Bareboat and Time charters are basically leases in which the charterer leases the vessel for a long period ranging from 1 to 3 to 5 years (can be even longer). The charterer and the vessel owner will agree on a fixed daily payment (typically X dollars per day) for the duration of the charter. For context, one can time charter in/out a standard product tanker known as an MR (see further below) today in the $13,500-$14,000 range. Once the vessel is leased out, the charterer effectively has control over the vessel for the duration of the lease to use the vessel to haul their cargo wherever they need it to be hauled. If they have no cargo, the burden remains on them to pay the "daily charter hire" to the vessel owner.

Who pays the operating expenses?

There are two basic unit level costs involved in operating a ship (not thinking here at the company level where you have the added cost of SG&A): 1) vessel operating expenses, primarily the crew and 2) voyage expenses, notably bunker (fuel) costs and port costs (i.e. costs charged when you enter a given port). Under a bareboat charter, both categories of expenses are born by the charterer (akin to a Triple Net Lease in the world of Real Estate - in fact, in many senses shipping and real estate have very similar business models and many refer to shipping as simply floating real estate). This is why it is referred to as a bareboat charter - you charter in the vessel bare and it is on you to find the crew, pay for the bunker fuel and all other associated costs. In a Time Charter, the owner provides the crew and covers the vessel expenses. The charterer, however, is exposed to the voyage expenses and thus exposed to fluctuations in bunker fuel prices.

The third category, voyage, or spot differs from the prior two in that someone who has cargo to move will contract with a vessel owner to use their ship for a specific voyage: say to take cargo from Rotterdam to New York or from Saudi Arabia to Europe or Australia to China. The spot market differs from the charter market in the way in which the rates, or prices for the vessel are quoted. In the charter market, as noted, contracts are done on a per day basis. In the spot market in contrast, the two parties will negotiate a price to cover the entirety of the voyage. Each party has a rough sense for how long the journey will take though the speed at which the vessel may operate will be subject to negotiation. The parties will agree on a single number that covers payment for the entire voyage. So in this framework, the spot voyage from Rotterdam to New York may be contracted at a price of $1.4mm.

Who pays the operating expenses in a Spot charter?

In the spot market, the owner is responsible for paying both the operating expenses (providing a crew etc.) as well as to cover the voyage expenses. Effectively, the one with the cargo to move is contracting out a single dollar value to have the cargo moved and is not exposed to any other costs. Generally speaking, this entity is indifferent to the specs/age of the ship which is carrying its cargo - 'as long as you get the cargo from place A to place B, I am happy to pay the $1.4mm. How much YOU, the ship owner makes is your problem.' And how much the ship owner will make is indeed going to depend on the nature of the ship. Different vessels will have both different operating expenses (the older the vessel generally speaking the higher the operating expenses) as well as different voyage expenses. Using again the MR example from above, a standard MR built a few years ago may consume 25 tons of bunker fuel a day going around 12-14 knots (speed). In contrast, a modern designed eco vessel (really only coming on to the water in the Product tanker space in the last year or so and with all orders currently place pretty much of this design) may consume 2-4 tons per day less (depends on who you ask). This difference can really add up. At say $600 a ton for bunker fuel, the savings are $1,200 to $2,400 A DAY. Multiplying this across a year - 360 operating days: 360* $1,800 (midpoint) = $648,000 in savings. This is how one vessel owner may end up with higher profit compared to another vessel owner even if they each receive the exact same spot contract. This is the primary reasons why STNG is keen on operating its vessels in the spot market currently as that is the best way one can maximize the benefits stemming from having lower fuel consuming vessels. In the time charter market where the charterer has the burden of the voyage expenses a charterer may not "buy into" the fuel savings that the STNG vessel affords and as such may offer the same daily charter rate to an eco and a non eco ship thereby stripping STNG's eco vessels of any cost benefits they may have. In the spot market, however, since the owner shoulders the fuel burden and voyages are contracted out on a Gross/pre voyage expense (including bunker fuel) cost basis, STNG may receive the same voyage hire as someone with a non eco ship but since STNG has the burden of fuel, it will benefit from lower fuel consumption and hence a higher TCE or net daily revenue rate.

To allow for apples to apples comparison between the way 'rates' are quoted in the Time Charter and Bareboat markets (on a dollar per day basis) and the Voyage/Spot market (on a total value received for the duration of the voyage), it is industry standard to transform the voyage dollar amount paid into what is know as a "Time Charter Equivalent," or TCE. Effectively, this attempts to look at the voyage payments on a per day basis making it comparable to the Time Charter rates in the market. The voyage rate, however, is a GROSS number in the sense that it is Gross of Voyage expenses (bunker costs and port costs) since the vessel owner and NOT the charterer is responsible for paying the voyage expenses. Accordingly, one must deduct the voyage expenses to get to a Net Revenue number for the duration of the voyage. One can then divide the total received on a net basis over the days of the voyage to calculate a per day rate which is the TCE. It is extremely critical to highlight that when doing so, the convention assumes the days in the voyage in which the ship is both laden (carrying cargo) as well as ballast (empty) - the convention is to assume that if a vessel receives a contract to take cargo from A to B, which are 10 days apart, then the total payment is amortizes from a TCE standpoint over both the laden period from A to B (10 days) as well as the ballast period in which the ship returns back to the port at A from which is started (another 10 days). There are also some port days (call it 2 days on each end) which would be added in. Using dummy numbers, if a voyage is struck for $1mm for a haul between ports which are approximately 10 days apart (using some basic assumption on speed and fuel consumption) and the vessel is assumed to consume a total of $500K worth of bunker fuel and spend on port costs, plus the expected time at each port to receive and unload the cargo is 2 days each, then the TCE calculation would be as follows: $1mm - $500K = $500K Net Revenue / (10+10 +2 + 2 = 24 days) = $20,833 TCE. This is a way to compare say to what the current rate a vessel owner could receive if he or she chartered out the vessel on a 1 or 3 or 5 year time charter to a charterer and lock in a daily rate which may be higher or lower than the $20,833.

