In this article, we continue the discussion of one of the most important macro topics of 2022. A macro topic that will follow us for decades. A topic that comes with significant risks for large parts of the world and opportunities for investors who know what to look for. A topic that is driving geopolitics and macroeconomics.
Ok, that’s enough.
I’m talking about LNG, as the title already gave away. This year, I’ve written several articles on liquid natural gas as it has become a key geopolitical topic due to the Ukraine war on top of being one of the key commodities to provide reliable and affordable energy for the global energy transition.
In this article, I will explain why LNG is so important as an energy source for decades to come. We’ll also discuss the current situation, which is extremely bullish for LNG and natural gas.
Then, I will give you two stocks that, I believe, offer tremendous long-term value. Both offer income (dividends) and high (expected) capital gains.
So, without further ado, let’s get to it!
A Quick Note Before We Start
I often use LNG and natural gas as synonyms. While it is technically wrong, it often helps me a bit better to get my point across. Essentially, LNG is liquified natural gas. Natural gas is first purified to get rid of stuff like butane, propane, CO2, and even oil and water. It is then cooled down to -260F (-160C) and put into ships for transportation.
LNG is the only way some exporters can transport natural gas. For example, there are no gas pipelines connecting the United States and Europe.
Hence, ships carrying LNG use re-gasification infrastructure to turn LNG back into natural gas, which then flows to commercial and residential customers.
The World Is Longing For LNG
In November, I wrote an article covering my thoughts on the global LNG boom. Essentially, natural gas (and LNG) is the only fossil fuel that is expected to have a bright future.
In February of 2021, well before Russia set foot in Ukraine, McKinsey & Company wrote the following:
Gas will be the strongest-growing fossil fuel and will increase by 0.9 percent from 2020 to 2035. It is the only fossil fuel expected to grow beyond 2030, peaking in 2037. […]
Meanwhile, LNG is set for stronger growth, as domestic supply in key gas markets will not keep up with demand growth. Demand is expected to grow 3.4 percent per annum to 2035, with some 100 million metric tons of additional capacity required to meet both demand growth and decline from existing projects. LNG demand growth will slow markedly but will still grow by 0.5 percent from 2035 to 2050, with more than 200 million metric tons of new capacity required by 2050.
LNG/natural gas offers a clean alternative to coal and oil. It’s easy to transport and it can be used in a wide variety of applications. Hence, the biggest users of energy are expected to be the drivers of LNG demand. Shell (SHEL) estimates that Asia will account for 70% of global LNG growth through 2040 – meeting 75% of Asia’s incremental gas demand. In 2021, global LNG trade hit 380 million tonnes. An increase of 21 million tons versus 2020. by 2040, global LNG demand is expected to be north of 700 million tons.
While Shell did not add an x- or y-axis to the demand and supply chart in the infographic above, there is no denying that nobody expects that supply growth can keep up with demand growth. Especially not because LNG is a fossil fuel (natural gas). Higher natural gas production isn’t what environmentalists are looking for. This includes ESG corporates, NGOs, and “progressive” governments. I will elaborate on that in a different article.
Moreover, there are just a few countries that can produce huge natural gas volumes. The United States is one of them. It’s number one.
Josh Crumb made the case that LNG is going to be the most important commodity over the next 20 years. He says we need better benchmark prices and a framework that makes LNG buying as reliable as buying crude oil or Henry Hub natural gas.
I agree with that, especially because 2022 changed the situation dramatically. Now, Europe and Asia will be competing even more intensively for LNG supplies in the years ahead.
Short-Term Demand Is Even Stronger
I have commented on more or less every move of Dutch TTF natural gas prices (European benchmark) since the end of 2021 (pre-invasion) when I covered geopolitics and macroeconomics for institutional and private clients at Intelligence Quarterly. Before Russia even hinted at an invasion, prices were at EUR 20. Prices moved to more than EUR 300 in the second half of this year. That was based on the attack on or sabotage of Nord Stream 1, Russia reducing flows through other pipelines, and the fact that Europe is now completely reliant on foreign LNG to plug the Russian export gap.
Then, prices came down crashing. That was mainly based on two reasons. Reason one is the fact that the surge to more than EUR 300 was just nuts. Reason two is more reasonable. European gas storage levels were high. The Fall months were rather warm, so demand was much lower than expected. Also, companies had reduced natural gas demand. So, there was too much natural gas, believe it or not.
Hence, people started to celebrate that Putin had lost leverage over Europe. After all, prices had come down to pre-invasion levels.
As much as I would love to agree with that, it’s not true. Even worse, it’s a dangerous assumption – when planning for the future.
After all, we (Europeans) are now in a situation where inventories will quickly fall. Even worse, this year, Europe benefited from Russian gas flows. Until June, monthly gas flows were close to 10 billion cubic meters.
Now, flows are less than half of that. Most of it is now about to be LNG.
