Trade Alert: Oil Tankers
Originally published in TDV in April 2020
The recent oil price collapse is being exacerbated by storage concerns. With storage capacity running out amid a rising oil glut, however, the oil tankers are poised to benefit from pricing power. Oil tankers are ships specifically designed for the storage and transportation of crude oil and refined products.
Buy our basket of four tanker stocks for a 100% overall return,
Buy Euronav (EURN) at $12 or better ($8.5 stop loss),
Buy Frontline (FRO) at $11.5 or better ($6.7 stop loss),
Buy Teekay Tankers (TNK) at $26 or better ($19 stop loss), and
Buy Nordic American Tankers (NAT) at $5.5 or better ($3.25 stop loss)
Negative Oil Prices?!
On Monday, crude oil prices went negative!
But not really. What actually happened was that storage costs are rising in real-time.
Let me explain.
The May WTI crude futures contract closed Monday at -$37.63 a barrel, a one-day drop of $55.90, or 306%.
Unlike an options contract, futures contracts do not simply represent a right to buy or sell something in the future, they are literal agreements to buy or sell something in the future (a specific quantity at a specific date and price). They are not quite like shares, where you own the asset outright, but they are legal agreements obligating you to buy or sell the underlying thing or commodity at a fixed (usually standardized) date and price. The broker lets you put up only a small amount, your margin. And most traders are speculators who never intend on owning the contract through maturity at the most normal of times. But times aren’t normal.
The May contract expired at Tuesday’s close. Any speculator who is long but doesn't want to take delivery had to cover by Tuesday's close or be on the hook to take physical delivery of the actual crude. Traders who were long panicked out, paying dearly for the privilege rather than risk-taking physical delivery on their doorsteps. Not literally, but with no available storage capacity, who knows where the delivery will take place!
In a market already flooded with supply, however, the negative premium just reflects the cost escalation, though it is currently irrational. Nobody knows the situation with capacity or with oil prices in the future. The contracts out more than one month are still pricing in a positive oil price.
The reason for the madness is that storage capacity is unprecedentedly tight. The latest report from the Energy Information Administration stated that crude storage capacity was 65% full. The storage problem is so dire, Plains All American Pipeline (NYSE:PAA) even requested its customers to stop producing oil.
According to Robert Yawger, director of energy at Mizuho Securities USA,
"If crude storage levels continue to rise at their current clip, U.S. inventories will break their all-time record in two weeks and reach maximum capacity in eight to nine weeks".
The Department of Energy has taken notice of the situation, offering nine companies the use of storage space in the nation's Strategic Petroleum Reserve. They are also weighing a bailout for the domestic oil industry, paying companies to leave their oil in the ground. In other words, nobody has capacity and nobody knows where the price is going to be in a month or two, although we would dare to suggest that the price will be higher. I would have never thought that oil could fall this much. But then, I never imagined the extent to which the world economy would get shuttered or that the oil cartels would choose that moment to engage.
Macro Implications of the Oil Price War
As far as the oil price decline goes, it's a double-edged sword. It's both good and bad.
Obviously it's bad for the banks and other financials that own too much oil debt and equity, for some economies heavily dependent on oil income (at least short term), and many governments. On the other hand, however, it is a boon to the users of energy: transportation, mining, consumers, and the net importers of oil.
I will cover the broader impact on commodities and assets like gold and stock prices in my next newsletter.
The amount of trouble this will cause for many people leads me to see further downside in stocks - just as much as a result of the oil price collapse as everything else - as well as economic growth, job losses, deaths, misery, and ultimately, as this all unfolds over the next few years, I will tell you, you will see the collapse of the dollar and at least one western government that will push up interest rates on government debt to levels not seen since the EU crisis. And I think it will be the US or UK governments. Investors are still in a state of shock.
It is still hard to calculate the changes that will be permanent or long-lasting. We are seeing volatility now but the big things will come to light soon, and the bear markets will set in on US paper. However, the central bank is committed to a policy that will destroy both the government’s debt and the currency that it is based on.
The US dollar price of oil has nowhere to go but up once enough production is cut - it would be great if it is done by economics rather than cartel actions - and capacity frees up, but that may still take some time.
Pricing Power Gives Tankers the Best Short Term Leverage
Meanwhile, it may validate our hypothesis on tankers.