Technical & Commercial Management & Pools

Vessel owners often contract out the technical management, which refers to the day to day operating of the ship (i.e. supplying the crew and effectively running the ship) and commercial management which is akin to the 'back office' of the vessel (entities which find the charter hires for the vessels - these are brokers who interface with those who have cargo which needs to be moved). SNTG outsources its technical and commercial management to the Scorpio Group which is owned by the Lolli-Ghetti family. Scorpio's founder, Chairman and Chief Executive Officer, Mr. Emanuele Lauro, is a member of the Lolli-Ghetti family, which has been involved in shipping since the early 1950s.

Utilization & Pool, Triangulation - How things work in shipping

Like any commoditized industry, shipping is very much driven by utilization. The more your vessel is utilized the more revenue days you book and the more your vessel will earn. To help maximize utilization, many vessel owners place their vessels into what are known as "pools." Scorpio Group manages several pools with vessels of the Scorpio fleet as well as other parties. The primary aim of the pool is to maximize the overall revenue that the combined fleet can generate. If one has only say 3 vessels, they may all be in parts of the world which do not have favorable spot market rates at a given moment. Participating in a pool brings scale which beyond the usual benefits of scale (including purchasing power - beneficial for the purchase of things such as bunker fuel), allows for maximized vessel utilization across the fleet. Pools have a system whereby different vessels are given points in the pool which are determined by their relative cost structure as well as relative attractiveness to charterers. The revenue of the pool is aggregated and distributed to the various vessels on the basis of the pool system.

In the crude or dry bulk sectors, a typical voyage in the spot market will lead to a vessel finding itself ballast (or empty) upon delivery of its cargo. This is because there are fewer routes between locations of supply and locations of demand of the underlying product. For example, a dry bulk vessel may pick up iron ore in Australia and then bring it to China. Once in China, however, there may be nothing for the vessel to pick up so it returns empty back to Australia and hopefully picks up additional cargo on a new voyage hire. Similarly, in previous years, though obviously less prevalent today in the post shale world, a VLCC (Very Large Crude Carrier - one of the largest tankers that is used to carry crude) may bring crude from the Middle East to the US East Coast but then has nothing to bring back (especially because it is currently illegal to export crude). This is in part why when thinking about TCE, the ballast part of the voyage is factored in since the assumption is that the total payment received covers both legs of the journey (essentially amortizing the revenue received for bringing something from place A to place B for the period it takes you to return to place A.).

The product tanker sector, is unique in that it allows for what is known as triangulation. Due to the myriad of products which can be carrier as well as the much larger number of locations which both may supply or demand these products, the permutations of different routes is exponentially greater than it is in the other sectors. Accordingly, when the vessel that takes a voyage hire to bring say gasoline from place A to place B gets to place B, it may not simply return empty to place A. Rather, it may pick up something in Place B or somewhere nearby place B to then bring to place C. It may do this several times before even returning back to place A. Accordingly, the actual TCE which this vessel earns will be much higher as the supposed ballast periods which the voyage calculated TCE accounts for are in fact revenue generating periods as the vessel successfully picks up a new cargo at the second port where it discharges its first cargo. Triangulation is key to understanding a major driver of what is attractive about the product sector and what further accounts for increased revenue day utilization over and above the benefits which a vessel gets for participating within a pool (something which crude and dry can get as well through dedicated crude and dry pools).

Where are we in the Product Tanker cycle?

A note on "Price" before we assess where we are in the current cycle...

