Select tanker stocks could provide returns of 100%-200% or even more… if they manage to stay alive, that is. The "dirty" carriers in particular - which transport crude oil as opposed to "clean" refinery product - have been crushed by the weight of rock-bottom tanker rates. Share prices are low because survival is in doubt. Too many ships plus weak demand trends have created a capacity glut, destroying profit margins and putting carriers on life support.
As the scrapping of old ships reduces capacity, however, dirty tanker rates should rebound along with long-term transport demand. This, in turn, could lead to major upside for the survivors.
So far this year, signs of a turnaround in shipping stocks' fortunes have been evident just about everywhere. The SEA ETF, which is exposed to stocks across the shipping industry, is sitting on gains of 22% year-to-date (beating the S&P 500). From liquid natural gas (LNG) to container shippers to dry bulk carriers, rising charter rates are paving the way to profitability.
But this has, so far, yet to be the case for tankers - in particular those carrying crude oil, which continue to operate ships at far below break-even rates.
How bad is it doc?
At first glance when looking at indices of freight rates, it appears the Baltic dry bulk carrier's 90% crash during the financial crisis was far worse than the declines in tanker rate indices. What tanker indices fail to show, however, is how dire the situation is for owners of the largest crude oil carrier.
When oil prices declined from a peak of $150 to less than $40 a barrel during the fall of 2008, a situation of contango developed in the crude oil futures market, where it became profitable to store oil as forward prices of oil were higher than expected spot prices.
Since tanker rates had already been declining, a strategy used by many oil traders consisted of chartering Very Large Crude Carriers (VLCCs) and using them as "floating storage" since the money gained from selling oil at a future date was more than enough to cover the freight rates incurred.
Unfortunately for tanker owners, oil markets rebounded fairly quickly as demand for oil recovered, removing the contango conditions of the market and making "floating storage" plays unprofitable. High freight rates during the years prior to 2008 had encouraged shipowners to order the construction of a great deal of VLCCs, leading to a major glut of new ships, aka "newbuilds," just now being launched.
The U.S. shale revolution has also weighed on demand for crude oil transportation, as increased oil production in the U.S. has drastically reduced the need for oil imports. The increased refining activity of Middle Eastern oil producers has also shifted demand from "dirty" crude oil carriers to "clean" refined product carriers.
This relatively weak environment for demand is compounding the effect of the supply glut in the dirty tanker and in particular VLCC space. Owners of VLCCs estimate 13% of the fleet or 75 ships need to be scrapped to right the supply imbalance. While the demand trends affecting crude tankers are not helping, the overabundance of tankers remains the main depressant of freight rates.
As of late August 2013, daily rates for VLCCs lingered at $1,515, a very far cry from the $229,484 a day they commanded in December 2007. As the pace of scrapping older tankers hits record highs, dirty tanker rates have yet to turn up. Expectations are for higher rates starting next year but until current cash, or "spot," rates begin to increase, the shares of crude oil carriers will likely continue to stagnate.
Smaller Suezmax, although facing a less steep drop in rates as VLCCs, have also seen freight rates decline year-after-year since 2010 and the end of "floating storage" plays.
While there is a broad range of publicly traded tanker owners and operators, we focused our efforts on companies which mostly own crude carriers. We will therefore discuss:
- Frontline (FRO) and Teekay Tankers (TNK): two of the world's largest tanker owners
- DHT Holdings (DHT) and Nordic American Tankers (NAT): two smaller players
- Tsakos Energy Navigation (TNP): a large and diversified Greek tanker owner
The Big Guys
FRO and TNK are probably the names most familiar to anyone with a cursory knowledge of the tanker industry. Teekay is a recognizable name in the shipping industry, while Frontline is shipping magnate John Fredriksen's most concentrated tanker company.
Both companies have seen earnings expectations worsen over the past few months, with forward 2014 earnings of $0.07 at TNK and a dismal -$1.24 at FRO. Considering FRO was able to trade at twice the current share price when yearly earnings had already been announced at -$1.40 for 2011, a true turnaround in tanker rates could lead to major expectations revisions, and thus quick gains in the stock prices of both FRO and TNK (trading at roughly half early 2012 levels).
FRO's founder, John Fredriksen, has since founded a new venture dubbed Frontline 2012, to which he ceded control of some of FRO's most promising ships, and through which he ordered a great deal of newbuilds in expectation of a market bottom. While Fredriksen may have been proven wrong in the short run, FRO's current fleet of 31 VLCCs with a breakeven rate of $23,104 a day, and 18 Suezmaxes with a breakeven rate of $18,407 a day, is about as direct an exposure to a dirty tanker turnaround as one could hope for. A return to 2010 price levels would imply a ten-fold rise in the share price.
While this 10-fold price increase would certainly fall into the "best-case-scenario" category, a reasonable case for a 100% to 200% increase could be made based on shifting expectations for long-term survival and a return to profitability in the next year or two.
This being said, FRO has warned investors it is likely to default on its $225 million in convertible bonds due in 2015 if VLCC rates do not improve soon. The conversion into equity is priced at $36.5567 or well over ten times the current share price. Total long term debt is $478.3M and FRO's debt-to-equity ratio is 4.736.
