How Liquefied Natural Gas Could Come to the Rescue for Royal Dutch Shell and BP

Oil and gas companies are making big strides to build out their liquefied natural gas, or LNG, businesses. There's good reason for this. Liquefied natural gas is a particularly interesting corner of the energy spectrum because it's easier to store and transport than other energy forms, including traditional natural gas.

That's because LNG occupies up to 600 times less space than natural gas. And, thanks to soaring demand for energy in the emerging markets, oil and gas companies are plowing huge amounts of resources into developing their LNG operations.

Recently, European integrated majors Royal Dutch Shell (NYSE: RDS-B  ) and BP (NYSE: BP  )  struck agreements with Kuwait to supply the nation with LNG. The agreements are worth billions of dollars and will involve long-term contracts. As the integrated heavyweights grapple with disappointing production of oil and natural gas due to field declines and uninspiring returns on new projects, LNG holds the potential to get production going in the right direction once again.

Scorching summer months will require lots of energy
Royal Dutch Shell and BP have signed deals with Kuwait just at the right time for the Middle East. That's because the extremely hot summer months in Kuwait will require a great deal of energy in that part of the world.

Royal Dutch Shell will supply Kuwait's state-owned oil company in a deal worth an estimated $12 billion. Separately, BP signed a five-year deal worth $3 billion with Kuwait. These are important developments for both companies, as the long-term nature of the agreements provides a great deal of certainty. Long-term contracts are critical for oil majors, as they provide both an assurance of demand and the clarity needed to initiate significant projects.

Demand for LNG in the emerging markets, including the Middle East and Asia Pacific, is extremely promising. Royal Dutch Shell's management expects strong continued demand over the next several years, and contracts such as these are a solid first step in servicing that demand.

The agreements couldn't come at a better time for the Middle East, which is about to experience a scorching summer. But the deals are extremely timely for Shell and BP as well since they didn't do so well last year in a tough environment for integrated energy majors more broadly.

Cost cuts and asset sales risk future production growth
Royal Dutch Shell's core net profits fell by 23% last year, prompting the company to undergo what management delicately termed "hard choices" in its portfolio. Basically, the company is resorting to cutting capital expenditures in light of disappointing upstream projects and sharply narrower refining margins. To that end, Shell plans to reduce capital expenditures by $9 billion in 2014 from $46 billion in 2013 to an estimated $37 billion this year. That represents a severe 20% drop.

This is a concern since Shell's production is already going in the wrong direction. Average total production fell nearly 9% in the first quarter to 3.2 million barrels of oil equivalent.

Likewise, BP has experienced falling production and profits over the past year. First-quarter average production dipped below 2.25 million barrels of oil equivalent, and profits fell 23% year over year. BP is suffering from both higher exploration costs and write-offs along with lower production and lower liquids realizations.

In response, BP is taking a similar path to Shell, which is to cut costs and unload non-core assets. BP divested $17.1 billion worth of assets last year. Going forward, expect this to continue. BP expects to generate an additional $10 billion from divestments by year-end 2015.

Of course, these actions are not without a fair amount of risk. Unless the proceeds from cost savings and asset sales are redeployed in new projects, future production may keep declining. Fortunately, both Shell and BP are continuing to invest in LNG, and their newly secured contracts with Kuwait are a prime example of that.

LNG could save disappointing production
Liquefied natural gas holds great promise. It's a clear, non-toxic liquid that is formed when traditional natural gas is cooled to extremely low temperatures. LNG also has fewer harmful emissions than diesel and crude oil. As a liquid, LNG is much easier to store and ship; and since demand for natural gas is exploding across the globe, LNG represents a huge opportunity.

Oil majors across the board are suspending new projects or cancelling them altogether, which could put them in dire straits later on. Fortunately, LNG represents one major area that both Shell and BP continue to invest in, and the potential is clearly compelling.

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