“A war of ideas can no more be won without books than a naval war can be won without ships. Books, like ships, have the toughest armour, the longest cruising range, and mount the most powerful guns.” – Franklin D. Roosevelt
“There are no rogue ships; there are only rogue shipowners.” – Maritime Double Shots by Barista Uno
“Twenty years from now, you will be more disappointed by the things you didn’t do than those you did. So throw off the bowlines. Sail away from safe harbour. Catch the wind in your sails. Explore. Dream. Discover.” – P.S. I Love You by H. Jackson Brown Jr.
Buy what the British government is selling. Buy what the Chinese government is telling you to buy. These are two pieces of sage advice we received from a certain Mr Wang, whom we had the good fortune of being introduced to early on in our investing careers. Mr Wang is, in today’s parlance, a private equity investor. To us he is both a mentor and an enigma.
Mr Wang speaks the Queen’s English, read mechanical engineering at one of the elite American universities, and started off his career in merchant banking in the City of London during the Thatcher years. Mid-career he packed up his bags and moved to China to set up his proprietary investment practice, which he continues to manage today.
Over the years we have turned to Mr Wang for advice on investment matters related to China and he, to our collective memories, has never failed to tell us to buy what the government is telling you to buy. What does that mean? What is the Chinese government telling us to buy and how?
Mr Wang attributes much credit for his, by almost any standard, very successful track record in China to always following the Chinese government’s lead. The Chinese government uses the National Congress – held every five years – as a platform to communicate it strategic and economic priorities. The National Congress, Mr Wang says, is where and when Communist Party tells the whole world where and what to invest in in China.
At last year’s plenum, Mr Xi Jinping emphasised that pollution control is a key priority for the Chinese government. Going forward, China will pursue a development model that fosters, in Mr Xi’s words, a “harmonious co-existence between man and nature”. Somewhat predictably, the authorities hired environmental inspectors from around the country following the National Congress. These inspectors were swiftly dispatched into the China’s industrial heartland in a rush to meet year-end air pollution targets. Thousands of polluting factories were forced to shutter or curtail capacity. Officials in their desperation even forced households to switch from coal-fired to gas-based heating without ensuring the ample availability of natural gas for the freezing winter months. Natural gas prices duly doubled.
Natural gas is not easily transportable over long distances. Where natural gas cannot be delivered by land, it must be liquefied and delivered by ship in the form of liquefied natural gas (LNG). Basic economic theory dictates that for shipping of LNG to make economic sense natural gas prices at the point of delivery must be sufficiently higher than prices at the point of dispatch to compensate for the costs involved in liquefaction, transportation, and regasification. The Chinese crackdown on air pollution and coal-based heating resulted in a sharp increase in the differential between Henry Hub gas prices and Asian gas prices. For example at the peak of the Chinese winter in December last year, the differential between the Japan-Korea Marker and Henry Hub reached three-year highs at USD 8.11 per MMBtu. Well above the USD 4 to 5 per MMBtu differential estimated to make LNG transportation between the US and Asia economically viable. While the spread has come off the highs, it has on average remained more than 50 per cent higher through 20 February this year as compared to the same period last year and also remained above the economic viability threshold for LNG transportation.
Chinese imports of LNG during the fourth quarter of last year surged 54 per cent in a scramble to meet fuel shortages amid peak winter demand and the drive to decrease coal use for household heating.
Chinese Monthly LNG Imports 
Source: Bloomberg
While the surge in demand was unprecedented, Chinese demand for LNG will only continue to grow. Already, 40 per cent of its gas needs are fulfilled through LNG imports. The country understands its reliance on LNG imports and has plans to construct new LNG import terminals and develop pipeline infrastructure to be able to transport gas further inland. At the same time, globally 100 million metric tonnes of liquefaction capacity is projected to be added annually from 2018 through 2020. Chinese demand is coming at a time where the world is flush with LNG supply and the supply is only going to increase. LNG producers have every incentive to ship their product to China, none more so than US producers.
The US Department of Energy projects that US LNG production capacity will quadruple by the end of 2019, making the US the world’s third largest producer of LNG, placing it behind only Qatar and Australia. Moreover, the International Energy Agency expects the US to become the world’s leading LNG producer within a decade.
US Monthly LNG Exports
Source: Bloomberg
The natural gas and liquefaction production capacity to be delivered over the coming years, particularly in the US, means that there could potentially be a global LNG supply glut. In such a scenario US natural gas prices and by extension LNG prices are unlikely to sustainably re-rate to the upside. Low Henry Hub rates and high Asian demand, however, are the perfect combination for a sharp pick-up in the demand for LNG carriers.
We think LNG carriers are one of the ways to play the Chinese pivot towards cleaner energy.
Investment Perspective
Spot charter rates for benchmark LNG carriers averaged USD 46,000 per day during 2017, a 37 per cent increase over average rates achieved during 2016. And in December, driven by the surge in Chinese demand, spot rates averaged approximately USD 70,000 per day – the highest level reached in over three years.
Last year was also the first time in over three years that LNG carrier supply growth trailed demand growth. Demand growth is expected to outstrip supply growth once again in 2018. Despite the improving supply and demand dynamics, absolute carrier capacity still significantly exceeds absolute LNG shipping demand. This, however, could reverse by as early as 2020. Some analysts even estimate that available capacity could be as much as 30 per cent below demand in 2020.
LNG carriers are highly specialised and complex tank ships that are designed to store LNG at -160 degrees centigrade. Typically, LNG carriers require two and a half years of build-time. Meaning that charter rates are the only means by which the market can rebalance until such time that new vessels are delivered. Given that new vessel orders, as a percentage of the existing fleet, are at around five-year lows, vessel orders would quickly have to gather speed to avoid a supply deficit during 2020 – assuming demand expectations are reached. Compounding the problem is the 30 per cent decline in global shipyard capacity since 2011 – a meaningful pick-up in new vessel orders – LNG carriers or otherwise – could result in much higher build costs and longer build-times.
LNG Tanker Order Book (Percentage of Total LNG Tanker Fleet)
Source: Bloomberg
One of the major challenges LNG carrier operators have faced during the recent period of excess capacity is the unwillingness of charterers to commit to time charters – a time charter is the hiring of a vessel for a specific period of time. As demand for LNG shipping, particularly between the lucrative US-Asia routes, picks up, the supply surplus shrinks and new liquefaction capacity comes online, charterers – in this case likely to be LNG producers – will increasingly want to commit to time charters, which would not only reduce the financial risk for carrier operators but also drive spot rates up to much higher levels.
The LNG carrier industry is relatively concentrated – the top ten operators control 49 per cent of total capacity. If the larger players are able to show some restraint in ordering new vessels, they could reap the rewards of much higher daily rates for many years.
We are closely following LNG carriers such as Golar LNG ($GLNG), GasLog Limited ($GLOG), and shipping broker Clarkson PLC $CKN.LN to potentially add them to our list of long trade ideas.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.