Nearly one year ago on February 22, 2013, Frontline Ltd (NYSE:FRO) reported another in a string of disappointing quarters. During the conference call, despite the abysmal results that Frontline had just announced, CEO Jens Jensen made a comment that crude tankers were in a "tight market," seemingly implying that a nudge in the right direction could move rates back to levels at which owners could operate profitably again and not worry as much about the significant debt that had caused the values of their respective companies, whether publicly traded or privately held, to plummet from their 2008 highs to unprecedented lows in three short years.
The stock market one year ago wasn't buying Mr. Jensen's modest bullishness on the VLCC market. In fact, in the wake of near-zero VLCC day rates, the heavy selling in FRO had already begun an entire month prior to the ugly earnings report. The market took FRO from an intraday high of $3.68 on January 23, 2013 to an intraday low of $1.81 on March 5, 2013. FRO saw half of its market cap wiped out in six weeks. Around the same time, the stocks of other industry players such as Nordic American Tanker (NYSE:NAT), Teekay Tankers (NYSE:TNK), and DHT Holdings (NYSE:DHT) experienced similar declines. That's when things became interesting.
Emboldened short sellers of FRO, who remained focused primarily on Frontline's widely publicized $225 million convertible bond loan maturing in April 2015, continued to sell every small rally in the stock for the next few months. But something new was happening in the underlying business. Industry wide, VLCC owners were beginning to realize that their survival relied upon making some difficult decisions with respect to the size of the VLCC fleet. With no meaningful ability to buy time by further leveraging their already troubled balance sheets, VLCC owners recognized that a swift rise in day rates represented their best shot at avoiding bankruptcy. These same owners further realized that day rates were unlikely to rise appreciably if the fleet were to remain oversized compared to ton-mile demand. Short sellers, however, continued to rely on the assumption that no VLCC owner would want to be the first to fall on the sword with scrap values so low by historical standards.
But what many of Frontline's skeptics may still not understand is that even in the absence of an organized, collective effort by the industry to reduce the size of the VLCC fleet worldwide, history tells us that day rates are hyper-sensitive to small imbalances in the VLCC market. Stated in economic terms, demand for ton-miles is almost totally inelastic. Whether spot rates are near zero as they were in 2013 or at $105,200/day as they were in the second quarter of 2008, this figure is small compared to the value of the crude oil being transported. In his seemingly laughable "tight market" comment in February 2013, Jens Jensen demonstrated the foresight to see that even a modest amount of scrapping and drydocking could cause VLCC rates to firm up quickly.
Mr. Jensen has not forgotten that Frontline earned $698.8 million during FY 2008. He also knows that world oil demand is up significantly since 2008, even with slowing growth in China. World oil demand in 2008 totaled 85 million barrels/day. For 2014, the US EIA puts this number at 91 million barrels/day. The monkey wrench thus far for Frontline and its competitors is that the industry wide VLCC fleet numbered 486 vessels in mid-2008, compared to 623 vessels at the end of the third quarter of 2013. Meanwhile, 2008 and 2009 marked the only two years in recent history during which world oil demand declined on a year over year basis. Bubbly speculation among VLCC owners - at the worst possible time - caused the growth of the VLCC fleet to outpace worldwide demand for crude, and shareholders continue to suffer as a result.
So why should the Frontline shorts be concerned now? Simply put, a reversal in trends has begun. Notwithstanding the budding energy independence of the US, ton-mile demand for VLCCs can be reasonably expected to increase each year in line with current EIA projections calling for annual increases of about one million barrels/day for the next several years. Contrary to market sentiment, I predict that these VLCC rate increases will be significant, considering that this incremental consumption will occur almost exclusively in regions such as China that produce little oil themselves. Simultaneously, VLCC owners, who have learned a tough lesson on industry overcapacity, will remain risk averse when it comes to newbuildings, even as rates continue to rise. These two trends - coupled with recent regulations and operating efficiency considerations, both of which will tend to accelerate fleet size reduction by effectively forcing the scrapping of many vessels over ten years of age - will likely cause the pendulum to swing back in the direction of substantially higher rates. I believe that Frontline's skeptics could be missing this larger picture.
Frontline, with its fixed costs now well under control, with its balance sheet on the mend, and with its significant exposure to the spot market, stands to benefit from an unexpected rise in rates.
In my next piece, I will discuss another largely unanticipated mechanism by which VLCC spot rates may increase sharply. I will also discuss whether or not John Fredriksen has an incentive to be the white knight for Frontline should the need arise.
Additional disclosure: Although I have no current business relationship with any company whose stock is mentioned in this article, I have traded emails with their respective managements in the past. I have no plans to sell FRO but am short FRO 8.00 MAY 2014 calls against a small part of my long FRO stock position.