Recent Moves in the Shipping Industry

This past week saw a few interesting moves in shipping; first Marinakis buys two Suezmaxes and already levered up, then Peter G goes on Cramer's Mad Money to defend himself.

First off Crude Carriers (CRU). We heard that CRU started negotiations for those two Suezmaxes the day the Alma IPO failed! It shows how fast some owners can move. These two vessels were indeed the Alma vessels from the prospectus and are for very prompt delivery and there are not many Suezmaxes to be had at the moment as many sellers have pulled back and want to see how the market develops this year.

This was a good buy for CRU, although since a company typically can't do a secondary offering (follow-on) for at least six months after an IPO, they had to use and increase their credit line for the purchase. This will mean the company won't have much dry powder going forward until they can do that follow-on they have already alerted the market to. The company used $20 per share as the price they would "hypothetically" do a follow on at, but since they have to repay 2/3 of the credit facility within nine months, and the remainder within one year, we would expect they will do something probably in September to raise the equity, as long as their share price is around current levels.

Based on the five vessels and its current delivery schedule, we would expect the company to have a dividend of between $0.95 to $1.15 per share for 2010 and around $1.85 to $2.00 per share in 2011. This was calculated using consensus analyst VLCC rates of $40k p/d and $45k p/d in 2010 and 2011, respectively, and Suezmax rates of $31k p/d and $35k p/d in 2010 and 2011, respectively. All other assumptions were taken from their prospectus and some guestimates on my part.

The most interesting aspect of this deal was how quickly CRU used its facility to purchase these vessels. I am sure the company wasn't expecting to use the facility this quickly but saw an opportunity and jumped on it.

As for Peter G, he did a good job defending himself against Cramer, although Cramer didn't really come after him. It was a good showing by Peter and a compelling story for BALT, although I would rather wait until all the vessels have been delivered before investing.

This is the problem with all the recent shipping IPOs. They won't have their entire fleets in the water until at least June, and for Scorpio it is unknown. Until they take delivery of these vessels we expect the stocks to continue to trade sideways.

First Quarter Rates versus Estimates

Now that the First Quarter is over, we can look at what Crude Tanker rates are and compare them to what the analyst expectations are in the industry.

VLCCs averaged around $55,000 p/d in the first quarter, which is about $5k more than expectations of most analysts. This is good for FRO as you will probably see their earnings estimates revised upwards this quarter. Also good for OSG, and TNP.

Suezmaxes averaged around $38,000 p/d in the first quarter, which is about $8k more than the expectations of most analysts. This is great for NAT, and good for FRO, GMR, TNP and TNK.

Aframaxes averaged around $19,100 p/d in the first quarter, which is about exactly in-line with analyst estimates. This is neutral for most Afra players, including TNP, OSG, TK, TNK, and GMR.

Rough couple of weeks, random thoughts - IPOs first

The team here at the Tanker Insider has been travelling a lot this month and hasn't had time to post. A lot has happened since our last posting, Baltic Trading (BALT) and Crude Carriers (CRU) priced their IPOs, Alma pulled their offering, Aframax rates shot up to over $50k p/d in the Med, and $80k for the Baltic (ice), and came crashing back down to reality a week later. VL and Suez earnings have entered the doldrums of spring. There were also some goings on in New York and Connecticut that appeared well-attended, and the rumblings are that Tankers is the space to be in over the next two years. So much to talk about, but so little time!!!

Let's start with observations on recent IPOs. Our thoughts are that the investment banks misjudged the amount of interest out there for new Shipping Deals. BALT got priced because of Peter G.'s reputation in the investment community. Investors trust him; he has made good deals and bad deals, but has always been up front with investors and stays in front of them so he has earned their trust. CRU should have been an easy sell from an owner that also has a solid reputation with investors but turned into a very hard sell because of attacks from another tanker company, NAT, about the structure and other "fees" related to the deal. Fee structures in shipping have always been an issue with investors, and the only way to alleviate any concerns about fees is to show that your running costs are either in-line or lower than your peers. Unfortunately for Crude, there was no historical financials to show how competitive their operating costs are, so they were an easy target that couldn't defend themselves. The deal got done despite all the negative sentiment following the deal and its stock has traded down since the offering. All this culminated to haunt Alma, and it wasn't so lucky. After the Crude IPO, Alma followed on its heels and was caught in the middle of a storm. The spotlight shined even brighter on Alma after CRU traded down, and issues about its fee structure, the newbuilding delivery schedule, and the mixed fleet became conversations following the deal in press and in private as they were trying to get the deal priced. It proved to be too much for a fragile IPO market and the deal was pulled in the end. Our take is that the mixed fleets along with the prospect of waiting for mid-2011 for the Suexmaxes on T/C to be delivered were the toughest aspects of the deal for institutional investors, and the negative press probably killed retail interest.

