Weird things are happening in the economy now amidst this COVID19 crisis. Stocks sold off sharply, then largely recovered. Unemployment is rocketing higher and the oil market is in shambles. The chaos in the oil market appears to be offering an interesting opportunity. The oil tanker thesis has been floating around Financial Twitter, and appeared on Real Vision. This trade seemed interesting, but out of my comfort zone. I decided to investigate the opportunities from investing in oil tanker stocks, and share my findings in this post.
Current Oil Conditions
While I am by no means an expert in the oil market, there are a few interesting things going on that create this oil tanker trade. Right now there is an extreme imbalance between supply and demand in oil. Below is a chart from EIA showing global oil production and consumption. From the chart, it can be seen demand for crude has had a very sudden drop with the onset of the COVID19 crisis, where most economies around the world are shutting down or limiting travel. This type of sudden decrease in demand is unheard of.
With this drop in oil demand, you would think that producers would massively cut their production? Wrong, at the start of this pandemic, Saudia Arabia and Russia had a spat, and decided to go full steam ahead producing oil. To make matters worse, it is not trivial to reduce oil production, it is a slow process. The EIA data suggests there is an estimated 10 million barrel a day surplus of oil.
The oversupply in oil has created a bizarre reaction in the futures market. We recently saw the front month crude futures price go negative. The simple explanation of this is that there is so much oil that producers are paying people to take the crude from them because they are running out places to store it. Further out on the futures curve, the price slopes up, which is a scenario called contango. Contango means you can buy oil cheap now (or free?), store it, and sell it at a future date for a profit. Profiting from storing oil is where oil tanker stocks come in.
The Storage Problem
The massive oil glut creates a new problem: where does all this oil go? Data from the EIA states that there is about 650 million barrels of land storage in the US, with 1.2B barrels of storage globally. Below is a chart from EIA data showing the capacity utilization of US crude storage, where it can be seen storage 61% full at the latest data point.
With land storage rapidly filling up, and contango in the futures market, a scenario is created where oil tankers are being used for floating storage. As tankers are being utilized as storage, instead of transporting oil, the supply tankers available to transport crude decreases. This causes the price tanker companies charge to transport oil (called spot rate) rate to increase. Typical spot rates in 2019 were about $15,000 per day. Recently tanker companies have been charging over $200,000 a day to transport oil. Rates these high have been seen a few times in the past, but for very brief periods of time.
How Long Will the Rates Last?
It is difficult to predict how long these extremely elevated rates last. While $200k spot rates may not last for weeks or months, it seems very likely that rates will continue to surpass 2019 rates for some time. Even more difficult to predict is what magnitude these temporary increases in tanker rates factor into the full year earnings for these companies.
I believe the consensus among investors is that tanker rates settle back down to normal levels once oil production is cut, or demand rebounds. The counter to this argument is that oil producers can not flip a switch and cease production (why not). On the demand side, I’m not convinced global economies are going to immediately rebound from the COVID19 shutdowns. Basically everyone thinks oil production cuts will be swift, and we will have a V-shaped recovery in the economy. In my view, the mismatch of oil supply and demand will persist, although slowly improve throughout most of 2020.
Tankers: An Example of Operating Leverage
Now that I’ve covered the background information, let’s analyze the tanker business. Oil tanker companies are characteristically capital intensive because in order to expand, you must acquire more ships. The ships are purchased with debt, so tanker companies have high debt loads and interest expenses. Finally, tankers have high operating leverage, which can be beneficial but also pose a vulnerability.
A business with high operating leverage has a large amount of fixed costs, such as employee wages, fuel, ship maintenance, and insurance. These costs do not change much year to year. The leverage comes in when the business experiences higher revenues, while maintaining about the same operating expenses. This causes the operating income of the business to massively increase.
Oil Tanker Financial Analysis
Let’s dig deeper into the financial statements to better understand the operating leverage and estimate how much profit these tanker companies can generate. The table below shows rounded figures from Scorpio Tankers last annual report. While I’m using STNG as an example, the same analysis can be done to other tanker stocks. Between 2018 and 2019, Scorpio Tankers increased its revenue by 30%. Despite this increase in sales, the main expenses were pretty consistent year over year. This means the increase in revenue went straight to operating profits, which translated into a 12x increase from the previous year.
| (Thousands of dollars) | 12/31/2019 | 12/31/2018 |
| Vessel Revenue | 704,325 | 585,047 |
| Vessel Operating Costs | (294,531) | (280,460) |
| Voyage Expenses | (6,160) | (5,146) |
| Depreciation | (180,052) | (176,723) |
| G&A | (62,295) | (52,272) |
| Total operating Expenses | (574,353) | (574,505) |
| Operating income | 129,972 | 10,542 |
A Note on TCE
Additional concepts that need to be described are revenue days and Time Charter Equivalent (TCE). Revenue days is the total time the fleet has spent generating revenue throughout the year. Scorpio Tankers has about 115 ships in their fleet that spend most of their time generating revenue, but there are some periods where they are dry docked for maintenance. Time Charter Equivalent is a way to compare revenues from time chartering vs operating in the spot market, and is an industry standard way to measure operating results. Without going into the differences between time chartering and the spot market, the important piece is that TCE is vessel revenue minus voyage expenses. Another way to put this is that the tanker spot minus voyage expenses is the TCE rate. This is important since we want to see how the high spot rates affect the operating results of the business.
