MANAGING DIRECTOR AND CHIEF EXECUTIVE OFFICER'S REPORT
This past year was marked as a period of significant transition, both inside Liquefied Natural Gas Limited (LNGL or Company) and within the global LNG industry. It was also dominated by disruptive events that no one could have conceived or fully predicted. Against this backdrop, I write to you with a sense of purpose and optimism regarding LNGL's prospects for success.
Global political developments including Brexit, the U.S. presidential election, and constitutional referendums and political outcomes in European countries surprised many. Strengthening business fundamentals appear to support accelerating global economic growth but remain tempered by other geopolitical challenges and hostilities. Despite pro-business policies arising from some of the year's political outcomes and positive rhetoric regarding the LNG industry by the U.S administration, simple inaction or overhang of protectionism may still impede progress.
As anticipated, previously sanctioned new LNG supply ramped up at projects from the U.S. to Australia during the year. New countries opened their doors to LNG as a preferred source of energy. Markets explored the virtues of LNG for non-traditional applications such as marine bunkering and long-haul transportation fuels that supplement traditional uses for LNG. At the same time, project delays and plant outages kept supply growth partially subdued.
In 2016, global LNG demand grew by approximately six percent, to about 260 million tonnes per annum (mtpa) from 245 mtpa in 2015. By 2022, global demand is anticipated to approach 400 mtpa, a remarkable increase in demand.
On the supply side, Australia's 2016 LNG exports grew to approximately 58 mtpa. U.S. Gulf Coast projects were second in terms of supply growth with exports of 3.5 mtpa. Traditional LNG exporters - such as Nigeria, Yemen, Trinidad, Malaysia, and Algeria - exported reduced volume due to security issues, lower gas production, and growing domestic demand. New supply growth, principally from Australia, the U.S. Gulf Coast, and Southeast Asia, will continue to increase into 2018 and 2019 as previously sanctioned projects come on-line.
Most LNG marketing transactions in the year centered on the re-marketing of volumes by legacy capacity holders, marketing of excess capacity and/or cargoes, and traded volumes, all largely priced at or near marginal cost economics. In the end, LNG prices remained below the cost of new supply as new demand growth worked towards rebalancing the current oversupplied market. Spot LNG prices in Asia and Northwest Europe did rise in winter months due to extended cold weather, peaking at around $6.00, but prices have settled near $5.50 in Asia and at about this level in Northwest Europe as of June 30, 2017. Brent price, an important budgetary business driver for many LNG buyers, remains bearish fluctuating from a high of around US$56/bbl to as low as US$46/bbl, before closing at around US$48/bbl at June 30, 2017.
In this current oversupplied global LNG business cycle, commodity prices, economic drivers, and psychological factors buoy a wait-and-see strategy by most global LNG buyers. The events of the past year are a stark reminder of how quickly expectations and conditions can change and the importance of focusing on the things we control.
It is not lost on me that the dominant question on everyone's mind is timing - when can we expect offtake sales and when do we expect to take FID on our projects? On these points, I cannot provide absolute certainty. I am confident that management's priority is in signing offtake agreements with investment-grade counterparties in sufficient volume to realize a positive FID, financial close, and a move to construction and operation of LNGL's projects as soon as feasible.
Our development focus is in North America which is blessed with a prolific natural gas resource unlocked by the advent of expanding shale resource development. Through technological advances in the upstream industry, the cost to find and produce this bountiful resource is low relative to the cost of other global resource options. The dependability of long-term and low-cost natural gas feedstock is coveted by LNG buyers. Natural gas supplies from North American sources therefore mitigate and satisfy buyer concerns.
Since LNG 18 in Perth, the Company has consistently stated its expectations that global supply and demand would begin to rebalance by around 2022 when demand is expected to approach 400 mtpa. Most published third-party assessments of global LNG markets coalesce around this timeframe. This requires new supply sources at that time to sustain the balance against growing demand thereafter. To serve this forecasted demand and given the lead time required to achieve first gas at a new liquefaction facility, construction on new projects must begin in the 2018 to 2019 timeframe, with offtake contracting and FIDs occurring ahead of construction start dates.
