These are dark days for the owners of the world’s oil tanker fleet. How about this for an amazing statistic: this month, some of their ships became cheaper to charter on a daily basis than pleasure craft on one of Britain’s internal waterways.
“Hiring a 57-foot pleasure craft on the Grand Union Canal that links London to Birmingham costs £395 a day,” notes Alaric Nightingale for Bloomberg. Meanwhile, “returns from 1,000-foot tankers on single-trip charters delivering two-million-barrel cargoes of Saudi Arabian crude [oil] to Japan – the industry’s most important trade route – have plunged 99% over the past year to £360/day, says the London-based Baltic Exchange”. That’s dreadful news for oil shipping firms. To make matters even worse, operating costs have been soaring. Ship fuel prices – tanker owners’ single-largest expense – have jumped by 28% in 2011 as oil prices have surged. No wonder the share prices of supertanker operators have been collapsing recently.
But oil shipping is one of the most cyclical businesses around – it goes from boom to bust and back again as the global economy peaks and troughs. So when shares in such a sector slump, contrarian investors start to spot potential opportunities. For investors prepared to look through the industry’s near-term woes, there’s scope for a sharp rebound in tanker stock prices when the sector’s outlook improves.
Why the slump?
Let’s look at what’s caused the latest global slump in supertanker shipping charter levels, otherwise known as worldscale (WS) rates. At first glance, this collapse may seem surprising. The oil price has remained high, which suggests strong demand for oil. That in turn should mean solid demand for the ships that transport oil. After all, despite the growth in oil pipeline construction and usage, 60% of the world’s crude supply of near 90 million barrels a day is still shifted by sea.
The industry uses the biggest boats on the planet to do this. A Suezmax tanker – so-called because it can pass through the Suez Canal – has a dead weight tonnage (DWT – the maximum load a ship can safely carry) of between 120,000 and 200,000. A very large crude carrier (VLCC) has between 200,001 and 320,000 DWT. An ultra-large crude carrier (ULCC) is, as you’d guess, even bigger, with DWT up to 550,000.
But although the likes of VLCCs aren’t cheap – buying a new one would set you back more than $100m, even at today’s lower prices – shipping companies have generally been quick to invest in extra tonnage when they’ve seen a chance of making a fast buck or two.
In fact, some analysts reckon the oil transport business is one of the best examples of free markets in action. When there’s heavy global demand for oil, the cost of transporting it rises. That’s because the supply of available vessels diminishes. As a ship shortage develops, WS rates (that’s the prices you can charge for transporting goods, remember) rise. Tanker operators see these juicy price increases and naturally want to take advantage. So they order lots more new ships to cash in on demand. But as this new capacity enters the market, charter rates turn down again – a growing supply of ships means greater transport capacity, which pushes prices lower.
Add in the ups and downs of the global economy overall and all the ingredients are in place for a typical boom-and-bust cycle. If demand for crude oil drops at the same time as companies have fleets of new ships on order, the market finds itself oversupplied with tankers. Owners find that they’re losing money and so they mothball or scrap their spare ships. Eventually, this reduction in capacity leads to a rebound in WS rates again.
The 1960s were a classic case in point. They were a time of “fantastic growth”, says Jarle Hammer, ex-chief economist at Norwegian shipbrokers Fearnleys. “Measured in tonne-miles” – the amount shipped multiplied by the distance travelled – “the world seaborne oil trade quintupled in the 15 years after 1962.” As a result, a huge tanker-ordering spree – much of it on borrowed money – got underway. It all ended in tears.
The trigger was the second 1970s oil price ‘shock’, when oil cartel Opec realised it held the whip hand on global energy supply and so hiked oil prices. That hit demand for crude. At the same time, large-scale North Sea oilfield development meant a drop in demand for transport, as a major crude supply appeared on the West’s doorstep. Meanwhile the war between Iran and Iraq meant severe production cuts in the Middle East.
Crude tonne miles crumbled 62% in the eight years up to 1985. New supertanker orders plunged. As WS rates sank too, the oil transport industry really started to feel the pinch. “All ship owners and bankers know about the 1980s,” say shipbrokers Clarksons. “It was a recession and ‘distress’ situation that changed the way world banking temporarily thought about shipping risks.”
