Investment idea in oil tanker shipping

Oil Tanker Shipping - Long Thesis V3.pdf (1.3 MB)

Summary of the investment idea in oil tanker shipping: The free cash flows of oil tanker shipping companies will benefit from the floating storage demand created due to the mismatch between the slow reduction in oil production and the rapid reduction in oil consumption during the COVID‐19 period of global slowdown.

This impact is not yet factored into their current share prices (as at 23 May’20), though net debt position as at 1Q’20 is better than 4Q’19 and company management’s have guided that free cash flow generation for 2Q’20 is expected to be at similar levels as 1Q’20, if not better.

  • USA listed oil tanker stocks such as TNK, EURN, DHT and FRO look attractive on a value basis
  • P/E’s are below 7x after a long bear market (>90% stock price decline since 2008)
  • Debt is under control with Net Debt / EBITDA below 4x and improving
  • Ship charter rates (revenues) in 2020 are the highest in over 10 years
  • Global trading fleet is ageing, so some older vessels could be scrapped in the near future, while the orderbook (delivery of newbuild ships) is low
  • In the 2003‐2008 boom period, some stocks went up over 20 times excluding dividends

Details on the investment thesis: The shipping industry is cyclical. There was a boom in 2003‐2008 when ship daily charter (hire) rates increased and free cash flows improved. The shipping companies then ordered new ships, resulting in oversupply of ships and a drop in daily charter rates. Stock prices of companies have fallen since their peak in 2008.

See stock price graph (from yahoo finance) of NYSE listed Frontline below. The price was ~$15 in Sep’02, increased to ~$350 in Jun’08 and is ~$8 in May’20.

See slide 8 below from 1Q’20 presentation by Frontline on global fleet growth – Older ships (20 years +) could be potentially scrapped in the near future if they are uneconomic to operate.

In 4Q’19, spot charter (short term) rates increased due to a combination of supply side factors

  • Sanctions on Iranian tonnage removed some capacity from the global trading fleet

  • The anticipated implementation of IMO 2020 regulations (mandatory change in ship fuel emission requirements from high sulphur to low sulphur standards starting 1st Jan’20) caused some oil tankers being moved from the trading fleet into storage for holding compliant fuel oil

  • The dry docking (periodic 5 yearly repairs) of ships took longer (more days in yards), as new equipment (scrubbers) had to be fitted to comply with emission standards related to low sulphur fuel oil while using high sulphur fuel oil

  • USA imposed sanctions on Cosco shipping, further reducing the trading fleet

Since then, both spot and time charter (longer term) rates have been supported in 1Q’20 and 2Q’20 due to demand from oil storage requirements caused due to the COVID‐19 related global slowdown. As global oil consumption has reduced to ~80m bbls per day while production is ~90m bbls per day, the ~10m excess production has to be stored. Initially this was stored on shore based tanks and then on oil tanker ships (as the on shore storage capacity was not readily available). The continuation of higher charter rates from 4Q’19 to 1Q’20 has improved the liquidity position for tanker companies.

See slide 9 from 1Q’20 presentation by Teekay Tankers below that explains the recent deleveraging.

As mentioned earlier, this is a cyclical industry and investments perform well for few years over the cycle. So let’s estimate how allocating capital in oil tanker equities could play out over 2 ‐3 years.

Low case scenario assumptions:

  • Floating storage demand reduces over 1‐3 quarters and charter rates slowly decline
  • Meanwhile, cash continues to build over the 1‐3 quarters on the company balance sheets and they deleverage further in 2020

Potential outcome in a low case scenario: If charter rates are on average more than $19,000 to $25,000 per day after 1‐3 quarters, which is above the ship daily breakeven costs (operating costs, financing costs and G&A), the oil tanker shipping companies may probably distribute fluctuating levels of dividends to shareholders while the stock price appreciation will be low as companies now have healthy balance sheets.

Leverage and interest cover is reasonable as at 1Q’20 (see graph below as at 23 May’20, source – Koyfin) and may improve in 2Q’20, if charter rates are supported by oil storage demand.

