LNG is Still King, Despite Growth in Renewables (TGP, HMLP, GLOP)

For the first half of the century, oil and gas stocks outperformed the S&P by a wide margin, but in the last 6 years they have reversed significantly with the S&P 500 index up 90% and the energy sector index (XLE) down 60%.

The energy sector is a diverse world consisting land drilling, sea drilling, transport pipelines, refineries, export terminals, ocean shippers, shuttle tankers, retail outlets, and more. Generally, they are all interconnected and depend on the price of oil; if drilling gets hit because oil prices tank, the rest of the industry gets hit as well.

Only fossil fuel energy companies are considered to be part of the energy sector, oddly enough, and the reason is because there is nothing to drill, transport, refine or sell in a retail location. Renewable energy is captured from a device built in a location that harnesses the sun, wind or water and it continues to generate electricity ‘out of thin air’ until the device is replaced. Therefore, renewable energy companies are generally classified as either industrial manufacturers (who build the devices) or utility companies (who maintain the devices and sell the electricity downstream).

This article discusses the future of the energy industry as it pertains to natural gas & liquefied natural gas (LNG) and why the natural gas industry has a bright future ahead of it despite new regulations to address climate change, which will reduce the usage of other fossil fuels.

In the last section of the article we review specific companies that you can invest in that should perform well as the growing Natural Gas / LNG future unfolds.

First we review the current state of the energy sector.

The Energy Industry Downturn

The energy industry had been suffering since mid 2014 when China’s oil consumption slowed and OPEC decided to create an oil glut to gain market share at the expense of American shale producers. Saudi Arabia, the largest OPEC member, has the lowest production cost in the world, so putting competitors out of business by keeping the price low in the short term can reap long term rewards.

There hadn’t been much improvement to oil profits in the ensuing years due to the shale oil revolution that has produced millions of barrels of oil in the US heartland creating an excess supply. When 2020 finally came along, the pandemic sapped world energy demand which has been the industry’s coup de grâce.

Several well known firms have already declared bankruptcy and plenty more are on the ropes. And it’s not just small Exploration &Production (E&P) companies that have taken a hit either. Several of the largest Supermajors have had large impairments on their assets and Royal Dutch Shell cut their dividend for the first time since World War II. There has been some tremendous damage to the industry.

Investors Fleeing

Not surprisingly, this has caused investors to flee the sector.

Performance in the energy sector has back-tracked so much now that it has handed back not just years, but decades. “Energy is dead,” is a common refrain.

It’s not just individual investors either. There is another major influence hampering energy equity and bond prices: Environmental, Sustainable, Governance (ESG) investing. These are funds that specifically exclude ‘dirty’ investments such as fossil fuel companies (and other perceived unsavory investments such as tobacco and weapons manufacturers). And they are no longer marginal thematic investments catering to a small class of Sierra club members. Of the hundreds of funds now in existence, they now hold $250 billion and are growing every year.

When politicians around the world are busy creating public policy to address climate change and meeting 16 year old activists to hear their opinions on the subject, you know that there are big, mostly negative, changes on the horizon for the oil industry.

Any new regulations added to the energy industry raise its operating costs and make it harder to turn a profit. And with investor money flowing out of these company’s stocks and bonds, it raises the cost of capital creating a one-two-punch knockout on the industry.

As a side note, I have never been a big proponent of ESG investing mainly because some of the best performing stocks over the long term (such as MO, BTI, or ET for example) would have been excluded from the index an ESG portfolio tracks. It reduces the investment set, which reduces diversification.

I am not alone in that opinion and the venerable “Random Walk Down Wall Street” author Burton Malkiel wrote about the exact same thing in the Wall Street Journal recently.

New Sexy Investments

Furthermore, the financial media has been hyping the diametrical opposite story of clean energy and electric vehicles. The solar ETF TAN has nearly tripled this years and Tesla is up almost 600%. The more the stocks increase in value, the more articles the financial media writes about them, and the more investors jump on board. It creates a feedback loop. Profits be damned, they’re the future!

