In the ocean shipping rate market, consequences of world events intertwine. Each interacts with the other, and the net result distills down to a price for sea transport, whether it’s dollars per ton of cargo in the spot voyage market, or dollars per day in the vessel charter market.
Analysts and investors are now trying to solve an increasingly complex ocean shipping equation – how trade policies of U.S. President Donald Trump and tensions with China could affect oil demand, how that in turn could affect production cut decisions by OPEC, and beyond that, what it means to tanker freight rates, and by extension, tanker stock pricing.
“Tanker owners and charterers ignore OPEC at their own risk. [OPEC production] is having an outsized impact on the tanker market.”Poten & Partners
In its latest biannual outlook, released in April, the International Monetary Fund (IMF) projected that an escalation of the trade war could shave 0.5-1.5 percent from China’s GDP. The IMF lowered its global GDP growth estimate for 2019 and 2020 to 3.3 percent and 3.6 percent, respectively, down from estimates of 3.7 percent growth for both years in its October 2018 outlook.
Derrick Whitfield, energy analyst at investment bank Stifel, laid out the potential consequences for oil demand in a research note on May 28. He and his team estimated that under “a more punitive case than projected by the IMF,” in which global GDP growth was reduced to 3.0 percent this year and 2.7 percent next year, Stifel’s projections for global oil demand growth would fall to 1 million barrels per day (b/d) this year and to 500,000 b/d in 2020.
Stifel foresees two possible oil supply responses in such a scenario – a continuation of production cuts by OPEC and co-operating nations (OPEC+), and/or a reduction in U.S. onshore production, with the former leading to a more rapid price recovery for crude oil than the latter.
More OPEC fallout?
A decision on a continuation of the OPEC+ cuts will be made on June 26. Currently stated OPEC+ cuts are 1.2 million b/d, although actual declines are significantly greater. S&P Global Platts estimates that OPEC output hit an all-time high of 33.08 million b/d in November 2018, and had fallen to 30.26 million b/d last month, given additional reductions from Libya, Venezuela and Iran.
According to a recent commentary by energy and shipping consultancy Poten & Partners, “Tanker owners and charterers ignore OPEC at their own risk. [OPEC production] is having an outsized impact on the tanker market.”
“The magnitude of the demand decline can have a significant impact on tanker rates and profitability.”Derrick Whitfield, Stifel
Given the central importance of the crude trade between the Middle East and Asia, OPEC policy has a particularly significant effect on rates for very large crude carriers (VLCCs), vessels that are designed to carry around two million barrels of crude oil. “Since crude oil production and tanker employment are clearly correlated, changes in OPEC production had a direct impact on VLCC rates in the second half of 2018 and into 2019,” noted Poten.
According to Whitfield at Stifel, “Global seaborne transport of crude oil is 40.5 million b/d or 40 percent of global consumption. We believe [crude consumption] demand reductions would result in tanker demand growth [reduced to] 1-2 percent per year [in 2019-20].”
He continued, “The magnitude of the demand decline can have a significant impact on tanker rates and profitability. When OPEC cut production in November 2016, a similar amount of capacity was removed from the seaborne trade. During that time, average VLCC rates were $50,000 per day, with rates falling to less than $15,000 per day. Only in 2018, with rising U.S., OPEC and Russian oil production, did crude tanker supply and demand return to equilibrium and rates return to north of $40,000 per day.”
The implied equation is that higher trade tensions could equate to lower Chinese and global growth, leading to lower oil demand, increasing the chance of extended OPEC+ cuts, which consequently increases downside risk for VLCC rates and tanker rates in general.
From a stock-trading perspective, Whitfield focused on the consequences that would theoretically transpire in the wake of continued OPEC+ action. A decision to extend production cuts should increase oil prices and decrease tanker rates, implying that oil stocks and tanker stocks should move in the opposite direction.
“Given the negative correlation between oil prices as a response to OPEC action and tanker rates/equity values, we believe crude tanker equities could be an interesting hedge to the broader energy group,” he said.
Lessons of the past
The tanker/oil stock hedging idea is not new. It was a very popular strategy among hedge funds from the early 2000s until about mid-2015, when the tanker/oil relationship broke down. In that earlier period, the strategy’s popularity was very important to listed tanker owners because the energy funds using tanker stocks as a hedge were responsible for a large amount of the trading liquidity in the tanker stocks.
The price of crude oil fell sharply in 2014 and throughout 2015, causing oil company shares to plummet. In the same two-year period, and into 2016, tanker spot rates rose significantly. However, starting in the second half of 2015 and accelerating into 2016, stocks of major crude tanker owners such as Euronav (NYSE: EURN) and DHT (NYSE: DHT) sold off – losing their positive correlation with tanker spot rates. They also lost their negative correlation with oil stocks, and thus, their value as a hedge.
Wall Street analysts voiced three different theories on why this disconnect occurred. First, energy hedge funds were losing so much on their oil investments that they needed to sell their winners (the tanker stocks) to pay for the losers. Second, that tanker stock investors were focused on vessel supply not cargo demand, saw the wave of tanker newbuildings destined to hit the water in 2017-18, and bailed out of the equities early.
Third, tanker stocks fell because tanker asset prices were declining despite strong freight rates. Shipping stocks are generally valued based on the current market price of the assets – the ‘steel’ – not the discounted cash flow of projected future rates (which are too volatile to project).
In early 2016, several tanker executives publicly claimed that tanker asset prices were falling despite rising rates due to severe weakness in the dry bulk and offshore sectors; many tanker owners also possessed ships in those depressed segments, and were believed to have sold tankers at lower prices than they otherwise would have to raise money to pay for non-tanker commitments.
Whatever the reason, there’s a lesson to be learned from what transpired in 2014-16, one that seems trite but is typically unheeded. Predictions on crude tanker rates and stock prices are frequently wrong, because there are too many interlinked global variables in the full equation to be understood, except in hindsight.