This article is authored by Alirio Sendrea, head of research at Invexcel, based in Madrid. Alirio focuses on bottom-up analysis of European small and mid-caps.
During the last couple of weeks, rates of both crude (dirty cargo) and product tankers (clean cargo) have increased dramatically, reaching ten-year highs. The trigger has been US sanctions on China’s shipper COSCO for carrying Iranian crude just when the industry is heading into high season (i.e., winter in the North Hemisphere) and into its most transformational change (i.e., IMO 2020). Inevitably, the market has turned again to the Tanker industry pushing prices to the upside. Unsurprisingly, many tanker companies rush to pitch their virtues, trying to convince investors on why they are the best positioned to take advantage of the juncture.
All this is nothing but temporary noise. As part of the group of investors who have been patiently waiting for over two years for the developments to occur, this is a key moment to stick to the fundamental aspects behind the cycle.
This is a competitive, fragmented industry. Operators and ton owners, price takers by large, have shown historically a chronical lack of discipline which worsens the extreme cyclicality of the industry, especially for the downside. Key is to understand the current cycle, let’s tear apart and briefly summarized the different demand and supply moving pieces.
No matter what the surge in alternative energies, oil consumption increases as a reflection of the growth in world population and urbanization. Unsurprisingly, ~80% of consumption growth comes from Asia. Meanwhile, ~80% of the new oil extraction comes from the Atlantic basin, supporting the ton/mile demand, a key driver for the crude tanker industry.
Industry specialists forecast the yearly growth of oil consumption to be in a band of 1.1mbd to 1.4mbd. The same as you, neither do we believe in the forecasting power of specialists. However, let’s do some basic numbers. Considering 1.0mbd/year growth, assuming 50% of new barrels come from the Atlantic Basin plus the balance from the Arabic Gulf, and six trips/year/vessel (to simplify the complex even more, let’s think only in terms of VLCCs (Very Large Crude Carriers, a juggernaut able to carry up to two million barrels), the result is demand increase of 30+ VLCCs equivalent a year, i.e., ~2.5% of the global fleet.
Important to note, US shale oil provides not only for a mitigation to OPEC+ oil supply reductions but it’s also a great support for the ton-mile story. Gulf infrastructure was an issue to accommodate large carriers, but this is now being solved with new investments in ports and pipelines.
Newbuilds and Orderbook
Tanker industry comes from foolish ordering recently. As a consequence, 2019 is set to be a record year in terms of deliveries (in the VLCC segment, we are witnessing a 25-year record). However, the orderbook begins to fade in 2020, approaching record lows, and pointing to almost zero deliveries in 2021/2022. Current orderbook over global fleet represent ~10% for crude tankers and ~7% for product tankers.
There are good reasons to believe that there is no significant risk to this thesis, at least during the next 24 months. Access to financing has tightened and shipyard capacity has diminished and will continue to be limited.
Traditional source of finance for the whole shipping industry has been banks from the Northern Europe/Baltic region. These banks now suffer heavy regulatory burdens, which explains their diminishing exposure to the industry. And regulation for banks can only increase.
A few years ago, every ship owner had reasonable access to bank financing; today, it is mainly available to those with good track records and strong balance sheets. Alternative financing is available in the form of sale and leaseback transactions, but at a higher cost.
Part of the miseries in the tanker industry were caused by the increased capacity in shipyards (tankers are built mainly in South Korea, China and, in lesser extent, in Japan) and their irrational pricing policies when the orderbook began to shrink. Shipyards built at a loss for a time and ton owners placed orders to take advantage, worsening the fleet capacity issue which is still correcting. As the race took longer, the shipyard industry went into stress, some even went out of business. Nowadays, the sector has consolidated and surviving shipyards are subject to a tight control by their creditors.
Shipyard business is on average running almost at full capacity, their pipeline is very busy at least for the following two years as they are delivering tankers ordered during the mad years and the increased demand for LPG/LNG carriers.
Building a tanker takes, from ordering to delivery, between 18 and 24 months. All in all, it is not expected any significant additions to the global fleet at least until 2022.
