Oil Tanker Overview
As we have covered in other articles: INSW, TNK, STNG. The global oil tanker market has interesting dynamics. The Russian Oil Cap imposed by European nations at $60 per barrel has absorbed much of the limited supply of oil tankers. The embargo and price cap have dramatically increased the miles traveled by the global oil tanker fleet and has also caused TCE rates to rise quickly. In addition to this underinvestment in new ships, new regulations and retirement of older ships has caused Oil Tanker Fleets to collect higher rates and higher valuations per ship. It is in this context that we begin our analysis and justification of why we list Frontline (NYSE:FRO) as a ‘Strong Buy’ with a price target of $23.
Frontline is one of the largest global operators of oil tankers in the world with one of the largest and most modern fleets it puts them in a strong position to benefit from the current landscape. Tanker fleets are incredibly capital intensive with millions being needed to purchase and operate these massive vehicles. FRO has heavy exposure to the largest of all oil classes, the Very Large Crude Carrier (VLCC). These ships can carry 2 million barrels of oil vs 750,000 for the smaller LR2s. VLCC’s have less flexibility in terms of which ports they can dock in relative to their smaller counter parts, but what they lack in flexibility they make up for in scale. The oil tanker market is a simple one to understand generally.
Revenue – Cost Of Financing Ships – Ship Operating Expenses = Profit.
These businesses are capital intensive and have valuations typically backed up by the price of their fleets on the secondary market and the scrap market. The key to profitability and capital return is rates of chartering to be above the cost of operating the vessels.
In the second quarter, Frontline’s revenue per day for their fleets were as follows: VLCC at $64,000, Suezmax at $61,700, and LR2/Aframax at $52,900. This indicates that the earnings relationship between their segments has returned to its usual pattern of VLCC generating the most income vs previous quarters where we have seen Suezmax and LR2 trade near VLCC rates. The company recorded its highest Q2 profit since 2008, reporting a profit of $230.7 million or $1.04 per share and declared a cash dividend of $.80 per share which is a non-adjusted payout ratio of 77%. Over the last four quarters, the company has consistently rewarded its shareholders with dividends, paying out a total of $2.72 per share or a dividend rate of ~14% at current prices.
This strong profitability seems to already be translating to the third quarter where Frontline already has a significant portion of their shipping days already booked: 74% of their VLCC days at $53,200 per day, 67% of their Suezmax days at $48,800 per day, and 57% of their LR2/Afra days at $40,500 per day.
Despite the presence of macroeconomic headwinds, their impact on Frontline’s sector was minimal. The company’s operating cost remained fairly stable, allowing all incremental income to go directly to the bottom line and subsequently, back to shareholders. In terms of operational changes, the company transitioned to International Financial Reporting Standards (IFRS), choosing to capitalize its drydocking costs to be depreciated over a period of 2.5 to 5 years. In Q2 ’23, the company capitalized dry docking costs of $1 million and dry docked one of its vessels. Additionally, the company revised the estimated useful life of its vessels from 25 years to 20 years, effective January 1, 2023. This strategic move has resulted in increasing the company’s earnings by approximately $60 million for the year. What these changes allow is faster depreciation of their capital expenses which in turn allows them to lower their tax bill and allow them to retain more earnings and return more to their investor.
State of the Fleet
The company completed its new building commitments with the delivery of its last two vessels, Front Orkla and Front Tyne, in January 2023 and currently does not have any new builds on order. With full shipyards and used ships trading at high valuations we believe avoiding new builds is beneficial for FRO and their investors. The company deems the financial commitment involved in ordering a new build ship as not viable, as it would require over $50,000 per day consistently for a 20-year period to justify the investment. They have a limited need to replace their ships as their oldest ships were built in 2009 and a vast majority of the fleet is built after 2016. With ships typically having a useful/profitable life of 20-25 years FRO is well positioned to capitalize from cyclical tailwinds since they will not have to make any large purchases to support the market until at the earliest 2036. This means that the high rates do not need to translate in to large capital purchases to support their revenue. This is a problem that many others in the Oil Tanker Market have, where they have to purchase ships at elevated rates to support their revenue and earnings. FRO has the flexibility to sit back and let their assets simply make more money.
