Thesis (not my own)*:
Oil inventories are exploding daily. Land-based storage is filling if not already full. Off shore tankers are needed in a big way and are charging insane premiums to store the surplus.
Heres a June 2019 list of largest publicly traded tanker companies.
TK
FRO
TNP
NAT
SFL
DHT
* Transcript that details the thesis:
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Transcript: Opportunity in the COVID Crude Oil Contango Featuring: Harris Kupperman
Published Date: March 26 , 2020
Length: 00:16:57
Synopsis: What happens to the economics of oil when the global economy shuts down because of coronavirus? Harris Kupperman, CIO and president of Praetorian Capital, breaks down the chaos coronavirus has inserted into global oil markets and provides investors with an investment thesis based on the opportunity that chaos has created. In the context of the global shutdown, Kupperman reveals how the combination of the current oil futures contango, all- time highs in tanker charter rates, and the dearth of crude oil storage could lead to never-before-seen revenues and profits for the tanking companies. He walks viewers through the numbers, explains the underpinning economics of the oil markets, and provides time horizons and potential profit multiples for those looking to find opportunity through uncertain times.
The Expert View: Opportunity in the COVID Crude Oil Contango
DREW BESSETTE: What is happening in oil markets right now? Amid the coronavirus outbreak, some of the largest countries in the world have shut down. On top of that, the Saudis started a price war earlier this month. But where there's chaos, there's opportunity. Harris Kupperman, the president of Praetorian Capital, joins Real Vision to share his idea on how an unprecedented supply shock could present an incredible opportunity for investors. He runs down the numbers, walks through the logic, and provides what could potentially be an incredibly profitable trade. Without further ado, here he is. Enjoy.
HARRIS KUPPERMAN: Hi, everybody. My name's Harris Kupperman. Everyone calls me Kuppy. I am the CIO and president of Praetorian Capital. I also run a blog at Adventures in Capitalism. And we look for asymmetric opportunities where we're investing in something that's undergoing an inflection.
How is COVID-19 impacting oil supply?
Well, there's too much of it. That's the problem. If you haven't been paying attention, I mean, look out my window. I live on a busy street. There's no cars going by. My dad's scared to go to the golf club because of the virus. There's no airplanes going by. No one really knows how bad it's going to get, but every hour we hear of another state telling people to stay indoors and do nothing.
If you look at what the Chinese did, they had a partial shutdown of their economy and they had a 25% drop in total oil demand. Oil demand being about 100 million barrels a day globally. So if you assume that the rest the OECD does similar to China, I could see us at a 20 million daily surplus of oil. And if you look at how this worked in China, I could see this lasting 50 days, where, basically everyone stays indoors and does nothing, factories stop, nothing happens, and you really have a billion barrels of oil building up.
But then once they turn the switch on, they tell you you're allowed to leave your home, China's two months out of this process. They're not at full capacity yet. I could see us doing another 10 million barrels a day for 100 days. So 150 days, five months, and a billion barrels the first 50 days, a billion barrels the next 100 days, we're talking a two billion barrel surplus. That's a lot of oil, and no one knows where it's going to go.
Where is the excess supply going to end up?
Well, it's going on to tankers. That's obvious. We're going to fill up the land storage the next week or two. There isn't really that much excess land storage globally. And then it's going to go onto, tankers because that's the only place you can put this stuff.
How does storing oil on an oil tanker work?
Let's look at the costs and benefits of storing on a tanker, and let's start with just looking at the crude oil curve, because that's the key determinant of what's going to happen. So if you look at Brent Oil right now, the one year contango, which is the front month-- it's the back 12 month minus front month-- is $11. Okay. Now you take a very large crude carrier of VLC and you put two million barrels, because that's what it can carry, and you get to earn $11. It's risk-free because you are going to sell the future and you're going to buy physical today, and you're going to make $11 off the next one year. Interest costs are basically zero, all the other costs are basically zero, you're going to make $22 million, okay? It's risk-free.
Now the only cost, really, is the tanker. And that $22 million, Vitols and the Glencores of the world, they're going to go out and they're going to charter that tanker. And if you haven't guessed, most of the money is going to go to the tanker owner, because Vitol and Glencore, they're all bidding against each other. It's a pretty liquid, active market. So of that $22, let's say, $20 of it goes the tanker owner. Okay.
And we're not going to worry too much about the Vitols of the world. They're big boys. What they're going to do is they're going to go to the front part of the curve. And if you look at the three-month curve, it's $5 steep, and the six-month curve is $8 steep. They're going to go to the front part of the curve. We're just focused on what the one-year is.
