TheChek News Flow

Momentous step for US energy industry that is marred by poor LNG pricing amid oil rout

The Energy Atlantic, a 290-metre tanker steaming slowly through the Gulf of Mexico, is about to make history. It is scheduled to arrive on Tuesday at Cheniere Energy’s Sabine Pass liquefied natural gas plant on the coast of Louisiana, to be loaded with the first cargo of LNG to be exported from the “lower 48” contiguous states of the US.

The shipment is a momentous event for energy markets, marking the arrival of the US as a gas supplier to the world.

The plunge in oil prices since the summer of 2014 has dragged down the value of LNG, which is often sold on crude-linked contracts, and damped the excitement over US exports. The economics of shipping gas from the US were compelling two years ago, but are now marginal. Deteriorating market conditions have put the brake on any new investments in US LNG.

Even so, US LNG exports are likely to have a significant impact, holding down energy costs for consumers in Europe, Latin America and Asia. They will also provide tough competition for anyone hoping to build rival LNG plants, such as the proposed projects in east Africa, the west of Canada, or Russia. By the end of the decade, the US is likely to be the world’s third-largest exporter of LNG, after Qatar and Australia.

Combined with the new supplies from Chevron’s huge Gorgon and Wheatstone projects in Australia, which are scheduled to come on stream this year, exports from the US are making it a buyers’ market for LNG.

“There is an awful lot of LNG sloshing around the world at the moment, with even more to come,” says Frank Harris of Wood Mackenzie, a consultancy. “And that is putting downward pressure on prices.”

A decade ago, this prospect seemed wildly unlikely. US gas production was in decline and by the 2010s the country was expected to be a large importer of LNG, not an exporter.

The shale revolution, the result of advances in production techniques that made it possible to extract gas at commercially viable rates from previously unyielding rocks, meant that US production started rising again in 2006, and since 2011 it has been breaking new records every year.

Charif Souki, Cheniere’s visionary founder who was ejected from the company at the end of last year, was one of the first to see the potential for LNG exports from the US. In 2010, he submitted the first application to regulators to convert the LNG import terminal that Cheniere had built at Sabine Pass, which was being barely used because US domestic gas production was so strong, into a liquefaction plant.

Many in the industry were sceptical that the project could be made to work but the plan took a decisive step forward in October 2011 when Britain’s BG Group signed a 20-year contract to buy most of the production from Sabine Pass’s first “train”, as LNG production units are known. After that contract was signed, the trickle of proposals for similar projects turned into a flood.

The US Department of Energy has received applications to export LNG for 54 projects. If they all went ahead, they would have the capacity to liquefy about 60 per cent of the entire gas production of the US.

So far, however, just five plants have started construction: Cheniere’s Sabine Pass and its Corpus Christi project in Texas; Freeport LNG, also in Texas; Cameron LNG in Louisiana; and Cove Point LNG, on the east coast in Maryland.

Those projects have been able to make progress because they were fast enough at signing up customers on long-term contracts that guarantee their revenues. Since the end of 2014 those customers, mostly utilities in Europe and Asia, have been reluctant to make any further commitments.

The price of LNG delivered in north-east Asia, including Japan and South Korea, the world’s two largest markets, has fallen along with oil. It has dropped to about $6.65 per million British thermal units, just a third of its price of almost $19 per mBTU two years ago, according to Argus, the information service.

At that price, with benchmark US gas at about $2.40 per mBTU, plus liquefaction costs of $3 to $3.50 per mBTU, plus transport at about $2 per mBTU, LNG from Louisiana or Texas does not look commercially attractive.

Similar calculations apply in Europe. Benchmark UK National Balancing Point gas has dropped by almost a half since 2013 to about $5.20 per mBTU, meaning that LNG exports from the US to Britain are unlikely to cover all of their costs.

Since 2013, most of the new LNG projects launched worldwide have been in the US. However, the deteriorating economics make it unlikely that any new plants will be approved for a while.

The plants that have already started construction, though, are highly unlikely to be stopped. This is because the companies buying LNG from one of these plants have typically made firm commitments for 20 years under which they have to pay the charges they have promised, even if they do not use the capacity.

