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Oil Tankers Set to Fork Over Profits

By Elliott H. Gue and Yiannis G. Mostrous on June 19, 2008

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Editor’s note: As always, when energy dominates the investment landscape, I turn to KCI Investing in-house expert, Elliott H. Gue, for a fresh look at current developments.
We have a special invitation for our readers. KCI Communications, Inc., publisher of Growth Engines, is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with my colleagues Roger Conrad, Elliott Gue, Gregg Early and Neil George.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please call 800-832-2330.

Oil Insights

 

The largest oil exporters are the Middle East, the former Soviet Union (FSU) and Africa. The Middle East alone accounts for nearly 36 percent of global oil exports; the FSU and Africa each account for roughly 15 percent. These three regions taken together are responsible for two-thirds of global oil trade.

And the world’s reliance on oil trade is only going to increase in coming years. Oil production in key consuming nations such as the US and China is falling or, at the very least, not growing fast enough to keep pace with demand. Therefore, these nations will become increasingly reliant on oil imports to meet demand.

China is a perfect example of this trend at work. Consider that, a decade ago, China imported less than 1 million barrels of oil per day; according to the most recent figures from BP, China now imports more than 4 million barrels per day (bbl/d). That’s a more than fourfold increase in 10 years.

Tankers are key to this global trade in oil. Some 90 percent of all oil shipped from the Middle East is shipped by tanker. Globally, roughly 40 million barrels of oil per day are shipped on tankers; tankers account for just less than three-quarters of global trade.

And longer term, it’s a reasonable assumption that the world’s reliance on tankers will increase. According to the Energy Information Administration (EIA), the Organization for the Petroleum Exporting Countries (OPEC) will actually grow marginally in importance as an oil supplier in coming years. But the EIA also sees most of that supply growth coming from the Persian Gulf region; because oil exports from the Persian Gulf are predominately shipped on tankers, this would raise the importance of tanker trade.

An understanding of the tanker industry is important for reasons other than the potential growth in tanker trade. Tanker rates and chartering activity can offer important clues to broader trends in the crude oil markets.

Much of the world’s tanker capacity isn’t owned directly by major oil producers. Instead, third-party tanker operators own the ships and lease them to companies that need to ship oil. Tanker firms charge a daily fee, or day-rate, for leasing these ships.

There are two basic types of tanker contracts: time charters and spot contracts. Time charters involve leasing ships under long-term, sometimes multi-year contracts at fixed day-rates or rates that adjust based on inflation or some index. Occasionally, time charter contracts also include profit-sharing agreements that allow tanker owners to earn higher rates in extremely tight, strong tanker markets.

Spot contracts are signed based on short-term tanker supply-and-demand conditions. Typically, tankers booked under spot deals are leased for one-off trips. Spot rates can vary wildly based on both seasonal and longer-term factors.

The advantage of time charters is they offer stability and predictability in cash flows over time. Tanker operators with a high proportion of charters won’t experience wild swings in profitability based on volatile spot rates. However, spot contracts typically offer higher returns for tanker owners during strong tanker markets; operators have a sort of tradeoff between stability and a shot at big profits.

Some tanker operators target mainly spot deals, while others have a tendency or stated operational guidelines to sign time charters. Most operators use a blended strategy of mixing time charters and spot deals in an attempt to have the best of both worlds. As a rule of thumb, spot-heavy contractors will outperform firms with heavy exposure to time charters during strong markets for tanker rates.

The other differentiating factor when it comes to tanker operators is the mix of ships in their fleet. There are three important factors to consider when it comes to tanker fleets: ship size, double-hull tanker proportion of the fleet and fleet age.

There are currently around 1,979 crude oil tanker ships operating around the world with a total carrying capacity of 296 million deadweight tons (DWT). DWTs are a measure of a ship’s total weight capacity, including stores, crew, fuel, water and equipment—the higher the DWT capacity, the larger the ship. The table below highlights some of the major classifications of crude oil tanker ships and their size in DWT.

Strong growth in oil demand spells a strong uptick in global oil trade. And much of this demand growth was met by increased production of oil from the OPEC-10 producers; these nations export most of their oil via tankers, helping to drive more tanker demand.

And we can’t ignore the supply side of the tanker market. Rising oil trade and inventory restocking can pull demand for tankers, but the effect this has on rates depends to a great extent on how many tankers are available for chartering.

Tanker availability depends primarily on two factors: new build supply and scrapping. As to the latter point, tankers can be scrapped for any number of reasons. In recent years, the prime reason has been the phase out of single-hull tankers as mandated by the International Maritime Organization.

And other older tankers are scrapped for the simple reason that the rising cost of raw materials makes them more valuable as a source of metal. Some older tankers are being refitted to operate as floating crude storage facilities, drilling rigs or as floating production platforms.

The second source of new supply is simply new build ships. It takes several years to build a new tanker; the exact construction time depends on the type and size of the vessel, as well as the availability of shipyard capacity. A few different data providers offer information on how many new tankers are on order, how many new ships are being ordered and the total size of the tanker fleet.

Inventories looked bloated earlier this year but are now well below average levels; even more interesting, oil inventories are declining now in a period when we should be seeing strong builds in inventory.

And it’s not just the crude oil inventories. Stocks of gasoline and distillates in storage also continue to hover at lower-than-ideal levels. Stocks of both types of refined product are in the lower half of their average range for this time of year.

And without delving into a lengthy discourse, suffice it to say that inventories across the developed world are low for this time of year. According to the EIA’s most-recent, short-term energy outlook, inventory builds in the second quarter across the developed world have been far lower than average.

One year ago, inventories in the developed countries jumped 71 million barrels from the end of the first quarter to the end of the second quarter. This year, the EIA is looking for only a 30-million-barrel increase. This suggests continued tightness in inventories through the remainder of the summer.

Just as in the prior cycles, tight oil inventories during a time of year when inventories should be building spells one thing: an uptick in demand for imports. There’s already anecdotal evidence of larger volumes of oil headed west on tankers toward the Atlantic Basin from the Arabian Gulf.

Saudi Arabia, the one country with meaningful spare production capacity, has announced plans to boost its output. Higher Saudi output often means more demand for VLCC ships to transport that crude to supply-constrained markets.

Speaking Engagements

Be sure to wear a flower in your hair when you venture west to San Francisco. My colleagues Neil George, Roger Conrad and Elliott Gue will be heading to “The City” Aug. 7-10, 2008, for the San Francisco Money Show.

Neil, Roger and Elliott will discuss infrastructure, partnerships, utilities, resources and energy, and tell you what to buy and what to sell in 2008.

Click here
or call 800-970-4355 and refer to priority code 011470 to attend as our guest.

Also, be sure to check out our blog, At These Levels, for more noteworthy stories.

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