An overview of the capex boom in Canada's British Columbia

British Columbia is the Westerner province of Canada. Its main economic centre is Vancouver.

75% of the land is above 1000m, a continuation of the Rocky mountain chain and 60% of the territory is covered by forests. 

The local economy ex-Vancouver is therefore centred on natural resources – forestry products of course, but also increasingly mining and hydrocarbons.

The province of British Columbia has not attracted as much attention as the neighbouring province of Alberta, where major oil companies are developing the oil sands fields and are committing at least C$90bn of investments!

The local British Columbia government is left-leaning but has demonstrated a strong support for developing the mineral potential of the region. Tax credits for drilling wells and modest royalty rates (8 to 27%) ensure that energy companies have strong economics.

British Columbia location can be summarised as a gateway to resource-hungry Asia. With several deep-water ports or bays, there is a potential for shipping large quantities of minerals of oil and gas products.

According to the BritishColumbia province government, there are currently 985 projects with a total value of more than C$250bn to be executed by 2020 in the whole province!

If we dig into this list, we find C$185bn of resources projects or any projects linked to them (transportation, harbours, etc.). If we are conservative and estimate that only 1/3 of these projects occur, there will still be a C$60bn capex boom in the province. Moreover, already C$36bn of such projects have already been started.

Steel and mining

With British Columbia resting on the Rocky mountain chain (and its series of active or passive volcanoes), it is gifted with large mineral deposits. Coal and copper are the largest minerals mined but large gold deposits are also attracting new entrants. C$6.6bn of mining and metals projects have started, of which half is represented by Rio Tinto doubling the size of its aluminium smelter.

All eyes on LNG

Liquid natural gas is experiencing the strongest growth among fossil fuel. Its liquid form makes it easily transportable and storable (615 times more compact than the gaseous form)  and gas is proven to be a lower carbon option than oil and especially coal. Finally, LNG requires significant infrastructure which increases transparency (corruption or theft are a serious issue for oil producing countries). Once gas is extracted, it is transported via a pipeline to a liquefaction plant.

There are 5 major liquefaction plants projects today. It is unlikely that all go through but there is scope for at least two projects to be completed.

The projects are:

-          Kitimat LNG: $5-15bn, up to 10mtpa export, starting 2015. Apache, EOG, Encana JV

-          LNG Canada: $0.5bn, up to 1.8mtpa, starting 2014. Local producers

-          BC LNG: $12bn, up to 24mtpa, starting 2019. Shell, Korea Gas, Mitsubishi, Petrochina JV

-          Petronas / Progress Energy: $10bn, up to 7mtpa, starting 2018

-          BG Group: $15bn, up to 27mtpa, starting 2020.

For those projects to be economical, their sponsors need to hold sufficient resources and the liquefaction plant needs to be of sufficient scale, probably ruling out the LNG Canada project. Today, BC LNG and the Petronas projects seem to be the most likely to advance. The Shell-led project still lacks some gas to fill the pipelines, which should boost the value of resource holders.

The Kitimat LNG project has already cleared regulatory approvals but is slowed down by a lack of supply contracts from Asia.

New projects are also emerging, such as the CNOOC/Nexen or Exxon led projects, showing the interest of majors for the region, although the time horizon seems more distant in those instances.

Once these liquefaction plants are under construction, there will be a need for a larger pipeline to handle the volume of gas needed to feed these plants.

Two pipeline projects are currently under discussion at a cost above C$1bn per unit. 

Demand centres

Asia is currently the driver of global LNG demand. Asia currently consumes 150mtpa of LNG, half of current global production and this is predicted to grow by 90mtpa by 2020, a 6% pa rise.

While traditional buyers of LNG such as Japan and Korea should see their demand growth moderating, new users are emerging such as China, Thailand or India.

Asian customers often sign long term supply agreements (15 to 20 years) which provide visibility for the supplier and the LNG infrastructure owners.

Competing suppliers

The US

The shale gas revolution has boosted output markedly and the US is now in a position to export gas from 2016 when the first phase of the Sabine Pass LNG project in brought on stream. This facility will be at full speed in 2018 with export capacity close to 18mt pa. So far, this is the only project approved but two other projects could push the US exports to 27mt pa by 2020, or 5% of global supply then.

The key asset of the US is the gas pricing mechanism. The Henry hub pricing is providing potential diversification to overseas buyers as it is both not linked to oil prices and a spot price. This should be interesting for gas buyers looking to arbitrage gas prices globally.

Local extraction costs around $4-5mmbtu provide a healthy margin for exporters.

Middle-East

Qatar has now fully ramped up capacity and exports 77mtpa of LNG, half of it to Asia.

It is the largest gas exporter globally.

East-Africa

With large offshore discoveries in Mozambique and Tanzania, there is a potential for exports up to 35mtpa by 2025, doubling to 70mtpa by 2033.

While resources are present, drawbacks remain: the cost of drilling offshore is high, the political climate is not as stable and infrastructure is non-existent.

However, from 2025 onwards, the additional supply may pressure down prices.

Russia

Russia currently exports only 10mtpa of LNG, 7% of which to Asia but with two LNG terminals planned by 2020, could boost its exports to 45mtpa, which is 18% of the 2012 LNG export market.

LNG in British Columbia Canada

Current estimates put reserves in place at a minimum 1,300 tcf in the BC region. This compares with the global 2012 consumption of 116tcf, or more than 11 years of global consumption at current pace.

