ShipBrief  

9 March, 2020 

 

This Edition 

● Shipping Market Updates ● Investor Focus: Top Buys + Review of TGP & FLNG Results ● Macro Focus: Product Tankers And Is It Time To Buy? 

 

 

 

 

 

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Market Updates 

Dry Bulk: 

The BDI is making an effort to bounce back, however, the headwinds are very strong. 

Until significant demand begins to emerge from China, this segment is still largely an avoid. 

Aside from the demand destruction we have seen vessel deliveries so far have been heavily front weighted which hasn’t helped the 

market. 

Looking ahead we see some promising signs. First, is a total lack of interest in newbuild contracting which will keep vessel growth low in the future. The chart below shows the lag effect between contracting and when orders come to fruition. 

While we have a fairly busy 2020 to deal with as nearly 100 newbuilds are expected before the year’s end, if we can keep ordering under control it looks like 2021 could present some breathing room for the market to digest this latest influx of vessels. 

 

 

 

 

 

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Crude Tankers: 

In spite of all the negative headlines regarding crude demand destruction in China, data now shows that in the first 2 months of 2020, China imported 76.8 mln tons of crude oil by sea. This represents an increase of +3.4% year over year, compared to the 74.2 mln tons imported in the same two-month period of 2019. 

While this is encouraging the gains still lag behind previous years, down from the 18.6% growth seen in the same period last year, and also from the 5.2% y-o-y growth posted in 2018. 

In other news, OPEC+ is having a bit of trouble keeping a lid on production. The last round of crude price drops inspired a round of opportunistic global stockpiling. Could that be in the cards again? 

 

 

 

 

 

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Product Tankers: 

MR rates have quietly held their ground and LR rates are charging back. 

With MR rates at their highest off season levels in many, many years some are wondering if the selloff in product tanker stocks aren’t a bit overdone? 

More on that in this edition’s macro outlook. 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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Containers: 

Perhaps no other segment has experienced the sort of discombobulation than that of containers. Blanked sailings, massive reductions in port calls, and now container logistics are playing a role. 

The Wall St. Journal reports: “The coronavirus epidemic is upending the carefully calibrated logistics of global shipping, as plunging exports 

from China disrupt the trade of American goods, especially farm products such as fruit and meat destined for Asia. Congestion at Chinese ports and interrupted sailings have squeezed space on China-bound vessels and created an imbalance of the 40-foot long refrigerated containers used to ship fruit, meats and other perishables on three-week voyages across the Pacific, with many stuck on the China side.” 

Now, adding to all this will be an imposed 14-day quarantine on ships between port calls in Europe in light of growing concerns over the coronavirus.The outbreak has been found in several European countries, including France, Germany, Italy, and the UK. 

This delay will impact schedules in and around the region and could actually serve to keep vessels in service longer (or limbo if you like) thereby reducing the number of idle vessels. 

With each passing day of the trade war and now the Coronavirus outbreak container shipping is straying farther from what was once previously normal. This is impacting the short run for sure, but it also means that containers are likely to feel the impact more than any other segment due to the expected permanent shifts in supply and logistics. 

More than ever past models are no guarantee of future performance as the multiplier effect container shipping enjoyed beyond global growth, brought on by increasing global trade and expanding supply chains, is grinding to a halt with several factors conspiring to reshape the market, and not in a good way for these vessels. 

 

 

 

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LNG & LPG: 

A tale of two markets. LNG can’t seem to catch a break as weak demand is met with declarations of force majeure. 

Low natural gas prices in key Asian markets have ended any hope of a late season arbitrage play. Those low prices look to continue, even as China returns to work, as a warmer than average winter remains the real culprit. 

On the other hand, LPG, which was predicted to have the most stable outlook at the start of 2020 is certainly holding up its end of the deal. Steady demand amid this global panic is due largely to the very diverse demand composition with much of it revolving the necessity of food preparation. With more people staying at home instead of visiting restaurants it seems reasonable that LPG demand would remain steady. Remember, much of LPG is utilized in the household kitchen.  

The long term outlook for LPG continues to remain the most reliable and steady of any major segment. Short term pullbacks could be seen as potential accumulation points for investors with a medium term horizon. 

 

 

 

 

 

 

 

 

 

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Investor Focus: Top Buy List + TGP & FLNG Review We’ve been navigating very challenging markets for the past couple months and essentially everything energy or shipping related has been hit hard. With the Coronavirus, COVID-19, now established as a global pandemic, broad markets are accelerating their selloff. Russia and Saudi Arabia have also recently engaged in a tit-for-tat oil price war which threatens to further implode the energy sector. Although shipping is a seperate market and lower energy prices are arguably good for all segments of shipping, the stock prices often correlate closely together in the short-term, so I expect the pain to continue for many of our names.  

Just last week, I released a public update listing ‘12 Top Bargains’ to consider during the Coronavirus selloff. The full write-up is available via this link. In this edition of ShipBrief, I am going to add some notes on the firms I believe are best positioned, from that recent list of 12, in light of the recent oil ‘price war’ escalations. Crude tankers are the largest direct beneficiaries, and they already made up 4 out of the 12 names on that list, namely: 

● Diamond S (DSSI) - $10.09 vs. $21.00 Estimate (108% Upside) ● Euronav (EURN) - $8.53 vs. $14.00 Estimate (64% Upside) ● International Seaways (INSW) - $19.47 vs. $35.00 Estimate (80% Upside) ● Teekay Tankers (TNK) - $14.24 vs. $25.00 Estimate (76% Upside) 

All four of these companies, which were already very attractive recently due to the COVID-19 selloff, are likely to benefit massively from any sort of oil price war. However, considering energy is likely headed for a brutal week of trading, it is certainly possible that these names will trade down as well. In an efficient market we would see huge rallies in crude tankers today (9 March). Let’s see! 