When thinking about price in the context of shipping, we refer of course to rates - namely the rates which vessels can attain be it through the spot market on a TCE basis or through time charters. It is important to note, however, that there is no objective determinant of what the price/rate is and it is critical to understand what is assumed when thinking about rates. This is no different than any index which is based not on a finite and known quantity of observable transactions but rather a collection of data which is done by various market participants, generally brokers who through their vast networks in the industry try to piece together the facts on the ground. The only real facts are the actual transactions which take place involving two parties - either part A and party B engage in a time charter or part A and party B engage in a one-time voyage in the spot market. Those are observable data points. For calculating the time charter market at a point in time, brokers like Clarksons will gather as many data points as they have available, sometimes make adjustments for different specs or the age of a ship to try and come up with an index which one can look to see where the time charter market is for a given type of vessel (the data which Clarksons and others provides does not and practically cannot provide an index covering every permutation of vessels as every vessel is somewhat unique depending on its age, where it was build and other specs which may define it so the indexed data points are at best an approximation of the market for what we can view as generally similar types of ships. In the Product space for example, Clarksons lists 1 year TC rates for MRs which are classified as "Modern" and DWT of 47-48K. It is reasonable to assume that a newer vessel will command a higher TC rate than an older vessel albeit both are modern, say built in the last 5 years yet this distinction would not be captured by the Clarksons data). For the Spot Market, there are even more assumptions that underlie the data. First, there are dozens of routes. Clarksons provides data for what they view as the most popular voyages (i.e. Rotterdam in Europe to New York or Ras Tanura in the Middle East to Chiba in Japan or Singapore to Japan). All of these voyages are then put together by Clarksons' to come up with what it presents as "Average Earnings" for MR's which is the closest to the index for the spot market for an MR. The inherent flaw here is that not every MR will participate in all of these routes. This is especially the case when there is a sophisticated Commercial Management entity that is operating the vessels, and even more so in a pool structure, as the more favorable routes at any given point in time will likely be selected for voyages over the worse routes yet the average will incorporate at a point in time both the better and worse routes in the spot market. Many pool operators, including STNG like to tout that their TCE numbers are better than the Clarksons average. While this is notable, it is also expected given the nature of how the average is calculated and the benefits which especially the larger pools such as STNG have from higher utilization (again recall that the spot voyages assume no triangulation which serves to increase laden days) and sophisticated fleet deployment through the efforts of the Commercial Manager.

The Cycle of Rates & Values

When looking at the path that shipping rates have taken (can either look at the spot market quoted in TCE as outlined above or the timcharter market for 1 or 3 year charters as a proxy for rates a given point in time), most sectors followed a similar trajectory upward from the early 2000s (2002-2003) before peaking in the 2007-2008 period only to come crashing down. The magnitude of the crash from the peaks reached was a function of the supply and demand imbalance in each specific market. Generally speaking, with rates at elevated levels, the orderbook across sectors became enlarged as shipping companies likely made the classic error which begets the downfall of almost all shipping cycles of forecasting out the boom years into the future for a longer time than is realistic, leading to large amounts of orders made which when the orders finally come onto the water (especially in the context of generally dampened demand in light of the global economic slowdown amidst the great recession) led to a supply and demand imbalance whereby too many vessels led to a downward trajectory of rates.

The product sector was not immune to the boom and bust of the shipping cycle. Rates increased gradually from 2002-2003 and peaked in the 2007-2008 period before plummeting in 2009. Between 2010-2012, the Product Tanker sector saw relatively flat rates, whether if one looks at the spot or time charter market. In 2013, however, rates have begun to come in at levels materially above the flattish levels of the last few years. It is worth noting that there is seasonality in the product space with Q1/Q4 typically the strongest periods as refined products are in highest demand (i.e. cold weather brings on demand for heating oil). During the warmer Q2/Q3 quarters, rates are typically weaker as refineries often take outages during this period leading to lower demand for the transport of refined products. We note this as despite the high numbers for the first few months of 2013, we recognize that seasonality ought to push rates lower than where they currently are throughout the summer months. What is noteworthy is that we appear to have achieved a step function in the level of rates and would expect that the draw down be at levels higher than in previous years and with the average rate through 2013 and in the ensuing years continuing to churn higher for the reasons to be outlined shortly.

Getting more specific, we can look at rates in a few ways - all tell a similar story but do the nature of the data gathering outlined above, the numbers differ slightly by data provider:

1. Clarksons MR (Clean) Average Earnings Index (Spot Market = Voyages):

Here is the average rate (calculated weekly) since 2002:

One sees very clearly that rates ticked up starting in 2003, peaked in the 2007-2008 timeframe and then were fairly stable in the 2009-2012 period. In 2013, the average rate has been $16,215. Note that these numbers are NOT inflation adjusted. The historical average nominal rate since 1990 (as far back as the data from Clarksons goes) on this index is $14,994 and since 2000 is $17,902. We think the number since 2000 is probably a better number to a get a sense for an average rate as this at least mitigates the fact that we are not taking into account inflation as well any other changes which may have taken place in the sector. Admittedly this is a higher number and we are conscious of the data available.

2. Data from a DNB Shipping Sector Overview, 4/7/13, Pg 16 (Exhibit A in the Exhibits in the above referenced Google Doc) shows a similar trend albeit at higher levels. It is not clear what the rates are but our best guess is that this is the spot market (default assumption).

Similar data emerges from a presentation by another ship broker, ICAP in their March 213 "Product Tanker Market Outlook" albeit here again the numbers are different but the trend is the same (assume again here that these are spot market numbers):

3. We can also look at Clarksons time charter rates to get a sense for where we are in the cycle - namely at the trough to at best early innings of the slow build up from the tough:

The average since 2001 when the data is available from Clarksons has been $18,513.

Finally, in STNG's own slides we see a good overview of the rates, albeit the data is somewhat selective in starting with the middle of the prior cycle (2004) through the present (nonetheless it does show close to 10 years of data). See Exhibit B.

Putting it all together, the historical average rate be it spot or TC over the last decade which saw a classic peaking and then falling off of the shipping cycle was in the $17-19K range. If we dare go back as far as 1990 using spot rates whose calculation as noted above has many inherent flaws, the number is closer to $15K but this number is not inflation adjusted which seems to us a bad way to look at it when looking over a 23 year period which certainly saw global inflation. However you cut it, we are at or slightly above rates which are close to the lows of the last decade.

