Flex LNG Stock: High-Risk Investment (NYSE:FLNG)

One of the first words you learn in the investing community is risk. It is crucial for any investor to understand the risks he/she is willing to take. This article presents an overview of the LNG shipping industry and 3 specific risks that Flex LNG (FLNG) faces, which every investor should be aware of before investing. Although, the share gets a Buy rating, but, since I cannot judge the reader’s risk appetite, I want to make sure that this is a high-risk investment.

Business Overview

FLNG’s primary business is in the sector of transportation of energy via waterways. Specifically, FLNG is involved in shipping LNG using its fleet of 13 modern LNG carriers. The average age of its fleet is around 2 years and all of it ships have modern & energy efficient propulsion systems; MEGI or X-DF. Of the 13 ships operated by FLNG, 9 are owned by the company and 4 are under bareboat lease agreements from different lessors. At the time of writing this article, FLNG does not have any ship under construction.

The purchase of these 9 LNG carriers has resulted in a total debt of around $1.6 billion with interest rates ranging from six monthly (mostly) LIBOR + 1.2% to LIBOR + 2.25% with maturity terms between 2024 to 2032. Some of these loans also have fixed interest rates. However, FLNG has also initiated swaps (receive floating, pay fixed) on its variable interest rates loan. This converts $720 million of variable interest loans to fixed rate interest rate with a weighted average rate of 1.13%. For investors, this reduces the risk as there is no doubt that interest rates are surely going to rise this year. The swaps protect the cash flow of FLNG from variations and rate increases in interest rates in 2022.

The business of LNG shipping is that of exploiting the arbitrage opportunity in the LNG prices in different parts of the world. Middle East, USA, West Africa and North Europe are the major exporters of LNG and Far East (Japan, Korea, China, Taiwan), Indian Subcontinent (India, Malaysia, Indonesia), South Europe and North Europe are importers of LNG. The following Sankey diagram (a bit dated) gives a good visual representation of the world LNG market.

The diagram above represents the LNG movement at a particular time and contrary to my belief that systems stabilize over time, I was surprised to find that the LNG shipping market has no stability. The movement (import and export) of LNG depends on the prices of LNG in three major trading regions; Asia, Europe and USA. USA and Middle East are the exporters and Asia and Europe are the importers or as they are called in shipping terminologies the Pacific and Atlantic Basin, respectively. As mentioned above, the business of LNG shipping works on arbitrage and hence, when the prices of LNG is higher in the Far East, like it was after the Fukushima nuclear disaster, the ships are diverted to the Far East and vice versa. Today, LNG ships are being diverted to Europe. Higher the price difference between the exporter and the importer countries, higher is the charter rate the exporter is willing to pay to companies such as FLNG for transporting the goods to the importer. The following infographic from FLNG earning presentation explains this arbitrage opportunity.

Naturally, just like the seasons and cold weather affect the demand and price of natural gas, the ship charter rates are also seasonal and go through their ups during the winter and downs during the summer. To give you an idea of the volatility in the LNG shipping industry, it would have costed $320,000/day to charter an LNG ship to transport LNG to Asia on 29 Nov, 2021 (sign-in required). Today that same service will cost you only $50,000/day. This volatility makes the shipping industry an exciting (meaning risky) business and thus, requires very fast & up to date information to manage the investment.

Risk 1

Exporters of LNG hire FLNG’s LNG carrier services and pay charter rates as decided between them. Now, there are two ways in which a carrier is chartered. One is through the spot market, which is akin to a daily wage earner and the second is through a time charter contract, which is similar to being in an employment. The interesting point here is that, unlike being in an employment, time charter contracts do not guarantee a fixed cost per day structure. Instead, the time charter contracts entered by FLNG has variable rate components. Thus, FLNG’s revenue is linked to the highly volatile spot market shipping rates prevailing at that time, even for their time charter contracts. In comparison the interest expense, which is the major expenditure in FLNG’s income statement, is fixed. As per FLNG’s Q3 SEC filing, their net outstanding debt with variable interest rates is $632 million, which makes the fixed interest rates loan at around $1 billion. The combination of variable income and fixed expense is particularly risky and has the power to bankrupt companies.

Risk 2

FLNG’s 46% shares are owned by Geveran, a company based out of Cyprus. Interestingly, Cyprus does not tax dividends. The resultant outcome is that any value addition to the company will most likely be returned to the investors in the form of dividends so that the capital gains are minimal. As pointed above, the earnings in this industry are not stable. This means that investors cannot reasonably expect dividends to continue at the same rate as announced for Q3 2021. Although I am sure that the Q4 2021 dividend will be even higher, I am more concerned about dividends for the whole year. Even after including the best quarters for the industry, the TTM yield is only 8.6%. Unless you are interested in purchasing LNG shipping shares in a company traded on the US capital markets, the risk to reward ratio for FLNG is too high.

Risk 3

The third and final risk for FLNG is its dependence on the highs of Q3 and Q4 shipping charter rates for its survival in the long term. It is OK to have seasonal earnings for a company, but the volatility and the range of shipping charter rates is just too high. The lows during Q1 and Q2 are unavoidable simply because of nature. These quarters will experience summer temperatures and as such the industrial and residential heating requirements lessens, which results in reduced demand for natural gas in demand centers such as Europe and the Far East. So, it becomes absolutely essential that demand of LNG during Q3 and Q4 must rise in these centers for FLNG to earn the higher charter rates, generate cash flow, pay dividends and also payback interest and principal on their debt.

However, the demand for LNG in these quarters itself is dependent on the weather. I am not concerned with the overall change in the climate of the area and how hot the winters become in the long-term of 10-20 years. But, in the short-term, a relatively warmer winter could throw a big wrench in the earning cycle for FLNG. Obviously, this wrench will affect the complete LNG shipping industry, but the high debt and FLNG’s dependence on higher dividend payments during Q3 and Q4 (to keep the investors happy), makes it especially vulnerable. It would take just one abnormal low earnings season to disrupt the cyclical earning stability of FLNG. Once this card falls, the rest will be difficult to manage.

Additionally, this change can also be brought about by economies trying to dissolve their dependence on imported energy. Actions such as Japan’s investment into Hydrogen energy, France’s announcement of nuclear power plants and the China’s attempts at Nuclear Fusion are all attempts to get rid of imported energy dependency. Although these solutions are long-term but still are within our lifetime.

Conclusion

The GDP of the world is growing and increasing energy demand is a direct result of the growing GDP. On the way to a completely carbon-free future, natural gas seems to be the perfect transition fuel. There is no doubt that on the road to be cleaner, natural gas demand is only going to go up. In such a scenario, the LNG shipping business seems to be an ideal candidate for investment. However, because of the way the shipping industry works and the specific financial situation of FLNG, there are three risks that make investment in FLNG a very high-risk affair. Investment in FLNG would suit investors who can keep a constant touch with the global shipping charter rates and LNG demand in the European and Asian demand centers, information that are not easily available for the public.

In the short-term (Q1 and Q2) the dividends will decline and so will the share price but investors can get a healthy return if they invest right before the boom time starts before Q3 this year. For now, the share is a Wait and it is a Buy for later. However, just to emphasize, this is a high risk investment and only suitable for investors with a constant follow up on the shipping industry.