Note: This is a follow-up to previous sector commentary which was posted on 27 December 2018. Since that report the average shipping company we referenced has increased between 7% and 54%, with the median return at 14%. This compares to the weaker performance of the primary shipping ETF (SEA) at 10.5% and the S&P 500 at 9.4%. I believe we're just getting started.
Shipping Stocks: Still Barely Off Record Lows
As we covered last month, shipping stocks were caught in a brutal crossfire between the small cap and oil price sell-off during late-2018. The Russell 2000 (RUT) fell by 25% and WTI oil prices had collapsed by 40% during Q4-18, dragging down shipping stocks which were otherwise enjoying the best rates they had seen in several years.
The LNG sector in particular logged all-time record highs and crude tanker rates set multi-year levels along with product tanker rates are also hitting multi-year highs. Tankers in general were bolstered by the highest level of scrapping witnessed in over 30-years, which more than offset strong delivery levels and fairly tepid demand.
Are We Just Getting Started?
It might seem controversial, but I believe we are just getting started. Yes, even recently-mighty NNA, which has posted mega gains in the past few weeks, is just getting started and could see tremendous upside. Why do I think this?
- Record Low Valuations: Even after the pick-up the past few weeks, shipping companies still sit at lower P/NAV (i.e. tangible book) multiples than we've seen even during previous crisis periods such as '08-'09.
- Regulatory Tailwinds: The ballast water ("BWM") requirements and related capital expenses are pushing hundreds of previously borderline ships into the demolition yards. IMO 2020 will further separate modern efficient vessels from older fringe assets.
- Low Orderbooks: Forward supply expectations (in terms of % growth) are near record lows for many of the key tanker and dry bulk sectors.
- Major Demand Growth: Demand is correctly measured in ton-miles, NOT in raw total consumption. While the news-writers of today are discussing OPEC's impact on crude tankers, the real investors are looking towards the coming replacement from Atlantic basin sources (i.e. U.S. Gulf & Brazil). The same volume leads to nearly double the transportation need.
- Proper Capital Allocation: With many stocks trading at near-record lows, companies are taking the proper initiatives to repurchases shares instead of foolishly squandering capital on fleet expansion initiatives.
- Bonus: Potential US-China Deal: The latest recorded rumor on the US-China deal is for a potential 6-year $1T trade re-balancing. Although this might not be enough as U.S. stakeholders will argue for stronger intellectual property protections, reforms to foreign investment requirements, and a reduction in state subsidies, this marks tremendous progress. We should note that this sort of deal is extremely tentative, but if successful, that level ($1T over 6-years) of trade would require an almost unimaginable level of LNG, LPG, crude oil, agricultural, and other raw materials (perhaps even major met coal) purchases from China. Such a deal could lead to the largest boom in crude tanker rates since the previous record set in 2003-2008 and it would be massively bullish for several other sectors including LNG, LPG, and dry bulk.
Trade War in Focus
Our investment thesis and posturing is not directly related to the trade war, but it would be naive to think newsflow won't have an impact on stock prices. In terms of fundamental impacts, the current level of US-China trade is quite low for the major routes (only 2-3% of dry bulk and LNG flows while crude exports are still nascent), so there's not a lot of downside there, but the far bigger risk is that if the U.S. ratchets tariffs from 10% up to 25%, the already slowing Chinese economy could suffer a collateral blow. The trade war is already having a marked impact and it could get worse.
President Trump has taken notice and is savvy to push the issue. Whatever one may think politically on other related issues, the U.S. is clearly getting the better first step here in the trade conflict.
Source: Twitter, @realDonaldTrump
China has thus far given positive messaging, but as we've mentioned, its important for the deal to be a long-term win-win for both parties and it is also very important for the Chinese government, notably President Xi, to save face. Likewise, President Trump also needs to claim a major victory to try to pull away from domestic challenges.
