Opportunities In Tankers: An Interview With Calvin Froedge

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Summary

Arquitos Capital interviews tanker expert, Calvin Froedge.
We discuss what the markets are missing, the effect of contango, Calvin's thoughts on IMO 2020, and which stocks Calvin likes right now.
Calvin also shares the resources he uses to follow the industry.

Earlier this year, I purchased a basket of tanker stocks to take advantage of both structural and cyclical opportunities in the space. I follow a variety of sources and thinkers in the industry, and want to share some of their thoughts with readers.

The first interview in this "Opportunities In Tankers" series is with Calvin Froedge. Calvin writes extensively about tankers and generously shares his thoughts with his followers. You can follow him on Twitter @calvinfroedge and on Medium under the same handle.

SK: Thank you for taking the time, Calvin. What is your favorite position right now?

CF: My favorite position is Euronav (EURN). I think this is the safest "right or wrong" bet on the cycle due to valuation, fleet age, and management quality. Using even the most pessimistic forecasts possible (rates below break-even for two years) it's extremely tough to value them at less than $10 per share.

SK: What about Scorpio Tankers (STNG)? They just released earnings and management was enthusiastic in their earnings call. Where should shares trade at in the near term and why?

CF: Based on a conservative valuation of the fleet value and cash flows, Scorpio should be trading at $30 per share or more. A higher valuation is dependent on the stickiness of the cash flows. If the product tanker market proves to have legs throughout the rest of the year (and we don't need to stay at $160k LR2s, double the $17.5k fleet wide break-even is certainly fine by me) I think Scorpio shares should be hitting $50 by year end. That's highly contingent on rates holding up, of course. If we find ourselves at the beginning of a multi-year cycle of rates well above break-even, I can see Scorpio trading potentially much higher, based on both the cash flows it kicks off and the increasing value of its fleet.

In an extended "bad" market, Scorpio could face bankruptcy, but their stellar Q1 and Q2 have essentially ensured the company's profitability in both 2020 and 2021. Scorpio has essentially de-risked, and with an unexpectedly strong market, lower LIBOR rates, and still a low forward order book, the stars could be aligning for Scorpio to quickly deleverage and create incredible cash flows value for shareholders.

Their earnings call was good. Analysts came across as worried and I think management did a great job addressing concerns and highlighting the strong and strengthening outlook, as well as addressing confusion on earnings lag (not seeing high headline rates hit the income statement until weeks or months after they are seen in the indices).

Robert Bugbee was not as promotional as I expected, involved the rest of his team heavily, and really worked through the numbers and fundamentals, which reinforces my belief that he is no longer "playing games" and is putting the interests of the company's health and shareholder returns first.

SK: What other tankers companies do you like and why?

CF: Scorpio was an unexpected play for me, but I really like them right now. They are highly leveraged. However they have cornered an extremely tight refined product market and will conservatively make half their market cap this year. If the refined product market stays tight, Scorpio Tankers will be absurdly profitable. Management also seems to have turned over a "new leaf" and is behaving far more conservatively. It's important to remember that Robert Bugbee was part of the OMI team that played the last tanker super cycle perfectly and sold their assets for multiples above NAV at the top of the market.

I also like Teekay Tankers (TNK) as another leveraged play with excellent management that had the foresight to get some strong forward charter coverage in case the crude tanker market weakens. They also have an LR2 fleet and can benefit greatly from continued strength in that market heading into Q3 and beyond. I think many market participants would comment on the remarkable strength of the LR2 market.

I also find great value in Norway listed tanker shares as they trade for far less than their intrinsic worth and will pay enormous dividends this year. Diamond Shipping (DSSI), International Seaways (INSW), and Tsakos Energy (TNP) also all offer good value on a valuation basis.

SK: What is the market missing on these companies?

CF: I think the biggest thing the market is missing are the underlying fundamentals that have made these rate spikes possible. It's all about the fleet order book and the factors that prevent it from getting bigger. Some of your readers may remember the incredible heights that tanker stocks soared to between 2004 and 2009. One year Frontline (FRO) paid out double its share price in dividends. Some names increased more than 50x trough to peak. Tankers paid out billions in dividends. A lot of people got rich. Owners thought that would continue for ever and ordered a bunch of ships. At one point the order book was more than half of the fleet. Oversupply crashed the market and tankers got this "destroyers of capital" bad rap that they've lived with for the past decade.

Some of the people I respect most were predicting a new super cycle starting last year. In January that's certainly where things were heading. Then COVID-19 hit. No one predicted the strong tanker market that came after, but some do think a bad year or two is possible. All of them see a cycle of incredible returns immediately following.

