A year ago, researchers with UH Energy proposed a complex contracting system to expand LNG markets by providing incentives for new buyers to switch from coal and oil to LNG, explaining the details in a research paper.
This system, described in “LNG Projects Have Stalled. A New Business Model Could Help,” recognized that large natural gas producers had a compelling interest in the development of new LNG projects to access new international markets for their growing production. However, the next generation of projects had stalled due to low international spot LNG prices and the unwillingness of traditional LNG consumers to commit to long term supply contracts at prices adequate to allow developers to attract debt capital.
A recent announcement by Apache and Cheniere is a step in the right direction, but it risks resulting in highly volatile netback prices to Apache. A June 3 press release described the benefits of the new contract:
Cheniere Energy, Inc. (“Cheniere”) LNG, +1.48% announced today that its subsidiary, Cheniere Corpus Christi Liquefaction Stage III, LLC (“Corpus Christi Stage III”), has entered into a long-term gas supply agreement (“GSA”) with Apache Corporation (“Apache”) (NYSE, Nasdaq: APA). Under the GSA, Apache has agreed to sell 140,000 MMBtu per day of natural gas to Corpus Christi Stage III for a term of approximately 15 years. The LNG associated with this gas supply, approximately 0.85 million tonnes per annum (“mtpa”), will be marketed by Cheniere. Apache will receive an LNG price, net of a fixed liquefaction fee and certain costs incurred by Cheniere, for the natural gas delivered to Corpus Christi Stage III under this agreement. The LNG price is based on international LNG indices.
“This first-of-its-kind long-term agreement with Apache represents a commercial evolution in the U.S. LNG industry, as it will ensure the continued reliable delivery of natural gas to Cheniere from one of the premier producers in the Permian Basin, while enabling Apache to access global LNG pricing and receive flow assurance for its gas,” said Jack Fusco, Cheniere’s President and CEO. “This commercial agreement, which is expected to support the Corpus Christi Stage III project, reinforces Cheniere’s track record of creating innovative, collaborative solutions to meet customers’ needs and support Cheniere’s growth.”
“Apache’s agreement with Cheniere is part of the company’s long-term strategy to leverage the scale of our assets in the Permian Basin and diversify our customer base and cost structure by accessing new markets for natural gas produced at Alpine High. We are pleased to partner with Cheniere in this innovative marketing agreement,” said John J. Christmann IV, Apache’s Chief Executive Officer and President.
This agreement will provide a steady cash flow to Cheniere from the agreed liquefaction fee and recovery of “certain costs,” which should allow the company to finance construction of its Corpus Christi Stage III LNG project. However, Apache may be exposed to high price risk if Cheniere is unsuccessful in marketing its LNG or is obliged to accept low market prices. This may occur if international LNG markets grow more slowly than developers add LNG capacity.
Apache and Cheniere will have a shared interest in expanding the LNG market by encouraging industrial and power generation companies currently burning diesel, coal and fuel oil to switch to natural gas. As we pointed out in our 2018 paper, this should include loan guarantees and other incentives to companies that agree to switch fuels in favor of LNG.
The alternative would be to allow LNG prices to collapse as abundant supplies exceed existing consumption and let the low prices stimulate market growth and raise prices in a recurring price cycle. It would seem prudent for Apache to act as an aggressive partner to keep the pressure on Cheniere’s marketing strategies and plans with the intent of mitigating the volatility of Apache’s achieved netback prices.
In our view, a robust business development strategy should include:
- Research on companies currently burning oil products or coal, with the goal of creating a portfolio of dedicated prospective customers;
- Long term LNG supply agreements with industrial and power generation companies;
- End use LNG pricing that is competitive with the displaced fuel, possibly with some ceiling and floor provisions, and recognizing the environmental benefits of LNG;
- Financing for the end user investment in plant and equipment needed for switching to LNG.
It is appropriate that U.S. natural gas producers should shoulder the price risk endemic in trading their commodity, but they would be wise to also take steps to dampen the price volatility that would accompany reliance on spot LNG markets.
Chris Ross is an Executive Professor of Finance at the C.T. Bauer College of Business and the University of Houston, where he teaches classes on strategies in the oil and gas industry. He also leads research classes investigating how different energy industry segments are creating value for shareholders. Ross holds a Bachelor of Science in Chemistry from King’s College at the University of London and a PMD from Harvard Business School.