Globally, there is almost 900 mtpa of proposed new liquefaction capacity. North America accounts for approximately 660 mtpa of this amount. Most of these proposals, particularly higher-cost greenfield developments, face significant challenges due to economics, regulatory issues, time to market, and other factors. With numerous projects competing for offtake contracts, only the most regulatory mature and cost-effective proposals are likely to succeed. Most will never be built.
Importantly, during 2016 only 5.9 mtpa of incremental LNG capacity reached FID - 70 percent below 15 year averages. 2017 will likely be even quieter for new supply FIDs. Per industry commentators, only 10 percent of the 900 mtpa of proposed new capacity has the potential to reach FID prior to the end of 2019. As a further subset, only a small percentage of these projects are currently fully permitted from a U.S. Federal Energy Regulatory Commission (FERC) and U.S. Department of Energy (DOE) (or equivalents) perspective and have the corporate backing required to progress to sanction and into construction. Given these circumstances, the number of projects capable of delivering LNG into 2022 are very limited.
This current constricted trough of new entrant investment decisions creates LNGL's opportunity to lead the next wave of LNG supply sources. It is incumbent upon us to prove to buyers that Magnolia LNG is the project of choice.
As we all know, offtake capacity agreements require two parties, a willing buyer and a willing seller. Terms of these arrangements must balance both the buyer's need for competitively priced gas into their end markets and the seller's need to achieve financial close and provide a return of and on capital deployed. In today's market, there are more willing sellers than buyers, which is a contributing factor as to why there have been no long-term LNG offtake contracts of size signed since early 2014. The current LNG oversupply allows buyers time to probe sellers on their willingness to diversify from traditional pricing structures, to adjust contract tenors, and to agree other buyer friendly terms. These efforts have slowed long-term contracting activity.
The situation has been further challenged by the sheer number of sellers seeking to engage in offtake negotiations with buyers. The reality is that nothing can prevent hopeful developers from proposing offtake terms to buyers despite the immaturity of the associated projects and unsubstantiated pricing constructs. These speculative proposals cloud the commercial landscape for buyers looking to contract for new LNG volumes with viable projects on bona-fide terms and conditions.
In this highly competitive market, buyers face the challenge of assessing both the economic opportunity of a proposal as well as the probability that a developer's proposal achieves a positive FID and becomes operational. For a willing buyer, long-term liquefaction offtake agreements represent financial commitments in the billions of dollars, which is a significant commitment for any company to make. When considering these issues and the magnitude of the financial commitment offtake contracts introduce, buyer's diligence is understandable and patience on the part of sellers is a virtue.
During the year, LNGL undertook a very detailed assessment of the competition in comparing their strengths and weaknesses to Magnolia LNG, which culminated in an investor presentation made on March 31, 2017. It elaborates on a competitive basis why Magnolia LNG remains the best economic choice for LNG supply. Most of the content in that presentation has been subsequently validated through disclosures made by many of the competitors contained in our study. However, these competitors continue to speak about ranges of EPC costs that are yet to be determined, using words such as "target", "expectation", or "approximation". Not only do most of these disclosures lack executed contracts in support of their claims, they also fail to encapsulate the all-in costs to construct. Depending on the project, significant incremental capital may be needed for flood protection, waterway dredging, pipeline construction, installed generation capacity, and similar other costs required to ultimately produce LNG. These costs require a return on the capital employed that must be financed. This means these costs must either be passed through to the LNG buyers and included in offtake pricing, or result in lower returns to the developer that threaten the viability of achieving project financial close. Based on our analysis, I remain steadfast in my belief that LNGL's technology, projects, and people represent the most certain, economic, and real business partner for prospective LNG buyers.
Upon acquiring rights to the Magnolia LNG site in 2012, the LNGL team meticulously positioned the Company to seize on the current market opportunity. Few developers are as well positioned as Magnolia LNG to unequivocally state that they are 'shovel ready' and to provide offtake pricing without reservation or conditions precedent. Our competitive advantages of regulatory certainty, site selection attributes, operational reliability, production efficiency, environmental impact, and full life-cycle cost and economics differentiate Magnolia LNG as the best positioned North American liquefaction development project capable of delivering first gas in 2022.