According to Macquarie bank's research, the all-in cost of LNG (extraction, pipeline fees, liquefaction and shipping to Asia) should be around $8.60-10mmbtu.

This means that as long as LNG prices remain above $10mmbtu, Canadian projects will generate positive economic returns.

British Columbia is a natural place to ship natural gas to Asia. A LNG carrier takes 8 to 10 days to go to Japan from British Columbia while it takes 13 to 15 days for Qatar shipments to arrive and up to 30 days from the Gulf of Mexico depending on the Panama canal availability. Only Australia is closer with shipping times of 6-8 days.

 

Since 2010, around C$8bn of JVs and various capital commitments have been made in the area, mostly by Asian national oil companies wishing to secure future shipments. A list is compiled below. This bodes well for future infrastructure spending as those projects need to be enhanced.

Risks to the scenario

The main risks to the capex boom scenario can be summarised into the following points: political or red tape blocks, economic uncertainty delaying decision-making and last but not least, a potential oversupply of projects globally affecting long-term economics of the projects.

We need to focus on the last item as we cannot simply predict the former two with accuracy.

As we saw with competing suppliers, the capex boom in BC is mirrored in other parts of the globe and may imply the risk that the supply answer is too strong.

Currently, more than 150mt of new LNG capacity has been announced in the last two years, which represents half the current global demand. This capacity should be online by 2020 although there should also be some slippage as it happens with large infrastructure projects.

Current LNG demand is growing by a healthy 6% pa and should absorb some of this extra capacity.

However, while most companies expect the 6% trend growth rate to materialise, we could experience a slowdown based on higher energy efficiency, slower global GDP growth (especially in China or India) or lower prices of competing fossil fuels (see the drop in coal prices).

If 6% annual global annual demand growth matches the amount of new capacity proposed currently, a trend growth rate of 4% would imply more than 55mtpa of extra capacity. Since these projects are long-term in nature and cannot be stopped once initiated, we may start to see the LNG price dropping to reflect the future glut.

Therefore, investing in the equity of owners of the projects is a dangerous proposition as the downside is large in case of supply glut while there is no material upside scenario.

Playing this theme in the portfolio context will require thinking outside the box.

Portfolio plays

LNG transportation companies

Pipeline assets are rare and the new pipelines have not being built yet.

LNG shipping is another way to get exposure. We find that the shipping dynamics blur the growth story. Many LNG carrier ships have been ordered recently speculatively and may not match the growth in demand.

We are looking therefore for operators where new ships are tied to long term supply contracts, securing cash-flows and dividends. We can suggest Golar LNG Partners (GLMP US), Hoegh LNG (HLNG NO) and Teekay Partners (TGP US) as potential candidates. The risk to these equities is a significant fall in shipping rates which could lead their existing clients to force a renegotiation of shipping rates. From that perspective, we prefer Hoegh LNG, where leverage is lower.

We would shy away from other operators such as Golar LNG (GLNG): their contract structure is more short term in nature. We expect rates to trend down given the high industry capacity additions.

Suppliers to the boom

While energy companies represent an obvious play, we cannot trust them to have the capital discipline to generate high returns given their poor historical returns.

A better way to have exposure to the capex boom is through derivatives of this boom, namely suppliers: construction, transports, accommodation, catering, local real estate, etc.

Focus case on Entrec - ENT CN

Entrec is a key supplier to the boom: they are a heavy haulage and lift services company based in Kitimat, right into the capex boom area.

They specialised into transporting cranes, heavy machinery needed for pipeline, mines construction as well as operating large cranes on building and drilling sites. They are the market leader in their segments and are buying smaller rivals to consolidate the market further. This industry has strong barriers to entry (need of qualified personnel, operational track record and corporate relationships).

The company is more than doubling sales currently (to a minimum of C$250m this year probably), with 80% of this growth coming from bolt-on acquisitions. Ebitda margins are 25%, suggesting that the niche is well defended. A quick look at accounting practices does not reveal irregularities: depreciation rates seem adapted to the activity and the company does not use shenanigans such as accruals to flatter reported performance.

If we annualise the current sales of Q1 2013, we arrive to a valuation of only 6x 2013 PE, which implies the company will liquidate itself soon!

Current market cap is C$150m, the P/BV is 1x and the value of their fixed assets retrenched of the debt is C$75m which gives some margin of safety. Debt is contained at 1.5x Ebitda which should be absorbed with the fast topline and cash-flow growth of the company.

To sum up, the reasons to own this company:

-          Market leader in an area promised to a large rise in revenues

-          Excellent management team, strong balance sheet

-          Valuation not incorporating the current high activity level

We can expect the shares to double over the next 3 years and the starting low valuation is a good margin of safety.

A final word on units in the natural gas world

If you feel lost with the various units, we have translated them below.

1 cubic meter of natural gas = 35.3 cubic feet of natural gas

1 cubic foot of natural gas = 0.0283 cubic meter of natural gas

Billions

1bcm = 0.73mt

1bcf = 0.021mt

Trillions

1tcm=730mt

1bcm=6.29m boe (baril oil equivalent)

1tcm=6.29bn boe

British Columbia has over 1300 tcf of recoverable shale gas reserves or 36.79tcm or 26,857mt or 231.4bn boe, which is 2.7 years of global oil consumption!