Small-cap exploration and production company Cheniere Energy Inc., armed with 7,000 square miles of 3-D seismic but little production or cash flow, has become one of the country's leading developers of new liquefied natural gas (LNG) terminals. The company that in 2002 had to borrow money to make payroll ended up with a market cap of $1.6 billion by year-end 2004 and $1.1 billion in funding for LNG plant construction. How? Oil and Gas Investor asked chairman, chief executive and co-founder Charif Souki. With more than 20 years of investment-banking experience and an MBA from Columbia University, Souki has been banging the drum for five years about the potential-and the need-for LNG terminals in the U.S. as North America faces becoming a net importer of gas. For a long while, people discounted the story. Now they are listening. Cheniere's credibility is building. The Federal Energy Regulatory Commission (FERC) has approved three of the four LNG terminals in which the Houston company has a stake. The first, already under construction in Freeport on the South Texas coast, is owned by Freeport LNG Development LP, in which Cheniere is a 30% partner. It owns three other LNG projects 100%. One is at Sabine Pass in Cameron Parish, Louisiana, where ground was broken in March, and another is in Corpus Christi and received final FERC approval in April. Applications for the fourth terminal, Creole Trail, and an accompanying new pipeline, all in Cameron Parish, are before FERC now. Cheniere expects final approval in 2006. If all four LNG plants are operational as expected between 2008 and 2010, their combined regasification send-out will be 10 billion cubic feet (Bcf) a day, with 40 Bcf of LNG storage. The U.S. Energy Information Administration says that Texas and Louisiana alone used nearly 15 Bcf per day in 2003. The plants will cost an estimated $650- to $950 million each, depending on size, and including land, docks, LNG storage tanks and the regasification facility. Such massive projects are an ambitious undertaking for a company whose market cap was only $17 million in 2002. Since then, Cheniere has bulked up. It hired new people with LNG experience, negotiated terminal use agreements (TUAs) with key customers, and arranged financing. In April 2005, Stanley Horton, a 30-year gas industry veteran, joined the company as president and chief operating officer. He was previously COO and president of Southern Union, which operates the Lake Charles, Louisiana, LNG terminal. In February 2005, Sabine Pass LNG entered an $822-million senior secured credit facility with a syndicate of 47 banks and financial institutions, led by HSBC and Societe Generale. Bechtel Corp., which has the contract for engineering, procurement and construction, broke ground in March. Despite development risks and enormous costs, Cheniere is making it happen. The Sabine Pass terminal is furthest along. Last November, Total SA exercised its option to acquire 1 Bcf of daily regasification capacity at the site and Chevron took capacity of 700 million a day. Both paid reservation fees to Cheniere aggregating $37 million. How did all this come together and what are the economics? Souki and Keith Meyer, president of wholly owned subsidiary Cheniere LNG Inc., explain here. Investor You sold all your proved working interests in E&P assets in 2002 and since then, you haven't drilled any wells. Are you officially out of the E&P business? Souki No. We continue to generate prospects, mostly offshore Texas, and sell them. It's nice to have a finger on the pulse even if it is a small part of our business. We have been successful, but the wells are getting smaller and more expensive. We have 7,000 square miles of prestack time-migration 3-D data. And we own 9% of (privately held producer) Gryphon Exploration. Warburg Pincus owns the remainder. Investor Originally investors were skeptical of your ability to execute an LNG plan. Souki People are taking us more seriously now. We prefer to be judged by what we do. We developed this LNG business model five years ago and it has remained the same for those five years. In the beginning, we executed it with very little means. Investor How did you arrive at LNG so far ahead of everyone else? Souki LNG is going to be a significant amount of domestic consumption by the end of the decade. The U.S. will need 15 to 18 Bcf a day by 2010. That's what convinced us imports are going to be more important. And, we looked at rising finding costs in the Gulf of Mexico and said this is not sustainable. Those costs are north of $3 a thousand cubic feet (Mcf) and the Gulf Coast onshore is probably not far behind. And we saw the decline curve. The Gulf used to produce 14 Bcf a day and now it is down to 12 Bcf if you include production from deep water. So I continue to expect the Gulf will decline during the next five years-the only factor sustaining it is $6 or $7 gas. I see nothing to change the high finding costs. Investor Why not just expand elsewhere the way Newfield Exploration has expanded to Utah and PetroQuest Energy has purchased assets in the Midcontinent? Souki We looked at most of the major basins in the U.S. and saw nothing interesting, with the exception of the Rockies, and everybody is there. For a small company like us, how were we going to compete? Investor But why LNG? Souki We didn't start out with that. We were looking at the trends in E&P-the major equilibrium point where gas prices would settle. You had bankruptcies of offshore players like the old Petsec Energy and Forcenergy. Very smart people like the Zilkhas were getting out of the Gulf. When you looked at finding costs versus DD&A, something was not computing and we were convinced the trend was not going to change. Big companies like Anadarko Petroleum and El