Why will these companies perform better? Namely due to an expected surge in demand for oil storage. This storage demand is driven by two factors. First, with increasing exports, we’ll also start to see a glut of oil on the oceans as global demand/imports cannot keep up, especially if COVID-19 continues to slow down economic activities. This oil must be stored somewhere and in a pinch, floating storage is the easiest solution. Additionally, this price war is likely to be considered a short term tactical move, which means we should expect to see spiking contango in the oil price futures (i.e. significantly higher prices 6-9 months from now versus March-April pricing). This contango will open up arbitrage opportunities for global commodities traders to buy front-month oil offset with delivery in 3-6 months.  

Generally speaking we need $3-$5 of contango over 3-6 months to drive massive floating storage. As of last week there was only about $1 of contango and we haven’t seen that $3-$5 level since 2016-2017. Last time around floating storage spiked significantly, and especially since crude tanker rates have fallen from the $100-$150k range down to about $30-$40k, I expect we could see that pop back up.  

 

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Another factor which benefits all shipping companies is that the benchmark ‘time-charter equivalent’ (“TCE”) rates are based on gross revenues minus ‘voyage costs,’ of which bunker fuel is the primary factor. With oil prices plummeting, bunker fuels will come down fast, and if overall shipping costs remain at similar levels, all TCE levels should start to improve a bit. We’re already seeing this effect play out in dry bulk rates, and Panamax and Supramax rates have been rapidly improving the past few weeks. Almost all of that improvement isn’t due to higher shipping costs, but rather to lower bunkers. 

If oil tankers are hired for storage, their fuel consumption costs will be very low meaning their customers could pay a similar gross rate per day to hire those vessels, but the net reported TCE could be $20-$30k/day higher than a comparable transport route. That aforementioned $3-$5 contango level supports a TCE in the $50-$60k/day range, which is extremely healthy for a low-risk guaranteed hire. I suggest investors should frequently monitor the Brent Crude Oil Futures to see where these levels sit. They were under $1.00 last Friday; as of Sunday (8 March), the range is closer to $1.00-$2.00. We need to see $3-$5 for the 3-6 month ranges to really be printing money.  

Takeaway: Strong Speculative Buy on DSSI, EURN, INSW, TNK -- Watch Crude Futures for Storage 

With that latest market update covered, I’m sharing my review of both Flex LNG (FLNG) and Teekay LNG Partners (TGP) earnings as these were significant positions for us. I am still long both firms and impressed with their earnings levels despite market volatility.  

Flex LNG Earnings (Reported 26 February) 

Flex LNG reported a TCE of $94,000/day. Utilization was undisclosed, but it seems to be at least in the 90%-range. Flex also signed 2 charters, one of which is for 5-years, and the "Flex Enterprise" charter was extended for another year as well. These were done Nov19-Jan20 prior to the sentiment plunge, reflecting a prudent move by management.  

FLNG reported adjusted earnings of $0.41, which compared to my estimates for mid-$80k/day TCE and EPS of about $0.25. I had previously called out that analyst estimates ($0.45 average, $0.42-$0.47 range) looked extremely high and suggested a TCE of $100k/day or better. Flex actually blew out reasonable earnings estimates, but analyst figures were so sky-high that somehow this was translated as a "miss." This is one of the most ridiculous 'misses' I've seen- this was a blow out performance!  

Furthermore, despite the plunge in LNG shipping rates, FLNG expects Q1-20 TCE will be close to $70k/day. This compares to our live analytics market expectations of $67.3k/day for Q4 ($27k blowout in Q4!) and our current Q1-20 average tracking at $56.5k ($14k outperformance in Q1). Very nice! 

Newbuild Program: Ahead of Schedule, Capex Balanced 

Flex reported that their entire newbuild program is progressing ahead of schedule and we should see three additional ships on the water by mid-year with three more during the fall. It looks like FLNG might only have one vessel set for 2021 delivery if this schedule keeps up. 

 

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Source: Flex LNG, Q4-19 Earnings Presentation, Slide 6 

Flex has $937M in net capex remaining, but they've lined up full financing for the 2020 deliveries with only $56M net cash required this year. The 2x 2021 newbuilds still need to be financed ($126M due), but even at a very disappointing 50% leverage to value ($95M debt apiece), this would imply another $62M net cash needed in early-2021.  

 

Source: Flex LNG, Q4-19 Earnings Presentation, Slide 14 

Keep in mind that FLNG has achieved previous sale leaseback financing of up to $150M per vessel, so if they take that route again, they could actually end up with net cash receipts on their ship deliveries into 2021.  

 

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In the worst case, FLNG will need $118M for capex through mid-2021, which compares to $129M liquidity as of 31 December. They're going to generate another $40-$50M in net operating cash flow by mid-2020 as well. 

Smooth Debt Amortization 

FLNG has higher leverage than I'd like to see with 68% debt-to-assets ("D/A"), which is probably why they aren't rushing to do share repurchases here. However the debt is very stable with no meaningful hurdles until 2024-2025. 

