Folks who know Our Man will have heard him talk about this idea at various points over the last 6-9 months. He’s been quietly working away on it and it’s close to going into the portfolio, which I guess makes this a nearly fully-baked idea! Hopefully, the half-baked series means that ideas like this will be shared earlier in the process!
The Shipping sector does not have a good reputation in the investor community, having burned most who have invested there and largely ignored by the rest. What’s the deal?
It is one of the only places where prices are still way below 2008. For example, here’s the chart for Frontline, one of the world’s largest oil tanker shipping companies. Yup, it trades at ~$5, having been over $200 before the Financial Crisis.
However, the poor performance since the crisis is for good reasons.
- Over-Supply: The run-up in prices leading into 2008 led to massive oversupply and low rates since has helped perpetuate it. As ships have 20-25 year-lives, it takes a LONG time to work it off that over-supply!
- Trade War: 70% of global trade is done via shipping, so the sector doubly out of favor at the moment
- Operational leverage & Incentives: Most of the industry’s costs are fixed (buying/building a ship) and the operational costs are relatively low, which means that there is huge operating leverage. In good times, this sees revenue drop quickly to the bottom line and profits can rise sharply but in bad times the opposite happens. What’s worse is that ship-operators have an incentive to show no price discipline in those bad times, i.e. they set price to cover only their operational costs.
- Financial leverage: To further increase the volatility, most operators are financially levered (both directly and indirectly). Ironically, despite the leverage leading to bankruptcies it does not benefit the strong players as firms go through pre-packaged Chapter 11’s rather than having to sell ships at a big discount.
The combination of the last two is why many investors hate shipping, when it goes wrong it goes spectacularly wrong very quickly!!
However, there are some strong signs that Shipping may fit OM’s Dislocation paradigm!
i) Reaction: Your reaction to this is probably “mate, really…are you crazy?”
ii). Value/Cheap: It’s now old fashioned value/cheap; the companies are trading at or substantially below book value.
iii). Narrative: Finally, this is about to change due a major regulatory initiative - IMO 2020 – that goes into effect on January 1st, 2020.
- What is IMO 2020? Well, it’s 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%.
- There is no ease-in or adjustment period. Jan 1st, 2020 is the drop-dead date for compliance.
- Ship operators have 3 choices: Use low-sulfur marine gas oil (MGO), retrofit their ships to use liquefied natural gas or install scrubbers (to capture the pollution causing materials).
- Scrubbers are a popular choice but are expensive ($1-10mn/ship) and no panacea (diluting pollutants and dumping in ocean vs. into air). Given the congestion in major shipping lanes (Singapore, English Channel, in the Gulf of Mexico, etc.) this means that certain ports (including the world’s largest, Singapore) are already banning the use of open-loop scrubbers. This reduces the cost effectiveness of scrubbers, though their ‘apparent’ effectiveness is already debatable*.
Created by London-based data visualisation
studio Kiln and the UCL Energy
Institute
- Given the costs of the various options for IMO 2020 compliance a number of older ships are expected to be retired, reducing the supply of vessels.
So, how to take advantage of all these changes?
Here are a few things that OM has drawn from the above:
- Size matters. The bigger firms have more flexibility, be it the ability to pass on costs to clients or just in waiting to see how the port-related risks with scrubbers plays out.
- In many ways IMO 2020 isn’t a shipping debate, but an oil production/refining one; there is now a price on sulfur content in oil, and this will create dislocations and arbitrages in that market.
One of the biggest disruptions will be in the high-sulphur fuel oil (HSFO); HSFO fuel was often created by mixing very high sulfur and very low sulfur oils. Will this still be the best economic choice or will refiners change their feedstocks and choose not to make HSFO?
Why mention this? Because it matters for oil tankers (as opposed to dry cargo, cruise ships, etc.) as they carry oil, and oil routes are about to change depending on the new refining needs. For example, US Gulf Coast refiners currently don’t crack high sulfur oil as it is uneconomical. Instead they use shale oil, which comes at a discount. How does this change in 2020 if/when shale oil becomes more expensive as increased pipeline capacity comes online removing the discount and the price of high-sulfur oil falls.
What does all this mean for Our Man’s portfolio?
It’s going to focus on companies with large fleets that move oil or finished petroleum products!
Specifically, he’s starting with Scorpio Tankers (STNG, leading transported of refined petroleum products) and EuroNav (EURN, largest independent listed oil tanker company). He’s also looking at Navigator Holdings (NVGS, largest fleet of liquefied natural gas carriers).
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Side Note:
* Economically, scrubbers actually add to the industry’s incentive problems. Scrubbers are paid for up front, with shippers ‘benefiting’ from the lower price of HFSO fuel to ‘earn’ it back. This adds to the operating leverage (more fixed costs) and there are clear issues with this:
(i) Unless freight prices are based on the more expensive low sulfur fuel (MGO), the shipper is worse off vs. pre-IMO 2020 (it pays the capex, but fuel costs and pricing stay the same)
(ii) Will the spread between MGO and HSFO fuel remain the same?
This isn’t known yet; people are assuming it will but we can look at some history as a guide;
- Shipping moved to tighten Emission Control Areas (ECAs) - where stricter controls were used to minimize airborne emissions – from 1.0% to 0.1% in 2015. Part of the assumption and expectation was that the fuel spread would compensate shippers. It did not, the spread collapsed along with the oil price in 2015.
(ii) Finally, will there be a change in regulations (or a veto of scrubbers by major ports) that changes the payback period or makes the capex wasted. While this sounds crazy, there is precedent here.
- Following the Exxon Valdez disaster, the IMO mandated the move from single-hull tankers to double hull tankers. The IMO date for obsolescence of single hull tankers was 2015, yet there were almost no single hulls afloat after 2007! Why? The oil majors just wouldn’t contract them. Incidentally, this was a major boon to stock prices for the well positioned companies (see FRO chart above, I’ll wait. Yeah, it went from ~$2.5 to ~$280 in ~5yrs…and it’s almost come all the way back down; that is shipping!)
Now bring it forward to today, Singapore is the world’s largest port, and is known for being very commercial. Do you think they didn’t consult any of the other major ports and acted alone when unilaterally banning scrubbers in their water?
So, take it with a large grain of salt if you hear someone telling you scrubbers are the perfect solution to IMO 2020!
