Dislocation opportunity with beaten-down prices, investor disinterest, attractive valuations and fundamental trends.
Supply and Demand trends are attractive, with order books low and US becoming an exporter of crude and petroleum products.
IMO 2020 is the cherry on top - a rare regulatory change that impacts both supply and demand, but most importantly changes the narrative around shipping.
The best dislocation investments show a investor lack of interest coupled with attractive valuations and positive underlying fundamentals. Finally, they require an event or catalyst that will change the narrative around the sector/companies and encourage investors to return to the space.
I will explain below why I believe that as we enter 2020, crude and product tankers are in that rare moment where these factors are lining-up attractively and present a strong investment opportunity.
The Massive Caveat Emptor
Shipping is a terrible industry to invest in. It is a cyclical business with high fixed costs and low operating costs that leads to ugly economics. Where else could you lever up to buy an asset that has a 20-year life but which is only profitable for 6-8 quarters of that life cycle. Historically, this has been compounded by largely untrustworthy management teams who have engaged in all kinds of self-dealing transactions! Meanwhile, in shipping’s rare moments of profitability, lenders have been foolish enough to loan ship-owners more money and ship-owners have ordered yet more vessels. This has led to an excess supply of vessels that destroys the industry’s future profitability.
Why invest and why now: Supply & Demand Trends
Shipping is a terrible business that’s been oversupplied for years, leading to collapsing share prices, investors ignoring it and attractive valuations. This excess supply and subsequent losses led to bankruptcies/restructurings which saw lenders taking losses and equity issuance from the surviving companies and no capital to finance new vessels. Meanwhile, a major regulatory change (IMO 2020) is being enacted on January 1st, 2020 and will potentially cause further disruption to both supply and demand.
We have discussed the attractiveness of optionality in investments before. In Shipping, the operational and financial leverage means that for all of the sector’s many warts, in those 6-8 quarters that a vessel is profitable you make so much $$$ that it pays for the entire vessel. I believe we are at one of those inflection points due to the combination of the companies already being around break-even, the constrained supply of new vessels, attractive pricing and trends, and the potentially disruptive impact of IMO 2020.
My focus is on Crude and Product Tankers, where I believe that the demand and supply trends are the strongest. Crude Tankers transport unrefined crude oil to refineries, and Product Tankers move the refined oil products (e.g. light petroleum products) to points near consuming markets.
Background since the financial crisis
Since Great Recession, shipping has been a story of oversupply and bad rates. Whenever there were brief respites and shipping rates increased, investors lent money, ship owners ordered more ships, and rates got crushed as this new supply entered the market. Unsurprisingly, this led to falling stock prices, defaults and massive dilution for equity holders. It has also meant that many of the lenders to shipping companies (especially German banks/retail investors) have exited the market.
For example; Scorpio Tankers (STNG) since its IPO in early 2010...
Yup, that’s a fall from the $130 (split adjusted) IPO price to a low of $15 in late 2018.
Unsurprisingly, after restructurings that saw debt holders suffer meaningful haircuts and further equity raises, investors have not been too keen on the shipping sector. Valuation reached an extreme in late 2018 and early 2019, when crude and product shipping companies traded for about 50-70% of their book value despite seeing stronger rates and with the IMO 2020 catalyst on the horizon. Though the stocks have risen meaningfully since the start of the year, they still trade at a discount to book value. This is with rates still stronger than prior years and IMO 2020 only now starting to penetrate generalist investors’ consciousness.
Supply, Demand and Rates
As the chart below suggests, the order book for Crude tankers is near the lows of the last ~25 years and this dynamic is further improved by the increasing age of the fleet. The story is the same for Product tankers, where the order book is the lowest (as % of the fleet) since March 2000. This discipline has largely been driven by shell-shocked management teams following the (often multiple) restructurings coupled with the limited new capital available to the sector.
On the demand-side, oil demand has grown incrementally by a couple of percent per annum over the last 2 decades and is projected to continue its slow growth for the next few years (the IEA predicts a plateau in 2030). More importantly there is a major structural change in the marginal exporter of crude and petroleum products, with the US taking over this role from the Middle East. The discovery of shale oil has led to the US being responsible for up to 85% of the global increase in oil production. This has seen US exports of crude oil double since the start of 2018. Petroleum products show a similar story and should accelerate in 2020 as new pipeline capacity to refiners comes online.