 

Source: Flex LNG, Q4-19 Earnings Presentation, Slide 20 

2024 Maturities: Not Much Tail-Risk 

If we look at the 2024 maturities (Balloon of about $190M on the Constellation and Courageous & a balloon of about $75M on the Flex Ranger), on even a ludicrously fast depreciation curve of 20y to residual those ships should be worth about $130M apiece. They'd need leverage of about 60-70% to roll the entire enchilada and that's off a rapid depreciation curve. If we use a more tenable 30y-to-residual, those ships would be worth about $140-$145M and they'd only need leverage in the upper-50% range to roll the whole facility. 

2025 Maturities: Slightly More Risk, But Not Much 

If we look at the 2025 maturity, we should see a balloon of about $470M against 5 ships, so about 70% on the 20y curve and about 62% on the 30y. Furthermore, the facility allows Flex to draw up to another $50M in financing if those ships were to be fixed on long-term charters. Thus far they've secured one of them on charter already.  

 

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Source: Flex LNG, Q4-19 Earnings Presentation, Slide 15 

Investor Day Presentation- Must Review! 

Flex also held their Investor Day on 26 February and their presentation has excellent slides on both the overall market review and their advantages of modern tonnage. They also share financing facility updates. I highly recommend reviewing the entire slide deck, available via this link. 

FLNG Financing: Higher Leverage, but Low Cost Borrowing 

All of FLNG’s core loans are done between LIBOR+2.2% (3.84% equivalent) and L+3.5% (5.14% equivalent). Their highest levered lease is done at a 6%-fixed equivalent. The banks aren't worried here! Of the 3 leased ships, two have a put/call structure at $75M in 10 years and one has a purchase option of $78.75M in 10 years. Purchase options also start as soon as two years if FLNG decides they want to switch to lower cost financing. 

On 20y-to-residual and 30y-to-residual curves, these ships would be worth about $105M to $133M at their ten year mark, so the purchase options are massively in FLNG's favor. 

Market Review: Modern Tonnage Squeezes Out Legacy Units 

 

Source: Flex LNG, Q4-19 Earnings Presentation, Slide 42 

 

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Modern tonnage only makes up about 15% of the current floating tonnage and about 27% pro forma, yet the economics are strikingly different. MEGI/XDF ships can attain $15-$20k premiums to TFDE and closer to $30-$40k premiums to steam vessels. Additionally, average utilization rates are higher: 

 

Source: Flex LNG, Q4-19 Earnings Presentation, Slide 41 

The delta between steam utilization and MEGI/XDF would likely have been far higher yet if not for nearly 200 steamers on fixed contracts in 2019.  

FLNG Focus Question Review 

The following section presents our original 'focus questions' from our original Q4-19 LNG Sector Preview hosted at Value Investor’s Edge along with updated commentary following FLNG’s results. 

Major dividend payout? Any repurchases? Flex is a Fredriksen firm which means they typically are heavy dividend payers. However, a repurchase transaction makes much more sense in this market as Flex sits at a discount of over 40% especially when Q4 cash flows are factored in. Will they pay a huge dividend or split the difference and do some repurchases? 

Flex kept their dividend flat at $0.10/qtr even when their previous policy and guidance would have suggested a payout as high as 40-50 cents. This was prudent considering the uncertain market and the clear lack of enthusiasm for LNG investments; however, they also didn't announce a repurchase plan.  

Three company execs, including CEO Oystein Kalleklev, each purchased 5K more shares on 26 February in a show of support; however management ownership remains lower for now. Hopefully this will increase, but I'd rather see a repurchase so we can all benefit.  

Utilization compared to TFDE ships? During the past bull LNG market runs, TFDE rates were notoriously lagging the market indices and overall utilization was poor to boot. I typically discount the trailing index by about 30% and then expect further utilization losses on top of that, which has been pretty accurate for TFDE ships. Do we see the same thing for modern tonnage after adding the $10-$20k margin, or do they do a much better job of maintaining full utilization and matching index levels?  

Utilization wasn't directly disclosed on the call, but judging by the EBITDA numbers, it looks like Q4 was at least in the mid-90% range. Utilization was higher in the entire sector with Golar (GLNG) also 

 

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achieving 90% utilization and a $77k/day TCE. This means that FLNG's outperformance as compared directly to GLNG was about $17k/day. That makes sense as we've been expecting $10-$20kpd spreads on average over time plus the benefit of stronger utilization.  

Conclusion & Fair Value Estimate: FLNG Reiterated at $14.00 

Flex produced a phenomenal result for Q4-19, with adjusted EPS of $0.41 even with less than half of their fleet on the water! With the full fleet, we likely would have seen 85-90 cents. It's not responsible to annualize the strongest quarter of the year, but even with seasonal smoothing, FLNG could have produced pro forma annualized EPS of about $1.50-$2.00.  

2019 was a decent year, but hardly a gang-busters one, roughly mid-cycle. FLNG is trading at about 4-5x normalized earnings. Furthermore, their NAV is $13.64 as of 31 December financials and if we include January and February cash flows, we're into the lower-$14s. Newbuild replacement costs currently range about $185-$200M and FLNG's brand new fleet is currently valued by VesselsValue between $168M (2018-built vessels) and $185M (2021s). This is not an aggressive NAV. 

Initial headlines said FLNG 'missed' expectations, but this was based on ridiculous analyst expectations of over $100k/day in TCE. I actually estimated closer to $0.25 in earnings myself and considered Q4-19 to be a ‘beat’ of realistic expectations. The biggest risk with Flex LNG is their overall balance sheet leverage, but it is offset by a very smooth amortization profile until 2024 and the best assets in the world. I believe FLNG is fairly valued at $14.00/sh, which would be a 131% appreciation in share pricing from today's levels.  