The story on the vessel value side is very much the same. One would expect rates and values of vessels (be it orders for newbuilds from the shipbuilding yards or data from transactions of sales of ships in the secondary market) to travel together as value is a function of the underlying cash flow a vessel is expected to achieve for the buying party. The buyer and seller may have different views on where rates are heading and this is what makes for markets. From a value standpoint,

Vessel values are currently close to historical lows (and this is on a non inflation adjusted basis). MRs are being valued in the low $30mm range currently. In recent weeks values have ticked up with rates and newbuild prices in the yards are being struck for levels closer to $35-36mm. Just looking at newbuild prices, the average newbuild price since 1998 (as far back as the Clarksons data goes) through April 2013 was approximately $36.3mm. This is NOT inflation adjusted and does not account for the fact that current vessels being built are of the eco design discussed below which requires increased sophistication in the construction process and therefore is more costly to build than the vessels of earlier years. Accordingly, it is easy to see why the $36mm number since 1998 on a non inflation adjusted basis fails to truly capture even the average value of the current eco vessels being built which will comprise the bulk of STNG's fleet (were there data available which could synthetically show us the value of such eco vessels over the last 10-15 years this obviously would be of greater interest).

Exhibit C shows the historical vessel values for newbuilds since 1995 and clearly paints the picture that even on a nominal basis and not inflation adjusted, current valuations in line with current rates are near to slightly above the lows (RS Platou's 4/9/13 Presentation on Scorpio Tankers)

Who cares about history? What is the current supply & demand outlook and why should we think that rates and values will continue to improve? What is the current outlook?

There is a clear relationship as is obvious between utilization (effectively how tight supply and demand are) and rates. And rates drive value. We are currently sitting amidst an inflection point which stems from both the supply and demand side of the equation. In short, supply growth is reaching multi year lows while demand is poised to grow. Together, the gap between demand growth and supply growth will widen which we believe will lead to higher rates and higher values. Historical levels provide a framework of the types of levels one can expect we should average too, especially when the supply and demand outlook is much more favorable than it was at the beginnings of prior cycles, notably due to changes on the demand side. There is a high correlation between utilization (however it is calculated) and rates. Tight supply and demand will drive up rates. The historical average assumes a level of utilization which many participants we have spoken to believe we will begin to hit in the near future. Accordingly, the historical levels are not simply relevant because they existed before but rather as an indicator for what level of demand (in relation to supply) is required for different rate levels (and this analysis is AGAIN on a nominal basis); (one area of discomfort we admit is HOW utilization is calculated - we have seen a few methods and most are different from simply taking used supply and dividing by available supply - in part again due to the complexity in calculating the numerator and denominator. As such, some use proxies for utilization....such as rate levels which begins to get circular).

Furthermore, current rates fail to provide an adequate return to investors and unless rates do move higher, the orderbook in the outer years will shrink which will make the case for tightened supply and demand which by the sheer forces of economics (aka the laws of supply and demand) will push prices higher. History merely shows that there are precedents for higher rates and that tighter supply and demand ought to push us into that historical range (albeit we are keenly aware that what happened in the past need not repeat in the future). See Exhibit D which sharpens this point.

Supply Side

On the supply side, like most sectors in shipping, the product sector saw rapid expansion in the mid 2000s with double digit fleet growth as measured by DWT added to the global fleet between 2003 and 2010 not below roughly 9% (and as high as 15% in several years). This is using data calculated by DNB (see Exhibit E). Calculating global supply needs to be done on a vessel by vessel basis and there are different ways to calculate supply (notably relating to excluding or including certain vessels which may trade in the product space, such as those flagged as chemical carriers). Across data providers/brokers, however, the picture is the more or less the same. The current orderbook (i.e. orders in the yards for delivery in 2013-2015) is roughly 10%, again using DNB data but consistent with other sources. This is on a global fleet of approximately 2,270 vessels (includes varying sizes of "Clean" or Product vessels) and approximately 119mm DWT currently on the water as of April 2013 (the vessels count and DWT is per the RS Platou database per their April 9, 2013 Presentation on Scorpio). The 2K vessel or so fleet and ~115-120mm DWT capacity is consistent across most brokers with the exception of Drewry Shipping Consultants which excludes chemical carriers from the global product fleet (which is in contrast to almost all brokers/data providers in the space). The fleet according to Drewry was approximately 1,239 vessels at 12/31/12 with total DWT of 70.9mm. STNG uses the Drewry numbers in their 20F but from what we understand believes it was a mistake as the Drewry calculation is thought to be flawed in its exclusion of all chemical carriers (as many of the chemical carriers excluded, roughly 800 can be used in the product space). Nonetheless, Drewry's numbers conform from an orderbook % standpoint more or less as Drewry puts the orderbook at 12/31/12 as roughly 11.7% of the total fleet (this is the orderbook for delivery across all future years). DNB (same source we have been citing) notes that at 9% (recall they use a different denominator than Drewry, closed to 113mm DWT close to RS Platou), the fleet to orderbook ratio is "the lowest in 12 years."

