STNG (An Undervalued Opportunity in a Cyclical Industry That’s Overcorrecting Supply) : stocks

COMPANY OVERVIEW

Scorpio Tankers, and its subsidiaries, transport refined petroleum products worldwide. They are a product tanker operator meaning they transport refined oil products (e.g. gasoline, jet fuel, kerosene, etc.), as opposed to an oil tanker operator which transports crude oil.

As of 8 September, 2021, Scorpio owned, finance leased, or bareboat chartered 131 product tankers, which included 42 Long Range 2 (LR2), 12 Long Range 1 (LR1), 63 Medium Range (MR), and 14 Handymax tankers with an average age of approximately 5.6 years, making it the youngest and most modern fleet in the industry.

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MISPRICING

At a current market cap of just under $1B STNG is trading at roughly 50% below its book value. The market has underpriced STNG because of three primary factors:

1. COVID induced floating storage demand

2. A COVID induced 20-year low in daily tanker rates

3. A lot of debt that the company can handle

The first factor, floating storage demand, prevented Scorpio from leveraging its advantage as the youngest ECO product tanker fleet in the industry.

The COVID shutdowns caused global demand for oil based products to rapidly decline. Supply outstripped demand and land based storage facilities filled up quickly. The lack of land based storage led to ships being contracted as floating storage, where Scorpio has no advantage because a leaky twenty year old rust bucket with no engine can fill up its tanks and do nothing just as effectively as a brand new ECO tanker.

Floating storage demand has prevented Scorpio from realizing its advantage as the youngest ECO product tanker fleet in the world

Floating storage demand has been on a steady return to normal throughout 2021, meaning product tankers are returning to their routes. Scorpio will leverage its industry advantages as product tanker demand increases in 2022 and 2023, but the market hasn’t priced this in yet.

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FINANCIAL HEALTH SUMMARY

PROS

• Assets more than cover long term liabilities ($4.82B vs. $2.73B)

• Debt-to-Equity ratio reduced from 125% to 54% since 2018

• FCF growing around 62% since 2016

• Enough cash flow to operate for another three years

CONS

CONCERNS

This isn’t a detailed financial analysis. All we need to know for this thesis is that Scorpio has enough assets to continue operations until market demand increases and Scorpio can leverage its advantages as the youngest ECO product tanker fleet operator.

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THE MODERN FLEET ADVANTAGE

Fuel Cost Advantage

On 2 January 2020, just before COVID strangled world economies, new regulations limiting sulphur content in ship fuel oil came into force. This new regulation limited all ships without exhaust scrubbers to only use Very Low Sulphur Fuel Oil (VLSFO) containing 0.5% or less sulphur by mass as opposed to High Sulfur Fuel Oil (HSFO) containing 3.5% sulphur by mass. This nearly doubled the cost spread between VLSFO and HFSO in January 2020. However, the COVID-19 pandemic and the collapse in oil price quickly narrowed the spread.

The price of VLSFO was nearly double the price of HSFO prior to the COVID-19 pandemic and is still around $100 more expensive in September 2021. Source: Ship & Bunker

The VLSFO/HSFO spread quickly narrowed in January 2020 but has maintained an average spread of about $100 per metric ton (mt) in 2020 and 2021. This means ships with scrubbers still have about a 17% fuel cost advantage over ships without them, and that advantage is likely to increase with growth in shipping demand (e.g. economies opening back up) or an increase in oil price (e.g. increased oil demand and/or increased inflation). So how much advantage does STNG have compared to other product tanker fleets?

A lot

Scorpio also benefits from having a 100% ECO product tanker fleet. ECO tankers are more fuel efficient through the use of modern engines, improved hull designs, and other efficiency improvements. While Scorpio’s fleet is 100% ECO the majority of the global fleet is not. This enables Scorpio tankers to leverage additional fuel cost savings beyond the global fleet average. The combination of high scrubber installations in a modern ECO fleet will be a major factor in Scorpio’s pricing advantage as shipping demand increases.

Scorpio operates a 100% ECO fleet while the industry as a whole is well below 50%. Source: Scorpio Tankers Inc Company Presentation September 2021

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Fleet Age Advantage

Scorpio will have a significant pricing advantage in the coming years due to the age of its fleet.

According to Euronav, the overall life of a tanker vessel is 20-25 years. A quarter of the global fleet will be over 20 years old within the next 15 months.

More importantly for Scorpio, some product ship charterers consider it too risky to contract ships older than 15 years. 38% of the current global product tanker fleet (863 vessels) is over 15 years old, and 81% of the current global fleet (1,819 vessels) will be over 15 years old within the next five years, with the majority hitting this mark by EOY 2024.

Over 80% of the current global product tanker fleet will be over 15 years old in 2026

The average Scorpio tanker is 5.6 years old and will not reach 15 years old until 2030.

This information is slightly outdated as the BW/Hafnia merger now operates a 203 vessel fleet, but Scorpio’s fleet is still younger. Source: Scorpio Tankers Inc Company Presentation September 2021

But won’t other operators just build more ships to replace their aging fleet? Right now the answer is ‘No’.

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Tanker Supply is Shrinking

Low daily tanker rates, high construction costs, and high scrap metal returns are driving down tanker supply, and may lead to a significant industry over correction that will drive daily rates higher.

Product tankers are being demolished at a record pace and very few new ones are being built to fill the hole they’re leaving in the tanker supply. Product tanker daily rates are below operating costs, and scrap metal prices are sky high. This combination makes it very tempting to pocket $8M by scrapping a 20 year old fully depreciated tanker whose original cost was $35M.

Returns for scrapping old tankers are the highest they have been in years

This combination of low daily rates, aging fleets, higher fuel costs due to regulations, and record prices for scrap metal is contributing to record levels of Product Tanker Scrapping.

Orders to construct new ships are also at all-time lows.

Orders for new product tankers are at near record lows

Current orders will replace 6.7% of fleet capacity while an average of over 8% of the global fleet will become 15 years old each year over the next five years. Newbuilds simply aren’t replacing the lost capacity, and they’re definitely not replacing capacity for charters of ships less than 15 years old.

MR vessels, the same class seeing record demolitions, are not being replaced fast enough to keep up with the number of ships being scrapped

Product Tanker newbuild orders also aren’t likely to increase soon due to the low daily rates combined with the rising cost in ship construction. It is simply too risky to order new vessel construction in this environment.

30% of vessel construction cost is steel and steel prices have dramatically increased in 2H2021

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BEAR CASE

• We are past peak oil and demand will never be what it was prior to 2019

• Inflation is transitory and we won’t see an inflation driven rise in oil prices

• Inflation is transitory and ship construction costs will settle down to a point where the industry will build more if justified by demand

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TL;DR: Scorpio’s investment in a 100% ECO fleet since 2015, and use of the 2020 lull to install more scrubbers, has positioned the company to dominate future product tanker route pricing as inflation raises oil costs and oil product demand rises in 2022 and beyond. At 50% of book value STNG is an excellent value with a reasonable margin of safety due to the ability to continue to operate at a loss on current assets and cashflow. The value increases significantly if inflation is here to stay.