Teekay LNG Partners Earnings (Reported 27 February) 

For yet another quarter, TGP presented exceptional results, with adjusted earnings of $0.56 and DCF of $0.92. Keep in mind this is simple DCF (i.e. total distributable cash flow divided by outstanding units), but even if we included the implied GP/IDR splits, TGP would be producing about $0.77 in payable DCF, easily within the maximum payout range. Management continues to hyper-focus on deleveraging, but they did repurchase 563.7K shares since November, all of which occurred in early-2020. In the past 14 months, TGP has repurchased 3.5% of their units in the $13s. This isn't as much as I'd like to see, but clearly a step in the right direction. 

TGP's growth program is now fully complete and the Bahrain Re-Gas facility is receiving payments. They successfully sold their Awilco vessels via the contract obligation and pro forma liquidity is over $400M. They have no meaningful debt maturities on the horizon, so the majority of the deleveraging will be through regular debt amortization, lease repayments, and the upcoming $115M NOK bond.  

TGP Leverage Still Too High 

TGP's leverage still needs to decline to hit their target range of 4.5-5.5x as the combination of debt paydown and growth delivery has brought them to nearly 6x. TGP still expects to enter this range by early-2021.  

 

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Source: Teekay LNG Partners, Q4-19 Earnings Presentation, Slide 10 

When pressed about growth on the call, management affirmed that their priority remains deleveraging, but they also pointed to the distribution increase and continued repurchases. 

Additional Growth: Heavily Inferior to Repurchases 

Another reminder that any growth they might undertake wouldn't likely hit the water until at least 2024, so there's significant room for a combination of heavy deleveraging and future higher payouts until then. Management (both Mark and Scott) have promised me on several occasions that they will NOT pursue any growth project unless it exceeds the ROE from repurchasing units. On the call, TGP confirmed the current returns are 8% or less and they would pursue 70-80% leverage on any projects. 

At an 8% ROA and 75% leverage at 5.5% fixed, the ROE would be 15-16%. TGP's best project is Yamal at about 10.5% ROA with 75% leverage at 6% fixed, which is an ROE of about 24%.  

With TGP's 2020 mid-point earnings guidance of $2.85 and forward annualized DCF of nearly $4.00, TGP's current yield is between 21% and 30% depending on metric of choice. This makes almost all growth projects dilutive (as compared to unit repurchases) based on current unit prices. It's pretty much impossible for TGP to prioritize further growth under $15/unit and still pretty difficult to justify further growth for anything under $20/unit (14-20%). 

Minimal Charter Risk on Older Vessels 

A frequent question on TGP involves their near-term charter risk, especially since the LNG carrier market has rapidly cooled recently. The following two slides review their consolidated and joint-venture fleets. 

 

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On the consolidated fleet side, there are no contract rolls until mid-2021 and the first 3 are modern MEGIs at modest rates. If anything these levels could improve. The next two ("Polar" and "Arctic") are highly specialized anti-sloshing units which were recently signed on charters. Not concerned there. 

The first 'real' risks here are the "Hispania Spirit," "Catalunya Spirit," and "Madrid Spirit" carriers with expirations in Sep 2022, Aug 2023, and Dec 2024. Thereafter, no real risks until the trio of steamers in 2026-2027 (2.1x net). I estimate the Spanish trio in the mid-$70s and the Ras Laffan JV ships in the mid-$60s. Replacement charters would probably earn about $30k in today's market.  

 

Source: Teekay LNG Partners, Q4-19 Earnings Presentation, Slide 5 

The joint-venture fleet has slightly more near-term exposure, but it also contacts a massive book of long-term deals. TGP has a trio of ships (1.5x net) coming off charter at the end of 2020, falling from about $80k to likely about $50k/day. The "Excalibur" is a finance lease and will likely be divested. 

The "Magellan Spirit" is an in-charter, which TGP operates from its JV (weird setup, but it has been super profitable). Essentially 2-net ships at risk here.  

 

Source: Teekay LNG Partners, Q4-19 Earnings Presentation, Slide 6 

 

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I am frequently asked about TGP's charter risks and there's a lot of skepticism to the sustainability of DCF. Although it is likely true that TGP's DCF will peak in 2020 at about $4.00/unit (unless they repurchase significant units) if LNG markets remain mediocre, there's not too much risk to the downside as debt reduction should bring down financing costs at a similar speed as any risk from the minimal charter rolls.  

TGP Q1-20 Guidance: $5M Q/Q Expected Uptick 

TGP provides an excellent Q1-2020 outlook slide which calls for earnings to improve about $5M q/q. They lose about $4M net earnings from the Awilco divestiture, but TGP is saving $5M in financing costs by removing that debt and also riding lower LIBOR levels.  

Small hit from the shorter quarter, with a $6M increase from the uptake of the final growth projects (2x Yamal, Bahrain Re-Gas).  

 

Source: Teekay LNG Partners, Q4-19 Earnings Presentation, Slide 17, markings added 

TGP Focus Question Review 

Bahrain FSU commissioned? The Bahrain FSU is TGP’s last major growth initiative and we know the full construction and connection is now complete. Will they be able to achieve full commercial acceptance prior to the quarter results in 26 February? Let’s hope so! 

Yes! Although the offtake isn't being fully utilized yet, TK is receiving full commercial payments on their 30% stake in the Re-Gas facility and they have been receiving full FSU payments for over a year. All growth is now complete. 