Getting a lowly 8-9% dividend is so boring, comparatively.

Investing Cycles

For anyone paying attention, Bitcoin, blockchain, cannabis and hydrogen stocks were all themes of the recent past that created massive price run-ups in a short time period due to extensive media coverage, before eventually biting the dust (Bitcoin bit the dust, but has come back again at the end of 2020).

Another example is the tech stock story of 2000 that was hyped beyond recognition as ‘new economy stocks that were going to change the world,’ and then tripled before spectacularly diving into the ground. It took over 14 years for Microsoft to reclaim its year 2000 peak high, for instance. The year 2000 changed the trajectories of a lot of investment accounts, that’s for sure.

These trends can last for a long time and can go any which way in the short term, but ultimately the return on invested capital is what drives stock prices in the long term. Investors need a return on the capital they put in either through dividends, buybacks or metrics that show the business will compound capital over a number of years. Joel Greenblatt wrote a great book and runs a hedge fund on the principle of earnings yield: how much money you put in and how much money you get back. It’s a core principle of a well run business.

If the only thing driving a stock higher is a greater fool, eventually you run out of fools. Think about this, Tesla is worth more than all global car companies combined, trades at 15 times sales, but only sells 1% of the global vehicles (~600k cars per year). And almost all its market cap has come in 2020. Tesla has big shoes to fill regardless of whether it will triple sales or makes a good car.

The exact opposite has been occurring with energy stocks, where people are running for the exits and are willing to dump their fossil fuel holdings at any price. Some of these companies generate billions of dollars per year in cash flow, trade at less than 2 times sales and pay 10% dividend yields.

I will spare you the Warren Buffet clichés, but I’m sure you’ve heard the one I am thinking of a hundred times already.

Natural Gas

So with the energy investment backdrop in your mind, this brings us to natural gas and ultimately the topic in this article.

Natural gas is the cleanest fossil fuel consisting of methane that when burned, converts to heat, water vapor and carbon dioxide. Both consumers and industrial companies use it to heat homes & offices, heat water, use as a cooking fuel and create fires for ambience in homes and hotels. Chefs routinely prefer a flame instead of an electric coil due to the distribution of heat.

What most people don’t know is that about 40% of electricity in the USA is generated from natural gas. Globally, electricity created from natural gas is roughly 20%, but growing rapidly especially in countries that are trying to phase out coal (China) or reduce nuclear energy (Japan). Japan and China are the two largest global importers of natural gas.

Natural gas is cheap, widely available, easily stored, can be compressed into a liquid and transported by sea. It isn’t affected by events that impact renewable energy supplies, such as cloudy skies, hot temperatures, snow, or lack of wind.
And when used for household heating, it has a 90%+ efficiency rate (compared to electric heaters which first rely on electricity generated from another source and then sent across the state, retaining only 30% of the original energy content).

You can also run cars and buses off compressed natural gas (something exceptionally underutilized, in my opinion).

Natural Gas Trends

There was a time not long ago when natural gas utilities were considering the end of their business model since natural gas production in America, along with oil, had steadily dropped since the 1970’s. This all changed with the advent of the hydraulic fracturing technology put into use in the mid 2000’s that made what was once unrecoverable, recoverable.

Natural gas is now plentiful in many locations in the world. US reserves are now more plentiful than anytime in history, and that is after pulling it out of the ground for nearly 100 years.

World Growth Energy Needs

The worldwide pandemic has reduced energy usage globally (US energy use hit a 30 year low!) since many countries and states have imposed lock-downs on businesses and restaurants and fewer people are traveling, but this is only a blip in the road. The planet is expected to add 2.1 billion people by 2050 and as more emerging economies develop; their energy demands will need to be met.