Thankfully, there is lots of low-hanging fruit that would benefit both countries. China's foreign investment and intellectual property abuses have been limiting their attractiveness for new foreign capital, which hamstrings their economy. Although subsidizing state-owned enterprises is a popular domestic policy, China must realize that long-term performance is weighed down by these arrangements. Finally, the U.S. offers some of the cheapest and highest-quality sources of crude oil, natural gas, LPG, and agricultural products. I'm optimistic on the basis of pure common sense, but we are admittedly in trying times and U.S. insiders have recently been more cautious.
Advanced talks will start next week as Chinese Vice-Premier Liu He travels to Washington. All eyes are here for now.
Source: South China Morning Post, 20 Jan 19
This selection is down between 17% and 43% since October 1st, underscoring the terrible nature of the current markets. Note these are all firms with strong underlying performance, and repurchases or insider buying. GLOG in particular is finishing a quarter that included all-time record high LNG shipping rates. Yes, the highest rates ever recorded.
There are considerable misleading narratives in the market, primarily prevalent in the tanker space, but also in the LNG sector and dry bulk space. We'll address one of these here and tackle others in future updates and private research reports.
False Narrative #1: OPEC Exports will Drive Tanker Markets
The historical adage for tankers has been that we can tell the strength of the markets by watching the days available for tankers in the Arabian Gulf ("AG"). This used to be true, and still plays a strong role to some extent. From the 1960s until recently, AG to the U.S. Gulf ("USG") was a major trade line and with U.S. exports growing year-over-year, one could simply chart the market demand in this fashion.
Source: Energy Information Administration, U.S. Imports of Crude Oil (Annual)
Then in the 2000s, a new consumption engine hit the market: China. Crude flows surged and OPEC rolled in the cash as they now had two major customers to feed. The below chart is slightly outdated, but the growth line is quite clear.
Source: CEIC Data, China Crude Oil: Imports
This reality has now been shaken to pieces as OPEC has finally realized they can no longer 'defend market share,' and they must cut exports and concede supply if they want to continue to influence global oil pricing. Unless every major OPEC member wants to go bankrupt, this is what we're likely to keep seeing and the current OPEC cuts might just be the first of many.
What's on the flip-side of this? U.S. oil exports. The U.S. has recently set record levels of oil exports, but they are currently restricted due to insufficient pipeline infrastructure and outdated ports which cannot handle supertankers ("VLCCs") capable of 2M barrel capacity. Experts believe that exports could further double by 2020, and I believe they could theoretically triple by the mid-2020s, especially if China is pulling.
Source: Energy Information Administration, U.S. Exports of Crude Oil (Monthly)
What does this mean for crude tankers? It is the most bullish set-up we've seen in nearly two decades and a massive surge of USG-Asia trade could ignite a bull run that would rival the mid-2000s. Why? The route from Atlantic basin producers (Brazil is also growing) to China is double the distance from the Arabian Gulf to China. Distances to India are even larger yet!
Euronav (EURN) clearly illustrates this in their recent presentation. Demand growth is set to double, even with the same amount of end-consumption. Yes, China growth could totally stagnate and tanker demand would still surge! They estimate that Atlantic basin production will provide 81% of forward supply growth. I suspect they might be aiming too low. The more OPEC cuts, the more the U.S. and Brazil will have room to expand.
Source: Euronav, December 2018 Presentation, Slide 15
This trend is very bullish for all crude carriers involved, but particularly for the largest VLCC class. DHT Holdings (DHT), Teekay Tankers (INSW), International Seaways (INSW), Frontline (FRO), Navios Maritime Acquisition (NNA), and Tsakos Energy (TNP) are among those most involved.
What are major analysts doing? Some are bullish, but the latest headline was a major sector downgrade by Wells Fargo. Ouch!
Not everyone is missing the forest for the trees, Jefferies is quite positive on the sector and Cleaves Securities analyst Joakim Hannisdahl is certainly not sleeping on the job! He's printed a 246-page report and points to the oil tankers space as a significant overweight.
