Super Tankers and Super Volatile Oil Prices

The recent oil shipping research that I released was actually quite timely. What appears to be adverse price movement (as can be said with the financial companies' research as well) is actually an opportunity. Be sure to attain positions in small increments. I will elaborate below, but first let's peruse this news item born from the bullish comments of Frontline's (FRO) CEO.

From Bloomberg:

Oil traders are seeking as many as 10 supertankers to store crude, potentially taking the amount hoarded at sea to almost five days of European Union demand, according to Frontline Ltd., the largest owner of the vessels.

About 25 of the carriers, each able to hold about 2 million barrels of crude, were already hired for storage. There are enquiries for 5 to 10 more, Jens Martin Jensen, Singapore-based interim chief executive officer of the company’s management unit, said by phone today. Traders are storing crude to take advantage of higher prices for supply in the future.

Thirty-five supertankers represent about 7 percent of the global fleet of very large crude carriers, according to data from London-based Drewry Shipping Consultants Ltd. Storing oil in tankers may buoy rental rates that fell by a record 78 percent last year as slower economic growth sapped demand for energy.

“I’ve never before seen storage demand on this scale,” said Didier Labat, a Paris-based shipbroker at Barry Rogliano Salles who has worked in tanker markets for about 20 years.

Commodities prices fell the most in five decades last year, with crude dropping more than $100 from the peak of $147.27 a barrel in July, as simultaneous recessions hit the U.S., Europe and Japan. Oil demand in 2008 fell for the first time since 1983, according to the Paris-based International Energy Agency.

Traders are seeking to lease ships for three to nine months, Jensen said. Crude oil for December delivery traded at $61.90 a barrel as of 10:49 a.m. in London, $13.66 more than the February contract. Oil companies and traders may be able to profit from storing the oil, assuming shipping, insurance and financing costs are covered.

...

Iran, the second-largest member of the Organization of Petroleum Exporting Countries after Saudi Arabia, idled as many as 15 of its biggest ships in May to store crude oil. That contributed to three consecutive months of higher rental rates for ships.

The cost of delivering Middle East oil to Asia, the world’s busiest route for supertankers, rose yesterday for the first time since Dec. 5, according to the Baltic Exchange in London.

Forward freight agreements advanced. The derivatives are used by traders to bet on the future price of hauling Saudi Arabian cargoes to Japan, an industry benchmark.

The contracts traded at about 46 Worldscale points for the fourth quarter, according to prices from Oslo-based broker Imarex ASA as of 10:34 a.m. London time. They closed at 45 yesterday.

...

Worldscale points are a percentage of a nominal rate for more than 320,000 specific routes. They give owners and oil companies a starting point for negotiating hire rates without having to calculate the value of each deal from scratch.

Frontline, based in Bermuda, has advanced 13 percent in Oslo trading this year. The five-member Bloomberg Tanker Index has gained 12 percent...

To contact the reporter on this story: Alaric Nightingale in London at [e-mail]

And this just crossing the wires as I type this article:

"US Crude Oil Inventories Rose 6.68 Million Barrels Last Week"

Hmmm! Methinks there may be some softening still, in these markets.

Now, what does this mean to my subscribers? Well....

Frontline has been hired for floating storage for up to 50 mn barrels of oil, or roughly 20 to 25 oil supertankers over the past two months. There has been a recently surge in bookings for Very Large Crude Carriers (VLCC), which carries 2 mn barrels of oil, to store crude oil for future delivery owing to the oil market's contango structure wherein traders can buy oil and store it and simultaneously enter a forward sell contract. We believe that this arbitrage trading would not be sustainable once the spread between current spot and future prices normalizes to historical levels.

We have computed historical Contango (Backwardation) for 1 month, 2 month, 3 month and 12 month oil price futures. The present contango for oil prices is highest since 2000. At present the 2 month, 3 month and 12 month oil futures are trading at a premium (discount) of $4.55, $6.76 and $14.51, respectively against average premium (discount) of $0.18, $0.21 and -$0.84, respectively, since 2000.

(Click the graph to enlarge to print quality.)