And while it is true that renewable energy will continue to grow and is forecast to eventually be the lead form of energy generation by 2040, natural gas usage is also forecast to grow another 30% over the same time period, with Asia leading the way.

In a BP published report, the Rapid Transition Scenario forecast to limit the rise in global temperatures by 2100 to below 2-degrees Celsius above pre-industrial levels, shows that natural gas will be broadly unchanged from its current level all the way to 2050.

Natural Gas Is Used In Concert With Renewables

And while the IEA recently concluded that solar is now the cheapest form of electricity generation, that conclusion is really drawn from the brushed over “revenue support mechanisms” (i.e government subsidies) that artificially push the cost of manufacturing production down. Electricity generated from natural gas is the cheapest source of electricity and doesn’t require subsidies to do so.

The IEA also states that “from an energy transitions perspective, natural gas can provide near-term benefits when replacing more polluting fuels,” which is exactly what is happening with coal. And it will also act as the bridge during peak demand or when the sun isn’t shining.

How to Transport Natural Gas?

There are two ways to supply natural gas to nations that then feed the supply into their local natural gas distributors, pipelines or via LNG carrier (LNG tanker).

Pipelines

Pipelines are usually what most people are familiar with. They are very efficient, but require multinational agreements and easements across potentially hundreds of miles of land or sea. It really only makes sense if the supplier and consumer countries are not terribly far from each other. For instance, it would be very difficult for the USA to build a pipeline from the mainland to China since pipelines would have to be built across Canada and Russia.

The second problem with pipelines is that they tie your gas supply to a single source nation. One of Europe’s largest sources of gas is through a pipeline from Russia, the Nord Stream. Europe has to balance the idea of cheaper energy for their citizens, with the idea of enriching a nation that has demonstrated hostility towards other nations, and has aspects of a dictatorship.

Liquefied Natural Gas (LNG)

The other way to transport natural gas is by sea through a specially designed LNG vessel. Natural gas is cooled to minus 260 degrees Fahrenheit which transforms the gas into a liquid and then loaded onto the ship. The advantage of this method is that a large amount of energy can be compressed into a small space (a single load can heat 45,000 homes for a year) and the importing nation can trade with any of the LNG exporters in the world. An importer can avoid geopolitical issues and tariffs by choosing another LNG supplier as they see fit.

The two largest producers of natural gas, Qatar and Australia are essentially islands so the only real options they have to supply it is through LNG export terminals.

An interesting case is Bahrain. They are only 150 miles by land and only 22 miles by sea from Qatar. They technically could build a pipeline and have a very efficient delivery mechanism, but instead they decided to build an LNG import terminal providing them with options for LNG supply around the world. Why? Diplomatic relations between Qatar and 4 powerful Arab countries were cut a few years ago over perceived transgressions for support of militant groups. The most efficient routes can be the most diplomatically sensitive ones.

LNG Trade Continues To Grow

In the past five years, global LNG trade has increased by 45% and in 2019, China became the largest importer of LNG. PetroChina, China’s largest natural gas supplier, has predicted that China’s demand for LNG will double over the next 15 years despite the effects of the pandemic and the rising importance of renewables.

The USA is the third largest producer of liquefied natural gas and has only been exporting it since 2017.

And with the current trend, India’s demand for natural gas could match China’s eventually.

We are still in the early stages of the LNG revolution.

LNG is a Long-Term Contract Based Business

The chief reason that exporters and importers require long term multi-year contracts with each other is because huge capital investments in infrastructure are required to build the facilities to export and import it. Land needs to be purchased next to the sea, pipelines, storage tanks, and liquefaction facilities need to be built to the export terminal. And then on the import side, sea land, regasification facilities, storage tanks and pipelines need to be built as well.

The final price tag for a single facility can be $18 billion.

Additionally, to get the LNG from export to import terminals around the world, vessels that cost over $150 million are necessary to transport it (there are also multiple designs for LNG carriers which affects the storage capacity, price and efficiency).