Income Statement Analysis
Using the simplified income statement in the table below, the operating income can be constructed from the revenue days and TCE. We can figure out the TCE revenue for the year by multiplying revenue days (42,000) by the TCE rate (17,000) to arrive at a TCE revenue of $714M. Voyage expenses amounting to $6M are added back to get the total revenue of $720M.
| Revenue Days | 42,000 |
| TCE | $17,000 |
| TCE Revenue | $714,000,000 |
| Voyage Expense | $6,000,000 |
| Total Revenue | $720,000,000 |
| Operating Expenses | $575,000,000 |
| Operating Income | $145,000,000 |
By working our way up to the total revenue, now we can go down the income statement to calculate the operating income. Operating expenses mainly consist of vessel operating costs, depreciation, and G&A. These add up to $575M, which means the operating income is $145M.
Estimated 2020 TCE Rates
The above calculations are based on 2019 figures where the spot rate/TCE are in the neighborhood of $20,000 per day. By adjusting the TCE to reflect the elevated 2020 spot rates, we can recalculate the operating income. For this analysis I’ll use an estimated yearly average TCE of $40,000 per day. This number seems modest given the spot rates of $200,000 per day, but it is hard to predict how spot rates will hold through the year. I would rather be conservative on my estimates even though there is a good chance of average TCE being significantly higher than $40,000 per day.
Income Statement Analysis Round 2
An updated income statement, with the new TCE rate, is shown in the table below. Even though we increased the TCE, the revenue days, voyage expenses, and operating expenses will stay the same since they do not vary much year to year. Multiplying the new TCE by revenue days arrives at a TCE revenue of $1.68B. Subtracting voyage and operating expenses shows an operating of 1.01B, which is almost seven times greater than the 2019 example. That’s the benefit of operating leverage when it works in your favor!
| Revenue Days | 42,000 |
| TCE | $40,000 |
| TCE Revenue | $1,680,000,000 |
| Voyage expense | $6,000,000 |
| Total Revenue | $1,674,000,000 |
| Operating Expenses | $575,000,000 |
| Operating Income | $1,099,000,000 |
Going further down the income statement, we can estimate the net income using the $40,000 per day TCE. The main expense after operating income is the interest expense on all the ships. This amounts to about $185M. Subtracting the interest expense from the operating income equates to a net income of $920M. The current shares outstanding for Scorpio is about 49.85M, so the earnings per share is $18.45. Compare this earnings per share to the current price of around $20, which creates a price to earnings ratio of 1.08. A price to earnings ratio this low is ridiculously cheap, therefore we should expect investors to buy up the stock to reach a more reasonable P/E ratio. Additionally, the management at the tanker companies could reward shareholders with a generous special dividend or share buyback.
| Interest Expense | $185,000,000 |
| Net Income | $920,000,000 |
| Shares Outstanding | 49.85M |
| EPS | $18.45 |
| Current Price | ~$20 |
The Trade
Since the high spot rates affect all oil tanker companies, I think the best method for investing in oil tanker stocks is to buy a handful of them. The four companies I have bought are Teekay Tankers (TNK), Frontline Ltd. (FRO), DHT Holdings (DHT), and Scorpio Tankers (STNG). These companies have a variety of fleets sizes, and composition of the fleet. Ships ranging from the largest VLCC to medium sized Suzemax tankers are represented. Since this is an industry play, where each stock should benefit equally from the higher rates, I am not looking to do in depth valuations on each business. Each one of these stocks I have allocated about $1750, which combined makes up about 8% of my portfolio.
Lack of Price Movement
While the spot rates have been elevated for over a month, and this trade has become somewhat popular on FinTwit, the stock prices for tankers have yet to respond. One reason for the lack of price movement is that oil tanker companies are mediocre, cyclical, capital intensive businesses, which means they have booms and busts. Furthermore, tanker companies are notorious for being poor stewards of shareholder capital. These factors have turned off many people from buying into these companies.
My other theory for the lack of price action is that a lot of people are watching from the sidelines, waiting for the latest quarterly earnings to come out in order to validate that these companies are raking in some cash. All four of the tanker companies I own announce Q1 earnings in May, so hopefully the catalyst will begin soon.
Plan Going Forward
My game plan is to see if these stocks readjust to a normal P/E ratio after the Q1 earnings are released. From there, I will assess the likelihood of the high earnings persisting through the year. I am not interested in holding these stocks for a long period of time, and I do not want to try to perfectly time the top of this trade. It is possible that I’ll hold these companies for a couple of quarters, but if they significantly run up during Q1 earnings then I may quit while I’m ahead.
Besides seeing what these companies are earning with these elevated spot rates, there are some other factors that I’m considering with regards to the timeline of this trade. The crude storage capacity is the key driver to this thesis, so I will be watching for drawdowns on capacity utilization. The cause of these drawdowns would stem from the supply and demand imbalance to normalize. Finally, as the country opens back up, it is possible the consumption of oil will return closer to normal.
Conclusion
Hopefully this post provides a sufficient overview of investing in oil tanker stocks, with simplified analysis of the current situation in the oil tanker industry. While trades like this are out of my comfort zone, I feel supported by the fact that the high spot rates are public knowledge, and the high profitability of these companies is not caught up in hope and dreams. However, this position could prove to be a lesson in sticking with my circle of competence, we shall see!
You can check out my latest stock buys here.