Scorpio Tankers (NYSE:STNG) is the biggest owner of product tankers and operates within the Scorpio pool (the largest in the product tanker space). I have been following this stock for a very long period of time because I believe it represents a great value opportunity. However, I always postponed an investment decision because of what I thought was an unjustified correlation with oil prices. I now see reasons to believe that we may be close to a good entry point, and in this article, I will provide some evidence of it.
Oil price correlation
In theory, product tankers should not present a strong positive correlation to crude oil prices. In fact, charter rates are driven by supply (ships entering and leaving the global fleet) and demand (quantity of oil products demanded). I underlined quantity because this is very important. Low prices tend to stimulate demand and therefore benefit companies whose business is built on the volume of products shipped (such as in the case of tankers). That said, Scorpio has shown a surprisingly strong positive correlation to oil prices in the first half of 2016.
Using an online stock price correlation tool, I decided to calculate the correlation of STNG and USO (an ETF that tracks Crude Oil futures) during different periods of time: the collapse at the beginning of the year (January 4th to February 10th), the subsequent rally (February 10th to June 8th) and the most recent weakness in oil prices (June 8th to date). I finally looked at the most recent subset of data (the last couple of weeks). All the correlation data points are visible in this table:
As you can see, during the first leg down in oil prices, there was a significant correlation between STNG and oil prices. That correlation has gradually diminished and it has been at its lowest level in the last couple of weeks. Although it may still be early days, I see a sign in it that this correlation is slowly breaking up.
Now that I am more comfortable than before on the oil correlation issue, let's also look at the fundamentals. First thing to think about it is the status of supply and demand. In terms of supply, I find the following charts from the most recent Ardmore Shipping (NYSE:ASC) (a competitor) presentation very compelling:
Source: Ardmore Shipping website
As you can see, the order book as a percent of the fleet for Medium Range Product Tankers is at the lowest level since the early 2000s. The second chart is even more interesting because it paints the picture of a net fleet growth rate that will constantly decline over the rest of 2016 and 2017 to a bottom of 1% by the end of next year. Obviously, given the time to build tankers and the limited number of shipyards, accuracy of these figures is very high. On the other hand, when we talk about demand, accuracy is not as high, but we can try to extrapolate future consumption from the data of the past. The following chart from a recent Scorpio Tanker presentation shows the World Seaborne Refined Product Trade since the beginning of the century:
Source: Scorpio Tankers website
The long-term CAGR has been 4.5%, and I invite you to notice how the volume of shipped products grew every single year, including during the 2008 - 2009 global financial crisis. These charts provide me with comfort about the fundamentals of the sector and the sustainability of current rates.
I believe the best way to evaluate Scorpio is through the cash flow it generates. In fact, as Scorpio is a financially and operationally leveraged company, a simple P/E analysis would not make any sense. Considering that the company does not pay any income tax, the cash flow generated in 2016 will be approximately $210 million. This is my own personal estimate based on a conservative $300 million EBITDA projection and $90 million of interest payments (in line with the payments in 2015). That cash flow is equal to 26% of the current market cap, and based on the analysis of supply and demand shown above, is poised to grow in the next couple of years. One important element in the picture is the fact that the company every year pays out a significant part of that cash flow, with the dividend yield being equal to 11% at current prices.
Summarizing my analysis, I see a company with a very interesting current valuation in a sector where fundamentals seem to promise a clear future at least for the next couple of years. The main issue of the first half of 2016 (high oil price correlation) is gradually reducing its relevance, and you are effectively being paid 11% per annum to wait and see the investment thesis playing out. For all these reasons, I am a buyer of Scorpio Tankers at current levels.
Disclosure: I am/we are long STNG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.