Tanker fleets are getting old. Vessels older than fifteen years represent ~20% and ~16% of the crude and product tanker global fleets, respectively. For those new to the shipping industry, compulsory drydocking (Special Surveys) take place every five years up to year fifteen and every two-and-a-half years afterwards. As the hull and engines get older, Special Surveys get more expensive. As a consequence, depending on rate environment and expectations, beginning year 15, ton owners face the dilemma of going ahead with the next Survey, move to storage or sell to demolition. Obviously, there are other factors playing like oil/products inventory levels, steel scrap values, opportunity to move from dirty to clean cargo or vice versa.
This time, Special Surveys come with some different caveats.
First, beginning October 2019 vessels traveling on ballast should install in their next Special Survey a “Ballast Water Treatment” filter to meet environmental regulations. This adds something from $0.5m to $1.5m, depending on vessel size.
Second, IMO 2020 regulation enters into force on 1 January 2020, setting a 0.5% sulfur cap on the fuel used for shipping. This is a transformational change for the industry as there are two possible options to meet this regulation: burn MGO or any compliant blend fuel meeting the cap (the latter being developed by refiners, this won’t be a short term option for the whole market given expected homogeneity and stability issues) or install a costly filter named Exhaust Gas Cleaning System AKA “Scrubber”, which cost ranges from $2.0m to $5.5m depending on vessels size and specifications.
In the meantime, owners are happily taking advantage of current juicy rates. But this will not last for longer, they will face the dilemma sooner than later and options are basically:
A. Incur in expensive Surveys in addition to retrofit costs:
a. Install the Ballast Water filter and a Scrubber, or
b. Install the Ballast Water filter but not a Scrubber. In this case, the old vessel choosing to burn more expensive fuels will compete with younger and more efficient vessels, and with those that installed Scrubbers,
B. Take their vessel out for storage, or
We believe that incurring in such high investments is not an option for very old vessels, so we will see mainly options B and C for vessels older than fifteen years.
Tying the numbers to the low orderbook and structural demand increase, we expect a supply-demand inflection point very soon.
Some Words on IMO Regulations
Vessels that have chosen to install Scrubbers are taking advantage of imminent Special Surveys for necessary retrofits which lengthens the drydocking time. Therefore, a short-term constraint in supply will concur with the busy winter season.
Furthermore, IMO 2020 represents a great opportunity for the Product tanker segment. The need of compliant fuels and their storage in almost every single port imply more cargo moves around the globe.
Thinking more long term, IMO 2030 is on sight with a target to reduce CO2 emissions by at least 40% by 2030. For those looking to invest in a ship with a 20/25-year useful life, this is a material aspect to consider as more than half of the life of that vessel will be available when this new regulation gets enforced. Today, there’s no clear path to follow. LNG seems like the long-term winner, however the investment in retrofitting seems quite pricy (some talk of $15+ million). New, more efficient engines using the same fuels could be and option, but need to be designed… and tested.
Don’t Overlook the Risks
Leverage matters a lot. Many participants feel that non-recourse debt (i.e. attached to vessels which do business by their own as separate legal entities) is a wildcard that can be drawn at convenience.
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About The Author: Alirio Sendrea
Alirio Sendrea, CFA, is the Head of Research at Invexcel Patrimonio, a multi‐family office based in Madrid, Spain. The aim of his team is to use a thorough fundamental research method to find attractive long‐term investment opportunities in European equities. While he defines himself as a generalist buy‐side equity investor, he has hands‐on experience in Financial Services, Shipping, Information Services, Alcoholic Beverages and Business Services. Alirio has more than 17 years of experience in Financial Analysis, Valuations, Investment Advisory, Auditing, Restructuring and Treasury, working with entrepreneurial families and global companies. He has been a CFA Charterholder since 2014 and a Certified Advisor since 2018. He completed the Enterprise Valuation Program at Instituto de Estudios Bursátiles (Madrid, Spain) and holds a bachelor’s degree in Accounting from the Universidad Central de Venezuela (Caracas, Venezuela).
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