Description

I stare lovingly

at fat, juicy cash flow yields,

holding hands with Bowd.

Prices swing wildly.

Soothed by intrinsic value,

we both ignore them.

(Note to the barbarians: It’s haiku)

Herein I revert from no-intrinsic-value bitcoin to the deepest, dirtiest value in my book: refined crude products tankers.

I own STNG, I own VAL, I own TDW, I have my kid in TNK, I sometimes kick around TRMD with Bowd, I’ve followed other tanker and rig stocks. All these businesses buy big, expensive, complicated assemblies of metal and lease them out to the oil & gas industry.  Most have been written up here and discussed on comment boards. I have a few new things to say about them, most of which apply to the entire group. I also cover old ground for context.

I’ve picked STNG because I’ve known it the longest and it probably has the biggest short-term catalyst coming.  Unlike VAL and TDW, STNG is currently over-earning. The factors driving the over-earning will fade or collapse, earnings will fall, the stock price will probably fall at that point. But, similar to bitcoin: From what starting peak price, and by how much? Probably higher than here, and by not enough to make the stock an “avoid.” The probability-weighted intrinsic value is great and will still look great then. Do you prefer a 3x current cash earnings multiple that will someday rise to 7x (assuming the stock price doesn’t move), or a 20x multiple that will fall to 7x in two years? If the latter, you’re a TDW prospect.  I like both, I own both.

INDUSTRY DEMAND & SUPPLY

Back to the industry perspective. While each of these stocks has its important idiosyncrasies, from now on they are all the same trade, at the most important level.  The trade is:

It’s a sunset industry, but it’s going to be a beautiful sunset.

The foundation behind this point is this old industry quip:

The world needs 501 tankers, there are 500 available => industry boom!

The world needs 499 tankers, there are 500 available => bust!

That's barely an exaggeration. Day-rates (revenue per day per vessel, or rig) are highly sensitive to slight changes in the supply/demand balance.

Demand for rigs, OSVs, and tankers is going to remain robust for years to come, because demand for oil will remain robust, despite humanity working hard to reduce it.  Developed-world reduction of most kinds of fossil fuel uses will take decades to accomplish. (Most obvious example: If X% of future car sales are EVs each year, growing to Y%, how many years until the global fleet is Z% electric?)  Meanwhile, oil usage in emerging countries, with well over half the world’s population, will keep growing despite energy-mix-shift as they grow richer and grow energy use per person. The resulting total oil demand has not yet peaked and, when it does, it will decline slowly. 

By the way: The International Energy Agency’s demand forecasts for a peak within X months are total wishful-thinking BS.  They have been wrong every year for several years (they keep pushing out the peak) and will keep being wrong. 

Also: you need new oil wells to replace depleting ones even when demand falls.

The oil E&Ps (exploration & production companies) are confident enough of future demand to be greenlighting new offshore projects with huge up-front capex, multi-year payoffs, and even longer production lives.

Supply is a different story.  It’s only a slight exaggeration to say supply will never rise again and will likely fall faster than demand.

In the mid-2000s, when the consensus was "China buys everything forever," every rig/OSV/tanker supplier massively overbuilt new capacity and destroyed their industries’ supply/demand balance for a good ~12-year stretch.  They literally will never do that again. The 2008-2020 scars are deep; management teams and investors learned their lesson.

More reassuringly for us inference-makers, the economic incentives for them not to do so are clear.  These huge expensive hunks of metal last 20, 25, 50 years.  The oil industry sunset is going to be slow, but it’s not going to be that slow.  No one wants to sink $1 billion into a new rig that’s going to be useless long before its theoretical life ends.  There might literally never be another rig newbuild order again.  The same is true to a lesser extent for tankers and OSVs - and their lives are shorter.  Some newbuilds are needed to replace the vessels that age out.  

Also, the shipyards that build these assets all crashed and permanently laid off most of their workers.  Most of the capacity is gone permanently, and what’s left is booked solid for years with the few orders that do exist, and most of those are for other types of vessels. You couldn’t get new metal out of a yard within ~4 years if you wanted to.  You can read or listen to almost any earnings call in any quarter from any of these companies and get a credible explanation of why no one is going to order newbuilds.