TNK's 13 Aframax, 10 Suezmax, 1 VLCC and 10 Product Tankers offer a little more diversification, while its profitable product tankers offer investors extra protection. While share gains may not be as explosive as at FRO in the event of a turnaround, this is a company that can still benefit a good deal if dirty tanker rates turn up.
Debt-to-equity is a lower but still high 2.521 and the company has no significant debt maturities until 2017. Total long-term debt meanwhile is $730.21M.
A high level of short interest for FRO and TNK (respectively 19% and 11% of float) could be an additional important driver of a recovery in share prices if dirty tanker rates make a rebound.
Two Smaller Companies
DHT and NAT may not be household names, but they offer two additional ways of playing an eventual rebound in tanker rates. DHT is diversified across the various dirty tanker classes, with four VLCCs at a breakeven of $28,900, 2 Suezmax carriers at a breakeven of $24,000, and 2 Aframax carriers at $19,000 per day. Shares of DHT have lingered between $4 and $5 this year, as the company's focus on dirty tankers and high breakeven rates promise little near-term reprieve. Forward earnings expectations currently stand at -$1.29.
DHT's debt-to-equity ratio is 0.912 and total long-term debt $155.96M. DHT's next installments on its debt are for $4.9M to be repaid in 2015, $38.2M to be paid in 2016, and the rest thereafter.
NAT has clearly taken a different approach as it specializes in Suezmax carriers, owning 20 of them at a low breakeven rate of $12,000. This suggests NAT's shares should be especially sensitive to a turnaround in dirty tanker rates, although NAT's dividend yield above 7% appears expensive and forward earnings are at -$0.72. With over 21% of NAT's float held short, the initial stages of a turnaround could involve very rapid share price increases.
NAT's debt-to-equity ratio is the lowest of the bunch at 0.248 and total long-term debt of 210M. NAT's credit facility matures in November of 2017.
The last stock in our group, Greek shipper TNP, owns and operates a wide range of dirty, clean and even LNG tankers, including 1 VLCC, 10 Suezmax and 8 Aframax in the dirty tanker sector, 2 Suezmax shuttles, 3 Aframax LRs, 9 Panamax, 6 Handymax MRs, 6 Handysize MRs in the clean tanker sector, and 2 LNG tankers. Such diversification should protect TNP's earnings which are expected to hit $0.15 next year - by far be the highest of the group by 2015. While this diversification has helped TNP see a smaller decline in share price over the past few years, shares still trade at less than half their 2010 levels.
TNP's debt-to-equity of 1.48 places it in the middle of our group although total long-term debt of $1.439B is the largest of the group by far. Balloon payments on the firm's term loans are due beginning in October 2016. While debt appears high when compared to NAT and DHT, TNP's clean product tankers and LNG tankers make TNP more likely to be able to service its own debt.
For TNP to truly see its potential as a major diversified tanker owner reflected in its share price, dirty tanker rates will have to start increasing. In the meantime, this is perhaps the pick most likely to survive of the bunch, although the upside opportunity seems more limited.
What to Monitor
While the Baltic dirty tanker index will ultimately give investors the best idea of where tanker rates are going, other metrics may be worth watching. Counterintuitively, a slowdown in the pace of tanker scrappings - a factor in reducing capacity glut - would be a bullish sign for tanker chartering rates. Indeed a slowdown in scrappings would be a sign tanker owners are confident the glut in supply is no longer such a pressing concern. Chinese oil demand is also important for crude oil carriers, as crude oil is typically transported from the Middle East to China in VLCC tankers. As China has passed the US as the world's largest oil importer and is setting new records for oil imports, China is taking the leading role in dictating demand for oil transportation.
The catalyst which led to rapid rises in dry bulk freight rates and share price increases for dry bulk carriers was the combination of a topping in dry bulk scrappings and renewed iron ore demand from China. The downtrend initiated in dry bulk scrappings during the summer of 2012 was a sign of confidence from dry bulk carriers with regard to the future of their market. This confidence was vindicated when iron ore shipments rebounded this past summer.
For a true rise in dirty tanker freight rates to occur, it is likely some sort of top will have to be reached in tanker scrappings since there seems to be little potential for a major upside surprise in terms of Chinese demand. So while tanker freight rates may begin to rebound on the back of growing Chinese demand for crude oil, it is important to remember that shares will probably only truly recover once tanker owners begin to express some confidence that they will survive this supply glut.
Not out of the woods yet
It should be emphasized that the possibility for outsized returns comes with meaningful risk. None of these companies are likely to announce positive earnings in 2013, and only TNK and TNP are expected to announce positive earnings next year. More importantly, debt levels across the group are high, and unless dirty tanker rates bottom and rebound soon, many of these companies will have to go through some form of restructuring (with shareholder equity not living to tell the tale).
One way to view it is that shares of tanker stocks resemble aggressive out-of-the money call options. While time is relatively short for a turnaround in profitability, shifts in oil consumption and transportation patterns could ignite a rapid increase in stock prices if owners in the space become even moderately more optimistic about the ongoing supply glut.
Shares could decline further, particularly if dividends are cut to meet debt maturities, but if there is an opportunity in this group, it is to the upside, however risky it may be.