Source: Gersemi Research, 21 Jan 2019 Report, Page 4
Joakim quips that tanker rates have gone "skywards faster than a Saturn V," which isn't too far off the track, but where have share prices went? Nowhere!
Source: Google Finance, DHT Share Price
The market has completely ignored the strengthening of rates and shift in sector sentiment. Meanwhile underlying asset valuations have risen more than 10% across the board as all the major industry players are paying attention.
Why is DHT doing so poorly? Part of it is the aforementioned small-cap weakness and trade war concerns, but another major factor is the strengthening correlation between tanker stock prices and the U.S. oil prices (USO). The below chart shows the past two-years of correlation, with a strengthening to the 0.5 range the past quarter.
Oil prices have essentially zero predictive power for tanker market rates and in some instances, dropping oil prices can boost contango (i.e. higher prices in the future) and boost demand for floating storage. Additionally, volatile prices can lead to additional trades and higher demand for transportation.
There's no predictive correlation to actual performance and if anything we should see a slight negative correlation, yet here we are. Oil prices drive tanker stock prices (in the short-term).
Source: Portfolio Visualizer, DHT vs. USO
Responding to the Disconnect - Major Repurchases
As we've covered, shipping stocks are trading at near record lows while prospects are quite strong and current rates have been excellent. Firms have recently stepped up to the plate to repurchase shares. Since our last update (see full previous list here) we can add DHT Holdings (DHT), Navios Maritime Partners (NMM), and Euronav (EURN) to the list of participants. EURN in particular has repurchased 1.42M shares (around $10M) just in the past month. NMM has announced a $50M program, which is good for nearly 25% of the entire firm. Finally, Stealth Gas (GASS) also signaled a major repurchase program is in the works.
This is an excellent use of capital, but analyst reactions have been mixed.
Source: TradeWinds, 8 Jan 19 Article
Deutsche Bank analyst Amit Mehrotra has been the most vocal in his commentary arguing that companies might be better served by keeping cash on their balance sheet. He also cautions against reduced trading liquidity if shares are taken off the market.
In my view, these allocations are clear-cut wins. If a company is trading at a fraction of their net-asset value and has excess liquidity, they should plow whatever they can into buying effective $20-bills for $10. If their liquidity is tight, they should dispose of older assets and use proceeds to buy back shares.
I believe that trading liquidity concerns are a sorry focus point and this tack misses the long-term point entirely. If shipowners want to see their stocks trade at stronger levels, they need to convey trust to their investors that funds will be utilized appropriately. When shares trade at steep discounts, assets should be exchanged for shares, thus optimizing the capital structure. I do however agree with Amit that balance sheet liquidity is important.
At these prices, there is no excuse to sit around at major discounts and twiddle thumbs. Inaction even gets to the point of being abusive with shareholder funds. Thankfully, as we've noted, firms have started taking action in droves.
I'd previously called out Teekay LNG Partners (TGP), DHT Holdings (DHT), and Navios Maritime Partners (NMM) for not repurchasing, but they have stepped up with $100M, $50M, and $50M programs respectively in the past month.
Additional firms that need to get moving? Genco Shipping (GNK) and Teekay Tankers (TNK). Genco trades at nearly a 50% discount to NAV while also boasting a rock-solid balance sheet with around 30% debt-to-assets. Teekay Tankers also trades at a discount of more than 40% and trades at about 3x expected free cash flow.
Even after a fairly strong beginning to 2019, shipping stocks remain near all-time lows in valuations. Underlying markets have been strong and repurchase programs are leading to additional value creation.
As mentioned a few weeks ago, the best time to buy is when panic is in the air and everyone is cursing the sector. I still believe the risk/reward skew is very strong, and I am very long the sector. Earnings season begins this week with Euronav (EURN) reporting on Thursday. I am looking forward to a string of earnings beats and have established several related trades.
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Disclosure: I am/we are long DHT, CPLP, GNK, NMM, NNA, GASS, STNG, SBLK, TGP, TNK. 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.