At a time where the coronavirus has wreaked havoc around the world and where oil demand has crashed it might seem strange that those who transport oil around the world are seeing record high rates. But that is indeed the case. And the primary beneficiaries are the owners of the bigger vessels, the Very Large Crude Carriers. Those are currently Very Large Cash Cows printing money at a pace that rival that of the central banks…
In this post I will provide an investment idea that I think is uniquely positioned for the current situation, ADS Crude Carrier. The key is this:
Large vessels with short lives and a business model that is all about distributing cash in massive amounts to shareholders in the near term.
(For a quick summary scroll down to the end of this article)
Why are current rates so high?
Before I get to the company specifics here is a bit of background on why the current collapse of oil demand has ended up benefitting tankers immensely here and now.
What we have now in the oil market is the rare situation where short-term contracts are priced much lower than those further out into the future. This situation is known in the commodity markets as contango. The bigger the gap, the steeper the contango: https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html
This has come about because short-term demand for oil has collapsed by unprecedented 30+% due to the coronavirus situation we have all been subjected to. And because production is much higher than the demand the market is way out of balance even when factoring in a huge production cut by OPEC. So this excess oil must go somewhere: Hello tankers!
Oil traders can benefit from this by buying short-term contracts and simultanously sell contracts further out and lock in the difference. Except, they don’t get to keep all the spoils. Actually by the far the majority of it goes to those who can store the oil that is being bought. And since the world is soon running out of storage on land rates for storage on tankers have increased tremendously.
In fact, to rent a VLCC for storage at this moment for six months the contango supports rates above $110,000/day and for one year $70,000/day. Contrast that with a cash break-even for an 18-year old VLCC at around $15,000/day. And tankers tied up for storage decreases the overall supply which pushes up rates for the vessels that get booked for what they were actually built for: sailing, transporting oil. Just yesterday a VLCC was fixed at $187,000/day for an 80 day trip.
There will come a time, however, when rates will plummet from these high levels and that could happen once oil demand start to outstrip production again. This sounds like a great thing for tanker demand but the problem is that initially there will be a drawdown from all the inventories that have been stored. So the whole storage story is double-edged. But the good thing for tankers is that earnings are many multiples above break-even now so it isn’t as easy as to say that a bad month cancels out a good month. Each month that this goes on is tremendously valuable for tanker owners. Those negative on the sector point to the inevitable hangover that will follow. And they are right. But it doesn’t matter all that much to the bull thesis since some tanker owners are likely to earn their entire market cap in 2020 alone.
ADS Crude Carrier – well positioned for this particular market
And this gets to the heart of why I have picked ADS Crude Carrier ahead of other tanker companies for this particular environment.
ADS is listed on the Merkur Exchange in Oslo. The share price currently is 25 NOK and the market cap 585 MNOK ($57 million).
The company owns three 17 ½ year old VLCCs with an average life of 30 months left in them before they are likely headed for recycling.
Of those 30 months 5.5 months have been locked in at rates that cover more than half of the current market cap in operating earnings(!). On a per share basis this is equal to roughly 13 NOK/share – all of which I expect to go towards dividends and debt reduction (less future vessel opex) as per company policy.
Since rates are ”unnaturally” elevated now it isn’t as simple as saying 30/5.5 x 13 NOK to get at the expected return to shareholders over those 30 months but it does go to show that there is a huge margin of safety already built into the numbers, even in the unlikely event that rates crash through the floor in the very near term. I will get to my baseline assumptions for rates for the rest of the period a little further down in this article.
Based on conversations with management I expect capital expenditures and fleet renewal to be zero in 2020 and 2021. And in H2 2022 the base case as I understand it is that the three vessels will likely be recycled and earn their steel value and the remaining debt will be paid off.
The math of it based on current steel prices looks like this:
So approximately 4 NOK/share of additional value when adding back working capital and subtracting the debt. Note that the number supposes current steel prices 2 ½ years down the road which of course is a very big if. For the number to be negative steel values will have to decline by more than 30% from already depressed levels. I don’t deem that a likely scenario but of course not an impossible one either. If steel prices revert to where they were in the fall of 2019 ($16 million per vessel rather than $13 million) the total value would be 8 NOK. In other words, I suspect 4 NOK is on the conservative side.
There are other possible scenarios in H2 2022. One is if rates are still expectionally strong the company could decide to take the vessels through a survey that would potentially give them an additional life of 2.5 years. From my understanding this is unlikely to happen.
Another scenario in a strong but not crazy strong market is that the vessels can be sold as storage vehicles. This supposes ADS will be able to get a higher value than they would by recycling the vessels. Also not a likely scenario from my understanding.
So while both of the above two scenarios are unlikely they do provide free optionality for the company. So what is the value of that?
My estimate is 5 NOK and that is the number I will use going forward but it is very hard to assess, admittedly.
The theoretically correct way to find this number would be to multiply the value of all the possible scenarios by the probability of each and then add them all together. Too many unknowns to arrive at an accurate number of course but it certainly is above 0 even though 0 is the outcome in most scenarios. The reason is that some scenarios are worth a lot.
For instance: Supposing ADS were able to sell the vessels for $26 million per vessel in H2 2022 for storage or trading instead of recycling them at $13 million that would equate to 13*3=$39 million of additional value, which is 17.60 NOK per share.
