Four shipping investment ideas
I recently read a presentation on Scorpio Tankers (NYSE:STNG) pitching the company as a potentially undervalued stock. Following research I have come across several other ideas that may be worth looking into. I pass them along for readers’ potential benefit.
The original pitch for Scorpio went like this:
- Shipping industry is at bottom of cycle and rates are up YoY
- Fleet ageing and scrapping rate moving ahead of replacement rate in the near term (aided by IMO 2020 – more on this later)
- Scorpio has youngest fleet and, by installing scrubbers, will be in the minority that can comply with IMO2020 without using LSFO (more on that later too)
- Installation of scrubbers likely to create temporary but meaningful decline in vessel supply which will accelerate increase in shipping rates
I am less bullish than the author on the maximum upside but I estimate up to 3x is plausible over the next couple of years, based on a best case scenario if shipping rates revert to their 15-year average.
An important question what happens to tanker hire rates. I think the conditions are in place for a short term improvement over the next 1-2 years, but medium term there still appears some excess supply to be worked off and new ships still coming to market (albeit below replacement rate).
The tanking industry appears to perform inversely to oil prices. Lower prices = more volumes and lower cost and vice versa. Scorpio Tankers is the first idea (and in truth, it’s not my idea).
Second is the spread between the price of LSFO and HSFO. In 2020 there is a regulation coming in called IMO 2020 which limits the amount of sulphur that various vessels can emit. Vessels either need to start purchasing Low Sulphur Fuel Oil (LSFO), which is more expensive, or install scrubbers. Very few in the industry (I estimate a couple of thousand vessels out of ~50,000-70,000) appear to be moving to install scrubbers; most seem to be either unwilling/unable to spend the capital or are waiting to see what the additional costs of LSFO look like.
The additional cost of LSFO relative to HSFO over time. From Scorpio Tankers presentation.
As a result it is likely that there will be substantial additional demand for LSFO beginning next year. How great this demand is, what impact on pricing it is likely to have, and the key beneficiaries (who manufactures LSFO?) are for you to discover. If the impact is meaningful, and I struggle to see how it won’t be given the mandated increased demand and the size of the global fleet not installing scrubbers, then shipping fleets with scrubbers installed (Scorpio) potentially have a minor cost advantage for the years it will take for competitors to get scrubbers. The estimated benefit to Scorpio is 20% lower fuel costs by using scrubber + HSFO instead of LSFO based on the above forward pricing curve.
The penalties for noncompliance with IMO 2020 are likely to be stiff enough to deter noncompliance in many jurisdictions, relative to the cost of scrubbers or petrol.
In addition to refineries, another beneficiary of increased LSFO demand are product tanker companies (oil products, as distinct from crude oil) like Scorpio. LSFO industry participants are the second idea.
Demand for scrubbers lends itself to firms that provide marine services. One shipping company has taken a substantial stake in its own scrubber firm to ensure it has supply. One publicly listed company, Wartsila Oyj (HEL: WRT1V), looks like a key beneficiary. It has $5bn in revenue, a $6bn forward order book (next 24mths), a decent balance sheet, and has been around since 1834. Wartsila has the largest scrubber installation market share at around 20%. Alfa Laval AB (STO: ALFA) in Stockholm is another possible beneficiary.
Some of this is priced in already, but at $2-4m per scrubber and up to several tens of thousands of possible installations, there is likely additional potential upside to both companies here. It is likely to be a one-off benefit over the next few years (with some trailing demand for scrubber maintenance/repair). I am thinking it might be possible to buy the companies now and then sell/short them as scrubber installations trail off (or for example if LSFO becomes more widespread & cheaper than expected). Wartsila and Alfa Laval appear to trade roughly in line with historical multiples. Alfa is a smaller company that may find it easier to benefit, although it also appears to have a lower market share in scrubbers.
A key risk/opportunity is that if shipping charter rates normalise sustainably, demand for the other services of these companies is also likely to increase over a period of years and thus Wartsila may be a difficult short
. Conversely, if LSFO becomes an easier solution than scrubbers, they may not benefit from this trend.
A key element is the assumption that scrubbers will be installed. Logically speaking, it makes a lot more sense for a scalable solution (wider supply of LSFO) to be provided rather than manually installing scrubbers on 50,000 vessels. However, how hard is it to increase the supply of LSFO? What is the lead time? How long will the advantage of having scrubbers last, vis a vis the additional cost of LSFO?
Further research on valuation and the opportunity is up to you, but the scrubber installers are my third idea.
There is an another tanker business – Teekay Tankers (NYSE:TNK) that appears to be in fairly deep strife. In addition to being overlevered it has a very old fleet – approaching 15 years old. The typical retirement age of a tanker is around 20 years and after 15 years some customers become reluctant to hire older tankers. With so much debt I struggle to see how Teekay will rejuvenate its fleet.
There is also Scorpio Bulkers (NYSE:SALT) which owns about $90m worth of Scorpio Tankers and has its own bulk freight business (which is a different business to tanking). The Baltic Dry Freight index has been smashed over the last month or two and reflects industry pricing at 15 year lows. If anything, SALT may be in for more pain in the near term. However, some of the same dynamics with scrapping and declining fleets are playing out in bulk freight and so SALT may also be worth keeping an eye on.
One thing I think should be possible for both the tanking and bulk freight industry is to assess the number of ships available, the rate of scrapping, and the number and delivery date of new orders. This information is all public (it just takes time to aggregate) and it should be possible to form an estimate of when the market will tighten. Ideally I think you would want to catch the industry as the last 20% of available supply starts to tighten, and it appears possible to build an estimate of this from publicly available information – it just takes too much time for me. That’s the fourth idea.
Food for thought.
I own a small number of shares in Scorpio Tankers. This is a disclosure and not a recommendation.
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