The US LNG projects will add to global oversupply. Bernstein Research has estimated that the world’s liquefaction capacity will in the next three years rise by 90m tonnes per annum, which is about 35 per cent of present demand.

Nikos Tsafos of Enalytica, a research company, says US LNG should help hold gas prices down for a few years at least.

When the global oversupply is finally absorbed by rising demand, the next wave of plants in the US, including projects backed by ExxonMobil and Kinder Morgan, will be poised to benefit.

There are other promising potential new sources of LNG in the world, including the projects to develop large gas discoveries off the coast of Mozambique.

But those are relatively unknown quantities compared to the familiar patterns of development in Texas and Louisiana.

“If those other projects don’t happen, we can always resort to the US,” says Mr Tsafos.

Global investors are planning to cut their exposure to hedge funds in 2016, following a disappointing performance in the past year, according to a survey.

The poll data, from research group Preqin, will be met with dismay by the hedge fund industry, which had hoped volatile stock markets would encourage investors to seek alternative sources of return. It is also likely to add extra pressure on hedge fund fees.

Preqin’s survey of institutional investors showed that more are planning to cut their hedge fund holdings this year than are planning to increase them, by 32 per cent to 25 per cent.

The downbeat results, which will be published this month in Preqin’s annual report on the industry, also show that one in three investors were disappointed by returns from their hedge fund portfolio in 2015 and have less confidence in future returns than they had a year ago.

Institutions such as public pension funds have been questioning the high fees charged by hedge funds — sometimes as high as 2 per cent of assets, plus a 20 per cent cut of investment profits — for several years, but have still ploughed more money into the industry in search of returns that are uncorrelated to traditional equity and bond markets.

The size of the global hedge fund industry was assessed by research firm HFR at $2.9tn at the end of the third quarter, but the Preqin survey suggests it may be close to peaking.

A year ago, the same survey showed investors planning to increase their hedge fund holdings, by a margin of 26 per cent to 16 per cent who said they planned to reduce exposure. The balance appeared to tip in the middle of last year, when an interim poll by Preqin first showed a higher number planning to cut their holdings.

The forthcoming report comes on the heels of another disappointing year for hedge funds. Following losses in December, the industry ended down 0.85 per cent for 2015, according to HFR’s fund-weighted composite index.

Energy sector funds and those specialising in distressed debt — many of which piled into oil company bonds before another fall in the oil price — suffered some of the worst losses last year. Tech sector funds and volatility trading strategies performed best.

This was only the fourth calendar year since 1990 in which the industry has shown a negative return, according to HFR.

“Low interest rates, steep commodity losses and intense equity market volatility contributed to a challenging environment in 2015, resulting in a wide dispersion between the best and worst performing funds,“ said Kenneth Heinz, president of HFR.

“With volatility accelerating into 2016, strategies which have demonstrated opportunistic performance throughout 2015 are likely to lead industry performance.”

Seeing the back of 2015 suited many investors just fine. But what if 2016 is even worse? At the risk of tossing fuel on a raging fire, here’s an inventory of ways Asia could blindside the world.

INSTABILITY IN BEIJING

China’s 2016 is already off to a bad start, if last week’s nearly 10% plunge in the Shanghai Composite Index is any guide. We can debate just how far gross domestic product slipped last year—Lombard Street Research says to 3.7%—but the key indicators of the economy will be in the halls of Beijing power and on the streets of the country’s major cities.

A chill beyond anything China has seen since the 1990s is descending on living standards and corporate profits. At the same time, its share of the world’s most polluted skies, rivers, and food supplies is rising apace.

President Xi Jinping’s efforts to replace smokestack industries with a services sector independent from state-owned enterprises have been glacial. His go-slow approach could backfire and catalyze a bull market in protests—not of the magnitude of Tiananmen Square, perhaps, but enough pressure to spook markets and fuel power struggles between Beijing’s reformer and advocates of the status quo.

