Why long-term contracts help liquefied natural gas carriers
Cycles and volatile rates
Given that LNG carriers require a few months to construct—about 28 to 34 months, according to Golar LNG Ltd. (GLNG), there could be short-term timing disconnects between the delivery of a new LNG vessel and the LNG cargoes they were ordered to transport. The timing of LNG project upstarts, newbuild delivery lead time, the economics of investing in newbuilds, economic cycles, and structural weaknesses or strengths in natural gas consumption are some factors that shape the industry’s cycles.
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As the chart above shows, spot rates for LNG carriers have fluctuated wildly in the past, ranging from as low as an average of ~$34,000 a day to recent highs of ~$128,000 a day, which we can attribute to the inelastic nature of the shipping industry’s supply.
Sensitivity to cycles
While companies that do operate in the spot market are subject to volatile earnings, keep in mind that most LNG carriers such as Golar LNG Partners LP (GMLP), Dynagas LNG Partners LP (DLNG), GasLog Ltd. (GLOG), and Teekay LNG Partners LP (TGP) are contracted out long-term (for five years or more) with inflation adjustment features, under which rates are much less volatile than the spot market. In some cases, these contracts are agreed upon for up to 25 years.
As we noted earlier in this series, long-term contracts have been dominant because these vessels are costly to build, so LNG owners are more cautious about being able to generate adequate returns on investments. But their dominance is also because shipping costs can make up 15% of landed LNG gas prices for importers such as utility operators. To hedge against the volatility of spot rates, most utilities are also interested in engaging in long-term contracts.
Certainly, this could change in the future if newbuild prices came down, the LNG shipping industry’s rivalry intensified, and shipping rates came down to the extent that the cost of shipping makes up only a small percentage of total delivered price. This could make investing in LNG carriers more risky, although it’s probably going to take years before this happens.