LPG rates (MGC) still moving up? Multigas divestiture yet? TGP’s LPG exposure was a heavy net negative for several years, but we started to see this shift positive in mid-2019 and there were a handful 

 

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of charters at the Exmar JV which were up for renewal in late-2019. Management considers the Exmar JV to be a core asset, but they are looking to divest their multigas ships. Have they lined up a deal yet? 

TGP reported a $1.74M partnership profit on the LPG business versus a $1.03M profit in Q3-19 and a $3.3M loss in Q4-18. This is slowly improving, but not enough to heavily move the needle yet. EBITDA was $10.1M versus $9.86M last quarter and $6.9M last year. Very slight uptick. Unfortunately there was no real discussion on the call, nor mention in the presentation. 

Awilco full cash available? Use of proceeds? The Awilco deal has reportedly been completed, which reduces TGP’s debt by about $160M and adds around $100M of free cash to the balance sheet. What is their primary use of proceeds? 

TGP is just hoarding cash for now, but I do expect them to fully repay the NOK bond in May given current market conditions. They also have room to further increase the repurchase program.  

NOK bond refinanced? Plan to pay down? TGP has a $115M NOK bond due in May. What is their plan with this? They easily have the cash to just repay the bond, but perhaps they will try to roll a small portion for flexibility? 

Management kept their options open here, but I believe it makes sense to just repay the entire thing given their huge cash balance and the weak overall market sentiment.  

Any repurchases? TGP was locked out of repurchasing during the COSCO-related crash last fall and then they suggested/signaled that their “opportunistic” repurchase range was in the $13s. Have they been acting at all on the recent weakness or are they still in a quiet period? If they haven’t bought any units yet and shares remain in this current range, I expect they will begin repurchases following their results. 

Although this is not as much as I would ideally want to see, they clearly recognize value and are acting consistently to repurchase, especially when shares are in these weak ranges. TGP repurchased nearly 600K units, all of them in early-2020 as confirmed on the call: 

 

Fair Value Estimates: TGP Reiterated at $20.00 

After reviewing the Q4-19 results, I am firmly reiterating my 'fair value estimate' for TGP at $20.00, which is roughly equivalent to their adjusted NAV and also 9x EV/EBITDA (69% implied upside). 

 

 

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Macro Focus: Product Tankers And Is It Time To Buy? 

 

Overview 

After about 20 years of participation I have gone from the reactionary trader, who would have been trying to make sense of daily soundbites and form a coherent thesis in times like this, to the serene investor that accepts what they do not know and instead allows for a sort of fill in the blank scenario as reliable data becomes public. 

This patience and acceptance of the unknown, ironically enough, grants a great deal of clarity. While we do not know some things at this point, we can be certain of others. With that certainty comes actionable knowledge. 

Since the serious onset of the Coronavirus I have made no secret about my aversion to this market in the short run. But as almost two months have passed since the initial outbreak the disconnects are becoming glaring obvious, to the point of where even I (a conservative investor by shipping's standards) am taking notice. 

One of these disconnects is in the product tanker market where rates for MRs have held up exceptionally well yet stocks have plummeted. 

Product Tanker Rates 

Before we get to rates let's get a brief reminder of the bloodbath we have seen since the start of the year in the product tanker segment. 

 

 

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With 30% to 50% losses among companies associated with or exclusively engaged in the product tanker trade one would naturally think that rates had fallen off a cliff as well. 

 

Source: VesselsValue 

However, MR rates have recently bounced back during what would normally be a declining market heading into the seasonal low. They are at their third highest point since 2016 and over double what they were this time last year. 

Furthermore, we only saw rates nearing this level at the start of 2016 for a brief time as peak season was ending and the bullishly memorable 2015 came to a close. They never appeared in 2017 and only reached those levels in 2018 during peak season. 

Finally, as expected, 2019 didn't disappoint as rates held in solid territory for much longer compared to 2018, by approximately 6 weeks. 

Yes, it's very fair to point out that LR rates haven't fared quite so well. Many suggest it's because their crude tanker counterparts took a beating and there may be some truth to that, but a better answer is found when digging a bit deeper. 

First, let's start with a bold claim that the LR2 structural balance isn't really as far out of alignment as rates might lead you to believe. 

January 2020 cargo miles traveled for the LR2 class (98.42 bn DWT NM) appear about even compared to January 2019 (98.10 bn DWT NM). 

 

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February of 2020, which saw the massive impact from the Coronavirus, only saw a less than 5% drop in cargo miles traveled (84.63 bn DWT NM) compared to February of 2019 (88.70 bn DWT NM), for the LR2 class. 

Consider the exposure this specific class has to East Asia, or better yet look at the top three regional routes for LR2s over the past year pictured below. 

 

Source: VesselsValue 

In this context we can see why the drop in rates may have been so pronounced. 

LR2's present attractive economies of scale for long hauls like those from the MEG to Asia, where port infrastructure in both areas can support these large vessels as well as the supply/demand. 

However, MRs will continue to have an advantage over LR2s in South America, the US and West Africa as many ports in these areas have restrictions based on the vessels’ DWT, draft, length, or width. 

Therefore, these smaller vessels did much better than their larger counterparts in terms of the Coronavirus impact as their diverse trade routes relied less on impacted areas or the actual epicenter, whereas the LR2s were concentrated in the most affected areas. 

LR rates will begin to bounce back as these trade routes are reestablished. Possibly much sooner than later due to the inelastic nature of refined products. 