It also takes years to build all of this infrastructure, and so a company isn’t going to risk multiple billions of dollars if they aren’t certain that there will be any business for it after it is all built.

The Necessary Condition for Profits in LNG

The obvious relationship for steady profits for LNG exporters is lots of demand in the import nations and plenty of supply in the export nations, which creates a price differential between the two markets. The usual futures markets referenced for comparison are the Henry Hub, Dutch TTF Natural Gas and LNG Japan/Korea Marker contracts.

The larger the price differential between the source are the destination, the better for the exporter since in order for the exporter to make money, the spread needs to cover the cost of the commodity, liquefaction, shipping costs and the regasification. Teekay, a large LNG shipper I discuss below, estimates that only a $1 spread between the Henry Hub and Asia prices is required to be profitable for an exporter.

The spread has started to widen as the JKM has been turning up on winter buying and there are drilling strikes in Norway.

However, the short term relationship between these markets doesn’t affect most of the shipping companies, since if the company is well run, most of the ships will have multi-year contracts that lock in a favorable spread. But ships do eventually roll off contracts. In that scenario, if they can’t renegotiate a favorable deal to both parties, the ship is destined to the spot market which is heavily dependent on this relationship.

And of course, having a large spread between the markets is not the only requirement for company profits. A company also needs to be well run with management that can secure new contracts before old contracts roll off, buy ships where the investment will be recouped, doesn’t bleed the company with bloated salaries and excessive crew, they properly maintain their ships, and create consistency in cash flows for all stakeholders.

If they are inefficient allocators of capital, when the tide goes out, the ship runs aground. A lot of energy companies burned through billions of dollars of capital over the last ten years because the equity and debt markets were very loose in their standards. Investors have become more discerning after losing so much.

How to Play the LNG Trend

There are a few ways to capitalize on the natural gas and LNG trend but this article focuses on the last option. The set of options are:

• Buy a natural gas ETF or ETN
• Buy stock into a natural gas exploration & production (E&P) driller
• Buy stock into an MLP that focuses on the transport of natural gas.
• Buy stock of a company that exports LNG
• Buy stock of a company that ships LNG from exporter to importer

Each of these methods has various pros and cons.

Natural Gas ETF / ETN

I primarily mention this avenue to preempt those who are aware of these exchange traded products and steer them away from them.

But for those who don’t, there are exchange traded funds and exchange traded notes that buy natural gas futures, such as the United States Natural Gas Fund (UNG) or the more famous VelocityShares 3x Long Natural Gas ETN (UGAZF), that seeks to apply three times the daily leverage of the futures. They generally all hold a constant weighted 30 days of futures expiration by buying the two nearest contracts and then rebalancing them daily as time moves forward.

There are several reasons why I don’t recommend these products.

Firstly, it’s direct exposure to the commodity but you are playing the price of the commodity but not the business of it. What I mean is that if the market were to stay perfectly balanced and supply would meet the exact demand, the price of the commodity would stay the same and you would not make any money regardless of how much natural gas is sold around the world. When you buy these products you are betting that a short term move such as a supply disruption will kick the relationship out of kilter and drive the price higher. It’s speculation.

Secondly, not only do these funds have steep management fees, in the futures market the term structure of commodities is often in contango. This means that contracts for delivery at later dates are more expensive than futures at closer dates, which are all then priced above the spot rate (the price that a buyer would pay today). As time draws near, both contracts drift downwards toward the spot price. So the flaw in this strategy is that you are always buying contracts that are losing a little bit of money each day, and then paying management fees on top of it.

And thirdly, the daily rebalancing feature creates a mathematical ‘flaw’ in volatile products and the levered funds exaggerate it. For example, if an asset moves up 10% one day and down 10% another day, you are actually down 1% (1.1*0.9 = .99). But if you buy the 3 times levered product that converts the up return to 30% and the down return day to -30% this results in a loss of 9% (1.3*0.7 = 0.91).

