Eric Robken SeekingAlpha Interview
Ashland Heights Capital Management, LLC is a registered investment advisor. We discussed why MLP ETFs are not the best way to gain exposure to the growth of LNG, how natural gas/LNG can be key contributors to lower emissions and lessons learned from their long experience in the industry.
SeekingAlpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?
Eric Robken, Ashland Heights Investments: I focus on the energy shipping sector, particularly LNG shipping, where we believe there is a significant disconnect between future prospects and current valuations. I have selected this sector using a top-down analysis, looking at which areas of energy are most likely to benefit in the near-term from the trends of lower-carbon energy and affordability around the globe. Then, from within the LNG shipping sector, taking a fundamental bottom-up approach, dissecting the business down to its core operations, competitive advantages, and drivers of value. Finally, summing the intrinsic worth and comparing with current market prices against a backdrop of historical valuations and future growth prospects. To execute this strategy, Ashland purchases long positions of primarily common and preferred stock.
SA: What type of reader should follow your work?
ER: Income-oriented investors may be particularly interested in our reports as most of our holdings pay out substantial quarterly distributions.
However, the benefits of this sector do not end at income. LNG shipping is an interesting twist on the traditional midstream oil & gas (MLP) complex. In many ways, it picks up where Alerian MLP leaves off. Whereas traditional pipelines are becoming land-locked and under ever-increasing public scrutiny, LNG has proven to connect domestic and international markets, while showing a lessened environmental exposure. This will be critical if the emerging economies of the globe are to succeed in gaining access to affordable sources of energy while avoiding irreparable harm to the atmosphere. It’s hard to believe that this small market cap segment can serve such diverse investor interests as income and value. Nevertheless, given the relatively young age of the LNG sector, one must be forward-thinking and not overly fixated on the past.
Our work also gives readers an inside view to the LNG shipping sector. By bridging the macro to the fundamental, we present a thesis characteristic that is uncommon to the energy market. As this sector is currently just an afterthought lumped together with ‘oil’ and ‘shipping’—two of the most dismal performing sectors in the entire market—we point out its uniqueness and why it should be viewed independently from commodity-based stocks. If you approach it this way, we believe that the outlook is apparent—a substantial undervaluation which will correct itself in due time.
For example, in my latest piece, I evaluate Teekay LNG Partners (NYSE:TGP) in a report titled “The Cash Flow Era Begins”. I discuss the recently concluded newbuild program which has added substantially to cashflow and distribution coverage, as well as the durability of many of its charter agreements. In the midst of the unstable market we are living in, TGP brings some stability and visibility. Not only is the distribution undervalued, but the share price itself is underpriced by at least 100% according to our valuation.
SA: Can you discuss the near and long-term outlook for liquefied natural gas (“LNG”) and the key drivers of supply/demand?
ER: LNG demand is expected to grow anywhere between 2-4% annually. While global demand for coal has certainly peaked, and many people speculate that demand for oil may have already peaked, most energy-focus groups, such as the IEA, predict that “peak gas” will not occur until 2040 at the earliest—leaving plenty of runway open for near and medium-term growth. Though not a perfectly clean form of energy, gas presents a substantial step forward in progress toward reducing greenhouse gas emissions—50% less than coal and 25% less than oil-based fuels. The improved environmental aspect is a key driver for growth as it allows for international financing from institutions such as the World Bank. It also serves as a way for developing countries to satisfy huge surges in energy demand without causing intensive atmospheric pollution and smog.
Aside from environment, there are also physical factors driving the rise of supply/demand of LNG. Advents in technology have made natural gas supplies become abundant in the past decade, even rivalling coal as being one of the cheapest fossil fuels available. The liquefaction process know-how has been acquired through over two decades of successful projects around the globe, leading to cost efficiencies and giving rise to the availability of LNG on a global basis. Of course, via pipeline, there is another way to transport gas across borders, however, there will always exist physical and geographical limits which make long pipes impractical. Furthermore, as the energy transition to renewables accelerates, entities will become less interested in placing expensive, permanent pipeline infrastructure in the ground, when they could work with temporary, floating-type LNG import solutions at a fraction of the cost.