According to International Energy Agency, the cost of storage in VLCCs is around 90 cents a barrel per month and an additional 30 cents a barrel or more to cover capital costs, insurance and other costs. We have determined the possible arbitrage opportunity taking into consideration the above storage cost assuming that a trader buys oil at spot and stores oil for specific duration and simultaneously enters a short futures contract. Due to high contango in the futures contract there has been an arbitrage opportunity for an investor particularly in the month of December.

As a result many players (Royal Dutch Shell PLC (RDS.A), BP PLC (BP), and Koch Industries) had booked VLCC for storage in December to exploit this trading opportunity. As premium in the future market normalizes due to market forces (in fact the premium in the 3 month future contract has already declined from $13.3 as of December 22, 2008 to $6.7 as of January 6, 2008), speculative demand for vessels for storage purpose will ease. (We have already built in high capacity utilization rates for FRO in our model with net capacity utilization of 98% for own fleet vessels and 96.2% fir Managed fleet vessels for 4Q2008.) Also we regard this news as negative for Frontline, since it reinforces our view that the company is finding it difficult to charter ships on voyages, in a market already plagued by lower freight rates, and is resorting to short term demand fulfillment.

I welcome my subscribers to revisit the Frontline analysis as well as download the oil price arbitrage spreadsheet that accompanies this article. Professional subscribers should take particular notice of the macro argument made in the thesis.

Oil Price Arbitrage Addendum (Excel 2003) 2009-01-07 09:55:07 1.31 Mb

Frontline Investment Summary - Retail 2008-12-18 14:13:16 363.84 Kb

Frontline investment highlights - Pro 2008-12-18 14:16:07 473.47 Kb

Comments

[andy93109:]

It seems that removing tankers from service for storage is the a very effective way of removing supply to market. I am reminded of the electricity deregulation in California's 'spot' market. Several Power plants went offline for 'repair' (similar to production cuts but faster) but then the remaining plants had sufficient capacity to produce the state's required capacity however the power transmission lines those plants had access to did not have sufficient capacity to get the power into the state. The spot market spiked and the state lost billions.

How many tankers are there worldwide? Does 50mln bb represent a large number? 5% or more?

Jan 08 10:55 AM

[Between The...:]

The world consumes 80 mil bbl a day, with the US scarfing down about 25% of that total. This means stashing 50 mil bbl would only be a small adjustment to total world oil consumption, a mere 8% of the US needs for one month. With the short term inelasticity of the price of oil (estimated at 0.3-0.6 by various sources), hoarders will get their desired bump in oil prices as every 1% of oil they can remove might yield 2% in price. However, once short-term oil storage capacity is fully utilized (and much was created during the oil bubble of 07-08), the cost of renting a tanker will increase, hoarding will stop, then net oil production will rise again and prices will fall. However, there will be a conspicuous number of full-tankers parked in ports around the world, providing a cushion against rapidly rising near to mid term oil prices. Any investors using leverage to purchase and store oil for future delivery could easily lose their shirt as the speculative oil moves into and out of the market.

Jan 08 02:54 PM

[Conan the B...:]

35 Suezmaxes=7%, thank you. I was wondering how many there were in the world.

FRO has added 6 of theirs to the Gemini Pool which coincidently, with their addition, comprises the same number, 35 SMs. If the Pool works like I think it will, competition for cargo will decrease.

Additionally, this year marks the end of the Single Hull Era. With their removal throughout the year, Oil tanker rates will benefit. (Scrap steel anyone?)

I own some shares of TNK, a spin off from TeeKay (TK) which still owns more than 50%. It was structured by TK to pay out almost 100% of their income (ex expenses).
I personally believe it was a Tax dodge.

Be it as it may, TNK is a pure oil shipping play, few shares O/S, they are supposed to complete their fleet of 12 vessels, 4 Suez, by the middle of this year with the delivery of two Suez sized tankers. Ordinarily, with credit markets in this state and day rates so low, this costly addition should make one wonder whether TNK will be able to complete the transaction. TNK is taking delivery from its parent, there won't be a problem. All Double Hulled with an estimated life span of 20 years.