As the International Energy Agency reports, Europe may lack almost half of the volume it needs to fill storage sites to 95% by next winter. Half!
Even if demand falls by only 9%, new injections of close to 70% of storage will be needed.
This means that Europe will be heavily competing with China (and other Asian nations) for scarce LNG supply in the next 20 months (and beyond).
Hence, Europe is even going back to buying Russian LNG. Yes, Russian LNG. Europe won’t buy Russian natural gas, but it is accelerating purchasing of liquid natural gas – while sanctioning oil and coal.
As a result, the situation is a bit worse than it looks like. After all, European nations are now also dealing with sky-high electricity prices as consumers are shifting demand. According to Javier Blas:
In a sign of how high things are, if wholesale costs were to remain at current levels for the rest of the month, the British power market would achieve its second-highest monthly average ever, only behind that for August.
To summarize what we have so far, we’re dealing with a situation where global LNG demand is expected to rise on a long-term basis. The decarbonization of industries will require affordable (that’s currently not the case) and reliable sources. LNG can deliver on both these requirements. Renewable energy can not. At least not now.
Moreover, because of geopolitical shifts like the war in Ukraine, the world suddenly faces a huge supply gap. While I’m not a fan of gloom and doom predictions, 2023 will be a wild year for energy markets as global nations will compete for scarce LNG supply.
It will be something Hollywood might call “The Winter Games” after this crisis is over.
Hence, I expect LNG pricing to remain highly favorable. The biggest winners will be companies producing natural gas (in the United States) and companies that ship LNG. Hence benefiting from tailwinds when negotiating long-term contracts.
That’s what my two picks are based on.
1. Cheniere Energy (LNG) – 1.0% Yield
Please hear me out before getting mad that I give you a 1.0% yielding dividend stock.
As the company’s ticker may suggest, Cheniere is a go-to stock for LNG investors. With a market cap of $40.6 billion, Houston-based Cheniere is one of the world’s largest LNG companies. Founded in 1996, this Fortune 500 company became the first US company to export LNG in 2016.
As the chart below shows, the US started to increase LNG exports in 2016. Now, the US is exporting more than 300,000 million cubic feet per month.
Zooming in a bit (chart below), we see that exports have gradually improved between 2016 and 2020. During this period, exports mainly came from the Sabine Pass terminal in Louisiana. That terminal has been developed since 2005. It’s owned by Cheniere Energy. Sabine pass is located along one of the few deepwater ports on the Gulf Coasts, suitable for LNG. The region also has an excellent infrastructure with access to South East Texas and other US markets.
In the first half of 2022, the US became the world’s largest LNG export nation. This happened despite an incident at Freeport LNG, which is expected to be resolved in early 2023.
According to Cheniere:
Cheniere alone was responsible for approximately 1/4 of Europe’s LNG imports this year. As the top middle chart illustrates, U.S. LNG volumes surged over 200% year-on-year in the third quarter as Nord Stream flows came to a halt by the end of the quarter.
The company now operates six liquefaction units (called “trains”) at its Sabine Pass facility. It also has Corpus Christi operations, where it operates three trains. The company’s infrastructure projects were all completed within the budget and ahead of schedule. The company now can deliver 55 million tons of LNG per year. It could add 10 million tons soon as it is expanding in Corpus Christi.
Roughly 85% of the company’s LNG is sold through long-term contracts. The remaining is sold by Cheniere Marketing, which means the company will benefit from high spot prices. The company also buys LNG from third parties.
With that said, the single worst thing about companies like Cheniere is the fact that building LNG facilities is so darn expensive. It also comes with high risks. This includes regulatory risks, financing risks, contract risks, and so many other risks.
Hence, it’s great that Cheniere is one of the most mature LNG businesses in the world. It is now in a good spot to export LNG thanks to completed projects.
Thanks to lower CapEx and high operating cash flow, the company is expected to do $7.3 billion in free cash flow this year. Followed by a decline to $4.2 billion in 2023 (as market participants expect prices to moderate, which is not extremely likely).
Even if we ignore 2022, $4.2 billion in FCF is still 10% of the company’s market cap. That’s a huge number and it allows the company to quickly reduce debt and grow its dividend.
Hence, LNG is expected to end this year with just $22.1 billion in net debt. That’s less than 2.0x EBITDA. In 2018, the company had more than $27 billion in net debt, which was 10x EBITDA.
Earlier this week, the company announced the redemption of 7.0% senior secured notes due 2024 – a year earlier than expected.
The company’s credit rating is BBB.
It also means that dividend growth is now finally in a better place. After all, debt levels are down.
The company declared its first quarterly dividend (ever) in September 2021. Back then, it was $0.33 per quarter. The company hiked by 19.7% in October of this year.
Going forward, I expect aggressive dividend growth to last. The company can maintain aggressive dividend growth, without exceeding a very conservative payout ratio of 20%. Imagine the power of this on a long-term basis.