Paso were saying it would take $3.50 or $4 to justify exploration but finding costs were going to $3. At that point the conclusion was, exploration offshore has a very short life. You can get the leases and you can get lucky, but it takes a lot of money and there is substantial engineering risk in deep water. That led us to think about having to import gas, which led us to LNG. Investor Isn't it more expensive than E&P? Is there room for a small company like Cheniere to do this? Souki The myth was it would take $5 to import LNG but you can land it all day long for $3.50 from almost every major gas-producing country in the world. We looked at two things. If there is an infinite number of possible LNG sites, we could do the permitting and construction and maybe sell a site to someone who needs it in a hurry. That model has been used in the independent power-generation business. Or alternatively, if LNG sites are scarce, then you have something different-a lease that is critical, where you build a facility big enough to benefit from economies of scale. We explored the possibilities from Maine to Mexico and concluded there were few sites that actually worked. Investor And Freeport, Texas, was first. Souki Yes. Then we met Michael Smith (former chief of Gulf-focused Basin Exploration) three years ago and he believed in us. That was good timing. Look, we were a company whose market cap was $20 million and we were talking about billion-dollar facilities! We had to make sacrifices, so we brought in Michael and relinquished management of Freeport to him. He took over the negotiations with Dow Chemical and ConocoPhillips. Having done that, we could go on to Sabine Pass. And now, here we are in 2005: we have three permits in hand, of which two have started construction. For the third, at Corpus Christi, we hope to break ground later this year. We've filed with FERC for the fourth, Creole Trail. We are very comfortable with where we are-and we're very busy. Three years ago we had 13 employees and now we have close to 90. It's been a challenge to attract good people-but they all have experience in LNG or gas pipelines. Investor They are led by you, Keith. How did you get involved? Meyer I ran into Charif at a conference about five years ago and realized we were both beating the same drum-but no one was marching to it at that time. I've spent most of my life in the pipeline business, such as at CMS Panhandle, which owned the Lake Charles LNG plant, so I was paying attention to the nation's gas-supply situation. The Gulf of Mexico provides 54% of our supply but is declining fast. I saw that we were heading for a gas shortage and we had no alternative except LNG. Investor Your model is to build and operate the receiving terminals and find customers that want capacity. Do you worry if they can't get LNG supply? Meyer Oh, no. We have a long-term global supply surplus right now and a number of nations are trying to become North America's preferred supplier. Investor But what if your terminal is only half full? Meyer We have long-term terminal-use contracts [capacity reservations] at Freeport and Sabine Pass so our income doesn't depend on volume throughput. Souki A component of our strategy is that we will reserve a portion of the capacity for our own use-potentially involving upstream endeavors, which will expose us to the gas spot market a bit. But the contracts we have with Chevron and Total are enough to service the debt and leave us a little profit. Investor How are you financing this? Meyer JP Morgan, Merrill Lynch, Petrie Parkman and Pritchard Capital did an equity deal, raising close to $300 million in December 2004. Then in February for Sabine, we closed a project financing with HSBC for an $822-million credit facility. We have nearly $300 million in the bank and zero debt. That will change, obviously. The majority of Freeport is being financed by ConocoPhillips. Investor Walk us through the economics at Sabine Pass. Meyer Total will pay $125 million a year for 20 years starting in April 2009 and Chevron will pay us roughly $90 million for 20 years starting in July 2009. So, we'll have about $215 million a year of revenue from Sabine versus $30- or $40 million to operate it. Plus, we expect distributions from our interest in Freeport of about $15 million a year. Souki For 20 years we'll have net cash flow. You can discount that however you want, but keep in mind, our customers are investment-grade credits. We will charge 32 cents per million Btu as a tariff plus 2% of throughput for fuel and power. If you think you can get capacity elsewhere and cheaper, then fine. I don't think you'll find another company proposing an LNG project that is so public about its rates. It's a number we think the market can live with. Our customers will make a lot of money monetizing their gas reserves. Investor What's your next challenge? Souki I think to stay focused on our business plan. We are doing what we have to do. We are a service provider; it is up to the companies to provide tankers and LNG supplies. We are marketing Corpus Christi and Creole Trail now, the only two terminals we have with capacity left. Michael wants to expand Freeport's capacity and we are thinking about expanding Sabine Pass to 4 Bcf a day. It was a challenge to convince our "anchor tenants" that we were serious, that we had some attractive real estate and we had the wherewithal to get these built. You overcome that by continuing to deliver on your promises. Having Bechtel build Sabine Pass is very comforting. It's just a matter of execution now. Let the facts speak for themselves. When people said, "There are other sites," we said, "Fine, go pursue them." We're not saying we are the only ones in LNG. The U.S. is going to need more LNG capacity than just ours.