See slide 6 below from 1Q’20 presentation by Frontline ‐ Daily breakeven costs and operating leverage.

High case scenario assumptions:

  • Floating storage demand reduces over 1‐3 quarters

  • After COVID‐19, as the global economy stabilises and daily oil production is adapted to oil demand, the IMO 2020 regulations impact may result in high sulphur fuel to cost much lower than low sulphur fuel. This fuel price spread differential would make older ships without scrubbers (using low sulphur fuel) uncompetitive to operate versus newer ships that may have scrubbers (for high sulphur fuel) or are fuel efficient

  • This would increase ship scrapping of the older vessels, reducing the supply of trading fleet and improving the charter rates while the newbuild order book is low.

See slide 18 from 13 May’20 investor presentation by Euronav below.

Potential outcome in a high case scenario: This scenario may result in stock price appreciation and increased dividend payments to shareholders for a 2‐3 year period until newer vessel are delivered.

See slide 5 below from 1Q’20 presentation by Teekay Tankers – Rates in 1Q’20 have been the highest in over 10 years

See slide 7 below from 13 May’20 investor presentation by Euronav – Outlook for 2Q’20 is good

Equity valuations (as at 23 May’20, source ‐ Koyfin)

Risks: Average daily ship charter rates quickly trend to below daily ship breakeven levels in 2020 of approximately $19,000 to $25,000 per day due to a combination of factors such as

  • Floating oil storage demand disappears quickly in 2020, if oil production cuts are rapid

  • Global oil demand recovers slowly to ~100m bbls per day resulting in reduced demand for ships to transport oil

  • Low price differential between high sulphur and low sulphur fuels would allow older ships to operate for longer and there is less scrapping

Let me know if I have missed any key risks or overlooked any major supply or demand dynamic in my investment thesis. Thank you.

Disclosure: I am long TNK, EURN, DHT and FRO.

1 Like

Hi Amit,

Oh wow, many thanks for posting your write-up. I can see why you are attracted to the sector. Very much a deep value/contrarian play – where the upside could be substantial if things turn around. I must admit I do not invest in oil-related shares – they always seemed to go wrong for me!

I don’t know about the debt. Interest cover of c4x seems thin. I don’t know if these operators have always operated with debt and what the balance sheets looked like when the sector was last on its knees back in 2003. Question I would be asking is what has to happen to oil/tanker rates etc for this sector to require extra funds to shore up their balance sheets. I sense the lowly valuations are implying rights issues are a risk.

Funnily enough I came across this video on Youtube:

Needs to be played at 1.5x speed unless you have time on your hands. Have not watched it all and so did not get to the conclusion. But there is a good discussion in the comments, so there are pros and cons to the sector.

Maynard

Hi Maynard - Thanks for your comments and the youtube link.

This is a transportation sector play, rather than oil related. I dont think the energy sector sentiment should affect oil tanker shipping stocks except for Contango (future oil price higher than spot making storage attractive).

Net debt is reducing as cash flows from 4Q’19 to 2Q’20 are expected to be good. Each ship is financed with 70% loan to value or below. There is sufficient equity value in the assets.

EURN has good interest cover of ~4x. Other companies are lower, through operating cash flows are improving, as rates in 2Q’20 are expected to be good. There is minimal currency mismatch (both debt and revenues are mostly in US$). Only if ship charter rates are consistently below $14k pd would interest payments become an issue, as opex is ~$8k pd, G&A is ~$1k pd and interest is ~$5k pd.

There maybe a need for a rights issue for the more leveraged companies, if rates are consistently below $25k pd for over a year. Some companies are more conservative eg EURN has liquidity runway for ~2 years.

I think valuations are low, as these are cyclical companies that have not generated returns for equity holders for over 10 years, therefore investors are currently not interested in such kinds of companies. These companies are also not constituents of major indexes, so do not benefit from passive investor flows.

EURN, DHT and FRO are forecast to pay dividends of ~5% per quarter or ~20% per year at current share prices, assuming charter rates are consistently above $25k pd.

Amit