During the third quarter, we also declared and paid our fourth quarterly dividend of $0.33 per common share, bringing our total dividends paid to $1.32 per common share. Under our new capital allocation plan, we increased the dividend by 20% for the dividend related to the third quarter to $0.395 per common share and maintain our commitment to increasing the dividend by approximately 10% per year through Stage 3 construction, which will grow us into around a 20% payout ratio over time.
Needless to say, I also expect long-term capital gains.
The current LNG analyst price target is $208. I agree with that as the company is trading at just 6.8x NMT EBITDA. However, it’s not a deep-value opportunity as LNG shares have done very well this year. Depending on the market, I am hoping for an entry closer to $140.
With that said, stock number two comes with a higher yield!
2. Chesapeake Energy (CHK) – 13.4% Yield
Chesapeake Energy is a fascinating turnaround story. Before 2021, it was a struggling natural gas company unable to thrive in a low-price environment. In 2020, the company went bankrupt. In 2021, the company emerged from bankruptcy, after which it acquired Vine Energy, an operator in the Haynesville Shale.
In 2021, CHK produced 463 thousand barrels of oil equivalent. 69% of this was natural gas.
Now, CHK has gone from a pain in the [you know where] to a natural gas cash cow with a high dividend, supported by very high free cash flow.
The company has more than 15 years of inventory, low breakeven prices, and a balance sheet with a net-debt ratio close to zero.
After the 2020 pandemic, the company used high natural gas prices to boost free cash flow. The company is expected to average $2.5 billion in annual free cash flow between 2022 and 2024.
These free cash flow estimates imply a 20% FCF yield, using the company’s $12.6 billion market cap. Note that the fully diluted market cap is $13.8 billion! That’s based on 13 million warrants that are still outstanding. That puts the implied FCF yield at 18%, which is still extremely elevated.
Not only does the company has a low leverage ratio, but its credit rating was also lifted to BB in October. I expect the company to be rated BBB before the end of next year.
Moreover, because of the company’s large natural gas footprint, it is a major player in LNG (natural gas supply).
Chesapeake not only has low-cost locations, but also strategic locations close to LNG liquefaction plants.
According to the company:
We expect to leverage our capital efficiency leadership our growth flexibility and our midstream partnerships to participate Chesapeake to be LNG-ready as the macro tailwinds from the significant increase in demand due to export capacity expansions arrive in the second half of the decade.
We’ve been consistent in our message to grow and capacity additions are available to meet incremental demand. As export capacity doesn’t begin to increase until at least 2024, we’re setting up our near-term volumes to be relatively flat and begin to ramp slowly as we approach 2024. We’re truly excited about what this setup means for our shareholders as we’re uniquely positioned to deliver differential shareholder value […].
CHK is in a great spot to deliver much-needed volumes as the US brings online more LNG export facilities. On top of that, the company benefits from elevated natural gas prices.
Now, onto the dividend. On top of buybacks to repurchase common shares and warrants, the company aims to return close to 50% of post-base dividend FCF to shareholders. In other words, when free cash flow is strong, the dividend is high.
On November 11, the company announced a $3.16 quarterly dividend. This implies a 13.4% annualized dividend yield. The dividend was hiked by 36.2% on the day of the announcement.
In other words, CHK has turned into a great tool for energy income. Especially when looking for natural gas/LNG-focused assets.
Moreover, CHK shares remain undervalued.
The average target price of CHK shares is $150. More than 50% above the current price. The company is trading at less than 3.0x NTM EBITDA, which is too cheap.
I rate CHK a buy.
However, please be aware that CHK is way more volatile than Cheniere Energy. Be careful when buying energy assets. It’s not comparable to the average dividend stock that pays a quarterly dividend without exposing investors to high volatility.
In this article, we discussed one of the most important macro themes in the world: LNG. Global LNG demand is expected to grow for decades to come as global energy demand rises on top of global decarbonization.
Short-term, the LNG bull case is even stronger. 2023 will be a wild year as both Asia and Europe will be competing for very scarce LNG supply. Especially Europe will have to buy every drop it can get its hands on, given the high risks to be unprepared for the 2023 winter.
I highlighted two dividend stocks that are likely to generate wealth for shareholders for decades to come.
Cheniere has a low dividend, but a lot of growth potential. It is one of the biggest winners of overseas LNG demand as it has the facilities to export LNG and lower CapEx, allowing shareholders to immediately benefit from the surge in demand.
Chesapeake is different. It’s a natural gas producer that indirectly benefits from high LNG demand. It has a high inventory, low breakeven prices, and high free cash flow. Shareholders directly benefit from strong prices through the base and variable dividends.
I expect that both dividend stocks do very well for many decades to come.
Needless to say, CHK is rather volatile. Please be aware of that and monitor both investments to buy on weakness – if these stocks make sense for your portfolio.
(Dis)agree? Let me know in the comments!