There are too many liquefied natural gas projects. Worldwide, developers are planning a record number of new supply facilities to serve limited demand. Fundamentals behind that demand are weak, which suggests a gas bubble may form.
By itself, LNG is a marginal commodity. Because it is costly to produce, deliver and handle, it is frequently the last choice for consumption in local energy markets.
LNG is expensive because it not the same fuel as natural gas. LNG producers buy natural gas at local market prices. They transform that natural gas into LNG using specially constructed facilities that compress, filter, refrigerate, liquefy and store the finished product in cryogenic tanks.
Considering the specialized equipment needed to convert and handle liquefied fuel, it's not difficult to understand why LNG export facilities are capital intensive. In fact, a typical LNG export facility may cost developers several billion dollars a copy to build.
It is not just export facilities. Specially constructed LNG tankers and LNG import facilities are also capital intensive. Each tanker can cost approximately $200 million. If there are not enough tankers, supplies can become constrained and the market becomes constrained.
LNG import facilities must be built at seaports, which also have access to natural gas pipelines. Those facilities must be able to accept cryogenic fuel, store it in specially constructed tanks, convert the LNG back to natural gas, meet pipeline standards and pump it into the local pipeline.
If a nation lacks LNG import facilities, they cannot accept or use LNG. Therefore, the market for LNG is limited to nations that already have LNG import terminals and need to import fuel.
Today, Japan is the world's dominant consumer. They consume almost a third of all LNG produced. Following Japan in order of demand are South Korea, China, Europe and North America (as one region of North America considers exporting LNG, another region plans to import LNG).
Looking ahead, Japan and China are expected to be growth markets. However, expectations could be exaggerated as some may miscalculate Japan's needs (more on that later). South Korea is a stagnating market. Europe is a declining market. Altogether, by 2016, world consumption may expand by only 10% or 15%.
Meeting incremental demand is burgeoning supply. Today, there are several producers in the market. Qatar is currently the world's largest supplier. After Qatar in order of production are Malaysia, Indonesia, Australia, Nigeria, Trinidad & Tobago, Algeria, Russia, Brunei and Oman.
World supplies are expected to grow. Australia, Algeria and Russia have aggressive plans to expand their exports. In fact, Australia is investing approximately $200 billion in new LNG infrastructure and they may displace Qatar as the world's largest supplier.
Chevron (CVX), Apache (APA), Royal Dutch Shell (RDS.A), Kuwait Foreign Petroleum Exploration Company, Kyushu Electric Power and Tokyo Electric Power have equity stakes in Australia's newest LNG projects. Those projects have long-term offtake agreements from Japan's electric utilities.
At the same time, Canada and the U.S. plan to add to growing world supplies. Cheniere Energy (LNG) has U.S. approval to export LNG. Dominion Resources (D) is also seeking US approvals. Exxon Mobil (XOM) and other majors are also considering exporting LNG from Canada and the U.S.
There may be a supply bubble building. While some longer-term agreements have margins locked in, new contracts could see significantly lower prices.
LNG's demand-side is overly dependent on just three Asian countries. Should any of these economies sputter, force majeure clauses may be declared and the LNG market could collapse.
Look no further than Japan. Because of the Fukushima incident, many believe Japan's utilities will permanently shutter all their commercial nuclear power plants. In place of nuclear power, developers believe Japan will be forced to use more LNG to produce electric power.
Importing LNG and other pricy fuels is affecting Japan's economy. LNG costs Japan approximately $140 a megawatt-hour to produce electric power. In comparison, Japan's nuclear power plants could produce electricity for $25 per megawatt-hour. The difference is contributing to Japan's growing trade deficit. Analysts believe that deficit is largely caused by soaring energy costs.
In a recent RealMoney column, Roger Arnold warned investors about Japan. It appears that before the Fukushima event, Japan was doomed to insolvency. Arnold explained, "Japan is now in a terminal vicious spiral."
Japan's economy aside, investors should consider LNG's expanding supplies and fragile demand. A supply bubble may be appearing, which may cause prices and margins to fall.