From a financial standpoint, the company maintains strong liquidity, with $719 million in cash and cash equivalents as of June 30, 2023. The company’s leverage ratio is also healthy at 51%. This strong balance sheet in addition to minimal ship purchases for the foreseeable future shows that we can expect to have continued high payout ratios while the company can also effectively manage their finances.
So much of the oil tanker market is driven by global demand and events we believe that it is important to highlight some of the key points that management brought up in their latest earnings call.
The Asia Pacific region is driving volume, with an increase in demand by 1.8 million barrels per day, indicating a 5% increase in volume for shipping. China’s oil import numbers have reached an all-time high, a trend that is inconsistent with other macroeconomic indicators from the country. Historically, China has been observed to reduce imports by 1-2 million barrels per day, which could result in a notable decrease in demand. However, it remains uncertain whether China’s heightened imports are in preparation for stimulating their economy, exporting oil during the winter, simply stockpiling crude oil in anticipation of a price surge, or potentially getting ready for a move on Taiwan.
Analysts predict that oil demand will grow by about 2 million barrels per day for the second half of the year, suggesting a positive outlook for the industry with OPEC production cuts leading to an increase in tonne-miles which particularly benefits VLCCs.
The G7 oil price cap is impacting Russian supply, particularly with reference to Urals oil price, which could potentially alter the supply-demand balance in the global oil market. With the trade routes out of Russia becoming less lucrative it has led to a decrease in the willingness of operators to continue operating within this market. Add in war-related risks and the desire to engage with the Russian market drops even further. As a consequence, vessel capacity has increased in non-Russian markets, specifically observed in the Suezmax and Aframax markets, placing downward pressure on rates.
Despite these challenges for Russia, product exports have remained relatively stable with gasoline prices currently nearing the price cap of $100 per barrel. However, Russian exports have seen a significant decrease, falling by 1.7 million barrels per day since its peak in April. Analysts predict that the Russian owned fleet will likely struggle to maintain its current export volumes. To sustain these volumes, Russia would need to acquire more assets from the non-Russian trading fleet, requiring a significant amount of vessels. With such limited supply of ships this could provide an additional backstop to vessel valuations, both new and used.
Of the approximately 150-200 shipyards worldwide that service relevant commercial segments for the company, over 100 are building dry bulk vessels, more than 80 are working on container vessels, but only 13 have a tanker in the order book. Among these 13, only a few are capable of building VLCCs. This systematic global ship building deficit is something we suggest investors keep an eye on.
In our assessment, FRO’s modern fleet provides them with a robust shield against regulatory risks. However, they face pronounced challenges from geopolitical and market dynamics. Given that their predominant fleet consists of VLCCs, they might not capitalize as much from the surging product rates as other entities that are exclusively product-centric. Elevated product margins tend to favor LR2s and Suezmaxs over VLCCs. While the current market climate is favorable for all, product tankers are particularly riding a stronger wave. Despite FRO’s involvement in both segments, this might curtail their potential advantages compared to other competitors.
Furthermore, operating on a global scale inherently brings geopolitical risks. Factors ranging from EU policies and OPEC resolutions to potential conflicts in the South Pacific, and even meteorological conditions can influence FRO’s operations. Nevertheless, we are of the view that the repercussions on FRO are minimal compared to the global fleet at large. Moreover, the prevailing macroeconomic conditions globally appear to be in FRO’s favor.
FRO trades at a justifiable premium relative to the rest of the tanker market. They currently trade at an EV/EBITDA of 7x vs a Near Peer average valuation of 4.84. While this valuation leads this pack we believe that the limited downside risks justify the elevated price. With low fleet growth, high product margins, and high payout ratios we believe that this price is justified and likely to climb if these elevated rates cement at these new levels. We place a price target of $23 based around an expected FWD dividend payment of $3.40 and a valuation of a 15% dividend. We believe that continued high rate charters are likely and that elevated and consistent rates will show the market that these prices and dynamics are here to stay. We believe that a combination of STNG, INSW, and FRO will allow an investor to have diverse exposure across a variety of fleets, capital allocations, and valuations. This sector has too many structural tailwinds to ignore and we believe offers some of the strongest Risk:Reward ratios available.