Now cut to today and Scorpio Tanker, the Italian Tanker company, that priced last night slightly below the range. Scorpio was masterfully scripted as the deal for people who want to invest in tankers but are unsure if the timing is correct. Their whole pitch was "Give us the money now and we will invest it when the time is right". Only someone with the reputation of Robert Bugbee could have gotten away with such a pitch in today's markets and they did a great job getting the deal done.

What does this mean for future IPOs? We would guess that the markets will be quiet at least until the summer, and that BALT, CRU and STNG will have to show some positive momentum before we see another shipping IPO.

Tanker IPO Rumblings

Over the past few days, we have heard rumblings about several shipping IPOs in the pipeline. BDI has been out there, a Tanker Company, Scorpio Tankers, announced their IPO last night, and we hear a few others may be following. The new model appears to be; small fleet with low debt, strong management team, sell a large portion of the company, and use proceeds to buy cheap assets at "distressed" levels. BDI has been looking for such vessels for a while now, and others are out there searching on both the dry and wet side so that they can try and push through the IPO window over the next six months.

Gone are the high dividend payout model, and we say good riddance! Almost every high-dividend payout tanker model was doomed to fail from the start (Arlington and DHT being the most prominent). Paying out all your cash is a sure way to a slow death since they are dependent on the capital markets to raise money to replenish their fleet. The only company that succeeds at this is NAT since they have NO Debt and a management team that has executed this model for a long time now, but NAT's return on equity remains low compared to others in the industry and if the market was to recover in a big way, its valuation would revert back to below its levered peers.

Growth is always important for shipping companies, and we were always surprised about how popular the "high dividend model" was as it is a great tool for investment bankers to guarentee fees (as companies must continually do follow-on offerings), for shipowners to get high premiums to their Net Asset Values, but not great as for long-term shareholders as these companies couldn't retain enough of its cash to either grow the fleet or pay down debt if/when the markets turned sour as they did in 2009 and ended up having to restructure their dividend policies or sell out. Dividends are important, but a prudent dividend strategy (ala TNP) should be prefered to wild dividend swings although it doesn't seem that way.

We think these new tanker deals will hinge on investor's trust that the management teams will be able to effectively execute their business plans. So it will be important to have names that are respected in the industry behind these deals. However, with the current tanker market backdrop, it will be interesting to see how much appetite there will be for these types of deals.

Tanker Orderbook

Our friends at the Ton Mile Trader did some interesting research on the tanker orderbook and I wanted to comment on that article and give our observations to go along with their findings.

We have been reading a lot about the tanker orderbook, and while it does loom large for this year, we are cautiously optimistic that delays will be larger than 10% as well and probably closer to 20% this year. The banks are now deciding what owners to stand behind and which ones to throw under the bus (aka The Credit Committee), and this will also have an effect on deliveries and delays.

We have had several discussions with yards, banks, and other owners and there have definitely been cancellations, although no official confirmations and the exact number may never be known. The yards are desperately trying to cover them up and re-sell the slots to stronger owners, so they never have to report it as a cancellation. However, almost every yard we have spoken to was offering slots abandoned by other owners for sale at slightly discounted prices so some owners must have walked away.

We do feel that the delays will strengthen the picture for tankers, however, as the orderbook is pretty bare going into 2012, and hopefully owners will be slow to order tonnage as long as the current orderbook remains an issue. Our expectations are based on owners learning their lesson, which isn't a given, so we remain concerned but are cautiously optimistic.

Are Chinese Banks the Answer?

The latest talk around the shipping industry has been that the Chinese banks may make up for the decline in lending from the European ship lenders. After TORM, OSG and others agreed to enter into credit facilities with Chinese banks, every shipowner is now aggressively trying to build up relationships with their friendly neighborhood Chinese bankers. We hear that Chinese banks are willing to finance up to 80% of the asset value of a new vessel, if it is from a Chinese shipyard with a Chinese charterer.