But of that $20 million that goes to a tanker owner, the tanker that would be doing a crude storage, it's an old vessel. It's a 20-year-old vessel. It's probably worth $25 million at most. And you're going to make $20 million on a $25 million investment, but because you're only $5 million above the scrap value, you only really need $5 million of equity to hold onto this thing. So you're making four times your money. And any time you can make four times your money in one year, you're going to do it, and you're going to do it as many times as you possibly can.
So what this is going to do is it's going to take a lot of older vessels out of the existing fleet, because every guy is going to say, I can lock in a one-year, risk-free, four times my money investment? I'm going to do it. How will more tankers going into storage impact tanker charter rates?
The next step is most of the oil fleet globally is used to transport oil, not to store oil. At any one time of the 800 and change tankers of VLCs globally, a few dozen, maybe, are in storage at most. Most of them are transporting oil. But as you start taking a few a day out of the global fleet to store oil because the contango is so steep, where it's going to do it it's going to push up the charter rates of the vessels that are moving oil around. Because you only have so many vessels, and oil stuck in the Arabian Gulf isn't worth much. You can't turn it into dollars and you need to send it to a country that needs it to turn it into dollars.
So right now, let's do some quick math, okay? Ignore what tankers are earning right now. They are earning $300,000 a day, which is crazy. That's higher than the all-time high. That's a few times the all-time high, minus a few spikes over the last 10 years. But let's just assume it earns $100,000 a day, which is one third of what it's earning today. And mind you, this time last year it was earning about $25,000.
Let's say it's earning $100,000 a day. That means it earns $30 million after expenses for the year. Okay, that tanker is a 10-year-old tanker on average. It's worth about $50 million, and you need about $20 million of equity to hold onto it. That means you make 150% of your equity each year. Now remember, the current rates are $200,000 to $300,000. Let's do the $200,000 number. That means you get $65 million on $20 million of equity. That means somewhere between current rates and half of current rates, you're going to make between one and a half and three times your money this year, owning a tanker. Those returns on capital are unheard of in this industry.
Is this priced in?
Of course not. We're right now having the steepest market collapse in 100 years. Everyone's panic selling. These things are in indexes that are panic selling. This guy's just getting liquidated. It's not priced in. What's the crazy part is that you can actually buy a lot of these tanker companies at half of net asset value. So when you think about that, on stated equity, you're earning between one and a half and three times your money. Now if you could buy it at half of that asset value, you're making somewhere between three and six times your money. And this is almost guaranteed, locked-in, risk-free stuff.
Now the question is, how long it's going to last for? Why can't it last a year or two? When you start thinking this all through, if you're going to put two billion barrels on vessels, you're going to have two billion of surplus and probably a billion and change that sits on vessels, and then the world goes back to normal a year from today and you start running at a five million a day deficit, so it took you 400 days to work through those two billion barrels and get back to a normal level of OECD inventory.
So you might be looking at two years, maybe even three years. So why can't you make 10 times your money on this investment?
Can the Saudis' new oil war impact your thesis?
Well, this is beyond the Saudis, okay? Tanker rates started spiking when the Saudis lifted every vessel globally and tried to flood the market with oil. That was last week's news. This week's news-- and mind you, they were adding two million barrels and the rest of their friends in OPEC plus were adding maybe another million barrels. So that was three.
This week's news is my governor's told me to stay home and he doesn't know when I can leave my house. Like, it's a different order of scale now. It's 20 million barrels, maybe even more. It's totally different than the Saudis and the Russians. And even if they cut production now, it's just a different order of magnitude because it's on the demand side, not the supply side. I think the Saudis started this process, but it's out of their hands now.
What if quarantines end early?
Are you kidding? Like, what governor is going to go up on TV, say, everyone can leave their home, and then tomorrow someone dies? Like, that's a sure fire way to never get elected to public office again. You might even get sued. You might get arrested. I don't know. No, they're going to keep this going a lot longer than is rational and logical. If you think of governments, they'll take a problem and always make it worse.
I think they will keep this going for a few weeks past the point, when it's obvious that the virus has flared out. And even then, once you're out of your house, how many people are going to leave your house? Think of my poor dad. He's 73, he's scared to go to the golf course. Once they tell him it's okay to go to the golf course, he's still not going to the golf course. So who's going to drive their cars? Who's going to take jets all over the place?
I've canceled all my meetings. All the conferences I normally go to each year, they're all canceled. No one's traveling. This is going to take a long time to build back up. And I think that glut's just going to keep building. And while it's building, they're going to book a few tankers a day every day to store this oil.
What is the earliest you think this global oil demand slowdown ends?
I think that's six months out. I think your 2 billion barrels, and every time they close down another major global city, it's just pushing that timeline out and building up the surplus. When you think of the crude oil curve, you really think it through, the front end of the curve right now is sitting there at 27, but if it's going to cost you a few dollars a month to store oil, at some point that front of the curve just goes to zero.