In summary, we believe that LNG is a good hedge to both of the future potential scenarios, one being fast adoption of renewable energy and the other a “business-as-usual” case.
SA: Do you think the current investment vehicles (such as funds, ETFs, etc.) available to play this trend are inadequate and/or lack meaningful exposure to it? What are the best ways to play this?
ER: Overall, there is very little exposure to LNG in MLP ETFs. The Alps Alerian MLP (NYSEARCA:AMLP) has about 4% allocated to Cheniere Energy (NYSEMKT:LNG) and virtually no other direct exposure. Understandably, gaining targeted exposure is difficult given that LNG is mostly the domain of large integrated oil companies, such as XOM, CVX, and RDS. Cheniere, as a pure play LNG exporter, is kind of a unicorn in that regard, and the small cap shipping companies that we follow do not meet the market cap hurdle to appear on the radar screen of ETFs and other funds.
Furthermore, the traditional MLP ETFs are a bit inefficient in regards to taxes. Since there are still some major MLP’s which issue Partnership K-1’s rather than 1099’s, as C-Corps, including all LNG shippers, do, the ETF has to roll-up these entities and keep track of deferred tax liabilities. Furthermore, U.S.-based entities are subject to higher tax rates than offshore-domiciled LNG transport companies. This liability must be paid by the investor in the MLP ETF and effectively reduces the yield of the fund. Proponents argue that one of the primary tax benefits of K-1 MLP’s is the typical tax deferred return-of-capital classification of distributions. However, LNG entities enjoy this same benefit and are able to return distributions to shareholders, in most cases, as a return-of-capital, thereby avoiding investor taxation as ordinary income.
Given the small-cap nature of LNG shipping, where the average market capitalization is roughly $500 million, we think the best way to play the demand surge is through a collection of individual investments focusing on income streams. Part of what is unique about this sector is that it is both small-cap and income. Typically, when you think of income, you think of the large stalwart-type companies, or bond ETFs. These are showing historically low yields. There are also real estate trusts which are heavily reliant on leverage and external factors, such as accommodative fiscal policies. LNG presents a high-yielding income stream from tangible assets with ample visibility into future cashflows. The amount of leverage required to accomplish this is quite reasonable.
SA: To follow up, how does LNG fit into the secular trend away from fossil fuels and towards renewables? Are there any misconceptions you see about its value/use?
ER: Natural gas has thus far demonstrated to be a key contributor in the quest for lower GHG emissions. In fact, the U.S. has succeeded to lower emissions largely on the back of higher electricity production from natural gas. While renewables remains the final long-term destination, to get there it is clear that reliable gas needs to be in the mix. And for the developing nations that need immense amounts of energy to drive manufacturing, middle-class living, and industrialization, natural gas presents the best compromise between energy and environment. The dislocation between the epicenters of production (Qatar, U.S., Russia) and consumption (Europe, SE Asia) is what drives the necessity to liquefy the gas and ship it.
Aside from being a fuel for power generation, natural gas is a key feedstock for fertilizer, heat input for manufacturing such as steel construction, and is even becoming an alternative marine fuel in the wake of IMO 2020 targets for reducing emissions in international waters.
Looking forward, as some hypothesize a hydrogen-based fuel economy, natural gas could even be used to produce hydrogen through the methane steam reforming process, which would be carbon-neutral provided that the CO2 product could be captured and stored (carbon capture storage—CCS).
SA: What are several key lessons you’ve learned in your >15 years of experience in the natural gas sector? How has the sector changed during that time and how do you see it changing over the next 15 years?
ER: The natural gas industry has changed a lot during this period. For the first decade of the 2000’s, natural gas was a scarce commodity. The advent of shale gas technology changed that. The U.S. went from being a large importer of gas, from both pipeline and LNG sources, to being one of the world’s leading exporters. This reversal happened in less than a decade. And as a result, gas has succeeded to displace coal as a fuel source in many countries around the globe, breaking a long-term trend of rising carbon and particulate emissions. Consequently, the market price for gas in the U.S. has dropped precipitously—from a high of $13/MMBtu in 2008 to around $3 since 2015. Likewise, in other gas consuming nations, prices have fallen dramatically. The impact has been a boon for divergent industries, such as manufacturing, chemicals, transport, and power.