Could Shipping Stocks Be Discounting A Much Worse Market? 

Transportation is a leading indicator, so goes the theory. For that to be true you need to look at data and not stock prices driven by sentiment. 

Over the past five years that I've been covering shipping I've done quite a few dives into how, if, and when shipping stock prices begin to show the impact of a shifting market. 

Sentiment has much to do with these moves as one might imagine, since shipping bear markets have been a recurring theme since the Great Recession. 

The popular belief is that the market is some sort of forward discounting mechanism and in many ways it is when things are in a perfect state. But shipping is anything but perfect. 

 

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In short, I've found that bear market reactions are much stronger and more swift as traders do not wait for bad news to manifest on the balance sheets or, as seen in this case, in the form of operating revenue (charter rates). They sell first and ask questions later. 

However, when it comes to bullish shifts there is an equally strong reluctance or adversity to believe the forecasts. In February of 2016, when dry bulk found a bottom amid a historic downturn, there was no forward action in the stock market until dry bulk rates began moving up and the structural market balance improved. 

For more on that you can turn to this July 1, 2017 report: Can Dry Bulk Stocks Offer Insight To Time A Tanker Market Recovery? 

There you will find an analysis of vessel prices, stock prices, and market rates during this recovery and how they each unfolded during that recovery phase. Part of my conclusion read: "the market didn't predict a recovery well ahead of time and rates provided the catalyst for a turn in stock prices. Stock prices responded to the rate bottom in a matter of days while asset values lagged behind by a couple months." 

It's also noteworthy that crude tankers were in a bear market at this time and this analysis was a piece of the puzzle which again asserted a correct recovery timeline. I noted, "The conclusion of refinery maintenance in the spring of 2018 therefore provides the first somewhat promising macro backdrop for the beginning of a corrective phase. While that may be the first potential turnaround point, it is probably quite a bit early. A more likely date may come as the summer concludes." Of course, we now know that October of 2018 presented the turnaround point where tanker rates emerged from the doldrums into profitability. 

Getting back on track here - The point is that even following the biggest bloodbath in dry bulk history the market still observed fundamental developments, though it wasn't anticipating them. 

Currently, we have a market that isn't even observing fundamentals. 

For example: 

 

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Notice that while MR rates are going one way Ardmore Shipping, a heavily intensive small product carrier, is seeing their fortunes go the opposite. 

Given the historic lack of long term forward visibility in shipping stock prices, which tend to track more of a reactionary sentiment, it is not a bold statement to say "this market is disconnected." It is not permanently broken, but it is now being governed by sentiment, trading, algos, trends, technicals, etc. 

 

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No, shipping stocks are not pricing in Armageddon, they are simply a victim of being a very easy short trade target. 

Refined Products 

Two things are worth reviewing at this point. One, the inelasticity of refined products. Two, the nature of the supply chain with regard to timing. 

Refined products and crude are relatively inelastic during traditional economic activity. Meaning there is little room to curb use of these products. 

Extreme economic shocks have played a role in past episodes of demand destruction, whether it be from recessions, crude price spikes, or in this case a black swan viral outbreak. However, normal patterns always return, or at least have until this point in history. 

Therefore, as this outbreak runs its course we will see a return to trade normalization and fundamentals. This isn't a bold claim when talking about the medium to long run, however, the short run is a bit dicey as it is highly dependent on when containment is achieved. 

Trade normalization will take a bit of time to return and this is because of the timing involved in the supply chain. 

Let's start at the beginning, when cargoes were being shipped, both refined products for end use and crude feedstock. Those cargoes at sea were greeted with news of an outbreak in China which had a nearly instant impact on demand. Refined product demand fell and a glut began building up in the supply chain. Product which was set for end use was instead stored and that action worked its way all the way back through the refineries, tankers, and finally crude producers. 

Now, consider the fact that the results of this demand destruction became apparent almost immediately throughout the entire supply chain. A supply chain that can extend several months out due to the nature of crude purchasing, loading, shipping, unloading, refining, distributing, and then using the end product. Even a supply chain that only involves the refined product transportation from one region to another could mean weeks. 

Many economists are predicting a somewhat "V" shaped recovery and I am in that camp until we see far more worrisome statistics regarding the outbreak. 

What this would mean is that once a meaningful return to normalization begins crude tanker rates should begin to move followed by product tankers. 

But the potential now exists short term crude and refined product demand to outstrip current market trading capabilities and eat into stockpiles due to the lengthy nature of the supply chain, especially in China. 

 

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As cargoes are quickly sourced to remedy this, the potential for a snap back rally in rates becomes present. 

This could make for an interesting Q2 as refineries that would normally be under maintenance may be pressed to up utilization to make up for lost time and also take advantage of possibly more attractive margins. That's a wildcard here. Will refiners undergo maintenance as normal? Or will they defer some till the end of the summer or perhaps next year? 

Fundamentals 

There is no question that fundamentals will return to eventually govern price action in the market again, the question is when? That I don't have an answer for, but I can provide a bit of a guide as to what we can expect once we do see a return to normal. 

Since the start of Autumn in 2018 we have seen a steadily improving market. Slowing vessel deliveries and growing cargo mile demand resulted in a tighter market and the forecast, up till the outbreak, was for that to continue through 2020 and into 2021. 

Nothing major has changed. 

The product tanker orderbook still looks favorable and the projected cargo miles traveled for this segment won't suffer nearly as much stock price drops might have you believe. 

