Tanker stocks weekly analysis introduction

Introduction: Recap
During the first half of the week from August 5 to 9, concerns over China’s poor industrial activity as well as the Fed’s announcement that tapering will begin soon kept oil prices and the share prices of tanker companies weak. But positive industrial output growth and retail data in China for the month of July supported tanker stocks by the end of the week. As a result, tanker stocks ended the week mostly unchanged from the prior week.
Weekly key indicators
While tanker stocks have performed well since July on the back of higher tanker rates—driven by higher oil prices, lower supply growth, and brightened worldwide economic outlook—questions remain over whether the recent climb will continue over the next few years. At the end of last week, we saw some interesting developments within the tanker industry. Nordic American Tankers Ltd. (NAT), which reported its earnings on August 12, was quite optimistic about the third quarter prospects of the tanker industry. Yet Jefferies downgraded the company to underperform from a hold on Tuesday, August 13, claiming that the premium is unsustainable “once the surge in Suezmax spot charter rates inevitably subsides.” So who might be right?
In addition to the key indicators we follow on a regular basis that are showing interesting developments, we’ll also explore seasonality, the EIA’s (Energy Information Administration’s) future world oil production outlook, and China’s oil imports.
Ship orders fall and activity remains weak
The significance of ship orders
One measure that reflects managers’ assessment of future supply and demand differences is the number of ships on order. When managers expect future demand to increase more than supply, if they also expect to generate profits with the investment, they often place new ship orders. But when managers expect excess capacity to continue or grow, they refrain from placing more orders—sometimes even delaying them for a price. So the number of ships on order rising is a positive sign that shipping rates will likely rise in the future. Since tankers generally take more than two years to construct (sometimes up to five years), the metric is often more relevant to long-term investment horizons.
August 9 update
For the week ending August 9, the number of crude tankers on order as a percentage of existing ships slipped to 6.34% from 6.46% the week before, as published by IHS Global Limited last Friday.1 Orderbook as a percentage of existing capacity in deadweight tonnage, on the other hand, rose from 9.74% to 9.82% over the same period.
Ship orders turn around
Since the beginning of the year, we saw managers returning to the shipyard to sign contracts for new ships to be constructed. As a result, we saw a turnaround (or possible turnaround) in the number of ships on order and the orderbook. This was encouraging, as it reflects managers’ optimism regarding the long-term outlook of the tanker industry.
Key question raised
But the weak turnaround in orders shows that fundamentals aren’t as strong as managers thought, with many uncertainties remaining. Plus, the weakness in the data raises some key questions about who’s buying these assets. Are orders coming from a few major companies, such as Scorpio Tankers Inc. (STNG), which has been aggressively placing new orders for fuel-efficient ships, or is it an industry-wide trend? Perhaps there are only a handful of companies driving up orders and an industry-wide recovery isn’t there yet.
Activity remains weak
Tanker companies are quick in their earnings presentations to mention that orderbooks are at a record low compared to a few years ago. While that is great because it reduces future supply growth and will provide some great long-term investment opportunities for investors, tanker companies’ order activity reflects either uncertainty or the expectation that supply and demand won’t tighten much in the near future.
This bodes negative for tanker companies such as Scorpio Tankers Inc. (STNG), Nordic American Tanker Ltd. (NAT), Ship Finance International Ltd. (SFL), and Tsakos Energy Navigation Ltd. (TNP), as well as the Guggenheim Shipping ETF (SEA) in the short to medium term.
1.    Analysts often common-size order figures as a percentage of existing capacity or existing ships to factor in growth of ships over time.
Ship construction activity rises, caution ahead for investors
Crude tanker construction activity
The second indicator that investors look at is construction activity. This provides additional data, on top of crude tankers on order, about when managers want to receive ship deliveries so that they can generate maximum profits. If managers expect supply and demand differences and shipping rate increases farther into the future, they’ll ask to receive the ship deliveries later. This will lower construction activity in the near term. So when construction activity isn’t rising, investors can expect shipping rates to remain at current or lower levels in the short to medium term, which is negative for shipping companies in a depressed market. On the other hand, lower construction levels will translate to lower capacity growth in the future.
August 9 update
The divergence we saw last week, August 5 to 9, in the number of ships on order and on “orderbook” (see Part 2) reflects an increase in construction activity. The number of crude tankers under construction rose from a record low of 35 last week to 36, while the number of ships on order fell from 149 to 146. This means ship construction firms have begun to work on more vessels than the number of ships delivered.