Look at the time term chart of any of these products to see what I mean.

Exploration & Production

I generally avoid E & P companies because their business model is super dependent on the price of the commodity. It’s a feast or famine business that always seems to revert to the famine scenario mainly because the cost of production for US producers is significantly higher than other global players.

Additionally I really haven’t been impressed with any of the way these companies have been managed. They’ve gorged on debt and also overspent on wells and production, which has created a lot of oil and gas, but has destroyed billions in investor capital at the same time. The WSJ estimated that the industry burned through $280 Billion over 7 years.

At the Petroleum Update’s 2019 Northeast Petrochemical Conference in Pittsburgh, the former CEO of EQT Corp, one of the largest natural gas producers, had this to say:

“The biggest problem is the shale gas revolution has been an unmitigated disaster for buy-and-hold investors in the shale gas industry…I’m not aware of another case of a disruptive technological change that has done so much harm to the industry that created the change…Excluding capital, the big eight basin producers have destroyed on average 80% of the value of their companies since the beginning of the shale revolution

Steve Schlotterbeck, Former CEO for EQT Corp

And although comically named “the best managed oil and gas company” in 2007, the the legendary Chesapeake Energy filed for bankruptcy in 2020. They were once the largest independent natural gas producer but overpaid for drilling land, engaged in a lot of shady related transactions with the founder & CEO, and with natural gas prices low for several years, had to fire-sell assets to keep the lights on towards the end.

Needless to say, I haven’t seen any E&P company I have been excited to throw money at.

Natural Gas Master Limited Partnership (MLP)

I’m a big fan of a few select MLPs, but very few of them are a pure play on natural gas and usually more of their revenues come from the transport of oil or LPG (Liquefied Petroleum Gas). The diversification can be a good thing but their business models are not necessary the best way to capitalize on the LNG revolution.

In the future I will write an article on my favorite MLPs and why, but the next two I discuss are more direct ways to capitalize on LNG trade.

LNG Exporter

The next option is to buy into a business that exports LNG. Cheneire (NYSE: LNG) was the first LNG exporter to get approval in the US, and the anticipation of big profits was astounding. They are the only pure play LNG exporter on a US exchange. The other LNG terminals that have come online since Cheneire got its head start are part of privately held businesses or larger MLP pipeline companies.

However, in anticipation of this first mover advantage, the stock price roared 31x in about 5 years and the CEO was the highest paid CEO at the time with a $142 million payday. They were doing road shows with asset managers (even I attended one) pumping up the story of all the money they were going to make, that is, in a few years. Investors and speculators were willing to pay any price to board the stock.

And this is why: exports were forecasted to skyrocket, and they did.

But I am never a fan of this kind of ‘story stock’ because the price gets bid up so much that the reality never meets the expectations. Sure enough, the subsequent stock performance has been negative since it peaked, and the stock hasn’t done much for five years. This is pretty common with stocks that are fluffed up to the moon.

Right now I don’t really see anything special about the stock. It’s fairly valued, loaded to the gills with debt and doesn’t pay a dividend (although a MLP they control does).

LNG Shipping

The final way in this article to play the LNG trend is through an ocean shipper, which is conceptually like a moving pipeline. There are at least a half dozen public LNG shipping companies that come to mind and some of them we will discuss now.

Almost all of them have both a corporation and a high yielding MLP structure that you can invest in, but even for the MLPs that I discuss here, they choose to be taxed as US corporations (they are often incorporated in the Marshall Islands, a US territory), so you never have to deal with the dreaded K-1 tax form and you still get a 15% tax favored dividend.

If the retaliatory tariffs that China applied to the US LNG market come to an end in 2021, it would likely be a positive for both exporters and shippers as more LNG cargo would be exported to China. We are starting to see more agreements being signed in anticipation. However, while LNG shipping companies don’t require any particular importer or exporter and go where the demand takes them, more LNG moving around the planet is a benefit to their business.

