US LNG operators face headwinds

Global Energy Report 2023
12 min read

In less than a decade, the US has transitioned from being an importer of liquefied natural gas to one of the largest exporters, now in the company of Qatar, Russia, and Australia. By Terry Pratt, Fitch Ratings

This miraculous turnaround has been driven by interrelated factors offering buyers of US LNG layers of diversification in their global portfolios. While a clear view of long-term LNG demand remains elusive, the ability of US LNG projects to secure a large number of offtake contracts in the past two years indicates that buyers remain bullish on long-term LNG demand and confident that a US industry can meet ever-increasing production requirements. Additional near-term growth for US LNG is likely, but a number of headwinds will influence the pace of growth.

The American shale gas revolution provided the foundation for the original build-out of LNG export capacity by giving confidence to buyers that projects could meet production requirements over a 20-year contract tenor. Annual growth rates in gas production have been sustained except for the dip during the Covid-19 pandemic. Production has returned to pre-Covid levels, but the rates of growth are below pre-pandemic levels.

Lower growth is not a sign of basin depletion, but rather a result of producers allocating more capital to shareholders and less into drilling in the current business environment. However, the future potential is very strong, reflected in the US Energy Information Agency’s recent reporting that the industry increased proven gas reserves by 31% during 2021.

A robust natural gas supply network is another key pillar in favour of buyers that support their willingness to take risk associated with a long-term commitment. It gives US projects the ability to buy gas from essentially every major producing region in the US, which reduces basin risk. Second, it includes highly liquid trading hubs providing price and volume benchmarks for buyers to help them gauge the economics of purchasing gas from the US or other countries. Pipeline system expansion to accommodate growing production has generally been supported thus far by federal and state regulators. However, rising environmental consideration are adding to the challenge of getting regulatory approval for some new pipelines.

Federal and local regulators have played a major role in the development of the sector by providing consistent approval to export LNG, establish LNG facilities, and support the development of natural gas pipelines in many regions of the country. The well-established regulatory regime provides buyers, project sponsors, and lenders with more assurance in reasonable regulatory outcomes that underpin very long-term investments. However, local regulators play a critical role, and the differing attitudes about LNG have resulted in a concentration of projects in the Gulf Coast, where large energy projects are most receptive.

A key risk of the sector – completion risk – has proven to be manageable and has further fortified buyer confidence. Sabine Pass was the first project to establish a conventional large-scale LNG export project in North America. While it contracted with Bechtel to build the original trains under EPC-style arrangements, there was understandable concern of completion on time, within budget, and to specification given the first-of-its-kind construction on such scale in the Gulf Coast.

The track record of Bechtel for the Sabine Pass and Corpus Christie facilities has been excellent. Other projects such as Freeport LNG and Cameron LNG were able to work with financially challenged builders to achieve completion and operate as planned despite major issues with ECP contractor creditworthiness, though delays were considerable and costs exceeded expectations. Furthermore, some large projects using innovative modular technology, such as Elbe Island and Calcasieu Pass, have also established a successful completion record. However, in some cases, commissioning appears to have taken much longer than for comparable projects.

The operation and maintenance profile for most US LNG projects has largely been in line with original expectations, with a few notable exceptions. Several factors underpin this success. Most projects use commercially proven technology and attracted highly experienced personnel from around the globe to manage operations and turnarounds.

Contracting strategy also plays a role. US LNG projects typically leave a portion of their capacity uncontracted with non-affiliated third-party buyers. This cushion helps ensure that the project can meet third-party contract requirements where the key revenue is made. Projects will typically contract excess capacity with an affiliate that has the right to request LNG only when that capacity is available. Despite this favourable record, unexpected outages are always possible, as seen with the complete outage at Freeport in the summer of 2022 that is only now is being resolved.

Another distinguishing attribute of US LNG is the contractual arrangements adopted by the industry that have remained fairly consistent across most projects and give buyers and projects important benefits. These contracts along with good operational and cost performance have allowed most US LNG projects to achieve credit ratings profiles at or near investment grade. Generally, two types of offtake contracts underpin US LNG projects. Most projects use a sale and purchase contract (SPA) in which the buyer requests an amount of LNG and the project obtains the gas, produces the LNG, and loads it into the buyer vessel at the berth – so called free-on-board delivery.