Positive and negative
On one side, this is positive because it shows the possibility of tightening supply and demand fundamentals, because managers try to estimate when rates will recover so that they don’t receive ships earlier than wanted. A leveling-off of construction activity, which managers seem to be aiming for, will show that the worst capacity increase we’ve seen over the past few years is history.
However, if the increase in construction activity leads to higher supply growth that eventually outpaces demand growth, it bodes negative for shipping rates. While rising construction activity isn’t necessarily negative, the weakness in orders (as we saw in Part 2) is a bit worrisome.
Caution ahead
So unless we see shipping rates rise out of normal over the next few months, the recent increase in construction activity could pressure supply in the medium term, and could negatively hit earnings and share prices for tanker firms such as Teekay Tankers Ltd. (TNK), Nordic American Tanker Ltd. (NAT), Ship Finance International Ltd. (SFL), Tsakos Energy Navigation Ltd. (TNP), and Scorpio Tankers Inc. (STNG) over the medium term. This will also affect the Guggenheim Shipping ETF (SEA), which invests in large tanker firms that tend to have healthier financials.
Capacity growth continues to fall, higher supply growth to come
The importance of capacity
Capacity, in a commoditized industry like shipping, is an important metric that directly impacts companies’ top line, or revenue performance. When capacity grows faster than demand, competition will rise among individual shipping firms as they try to use idle ships and cover fixed costs. This will lower day rates, which will negatively affect bottom-line earnings, free cash flows, and share prices for tanker companies.
August 9 update
For the week ending August 9, tanker capacity measured in deadweight (the weight that a ship can safely carry across the ocean) grew 3.76% year-over-year based on data provided by IHS Global Limited. This is the lowest increase the industry has seen in at least five years.
Capacity growth hit as high as 11% and 8% in 2009 and 2011, as managers got too caught up with an increased flow of business before the financial crisis and over-ordered new ships. It has fallen since managers realized business wasn’t going to grow as fast as expected, which led to declines in new orders and a subsequent top in supply growth.
While ship orders (see Part 2 and Part 3) reflect managers’ expectations of future demand and supply, investors also look at capacity growth to get a sense of how fast current supply is growing and whether demand will meet it, instead of simply relying on managers, who can get caught up in the day-to-day operation without seeing the bigger picture.
Weekly growth rate
On a week-to-week basis, capacity fell by 0.19%. A larger number of ships being scrapped, relative to new ship deliveries, is the likely reason for this decline. Lower supply growth has been positive for shipping rates because it reduces competition and pricing pressure. But the key question here is will the weekly capacity growth rise back up towards 0.05%+? It looks like it will, with RS Platou showing 41% of total deliveries for 2013 still remaining in its latest July report.
Interpretation
So unless we see companies aggressively scrapping new ships or companies delay receiving new ships, we’ll likely see higher week-over-week supply growth until the end of the year. This could negatively impact the share prices and earnings of tanker firms such as Tsakos Energy Navigation Ltd. (TNP), Ship Finance International Ltd. (SFL), Nordic American Tankers Ltd. (NAT), and Teekay Tankers Ltd. (TNK) this year. While the year-over-year growth rate could fall further, because it appears a large amount of new ships were being delivered during the second half of 2012 based on the week-to-week growth rate chart above, it could still remain higher compared to demand growth. This would also negatively affect the Guggenheim Shipping ETF (SEA), which has performed better because several holdings are listed in Japan and Europe.
Why oil demand seasonality affects tanker stocks
The significance of global oil demand
Because oil shipments depend on the world’s economy and oil consumption, global oil demand has an impact on tanker business. When oil demand picks up, tanker companies benefit, as countries in the Americas, Europe, and Asia ask for more oil. However, when oil demand falls, it will negatively impact the oil shipping business by bringing shipping rates down.
Higher oil demand ahead
According to the EIA (Energy Information Agency), oil consumption is expected to increase to 90.5 million barrels per day in the third quarter and 90.8 million in the fourth quarter, up from 89.5 million in the second quarter. Improvements in the global economy, from Europe to Asia to the United States, are the first reason for the 1.0% to 1.3% higher oil demand. The second reason is seasonality. As we approach the cold winter once more, people will start using heating oil to keep buildings warm. As a result, oil demand picks up. Although seasonality has fallen because people now also use cars to travel during the summer, it still is significant.