Teekay LNG

Oct 4, 2021 Update: TGP general partner agreed to sell to Stonepeak for $17 a share (only a 9% premium at the time of the announcement). They own 41% of the common shares, so only need to convince 9% of shareholders to vote yes on the merger, but I suggest voting no if you hold shares. The sales price is only at book value. I’m actually blown away why the GP wants to basically just give it away when the LNG market is super hot right now.

My favorite of the LNG shippers is Teekay LNG (TGP). They are one of the largest LNG and LPG (Liquefied Petroleum Gas) companies with 77 vessels (47 LNG, 30 LPG, with various levels of partnership interest). They also have a 30% interest in the Bahrain regasification terminal I mentioned earlier and it is scheduled to begin operations in Q4 of 2020 leading to an additional cash flow stream.

Like most energy companies these days, the stock is currently yielding around 9%. Of course many investors are scared of stocks yielding more than 4% and fear dividend cuts are on the horizon when this happens. It’s a legitimate fear if you take it on face value, because many companies do cut their dividend at these levels and even TGP cut their dividend 80% back in 2016 during the energy rout which led to a precipitous share decline. Several other energy firms have also cut this year.

However, not only have they made statements about being committed to returning cash back to shareholders, their cash flow, income, and distributable cash flow (DCF) metrics actually lend credence to these statements. In fact, without any capital expenditures planned in the near term, I calculate they have about $1.79 per share of free cash flow after factoring in distributions. This makes their DCF coverage about 2.64x, which is very strong.

And while their Price/Earnings ratio is under 10, their P/DCF ratio is under 5. The difference between the two figures is because ships incur a non-cash depreciation which reduces earnings, but not their cash flow.

Furthermore, the partnership is trading at about 80% of book value, but with the current pandemic market weakness, any impairment of ships could wipe out that discount. A few other shippers have taken impairments this year for this reason.

The CEO has made some very bullish statements over the last year. For example at the beginning of 2020 he stated,

“We are currently in the process of completing the last of our recent phase of growth projects… With nearly all of our current growth projects delivered and generating cash flows under long-term contracts, we are moving from a phase of project execution to a period of significant cash flow generation, which we believe will enable the Partnership to allocate capital towards balance sheet de-levering and returning capital to unitholders.”

Mark Kremin, Teekay LNG CEO

And this is exactly what they have done since. They’ve repurchased millions of shares and aggressively raised dividends since the 2016 cut.

My only real source of contention with management here is the incentive distribution rights (IDRs) conversion transaction that they completed this year which negated a large portion of the share buybacks.

IDRs are unique to partnerships and provide management with increasing levels of cash flow as the distribution increases across various tiers. Theoretically it is to incentivize the management team to keep increasing the dividend, but generally the terms are very favorable to the general partner (GP). Over the last few years, partnerships have started exchanging IDRs into common stock because it is a drag on performance. I have yet to see a deal that has been favorable to the unit-holder, so this point of contention is not unique to Teekay.

In Teekay’s case, the general partner exchanged them for 10 million shares worth around $125 million. Why was it a bad deal for unit-holders? Because ever since they cut their dividend back in 2016, the IDRs haven’t paid the general partner a cent, and the current distribution is way under the threshold to start paying it again anytime soon. The IDRs were basically worthless to them.

It would take years of dividend increases to be worth the deal that they traded it for. They were able to push this through because the parent company Teekay Corp (TK) owns the majority interest, as is typical in MLPs. The good news is that this is only a one time deal and something that unit-holders don’t have to worry about in the future.

On a positive note, they have been de-levering their balance sheet, which strengthens an equity holder’s position. In the 2020 Q3 earnings report they reported that they reduced net debt and annual interest expense by 9%. The CEO added,

“Importantly, we expect this trend of debt reduction and declining interest expense to continue while simultaneously paying an annual distribution of $1.00 per common unit, which is well-covered by our stable earnings and cash flows.”