By 1984, 25% of the world tanker fleet had been laid up. Between 1983 and 1987, borrowers defaulted on $10bn-worth of shipping loans. Emergency measures had to kick in. Shipyards, banks, even governments had to become tanker owners by necessity. In short, the global oil transport industry was in a mess.
The turning point for shipping
So it’s no surprise that during the rest of the 1980s and through much of the 1990s, shipyards’ order books dried up. Meanwhile, crude prices stayed very depressed. These days such low levels seem unreal, but in 1998 oil fell to $10 a barrel. With the value of their cargoes so low, there was little incentive for tanker owners to take on more tonnage.
The industry didn’t need more problems. But in the middle of the slump, another developed. Almost all tankers back then were ‘single hulled’. In other words, if they were holed below the waterline in an accident, the environmental damage could be horrendous. The 1989 Exxon Valdez disaster in Alaska, which prior to last year’s Gulf of Mexico explosion was the worst American oil spill ever, showed just how horrendous. But just when tanker operators worldwide must have been about to throw in the towel, suddenly the market began to turn.
Many of those 1970s-built single-hull ships came up to ‘special survey’ time. That’s the equivalent of a supertanker’s MOT. If you fail, you’re off the water. With WS rates at rock-bottom, many tanker owners reckoned it wasn’t worth spending the money trying to get their ageing fleets past the inspectors. So they packed most of their rust buckets off to the demolition yard. Of course, as they did so, they were sowing the seeds of the next tanker boom. That scrapping curtailed the supply of ships before replacements became available. Meanwhile, oil prices finally started rising as demand increased. WS rates began edging higher.
Costs of chartering supertankers were – and still are – very volatile. But as the ‘noughties’ got underway, they climbed by enough on average to prompt a flurry of orders for new tankers. By now these were for ‘double-hulled’ boats to cut the risk of oil spills – in lay terms, if the outside of a ship was holed, there was an extra layer inside to keep the cargo in.
Look at the near-ten-year chart (above) of the oil price measured in US$ compared with the Baltic Dirty Tanker index (BDTI). This is a compilation of charter rates on a spread of global shipping routes and is the oily equivalent of its better-known cousin the Baltic Dry. Sure, it took until 2006 for total oil tonne-miles to exceed 1978 levels. But until the back-end of 2008, a steady chartering market meant happy times again for tanker operators.
But guess what happened next. Enthused by all the money they were making by shipping ever-more pricey oil around, ship owners decided to build their fleets up once more. Again, they ordered too many, creating a major vessel oversupply. In early 2006, the world supertanker order book comprised 20% of the existing fleet. By the mid-2008 oil price peak, the percentage of the VLCC fleet on order had hit 55%. Put another way, the current world VLCC fleet totals 565 vessels. More than 25% of these ships entered service between 2008 and 2010, according to shipbrokers Fearnleys. While this period also saw some ‘retirements’, these ran at only half the level of additions. Unsurprisingly, rates collapsed once again.
Does another lost decade loom?
What, then, is the state of the global tanker market today? At first glance, it’s horrible. WS rates have been crushed, asthe chart shows. New-build prices have plunged by a third from their mid-2008 highs. In theory, the VLCC order book is still 30% of the current fleet, which would mean the supply of new ships wouldn’t slow anytime soon. This all means the industry has started a “brutal down-cycle”, says Frontline vice-chairman Tor Olav Troeim, who reckons it could take years and “a lot of pain before we’re back in positive territory”.
So if one of the industry’s senior men is talking in such terms, why are we suggesting tanker stocks as a place to put your money? Particularly as most of the analysts who monitor the industry are equally gloomy? Because we’re now seeing the next boom-and-bust cycle playing out. The time to buy into shipping is when the experts are at their most bearish and the sector’s share prices are tumbling – as is the case right now. Indeed, by the time sentiment has turned for the better, shipping stocks will already have surged much higher again.
What are the likely catalysts for an upturn in shipping fortunes? There are not many obvious ones right away. ‘Bunker’ prices – the cost of tanker fuel – keep climbing. Moreover, despite a pick-up from the WS lows of earlier this month, the shorter-term charter rate outlook still looks grim. The threat of new ships entering the market is casting a pall over future rates.