Seasonality in the Baltic Dirty Tanker Index
This also reflects in the Baltic Dirty Tanker Index, which depicts the price of shipping oil across the ocean in the spot market. Based on the past four years of data, tanker rates have historically shown a tendency to increase from September to January, while other months tend to be weak.
Historical share price performance
Interestingly enough, tanker companies have historically performed badly during the third quarter and for most of the fourth quarter—despite increases in oil demand during the third and fourth quarters (see the first chart above). While possible explanations are numerous, including summer market sell-offs and negative market sentiment, the maturity of time charter contracts are the likely reason for this pattern. Although time charter contracts can support companies to earn higher rates when the market rates for shipping oil fall, revenue will fall when these valuable contracts mature.
So, while the 1.0% to 1.2% increase in oil demand due to seasonality is positive for tanker stocks such as Tsakos Energy Navigation Ltd. (TNP), Teekay Tankers Ltd. (TNK), Frontline Ltd. (FRO), and Nordic American Tanker Ltd. (NAT)—as several companies have noted in their second quarter earnings presentations—it’s questionable whether oil demand will be the catalyst for higher share prices throughout the rest of 2013.
Why China’s oil imports drive global tanker stocks
China replaces the United States in oil shipments
There are two key driving forces of oil shipment demand today, which has been a trend for the past five years: an increase in growth in China, countered by a decrease in oil shipments to the United States. In 2010, the largest importers of oil in the world were the United States, China, Japan, and India. The United States imported 459 million metric tonnes of oil (21% of total), while China, the second largest, imported 239 million (11% of total), according to data from the U.S. EIA (Energy Information Administration). Driven by economic growth and car use, China imported a record amount of 271 million metric tonnes of oil in 2012. But over the same period, the United States reduced its import to 423 million metric tonnes due to a domestic energy boom (explained in Part 7).
Negative year-over-year growth
Although we’ve seen higher oil consumption from 2012, (see Part 5), a recent monthly report by RS Platou (an international ship and offshore brokers and investment bank) shows that global shipments of oil fell 3.0% year-over-year during the first five months, which was worse than the -2.6% seen for the first four months. Weak import growth from China, due to last year’s stockpiling activity, and continued production growth in the United States were the main causes for the negative year-over-year figure. That has negatively impacted tanker companies earlier this year.
China’s oil import to rise
On an annual basis, China’s 2013 oil imports are unlikely to grow much from last year, because China continued to import more oil even while consumption growth fell due to lower economic growth in 2012. However, oil imports could rise further throughout the second half of this year, as the country’s currently importing less its long-term trend line. Higher industrial output, driven by better outlook in Europe (China’s largest trading partner) and the government’s determination to maintain stable growth throughout the end of the year and meet its target of 7.5% economic growth adds to the probability of its oil imports rising.
If this were the case, it would positively impact tanker rates in the short to medium term. This would then be positive for tanker companies such as Teekay Tankers Ltd. (TNK), Tsakos Energy Navigation Ltd. (TNP), Nordic American Tanker Ltd. (NAT), and Frontline Ltd. (FRO). The Guggenheim Shipping ETF (SEA) would benefit as well.
U.S. oil imports continue to fall due to U.S. energy boom
Energy boom in the United States
The United States has historically been the largest importer of oil. But since horizontal drilling and hydraulic fracturing technologies (which made it possible for energy companies to extract oil from areas where oil extraction was initially considered impossible and uneconomical) started to take off after successful trials, the United States has begun its journey of becoming an energy-independent country. The EIA estimates that the country will become the largest producer of crude oil within the next few years, knocking countries such as Russia and Saudi Arabia off the top chart.
Higher production, fewer imports
While the U.S. energy boom drew millions of dollars, made a few people rich, and helped reduce the country’s trade deficit, it destroyed tanker companies. Originally expecting global oil shipments to grow briskly—like they did before the financial crisis—tanker companies saw a new reality: a decline in oil shipments to the United States. As production grew in the United States, U.S. oil refiners began to rely less on foreign oil. That meant less business for tanker firms that have historically relied heavily on the U.S. economy, which negatively affects shipping rates. U.S. crude oil imports, which stood at 10 million barrels per day, soon fell to just under 8 million barrels per day.
