Tankers: Sending Out An S.O.S.

 |  Includes: FRO
by: Elliott Gue

To say that the past three years have been challenging for companies that own and operate oil tankers is an understatement. At the height of the financial crisis and Great Recession, tanker companies struggled to cope with the evaporation of short-term financing and a precipitous decline in global oil demand.

The economic recovery has brought little relief for tanker companies with substantial exposure to the spot market, where vessels are available for short-term leases. Although US oil demand has recovered from its recessionary nadir and consumption in China and other emerging markets has increased markedly, spot rates have recovered only marginally over the past few years.

In many ways, these challenges are the industry’s own doing: Tanker capacity has swamped demand for oil shipments. The roots of this overhang trace back to the last bull market for tankers, when many operators ordered new vessels from shipyards based on overzealous assumptions about demand trends.

Shipbroker Clarkson estimates the industry’s current order book at 155 new very large crude carriers (VLCC) -- about 30 percent of the existing fleet of double-hulled vessels--39 of which are slated for delivery in the remainder of 2011. In the second quarter, 15 of the 18 newly built VLCCs slated for delivery actually joined the fleet. If all outstanding orders are delivered, the global fleet of VLCCs could swell to more than 700 vessels.

Recognizing their plight, tanker operators have sought to cancel or postpone these orders. Some tanker operators have also converted outstanding VLCC orders into carriers capable of carrying liquefied natural gas (LNG), a market where tanker rates continue to climb amid rising demand for natural gas in Europe and Asia. You can see why I am so bullish on LNGs in my InvestingDaily.com article, Bearish on U.S. Natural Gas, Bullish on International LNG

Scrapping older tankers and single-hulled models remains the best way for operators to address the industry’s overcapacity. Akron Trade & Transport of the United Arab Emirates recent sale of the Astakos single-hulled VLLC -- the oldest vessel in the fleet -- to an Indian scrap yard for more than $550 per deadweight ton should encourage more tanker owners to pursue demolition.

These mounting headwinds, coupled with concerns that a global economic slowdown will weigh on crude oil demand, have sent day rates in the spot market spiraling lower. The Baltic Dirty Tanker Index, which measures the cost of seaborne oil transportation based on 12 shipping routes, has declined by 45 percent from year-ago levels.

With new one-year time charters going for roughly $22,000 per day, companies welcoming newly built VLCCs to their fleets face major challenges: This day rate is at least $8,000 to $10,000 below the break-even rate on many of these vessels.

Given these difficulties, it’s little wonder that Frontline’s (NYSE:FRO) Vice President Tor Olav in late May told delegates at the Nor-Shipping conference: “We have to go through a lot of pain before we’re into profitable territory. We have just started on a down cycle, which is going to be brutal.” Only 11 percent of the company’s vessels will be covered by time charters in 2012.

These headwinds prompted analysts to lower their earnings estimates for tanker operators. Meanwhile, the Bloomberg Tanker Index has plummeted by 32.2 percent over the past 12 months. Given the uncertainty surrounding day rates in the spot market and the length of time before we may see a recovery in the shipping market, income-oriented investors should instead consider investing in the MLP or integrated oil and gas sectors. You can find out why I am so bullish on these industries in my article, "Big Returns for Midstream Oil and Gas Companies."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.