Looking forward, gas should continue to displace coal and, to a lesser degree, oil-based fuels. The technology is here to stay and the hard-fought lessons learned in the U.S. could be mimicked by other countries that have vast gas reserves. It is apparent that there is a future for gas in a world which is increasingly favoring renewable sources of energy. One of the profound challenges of this century is to electrify the developing nations on a carbon-neutral basis. No currently developed country has come even close to accomplishing this.
I think you will find that the industry leaders will be keen on maintaining the presence of natural gas in the energy picture, perhaps by cleaning up the supply chain even further. Most industrial marine vessels could be converted from burning fuel oil at present, to burning natural gas, reducing emissions considerably. However, to fully turn over this market segment would require some policy framework. The recent IMO 2020 pronouncement is a good step in this regard.
SA: Given the zero-interest rate environment, is the energy/shipping sector a good place to look for yield? What types of companies are the most (or least) attractive for income investors here? What are the risks to watch out for?
ER: If you’re looking for yield, we believe LNG shipping deserves a place at the table, particularly in these times of near-zero rates. As these companies have preferred stocks trading in the market, with yields often exceeding 10%, an income-oriented investor may find these types of investment vehicles attractive given the level of risk which we believe is relatively low as illustrated by large coverage multiples. Look for the companies which have long-term charters backed by high-quality counterparties. This will underpin a dependable cashflow to serve the distribution.
The looming risk is mainly the charter expirations of the underlying business. A few of these companies have significant expirations in the next 2-3 years which we suspect could be a challenging time to relet carriers, given a higher supply of ships during a time of relatively muted demand. In our research, we are careful to point out the future charter expirations and the potential implications to investors.
SA: A recurring question in this interview series is about the mispricings created by the coronavirus and its short and long-term impact – can you weigh in on this?
ER: This area is probably one of the hardest hit by Covid-19 in terms of share prices. Short-term, it’s difficult to say that there has been any material impact, other than perhaps that the companies are being a bit more fiscally conservative regarding payouts. This is to be expected during any economic disruption. Looking at the longer-term, I could see a scenario where some projects are delayed due to a slower economic recovery. Perhaps even one or two major projects gets cancelled. A more likely case is a V-shaped recovery where the pace of newbuilding resumes to prior levels by 2022. In any event, I don’t think Covid-19 will structurally change the trajectory of this industry, given the critical need of most countries around the globe for affordable, lower-emissions energy.
SA: What’s one of your highest conviction ideas right now?
ER: Our highest conviction idea remains Hoegh LNG Partners (NYSE:HMLP) which we first wrote about in October 2019. The downstream regasification side of the value chain—meaning, the process to convert liquid methane back into vapor—shows the most promise, in our view. As supply becomes so plentiful, global gas benchmark prices are falling, and this is incentivizing demand in new locales. HMLP owns and operates special types of vessels which perform the regas process in an offshore environment, negating the need for expensive, permanent, onshore infrastructure. This type of flexibility is what many nations are seeking nowadays, given the fluctuation in energy costs and future demand needs.
HMLP holds a competitive advantage in this market which is essentially a triopoly with strong barriers to entry. It has paid a consistent distribution which currently yields 14% and the stock price is about 80% below our calculation of intrinsic worth. We believe that the market is discounting the upcoming demand wave for more regas vessels which will give rise for a new dropdown and this will further increase the distribution, pushing share prices higher. HMLP has ample balance sheet capacity to leverage one or even two more vessels, in addition to the four net vessels already under ownership.
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Thanks to Ashland Heights Investments for the interview.
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Disclosure: The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Past performance shown is not indicative of future results, which could differ substantially.
The simulated performance shown was created by Ashland, applying historical LNG shipping stock market cycles to present market prices in order to estimate potential future capital gains. Dividend returns are estimated by applying the current payout level and adjusting for future distributable cashflow as estimated by Ashland's analysis. The simulated performance shown is not necessarily indicative of future performance, which could differ substantially. The results shown do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight. The simulated performance was compiled after the end of the period depicted and does not represent the actual investment decisions of Ashland. These results do not reflect the effect of material economic and market factors on decision-making.