Is it worth it? While we commend the Chinese for trying to help buoy their shipping industry, as prudent businessmen, we should be very skeptical of deals that sound too good to be true. The true availability of this lending is questionable and owners should be wary of how much it will really cost. In China, payoffs to open doors and regular renegotiations are common practice as contracts have little value. Their property laws are much different than those of the European Union, and while I am no attorney, I would be worried about having too much exposure to a Chinese organization that would be willing to change the rules whenever they desire. It is also important to note that this financing is expensive, sometimes with spreads ranging in the 4% range, and after including all the added "costs and fees" of doing business in China, it is much more expensive than the typical ship financing.

We applaud shipowners who have the ability to do business in China, and any owner should look to diversify their lending banks as much as possible, however, owners should understand what they are getting into and shouldn't be quick to chase the dragon!

Bank Negotiations in 2010

Now that 2009 has come to a close, many shipping companies will have to test loan to value clauses of their debt covenants again. During 2009, vessel values fell somewhere along the lines of 40% to 60% on most classes and at the year-end the banks will come calling. For some owners, this will be the second year in a row they are faced with renegotiating their loans.

Gone are the days that shipping companies could borrow at LIBOR plus spreads of below 1%. Last year, many banks were content to increase margins to around 2% or 3% in order to grant a one year waiver. This year everyone is wondering what will happen, and we have a feeling that banks won't agree to waivers with similar terms this year. While the negotiations will be on an owner to owner basis, and depend on many factors, we can see the banks becoming even more aggressive in their tactics this time around. Last year, banks started pushing for owners to use them for more than just lending, insisting that if there was a stronger "Private Banking" relationship, then they could be more lenient on their demands on the “Corporate” side. Also, if there is any ancillary business, it should be done through them (such as interest rate and currency swaps) in order to keep them happier. Some banks even started to demand being a part of any equity deal a publicly-listed shipping company may do, despite having no expertise and doing nothing to earn those extravagant fees. It may get even worse this year, as banks may start asking for additional capital repayments to get loans in-line with expected vessel values and even higher spreads. With rates where they are, this may mean that private owners may have to dig into their own pockets to comply. It may be a bumpy ride, but it is also important to note that repossessions are still very rare and if the banks start arresting vessels it will cause a spiraling effect that would be more devastating for the industry and the banks themselves at the end of the day.

Eventually, there will be a tipping point with the banks that take a heavy handed approach, and while some owners may not be in a position to do anything about it in the near-term, it will come back to haunt their business eventually. Ship Owners, especially Greek Ship Owners, have a very long memory about such things and when conditions improve and in five year’s time, we may see a few new names at the top of the lending tables.

Has the Golden Boy lost his Lustre?

We hear that Peter Georgopoulos has decided to take time away from his pheasant hunting to hit the road to pitch his latest shipping creation, Baltic Trading, to investors. There has been a lot of talk in the industry about whether this deal will be successful or not and why. The structure of the deal is certainly attractive to the investment world, a company that emulates the strategy of Nordic American Tankers (NAT) in the drybulk sector, and would replace DryShips (DRYS) and Excel Maritime (EXM) as the stock to buy if you want exposure to the Baltic Dry Index (BDI). In truth, DryShips fell out of favor with this group of investors after they started time chartering its drybulk vessels and went out and acquired drillships, and is now the stock to buy if you want exposure in that segment of the shipping space.

However, we hear the deal isn't an easy sell as you would expect as Mr. Georgopoulos' recent track record for investors has taken several hits. First was the timing of General Maritime's (GMR) purchase of Arlington Tankers around the peak of the tanker market, followed by GenCo Shipping and Trading's (GNK) cancellation of six newbuildings when the market collapsed, which in hindsight, may not have been the best move since the market quickly recovered afterwards, and finally culminating with the latest bond offering from General Maritime, which ended up with a yield even higher than the Greek Government's (Ok Greece's yield isn't even that high but it may be in the same range soon enough)!

Peter "Gold" used to be the darling of the investor world, a Greek-American who understood both, Shipping and Wall Street. Over the course of his career he has made a lot of money for his shareholders and partners, however, the collective memory of the investment world is tends to be short and losing investments are remembered much longer than winning ones. This deal is being looks upon as a bellwether in the shipping industry, and if it succeeds expect to see several more shipping IPOs launch in the coming months, both in tankers and in drybulk. However, we view this deal as more of a test of the faith of investors in Mr. Georgopoulos, not the market as a whole and it will be interesting to see what happens.

Distressed???