Xi’s most ambitious campaign has been policing chatter in cyberspace—including seven-year prison stints for “spreading rumors” and forcing companies to rat out users engaged in “security incidents.” Clearly, he’s afraid of his 1.4 billion people and running out of options to keep them—and vital allies in Beijing—happy. That could lead to missteps and misunderstandings that unnerve markets.

TERRORIST MAYHEM

In the weeks after the Paris attacks in November, Russia issued a sobering warning to Thailand: Islamic State sent a 10- member squad to kill tourists. Indonesia, site of a devastating 2002 attack in Bali, also is tightening security. But what if China is the real soft target? On Nov. 15, Foreign Minister Wang Yi framed China as an equally vulnerable victim of terrorism at a Group of 20 meeting. The fight against militant groups demanding independence in China’s northwestern Xinjiang region, Wang said, “should become an important part of the international fight against terrorism.” Imagine the political chaos a single suicide bomber on a bullet train could generate. Or what if Uyghur militants targeted the Three Gorges Dam? That would be CNN’s story of the year.

JAPANESE DEBT CRASH

Shorting Japanese government bonds has been the ultimate widowmaker trade; a country running out of people can’t manage the world’s biggest debt burden indefinitely. Could it pay off in 2016? For all his talk about fiscal austerity, Prime Minister Shinzo Abe is borrowing with abandon. In April, the Organization for Economic Cooperation and Development warned a debt-to-GDP ratio approaching 250% will swell to more than 400% by 2040 without reforms. Last year, Tokyo’s debt hit a high of 1.057 quadrillion yen (about $9 trillion). Japan has three options: Make more babies in a hurry, import millions of workers, or slash borrowing. Since this government is likely to do none of the above, Japan’s bond bubble will only grow—until it can’t any longer.

FIREWORKS AT SEA

That brings us to rising tensions over tiny islands, rocks, and atolls. Beijing claims pretty much all of the South China Sea, blowing off overlapping claims from Brunei, Malaysia, the Philippines, Taiwan, and Vietnam. Yet the plot is thickening now that the U.S. and Japan are increasing naval patrols in ways that enrage Xi’s government. Tokyo and Beijing are engaged in an escalating territorial tit for tat. And Abe just reinterpreted Japan’s war-renouncing constitution as Washington drives warships through contested waters, much to China’s chagrin. All this potential war gaming, coupled with Asia’s accelerating arms race, makes for dismal economics. You don’t need Tom Clancy’s imagination to see how two ships, or fighter jets, colliding could quickly escalate into full-blown conflict.

THERE ARE MYRIAD other wild cards to ponder, including Taiwanese voters this month electing Tsai Ing-wen as the island’s first female president. The return to power of her Democratic Progressive Party, which has long favored independence over rapprochement, deeply worries Beijing. Might Najib Razak’s party in Malaysia grow tired of the numerous scandals swirling around the prime minister and seek new leadership? Could Kim Jong Un do something crazy in North Korea—even beyond Wednesday’s alleged hydrogen-bomb test? How about the military junta running Thailand into the ground being challenged by another band of power-hungry generals? What if further declines in commodities pushed Australia into its first recession in two decades or destabilized President Joko Widodo of Indonesia? All we can say is, fasten your seatbelts.

Attention is likely to focus on China’s central bank and its management of the renminbi this week, after the markets regulator appeared to stabilise last week’s stock sell-off by scrapping a controversial “circuit breaker” mechanism and extending a ban on share sales by large shareholders.

The renminbi fell 1.5 per cent against the dollar in onshore trading last week to Rmb6.59 — a sharp move for the carefully managed currency. Traders have largely ignored the central bank’s guidance that they should focus on the renminbi’s stability against a basket of 13 currencies rather than volatility against the dollar.

Offshore the renminbi fell 1.7 per cent against the dollar to Rmb6.68, widening the spread between the two rates to a record level. The gap implies that international investors are pricing in further weakening of the onshore rate. Before the People’s Bank of China unexpectedly devalued the currency in August, the two rates traded at virtually the same level.