Trend remains intact
The latest data from the DOE (Department of Energy) showed a slight decline in U.S. oil production of 7.32 million barrels per day in May, down from 7.37 million in April, but the trend remains up. For this year, the U.S. Energy Information Administration expects oil production to average 7.3 million barrels per day. Since the first five months of production have averaged 7.2 million, with the lowest month at 7.03 million in January, production will likely hit towards 7.6 million by the end of the year to give us an average of 7.3 million barrels per day.
Import—which stood at 7.89 million barrels per day at the start of the year and fell to 7.74 million barrels per day in May—could fall further to 7.3 million barrels per day by the end of this year, assuming that U.S. oil demand holds constant. This means that the gain we expect to see out of China, of approximately ~0.4 million barrels per day (see Part 6) could all be wiped out.
Domestic production taking away supply
Although oil demand in the United States could increase with higher economic activity, higher domestic production will likely continue to displace oil imports. Oil consumption in the United States is no longer as high as it was before 2008 due to the use of more energy-efficient cars. As a result, even when we saw the broad stock market rise higher throughout the past three years, oil consumption hasn’t recovered. With more production coming online, U.S. production as a share of U.S. crude oil and liquid fuel consumption rose from 25% to 40%.
Oil production outlook mostly negative for tanker stocks
OPEC oil production
In Part 7, we saw that the possible gain in oil imports in China will likely be offset by a decline of similar weight from the United States throughout the end of this year. But the long-term crude oil trade doesn’t look encouraging either. To see why, let’s take some of the projections made by the U.S. EIA (Energy Information Agency) regarding OPEC’s oil production.1 Because the OPEC (Organization for Petroleum Exporting Countries) has historically supplied the majority of incremental oil demand, it’s considered a key indicator of tanker business. When OPEC production increases, more ships will haul oil to countries around the world. But when the collective countries’ output falls, so does demand for ships.
The United States: The largest production increase
Based on the EIA’s short-term energy outlook published in August 2013, the majority of future oil and liquid fuels production will arise from the United States, followed by Canada. In 2013, U.S. oil production and liquid fuels production will grow by 0.9 million barrels per day, which is higher than what we initially estimated in Part 7 of about 0.6 million barrels per day. Perhaps most of the production increase will come during the last quarter of this year. With China’s oil import only growing at 0.44 million barrels per day every year, China will have to become really hungry in order to soak up the falling U.S. appetite.
Non-OPEC production outpaces consumption
The possibility of other countries soaking up excess capacity due to falling U.S. imports is also close to zero. Until 2014, analysts expect non-OPEC oil production to exceed world consumption. That also means oil prices are unlikely to rise too much from the current price level. If there aren’t any supply disruptions, oil prices could be lower than now, which could hurt oil producers’ earnings.
OPEC production fall
To keep earnings steady, though, OPEC will likely cut production to keep the price of oil steady. In its latest public announcement of its decision to keep output stable in May, OPEC saw ~$100 as a good price level for oil and profitability. With the increase in production we expect to see from non-OPEC countries, OPEC’s surplus crude oil production capacity is projected to increase to 3 million barrels per day in 2013 and 4 million in 2014.
Impact on shipping companies
Lower OPEC output means fewer ships will be required to transport the raw material from the Middle East. The VLCCs (Very Large Crude Carriers)—which are the largest class of tankers used to mainly transport crude oil from Middle East and Africa to the rest of the world—will be most negatively affected by the development, followed by Suezmax ships that often ship oil on the same route. Frontline Ltd. (FRO), whose portfolio of ships holds the largest number of VLCCs, will be most negatively affected by the decline. While mid-size ships such as Suezmax and Aframax classes should fare better, they are nonetheless subject to a weak environment as well. So Tsakos Energy Navigation Ltd. (TNP), Teekay Tankers Ltd. (TNK), and Nordic American Tanker Ltd. (NAT) aren’t clear either. This uncertainty also applies to the Guggenheim Shipping ETF (SEA).
1.    The OPEC is an oil cartel whose mission is to ensure a steady income to the member states and to supply oil to customers. It includes major oil-producing nations in the Middle East and Africa.
Why shipping rates fell and will likely remain depressed
Shipping rates
The single most important indicator that affects tanker companies’ top line revenue is shipping rates. When supply grows faster than demand, it pressures shipping rates. But when supply growth can’t meet demand growth, shipping rates rise. Other factors that make tanker rates rise include the price of oil and labor.