Since joining LNGL in April 2016, my focus has been on refining our strategy to ensure we are best positioned to exploit our competitive advantages, with emphasis on marketing project capacity to LNG buyers and structuring financeable contracts. We believe many of our competitive advantages are sustainable in support of our three-path execution strategy for participating in global LNG projects.
This brings me full circle back to my confidence in LNGL's prospects for success. Most of the relevant data indicate a rebalancing of global LNG supply and demand around 2022. Although the population of potential new LNG capacity is very large, the number of projects truly capable of delivering first gas in 2022 is quite small. Natural gas is undeniably a substantial source of supply in the global energy mix and prospects for further market expansion are positive. In this context, specific competitive advantages for LNGL are easily enumerated, including:
- LNGL has up to 20 mtpa of development project capacity fully permitted;
- Magnolia LNG is shovel ready with EPC, equity financing, and regulatory processes contracted or approved;
- LNGL's construction timeline currently fits with a 2022 first gas delivery;
- OSMR(R) is a low-cost, scalable next generation LNG liquefaction technology that provides a full-cycleeconomic advantage shared by LNGL and offtake buyers, with no additional technology risk relative to otherproposed projects;
- The proliferation of natural gas production in the U.S. provides a dependable basis for long-term, low-costfeedstock gas supply for LNG production;
- Bear Head LNG has demonstrated its ability to be the most economic, long-term gas monetization plan forthe Western Canadian Sedimentary Basin in British Columbia and Alberta; and
- LNGL's commercial offerings aim to provide an acceptable balance between cost of gas required by buyersand return on capital required by shareholders.
In short, within the liquefaction development company landscape, LNGL is indeed one of the best positioned to achieve a positive FID and move to construction and operation. I am confident in our team to deliver this outcome.
In 2017, the Company solidified its position as a premier provider of LNG liquefaction solutions. However, we remain short of our goal of realizing FID on our projects, and our share price underperformed. Therefore, in addition to concentrating on marketing Magnolia LNG capacity, the Company made three key decisions in the last quarter of the fiscal year being:
- Initiation of exploratory efforts into redomiciling the Company to the U.S. accompanied by a listing of theCompany's shares on either the New York Stock Exchange or NASDAQ;
- Execution of an Amended and Restated Equity Commitment Agreement with Stonepeak InfrastructurePartners (Stonepeak), a New York headquartered infrastructure fund, relating to equity financing of theMagnolia LNG projects; and
- Exiting the Fisherman's Landing LNG project.
We recognize the focus required to deliver the final pieces needed to progress to a positive FID, financial close, construction, and operation of our projects. The immediate future operating environment in our industry is challenging and unpredictable, but our priority remains to deliver sufficient investment-grade offtake agreements to take FID. We shall execute these efforts in a safe, efficient, and fiscally responsible manner, and I firmly believe we will succeed.
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About Liquefied Natural Gas Ltd
- Magnolia LNG, LLC (Magnolia LNG), a US-based subsidiary, which is developing an eight mtpa or greater LNG export terminal, in the Port of Lake Charles, Louisiana, USA;
- Bear Head LNG Corporation Inc. (Bear Head LNG), a Canadian based subsidiary, which is developing an 8 mtpa or greater LNG export terminal in Richmond County, Nova Scotia, Canada with potential for further expansion;
- Bear Paw Pipeline Corporation Inc. (Bear Paw), proposing to construct and operate a 62.5 km gas pipeline lateral to connect gas supply to Bear Head LNG; and
- LNG Technology Pty Ltd, a subsidiary which owns and develops the Company’s OSMR(R) LNG liquefaction process, a mid-scale LNG business model that plans to deliver lower capital and operating costs, faster construction, and improved efficiency, relative to larger traditional LNG projects.
Liquefied Natural Gas Ltd