That is obviosuly a blue sky scenario but to put things into perspective: Earlier this week a 2001-built Suezmax vessel (which is half the size of a VLCC) was sold for $21 million which is a figure that is more than double its scrapping value even though it only had one more year left of trading. But of course the main reason for this price is the current contango making it an earning machine in the short term. I wanted to mention it because even though the contango likely will be long gone by 2022 other factors could come into play that would make the vessels sell above scrap value.
So what we know for sure is 13 NOK is in the bank for 5.5 months out of 30. This number is the most important of all because of the certainty of it and it is the basis of the whole safety thesis.
4 NOK for scrap value+working capital-debt. And 5 NOK for optionality. Those are both my fair value estimates and neither are close to being bankable.
In total: 22 NOK.
What then is the value of the remaining 24.5 months of vessel days? Again, remember this is a period with a lot of uncertainty in a space that is already known for high volatility so whatever estimates one arrives at will be extremely uncertain. At some point the current steep contango will no longer be in play and rates will go lower. Judging from analyst reports and adding a layer of conservatism I arrive at the following estimates for TCE rates going forward.
$60,000/day average for the remaining 6.5 months of 2020. OCF 12.60 NOK/share.
$40,000/day average for the 12 months of 2021. OCF 13.20 NOK/share.
$30,000/day average for the 6 months of 2022. (They reach their 20th birthday on different months: March 2022, August 2022 and October 2022 so 6 months is an average.) OCF 4.20 NOK/share.
Adding all of it together I arrive at 52 NOK per share. (Fair value is slightly lower because of the time value of money but I expect most of this value to be earned and distributed in 2020 already so not a huge effect.)
To give an idea of how quickly estimates might change let’s say in an upside scenario that the company manages to fix their two vessels ADS Serenade and ADS Stratus that will both be open for new fixtures in a couple of weeks time at the current rates of $110,000/day for 6 months then that would add another 8 NOK of value to the 2020 scenario. And in that case operating cash flow will exceed 30 NOK/share for the year with still approximately 150 of a total of 1095 vessel days left in the year. And again remember there is no capex for 2020 and 2021 so all earnings are headed for shareholder pockets.
In a downside scenario where rates fall to below break-even levels on a cash basis there is some protection in the possibility that the vessels can be recycled ahead of time.
One reason I like the thesis is that most of the cash that is currently being generated will be returned to investors in the very near term due to the company’s philosophy of returning excess cash on a quarterly basis.
An agreement with debtholders stipulate that once debt has been reduced from currently $36.6 million to $27 million all excess earnings (minus liquidity needs) can be distributed to shareholders:
Since earnings are so massive right now this debt reduction can be accomplished using cash flow from Q1 alone. According to my estimates ADS will earn approximately $15 million in operating cash flow in Q1. After debt reduction $6 million of that can be distributed to shareholders, equal to 2.70 NOK/share.
For Q2 I estimate operating cash flow to be $17 million and that all of it will be distributed to shareholders, equal to 7.70 NOK/share. So by August/September of 2020 my base case is roughly 10 NOK/share will have been distributed to shareholders.
So what can go wrong?
There are a few yellow/red flags that needs to be monitored by investors, such as party-related transactions. Because the two major shareholders John Fredriksen owned SFL (17% owner) and ADS Shipping (10% owner) provide both loans and technical management services to ADS Crude Carrier there is a question of whether interests with other shareholders are 100% aligned.
And there is also the question of whether they are incentivised to close up shop in H2 2022 or whether they will prefer to buy vessels when that time comes in order to continue earning management fees. This is not clear currently.
So besides declining rates this is my primary concern. On the flip side I expect investors to have received dividends covering more than the entire market cap by the time these decisions will be made.
Summary of the thesis – fair value: 52 NOK/share
I believe ADS Crude Carrier provides excellent downside protection and very decent upside potential despite an uncertain environment because of the following:
- They own three 2002 built VLCC vessels that are likely headed for recycling by H2 of 2022. This leaves 30 months of trading from January 1st 2020 till then.
- 5 1/2 months already booked at an average rate of 72,000/day in 2020 providing 13 NOK per share of free cash flow to shareholders. The stock currently trades at 25 NOK.
- The most likely scenario in my view is that the company will earn its entire market cap in 2020 alone.
- Company policy is to return excess cash as quarterly dividends to shareholders.
- The contango is exceptionally steep currently and this supports storage rates of $110,000/day for 6 months. Two of their vessels are up for booking within the next two weeks.
- Current scrap value plus working capital minus debt: 4 NOK.
- Additional optionality value in H2 2022: approximately 5 NOK.
- Tanker companies that own younger fleets always have to worry about others spoiling the party by ordering large numbers of new vessels thereby putting pressure on the value of their fleet. Not a problem when your vessels are soon heading for recycling. It takes two years for a VLCC order to be built.
- Red flags: Unclear whether there are conflicts of interest between the top two shareholders and the rest of shareholders longer term. Empire building has not been ruled out.
Disclaimer: I own shares in ADS Crude Carrier at the time of this blog post’s publication. Nothing herein should be considered investment advice. The post is to be considered a starting point for further investigation. Please perform your own due diligence before making any investment decision.