The SPA gives the buyer the right to request any volume of LNG from zero to a maximum quantity over a period. In exchange for the LNG and optionality, the buyer pays the project a capacity fee and a variable fee. The capacity fee typically has a fixed component to repay capital costs and provide an equity return, and an indexed portion to cover operations and maintenance (O&M) costs. The buyer pays the variable fee only when it requests LNG and the fee is typically equal to the cost of gas at a highly liquid hub plus an adder to cover transportation costs.

The ability of the buyer to request LNG volumes differs materially from some LNG offtake arrangements in other projects globally that require the buyer to purchase minimum volumes at prices indexed to Brent prices or other commodity prices. Some other US projects use a tolling contract in which the buyer provides the gas to the project, which in turn produces the LNG and loads it into buyer vessels. These projects earn a capacity fee and don’t bear any natural gas price or volume risk.

The US projects with contracted capacity cannot capitalise on currently very high LNG prices in Europe and Asia since they don’t sell LNG directly to those markets. Nonetheless, by selling LNG from uncontracted capacity to an affiliate, the sponsors of the projects are well positioned to benefit from demand and especially dislocations in European and Asian natural gas markets.

Additional SPA and tolling benefits for buyers include optionality to request any amount of LNG up to the maximum quality and the few restrictions on where the buyers can sell it. On the downside, buyers take global LNG basis risk, which can be substantial. Overall, the value of US contract flexibility has been well-proven during the Covid-19 pandemic and the Russian invasion of Ukraine. During Covid-19, natural gas demand plummeted globally and buyers from US projects simply chose not to request LNG. When natural gas prices spiked in Europe in 2022 following the shut-off of Russian pipeline gas, buyers of US LNG where able to obtain their maximum contract quantities from most US projects and sell them into Europe for substantial profits.

While some LNG projects are currently attracting new offtake contracts, numerous issues cloud the view of how longer-term growth may play out going forward. Foremost is uncertainty in natural gas demand over the long term, made clear by numerous forecasts indicating a wide range of global outcomes based on different assumptions about economics, technological advancements, decarbonisation goals, and other factors.

Generally, many advanced countries using large quantities of natural gas want to reduce environmental emissions through a transition to more renewable energy. But, many developing countries heavily reliant of coal are likely replace it with natural gas during a long-term transition to a low carbon generation mix. Much of Europe’s desire to end reliance on Russian pipeline gas is thought by many to be a major growth opportunity for US LNG, but Europe’s redoubled efforts to more rapidly build out renewable energy seems at odds with a material increase in long-term investment in LNG imports.

A number of challenges are pressing on the supply side. US developers compete with other LNG producers to secure long-term contracts. Most notable is Qatar, which has production capacity similar to the US and two projects in construction to boost LNG production by 49m tonnes per annum (MTPA) by 2027. Qatar will contract to underpin those capacity additions, and having projects in construction and very low cost gas from dedicated reservoirs gives it a competitive advantage.

LNG from the US and other countries is also in competition with pipelines to serve markets, especially into Europe and China. Several pipelines serving Europe may be able to expand capacity. In March 2023, Russia announced progress with China on the proposed Power of Siberia 2 pipeline project, which would deliver about 36MTPA of natural gas to China by 2029 – an amount greater than any US LNG project currently.

Rising capital and debt costs will also influence US LNG development, especially if other global suppliers don’t face similar cost pressures. The rise in capacity fees would run counter to the decline in fees that have occurred in the US projects over time as competition has expanded. Most existing projects may mitigate the costs risk through large expansions at existing facilities to capture economies of scale.

Finally, ESG factors are also influencing the US LNG sector, whose operations result in significant CO2 emissions. More buyers take carbon impact into account in their long-term commitments. Most US LNG project sponsors have announced plans to undertake some type of CO2 capture and sequestration efforts to make the overall product more environmentally friendly, which may help future contracting potential and improve their own ESG position. Relatedly, several projects use electric motors to drive compressors instead of the established method of on-site natural gas turbines, in order to lower emissions.

As of March 2024, the US federal energy regulator reports that 83MTPA of LNG capacity is in construction and that 118MTPA is approved to begin construction. It’s not clear which of these approved projects will move forward, but buyers interested in adding US LNG to their portfolios may have plenty of projects to choose from.

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