When will US LNG Terminals switch off

Now that even the most bull-headed traders have understood that high-price LNG and the seller’s market have gone away, the game has changed. Prodigious additional amounts of LNG will hit the energy consumption world and the question of where it all shall go is burning on everyone’s mind.

However, as strange as it seems, this is the less important issue. Because the volumes, albeit big, will come gradually and the market will have time to absorb. Don’t ever underestimate the capability of Europe to absorb huge amounts of gas once the price is right.

Yes, you get me right. There will be price competition on the old continent. Some like to call it a full-price war. The Russians will defend their turf tooth and claw and will do what needs to be done to prevent European customers from turning away.

They will break the oil link and tie their deliveries to hub prices, they will offer discounts to hub prices, and offer flexible services unseen in the past. And they will be nice, friendly, cuddly, … Ok, let’s not overdo it. The Russians will feel the sting and behave a bit better than in the past.

The thorny question is. When will those pesky LNG sellers switch their liquefaction plants off as the price they can fetch for their LNG will not cover their big cost stacks anymore? Surely those capitalists have already run market simulations and when costs outweigh gains, they will lie low until the market comes again. Don’t you think?

So, as a competitor, just aim at below the marginal cost of the LNG producers and you are fine. Are you?

Let’s get into the head of a US LNG producer. You have built your LNG plant and now the price has crashed. Two things happen here.

You look at your production cost and the price you can realistically fetch for the LNG plus – you look at your base safety net.

Let’s start with the second one – the safety net. Contrary to conventional LNG business models, most US plants have sold their liquefaction capacity and not physical LNG to buyers. This means that the LNG plants in the US don’t sell LNG per se but as a service.

The deal is that someone will pay them some form of almost fixed installment for a certain time, and they (the liquefaction plant) will liquefy gas on their customer’s behalf. They own the facility and provide the service. The gas plus the LNG is never their property.

As those liquefaction tariffs are pretty fixed and above the minimum money requirements of the liquefier, there is no problem at all. It may be that the market value of the LNG dips below the threshold for profitable LNG but to the plant owner and operator, this does not matter. It’s the customer that carries all the downside risks of this deal.

However, this promise of service is also tied temporarily. This means that the liquefier has promised to provide liquefaction services starting from a certain date up to a certain other date. This means that if the liquefier is ready to provide the service but the buyer does not use it, it’s lost like an empty airline seat.

This further means that – maybe by pure accident – the customers of the liquefaction plant (which in many cases are European utilities) pay the lion’s share of the cost the plant suffers and keep them financially safe no matter how low the LNG price goes. They might elect not to use the liquefaction service they pay for – but pay if they must and the service is lost for the future – at least this is what it looks like at first view. There is no MakeUp capacity in capacity contracts.

This also means that once the hard times are over – which might be many years from now – European customers have subsidized US LNG and when the prices come back they are much closer to the end of their contracts which also frees up the liquefier to sell capacity (or LNG) to whomever he likes in the future. All this on the back of a then fully depreciated facility enabling him to swamp the world with super cheap LNG.

Oh yeah, those European customers will then have to absorb this price shock by dumping as much LNG on the European market as they possibly can as it makes no sense to pay for the liquefaction capacity in the US and then pay again for Russian import gas which will, in turn, depress Russian gas imports to Europe. This further means that Russians indirectly bear the brunt of the US liquefaction cost meaning that they pay for building a world-class competitor in their core market Europe.

Strong stuff – ain’t it?

Oh, you might say that the Europeans might still pay for the capacity and not lift the LNG. Well, in that case, the liquefaction capacity becomes vacant and as I don’t see clauses for what happens to LNG that has been produced but not lifted, it will naturally revert to the liquefier which then can push it into the spot market.

However, let’s come back to the cost stack. Let’s assume that this safety net does not exist, and they must compete head-on with other gas providers (yes, with Gazprom too) for any market they can muster. Their CAPEX load must surely kill them – or is it?

Here US insolvency law comes into play. Chapter 11 is – contrary to most European and indeed most of the world’s insolvency procedures – protecting the company from its creditors far more than anywhere else. Europeans are commonly called the “Ayatollahs of creditor protection” and will strip the company of its possessions to pay those throwing money on the company back. Often killing the company in the process.

US law allows companies to restructure under the protection of Chapter 11 as it blocks all actions by the creditors effectively. Most of the time the debt is transformed into equity and a change of control ensues but the company survives and the new management has no interest in stopping operations. They are thus able to raise new cash with a clean balance sheet and will squeeze the bottle as hard as they can producing as much LNG as they ever can no matter where the sales price goes.

I will produce another post on the exact workings of these mechanisms – yes I am a lawyer, or I was one before I got infected with the LNG virus.

US LNG plants will produce all LNG they can no matter what prices do – they will never shut down for even a second. There is a corollary. In the 90ies, Natural Gas went so cheap in the US that some thought gas companies would belly up and make their last gasp. When Henry Hub reached one USD per MMBtu, everyone said that finally, operators would shut-in wells. They did not and kept the spuds open even down to 0.66 USD/MMBtu when prices started to recover.

The gas kept flowing despite all the chatter suggesting the opposite – and so will the LNG now keep flowing.