With LNG production at record levels – 134.8 million tpy (tonnes per year) in 2004 and a further 10.8 million tpy in capacity slated to start up this year – LNG ship financing should be buoyant. Moreover, with order books continuing to fill up, shipyards are under increasing pressure to deliver the 113 newbuilds now on order.

But despite the demand, LNG shipping, and hence financing, is not a margin spinner. According to one London-based banker, "with standard shipping, you make money. But with LNG shipping, there is no asset play: it's not a money-making machine. It will, however, become a more sophisticated market." It is estimated that in the past only in the region of 20 vessels have ever changed ownership.

So why is it that an industry with strong potential is finding it difficult to generate margins? Certain industry experts have been quick to condemn new entrants for pushing day rates on long-term charters down to a level where operators are finding it difficult to make any kind of margin.

New, not improved

Bahamas-based Teekay Shipping Corporation exemplifies this new breed of entrant. In early August, the shipper was awarded contracts to charter four vessels to Ras Laffan Liquefied Natural Gas Co. Limited (III) (RasGas III). The vessels are said to be charted at fixed rates, adjusted for inflation, for a 25-year period. Under the terms of the charter, there is an option to extend the term by 10 years to 35 years.

Teekay has also entered into agreements with Samsung Heavy Industries Ltd. to construct the carriers. It is estimated that the total figure for the deal is in the region of $1 billion. Teekay says that it expects to generate some $86 million in annualised cash flow from the operations.

RasGas III has also awarded 25-year contracts to a Japanese consortium led by Mitsui O.S.K Lines Ltd. to build eight LNG vessels. The total spend for the consortium – which includes – Mitsui & Co, Nippon Yusen KK, Kawasaki Kisen Kaisha and Iino Kaiun Kaisha – is $1.8 million. All eight vessels will be built at Daewoo Shipbuilding and Hyundai Heavy Industries in South Korea. It is too early to say what the terms of the charter will be, though it is expected that most of the LNG will find its way to the US.

The Q-flex class vessels on both these deals will range in capacity from 210,000 to 217,000 cubic metres, compared to 155,000 cubic metres for a standard LNG vessel. A Q-Max design, expected to be in the region of 260,000 cubic metres, is now on the drawing board; though, as yet, none have been ordered.

It is rumoured that the Japanese consortium came in with very competitive and very low tenders in order to avoid any chance of disappointment, since it had lost out in the past. Teekay, on the other hand, has raised industry eyebrows with its audacious tender. Some even believe the shipping company has been taking a hit on its initial transactions in order to steal a march on some of the established players.

New model fleets

Just how many new players the industry can take is as yet unclear. Those, however, with experience and a low cost of capital are expected to stay the course. "With every project bringing with it a lower and lower charter rate, it boils down to which ship-owner has the lowest cost of capital," says Siddharth Roy, global LNG shipping, at DNB Nor Bank in London.

It is rumoured that certain industry players may have to leave the market altogether. "It is inevitable that some shipowners will go. In many ways it's not bad situation; we see it as a positive development," says one industry expert.

The theory is that by shedding the opportunistic and those with higher capital costs, the sector will be able to mature and achieve balance at which all parties are making a respectable margin. Yet whether it will be the established players that leave the field or the new entrants remains to be seen.

Others in the industry have been quick to blame Qatari customers for engendering what, in effect, has become a proto-price war. "The problem with Qatar is that it is one of the most powerful producers; they have driven a high bargain and pushed long-term charters at unattractive rates," says a UK-based shipping lawyer.

While this may indeed be the case, it is, however, a rather narrow view of the current LNG market. And not everyone agrees.

According to a London-based shipping expert, "You have to remember that Qatar helped to open up the whole market. Therefore, it is really right to blame them? This is a market that has opportunities, and in the next natural cycle will bring with it even greater opportunities."

Even so, the current market opportunities have presented ship-owners with a number of headaches. "At present it is difficult for ship-owners; not only do they have to predict the energy market, they also have to predict their own market. I would hate to be the one to set up a five-year capex plan," adds Afonso Reis e Sousa, vice-president at Taylor-DeJongh, London.

Another headache for ship-owners is the dearth of crews that have relevant experience. With many experienced crews nearing retirement age, shi-powners will need to make a sizeable investment in training. Moreover, the surge in new builds will necessitate crews with the right experience. And these are simply not available.

Spot the market

With new entrants coming into the market, so too have speculative charters. There is a growing fear that those looking to make a quick profit will try to compete on the LNG shipping market. However, having ships lie idle and uncommitted has only driven down short-term rates to the region of $25,000 to $30,000 per day. In order for a vessel to break even, a minimum of $40,000 per day needs to be secured.

At the beginning of the year, there were up to 12 ships lying idle off the coast of Gibraltar. These were a mix of independent shipowners without firm charters as well as vessels owned by the oil majors, which were awaiting employment at new liquification plants.

Although much has been made of the LNG spot market, there are those who believe the term to be a misnomer. According to Iwamoto, "the 'spot market' is not an appropriate word to apply to LNG shipping. Spot cargoes (or spot sales) of LNG are increasing, but this does not mean that a vessel used for such spot sales does not have a long-term charter contract, because most of the vessels are tied up with specific time charter contract."

