Earnings Call Transcript - FRO Q2 2023

Operator, Operator

Good day and thank you for standing by. Welcome to the Second Quarter 2023 Frontline plc Conference Call. At this time, all participants are in a listen-only mode. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Lars Barstad. Please go ahead.

Lars Barstad, CEO

Thank you. Dear all, thank you for listening in to Frontline's second quarter earnings call. In the second quarter, we had a very untypical spike for VLCC and Suezmax towards the end. This puts us in a position to make some extra cash and also to carry some value into the third quarter. Most interestingly, this spike was caused by minor weather delays, telling a tale of how narrowly balanced our market is. The macroeconomic headwinds seem to have a very muted impact on our little part of the global macro puzzle, and we'll get to that later in the presentation. I think it's worth mentioning that in markets like these, Frontline’s efficient and transparent platform shines brightly, effectively turning revenues into shareholder returns. Our running cost remains fairly stable, as expressed in our cash breakeven levels, and all the incremental income goes straight to the bottom line and back to you, shareholders. Before I give the word to Inger, let's look at our TCE numbers on slide 3 in the deck. In the second quarter, Frontline achieved $64,000 per day on our VLCC fleet, $61,700 per day on our Suezmax fleet, and $52,900 per day on our LR2/Aframax fleet. I hope you're all fairly comfortable with these numbers. We are back to a somewhat reverted earnings relationship between our segments, with the VLCC making the most. We have secured quite firm numbers as we progress into Q3, with 74% of our VLCC days booked at $53,200 per day; 67% of our Suezmax days fixed at $48,800 per day; and 57% of our LR2/Afra days at $40,500 per day. And again, to remind you, all these numbers are on a load-to-discharge basis, which will be affected by the amount of ballast days we have towards the end of Q3. Now, I'll let Inger take you through the financial highlights.

Inger Klemp, CFO

Thanks, Lars, and good morning and good afternoon, ladies and gentlemen. Let's turn to slide 4, the profit statement, and look at some highlights. In the second quarter of '23, we recorded the highest second quarter profit since 2008 of $230.7 million or $1.04 per share. Adjusted profit came in at $210 million or $0.95 per share. Revenues came in at $513 million. We declared a cash dividend of $0.80 per share. I will mention that following the transition to IFRS, drydocking costs will be capitalized and subsequently depreciated over the period to the next scheduled dry docking, which is 2.5 to 5 years. In the second quarter, dry docking costs of $1 million have been capitalized and one vessel was dry docked in this quarter. In addition, I will mention that the Company revised the estimated useful life of its vessels from 25 years to 20 years, effective January 1, 2023. Let's then look at some balance products on slide 5. The Company has no remaining newbuilding commitments, as it took delivery of the last two VLCC newbuildings, Front Orkla and Front Tyne, in January 2023. The Company has strong liquidity of $719 million in cash and cash equivalents, including an undrawn amount of unsecured facility, marketable securities, and minimum cash requirements for banks as of June 30, 2023. We have a healthy leverage ratio of 51%. Finally, let's look at the cash flow potential on slide 6. We estimate industry-leading cash breakeven rates of $22,700 fleet average, including drydock costs for 8 Suezmax tankers in 2023, with 4 in the third quarter and 4 in the fourth quarter. The Q2 '23 fleet average spot excluding drydock was $7,300 per day. We see from the graph on the right-hand side that free cash flow indicates a strong potential return. If we assume VLCC TCE rates of $75,000 per day at a 5.5-year historic spread to VLCC for Suezmax and LR2 tankers, the annual free cash flow potential is $1.4 billion, or $6.34 per share, which translates into a free cash flow yield of 36%. With this, I'll pass the word back to Lars.

