The Tankers Are Back
By Elliott H. Gue
02 Sep 2006 at 07:00 AM
MCLEAN, Va. (EnergyStrategist.com) -- Last year, much was made of the slide in crude oil tanker stocks. While these companies continue to pay dividends well into the double digits, the group's performance in 2005 certainly didn't compare favorably with 2004's huge gains. But lately, the group has been perking up again; in fact, the tankers have been one of the best-performing groups in the energy space this summer. There's good reason for that shift.
Recall that tanker companies carry crude oil on behalf of the major oil producers. The oil companies pay the tanker firms a day-rate to transport that oil. Tankers don’t take ownership of the oil they carry; thus, they're not truly sensitive to oil prices.
There are really two types of tanker contracts: time charters and spot charters. Time charters are longer-term contracts generally cut at a fixed day-rate or a day-rate that adjusts annually for inflation, average fuel costs or some other index. Such contracts offer stability for the tanker firms; they more or less know how much they’re likely to receive for carrying the oil.
Spot charters are shorter-term agreements for single voyages. These contracts are based on prevailing supply and demand for ships at the time they're negotiated; tanker spot rates are highly volatile and have a huge seasonality component.
First, a little historical perspective is useful. Check out the chart below.
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Source: Bloomberg
This chart depicts the Baltic Dirty Index, an index of spot charter rates for a variety of tankers of different sizes. This chart shows spot rates going back to the end of 2001.
The seasonality in tanker rates is obvious here. Note, in particular, the four prominent spikes in this chart. The spikes occur at the end of each year and the very beginning of the New Year.
For example, the first spike on the chart is at the end of 2002 and in the very first weeks of 2003. That spike saw the Baltic Dirty Index rocket from around 500 to roughly 2,250 in just a few weeks time, only to fall back to 500 by the mid-2003.
These spikes represent the seasonal effect. Demand for tankers is highest in the first and fourth quarters. Therefore, spot tanker rates are also highest in these quarters. During the summer months, day-rates reach their nadir; tanker firms often use this seasonally slow period to repair their ships or perform upgrades. After all, it makes sense to take your ships offline when there's little demand.
Most tanker companies pay variable dividends. These firms simply pass a good chunk of their cash flows to shareholders as dividends. Therefore, in the first and fourth quarters, tanker dividends are much higher than in the summer quarters.
Dividends can be 10 (or more) times higher in the fourth quarter than in the third quarter of the year. Many make the mistake of assuming that these lower dividends constitute a dividend distribution "cut." But such variability is absolutely normal.
In fact, some tanker firms have recently taken steps to try to smooth out their dividends over time; the dividend variability has been a major contributor to volatility in the stocks. Basically, they hold back some cash in the big winter months, paying out a smaller dividend than they can afford. Then, in the weak summer months, they use that surplus to bolster their yields.
If there's any cash left over at year end, I'd expect to see a special payout or a big share buyback. The idea here is that a smoother dividend cycle reduces volatility in the stock. But a dividend smoothing policy doesn't change the fact that tanker rates are seasonal.
In addition to that seasonal effect, there are longer-term trends; some years have higher day-rates than others. These trends are based mainly on the number of newly built tankers (known as newbuilds) being delivered in a given year and the import demand from key importers like China and the U.S.
The easiest way to see this effect is to check out the Baltic Dirty Index in the winter of 2004-05. Note that 2004's day-rate spike was much larger than any other year covered in the chart above; the index topped 3,000. In fact, that year is widely regarded as one of the strongest in history (if not the strongest) for the tanker group.
The other point to note about 2004 is that even the slow months were better than average - the normal seasonal slump in day-rates wasn't as deep as usual that year. The reason for 2004's huge spot rates was simple: the global tanker fleet actually shrank slightly that year (lower supply) while demand for oil imports from China and the U.S. soared.
Contrary to popular belief, 2005-06 was not a bad year for tankers; it was, however, a more normal year. As the chart shows, the seasonal spike was roughly equivalent to, if not better than, the spikes witnessed in years prior to 2004. But a "good" year was not enough to keep the tanker stocks rolling because it came after a "great" year. In comparison with 2004-05, the 2005-06 season was disappointing.
The same can’t be said of this year. Right now, the Baltic Dirty Index stands around 1,424 compared to closer to 1,000 last year at this time. Tanker rates are running much higher this year than last year. In fact, current rates are basically even with where they were in 2004 at this time of the year. Also note that the low in tanker rates this year occurred a bit earlier than normal; the turn came about 60 days before it did in 2005. This is a sign that the tanker industry is doing better than last year.
Keep in mind that we're not yet in the peak season for day-rates just yet. The big spike normally begins in a month or two and tops out in late December. Starting from a higher base, I suspect that spike will carry significantly higher than it did last year; comparisons with 2005 will look favorable.
I see a couple of trends driving this action. First, Chinese oil demand grew much faster during the last year. According to the International Energy Agency (IEA), Chinese oil demand grew by 2.6% in 2005 and will grow by 6.1% in 2006 and 5.5% in 2007.
That 2.6% growth rate for 2005 seems to be a short-term blip as demand growth was strong in 2004 as well. This is bullish for tanker stocks; China is a huge oil importer, and hauling all that oil from the Middle East means hiring out more tankers.
Then there's supply. One factor overhanging the tanker group last year was the idea that a big chunk of new ships being built would be delivered during the next few years, leading to a glut of tankers. But other factors are mitigating this effect. Older tankers are being scrapped and retired; all single-hull tankers are being phased out. Notably, BP has decided to only lease out the most modern tankers (double hulls) going forward; this decision was made years ahead of the official deadline for phasing out single hulls.
Moreover, tankers have been pressed into other duties. Some are being refitted as floating production platforms, and others are being used as temporary storage facilities in the Middle East and Asia where storage capacity is lacking. If a tanker becomes a production platform, it's no longer a part of the global tanker supply.
Bottom Line
I’m looking for another 2004-like spike in day-rates this winter as we move into the seasonally strong period. Because most of my favorite tanker firms pass through their cash flows to shareholders as dividends, I’m looking for some big dividend checks out of these companies during the next few quarters.
To put this into perspective, one of my favorite tanker firms - trading around $40 - just declared a quarterly $1.50 dividend, payable this month. Keep in mind the quarter just ended is seasonally quite weak and yet the company still managed a big payout. If we annualize this figure, this company could pay upward of $6 - a yield of about 15%.
Copyright © KCI Communications, Inc. 2006
Elliott H. Gue is Editor of “The Energy Letter.” Click here to sign up for the free bi-weekly newsletter.
© Copyright 2006, Resource Investor.
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