Supply, Slippage, and Demos 

First, let's take an updated look at the product tanker orderbook. 

 

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Source: Data Courtesy of VesselsValue - Chart by Value Investor's Edge 

While the MR2 delivery schedule is a bit thicker than I would like, absorbing 2020's deliveries should be no problem. 

But here's a catch. All those vessels likely won't be delivered. Clarksons has recently reported that all major shipbuilding regions had experienced delays or outright closures. One shipyard indicated delays up to six months. Remember, the supply chain for these vessels runs deep in Asia meaning slowdowns in China could be impacting Japanese and Korean shipbuilding to a degree. 

In fact, 106 of those MR2 newbuilds are under construction in Japan, S. Korea, and China which significantly increases the chances of slippage for these vessels. 

 

 

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Source: VesselsValue 

Therefore, it's quite likely that many of those remaining MR2s set for 2020 delivery will be delayed. 

Additionally, let's take a quick look at the LR2s while we are at it. 

 

Source: VesselsValue 

Finally, let's just acknowledge that for product tankers any orderbook under 10% is attractive. LR2s are at 9.6%, LR1s come in at 0.5% and MR2s are looking at an 8.2% orderbook. 

The orderbooks are already fairly bullish, but the potential for delayed deliveries and therefore lower than expected gross fleet growth improves near term prospects. 

Gross fleet growth measures the number of vessels entering the market while net fleet growth measures the number entering minus those being retired (demolitions). 

The dynamic between net fleet growth and cargo mile growth make up the supply/demand equation with price being that of charter rates. 

As many might expect there is an inverse correlation between rates and demolition activity. If rates are low, or loss making, owners will part with a vintage vessel without a second thought, sometimes even earlier than expected if a prolonged bear market is in the forecast. Conversely, if rates are good owners will endeavor to keep as much tonnage on the water to capitalize on this cyclical window of opportunity. 

Demolitions are largely dictated by the current market and short term forecasts. 

 

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Before we get to this let's recap a section from the January Product Tanker Outlook for 2020: 

The MR2 fleet is poised for 5.2% gross fleet growth in 2020, but I am skeptical on this one. 91 vessels are 

expected, but I went through the current orderbook and found far too many aggressive timelines. Yes, a 

MR2 can be built in 12 months but that isn't typical. Nor are the 14-16 month timelines I see on these 

completion dates for a great number of vessels throughout the year. 

Looking at the completion times for dozens of recent vessels we find outliers, like a single 12 month 

completion or several 4.5+ year build times, but it's safe to say 16-24 months appears to be a good 

average bet. 

Therefore, it seems reasonable that deliveries this year will likely number in the high 60's to low 70's, 

which would be very manageable for the market. 

Gross fleet growth for the MR2 class has already been revised down since that point to 4.9%. However, that number will most certainly never materialize due to the reasons listed above but also because of Coronavirus linked shipyard delays due to labor shortages and supply chain snafus which will likely result in greater than previously projected slippage. Therefore, gross fleet growth for the MR2 segment will likely reach about 3.4% or perhaps even lower. 

The LR2 class is set for 3.9% gross fleet growth, but will likely be closer to 2.6% due to organic slippage combined with those shipyard delays. 

If those gross vessel addition numbers for MR2s and LR2s come to fruition (taking into account the very low number of LR1s being added) and total cargo mile demand growth for 2020 comes in upwards of 2.8% we are looking at a tighter market without any demolitions. 

But we have already seen two LR2s and two MR2s sent to the beaches in 2020, all in the 20-25 year old age range. Furthermore, there are significant scrapping candidates in both classes. 

 

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Source: VesselsValue 

Of these LR2 vessels, 6 in the 20-25 year old age range have special surveys coming up before the end of the year as well as a single vessel in the 15-20 year old range. None of them have the required BWT systems or are scrubber equipped. 

For the MR2 segment we see a decent number of candidates in the 20-25 year old age range. 

 

Source: VesselsValue 

Those with special surveys due are shown below. 

 

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Source: VesselsValue 

Out of those over ten years old and due for a special survey, only four vessels in the 10-15 year old range have the BWT. Of course, due to their smaller size and age none are scrubber equipped. 

The point is there are candidates and reasons to scrap. With some generous demolition activity we could actually see net fleet growth come in a full percent under gross fleet growth. 

Cargo Miles 

But will cargo miles keep pace with vessel growth? 

YTD as of March 3, we are only 0.69% below where we were this time last year in terms of cargo miles traveled. 

 

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Source: VesselsValue MR2 Projections as of March 3, 2020 

VesselsValue has projected that this quarter will see a slight gain in cargo miles traveled over Q1 of 2019. Yes, a slight gain! Honestly, I would have settled for a 2-3% drop over last quarter. 

Those that follow Ardmore Shipping are familiar with the next chart which shows cargo mile growth over the past years for product tankers. 

 

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Source: Ardmore Shipping 

Notice, the 2008 and 2009 years. When every other major shipping segment was experiencing a contraction in either one or both of those years, product tankers continued to witness gains. 

Next, look at the jump from 2014 - 2019. This was brought on by two major developments. First, low crude prices which inspired stockpiling thereby increasing demand. Second, a growing dislocation between refineries and end users which increased cargo miles. 

Now consider the current crude price environment and the fact that China is seeing a massive jump in refinery capacity which isn't required to fulfill domestic demand, therefore, products will be exported. 

The economies of scale for these modern mega refineries will inevitably eat away at other neighboring nations' domestic producers market share. This will lead to a growing trade in products which would benefit MRs the most in the SE Asia region. 