More recently, the PBoC has been letting the onshore rate weaken and intervening in the offshore market to limit the gap. Separately, the State Administration of Foreign Exchange has been scrutinising banks that help clients arbitrage between the two – a move that some critics feel is inconsistent with the International Monetary Fund’s recent designation of the renminbi as an official reserve currency under its Special Drawing Rights regime.

In a statement at the weekend, SAFE tried to reassure investors. “China’s economic fundamentals are strong,” the regulator said. “Foreign exchange reserves are relatively abundant and the financial system is largely stable and healthy.”

The PBoC last week blamed “speculative forces” for the renminbi’s recent weakness against the dollar. Last month, China’s foreign exchange reserves fell by a record $108bn — a number that reflects rising capital outflows as well as the cost of intervention.

Over the past 12 months, China’s forex reserves have fallen by more than $500bn, although many analysts argue that this is not a concern as the country currently holds far more reserves than comparable economies and can afford to let them run down further.

Europe Sets Up Digital ‘SWAT’ Team for Aviation Cyber Threats

European aviation agency’s team would identify and combat potential hacking attacks

Intended to be a kind of digital SWAT team for hacking attacks, the initiative launched last month goes beyond U.S. efforts and is the most dramatic example of the European Aviation Safety Agency’s increasingly aggressive approach to such risks.

The aim is to quickly provide technical assistance to carriers or national regulators anywhere in Europe in the event of a cyber attack, Patrick Ky, the agency’s executive director, said in an interview.

The move is also part of a broader campaign by the agency, which serves 32 member states, to expand its authority beyond traditional safety regulations. "We think the aviation system is quite vulnerable to cyber attacks,” Mr. Ky said.

Aviation authorities world-wide have said there hasn’t been a verified instance of an individual or a group successfully hacking into a commercial airliner’s power or flight-control systems while airborne. But, like many experts, Mr. Ky worries about growing potential threats as aircraft become more connected to ground-based computer networks, ranging from maintenance to navigation to cabin entertainment.

Mr. Ky said he has started to recruit cyber experts with the aim of reassuring political leaders and passengers that “we are ready and we are going to help” if aviation computer systems are compromised. The team will be supplemented by staff loaned from various national regulators.

He added that France, the U.K. and a number of Scandinavian countries have pledged to assist with the policy, and that he discussed the concept earlier this week with Peggy Gilligan, the top safety official at the U.S. Federal Aviation Administration.

Initially, the focus will be on cataloging and monitoring cyber-related hazards confronting commercial planes and other aircraft world-wide. But by late 2016, according to Mr. Ky, a core team of roughly a dozen troubleshooters should be ready to respond to specific incidents. He envisions 50 or 60 experts will eventually be dedicated to such work.

Leaders of EASA and the FAA have previously talked about cooperating on more-stringent design standards to insulate flight-controls and other safety-critical systems from potential cyber attacks. Each agency has asked its own phalanx of industry officials and outside experts to come up with recommendations.

But the U.S. and Europe are at odds over some principles, especially when it comes to the best way to safeguard smaller, private aircraft. Even if a joint approach emerges, sweeping regulations or legislation could take years to become final.

Rather than simply wait for that process to end, Mr. Ky and EASA’s policy-setting management board are intent on ensuring that timely, detailed technical assistance will be available to deter or minimize the impact of any computer breach.

“The aircraft when it’s flying, is quite immune” to such threats “at least for the time being,” according to the EASA chief.

But he said he is more worried about maintenance functions and other ground- based systems that can tap into onboard computers. “The risk is there,” he said.

Mr. Ky, who took over the agency more than two years ago, is now pushing to get certain security, operational oversight and aircraft-inspection responsibilities previously reserved for aviation regulators from individual countries. He has already shaken up the bureaucracy and clashed with some airline officials by moving into areas once considered strictly off-limits for the agency.

His campaign to broaden the agency’s purview will be debated by European legislators and politicians in coming months. Last year, the European Commission concluded that threats to “cyber security are increasing and may require new approaches to certification” of aircraft and major components.

Precisely how EASA will proceed, and what additional resources it will have, are expected to be a big part of the impending debate.