This transition to US exports really matters to shipping companies.
Why? Simple geography. The key for crude and product companies is where supply is sourced. It takes about twice as long for tankers to travel from the US to Asia, compared to from the Middle East and it requires twice as many tankers. As a ship-owner, that’s a meaningful increase in demand. With the supply of vessels fixed in the short-term, and limited new vessels on order, even small changes in demand can have major impacts on rates. Examples of this can clearly be seen historically;
Source: Clarksons Research Services Ltd, Clarksons Platou Securities Inc. From Marine Money presentation (slide 7)
The impact of these changes on rates has a material impact on profitability given the operating leverage (high fixed costs, low operating costs) inherent in the business model. For an example, take the example of the crude tanker company Euronav (EURN). The chart below, from Euronav’s October investor presentation, shows management’s guidance on the impact on EBITA (a measure of profitability) of an increase in rates. The back of the envelope maths shows that in the middle scenario below (with VLCC rates of $40K) would lead to earnings of ~$1.40/share on a stock that’s trading at $11 today.
Given the tightness of the market, and the impact on rates, could rates go much higher than $40K for VLCC's?? Scroll back up, and take another look at the VLCC Spot Rates chart above...
Catalyst to Change the Narrative: IMO 2020
These improvements in the supply/demand and the valuation support are what make the shipping thesis attractive. To supplement these, a large regulatory change - IMO 2020 - comes into effect at the start of 2020, and will likely serve as the catalyst for others to look at shipping and the narrative to explain the move in stock prices.
- A new regulatory regime that prohibits vessels from using high-sulfur fuel oil (HSFO) unless they can capture the pollution causing materials. The allowed sulfur content is falling dramatically from 3.5% to 0.5%.
- Jan 1st, 2020 is the drop-dead date for compliance, there is no ease-in or adjustment period
Ship operators have spent most of 2018 and 2019 working towards making their fleets compatible with IMO 2020. They have limited choices; use low-sulfur marine gas oil (MGO), slow-steam (i.e. take longer to do a route, effectively reducing supply) or install scrubbers (to capture the pollution causing materials).
For older ships, the choice largely comes down to whether to install scrubbers or not. Scrubbers are a pollution control devices that are used to remove particles from the exhaust gases of ships. Scrubbers are relatively expensive to fit, costing $3-5mn per ship, and require a vessel to be removed from service in order to be fitted. The cost represents about 6-10% of the value of a 10-year old VLCC, and this coupled with the time out of the water (i.e. not earning money, and reducing overall fleet supply), means that it's typically better to fit them to newer and/or larger ships. Given this, analysts are expecting older ships to be retired more quickly, further reducing the supply of vessels
In addition to the likely impacts on supply from the fitting of scrubbers and potential early retirement of older vessels, there is an added demand benefit for crude/product tankers. IMO 2020 affects the fuel that ships can use by placing a price on sulfur. For crude/product tankers this creates new demand with changing supply routes as oil refiners source different types of crude oil and the refined product is transported to ports.
Some Risks To the Thesis
A far from extensive list includes:
- It’s shipping! Did you not read the caveat emptor – it’s a terrible, horrible, no good, very bad industry.
- A global slowdown could impact oil demand, meaning headwinds for both the companies and the stocks.
- IMO 2020’s impact could be more akin to Y2K, meaning that rates wander around current levels.
- Common perception is that an escalation in the 'trade war' between the US and China would be bad. Our Man is a little more sanguine on that as trade wars mean the disrupting of old trade routes, and the creation of new and less efficient ones.
Crude and product tankers have set up as an attractive dislocation opportunity. With only a few pure plays in the sub-sectors, investors should focus on the largest and best run companies; Scorpio Tankers (STNG) in product tankers, Euronav (EURN) in crude tankers, and Diamond S Shipping (DSSI) that has exposure to both.
Their downside is currently limited by the current low valuations, driven in part by lack of investor interest after a period of terrible returns. This is at a time whenthe industry has finally been forced into disciplined ordering of new vessels (limiting supply) and demand is increasing as the US becomes an exporter of oil and oil products. Meanwhile, the IMO 2020 regulatory change, will change the narrative around shipping and persuade investors to return to the sector.
Disclosure: I am/we are long EURN, STNG, DSSI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Our Man has been long all holdings since early 2019.