Lars Barstad, CEO

Thank you, Inger. So let's go to slide 7 and look at what's going on in the current market. We've just been through a very volatile summer market, and hopefully, it's coming to an end. The key themes have been that the Asia Pacific continues to pull volume. We're seeing increased supply from what I would refer to as "new" exporters, as you can see on the bottom right-hand side chart. This includes the United States and Brazil. They're not really new contributors, but they are growing at least, alongside Guyana, which adds some spice to the mix here. As OPEC cuts production, predominantly around the Middle East, and with the continuous pull from Asia Pacific, we've seen ton-miles increase, benefiting VLCC ton-miles in particular. Year-on-year, or quarter of Q2 last year versus Q2 this year, demand in the Asia Pacific region is actually up 1.8 million barrels per day. That's quite significant, considering most of that oil is being freighted on tankers. This represents about a 5% increase in commensurate volume for shipping. Moreover, those 5% do not take into account a ton-mile effect. We've started to see the Russian price cap beginning to impact in Q2, and I will touch on that later. We are also observing refinery margins improving as we move towards the end of the maintenance season. Additionally, we have the background noise of virtually every analyst expecting oil demand to grow by about 2 million barrels per day for the second half. Let's go to slide 8, and I'll discuss the Russian price cap and the effect that has had on our markets. The G7 oil price cap came into effect in December 2022 and was set at $60 per barrel for Russian crudes. We are using the Urals as the reference oil price on the bottom left-hand side, predominantly the quality one discusses around Russian supply. As the price has moved above the cap, it has become increasingly complex to freight Russian oil. We've seen various policies among owners, with some being less willing to service the Russian market as the sanctions make it hard to justify lifting Russian barrels. These vessels are then returning to the non-Russian market or the regular Suezmax and Aframax markets, and this has put pressure on rates as the capacity has increased particularly in these fleet sizes. Product exports have been less affected and are currently flirting with the price cap, trading around $100 for gasoline. We have seen Russian exports falling quite rapidly due to this, with a loss of 1.7 million barrels per day since the peak in April—400,000 barrels of that being products and 1.3 million barrels per day of crude or fuel oil lost in the last 5 to 6 months. It will be interesting to see how this develops further. We are starting to hear analysts argue that the Russian-controlled or owned fleet is struggling to maintain volumes, which is evident in the export statistics. The only way they can replace the capacity would be to go into the non-Russian trading fleet and acquire more assets, of which a considerable number of vessels are needed to maintain their export levels. It is critical to observe how this situation unfolds. Now let's move to slide 9 and consider the refinery world. It's important to note that we've had a series of disruptions in the tanker industry over the last few years, and the seasonal summer slowness is correlated to refinery maintenance scheduling. On the bottom left-hand side, we see global refinery outages, which are volumes taken out due to maintenance work. There is a distinct peak in April and again in September and October, when refineries shut down to perform maintenance and thereby prepare for either the summer or winter seasons. This significantly impacts oil demand and also affects demand for tonnage. Currently, we are heading towards a high turnaround season in September and October, and demand for tankers appears fairly stable as we head into this period. However, one should remember that tankers are fixed ahead; VLCCs are now being fixed for mid-September, with oil landing in various refining regions by the end of that month. If you look at West African crude being fixed today, it will land in early October, while in the U.S. Gulf, we are already fixing oil that will arrive in mid-October. Over the next few weeks, we will hopefully witness the activity of purchasing managers from refineries planning to bring more oil as they come out of their turnaround period. In terms of refinery margins, they are firming—a result of outages and a significant signal of expected demand. Diesel margins are leading the way, as is typical for this season, given the historical winter demand for heating while summer demand is more focused on gasoline due to driving. We had a relatively mild winter last year in the Northern Hemisphere, but the jury is still out on whether we will see a repeat this year. As we move to slide 10, I'd like to bring attention to the fleets and orderbooks. A notable thing in this quarter is the increase in orders for LR2s, with 50 new LR2 orders being placed in the first half of this year, bringing the orderbook to nearly 20%. We utilize a 20-year effective lifetime for trading tankers; however, for an LR2, it essentially functions as a 15-year lifespan due to the coated tanks losing their quality over time. Charterers are hesitant to book a clean LR2 over 15 years old. When you consider this, the orderbook does not present troubling figures. The main worry lies in the lack of new orders for VLCCs and Suezmaxes. We have the highest percentage of the fleet above 20 years old we've ever observed, with 108 VLCCs and 85 Suezmaxes in this category this year. If you enter the market to book a tanker now, particularly a VLCC, you're looking at delivery times in the second half of 2026—three years from now, which does not align with expectations of sustained crude oil demand over the next 3 to 4 years. Moving to slide 11, I'm pleased to announce the highest second quarter profit since 2008 of $210 million, and a cash dividend of $0.80 per share. Over the last four quarters, if my records are correct, Inger, we have paid out $2.72.

Inger Klemp, CFO

That's correct.

Lars Barstad, CEO

With an average share price during that period of $13.9, that's a 20% yield—quite impressive, I believe. Demand from Asia continues to be supportive, and OPEC cuts are driving ton-miles. The price cap on Russian crude is beginning to impact the market, and we expect seasonal refining maintenance to come to an end with margins improving. This is what we anticipate will be reflected particularly in the VLCC, and secondly, the Suezmax market over the next few weeks. Ordering remains muted for larger vessels, but for LR2s, there has been significant activity in recent months. The big question is how this winter will play out. The overall largest question in the tanker industry going forward is represented by the chart at the bottom here: the tanker order book as a percentage of the fleet. I've provided a historical overview from 1996 to illustrate this trend. We see the dark blue line representing product tankers starting to respond, but not significantly at this stage. The gray line for VLCCs indicates virtually no new orders. With that, I think we can open it up to questions.

Operator, Operator

And now we’re going to take our first question. The question comes from Jon Chappell from Evercore.

Jon Chappell, Analyst

Thank you. Good afternoon. Lars, you mentioned in this closing slide the question about the winter. Everything seems queued up pretty well from inventories to the refinery maintenance coming to an end to the IEA's outlook for the second half’s sequential recovery. What can go wrong this winter? Is it just a macro event where oil demand continues to disappoint? Is there something related to Russia? Do the Saudis become more emboldened and keep more oil off the market to create a bigger inventory draw, but the tankers don't see the demand? Where can we miss the typical seasonal recovery that seems set up so well?

Lars Barstad, CEO

I think there are two key factors that need to be monitored. First is obviously China. There are mixed signals coming from China. In terms of oil transport, as I’ve mentioned, China seems to be operating at full capacity, with import numbers at record highs each month. However, this doesn’t correlate with overall macroeconomic data coming from China. If they are building inventories leading into winter, historically they have the capability to reduce imports by 1 to 2 million barrels per day. If that occurs, it won’t be bullish. So, determining China's intentions, whether they are hoarding crude in anticipation of a price increase, preparing for stimulus, or exporting oil, is crucial. That's the primary concern. Secondly, there's the weather variable, which is beyond our control. We need to consider whether we will experience another mild winter, like last year, or face a harsh winter that will positively affect demand. These are the two primary factors that raise my concerns.

Jon Chappell, Analyst

Okay. That makes sense. Just a follow-up question on strategy. I found it interesting that you noted the dearth. I mean, we all know that there isn't much of an order book, but you mentioned the concern about not having enough ships to compensate for some of the older vessels. It's rare to see Frontline without anything on your newbuilding plan. Given the need for a new ship could take three years for delivery, how should we think about your capital investment in newbuilds or secondhand ships going forward?

Lars Barstad, CEO

Regarding newbuilds, we are definitely sitting on the fence. We've discussed this before. You would need earnings above $50,000 per day over a period of 20 years to justify ordering a newbuild at current levels. Additionally, there are technology discussions and other factors to consider. We do not view this as a beneficial proposition. In terms of the secondhand market, we will always be looking, but modern tonnage available has been extremely limited. A couple of deals have been made, but the pace has been very slow, which hasn't presented us with significant options. I’ve previously mentioned that we might be in a harvest period, but it’s difficult to say.

Jon Chappell, Analyst

Would you consider harvesting by selling off older tonnage, or are you content with the fleet as it stands today?

Lars Barstad, CEO

We are fairly content with the composition of the fleet. Of course, there are some units that down the line we may consider letting go of, but overall we are comfortable. Many of the older vessels we retain are modified or derated, making them well-suited for upcoming regulatory changes. Therefore, we are satisfied with our current fleet.

Operator, Operator

Thank you. Now we're going to take our next question. Just give us a moment. The next question comes from the line of Amit Mehrotra from Deutsche Bank.

Chris Robertson, Analyst

Hi. Good morning, good afternoon. This is Chris Robertson on for Amit. Lars, I wanted to revisit the discussion around the supply coming back into the market from the Russian trade. Are these ships in the penalty box in terms of returning to the normal market? Are they trading normally? How much of that supply just won't ever come back? Can you elaborate on that?

Lars Barstad, CEO

Yes. We've previously discussed the 'dark fleet,' which refers to Venezuelan and Iranian trading vessels that are essentially in the penalty box indefinitely. Then, there's the 'gray fleet,' which has a questionable trading history that may struggle to find acceptance with compliant charterers. Lastly, we have the non-trading Russian fleet, or those that have touched Russian oil on a few occasions. When some of these units return to markets, for instance, the West African CD20 markets, they might have to lower their rates to gain acceptance. However, we haven't seen substantial resistance from charterers, provided the vessels don't have questionable history. It’s important to note that transporting Russian crude is legal as long as it adheres to the sanctions.

Chris Robertson, Analyst

That was good context. My follow-up question is about your comments on the order book and the absence of scrapping. Concerning 20-year-old vessels, can you provide insights on how much of a discount these vessels earn in comparison to the average, and does a minimal discount lead to extended lifetimes for these ships?

Lars Barstad, CEO

The portion of the fleet past 20 years isn't typically engaged in the normal freight market we compete in. It’s been quite some time since we've seen any 20-year-old vessels fixed by a commercial party. The last instance was IOC last fall. Rather than focusing on the discount, we assess their efficiency. This is why we tend to halve their efficiencies in our supply and demand model once they reach 20 years. There might be a scenario where ships need to linger in the market longer than desired, but only when we have strong earnings will charterers feel comfortable using older vessels for transportation. For that to occur, we need rates to reach $100,000, $150,000, or even $200,000 per day.

Operator, Operator

Thank you. We're moving on to our next question. This one comes from Omar Nokta from Jefferies.

Omar Nokta, Analyst

Lars, I have a couple of questions. As a follow-up to Jon's earlier inquiries, regarding your disinterest in ordering VLCCs due to timing and costs - does this sentiment apply to Suezmaxes and LR2s as well?

Lars Barstad, CEO

Regarding VLCCs, we are content with our Suezmax fleet, which is predominantly modern. We have signaled a belief that VLCCs can potentially offer our investors better returns due to size advantages. It can also be said that the same concern exists for Suezmaxes. The challenge in the shipbuilding market is that while owners aren't interested in ordering, shipyards are likewise uninterested in taking orders if they can build higher margin vessels. Currently, one can find between 150 and 200 shipyards in the world servicing commercial segments; however, over 100 are building dry bulk vessels, and more than 80 are constructing container vessels. Only 13 yards have tankers in their order books. It's quite peculiar, and additionally, very few shipyards can build VLCCs, creating a structural issue in our industry.

Omar Nokta, Analyst

Thanks, Lars. That's insightful. Something has to give at some point. Just one follow-up, considering what Jon discussed, what's the inverse of 'what could go wrong?' What could go right in terms of this market over the upcoming months? You've mentioned improving refining margins and higher LR2s. Should we expect LR2s to outperform momentarily, and what changes do you foresee for crude tankers to experience a bounce?

Lars Barstad, CEO

Ultimately, we need a demand of around 103 to 103.5 million barrels per day in December to maintain positive market momentum. If that demand projection holds, we could gradually improve. Additionally, Russia remains a significant factor, along with China. Given the demand projection, oil prices should behave reasonably well. This could motivate stakeholders to procure the assets necessary for their products' transportation, thus potentially reversing the trend of prior competition from former Russian trading vessels. This situation could also lead to older tonnage entering the Suezmax and Aframax markets. Moreover, there is a developing narrative concerning the headwinds from China regarding their economic strategies: will they allow the country to operate at limited capacity until they achieve a natural recovery, or will they stimulate their economy to increase demand? Both scenarios could lead to an additional 2 million barrels per day in demand and healthy import figures into China, painting an overall bullish outlook. However, it is crucial to remain vigilant and look for potential cracks within this seemingly positive environment.

Omar Nokta, Analyst

It certainly looks like all pieces are aligning, and we just need to see if they play out. Great. Thanks, Lars. I'll pass it over.

Lars Barstad, CEO

Thank you.

Operator, Operator

Thank you. Now we're going to take our next question, which comes from Chris Tsung from Webber Research.

Chris Tsung, Analyst

I have a quick question regarding your fleet. What are your plans for the 2010 built VLCCs without scrubbers? Would you look to install scrubbers, or could those vessels be sold, and what is the timing for those decisions?

Lars Barstad, CEO

That's a specific question. It’s likely that they will have scrubbers installed according to the drydocking schedule. Currently, they are making money consistently, so they remain a part of our fleet.

Chris Tsung, Analyst

Fair enough. One for Inger. Sorry, I missed the part earlier when you provided drydocking guidance. Can you repeat how many vessels you plan to drydock for the remainder of the year?

Inger Klemp, CFO

For this fiscal year, we plan to drydock 8 Suezmaxes, 4 in the third quarter and 4 in the fourth quarter.

Chris Tsung, Analyst

Okay. That's it for me. I’ll turn it over. Thank you.

Inger Klemp, CFO

Thank you.

Operator, Operator

And the next question comes from the line of Lo McGibben from Frank Winnie.

Unidentified Analyst, Analyst

Hi. Two questions. First, when you transitioned from a 25-year to a 20-year depreciation model, how much did that reduce earnings per share?

Inger Klemp, CFO

It totaled about $60 million for the year, which translates to approximately $0.36 per share.

Unidentified Analyst, Analyst

Thank you. That is a conservative approach, and I applaud you for taking it. Regarding the premium on modern vessels, could you share your insights on that? Specifically, when does the next major regulatory change kick in, and what contributes to the premium Frontline benefits from having the world's youngest fleet?

Lars Barstad, CEO

That's a complex topic with several components to consider. Primarily, the next significant change isn't from IMO regulations but from the EU ETS, which mandates carbon taxes for trading in Europe. This change will take effect next year, and while it may not heavily impact larger ships, it will affect Suezmax and Aframax. We believe that having efficient vessels will provide significant advantages. Additionally, the discussion surrounding alternative fuels is becoming increasingly important. Currently, it’s costly to use biofuels in your fuel mix; however, if faced with carbon credit costs, it becomes economically viable. That’s the regulatory landscape going forward. In terms of the premium we enjoy from our younger fleet, you also touched on how interest rates may impact it, especially since holding oil on a younger vessel is less expensive. While financing costs impact inventory levels globally, we've not observed significant effects in the spot market.

Unidentified Analyst, Analyst

What percentage of your business is European, which would be affected by the regulatory changes?

Lars Barstad, CEO

It varies, but on the whole, about 10% to 15% of our voyage days would be affected by the EU ETS.

Unidentified Analyst, Analyst

Thank you, and congratulations to both of you for running the most efficient tanker fleet in the world.

Lars Barstad, CEO

Thank you very much.

Inger Klemp, CFO

Thank you very much.

Operator, Operator

Thank you. Dear speakers, there are no further questions. I would now like to hand the conference over to Lars Barstad for any closing remarks.

Lars Barstad, CEO

Thank you very much, and thank you for listening in. The markets are a little bit in the doldrums right now, but I'm hearing signs of bottoming from various parts of the marketplace. Over the next few weeks, we hope to transition into the winter season, and we're looking forward to seeing what comes.

Operator, Operator

That does conclude our conference for today. Thank you for participating. You may now all disconnect. Have a nice day.

Lars Barstad, CEO

Thank you.