Description

It has become something of an annual tradition here at VIC to; call a bottom in product tanker rates, point out that Scorpio Tankers (STNG – USA) is the most leveraged to this bottom call, and then watch rates not recover, leading STNG to badly dilute shareholders (yet again). If you want more of a backdrop on the sector, read write-ups by TrustInGravity (converts), Gandalf, hao777, eal820.

I am making yet another STNG bottom call. The difference is that charter rates are actually recovering now (5-year highs), yet investors are so gun-shy and shell-shocked from 5 years of bad calls, that the shares have continued bouncing around all-time lows. This is all despite a pretty dramatic industry supply/demand recovery and the fact that IMO 2020 kicks in during Q3 2019. Now the market is suddenly tight, rates are at multi-year highs and the main catalyst that led to a surge in ordering for most of this decade (IMO 2020) is going to hit when the market is already tight.

Here’s what has changed that is leading the charter rates higher. Let’s look at supply first;

Supply

-MR new order book is thin at 5% of global fleet and around 10% for LRs

-38 product tankers were scrapped as of November 2018 (more were certainly scrapped in December), the highest since 2012

-Over 30 LRs were moved to dirty trades and will almost certainly never return to the clean fleet

-Fitting of scrubbers and ballast systems will lead to off-hire days which effectively will be equivalent to a fleet contraction of 2-5% a year during 2019-2021 depending on when they are installed

-Older boats will be inefficient once IMO 2020 hits, as they will not have scrubbers installed and have to burn low sulfur fuel and are getting scrapped now

-With crude tanker charter levels going up, new Aframax deliveries aren’t encroaching on the product tanker market for maiden deliveries

Demand

-US Light Sweet crude produces disproportionate gasoline, leading to long-haul trades as gasoline is exported

-After 4 years of de-stocking starting in 2014, global inventories are low and even if they stay low, fleet usage will increase to keep them at a constant level as opposed to reduced fleet usage as stocks were drawn down

-US jet fuel shortages and jet fuel surpluses in Asia

-General arbitrage globally is returning due to low inventory levels

-Mid-East refineries coming online leading to an increase in clean product exports vs crude exports previously

-Increases in Chinese teapot refinery usage leading to increases in exports of refined product

-Increases in exports of US refined product leading to an increase in ton miles

Importantly, all of these factors have hit BEFORE IMO 2020 hits. IMO 2020 says that as of January 1, 2020, all vessels must either fit scrubbers or burn fuel with less than 0.5% sulfur. While many companies have said they will eventually fit scrubbers to large portions of their fleets, as of January 1, most of those vessels will not yet be fitted with scrubbers, leading to a massive increase in the need for low-sulfur blends. Stocking these blends is expected to start in Q3/2019 and it is expected that demand for product tankers will increase by 5-15% (depending on who’s reports you read) due to disruption in traditional bunker fuel trade patterns.

IMO 2020 was the reason you wanted to be long product tankers sometime this summer. Now that rates are spiking even before IMO 2020 hits, I think you want to be long right now as IMO 2020 will be like lighter fluid on what is suddenly a raging fire.

Why STNG?

Scorpio is the world’s largest pure-play product tanker owner and they manage the world’s largest product tanker pool. Their pool consistently beats industry benchmark rates. All of their boats trade in the spot market. They are a low-cost operator—even after the external management fees they charge. They also have the youngest fleet of all eco-vessels (lower operating costs) and their whole fleet will be scrubber fitted by the end of 2020 except for the handimaxes.

While leverage led to substantial dilution on the way down, that leverage means it is a coiled spring on the way back up. To start with, small changes in vessel values go a long way towards increasing the NAV (10% increase in asset values leads to a $0.80 increase in NAV per share). They also trade at about 2/3 of NAV today (based on current vessel values which are at distressed historical vessel rates). Additionally, there is substantial operating leverage at STNG. Every $1,000 change in charter rates will lead to a $45 million change in annual cash flow—which isn’t bad on a current market cap of $1 billion.