Accordingly, over the next few years, the fleet is expected to grow, net of scrapping in the 2-5% range annually. See Exhibit E for DNB's forecast. This supply forecast is in line with that of other brokers such as RS Platou and Clarksons Research (the broker dealer subsidiary of the Clarksons Shipping Broker which is publicly listed and that has been referenced thus far): Clarksons Research net supply forecasts for 2013-2016E are 2.2%/2.2%/3.4%/2.6%. RS Platou in the abovementioned Scorpio presentation projects net growth of roughly 3.5%/2.5% and 2.5% for 2013-2015.

While the future is unknown, the 2013 and 2014 orderbook is more or less set. Repeated anecdotal confirmation by both public shipping companies as well as our discussions with various brokers in the market tells us that the yards are full through the end of 2014. This is further confirmed by the fact that recent newbuild orders have been placed for mid 2015 delivery. As such, we can take comfort in knowing how supply will grow over the next 2-2.5 years. Admittedly, given the nature of the shipping cycle, there does remain a major risk that the product tanker heats up, capital flows in, newbuild orders are placed for 2016-2017 delivery and the cycle may cool leading to a more balanced supply and demand environment. This is always the risk in shipping investing and we believe that this risk simply requires that the prudent investor be conscious of where we stand in a given shipping cycle (to the extent that that is knowable - at least troughs and upward and downward trends can be discerned) and not be too greedy - this requires selling perhaps before the peak is reached right at that sweet spot when the market extrapolates higher rates into the future as it always seems to do concurrent with shipping companies making the same error and placing large forward bookings. The market will likely drive the stocks of players exposed to this market higher and higher on account of this perception. Luckily, the orderbook takes a few years to come through so when we get to a point where the future orderbook for delivery two years out or three years out as a percentage of the current fleet starts to look like the mid 2000s and hits the 12-15% level (that is net growth), it is probably a good signal to exit what is hopefully a position that is dramatically higher from where one entered the stock. Compounding all of this is what was discussed above, namely that yards are operating currently at losses and vessel values will have to continue to rise if the yards are to accept more and more product tanker orders. When this occurs, the NAV of companies like STNG, will be lifted higher even inclusive of their undelivered fleet whose value will be even more "in the money" on account of higher newbuild valuations for comparable vessels.

Demand Side

The demand side of the Product Tanker sector is what is really interesting. Calculating demand - which is more or less the ton miles hauled (effectively multiplying the volume of cargo hauled by the distance hauled) - ranges from hard to exceedingly difficult to impossible, depending on who you ask. Some brokers try and calculate on the basis of data they gather from various routes (due to the sheer number of voyages and permutation of routes, this is almost an impossibility). Navios Group has a slide in their investor day presentation from Drewy data which notes that between 2004 and 2012, the CAGR for refined petroleum seaborn ton mile growth has been 6.9% (Exhibit F). Other data providers such as ICAP & DNB note that historically, CONSUMPTION of refined products (note: this captures demand of the underlying product and NOT the demand for the transportation of the product) has been approximately 4-5%. 

What does all of this mean for the future?

Going forward, there will be two key drivers of demand:

1) The first driver will be continued growth in consumption of the underlying product. This growth will come from developing economies such as Latin America and China increasing their consumption of refined products (for example as the Chinese move more and more from bikes to cars). This has historically been in the 4-5% range (full disclosure: we have not seen good data which outlines where this number comes from but it seems to be an accepted figure so it is possible that OPEC or another international provider has given data of this sort (we have seen some supply and demand models that take product as a % of crude and make assumptions around that. This seems highly speculative and at a minimum going forward, certainly product as a % of crude would expect to be higher as the crude trade growth rate shrinks and product grows faster). Some brokers peg this as a floor for their estimates on demand growth while noting unquantifable upside to this number stems from other factors, primarily driver #2.

2) Of extreme importance, there is a structural shift that is taking place in the global refinery landscape which is creating an added layer to demand. The underlying ton miles for the same amount of product (i.e. even if consumption demand was held flat) is growing as the distance between refineries and the location of consumption widens. This is occurring as inefficient refineries in Europe and other locations in the West are shutting down (Caribbean/Australia s well) while refineries are being built for export in the East. This is the "longer haul" argument by which ton mile demand will grow as the average haul grows. In a nutshell what is happening can be summarized as follows:

1. Closing down refinery in West; Europe shutting down refineries. That product will have to come from somewhere else. And need to think about quality and type of what they need – diesel in Europe versus gasoline in US. Europe also needs high quality products so will target modern facilities such as India, Middle East and going forward China. China currently does not produce the high quality refineries – they produce what they need and export the surplus but going forward may start to produce higher quality products.

2. Other question is where surplus of products exist: Growth will be east of the Suez: India in immediate term, China from end of this year and onward and the Middle East. 3 big exporting areas. This does not even factor the US or Russia which are also exporting (the US is becoming a bigger player in the exporting of refined product and Russia is also looking to upgrade its refineries to produce output which is higher quality and has more global appeal (that historical focus on military with limited global appeal).