But remember, this is the tanker cycle. Within a year the outlook could change drastically. With bankers less willing to fund new builds, the order book for new ships has already fallen sharply. “Tanker fleet growth of 2% for the year is noteworthy,” say Douglas Mavrinac andNicolas Nordstrom at Jefferies. “The current trend of deliveries is trending well below market expectations for fleet growth of 10%.” In other words, the tanker marker is moving back into balance much faster than expected, which is likely to bring about a quicker and more sustainable upturn in WS rates than the industry now forecasts.
Furthermore, there’s still plenty more scrapping to come. While today’s tankers are mainly double-hulled, 7.5% of the world’s VLCC fleet remains single-hulled. As the Weber Tanker Report says, these ships are unlikely to attract any bookings after this year, and so are ready for retirement. In turn, that will reduce the future supply of supertankers.
As we’ve already noted, oil production and prices are factors behind crude transport costs. While growth in China may be slowing, it’s still strong. Japan’s post-quake rebuilding programme is likely to mean increased oil imports in coming months. In the long run, demand for crude – and transport – can only keep rising. There may not be a sustained recovery for large tanker classes until 2013, as Weber says. But although “the crude oil tanker market is likely to remain volatile in the near-term”, says the Jefferies team, “we believe the longer-term outlook is attractive”.
To recap, our deep contrarian call on the turn in the oil shipping cycle may be a tad early. But deepening gloom in the industry suggests sector sentiment is nearing its worst levels. Before the upswing in charter rates does happen, tanker stocks could rise fast. Below, we look at the most promising stocks to buy.
The most promising shipping stocks
As noted above, charter, or worldscale (WS) rates, are highly volatile. Investors in this sector know all about it. Within the last decade, the Bloomberg Tanker Index more than doubled from the start of 2003 to autumn 2004, only to lose over half this gain by early-2006. From the start of 2007 the index put on 70% within 18 months, only to drop back by almost two-thirds since.
Yet these huge oscillations can provide great opportunities for contrarian players prepared to look through the near-term ‘noise’ of the daily newsflow. “These aren’t ‘buy and forget’ companies,” says the Power Hedge column on Seeking Alpha. “Investors who bought as the industry neared its cyclical bottom and then sold near the top would have earned substantial capital gains [plus dividends – see below]. The best way to play them appears to be to invest into the volatility.”
Our call on the turn in the oil-shipping cycle may be too early. But deepening industry doom and gloom suggests sector sentiment is near its lows. If you want to make the big profits, you can’t wait for the clouds to clear – before the eventual inevitable upswing in WS rates takes place, tanker shares could recover fast.
At this stage of the cycle, with most tanker owners struggling to break even or losing money, current price/earnings (p/e) ratios are meaningless – even if there are any earnings. But these are firms with very high operational leverage. In other words, if WS rates rebound, earnings will skyrocket. So a tanker company can move from having a triple-digit p/e to one in single figures very fast. A further point – most tanker owners have a policy of paying out most of their net earnings as dividends. So again, if their profits pick up, you really will see the benefit.
So, what to buy? While fleet operators tend to site their bases in the likes of Bermuda, they’re generally US-listed. The industry leader is Norwegian-run, $1.5bn market cap Frontline (NYSE: FRO), which has just reported a small first-quarter loss excluding exceptional items. Frontline has a large fleet consisting mainly of VLCCs and needs $30,000 a day to break even. In 2011’s first three months the firm’s been averaging $20,000 a day – clearly a problem. But with a large percentage of its fleet on short-term (spot) charters, Frontline is poised to cash in on a rate rebound.
Overseas Shipholding Group (NYSE: OSG) is the biggest US-based tanker owner. Though it operates smaller tankers as well as VLCCs, it’s in a similar financial situation to Frontline. First-quarter revenues fell 10% and losses grew. Yet on a 50% discount to net asset value (NAV), the shares could soon look very good value. So too with smaller player Crude Carriers Corp (NYSE: CRU), with just five big ships (two of which are Suezmaxes), but whose shares are on a discount to NAV of more than 30%.
For those who like the idea of a shipping recovery, but want something rather safer, charterer Ship Finance International (NYSE: SFL) could fit the bill. Unlike tanker operators, it’s still making good profits and paying decent dividends. Indeed, it’s made a payout to shareholders for 29 consecutive quarters – a stunning record for a shipping-related business. On a p/e of 11 and prospective yield of near-8%, it looks good value today. It’s also likely to benefit from the eventual WS rate recovery.
Category: Market updates