Last year, everyone you spoke with was searching for "distressed" deals. First, after the drybulk market collapsed, hedge funds, private equity funds and shipowners alike were chasing banks, shipyards and owners begging to be privy to distressed deals.  The drybulk market rebounded and values started to rise with very few distressed assets being sold. Then tanker rates fell off a cliff and everyone is now switching their focus to this industry in search of the distressed deal. It has become the "White Whale" of the industry, vultures are all circulating the distressed banks and owners waiting to jump at the first chance of a distressed deal. These deals, rumor has it, will offer returns far in excess of a typical deal, making the investors rich beyond their wildest dreams.

But will there be enough bloodshed in the industry to create such "once in a lifetime" opportunities? Hell, are these deals really even that great if they do arise? Let’s review the specifics of a said distressed deal, and see if they would really exist or be worth it at the end of the day.

The definition of a distressed asset/liability from the Financial Times is: An asset that is put on sale, usually at a cheap price, because its owner is forced to sell it. There could be various reasons for this, including bankruptcy, excessive debt and regulatory constraints. Debt itself can be sold on to a new owner at below face value (distressed debt).

So in order for an asset to be distressed it must have been purchased at a very high price and now the owner is being forced to sell it at a discount because of problems or lack of cash flow. The truth is that the tanker industry is characterized by strong owners and there have been several years of high earnings so there are a lot of reserves on the sidelines that should help them make it through these tough times.  In addition, as long as owners are willing to make their loan payments, banks are not going to go after the assets. Banks are also very slow to take any write downs that may cause increased downward pressure on values, and start a spiraling effect. Even if the the owners refused to pay and the banks were to act, it appears that there are so many vultures waiting for distressed deals that the prices will be bid up to non-distressed levels.

One type of distressed deal we are hearing about is where a bank has seized an asset and transferred the liability to a stronger shipowner. The terms of these deals typically allow the shipowner to purchase the vessel with little or no equity up front as long as they assume the liability on the vessel, but with values where they are today this liability is usually higher than the true value of the vessel in the open market would be. These deals also include a typical profit sharing agreement with the bank, so any earnings the vessel makes would be split by some predetermined formula. Does this sound like a great deal for the owner, lots or risk and little upside?

The only place we can see distressed deals occurring is at the shipyards, since if an owner has walked away from a deal, losing their deposits, the shipyards may be easily able to lower the price of a newbuilding to a lower level using the forfeited deposit as a subsidy. But even these deals are rare and everyone is fighting to be part of these deals, which will again cause the assets to be bit up to possible pre-distressed levels.

Given the above information, we don't expect to see many distressed deals in today’s markets unless the banks turn very aggressive against owners, or that rates stay very depressed for a longer period of time. We think a lot of people will be severely disappointed in their continued search for distressed tanker assets.

What Drives Vessel Values?

One thing I have learned about the tanker industry is that it is very close to a pure supply/demand driven market. The charterers use their leverage on the hundreds of owners to drive rates down when they can, and if there is a scarcity of vessels in a region, owners will drive rates up as much as they can. This is also true of vessel values. With the exception of how much they cost to build as a floor, most vessel values are directly related to what their expected earnings are and what owners are willing to pay.

We have done a lot of research on vessel values and read a bit of George Soros, and we can definitely agree that values are driven by two major factors; expected earnings of the vessel, and the amount and availability of leverage obtainable to finance the vessel.

When looking at expected earnings, it is important to note that spot earnings are not the primary drivers of values, time charter rates are. However, it is important to note that spot earnings are important drivers of time charter rates, along with future expectations so they warrant paying attention to. The problem is that spot earnings are very volatile in the short term, and tend to move in several cycles during the course of a single year, where as time charter rates are more stable and include expectations of future earnings, not just the current market trend. Running a quick regression analysis you can ascertain that there is a very high correlation of vessel values to one year time charter rates, and an even higher correlation to three year time charter rates. More specifically, the typical price of a five year old VLCC is over 90% correlated to the one year time charter rate over the past 10 years. The correlation to the three year time charter rate is even higher.

