Frontline's Idealistic Proposals Will Not Save the Day

| About: Frontline Ltd. (FRO)
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Scrap all Very Large Crude Carriers (VLCCs) over 15 years old. This is what Jens Jensen, CEO of Frontline Management and day-to-day manager of Frontline (NYSE:FRO) boldly proposed during the presentation of Frontline's Q2 results last week. He did not phrase it exactly like that; rather, his suggestion was that shipowners should collectively scrap the 50 oldest vessels in the VLCC fleet, a number he believes would eliminate the current supply overhang in the largest tankers' segment.

Perhaps not all investors in the sector are fully aware that at the beginning of 2011, only 40 double-hull VLCCs were over 15 years old, out of 507 trading at the time; 20 more VLCCs were built in 1996. So now, at the end of summer 2011, Jensen's suggestion to cull 50 vessels points necessarily to exactly those over 15 years old, at a time when most tanker owners use a 25-year useful life estimate for financing planning and depreciation purposes.

But desperate times call for desperate measures. The idea seems simple: According to Jensen, the price difference between a VLCC built before 1996 sold for onward trading and one sold for scrap is declining very fast. This is due to low charter rates depressing vessel market values while, in contrast, high scrap steel prices mean that the current residual value of a VLCC is almost $20 million. Despite the immediate opportunity loss (which Jensen puts at $500 million for the 50 oldest VLCC vessels), shipowners would immediately see an increase in charter rates and value for the rest of their fleet as a result of the tightening of supply.

Jensen may be right in principle, in that the market will in any event discriminate against those 50 older VLCCs. There can be a comparatively significant drop in earnings power once VLCCs and Suezmaxes hit 15 years since the oil majors have an informal policy to cut these vessels out, per Frontline's conference call:

Urs Dür - Lazard Capital Markets LLC

Right. And final question, I'm speaking to a couple of the stockbrokers that I know you know well. They're talking about VLCCs and Suezmaxes in particular once they're hitting 15 years of age already seeing some lack of interest from the major charterers. Are you seeing the same thing? Is there now set of an age creep on the demand for ships hitting more 15 than 20?

Jens Jensen

I think you are right. Some of the big oil companies, oil major, they have, I wouldn't say, it's written rule, but they have a rule that they would like to take ships which are younger than 15 years of age. But of course, we have seen rules being changed before when the market becomes back to normal again. But I think right now, of course, everybody they would like to have the most modern ships, and I think the most common age rule is the 15 years. Yes.

This signifies a clear and accepted bifurcation in the market between modern tonnage preferred by major charterers and less favored 15-20 or even 25-year-old tonnage, which is however perfectly capable to safely carry oil, albeit at a higher cost to the shipowner.

Beware of the Free Rider

Jensen's suggestion will not work. The fact that Frontline does not own elderly double-hull VLCCs able to be included in the proposed sacrifice will certainly provoke some heckling (perhaps Frontline can offer some of its old Suezmaxes instead – or spend some serious money to charter-in two dozen VLCCs for a year and have them slow-steam around the world). The current reality is that indebted publicly-listed and private owners will rather sell than scrap as long as there is a meaningful price difference between the two options. Private owners who can finance old VLCCs through equity or conservative debt at low initial purchase prices or who have fully depreciated and paid-for vessels in their fleet can make money at very low rates and frankly, don't give a damn.

Only two days after Jensen's call for united action, Oslo-listed Saga Tankers sold its 1995-built VLCC Saga Chelsea to a London-based Greek owner for $25 million. (Ironically, Saga Chelsea has been under Frontline's commercial management.) That is only $5-7 million more than the vessel's current scrap value. But after a failed merger with U.S.-listed DHT Holdings (NYSE:DHT), Saga Tankers needed the money to deleverage; it would have been interesting to see how management could have explained it to the shareholders (I don't know if there is a business judgment rule in Norway) or to its banks that it would have been better to take a pass on that $5-7 million in order to be the first in a crusade against tanker oversupply.

On the other hand, the unnamed private owner can easily finance a large part of the scrap value, then wait for a natural or forced rebalancing between supply and demand over the next five to 10 years in order to recover the equity and make a profit, perhaps free-riding on other owners' decision to lay-up or scrap their vessels. Historically owners have been willing to purchase older tonnage because such vessels can provide simply extraordinary returns if somehow the asset cycle turns.

This free rider problem is the almost immediate refutation of the suggestion for concerted VLCC owners' scrapping action. It is the same problem that led shipowners to continue to place both dry-bulk and tanker newbuilding orders long after oversupply concerns had been accepted as reality, hoping that other shipowners will stop ordering first.

The Saga Chelsea deal is the first VLCC transaction since the widely commented upon sale of the 2000-built Tenzan by Japanese giant NYK for $36m in mid-August – a very low price that both owners and shipbrokers insisted was not indicative of a new market level. It seems that the market is heading that way. This is not necessarily a bad thing since the market is naturally pushing vessel prices towards scrap values.

But any stabilization in such depressed levels also means that overleveraged tanker owners should start worrying about their next covenant test. Despite a more than 50% share drop since June 30, and an overall 75% drop since the beginning of 2011, Frontline remains an overwhelming sell for Norwegian security analysts just after the Q2 results. Other listed tanker owners such as Overseas Shipholding Group (NYSE:OSG), Teekay Tankers (NYSE:TNK), Tsakos Energy Navigation (NYSE:TNP) and Euronav (EONVF.PK) may have had slightly less precipitous drops over the same periods but all face more or less similar leverage issues (including charter-in and newbuilding commitments) and trade at multi-year or even historical lows.

Asset Prices Are Not Cheap Yet

Frontline has long been considered a potential consolidator in the tanker sector. I wonder whether it will be John Fredriksen, Frontline's chairman, CEO and principal shareholder, who will instead be one of the main beneficiaries of the tanker market plunge, together with other cash-rich private shipowners: John Fredriksen is sitting on a pile of cash as a result of his business acumen and the exceptional results of his various listed ventures, including Frontline, over the shipping super-cycle of the last decade. Fredriksen has been steadily bearish on the large tanker sector since at least 2010 while focusing on playing the asset cycle in the offshore drilling sector. He effectively said “sell” to the Frontline shareholders many times over – more recently, in May, as picked up a bit later by Bloomberg. Many investors did, in fact, listen.

While Jensen floats idealistic proposals, Fredriksen, whose bearish remarks reflect “a hidden agenda” according to Euronav CEO Paddy Rodgers, stands ready to recapitalize Frontline if necessary, then buy vessels on the cheap. Remaining long-term Frontline shareholders should keep some dry powder on the side to invest alongside the CEO at that time – not before.

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

Additional disclosure: I am long Euronav on NYSE Euronext Brussels.