The companies and investors have been telling this story for ~6 years, and it was slowly playing out for most of those 6 years.  It was temporarily destroyed by the Covid oil-usage crash; now it’s back with a vengeance.  Day-rates for rigs and OSVs are marching relentlessly higher. For tankers, they are averaging even higher increases but with the usual shorter-term cyclicality around the trend.

There’s a bonus driver for tanker supply: Governments, led by the EU, will likely implement some sort of new requirement for ship emissions or engine-type or fuel-type or emissions-capture device or something else, which would reduce the value of existing ships - relative to new ones. But the regulations’ details are not knowable today.  The regulatory overhang is a strong disincentive to ordering a newbuild. Even the small theoretical demand for tanker newbuilds that would otherwise exist keeps getting suppressed even further.  It’s possible that, by the time the EU gets around to finalizing something, no one will want to build for the other reasons.

These forces produce knowable, trackable, forecastable supply and demand numbers for tankers. Here are some key supply/demand charts from STNG’s latest investor slide deck. And here is the link to the source deck:

THE CURRENT BOOM IN TANKER DAY-RATES

Look at what these factors above have done to STNG’s average day-rates and quarterly EBITDA:

The recent numbers in these charts understate how much earnings have increased.  The orange bar for 1Q day-rates includes only contracts signed through mid-February.  Based on management comments and everything else I’ve seen, I expect 1Q day-rates to average around $42k, not $39k, and unless something changes, 2Q rates should rise to ~$45k.  That puts STNG’s 2Q EBITDA at around $330m and cash earnings at ~$295m ($5.85/share).  Full-year cash earnings would be $1.1 billion, near $22/share.  The stock is literally at 3x run-rate cash earnings.  If nothing changes.

Things will change.  The earnings jump has been caused not only by the long term factors, but also the following new factors that have occurred over the past 2 years, which have materially increased tanker demand. (Longer tanker routes = higher ton-miles of tanker demand.)

1. The EU stopped buying Russian crude products when it invaded Ukraine. Russia now must ship it many thousands of miles to India and China, instead of a few hundred across the Baltic Sea.

2. Houthi attacks in the Red Sea have shut down most tanker traffic through the Suez Canal; now they must go around Africa. (1Q rates have spiked since the orange bar above specifically because Houthi disruptions hadn't yet affected rates at that point.)

3. Drought in Panama has reduced Panama Canal traffic by ~half, so vessels must go around South America.

Each of these factors is almost certain to end.

Still: When some temporary event temporarily sends a normal stock’s earnings up 20% and sends its earnings multiple down from, say, 20x to ~17x, a value-investor shouldn’t care much. The earnings yield has gone from 5% to 6%. One year of those extra earnings is worth 1% to intrinsic value.

When earnings triple and the multiple (assuming flat stock price) goes from ~10x to 3x, the earnings yield goes from 10% to ~33%.  A year’s worth of those earnings is worth an extra 23% to the intrinsic value.

So you have to think very hard about: (1) How long is the bump going to last? (2) What will the earnings revert to afterwards?  (3) What will management do with that extra cash flow (squander or create value)? (4) What multiple should you put on the future normalized earnings?

The answers are unknowable outside a very wide precision band, but:  The Russia/Ukraine conflict and Houthi disruptions don’t have an end in sight. The longer-term trends I’ve described should keep earnings above previous levels even when the bumps end.  The long-term factors keep getting better and will keep getting better.  My best guess as to this unknowable number, based on watching this industry for many years, is that earnings will fall by ~half, with continued cyclical dips below and above that.  Thus my off-the-cuff numbers earlier that STNG stock, if its price doesn’t move, might revert to ~7x earnings.

I think the price should move up in the interim and that the normalized multiple should rise.  On to factors #3 and #4…

STNG IS MAKING FABULOUS USE OF THE EXTRA CASH FLOW, AND ITS EARNINGS MULTIPLES SHOULD RISE

STNG management spent years being overly optimistic about the future and therefore overleveraging the business, flirting with insolvency, and finally capitulating a bit by selling some vessels to survive just months before the big upward rates inflection.  But they still came out of it with great earnings power and the industry’s youngest fleet (which means very little need to rejuvenate the fleet, ever). Since then they have absolutely nailed the capital allocation.  They turned conservative enough to balance well between paying down debt and buying back stock, and to do each at just the right times.