The other driver of vessel values is the availability of lending. Recently, this has become a very important aspect of driving the values of assets. Long ago before the Lehman Collapse, most major shipping banks were throwing money at owners, loaning anywhere between 70% up to even 85% of vessel values (which were at historical high levels) at LIBOR plus a margin of less than 1%. This madness helped increase values even further as owners would only have to dish out $20 million to purchase a vessel worth $100 million and would be paying very low interest rates on that loan to boot! After the Lehman Collapse, most shipping banks stopped lending completely, which caused the Sale and Purchase market to dry up entirely. This was more pronounced in the drybulk market, mainly because when the banks stopped lending they also stopped issuing Letters of Credit, which virtually drove trade to a standstill. On the tanker side, this wasn't as much of an issue as the counterparties tended to be Oil Majors, with higher credit ratings than most banks. However, the global financial crisis caused banks to review their lending portfolios, and to their surprise the shipping portion was less profitable (and more risky) than loans in other areas. This caused values in the tanker industry to fall towards the end of 2008, despite the continued strength in earnings. In 2009 as earnings collapsed, banks pulled back lending to the industry even further, which coupled with the declining earnings caused vessel values to fall more than 50% in some cases.

What does this mean for values? Well, looking at the sale and purchase market in the tanker industry, you can see that things are finally starting to normalize. The combination of lower asset values and stabilizing earnings have started to make vessel acquisitions appear attractive. Banks are again starting lend money to would-be purchasers (although at maybe 50% to 60% of asset values at LIBOR plus a margin closer to 3%-4%), and this has thawed the sale and purchase market at the moment. We see room for values to increase another 10% to 20% from here if time charter rates remain at current levels. If earnings increase, we could see values increase further than that!

What will 2010 Bring?

Since I have been following the Tanker Industry, I have paid a lot of attention to predictions from the market savants. In 2007, everyone expected a strong year, and it was average. In 2008, everyone predicted a weakening market and, despite the global turmoil, it was a very strong year. In 2009, everyone agreed it would be a weak year, and it was. Now, predictions for 2010 are coming in all over the map. While there is a debate whether the market will be weaker or stronger in 2010, even the people who are bullish don't expect rates to be anywhere close to their five year averages. So will 2010 prove to be a strong year or a weak year? What, if any, will be the catalysts? What is important to follow?

There are several important developments in the tanker industry that will unfold in 2010. The first, and most important, is the pending orderbook, which stands at around 30.4% of the total fleet (132.3m.Dwt on order over 435.4m.Dwt total fleet size), entering 2010. Of this 30.4%, 14.8% (or 64.5m.Dwt) is expected to be delivered in 2010. This is a large percentage, but if you look at the pending phase out of single hull tankers (55.4m.Dwt of single-hulled vessels are in the market), the net growth of the fleet this year is closer to 3%-5% depending on how many single-hull tankers are phased out during the year. One thing to remember is that the amount of scrapping will be directly proportional to rates. In other words, if rates remain weak, vessels will be phased out faster than if rates were to strengthen. It makes no sense for an oil major to charter a single-hulled VLCC if they can charter a newer vessel at a similar rate.

The second development to watch is the demand for oil and oil related products worldwide. Everyone knows that demand for oil is growing rapidly in China, and that demand in the rest of Asia is increasing at a brisk pace, however, demand in North America and Europe continue to be the largest drivers for the Tanker market and we expect this to continue in the near term. To put matters in perspective, China’s crude oil imports grew 48% year over year in December to approximately 5.1 million barrels per day from 3.4 million barrels in the year-ago period. In the United States, crude oil imports averaged 8.0 million barrels per day in December, down 20% or 1.9 million barrels per day from 2008 levels. In other words, even though China’s imports grew by 48% year over year, it didn’t make up for the shortfall in demand from the US. If demand in North America and Europe returns to 2007-2008 levels this year, we should see an improvement in tanker rates. It is also important to note that despite the recent correlation of tanker stock prices to the price of oil, the correlation of tanker earnings to the price of oil is insignificant. Theoretically, they should be INVERSELY correlated, as cheaper oil should increase demand.

There is one question mark to this puzzle: When will the tankers in storage re-enter the market?

There are currently approximately 149 vessels used for storage. If the contango trade starts to unwind, these vessels will re-enter the market and weaken rates, if it continues to make sense to roll-over this trade, then the number of vessels used for storage may increase further. Lots of analysts expect this trade to unwind in 2010, but they also expected it to unwind in 2009, so we will have to continue to monitor the situation until it becomes clearer.

So based on what we expect to happen in 2010? In terms of earnings, we expect the year to be slightly better than 2009, although we are more bullish for the second half of the year. In future posts, we will go into more details about values and stock valuations, but this is a bit of a primer on what will drive the markets in the year ahead.