3. Where will the imports be?

• 1. Africa – demand growing but refining capacity not growing because no one wants to invest in West Africa due to political risks
• 2. Europe – refineries shutting down
• 3. Latin America – demand is growing fast but refinery capacity is staying flat mainly because focusing on crude production so throwing money after that (World refining capacity is already oversupplied so no need to build refineries unless have energy independence plan like US speaks of since quite cheap to bring from elsewhere)
• 4. Australia - This has led to trade routes which never existed before. For example, Australia is shutting down their refineries and making them into storage facilities. Australia used to get crude from Saudis and refine it – now they will get refined product from India which is a leg that never existed before.

50%+ of global demand for product is still in the west yet refinery capacity is continuing to shift to the east. This will drive the length of the average haul longer increasing demand as measured by ton miles.

Shifts in the refinery landscape is leading to product transportation routes that never existed before like the India - Australia route described above. Similarly, the US has become a net exporter of product in size much larger than it historically exported. There is now a robust route between the US Gulf and Europe which never existed before (and is helping drive European refineries out of business, further increasing Europe's reliance on foreign imports of refined product).

We had a call in the last few weeks with Navios management who noted that while demand was strong over the last decade, the real catalyst for rates moving forward is NOW as demand continues to grow (consumption growth + continued increase in ton miles) but supply growth slows. At a conference this past Thursday (5/9/13 - RS Platou Shipping Conference in New York), Navios publicly affirmed their belief in demand growth in the 7% range. When asked to disaggregate the growth, management pegged the bulk of it on to mile increases. This is particularly interesting since it means that from their perspective, future strong demand growth hinges less on a robust global economy (particularly in developing countries) to drive increased consumption.

See Exhibit G which is a slide from the Navios Group Presentation pg. 76 which captures the surpluses and deficits that are expected in the global supply and demand of refined products as the landscape changes between what it was in 2011 and what it is expected to be in 2017. The net impact will be longer hauls.

A third but less focused on driver of demand is increased trading of the product by trading houses such as Glencore and Vitol. STNG President, Robert Bugbee has noted both in private conversations we have had with him as well as at public forums such as the recent Capital Link conference in New York that the fact that the trading houses which have probably the best intel on the ground are taking their balance sheet and deploying it to actively purchase vessels and effectively go long the product tanker space is an excellent indicator of the near to medium term outlook for the sector. Anecdotally we have heard that traders are being given more capital to play with and are taking advantage of arbitrage opportunities that continue to arise globally. Bugbee himself said at the same Capital Link conference that Scorpio recently took a cargo of jet fuel from Asia to Florida despite Florida's proximity to the US Gulf. This highlights the trading which stems not from demand per se (as said demand could easily have been satisfied from the US gulf) but rather from trading opportunities to benefit from an arbitrage (in which the cost of transporting is not meaningful enough to ruin the arbitrage). This creates further demand for ton miles as traders haul product globally taking advantage of price differences worldwide.

Key Supply & Demand Analysis Takeaway:

Putting it all together, demand forecasts range from 4-5% (DNB/ICAP) based on consumption growth alone with upside coming from longer ton miles stemming from the shift in the refinery landscape. Demand growth will outstrip supply growth leading to a tighter market which should continue to propel rates higher.

One can see the widening of the gap between supply and demand well in a graph in the D'Amico (an Italian publicly traded Product tanker focused shipping company) March 2013 Presentation pg 18 (the graph shows that in the 2013-2017 period, we will experience the flip of the widening that took place between 2007-2010 in which supply growth markedly outpaced demand growth leading to depressed rates). Exhibit H.

What does all of this mean for STNG?

Putting it all together, STNG is best positioned (among all publicly traded shipping companies and likely private as well) to take advantage of the attractive features in the product tanker space. STNG is admittedly a "story" company or a "show me company" as it is by no means cheap on current numbers. The real play for STNG is when it has its full fleet on the water by the end of 2014 at which point there is good reason to think rates will have continued to churn higher and STNG could earn at least in line with the nominal historical average levels (call it $17K or above on its MRs).

Here is a snapshot of historical STNG and what STNG could look like in 2015 (see below for key assumptions):

Key Assumptions for 2015:

MR/Handymax: $18K TCE; LR1: $19K TCE; LR2: $20K TCE; Opex for the 3 classes of vessels: $6,242, $7,803, $7,647. Utilization in the 99% range which leads to 360 revenue days (365 operating expense days) which is consistent with industry standards and attempts to incorporate the days lost due to drydocking surveys which take a ship out of commission for roughly 2 weeks every 5 years. Assumes 16 year amortization on its debt facility, new debt funding as outlined below.

Maintenance capex: Maintenance capex in the industry comes in two forms: actual maintenance which is referred to as surveys. Every 2.5 years there is a minor survey which according to chats with STNG should cost about $50K a vessel (this assumes it can be done in the water which is the case 90%+ of the time). Every 5 years, special surveys take place in which the vessel is "drydocked" namely take out of action in the water. The cost varies but for an MR, according to STNG should be about $350K/$550K/$1mm for the 5/10/15 year surveys. By the time you get to 20 years, despite what is generally accounted for as a 25 year useable life (for accounting and often economic purposes) the decision to conduct a pricey special survey will be balanced by what one can get in the market for the vessel (as in current rates) and how much one would receive for simply scrapping the vessel (all vessels have a salvage value so the actual economic value of a vessel should never be depreciated to zero as there is value in the scrap metal within the ship - looking at recent scrappings on the Clarksons Shipping Intelligence Site as well as confirmed by conversations with brokers, LWT (Lightweight tons which is the number of tons in scrap metal one will be able to sell to a scrap yard, often in Bangladesh) are rough 15-20% of the DWT of a vessel. Current scrap is in the $400 per ton range.