At present, analysts estimate that the nascent spot market makes up some 10 to 12% of the market as a whole. Although this share is likely to increase by the end of the decade, it is unlikely to reach beyond the 20% mark. Whether LNG will develop a true spot market is still difficult to say, though there will continue to be excess production.

According to Gaurav Seth, head of global LNG shipping finance at SG Corporate and Investment Banking, "the development of the spot LNG market requires liquefaction, shipping and regasification projects to commission at a common pace. This is, of course, difficult to achieve as these parties have different spot LNG market aspirations. So far the shipping capacity for spot activity has outpaced the liquefaction and regasification projects, resulting in some spare tonnage."

The real question is how in the coming years committed capacity will compete against uncommitted capacity, and whether a two-tier market will evolve.

Given the current state of the market, it will come as no surprise that it has been Qatar that has tried to ring the changes. In June, Doha hosted the 1st International Middle East Shipping Forum, where high-ranking Qatari officials told the finance industry, in no uncertain terms to get its act together.

"Financial institutions should do more to recognise the good fundamentals of LNG projects in terms of ship financing," said Second Deputy Prime Minister Abdullah bin Hamad Al Attiyah, chairman of Qatar Petroleum.

The Second Deputy Prime Minister also highlighted the attractiveness of LNG compared with the volatility and commercial risk experienced in the shipping sector, and stressed the importance of innovative finance including Islamic finance, for funding LNG vessels.

Financial innovation has not been LNG shipping's strongest trait. Traditionally vessels have been financed through a mix of project debt and asset finance. Nevertheless, moves are afoot to push the envelope and to try to invigorate the market with more flexible and creative financings.

KG or not KG?

ProNav's recent KG deal for two of its LNG vessels, the Alexandra and the Britta, is being heralded as a major move in that direction. The deal marks a first in LNG shipping for the tax-efficient German structure.

HSH-Nordbank was the lead arranger on the $500 million transaction, which comprises $350 million of non-recourse project debt. It is estimated that the margin is around the 100bp mark with an average debt service coverage ratio between 1.3x and 1.4x. The deal has now been fully syndicated. The vessels have long-term charters with RasGas 2.

Commerzleasing und Immobilien (CLI), a Commerzbank subsidiary, raised the KG fund. The closed-end structure – where the ownership of the asset vests in the investors who then lease it to the salient party – is expected to allow investors a return of 6 to 6.5% compared with 7.5 or 8% for container vessels.

Although the deal has received plaudits from certain quarters, not everyone believes this is the shape of things to come. "I don't think the KG structure will dominate," say one industry source. "I know for a fact that three or four KG companies bid for RasGas and not one of them got it."

With German investors scrutinising returns on other assets, and arrangers looking for margins, future KG funds may be thin on the ground. "LNG is effectively a charterer's market, which means the charterer is in a position to work out favourable conditions. Therefore, it is difficult to raise funds here in Germany, where arrangers need a margin," says Heinrich-Werner Goltz, partner at Lebuhn & Puchta, Hamburg.

It is thought that a number of ship-owners have looked closely at entering the KG market, only to have stepped out at the eleventh hour. While the future for LNG KG may not be auspicious, other deals may come to market should certain prerequisites be met. "First, you need a decent return; and, second, within the terms of the charter, the risk between the owners and charterers has to be acceptable for investors not to have too much downside," adds Goltz.

Islamic issues' issues

The two markets that are attracting attention, and are being touted as growth areas by industry experts, are Islamic financing and the capital markets, but deals utilising both these financing solutions have been few and far between. With $300 billion of idle Islamic funds chasing potential assets, LNG vessels look to be an ideal fit.

Whereas longer tenors may have dissuaded Islamic financiers in the past, this may no longer be the case.
The last deal to have come to market was in 2002, when HSBC closed a $100 million deal for Brunei Gas Carriers Sdn Bhd for the MV Abadi. Since then, those marketing the product have had to contend with what is, in essence, an immature market.

However, a sukuk issue that launched in April may well prove the catalyst for this sector. The $26 million sukuk, which will part re-finance a VLCC (Very Large Crude Container), is the first transaction in the shipping sector to use an Islamic bond. More deals, each in the region of $100 million, are expected to hit the market in the near future. Islamic financing for LNG cannot be very far away.

The most obvious way the sector would tap the capital markets is through the placement of private bonds. With strongly-rated borrowers, banks would be able to fund construction while project bonds would take out the construction loan to fund the period post delivery.

Although securitization has been mooted, this financing solution looks to be a long way off. "The critical mass just isn't there. LNG is only a few years old, so the loan facilities aren't there," says a banking expert. Another factor would be the diverse country risks, though this is no longer an insurmountable proposition.

Acting up

If industry analysts are to be believed, the global LNG fleet will exceed the 400-mark by 2030, and outstrip the number of VLCC and ULCC vessels in the process. In the meantime, however, LNG shipping will need to overcome the market's conspicuous flaws in order to keep bankers and ship-owners interested.

Though what one expert calls "the current glut in the market' will likely be a short-term phenomenon, the market is expected to correct itself. But this correction may take place through deals done in Yemen, Equatorial Guinea, Sakhalin and Iran, where the increased political risk will certainly benefit ship-owners.

Some, however, as not so sure if this will be enough of a fillip. "The focus will remain on Qatari business. New tenders will bring with it an appetite to become part of the Qatar story," muses Roy. Which is not the sort of news certain ship-owners will want to be hearing.