Based on management comments and this management team’s past history at OMI, I suspect that they will use future cash flow on a rather dramatic buyback program—once the balance sheet is a bit better restored. I will give you a model, but it’s all just guess-work.

I think it is safe to take Q3/2018 numbers where they were slightly cash flow positive and annualize those numbers. TCE revenue was;

LR2                      $12,160

LR1                      $8,335

MR                  $9,494

Handymax       $8,852

Is it crazy to think that rates can be up $30,000 from these levels and stay there for a few years? They were there a decade ago. Hell, they were nearly there in December and they’re at $27,500 for LR 1 and $17,500 for MR today. That is roughly $9,000 higher than Q3 rates—leading to $400 million in incremental cash flow per year—even before factoring in the $500-$2,500/day that STNG normally earns beyond most benchmarks due to better chartering and lower operating cost eco-tankers. Additionally, the recently raised capital from the highly dilutive raise in October, will be used to pay down debt (increasing cash flow) along with funding the scrubber upgrades that have paybacks of under 1-year (which should also increase cash flow even before rates increase further in Q3 and onwards due to IMO 2020).

What will they do with the increase in cash flow? They’ve already shown their hand. They intend to pay off debt, unwind high-cost sale-leaseback transactions and buy back every share they can. All 3 actions are likely to be highly accretive.

The other important consideration is that if I’m wrong and rates stay low for the rest of 2019, they now have the liquidity to make it until 2020. No matter what, 2020 will see an increase in rates. At 2/3 of NAV, I don’t think you get hurt, even if rates don’t increase in 2020—meanwhile you could make multiples on your investment if rates do recover. Remember, the market is pretty stupid. At the bottom, these shipping companies lose globs of money and get valued at discounts to NAV. When things are good, generalist investors assume they’ll stay good and value them at multiples on cash flow or dividend yield—leading them to be valued at a few times NAV. I know that trading at multiples of NAV is insane, but it is what it is and history proves this fact out.

I don’t want to get laughed at by building a model showing them retiring 100 million shares a year while funding all of their bullet debt maturities, undoing their sale-leaseback transactions and paying the rest out in dividends—but that’s what will likely happen. Plug in $1 billion a year in cash flow ($22k increase from Q3), 2x book, assume asset values increase 30% and the share count drops by 300 million shares over the next 3 years. What do you end up with for NAV? Yeah, you’d laugh at me if I showed you. You’re clearly in multi-bagger territory though.

Awww screw it!! Here’s my model.

It’s the sort of very imprecise model you can draw on the back of a napkin after a few drinks because if I’m right on rates, the other metrics don’t matter. They pay down debt, cash flow increases from less debt service, they buy back shares and at the end of the third year, vessel values are higher. It’s worth noting that I’ve kept current assets constant rather than attributing some of that cash to the scrubbers as the decrease in cash will lead to an offsetting increase in vessel values. I’m using current vessel values and am likely off by $100-200 million based on whose database you use. None of these small numbers will matter if I’m right on what rates do. The real question is what rates do. However, if NAV/shr is $27 and we’re trading at 2x that, this is a 25-bagger.

I would be severely remiss if I didn’t say that the current management team has horribly bungled things thus far. They’ve been over-leveraged since inception. They’ve diluted investors like madmen. They pay commissions to an external manager. There are conflicts everywhere. That said, I don’t think these are bad guys and I think they want the share price up so that they can prove to everyone that they were right. Besides, they own a lot of stock and want to raise money for their new OSV vehicle—they don’t want this thing bouncing along the lows and would prefer that it’s at all-time highs.

FINALLY; this is shipping, this is investing in a leveraged company, this is investing with guys who have an external manager, bad things happen to good investors in shipping. Caveat Emptor!!

(Last month’s investor day presentation and call are great industry summaries and required listening for anyone who wants to learn more about STNG)

Catalyst

Rates stay high

Buybacks continue

IMO 2020 kicks in