NOTE - this note has been updated since originally posted.
This is a sister post to http://seekingalpha.com/instablog/927562-adjusted-return/186005-depreciation-policies-for-some-us-listed-drybulk-companies. Reiterating some of the material of the prior post, the two assumptions affecting the depreciation rate are a) the estimated useful life of a vessel, expressed in years and b) the residual or salvage value based on scrap iron price per lightweight ton (lwt or ldt). (The constants for each company are each vessel's acquisition cost, built year, acquisition date and lightweight tonnage. Method is straightline.) Longer useful life periods or higher residual value assumptions both reduce depreciation and increase reported income. Conversely, shorter useful life assumptions or low residual values both increase depreciation costs and reduce reported income.
Below is a list of depreciation policies adopted by certain listed tanker companies, for their tanker vessels (not FSO, FPSO, LNG vessels etc):
Useful life/Salvage value
Sovcomflot: 25 years/$490 per lwt
The U.S.-listed group maintains relatively uniform policies but I was struck by Euronav's estimate of 20 years for useful life and zero scrap value. Why would they use such a conservative policy?
A couple of hypothetical examples illustrate the point: Two tanker companies, TCA and TCB take delivery of 5 newbuild VLCC each during the same year, purchased at a price of $120m per VLCC for a total of $600m for each company. Each company sells 10m shares at $20 in an IPO in order to finance the equity portion of the vessels, the rest covered by bank finance; all vessels are entered into the same externally managed pool. TCA uses Euronav's 20 years/0 residual value depreciation policy, TCB, a variant of the Sovcomflot policy, say 25 years/$500 per lwt. We assume that each VLCC weighs 40,000 lightweight (scrap) tons to get some round numbers - that's a $20m residual value for each TCB vessel.
TCA's depreciation expense will be $30m annually over 20 years, reducing the book value of its vessels to zero. TCB's depreciation expense will be $20m annually over 25 years, reducing book value to $100m, which may or not be the scrap value at the time. All other things being equal, the difference is a $10m annual hit to the income statement of TCA compared to the one of TCB, for exactly the same ships. With revenues and cash earnings exactly the same, that is a $1 per share difference in reported income until year 20. The situation will reverse in years 21-25 or will result at a $100m one-time gain at year 20 for TCA if they decide to scrap (and assuming the scrap price is indeed $500 per ton).
Assume now a similar scenario where these ten VLCCs were 5-year olds bought at the same prices prompt delivery during the same year. TCA will now report a $40m annual depreciation charge over 15 years while TCB will report a $25m charge over 20 years - the gap widens to a $15m or $1.5 per share difference in reported income.
On the other hand, perhaps Euronav is on to something. Oil majors, large independent refiners and international oil traders have their own vetting processes for tanker vessels, requiring modern, well-maintained and efficient vessels. As the global fleet now becomes increasingly younger, and adding oversupply in the mix, even somewhat older tonnage will be left chasing spot trips with second-class operators. Scrapping will come earlier, useful lives will have to be shortened. Frontline used a 20-year useful life estimate until 2000.