Tanker earnings are a function of two things: vessel supply and oil exports. On the supply side, more than a quarter of the world's tanker fleet is reaching scrap age in the next five years, and the order book is at a 23-year low. If there are a few bad years ahead due to demand destruction from COVID-19, it will make the upside swing all the more violent to the upside due to all of the old boats that will be taken out of service. However, many of the same people who believe a few bad years are possible also think that storage, changing trade routes, delays, congestion, and other factors could continue to support earnings until consumer demand and global oil production recovers. Unless the world is truly ending, they all believe a super cycle is inevitable. In either case, the bear case or the bull case, the 2020s will very likely make tanker shareholders very wealthy. It's only a question of whether that starts now or in 24 months, but unless the immediate future looks very different from the present, it is a practical inevitability.

SK: You've been negative on Nordic American Tankers (NAT). Why do you think it's so overvalued relative to its peers?

CF: 56% of NAT's fleet reaches scrapping age in the next five years. Unless they can renew that fleet, it is very unlikely they will be able to participate in a big way in the coming super cycle. They may even cease to exist as an ongoing concern. An aging fleet and lots of debt relative to fleet value are a bad combination. Just to put it in context, Euronav is basically two DHT Holdings (DHT) and a NAT. DHT is basically two NATs. NAT should never trade anywhere near DHT. NAT's intrinsic value is somewhere between $2 and $3 a share depending on how generous you want to be on the valuation.

NAT has a history of serial dilution and unsustainable dividends. While unfortunately many companies shared these characteristics in the downturn of the last tanker cycle, NAT is an especially egregious offender. The recent NAT run up was focused on uninformed retail investors. It was the top traded stock on Robinhood for a few days. Trading volume was exponentially higher than at any other point in its history. If the market remains good, I expect NAT to trade below $4. If the market becomes bad, I expect NAT to trade in the $1-2 range.

SK: How long do you think contango lasts? Will the storage thesis hold up when that happens?

CF: This is very hard to predict. I think if you're only looking at EIA data you're probably doing it incorrectly. We've seen a lot of unprecedented events in the last several weeks, the most extreme being WTI going negative. Eric Townsend and Jim Bianco did a great podcast at Macro Voices where they outlined how this could continue. Speculation is fueling artificial demand for oil futures. USO has since rolled their contracts forward, but we could still well see a situation in the coming months where traders once again will sell front month crude at any price in order to avoid taking physical delivery.

Clarksons also has some very interesting floating storage data. They have already seen hundreds of tankers go into storage trades. 10% of the VLCC fleet is currently employed on storage. This isn't something that happens overnight. Either due to logistical constraints or contango once again widening, more ships on storage takes ships out of the spot fleet. Unless exports are reduced, spot rates will inevitably spike again due to a reduced spot fleet. You could lose 15% of export demand but if 20% of ships go to floating storage you're still going to see high rates.

Another perspective of the floating storage picture has been brought up on several conference calls already. There are floating storage deals and then there is "effective" floating storage, meaning ships that are carrying oil or refined products and can't discharge their cargo due to port delays, congestion, or on shore storage being full. I read an article recently where it was anticipated some cargoes off the coast of California wouldn't be discharging until July.

I believe you also need to differentiate production from exports, and consider compliance. The market sees a headline about decreased OPEC+ production and believes export demand will fall by the same amount. However, Russia and Saudi Arabia both consume around 3M barrels per day domestically. Saudi Arabia has just started enforcing tight COVID-19 restrictions, and Russia is trying to ease, but is fighting against increasing case and death counts. If Russia and Saudi Arabia are each expected to cut production by 2.5M barrels, but domestic demand is down 50%, does that mean the rest will be exported? There is also uncertainty as to whether it's possible for Iraq to comply due to the conflicting national and IOC (international oil company) interests, and Nigeria and Angola are seen to be under complying already. Demand recovery I also believe will be slower than many think. Spain has just extended lockdowns, Germany's restrictions will take months to ease, some countries have banned international air travel for six months, and reopening is being politicized in America.

On the flip side you have forced shut ins (US Shale) and voluntary cuts, new storage being found, the US SPR opening up, as well as pockets of demand opening up, such as Texas and Georgia attempting to go back to normal. The point is it's hard to isolate a single narrative or data point that supports either the bull or bear case. I think the smart thing to do (if you're playing tankers) is just trade them on valuation and consider them a call option on the storage/contango trade that pays (in Euronav's case) a 10% quarterly dividend, with a potential 10x or more when the super cycle comes.

Another interesting thing that happened recently was the Hin Leong firm that went bankrupt. This has essentially stranded nearly 80 tankers. Charterers don't want to hire them. That's a meaningful portion of the global fleet and could really lend support to tanker earnings. We're in unpredictable times and there is a lot of tail risk on both sides of the trade.

