What Royal Dutch Shell Is Doing To Solve LNG’s Biggest Challenge

By Gary Bourgeault: 19 Sept 2016

There is one basic thing Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) needs to do to take full advantage of its LNG strategy, and that is to boost demand by increasing the number of fueling stations in the markets they’re competing in.

The LNG market

In the short term it’s obvious little is going to change in regard to the health of the global LNG market, as there is still far too much supply, the pace of demand growth remains weak, and the price of LNG continues to be low.

There is a possibility this could change, as there appears to be some underlying demand for LNG, which if companies like Shell can put low-cost infrastructure in place, would be able to be tapped into and expand the market. Another factor not too many investors are taking into consideration is some countries that are exporting LNG are in danger of running out of gas as their existing contracts come to an end, which could have an impact increasing development in the LNG export business.

This is more important than most realize because it changes the dynamics of the LNG market in a way it hasn’t in the past.

In the case of exporters holding LNG contracts for the long term, the past practice was they would be able to renew their PSAs with no need to develop new liquefaction plants. The significance of that is they would be able to compete at existing price points, no matter what they were.

That moat no longer exists for some exporters because gas that was the basis of the deal is poised to run out close to the end of the contracts. That means in order to extend their contract, in a number of cases they could have to build out pipeline infrastructure or engage in huge drilling programs in order to have the gas available to support the existing export facilities.

Similar to the U.S. shale industry, LNG competitors who are able to respond quickly to these opportunities and are able compete at a low cost, could easily surprise to the upside.

LNG demand challenges

One of the major recent disappointments for LNG is the failure for demand to meet expectations. Probably the biggest reason for that is the underwhelming demand for LNG in the U.S.

Not that long ago the U.S. was considered one of the major markets for LNG, with the EIA projecting in 2008 that the country would import almost 50 million metric tons of LNG per year. Not only did that fail to materialize, the U.S. has become a net exporter of LNG. Consequently, the country has turned away approximately 15 percent of the overall global LNG supply. The problem was probable suppliers had already developed the capacity to supply the market.

The other supply/demand issue for global LNG is companies in Australia and the U.S., believing they had a moat to work from, increased liquefaction capacity. Now that all the capacity is operational, key historical markets like South Korea and Japan have had demand level out, and other markets like India and China have had LNG demand slow down.

These are major reasons the global LNG supply growth is outpacing demand.

Further out, in regard to Asian and European LNG imports, the current scenario is LNG accounts for approximately 48 percent of all gas imports to the two regions. That’s expected to increase to 60 percent by 2035. This is one of the reasons LNG competitors stay in the market, including Shell.

Prices for LNG have been extremely low in Europe and in Asia. This isn’t only because of the low price of oil, but from supply overwhelming weak demand. By 2020, estimates are LNG will be oversupplied by about 20 million tons.

According to Wood Mackenzie, in 2016 the markets driving the most LNG demand have been Egypt, Jordan and Pakistan. It sees LNG imports increasing 40 million tons annually, increasing the size of the global market by 16 percent.

Bank of America Merrill Lynch sees startup LNG projects in the U.S. and Australia adding about 135 million tons annually to production capacity by 2020. That represents a 50 percent boost in global supply.

For Shell, it’s looking at some of its major start-ups in 2016 adding 3.9 million tons per year of LNG. That’s representative of when they’re operating at full capacity.

What Shell is doing to boost demand and expand the LNG market

One of the things Shell and its competitors are doing with natural gas and LNG is to adapt to the current market conditions, and move away from a business model of selling to long-term customers. That’s been the way of doing business for years, but it is starting to change.

In order to expand the LNG market, some big companies are investing in various infrastructure projects in order to expand the market. Included with that strategy is building import terminals. What Shell is doing is taking a position in the gas market in order to take advantage of future demand growth. In an oversupplied market, those that already have a position will outperform those that don’t, meaning developing infrastructure for new markets, and helping developing countries afford LNG.

Under these market conditions, it should be considered a window of opportunity for those companies with the resources and improved efficiencies to be competitive.

One of the strategies Shell is employing to increase the LNG market is to attempt to convince governments of the benefits of natural gas on the environment, when compared against oil or coal.

As for some of its key markets, it has been working with the government of Jordan to build new facilities to import LNG. The first terminal was opened in 2016, and it made Shell a key supplier. Shell also entered into a deal in August to supply LNG to Gibraltar. It also involves building more infrastructure for importing.

Another part of its growth strategy for LNG is to tout the benefits of using LNG as a transportation fuel. It already has LNG truck fueling stations in the Netherlands and the U.S., but was forced to shutter to of them in Canada because of weak demand.

The shipping market is also of interest to Shell, which is looking for new regulations concerning fuel emissions to press shippers to switch to LNG to run their vessels. I’m not too impressed by this at this time, because reliance upon government interference in the market isn’t a predictable way to grow demand and market share. It could be valuable and profitable in the future to the company, but not at this time.

Shell is also using existing locations to increase revenue. For example, at Rotterdam’s Waalhaven harbor, it has added a unique nozzle close to the diesel pumps which are used for LNG. The purpose is to get itself in front of what it considers a strong trend in the energy sector.

In the LNG transportation business, Shell remains the most aggressive in the market.

The strategy is to gradually and consistently remove the biggest growth challenge for LNG, which is to provide refueling stations in numerous locations – whether on the road or at the ports. Shell’s believes it will be able to cover the world with LNG fueling facilities for shipping by 2020. It already supplies Carnival Corp. with LNG at ports serving two of its ships.

It also has operations in Singapore, where it where it is working truck-to-ship refueling stations, which should be operational by 2018. Shell is also looking to expand its business in Rotterdam, with plans in place to develop refueling barges.

Conclusion

In the short term I’m bearish on Shell’s LNG focus, as the market will take time to work the existing glut, and there aren’t many catalysts that will expedite the process. It’ll simply take time to do it.

While natural gas in general, and LNG in particular have a bright, long-term future, investors will have to be patient in waiting for significant results. Like Shell, traders could think in terms of getting ahead of the trend before it runs away from them, but I think it’ll take at least a couple of years before the market approaches a rebalancing, and it could be twice that long. It depends upon the global economy, which has been one of the reasons major LNG markets have stalled or slowed down.

All of this is happening while LNG supply continues to grow, with more coming to the market even at this time.

Another problem Shell faces is concerning hedges, which when it acquired BG, received a portfolio that was almost completely unhedged.

What’s interesting about Shell and its major competitors, is in the past they would have left the smaller markets to other companies, but now are seeing a lot of potential in developing markets. Shell is among them, and is working on positioning itself to ride the growth trend once it kicks in and the market rebalances.

For Shell, it is doing the right things in focusing on new markets and targeting various segments of the LNG market to expand its overall exposure to LNG. That will help to work down the glut (with other companies doing the same), while at the same time increasing its market share.

As Shell and its competitors work on penetrating new markets, investors will need to watch the impact in has on the LNG glut, CapEX, and where in the market cycle it has positioned itself.

Like crude, LNG will take time to rebalance and enjoy stronger prices. Shell is doing its part is hastening the process, but it’ll be further out before shareholders enjoy the fruits of its effort.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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