Barron's estimates this years payout to be in the $2.00 range.

TK did a couple of other spins with the same structure, an LNG and a shipping supply. TK is running the Gemini Pool.

TNK's last quarterly payout was $1.07, up from $.90. I originally bought with the expectation that the dividend would remain at .90, TNK's price was $17 at the time. It promptly tanked, I doubled up around $8 after the payout was increased. I hope it drops below $10 again.

So if Frontline manages to live up to your expectations, It may help reduce TNK's price.

The longer term fact is this. More ships will be needed to transport the same amount of oil because the distances to land based operations has increased dramatically.

IE. Petrobas's activity is 300 miles from shore.

The weakness in shipping rates may start rising before the price of oil does. IMHO

Jan 09 05:11 AM

[Conan the B...:]

Strike the last line, should read "Strength in" not "The weakness in".

Jan 09 05:51 AM

[Breadnight:]

Paultaut: I am sure Petrobras will utilize a pipeline to transfer it's petroleum production the 300 miles to shore.

I believe Reggie's summation, which we hinted at, would be to sell into the strength in these shipping companies. Their business models did not include this storage aspect a year ago. It is a plus to them in the short term, but indicates how weak their core business model is currently performing.

If you believe crude prices will continue to collapse (which I do), shorting these crude transporters is a good high beta play. I would recommend a strategy of shorting the shippers that couldn't make money during the boom times, those will be the ones to go under in the future.

The catch: is the recent strength in the shipping co's due to the storage issues due to crude contango, or is it value investors picking the bottom? Why has DRYS seen recent (huge) strength, they don't have crude vessels (that's not a fact, but I'm moderately sure of it)??

-if you're shorting an equity b/c of a flawed fundamental factor, you should make sure the recent strength is due to that factor. In this case I am not sure that is true... Your thoughts??

Jan 09 08:54 AM

[Breadnight:]

BTW, keep up the good work Reggie, even when I do not agree with you I enjoy the research based analysis.

Jan 09 08:56 AM

[Reggie Midd...:]

Breadnight, Thanks. I actually enjoy your lucid and well thought out comments - ditto for Pail. I am bearish on Frontline and currently short their common. I have issued a fair amount of research on them through my blog, and yes, there are fundamental weaknesses in their business model which (even with the storage +) will more likely than not show in the next few reporting cycles.

Jan 09 10:43 AM

[henarl:]

I have a large (for me) long position in FRO which I started building in mid 2007. Altho FRO lost a lot of share price in 2008, I was able to cover all of that with dividends and selling covered calls. Rather than selling at a loss and then selling short, I would prefer to continue selling covered calls against my position to mitigate any further downside. If share price increases, I will roll out and up to protect my upside. Also long NAT & OSG

Jan 09 12:10 PM

[Conan the B...:]

Breadnight: Pipelines from those fields are not even under consideration. It is not a simple matter to lay pipe at those depths for that distance. How many submersibles are able to withstand those pressures let alone work in that environment on a daily basis. Even Robotic submersibles will need experts to handle them from the surface.

Who builds them? Does anyone know? A deepsea underwater infrastructure play?

Jan 09 04:14 PM

[henarl:]

The whole Brazilian deep offshore oil program is on hold. At the present crude prices there is just no way to justify that kind of expense. It will probably be several years before any tankers will be needed there.

Jan 09 04:35 PM

[Lee 99:]

Good article, somewhat substantiated by Eugene Bukoveczky's 'contango' article published today by investopedia, but with better math.
The tanker industry is, can be and has been quite perplexing over the last decade. The best predictor, for some obscure reason, on stock price is the price of crude. That doesn't look good for FRO, but their management is very creative in times like this. I would not short at these levels.
It would be interesting to know what rates the tankers were getting for storage. Has to be less than transport w/ no bunkers or crews to pay for.

Jan 09 08:08 PM

[Reggie Midd...:]

@lee99: You'd probably short them if your read the research. If you like the math in the article, you'd love the math in the pdfs.

Jan 09 10:49 PM