Mark Kremin, Teekay LNG CEO

Since the interest expense coverage ratio is already greater than 3x, this bodes well for both preferred and regular unit-holders.

Finally, in their latest Q3 earnings report they reported that 96% of their fleet is under contract for 2021, with modestly decreasing rates for future years where they haven’t yet renewed contracts. But the stability of cash flows for the next year is already built in and the current low chartering rates for LNG during this global lockdown are not particularly relevant for TGP unit-holders. TGP is going to ride it out and make rates well above spot for at least the next year and more. This is important because the LNG market is currently oversupplied with ships, which doesn’t bode well for the companies with ships that don’t have contracts and are chartering in the spot market.

I own both the common and preferred units.

GasLog Partners

If you are willing to up the risk level, GasLog preferred shares (yielding 15%+) could be something to consider. On November 11, 2020, they announced a 92% reduction in their common dividend to save $22 million a year to pay down debt. This was the second dividend reduction in 6 months. Generally speaking, this is not a sign of confidence for any company to cut their common dividend twice, especially by this much.

Their challenge is that they are a smaller LNG shipper with only 15 carriers (their affiliated GP, GLOG, doubles the number of vessels, but GLOP doesn’t have an interest in those) and 5 of those ships are driven by steam propulsion and all five of them rolled off their contracts in 2020.

Steam ships are generally older ships that have a smaller capacity and aren’t as cost effective to transport LNG with. Therefore, they are hard to renew contracts for and are destined to either charter in the spot market when demand requires additional ships beyond what is already contracted or they become floating storage units.

However, the Q3 2020 earnings report showed that one of them received a three year contract and another received a multiple month contract, so it is not completely hopeless.

The spot market shipping rates fluctuate on supply, demand, and time of year. Earlier in 2020 when the pandemic started, the rates were very unfavorable with the canceled cargos and lack of energy demand, but that reversed significantly towards the end of the year. In December, steam turbine ships were closing in on six figure daily rates.

What impact will the steam ships be on the revenue? It is not clear because they don’t break down the revenue per ship or per class of ship. To be completely conservative, you would just assume that the 4 ships without a multi-year contract are unable to charter LNG loads so that 25% of the total partnership revenue takes a hit (steam ships earn lower rates to begin with).

More challenges remain beyond the steam vessels, however. A total of 8 dry-dockings will occur in the remaining 2020 and 2021, 4 of which will require a water treatment ballast system (WTBS). Typical dry-dockings take the ship out of the water for 30 days to perform routine maintenance to the hulls, rudder and engine but the pandemic could create delays. The water treatment system takes about two weeks and can be done concurrently with the regularly scheduled dry-docking, but a conservative assumption would be estimate 60 days out of water.

Each WTBS system costs $1 million.

On the bright side they have announced cost saving measures such as closing global field offices and with their dividend cut they are retaining more cash to pay down debt.

When you add all these points together, their preferred shares look to be 1.5x covered by the distributable cash flow (DCF) of $14.5 million for the first year (after paying debt financing, dry-docking and replacement reserves). After the WTBS and extra dry-dockings are taken care of, the preferred dividend should return to being 2.2x covered if they are unable to find revenues for the 4 vessels. Of course, things could improve by the middle of 2021 since three different vaccine candidates were announced in November.

To explain this calculation, I use the proportion of the voyage expenses and operating costs to compute the estimated future quarter from the assumed 25% reduction in revenue stemming from the steam ships. I also use the same method for all the dry-dockings compressed into a single quarter. A full year is then blended together with 3 reduced revenue quarters and the compressed dry-docking quarter so that the timing of the dry-dockings impacts the annual numbers, but not a single quarter. Then the following year 2022 is just 4 quarters of the 25% reduced revenue quarter.

