Sunday, February 15, 2015

Sizing up the Tankers - Supply and Demand in the Medium Term

Reminiscences of a Stock Blogger” is one these blogs I regularly mine for ideas. The writer “Lsigurd” has an amazing track record of picking cyclicals upturns. Because he traffics in some of the crappiest companies out there, he not only covers the fundamentals, but also tends to be very opportunistic and flexible. This is what I imagine Michael Burry in his days would do. Anyways, after reading LSigurd’s idea on tankers here, I did some research into the sector and ended up buying Teekay Tankers (TNK), Frontline Ltd (FRO), and Capital Product Partners (CPLP).

Of the three, TNK is my biggest position. And I added more after the strong earnings today. Unlike some of its peers where earnings are mostly eaten up by depreciation charges, TNK actually has a solid earning, not just cash flows. Taking into account new ships and higher rates, Teekay can get ~$1 of EPS in 2015 and cash flows (before capex) of ~$1.5/ share. Those cash flows give TNK the option to pay a higher dividend and be valued on that basis. The stock is trading at $6.1/share. Put a modest 8-10x multiple on cash flows and I see 100%+ upside.

The Industry

Beyond TNK and consider the tankers industry as a whole, these are just about the most leveraged companies you can find. You got a cyclical industry, high fixed cost/operating leverage, and on top of that high financial leverage. Clearly, I want to make sure the industry is on the upswing. For that I tried to separate out short term vs. longer term factors, and then define my investment time frame – Is this a trade or an investment? Can I take a 2-3 year view? Or is this quarter to quarter?

The media tend to focus on the shorter term positives: lower bunker costs, China accelerate their ramping up of strategic crude oil reserves, and the “contango trade” – the use of tankers as storage, which limits the supply of ships and increase prices. These are all great bonuses but not necessarily sustainable beyond a couple quarters.

Intermediate/Longer Term dynamics – How Far to Look Out?

What’s more interesting to me are the intermediate/longer term supply and demand dynamics. On the supply side, these companies just went through years of depressed economics and capacity rationalization. For the next year or 2, fleet growth now look well under control at low single digits or even negative. I would not project earnings out more than 2 years, and even that might be a stretch. The industry is not known for supply constraints and firms can convert their other ships to tankers.

On the demand side, increases look to be structural:

1. Vast demand. China consumes roughly 11.1mm barrels per day (mmbd) of crude oil, and but produces only about 4.6mmbd. The rest have to be plugged by imports. Put this in context, the U.S. consumes ~19mmbd, with 1/4 the population. China’s crude oil demands have a long way to go.

2. Longer trade routes. Crude oil from Middle East and Africa are increasingly going to east Asia instead of say United State. The longer routes mean higher utilizations for tanker fleets. This is not just because U.S. is increasingly energy self-sufficient. Refineries capacities too have increased dramatically in East Asia the past few years. In China you actually have over-capacity of refineries. Those trade routes should be there to stay.

For me, what limits the time frame on the demand side is the threat of competition from other types of infrastructure. For example, a China-Myanmar oil pipeline just opened recently. Under this scheme (see maps below), tankers would arrive at Maday Island in the Bay of Bengal; oil would then travel via a pipeline through Myanmar into China. This would cut short tanker routes from the middle east, which currently travels through the Straits of Malacca and then northward along the coast of China. Another potential source of competition is China getting more oil from Russia through pipelines. I’m sure there are many other examples, but the point is for tanker demand I wouldn’t look out more than a couple years, as these things change.

Current Middle East to East Asia route

An example of a threat for tankers - The new Myanmar-China pipeline could cut that trip shorter


So yeah, from a fundamental perspective, I can only look at the tankers one year at a time. It’s simply not possible to get hold a long term, 5-10 year view on these things. This is why I hesitate to put more than an 8-10x multiple on cash flows. Also, given my lack of experience in this area - there will be days when stocks are down 5%, 7% without any news, and I will have to respect the market and cut my losses when necessary, and add on the upswing – a bit of a momo play. Definitely a trade, not an investment. Tankers are currently 6.5-7% of my portfolio.

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