Oil tankers are ships specifically designed for the storage and transportation of crude oil and refined products.
The most commonly used vessel types for crude oil transport are Very Large Crude Carrier (VLCC), which can hold 1.9 to 2.2 million barrels of crude, Suezmax, which can hold 1 million barrels, and Aframax, which can hold 750,000 barrels. As demand for storage capacity heats up, these vessels can command a higher daily rate (TCE, or Time Charter Equivalent in industry parlance). There are other catalysts to this trade as well, such as the bankruptcy of Ocean Tankers, with creditors seeking to impound their vessels. But pricing power is key.
We are recommending four tanker stocks to take advantage of this situation. They are all up 2-4-fold from their 2018-19 bottoms, but like the precious metals stocks they sat out most of the bull market in stocks over the past decade too. They are still but a fraction of what they were priced at their highs back in 2010.
The tanker industry has had a few false bottoms over the years with many of the companies having brushed with bankruptcy following the 2008 crisis, and as well, following the collapse of the Chinese boom in 2010 (which led to a peak in gold and the commodity cycle). Tanker companies had over-invested in capacity and were over-leveraged going into those collapses. The good news is that they have restructured a lot of their debt now, and sunk a lot of new capital into modernizing their fleets. Another layer of good news is that they are likely shy to add new capacity after that harrowing experience, which left them for dead for the last decade.
Expect these shares to benefit from free cash flow and expanding margins going forward.
We would consider them as part of our defensive strategy but they are not going into the long term portfolio, this is a trade opportunity. We are looking for the basket to pump on average 100% from current levels.
Euronav (NYSE: EURN, MCap $2.54B) is the largest US-listed independent crude oil tanker company with a fleet of 75 vessels (48 VLCCs, 25 Suezmax, 2 FSO), of which 54 are exposed to spot market prices. Its top line turned the corner in 2018 again, besting its 2015 level, but a rise in costs prevented earnings from recovering as much.
Euronav has added a bit of debt to its balance sheet in the upturn again but it is manageable. The company earned 46 cents per share in 2019 with analysts looking for them to earn north of 2 EUR per share this year, probably before taking into consideration our view on the current situation.
In 2019 they generated cash flow of 243 million EUR, which we could see doubling this year, with most of it going to an increase in dividends. Euronav could easily soar into the $20’s if we are right, but so could the next one. Frontline (NYSE:FRO, MCap $2.14B) is an international shipping company headquartered in Bermuda, controlled by Norweigan billionaire John Fredriksen. It operates 21 VLCCs, 28 Suezmax, and 20 Aframax vessels. Its stock trades on Oslo as well as the NYSE under the symbol FRO. With low breakeven costs, the company offers operating leverage to rising TCE rates. Earnings estimates on this stock in 2020 are in the neighborhood of $2 per share, a double on 2019, before pricing in our view.
Teekay Tankers (NYSE:TNK, MCap $808.7M) operates 54 mid-size tankers, with 15% of the fleet contracted out at lucrative TCE rates, leaving the rest to the vagaries of the day to day cash market, which is tight right now. The company was founded in 2007 and headquartered in Vancouver, Canada. Sales have more than doubled over the last two years ending 2019 to nearly a billion dollars, with about 4% of that going to the bottom line. TNK earned $1.23 per share in 2019, which is actually down a lot from the 2015-16 period. The stock trades at 20 times earnings.
Consensus street estimates put earnings up at $9 per share this year and $7 in 2021, which would return the bottom line to its 2015 level more or less, though still on lower net margins. But that’s before higher rates. The company reported $118 million in cash flow in 2019 (3.48 per share), which will double probably this year to $7 per share. It doesn’t pay a dividend yet but that could be the good news that’s coming around the corner.
Nordic American Tankers (NYSE:NAT, MCap $706.71M) operates a relatively young fleet of 23
Suezmaxes with an average age of 11 years.
But the company has low operating costs of $8000/day and receives TCE rates in multiples of that (with one vessel commanding $100,000+/day). It has repaid a lot of its debt last year, insiders have been buying shares (with the CFO most recently spending $283,500 buying 60,000 shares at $4.725 per share) aggressively, and the company is constantly raising dividends. Plus, they are signing mega contracts with fat profit margins. Mostly that’s because their fleet is very young and therefore in demand.
Earnings for NAT are expected to come in near 90 cents in 2020.