With China being heavily crude import dependent this dynamic bodes well for crude tankers, especially VLCCs, as well. 

Finally, Ardmore issued this report on February 11, the height of Coronavirus panic. Notice the 2020 forecast calling for 4.8% cargo mile demand growth, which would outpace supply side growth further tightening the market and leading to higher charter rates. This was expected as IMO 2020 and Chinese refineries were all expected to be big stories. 

But how is that holding up? I modeled a few different scenarios and found between 0.5% and 0.8% deviation from projections could come as a result of the outbreak. A much smaller amount than I 

 

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would have thought so I spent quite a bit of time on this (more than I care to admit) but my findings remained consistent. 

What I did find is that MR loadings have remained fairly steady, MR rates (and recovering LR rates) are signaling a pretty tight market, cargo miles while they did take a brief hit are bouncing back, and the potential for stockpiling is as high as it's been since 2015. 

It's worth pointing out that the last four weeks have seen 282 combined loadings for LR2 vessels. This compares with 273 which took place in the last four weeks of 2019 and prior to the impact of the Coronavirus. This demand during what would typically be a slower than average time of year indicates a bit of a demand uptick from the push back effect - where cargoes were diverted but demand wasn't lost. 

Could that 4.8% actually come to fruition? It's going to be a tough chore and estimates like 3.5% - 4% cargo mile growth could be a bit more realistic at this point. But again, even that would outpace net fleet growth and lead to a tighter market. 

What If? 

Yes, be skeptical of any section that starts with that heading. 

But, what if the demand destruction we have seen will be mitigated or even negated by not only vessel slippage but the potential for increased demand through opportunistic or cautious stockpiling over the course of 2020? 

Right now we have experienced the brunt of demand destruction, however, the consequences of this outbreak with regard to slippage won't be felt until much later. 

The same can be said for any stockpiling effort which may come as a result of these low crude prices and products later on - courtesy of an aggressive V shaped restart of refineries which could keep prices down. 

It might not just be price sensitive opportunistic stockpiling that we see either. This latest situation has highlighted the delicate nature of global supply chains. Governments would be wise to prepare for situations that could disrupt the market for several months and right now many nations are not at that level. 

Therefore, the potential exists for market normalization to be met with slower than expected deliveries and possibly greater stockpiling. This would actually lead to greater than forecast market strength over the affected period of time. 

Newbuilds, S&P, Asset Prices 

 

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Think prospects are bad? Owners don't. In January and February of 2019 we saw a total of 11 orders placed for product tankers (MR2, LR1, LR2). But in 2020 over that same period we have seen 17 orders. This isn't a bad thing and the market can absolutely handle this level of action. 

In fact, it's a good sign for two reasons. First, continuing faith in forward prospects. Second, that during this whole situation, when the markets seem to be going crazy, these owners continued on with business as usual. 

However, going forward I would like to see owners place far more emphasis on second hand vessels. S&P activity for the MR2 class is lagging so far in 2020 compared to 2019. With rates rising we should begin to see greater interest in this market but also a corresponding move in asset prices. 

It's noteworthy that LR2s have seen a pickup in activity with 50% of 2019's total already being traded, which is being reflected in their asset prices as of late. 

Since the start of 2020 only the LR class and crude Aframaxes have seen an increase in value for vessels 8 years or younger. MRs join the party from year 9 onward with vintage 20 year plus vessels seeing the biggest percentage gains, though none exceeding 5%. 

On a side note, want to know where the biggest asset price gains have been since the start of the year? 15-20 year old Suezmaxes have seen upwards of 8%. 

The biggest disappointment has been the VLCCs which are down across the board due to the fact that they make up a vast majority (75%) of China's import capacity. However, they make for a solid comeback story as China restarts. In fact, 5-15 year old VLCCs are my top pick for the next six months. 

Conclusion 

This is a lot to digest, and I threw in a few wildcards, so let's just do a very easy summary. Of course, all of this assumes containment of the outbreak at this point, or only small recurrences. 

Stock prices are down as shipping made for a very easy China/Energy/Global exposure short trade. It was just too easy for traders to ignore. But as the trade fades and life across the globe returns to normal, so to will shipping stocks find their values reconnected to fundamentals. 

Fundamentals remain largely intact. Cargo mile demand destruction for product tankers did occur but not to a large degree and it certainly could have been much worse. Cargo loadings appear to be healthy, MR rates are strong and LR rates are recovering and likely to return to more than acceptable levels before mid year. 

The supply outlook just got a whole lot better as a high degree of likely slippage in the MR class was met with delays and outright shipyard work stoppages. 

 

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The supply/demand balance looks to favor a tighter market by the year's end as cargo mile demand growth should outpace net fleet growth. 

If a global recession does erupt history shows that refined product demand holds up well and downward demand revisions won't be too dramatic. 

Right now, the market is disconnected and for experienced traders only. 

IF you must enter, as I am feeling slightly compelled to do at this point, do not catch knives. Over time, try catching many of those little plastic swords that skewer fruit on adult beverages. Meaning trickle in. And if that doesn't work at least you have those beverages standing by. 

 

 

 

 

 

 

 

 

 

 

 

 

 

All information copyright by ShipBrief 2020 

www.shipbrief.com 

Note: This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. While ShipBrief believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on the available information and ShipBrief’s views as of the time of these statements. Readers should consult with appropriate tax and investment advisors as applicable before making any investment decisions. 

 

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