Again these are conservative estimates since the dry-dockings should take less time and their $22 million a year cost savings from killing the common dividend should lead to debt reduction and reduced financing expenses. If they impair the valuation of any of their vessels this is a non-cash charge and doesn’t affect the DCF.

I own both the common shares and preferred stock shares.

Höegh LNG Partners LP

July 27, 2021 Update: They cut the dividend to $0.01 per quarter because the of a “failure by the charterer of the PGN FSRU Lampung to consent to and countersign certain customary documents related to the new credit facility, ” meaning they have to contest this and find alternative financing. This is a black swan event since it’s not something that could have been predicted under normal business operations.

Höegh (HMLP) is an interesting stock play because their ships are a little bit different than typical LNG carriers. They own 5 floating storage regasification units (FSRU), which are basically LNG tankers that also have the equipment onboard to regasify the LNG to export gas directly from the ship.

While more expensive per shipment, they are useful for smaller, developing markets or locations where building the billion dollar regasification and storage facilities doesn’t make sense. These FSRUs are a hot commodity right now and Höegh has no charters expiring before 2025.

Right now the common units are yielding around 15%, so the market is forecasting a dividend cut. And frankly it’s a real possibility depending on how business goes for the rest of 2020 and their consideration for capital structure. Why?

Firstly, the DCF is compressed. I compute a paltry 1.17x coverage which is definitely in the danger zone. So far cash flow has been weak this year with the world energy demand sapped. Hopefully that improves as energy demand picks up.

Secondly, HMLP still has IDRs outstanding. While currently costing the partnership about $1.5 million per year, it has been en vogue lately for partnerships to initiate simplification conversions with generous terms for the general partners. If they do a simplification transaction and exchange them for common units, it is an absolute certainty they would immediately announce a dividend reduction right after since their dividend coverage is currently maxed out. The extra shares could not cover the payout.

On the plus side they are not overly leveraged with a NET Debt / EBITDA approximately 4.4 and the shares are trading only 20% above tangible book value. If they halve the dividend, they would still yield 8%, but the stock shares would probably drop 20% or more.

The preferred shares are rock solid, and I own both the common and preferreds.

Other LNG players

There are a couple more LNG shippers available to the market, such as Golar LNG Partners LP (GMLP), Dynagas LNG Partners LP (DLNG), and Flex LNG (FLNG), but they are smaller players and only have a handful of vessels each. The first two have been having a more difficult time this year and have both cut their common dividends to paltry amounts. Flex has only been publicly traded for a little over a year.

However, Dynagas may be turning around because they reported Q3 earnings and it was a pretty good report showcasing their fleet contracts for the next few years and strong earnings this latest quarter, but I have concerns about their interest expense coverage ratio being a little weak so I am holding off for the time being.

And while I have a similar concern for the interest expense coverage for Golar, I do own a little bit of their preferred stock.

Summary

Natural Gas is incredibly cheap fuel, abundant, relatively clean compared to other fossil fuels, and the energy content can be compressed into a small space. It also can be used in conjunction with renewable energy to pick up the slack when the sun isn’t shining or wind isn’t blowing.

The LNG market is setup to do very well for the next several decades with China doubling their imports and other emerging countries beginning to import it. While there are many ways to capitalize on this global LNG trend with varying levels of risk, I feel that LNG shipping will be the best beneficiary of the wide expansion of transportation for this fuel.

For the last several years energy stock prices have plummeted which has raised cash flow yields to incredible levels. Many of the LNG business operators are not exposed to the same problems that oil drilling companies have and many have long term contracts that guarantee profits for many years to come.

My preferred pick from all of the LNG shipping companies is Teekay LNG since they are one of the largest operators and have multiple long term agreements with many of the world’s largest gas companies. Their cash flow metrics also support their large dividend yield with minimal risk of reduction. The dividend also receives the favorable 15% federal rate.

For those companies with spot charters (GLOG/GLOP), currently the LNG spot market is hitting records.