to the Energy Information Agency, that's more than double the price of a crude oil tanker that could carry four or five times as much energy.

Yet despite the cost and the seemingly bad comparison to oil tanker economics, there were 55 LNG tankers under construction as of last year. Forty-six of them are designed to carry 138,000 cubicmeters of LNG, which translates into about 2.9 billion cubic feet of natural gas. LNG Shipping Solutions also notes that the ships currently under construction would raise the total fleet capacity by 44 percent, or from 17.4 million cubic feet of LNG (366 BcF of natural gas) to 25.1 million cubic meters of liquid (527 BcF of natural gas).

But even with the increased capacity, Plunkett's says demand will keep rising enough to make looking at LNG-related investments worthwhile. Plunkett's continues:

"An analysis conducted in late 2003 by the National Petroleum Council projected that the U.S. could meet as much as 14% of its natural gas needs through LNG imports by 2025, if sufficient infrastructure were built, including seven new LNG transportation facilities. Transporting LNG from distant countries presents massive technological and financial challenges, but importing LNG from those nations could provide much needed gas for the U.S., assuming America is willing to add to its already bloated import bills and balance of payment problems. One of the biggest barriers to wider use of LNG in the United States is a lack of terminals to receive it."

California is already witnessing a fight between those who see the benefits of cheap natural gas and those who don't want LNG terminals built offshore. But let's assume for a moment the cheap energy interests will win out over the NIMBY interests. Who will make all these new LNG terminals? And who will make the ships to transport the LNG from the rich gas fields of the world to the hungry energy markets of Asia and America? First, Plunkett's conclusion:

"The LNG business is already booming. Growth will continue as oil companies and oil-rich countries realize the benefit of transporting gas in liquid form. LNG technology is moving ahead rapidly, and costs for transporting it are coming down. Shipping and handling will become more competitive as more ships and facilities come into operation, and large quantities of LNG on the market could stabilize or even depress natural gas prices.

"Many markets outside the U.S. are also prime targets for LNG imports, including China and India. Japan is already a huge importer of LNG, there being little other way to transport gas to the island country...the United States contains vast quantities of natural gas in areas that currently cannot be exploited. The U.S. Geological Survey estimates that there are 1,400 trillion cubic feet of recoverable natural gas in the U.S., which would be enough to power the nation for decades.Most of this gas lies beneath regulated federal and state lands (particularly in Rocky Mountain basins, offshore America's east and west coasts and offshore the west coast of Florida), much of which cannot be drilled upon under present regulations.

"Environmental and regulatory concerns may mean that most of this gas will never be produced, unless economic imperatives intervene...For the mid-term, gas will remain in great demand, and prices will tend to be high. While there is significant additional gas to be found in the Gulf of Mexico, such projects take years to bring online. Meanwhile, the largest potential exporters of natural gas to the U.S. are those countries with the largest proven reserves: Russia, Iran, Qatar, Saudi Arabia, Algeria, Venezuela, Nigeria, Iraq and Indonesia, in that order."

If you take a look at Plunkett's list of countries, and if you're anything like me, you're probably pretty uncomfortable making investments in Qatar, Saudi Arabia, Venezuela, Nigeria, and Iraq. But the good news is, you don't have to.

With major oil and gas companies just beginning to develop LNG terminals and gas fields all over the world, the place to look at future investment opportunities is in the LNG shipping business. That brings us directly to South Korea, which has the good fortune of being in the heart of one of the most energy ravenous regions of the world. It also has some of the most successful LNG ship makers in the world.

Building LNG ships is complicated. For example, if you poured liquefied gas into a steel tank, it would shatter like glass. LNG ships are made of the kind of materials that can keep the gas cool once it's been liquefied, which involves thick aluminum, nickel steel, and balsa wood (for insulation). It's an art the South Koreans have perfected. And you can expect the South Korean shipbuilders to profit handsomely.

As the petro-political map of the world evolves, we'll be keeping a close eye on LNG. But the entire energy complex is in a strong bull market. Another way to invest is to go long some of those oil- and energy-related ETFs and index funds we discussed earlier. It wouldn't surprise me a bit if you can soon buy a crude oil or natural gas ETF the same way you can now buy gold.

Regards,

Dan Denning
The Daily Reckoning

Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 - where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends.

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