Shipping/Tankers: Can you spell C-O-N-T-A-N-G-O?

Yup, it’s yet another Tankers post!  If you think that all OM talks about is tankers, you’d be right and Mrs. OM and his colleagues can vouch for that! 

After the last update, OM kept buying tanker stocks until finally reaching the “stop buying” limit of 25% NAV on March 23rd.  This article helps explain why.

It was just over a year ago when OM first wrote about tankers, and November's update laid out the thesis' key points:

• Tanker Supply:  After years of oversupply, the tanker markets were finally tight with order books well below historical averages.  With the supply of vessels fixed in the short-run, small changes in demand can have a big impact on tanker rates.
• Operating (and Financial) Leverage:  The operational leverage of tankers, where most of the costs are fixed, means that a small change in rates has a massive impact on the P&L.
• Valuation:  The fall in the tanker stocks during January/February 2020 took valuations back to the early 2019 lows of 0.3-0.5x net asset value.
• Impact of IMO 2020: OM felt that IMO 2020 was going to be the catalyst that brought tanker stocks to the attention of others.  This was largely proving to be the case, though rates are very seasonal, January’s was the best January in a decade and February was heading in a similar direction.  It has since been usurped...

So what changed?

In the last three weeks there have been major changes to both the demand and supply for oil:

• Demand has collapsed.  In response to Covid-19 most of Europe, the US and India are on lockdown, while even the recovering parts of Asia (such as China) are only operating at 70-80% of historical levels.  Unsurprisingly, this has meant that the demand for oil and oil products has also collapsed, with some estimating it has fallen by 20 million barrels/day. 
• Supply has increased.  In the first half of March, OPEC+ couldn’t come to an agreement to reduce oil production after the Russians balked at further cuts.  Saudi Arabia responded by stating it would increase its own production by 2-3 million barrels/day and offering discounts to key customers.

These factors have led to the oil price plummeting.  It has also created two interesting things for tankers; the surplus of oil (10-20mn barrels/day) needs to be stored somewhere and there is a huge contango in the oil markets.

Oil can be stored on land in tanks, at refineries, at oil terminals and in countries’ strategic oil reserves.  However, there’s only ~1 billion barrels of storage available globally and the oil has to be shipped there on crude tankers that move really really slowly! 

Oil can also be stored at sea, in crude tankers, and the contango in the oil market is making this exceptionally attractive.   Contango is when the futures price of a commodity is higher than the current spot price.

This shows that magnitude of the contango, which is surpassing that of the Great Financial Crisis.  Today, someone buying oil and immediately hedging it six months out (by selling the future) can make ~$13.43 per barrel of oil profit, less the cost of storing it for 6 months.   Or put another way, you could make almost ~$27mn risk-free profit if you filled a VLCC tanker to store your oil.  How much to pay for that storage?  The answer has been a lot, the majority of your profit since the market for tankers is tight your profit is risk-free.  The impact of this is two-fold (i) its putting a floor on tanker rates, and (ii) every VLCC that’s used for floating storage is unavailable to transport crude (at a time when Saudi wants to increase production).  

What has this meant?

Well Q2 is typically the seasonal low for tankers as refineries go into maintenance and the deals signed today are for journeys in the second quarter.  Yet, as the chart below shows we’re seeing record rates – in fact rates haven’t been higher since the 1980s!!!

Source: Allied Shipbroking

The chart is for VLCCs, but you could substitute just about any crude or product tanker chart in there and it would look similar.

Will it last forever? 

Of course not but remember the operating leverage.  It means the sharp uptick in rates is dropping straight into the profits and free cash flow.  Combined with the low valuations, OMs tanker holdings are conservatively going to earn 25-50% of their entire market caps in just the first half of 2020.   Until last week, the market didn’t care and there’s a reason why this industry has seen companies and mgmt. aggressively buying shares!

It’s a perfect once in a generation positive storm; a tight tanker market, with massive excess supply and a huge contango incentivizing storage all at a time when cos are trading at low valuations.  

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take it that way.  For added clarity, while Our Man is invested in DHT, TNK, STNG, DSSSI and EURN - that’s a terrible reason for anyone else to invest in them.  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc.