A Safer Way to Play Higher Oil

Companies that own and operate tankers are in perfect position.
By Jim Jubak ,

If you want to make money in the energy sector but avoid seeing your investment sunk in the stormy market, think tankers.

Shipping companies that own oil tankers thrive when demand for crude soars. And thanks to new regulations calling for safer tankers, the global supply of these ships is growing more slowly than demand.

Oil demand is climbing. Nobody disputes that. Global demand for oil will climb by 3.7% in 2004, according to the International Energy Agency's Feb. 11 report. That forecast is a big jump from the 1.8% growth the agency predicted just a month earlier, and it represents the fastest growth in global demand for oil since 1997.

Driving the surge in global demand are growing economies in India, Thailand and Vietnam. But the biggest force in the global oil market is China, where oil demand grew at an annual rate of 10% in January.

Will Crude Oil Prices Fall?

Nobody is sure about supply, however. The Wall Street consensus is that supply will increase enough to cut prices to $25 per 42-gallon barrel from the current $36 level. For the theory to work, a number of events must come together:

  • Iraq will pump more oil soon.

  • Tighter limits just set by OPEC will lead to more cheating by members.

  • Global production will climb as political problems fade in countries such as Nigeria.

  • Higher prices now will lead to more drilling and more oil discoveries.

Some analysts even believe that crude oil prices will fall to $22 sometime before year-end. That's why Wall Street believes earnings from energy companies will fall in every quarter this year.

I think Wall Street's wrong about falling oil prices. So, obviously, do the investors who have bid up energy stocks such as

ExxonMobil

(XOM) - Get Report

,

Apache

(APA) - Get Report

and

ChevronTexaco

(CVX) - Get Report

by 25%, 26% and 35%, respectively, in the last 12 months. I think oil prices above $30 a barrel are here to stay, and long-term trends of rising demand and increasingly expensive discovery and production will push prices higher from current levels, even if you correct for the effect of a declining U.S. dollar.

But I could be wrong about the price of oil. So I'd love to find a stock or two that would let me capture the upside of higher oil demand if I'm right about supply and oil prices, and protect me from the downside if I'm wrong about supply and oil prices.

Tanker Supply Will Be Shrinking

Oil tanker stocks give me exactly that combination. Thanks to some regulations that take effect on April 5, 2005, about 12% of global tankers will be removed from the shipping supply.

The International Maritime Organization (IMO), an agency of the United Nations, has written new rules that accelerate the mandatory phase-out of single-hulled oil tankers and require stricter inspections of older tankers. The goal, set in the aftermath of the Exxon Valdez incident in 1989, is to replace those oil tankers most likely to leak in an accident with safer double-hulled tankers as quickly as is economically feasible. The IMO estimates that about 12% of the current global tanker fleet, the oldest single-hulled tankers now in operation, would be banned from service by the end of 2005. All single-hulled tankers would be banned by 2010.

Of course, that accelerated phase-out will cost almost all tanker companies money in the short run.

On the other hand, the accelerated phase-out will result in a rise in what tanker companies are paid to charter their ships. Tanker demand will grow by at least 3% in 2004, estimates Jefferies & Co., the New York investment banking firm. The demand could be more if the most recent International Energy Agency projections are correct.

The addition of new ships minus the scrapping of old ships, however, will result in the global tanker fleet growing by less than 3% in 2004. In 2005, Jefferies estimates, global tanker demand will grow by 2.7% -- I believe it will be closer to 4% -- and net global tanker supply (after new ship deliveries and after scrappings of old ships) will increase by 2.6%.

This demand/supply mismatch will make money for those tanker companies with:

  • The newest fleets.

  • The most tankers in the spot market vs. those whose ships are tied up with long-term fixed contracts.

  • The most new ships due for delivery soon.

  • The balance-sheet strength and cash flow to pay for new ships.

All of that ends up as a win/win situation for the sector overall. Let's get more specific. The winners I like are such companies as

Teekay Shipping

(TK) - Get Report

,

Tsakos Energy Navigation

(TNP) - Get Report

and

Stelmar Shipping

(SJH)

. They have the new ships available to take advantage of the supply shortage.

Teekay

Teekay Shipping, headquartered in the Bahamas and in Vancouver, B.C., is the largest owner of medium-sized spot tankers in the world. About 80 of its 137 ships operate in the spot market. The company's fleet averages 8.2 years in age. And about 76% of the fleet is double-hulled.

The company has 14 tankers and one shuttle tanker scheduled for delivery in the next three years. By my calculations, the company will generate about $800 million in free cash flow, even after paying for new tankers, in 2004. And Teekay has reduced its net debt to about 42% of total capitalization from 47% in 1998. (The company's debt-to-equity ratio is 1.03.)

Tsakos

Tsakos Energy Navigation, headquartered in Athens, Greece, is a small-cap version of Teekay Shipping. Tsakos operates a fleet of just 28 vessels. About 35% of its ships operate in the pure spot market. Another 32% operate in the longer-charter market.

Because the long-charter vessels operate at variable rates, about 70% of the company's tankers effectively operate in the spot market. The Tsakos tankers average just 6.8 years of age, and about 90% are double-hulled. Tsakos has nine new tankers on order, a huge number given the relatively small size of the company's fleet.

Tsakos has been on a heavy expansion program that started with just seven ships in 1997. That has driven debt to $537 million, or about 61% of total capital. (The debt-to-equity ratio stands at 1.56.) That's high, but the company will generate about $120 million in cash flow in 2004 by my calculations. Cash flows should be strong enough to pay down debt once the current buildout is completed.

Stelmar

Stelmar Shipping, also headquartered in Athens, concentrates in the small-tanker market. Thus, it has relatively little exposure to shifts in the volume of oil shipped on long ocean routes from the ports of OPEC producers. The company should complete an aggressive shipbuilding program by the middle of 2004 that will add 11 ships and bring its total tanker fleet to 41. That will give Stelmar about 20% more operating days to sell in 2004. Tankers are typically chartered on a per-day basis. The fleet will be six years old on average when the buildout ends.

Stelmar has the lowest exposure to the spot market of the three stocks in this group at just 50%. That limits the company's upside if tanker rates climb as I project, but it also gives the company more revenue and earnings stability. The debt-to-equity ratio, at 1.29, is in the middle for this three-stock group. Cash flow will come in about $110 million in 2004 by my calculations.

The Strongest Balance Sheet Wins

Which of these should you buy if you have to pick just one?

Teekay has added a fleet of lighters (smaller, flat-bottomed vessels used to move oil on and off tankers), floating storage platforms and a new logistics service business to its core tanker fleet. That gives the company more stability in its revenue, but also reduces its upside exposure to the tanker supply/demand cycle. The net asset value on this one is about $50 a share, so there's a little more downside to the current price than with Tsakos and Stelmar, but the company's balance sheet is far stronger than the two Greek-based companies.

I calculate a $77 target price of Teekay. That's about a 22% potential gain from the recent price, and better than what I'm looking at with either Tsakos or Stelmar by my numbers. So Teekay is my pick of the three, and I'm adding the stock to Jubak's Picks with this column with a target price of $77 by December 2004.

This pick fills out the Jubak's Picks portfolio's energy holdings and uses up the last available cash I have in the portfolio. I'm now 100% invested. To buy anything else right now, I'll have to sell something.

So in my next column, I'll rake through the technology sector to see if there are any stocks in that volatile area attractive enough to make me give up one of the solid but stodgier stocks I now own.

At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jubak at

jjmail@microsoft.com.

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