Frontline Is Experiencing A Severely Positive Catalyst

Jul.24.13 | About: Frontline Ltd. (FRO)


The West Texas Intermediate ("WTI")-Brent crude oil spread has narrowed very quickly lately, and the two are now close to parity. As recently as late 2010, WTI used to trade very tightly with Brent, and indeed WTI used to be generally a little more expensive than Brent due to WTI's better quality. The increased supply of Bakken and Canadian Oil Sands oil over the last few years created a bottleneck at Cushing, the location for the WTI future contract's contractual delivery point. Since the beginning of 2011, Cushing oil has been cheaper than Brent until now. During this time, prices for crude located right on the Gulf of Mexico were juxtaposed between the price at Cushing and other international prices. Judging by the recent return to WTI and Brent parity, it appears the supply constraints in getting US oil out of Cushing have been largely resolved. In addition, more pipeline capacity out of or bypassing Cushing is due to come online later this year, which should guarantee WTI doesn't drop to a steep international discount again.

Interestingly, Light Louisiana Sweet ("LLS") crude is now trading a several $/barrel premium to Brent after trading at a discount for the last couple years. This is presumably because supply constraints have moved further downstream past Cushing in the conduit between the Gulf and Cushing. Once transportation issues between the mid-Continent region and the Gulf have been resolved, arbitrage forces will narrow that spread. Regardless of when LLS and WTI converge, the point is that previously transportation-stifled North American crude is no longer available on the cheap at any point in the supply pipeline, so the old arbitrage relationships for worldwide crude are now due to return.

As I write this, spot LLS crude is trading at an over $8/brl premium to Dubai spot crude and over $3/brl premium to Brent. Although Dubai crude is more sour than both Brent and WTI, this differential is more than enough to cover the $1-2/brl freight costs for Very Large Crude Carrier (VLCC) borne crude from the North Sea, as the premium for LLS exceeds anything seen in the data I have from 2000 onward, aside from during Hurricane Katrina (Figure VI-13). VLCC rates have shot up in the last few weeks, and I expect them to continue to rise based on the relatively large price premium that LLS is now trading at.

Frontline's operations

Because of the glut of cheap Gulf of Mexico oil since early 2011, there was no need to charter VLCCs (oil tankers) to bring world crude supplies to US refineries, which are the best in the world. Instead, the refiners in the Gulf of Mexico could maintain tremendous margins by purchasing the inexpensive, fine quality Cushing oil, even after adding in relatively expensive rail and trucking costs to get it to the US Coast, as evidenced by the discount of LLS to Brent for the last couple years. The pricing incentive on refiners to reject other global oil sources is no longer there. Now that the old oil price relationships have returned, there is suddenly now a need to charter oil tankers again. Frontline (NYSE:FRO) is the pure play in this space. Frontline has languished for the last 2.5 years, and is priced for extrapolation into near-bankruptcy. According to Frontline's latest 20-F, its "VLCCs are specifically designed for the transportation of crude oil and, due to their size, are primarily used to transport crude oil from the Middle East Gulf to the Far East, Northern Europe, the Caribbean and the Louisiana Offshore Oil Port, or LOOP. Our Suezmax tankers are similarly designed for worldwide trading, but the trade for these vessels is mainly in the Atlantic Basin, Middle East and Southeast Asia." VLCC rates have jumped in the past couple of weeks, and should return to a level that makes Frontline sustainably profitable again. Rates do not have to return to anywhere close the $200-300K/day rates of '08 for a severe inflection in equity pricing to take place as the stock gets re-priced for extrapolation as a sustainable profit-making enterprise.

For instance, $23K/day is the VLCC breakeven rate provided in Frontline's latest 20-F as part of its book value impairment assumptions. At this rate, if rates go to merely $45K/day from the $19.3K VLCC rate and $14K Suezmax rate it actually received in 4Q 2012, and Frontline is able to put 90% of the 39 vessels it owned as of the end of '12 into service, then the company's gross profit would exceed $600K daily, which is over $200M annually. Net profit after subtracting $100M interest expense and minimal taxes would still be over $100M. This would be roughly in line with Frontline's 2010 performance, which was not on par with the booming conditions pre-2008, but was not the abysmal conditions since 2011, either. A P/E ratio of 10 applied to its 78M shares outstanding means a ~$13 share price, which would be a 5-bagger at the time of this writing. However, the $45K day rate and 10 P/E are intended to be conservative estimates for when the old oil arbitrage conditions are once again accepted as permanent. The spot rates between 2000-2008 had never dipped below $40K/day for very long, and tended to fluctuate between $50-150K during that time (Figure VI-10). However, overall vessel supply has expanded in the last several years, while overcapacity is mitigated by longer average transport distances, so the new equilibrium VLCC price remains to be seen. According to Frontline's last 20-F filing, 30 of its vessels operate in the spot market, so its success swings very much inline with the latest VLCC spot rates.

Trading considerations, psychology

I'm not one to pick bottoms, but I believe this is a bottom in Frontline, and it can go much, much higher. A way to hedge this would be to short front-month WTI or LLS futures against front-month Brent/Dubai futures. The idea is not to expect any gain on the hedge, but if for some reason the spread widens back to where it was, then the small gains on the oil spreads should offset the small losses on Frontline, while if the spread stays around where it is now, or WTI goes to a premium to Brent/Dubai, then the small losses on the oil spread should be overwhelmed by the massive gains on Frontline. Besides being long oil tanking stocks, another trade on this narrowing theme is to be long December '14 and December '15 WTI futures against short Brent futures at the same expirations because WTI is still discounted to Brent by ~$7-8/barrel at those expirations due to storage considerations. That's a trade that I have on as well, but Frontline has much more explosive potential. I'm long and I refuse to take a small gain. I would not be surprised to see a 5-10 bagger on this within a year. Comprehensive sector comparisons to determine appropriate P/E, P/B, and similar ratios are inappropriate at this time considering that fundamentals are now undergoing a violent inflection point, and the new baselines for VLCC rates are extremely difficult to forecast under these conditions. Once VLCC rates stabilize at a new equilibrium based on "a new normal" in oil price spreads, more precise projections will be appropriate. Suffice it to say that any sustainable increase over the breakeven rate of ~25K/day will bring about a rapid rise in the price of Frontline. The short interest for Frontline currently stands at ~10M shares. Perhaps that's from capital structure arbitrageurs who are long debt and have been winning on the short equity side of the pair. No matter who is short, it is time for them to cover the short equity side. This stock is too small to be on the radar of many funds. The higher it goes, the more buyers will be able to consider accumulating a position.

I am also long DHT Holdings (NYSE:DHT), Dryships Inc. (NASDAQ:DRYS), Knightsbridge Tankers Ltd. (VLCCF), and Teekay Tankers Ltd. (NYSE:TNK).

Disclosure: I am long FRO, DHT, DRYS, TNK, VLCCF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I will consider selling: 1) into a short term explosive upmove, in which case I will buy back in the following days, or 2) if the basis for my long changes. Otherwise, I intend to hold this for long-term gains, a timeframe which is unusually long for me.