And meanwhile, the back end of the curve is going get awful steep. Because when you think of what happens when you cut off 10, 20 million barrels, what's 2023 oil look like? Why can't that be 75 or 100? You're going to be steep for longer.
What is the impact of the US saying it will we fill the strategic oil reserve?
Nah, it's going to do nothing. Look, we're the richest nation on earth. Our strategic petroleum reserve, Trump's talking about 75 million barrels. That's about three days of surplus. We have two billion barrels coming at us. It's a rounding error. And the Chinese will fill up their reserve, and the Indians will do the same. It's just not going to move the needle. There's too much oil.
How much can producers cut supply?
Oh, obviously they're going to try to cut supply. But this takes time to cut supply. You don't just flip a switch and you don't produce oil anymore. And remember, a lot of these guys are near bankruptcy. They need the revenue to basically cover their interest expense. So no, they're going to keep flooding the market. They're going to probably keep flooding the market even if they're losing a few dollars a barrel. It's one of these things where it's expensive to cut supply, it takes time. Even then, you have to still run the oil through your systems and everything else.
I'm using this 150-day period where you hit two billion barrels, because just knowing how corporates work, you have a problem, then you wait two months for a board meeting, you don' t decide anything, you have another board meeting in two months and then you panic. So there's this a timeline and a cycle of this process.
And no, I don't think anyone's cutting today. The Saudis have basically told you they'll take it to zero if they have to. Eventually they will cut, and that's why you'll have a deficit in a year or two. But for right now, no, I think 150 days, two billion barrels is the part you need to focus on. If we're still doing a surplus after that, then who knows how big the surplus could get?
How does this compare to oil shocks in the past?
So there's been lots of shocks in the past. When you think of oil itself, when you're more than a few hundred thousand barrels on either side of equilibrium, you get wild moves in the price of oil. But let's ignore oil and let's just think of tankers. Every once in a while there's a geopolitical event and demand for tankers changes. Whether it was Egypt closing the canal when they had the revolution, or whether it was Trump sanctioning Costco in Iran, and you had these spikes, but they tend to be short lived. So you have a quick move up to 100,00, 200,000, and then it backs off fast.
This is different. This is going to stay elevated for a very long period of time, because the contango is 11 and I can't see how it doesn't stay 11, give or take, or get wider. And if it gets wider, you actually can earn more storing crude, that's just getting more vessels off the fleets to store oil, which then takes all the residual vessels and push their charter rates higher. The longer this goes on, the bigger the surplus is, the more money you're going to make and the longer it's going to go on for.
How do you play this thesis?
Well, I would say you want to buy tanker stocks. I don't want to get fancy with options. I don't want to think of anything else but tankers. I think you're best off buying yourself a diversified basket of tankers. I don't think you ever want to be making a bet, do I want to own this management team or that management team, this balance sheet or that balance sheet, this fleet configuration or that fleet configuration. I think you want to have a wide basket of these and bet on tankers.
There's some that I'm super excited about. But I don't think this is the right program to talk about individual names. I would just say that you should have a basket.
How will US shale oil producers be impacted?
No, no. I think it's actually going to work a lot like US agriculture, where we produce a lot more than our country needs. We subsidize them dramatically and then we export it. The greatest thing could ever happen is if Trump subsidizes everyone to keep producing oil at a loss, and we just keep producing more surplus. And no one loses their job.
We can print money in America-- we can print dollars that you need for the equipment. Other countries like Nigeria can't print dollars. Eventually they shut off before we do, and we end up just gaining market share. But that's a long process. They'll send my tankers to Pluto.
What are the most important takeaways for viewers?
Yeah. I just want to be clear. It might not be two billion barrels, it might end up being one billion barrels, it might be more. I think these are very fluid numbers, and you shouldn't anchor yourself too deeply on, is it to exactly on the nose at 1.6? The key thing is we're going to overwhelm land storage. And that's the point I want to make.
And then when it comes to tankers, are they all 10 baggers? I don't know, but if you get a triple, is that bad? I don't think you're going to lose much money.
So I just want to make that clear to people watching this. I sometimes speak in hyperbole. But something big is happening. No one's paying attention. The share prices haven't moved. And I really do think people should pay attention.
The big thing to keep in mind is that land storage is filling up. They're going to fill up ocean storage next. And they're going to run out of both, at the rate they're going. And it's going to push tanker prices sky high because it's going to absorb supply at a time when tanker rates are already at multi-year highs. Year over year we've been $10,000, $20,000 above last year's rates all year, even before the virus hit. So it's a strong market to begin with, and it's just going to keep getting stronger.
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