SK: How important is IMO 2020 in your thesis?

CF: At one point it was very important. And I think it will be again.

IMO 2020, for those who don't know, was a limit in the sulphur content of marine fuel. The regulations reduced allowable sulphur content by ~85%. That might not seem like a big deal but it has a big impact on refinery economics. Ships burn residual fuel, meaning what's left at the bottom of the barrel after the refinery has made gasoline, diesel, jet fuel, etc. For a refinery to make optimal profits they need to be able to sell the stuff left over. The problem is that the type of crude you run determines what your residuals look like. If you run watery shale crude, you don't have a very high residual yield, but it is low in sulphur. If you run a typical Saudi crude, you get a high residual yield, but it's too high in sulphur to be burned in ships unless those ships have scrubbers installed, devices that "wash" the sulphur out of the fuel.

There are some crudes that are chemically similar to the medium and heavy crudes (like from Saudi Arabia) but that are naturally low in sulphur. Those crudes are pretty rare, less than 15% of global supply, and back in January were trading for more than a 50% premium over brent. This was because the vast majority of ships were burning this new low sulphur fuel, and if you started with a heavy or medium sweet crude, you could produce more of it. It was closer to the process refineries were used to already - run a barrel of crude, sell what's left over to ships. However, because there's not enough of this medium/heavy sweet crude, refineries have to blend it with other stuff like diesel. Over the long term if most ships are burning low sulphur fuel oil you create a lot more incremental demand for diesel. You're taking diesel that would be burnt in a semi truck for instance, and you're blending it with residuals so ships can burn it. You're basically "watering down" the residuals to bring down the sulphur content. It's a dislocation, and you actually need more middle distillates (diesel). It's sort of a hidden demand feature. There's a blending ratio based on the sulphur content of the crude you started with. The more sulphur, the more distillate you need to mix. Since marine fuel demand hasn't really changed, you've now got extra residual fuel that you can't do anything with. In January we were already starting to see gluts of HSFO. Refineries, especially in Russia and Latin America, were dumping large amounts of it. This drove HSFO (high sulphur fuel oil) prices down, while LSFO (low sulphur fuel oil) prices skyrocketed.

This affected tanker markets in several ways:

- Increased crude demand due to higher distillate needs for blending pool

- Changing trade routes due to changing trade routes around refiner residual economics

- Ships that installed scrubbers (like Scorpio) were able to burn much cheaper fuel than their competition. That's actually part of why Scorpio had such a blow out Q1. At one point a lot of investors in the tanker space didn't want to touch any company that didn't have scrubbers installed.

- Ships without scrubbers (or fuel hedges) needed to burn more expensive fuel.

- Since regulations were also around sulphur content alone and there wasn't much of a spec, ship owners also had to worry about the quality and properties of the fuel. Even now I see something about this just above every week.

- Excess HSFO was essentially duplicated demand, it either needed to be stored till someone could figure out what to do with it, or it needed to be transported to another refinery that could process it. January actually saw a record spike of fuel oil imports to the US gulf from Russia where complex refineries like PBF Energy could remove the sulphur from the residuals and or turn it into another refined product.

I can't tell you how things are going to happen as oil markets rebalance. I think it's too complicated for anyone to really know... but I can tell you that once they do the above factors will once again be seen in the tanker markets. We had just begun to see how things would pan out when COVID-19 hit, and I expect these issues to be at the forefront again as demand recovers and inventories start getting drawn down. In summary it's just another factor that greatly impacts the tanker markets that quite possibly nobody is looking at. COVID-19 derailed that process - for instance nearly every tanker company has delayed or cancelled scrubber retrofits - so excess HSFO will be more of an issue than projected as the increased consumption due to scrubber adoption won't materialize till later.

SK: Thank you, Calvin, for sharing these thoughts today. Very insightful. As a final question, what resources would you recommend following in the space?

CF: I recommend the following:

Argus Media
Platts Oil
Freight Waves
Ship and Bunker News
Ship Briefs (J Mintzmeyer)
Cleaves Securities (Joakim Hannisdahl)
Tradewinds News
Anyone who uses the #OOTT hash tag on Twitter

This article was written by

Arquitos Capital Management

922 Followers

Arquitos Capital Management is the general partner to two private investment funds: Arquitos Capital and Arquitos Epicus. Arquitos Capital is an unconventional hedge fund invested in a small number of unique companies. Learn more here.Arquitos Epicus makes highly concentrated investments in asymmetric event-driven opportunities. Learn more here.

Analyst’s Disclosure: I am/we are long INSW, STNG, TNP, EURN. 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.

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