Oil Tanker Stocks and Contango

by | May 7, 2020 | General | 0 comments

Kuppy just wrote a post updating people on his gas play while talking a bit about the oil tankers. Here is the link to his post.

https://adventuresincapitalism.com/2020/05/07/takin-my-foot-off-the-gas/

He made some good points such as

“Most of these tankers trade at historically high discounts to NAV at a time when they have record earnings. I remain convinced that charter rates stay unusually elevated for a very long time due to storage demand. The contango will fluctuate wildly, charter rates will swing around. Please stop emailing me about what to do. I’m not your personal financial advisor. The oil glut keeps building and it needs to go somewhere. The contango is just a way to measure the price of storage at a moment in time. Stop asking what I’m doing with my portfolio. Unless you’re an investor in my fund, it’s none of your business. Stop freaking out when rates jump around. VLCCs mainly transport OPEC oil. Do you think the cartel focused on fixing the price of oil ignores the cost to transport it? They play games. They withhold cargoes. The members of OPEC may hate each other, but they hate high charter rates more.”

I wanted to add my two cents to that. Let’s bring back to the basics.

What is an oil tanker?

Dirty oil tanker is a ship that transports crude oil from the producer to a refiner. Product tanker is a ship that transports the refined product (ex. gasoline) from the refinery to the customer. For this illustration, let’s just talk about the dirty oil tankers.

You have production of oil on one side and you have tanker fleet on the other side. If there is more production, then there is more demand for transportation. If there is less production, there is less demand for transportation. I know that the demand and supply equation is more complicated than this but let’s just stick with this.

Over the last several decades, the production of oil increased almost every single year. This is because the demand for oil was increasing.

If the vessel fleet grew at the same rate as the oil production as shown in the following illustration, than the vessel rates would be stable.

Of course, we don’t live in such fantasyland. The reason why there was a supercycle from 2003 to 2008 was because oil production grew faster than the vessel fleet.

China happened during that time and single-hull vessels were phased out creating a shortage of double-hull vessels. The reason for why the vessel fleet grew slower than the oil production was not that important. What was important is that it happeneded and this allowed the oil tanker companies to earn adequate rates to reward shareholders handsomely.

Because the oil tanker companies were making so much money during 2003-2008 period, they ordered a lot of ships. As a result, the fleet grew much faster than oil production from 2009 to 2018.

This caused an oversupply of vessels. Consequently, the vessel rates were depressed causing investors to lose a lot of money.

After 10 years of oversupply, the situation changed in 2019 and the vessel rates started to improve because the order book was very low, financing for new vessel dried up, more and more of them got getting scrapped, and IMO 2020 was approaching.

The new supercycle was starting. Some investors realized that this was coming.

In other words, the growth of vessel fleet was going to be slower than the oil production. Then, when Coronavirus hit, things got complicated.

For the first time, demand for oil production collapsed and oil production cuts were about to follow. This is what investors had in mind.

As you can see, this picture is scary. No wonder the oil tanker stock collapsed at the beginning of the year. This is because of the fear of what could happen to vessel rates.

However, what really happened was this.   

The production of oil did not go down while the vessel fleet went down because some vessels got tied up in storage. As a result, the rates on VLCCs went from $20k per day to $300k per day.

Now, the rates are coming down because production might be decreasing faster than vessel fleet. Vessel fleet is still decreasing due to storage but maybe not as fast as the production drops.

Right now everybody is freaked out that when the peak inventory happens, the vessel fleet is going to start increasing at a faster rate (due to storage release) than the production.

So as you can see, this whole situation is about balance. During normal times, the demand for vessels comes from transportation. Right now, it comes from transportation and storage. As people are going back to driving, the transportation demand is increasing while storage demand will decrease. However, at this point, the storage demand is still increasing even though contango is smaller.

People are looking at contango, and are freaking out thinking that demand for storage is going away. It is not, at least not yet. Contango is just the cost of storage.

Let’s say contango a 6-month contango is $20. This means that the trader can afford to pay about $200k for storage.

$20 x 2 million barrels for VLCC = $40 million

$40 million is the arbitrage that the trader can generate. However, he doesn’t get to keep the entire thing because he has to pay, let’s say, $36 million to the ship owner. So he nets $4 million risk free.

Now, let’s say that a 6-month contango is only $5. Does this mean that the trader will not put a vessel in storage? Of course not. He will put it in storage because free money is free money. It doesn’t matter the amount.

$5  x 2 million barrels for VLCC = $10 million

If $9 million goes to the tanker owner, the trader gets to keep $1 million risk free.

The contango does not matter that much. What matters is that there is contango. As long as there is one, more and more ships will be put away decreasing the vessel supply for transportation. This should support vessel rates at reasonable levels until the oil production increases kick in.

As the owner of oil tanker stocks, you should probably care more about what the rates are for transporting oil than storing oil because most likely your fleet is younger instead of older. It is the older vessels that are used for storage.

So going forward, demand for oil will increase. Eventually, it will likely reach 100 million barrels per day. In the meantime, we don’t know how fast the vessel fleet will increase due to storage release. The slower the storage release, the better for rates. At the end of the day, we want to return to normal which is this. This is what started in 2019. This was the beginning of the next supercycle. The oil production was growing faster than the fleet.

Here is also another good article that just came out

https://www.freightwaves.com/news/floating-storage-is-far-from-dead-in-the-water

https://classicvalueinvestors.com/2020/05/07/how-to-value-a-stock-new-book/

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About Mariusz Skonieczny

Mariusz Skonieczny is the founder of Classic Value Investors.