Oil prices drag rates higher
One of these indicators that investors and analysts use to track the overall price of transporting crude oil across the ocean for a single voyage (the spot market) is the Baltic Dirty Tanker Index, published daily by the Baltic Exchange. Throughout July, the index rose from 580 to 624 on the back of higher oil prices—an increase of 7.59% since the beginning of July. Since then, tanker rates have pulled back slightly with oil.
Although oil prices are often a leading indicator of higher oil demand, part of the increase was due to unrest in Egypt, which means companies were passing on the higher fuel cost to customers. While this may result in higher revenues, it is unlikely to benefit earnings by much. Plus, companies may also be unable to take advantage of the recent rise in rates if they’ve already chartered their ships out, because a single voyage can take up to several weeks.
Rates will likely remain depressed
While better economic growth outlook and weaker capacity growth also helped push oil prices and shipping rates higher, it’s more likely than not that rates will come down again because of continuous growth in U.S. (non-OPEC) production and higher supply growth, as we’ve seen in earlier parts of this series. In a recent piece by Reuters, the billionaire shipping tycoon John Frederiksen said, “I do not see any special things before at least another couple of years. At least for the crude oil tankers.”
Tanker companies such as Tsakos Energy Navigation Ltd. (TNP), Teekay Tankers Ltd. (TNK), Nordic American Tanker Ltd. (NAT), Scorpio Tankers Ltd. (STNG), and Frontline Ltd. (FRO) may have to live with a depressed market—at least over the medium-term. This also applies to the Guggenheim Shipping ETF (SEA).
Why investors should track multiple tanker industry indicators
The importance of ship prices (vessel values)
The final indicator that investors use to assess the fundamental outlook of the tanker industry is ship prices and vessel values. When tanker rates are expected to rise or are rising, the value of ships themselves goes up. This can happen two ways. First, when new or incumbent companies expect earnings to increase or experience rising profits while ship prices have not, they will purchase ships in the secondary market to resell them at higher prices until they believe the market has priced them in. These firms may also charter ships out, expecting that they have acquired the assets at a cheaper price than what the true earnings of the ships are. Both cases will lead to higher ship prices.
Second, if the seller is expecting higher earnings soon (usually because of higher tanker rates), they will also be unwilling to sell ships at their current price and will only sell them at a higher price that they think is more than fair. Alternatively, if the sellers expect lower earnings, they will have to lower their ship prices. Otherwise, buyers won’t buy them. This works just like stocks traded in the market: when investors expect companies’ earnings to rise, share prices will rise—but when they don’t, share prices will fall.
Fifteen-year-old crude tankers
Prices for 15-year-old crude tankers as a whole have fallen since the peak of 2008. While there were slight improvements throughout 2010 and during the second half of 2012, due to higher imports out of China, they didn’t last long. June’s data, the latest available, was discouraging. Prices for 15-year old VLCCs (Very Large Crude Carriers) fell from $22 million dollars in May to $20 million. Suezmax, which held up better, stood unchanged at $11 million.
What’s important to note here is that ship prices aren’t a perfect reflection of when a recovery will take place, as they reflect the market’s perspective, and the market can be wrong and short-sighted. When tanker rates do recover, however, prices for ships should also turn around. But investors should look at a couple of indicators—not all indicators—to get a picture of the industry’s fundamentals from different angles in order to make better judgements.
New build prices
Perhaps a more reliable indicator is new build prices. In June, prices for new VLCC and Suezmax were unchanged from May at $90 million and $56 million, respectively. Because new builds take several years from the placement of orders to delivery (unlike 15-year-old ship vessels, which can sell right away in the market), prices for new builds often reflect the long-term outlook of the tanker industry. Yet the indicator is also not bulletproof since prices rose during mid 2010 amid higher oil imports from China and lower capacity growth.
As ship prices have yet turned around, they indicate that tanker rates will continue to remain depressed, which will be negative for tanker stocks such as Teekay Tankers Ltd. (TNK), Tsakos Energy Navigation Ltd. (TNP), Nordic American Tanker Ltd. (NAT), Frontline Ltd. (FRO), and Scorpio Tankers Inc. (STNG). They will also negatively affect the Guggenheim Shipping ETF (SEA).
Investors should track multiple useful indicators
But those who understood that there was still a large backlog of new ships that will continue to flood the industry by looking at ship orders (see Part 2 and Part 3) and U.S. production growth (see Part 7 and Part 8) would have known capacity growth would remain high. This also raises the need for investors to look at China’s economic growth outlook, because it can have a significant impact on tanker rates.
Source: Market Realist