Here are the net debt numbers over 6 years. Down from $2.6B at the start and $1.3B two quarters ago to $0.7B by June.  And of course, in those earlier days EBITDA was trivial-to-negative, while now net debt/EBITDA is <1.  The company’s breakeven day-rate (including interest expense) has plummeted, and its earnings cyclicality has fallen.

It gets better: STNG has not only been paying down debt, it’s been replacing high-cost finance leases on individual vessels with lower-cost and more flexible bank loans on pools of vessels. It has needed to wait to do many of these finance lease buy-downs until the contract terms allowed it.  A large chunk of the remaining buy-downs is occurring in 1Q and 2Q.

It gets better yet: The debt is almost all variable-rate.  Interest expense will fall further if market rates fall.

It gets better yet: STNG has been able to buy back large amounts of stock while also doing the debt paydowns.  And management has exquisitely timed one versus the other.  In 2023 they bought back 16% of shares, and then they announced a pivot to debt pay-downs.  Here’s how it went down:

I think STNG has executed better than anyone, but the same story is roughly true for all these companies.  This is a hated subsector (managements mismanaged for years) in a hated industry (evil oil & gas) with too much leverage and historically wildly-swinging earnings.  Managements got religion.  Everyone’s leverage is down.  Earnings are smoothing out.  Normalized earnings are rising.  Market caps and average daily trading volumes for the stocks are rising.  The multiples that investors are willing to pay for some of these stocks have been rising a bit.  Not enough, and not for all.  I think they have a ways to go.

STNG IS AT THE CUSP OF ANOTHER UPWARD INFLECTION - OF CAPITAL ALLOCATION, NOT EARNINGS

As detailed above, for all of Chairman Bob Bugbee’s annoying announcements that he’s purchased new call options on the stock (without ever mentioning the sales), I trust him to allocate STNG’s capital well.  Starting in ~June, STNG is going to have a whole lot more capital to devote to shareholders.  Its net debt will be down to ~$700m.  Finance leases will be down to ~$200m.  It has no need to reduce debt further and no need to buy new vessels.  It can go back to hoovering up stock, or paying big dividends, or both.  At 3x run-rate earnings or even 7x normalized earnings, I’m still rooting for buybacks.

The trust part really matters, as does the young fleet.  I also know TNK well.  TNK is also at ~3x cash earnings, and it already has positive net cash. It’s going to have zero gross debt by June.  But I don’t trust its management.  TNK has a particularly old fleet that it needs to refresh, it has no history of deploying cash well, and the entire Q&A on its last earnings call was analysts asking “please please please explain how you’re going to use the cash” and management effectively saying “no.”  I am keeping my kid in that stock only because they have big unrealized capital gains, plus, I guess, positive net cash + “really how badly could they screw this up?”  In contrast, I am excited to watch Bubgee get to work.

BUT WHY BUY NOW WHEN IT'S UP X% IN Y MONTHS?

Well, yes, the stock is up and you've missed the earnings inflection.  I'm not saying now is the one right time to buy oil & gas infrastructure.  But remember, the entire market is up 25-35% in 5 months depending on the index.  You haven't missed STNG's new capital deployment or a multiple re-rate.  Go pull up any chart of oil & gas ownership, oil & gas long/short ratios, multiples in absolute, multiples vs. other stocks:  Oil & gas stocks are as hated as ever.  The numbers suggest that the hate has gotten worse lately.  I don't think that will last to this full degree, in part for reasons stated above.  Particularly for the rig/OSV/tanker stocks; it takes a long time for professional investors with long memories to accept that these businesses and stocks aren't as crappy as they used to be.  I recently had a long back-and-forth with "the" axe on TDW, trying to figure out why that stock was up 15% on the day of its earnings release/call that had absolutely no surprises.  The best answer he could come up with is the above: It's re-rating, and a no-surprises earnings release like that can create a step-change in perceptions (particularly around risk) from less-involved investors.

Also: A simple valuation long, unlike valuation shorts, can work well.  If the multiple never moves but the earnings yield is high, the stock can keep rising as the company deploys that cash.

Catalyst

In all seriousness, the best business catalyst here would be the lack of negative catalysts, for even a year.

Beyond the business: New stock buybacks and perhaps special dividends.