As these are depleting assets, the second form of maintenance capex is some sort of conceptual withholding of cash which one can assume the company would need to renew its fleet continuously. Otherwise, the company is a melting ice cube whose life will come to an end. Accordingly, when thinking about valuation, it is critical to think about some sort of equity withholding as the debt is paid down to ensure that there would hypothetically be ample equity to use together with leverage to rebuild the fleet or at least ensure its continued renewal over time.

We cannot really say what rates will be except that we believe the supply and demand outlook argues for higher rates over time. Here is a sensitivity output of what EBITDA and Free Cash Flow for the company will look like in 2014 and 2015 assuming different rates (for all estimates, we assume a $1K premium for LR1s over MR/Handymaxes and $1K for LR2s over LR1s):

VALUATION

So what is STNG worth and is all of this supply and demand assumptions and the higher future rates factored in?

Here is current valuation of STNG along with projected valuation of STNG at 12/31/14:

The valuation above makes simple assumptions about the breakdown between debt and equity funding for the capex spend on the orderbook as follows:

While the % debt may seem high, especially in light of comments from Bugbee that the company intends to be prudently levered in the mid 50% range and certainly not above 60%, I am forced to use higher leverage to even keep the company at these debt levels (debt used here as a % of funding). Based on historical spend and current debt levels as well as the assumptions on cash generated from operations, we come up with the following pro forma debt and equity split for the total gross capex the company will have spent by the end of 2014 when its full fleet is delivered:

As can be seen, we are stretching to even get debt to funding at the 50% level as the company has "over equitized" its initial funding of the vessels it currently owns as well as whatever installment payments it has made on the vessels (includes both cash from operations as well as cash raised from the numerous equity offerings the company has engaged in including its IPO which excluding the May 2013 offering have netted the company approximately $915mm at a weighted average price of $8.10. Inclusive of the May 2013 offering, the company has raised approximately $1.2bn at a weighted average price of $8.14)

How to value STNG?

The two basic ways to value Shipping companies are cash flow based (traditional multiple or dividend oriented valuation) and asset based. In the boom years, shipping companies often traded on dividend yields and were very attractive investments within the portfolios of retail investors. When rates got crushed and dividends cut, stocks got crushed as well as retail investors fled in mass. Based on the above sensitivity table, it seems clear that if rates churn higher, STNG will be generating extremely high FCF. What is the right dividend yield for the business on HISTORICAL AVERAGE rate assumptions mind you (not even thinking about anything close to peak levels in rates) - the baseline in the model is just showing $18K a day for MRs which is more or less the historical average which given supply and demand is not hard to see STNG achieve (especially as it achieved rates of $20,726 TCE on its owned MR/Handymax fleet in Q1 2013. Yes that was $20,726.). We can play around with what the right yield is but I am confident it is not the mid teens yield (which again is using historical levels only and levels which STNG more than achieved in this very quarter, close to a year and half before it will have its full fleet and by which point the tightening of supply and demand should have further played out). If it trades at say a 7% FCF yield on what we would argue is a conservative rate assumption, the stock is worth $15 (albeit we need to PV it back to today). Here is illustrative valuation based on a dividend potential and again using $18K MR rates:

Alternatively, we can look at STNG's owned fleet from a steel value/NAV standpoint assuming that vessel values will continue to churn higher as rates churn higher and as has been evident in the prices of newbuilds ticking higher over the last few months. The first column shows the steel value of STNG TODAY. The second column assumes that over time the value will continue to churn higher and come close to historical levels (as noted above the vessels STNG is building are much better vessels as they have lower expenses stemming from their eco build yet we are nonetheless using historical pricing as a benchmark. The 10 and 20% increases simply assumes conceptually either that the market ascribes a premium to steel values in anticipation of future increases in steel value or a hypothetical look a what valuation looks like if we increase steel by that level (same difference as this is more or less sensitizing numbers to see the valuation potential):

Two areas of potential upside which are not being factored into current valuation but which can be material if either or both play out:

1) ECO Design & the benefits of newer vessels in the Product Trade

STNG has been touting the benefits which its Eco designed ships have compared to older non eco ships, even those built in the last few years. The key benefit stems from lower fuel consumption. While not intuitive, this gets manifested in higher Net Revenue. To understand why this is so, we must understand recall that as outlined above in the spot market, voyages are struck on a dollar per voyage basis and the vessel owner bares the cost of fuel. The TCE which is used in the industry to calculate the net daily take of the vessel on a voyage charter is net of voyage expenses including fuel. Two vessels with the same voyage hire may have markedly different TCE (a net number) due to differences in their fuel consumption. STNG argues that the eco ships burn much less fuel than non eco ships. There are many skeptics out there but on its last earnings call (Q1 2013) STNG spend a good majority of the time outlining the exact numbers which demonstrate that in fact there is a difference. STNG's owned fleet which is more or less eco generated MR “Time Charter Equivalent” results of $20,726/ day for STNG generated $16,453/ day for ‘time-chartered in’ vessels. STNG demonstrated that its eco ships outperformed its non eco ships by more than $3K. This is EXTREMELY meaningful in light of the numbers we have been discussing until now. This paragraph may be the most important source of UPSIDE in the STNG story though we believe that the STNG investment thesis is largely driven by the supply and demand dynamic and stands alone. The eco story if it continues to play out simply magnifies tremendously the standalone supply and demand story. All of the numbers above which we have discussed have simply been using historical levels as some baseline for where the market can get to. With eco, however, STNG is showing that the eco ships are outperforming the non eco ships on comparable voyages. While the jury is still out on whether there is sufficient data to warrant concluding eco truly provides a benefit and a benefit to this degree, it is worth looking at STNG's Q1 2013 presentation here (http://ir.scorpiotankers.com/getattachment/1238ad9e-8986-4271-b311-e47b85716a96/Scorpio-Tankers-Inc--First-Quarter-2013-Conference) which walks through the cash flow impact of having eco vessels. When STNG's fleet comes on line by end of 2014, only a small % of the worldwide fleet will be eco and this percentage will remain small at least for the next several years. Accordingly, one cannot simply shrug it off by saying all will be eco and all will benefit so the global cost curve will simply shift downward eliminating any source of benefit. On the contrary, STNG's vessels are poised to beat the index by a few thousand dollars if the numbers which STNG has demonstrated thus far continue to pan out. If this is the case, then the $17-18K a day of historical levels needs to be considered on an apples to apples basis for eco as $20-21K a day. Therefore, the $18K which we are assuming above for 2015 for STNG's MRs, would be akin to $15K a day, numbers which STNG dramatically beat in Q1 2013 with its owned vessels where it attained average rates of $20,726 a day.

One smaller benefit of the newer ships is that with their fresh annealized coating the newer ships are better positioned to enable it to go quickly from one cargo to another (=more triangulation) which is benefit of the newer ships relative to the older ships.

2) LR Trade

Thus far we have been focusing primarily on the MR trade. The MR has historically been the vessel of choice for the product trade and standard cargo sizes were in the trade were set for what MR's can carry. Initially, one would think larger vessels with the benefits of economies of scale in their operating expenses would be a better option. Nonetheless, MR's were the favored vessel as the multitude of ports to which the product trade comes and goes is much larger than that of dry and crude and many ports simply are not built to handle larger vessels. Additionally, there exists within the product trade the abovementioned arbitrage traders from the financial trading houses. Traders may look to bring over cargo but if done in large quantities such as the amount held by an LR1 or LR2, there simply may be no place to store the cargo until it is taken by end users over time. Accordingly, smaller vessels were preferred. If one looks at the LR rates against MR rates, one is therefore not surprised that despite the greater size, LR1 and LR2 vessels do not command a premium commensurate with the increased cargo that they can haul. In fact in Q1 2013, on a consolidated basis (ignoring the eco benefit highlighted by focusing on STNG's owned MRs vs. its TC in MRs), STNG generated $18,259 in its MR/Handymax segment with opex of $5,852. This compares to $19,172 and $6,840 for the much larger LR2 (Aframax) vessels. Overtime, the larger vessels which STNG and its competitors (including Frontline 2012) have been ordering may command much larger rates as ports worldwide are being expanded, the panama canal expansion will enable more accessibility via the larger vessels and in Europe and Australia, we have been told that refineries are being converted into storage facilities which enables traders to make larger bets and haul the larger sized cargo on the LR1s and LR2s. If this plays out, then the LR1 and LR2 vessels in the STNG fleet should begin to earn rates higher than the MRs on a net basis (TCE less opex) whereas currently the rates earned less daily opex are at best equal to less (as was the case in Q1 2013).

Management

STNG is led day to day by its President Robert Bugbee. Bugbee is a charismatic and promotional leader. We have met with him and heard him speak several times. He is very bullish on the bet he is making on the product sector through STNG and shows tremendous confidence that he is making the right decisions. While we do not love his promotional style, we are keen to let the numbers speak for themselves. He has repeatedly touted eco and in Q1, the numbers did more valuable talking than he could ever do. He had previous success as part of the management team at OMI with Craig H Stevenson Jr (currently working with Wilbur Ross' endeavors in the shipping space at Diamond S Shipping). Together, Bugbee & Stephenson (some cynically give Stephenson the credit though to be sure, Stephenson and Ross appear to have been too early to the party by investing in the product space several years ago at values which the CEO of D'Amico told me were just way too high), sold OMI to Torm and TK at the peak of the market in 2007. In our discussions with Bugbee, Bugbee made it very clear that he is conscious of the shipping cycle and as he did with OMI keen to sell before the market crashes. We take comfort in Bugbee's approach as he is not simply looking to build an empire but rather to best play the cycle. Bugbee is prudent in his use of leverage as outlined above and is hesitant to take leverage above 60% (60% funding). While timing the cycle may prove impossible, Bugbee's attentiveness to where we are in the cycle and his interest in ending growth mode (and thus massive capex) by end of 2014 middle of 2015 to enable STNG to have a few years to ride the cycle on its trajectory upward appears to be shareholder friendly.