Earnings Call Transcript - FRO Q4 2021

Lars Barstad, CEO

Thank you and welcome to Frontline's Fourth Quarter Earnings Call. We navigated through a market that turned out to be somewhat less dynamic than anticipated. Towards the end of the third quarter, we started to witness a recovery in freight demand, driven by rising export volumes, which carried on into the fourth quarter. Unfortunately, this increase was insufficient to significantly alter the vessel supply and demand balance, and therefore, rates remained relatively unchanged. Moving on to Slide 3, in the fourth quarter, Frontline achieved $6,500 per day on our VLCC fleet, $14,200 per day on our Suezmax fleet, and $13,900 per day on our LR2/Aframax fleet. So far in the first quarter of 2022, we have booked 58% of our VLCC days at $21,300 per day, 65% of our Suezmax days at $19,600 per day, and 56% of our LR2/Aframax days at $18,800 per day. All figures are on a load to discharge basis. To clarify how we attained these figures despite benchmark indices reflecting negative numbers, let’s refer to Slide 4. As we've frequently mentioned, Frontline boasts a large and diverse fleet of modern tankers. It's important to note that the indices meant to indicate market performance rely on methodologies that may be outdated, as modern tankers operate quite differently from older ones. The economic dynamics for modern tankers, especially with scrubbers, have changed significantly amid the wide price gap between high sulfur fuel oil and low sulfur fuel oil. Frontline’s fleet has an average age of 5 years, with 79% being ECO vessels and 54% equipped with scrubbers. The diagrams on the right side of this slide illustrate various benchmark indices categorized by non-ECO vessels, non-ECO with scrubbers, ECO vessels without scrubbers, and ECO vessels with scrubbers. For instance, according to the index, a non-ECO vessel without a scrubber earned an average of $5,400 per day on the VLCC side in Q4 '21, while an ECO vessel with a scrubber commanded a premium of $12,500 per day, attributed to lower fuel costs. This pattern continues for Suezmax and LR2 vessels. It’s crucial to consider these factors when evaluating Frontline’s shares, as we operate a very modern fleet with low cash breakeven levels. With that, I will hand it over to our CFO, Inger Klemp.

Inger Klemp, CFO

Thank you, Lars, and good morning and good afternoon, ladies and gentlemen. Then I think we should start or turn to Slide 5 and look at the income statement. Frontline achieved total operating revenues, net of expenses of $101 million in the fourth quarter and had an adjusted EBITDA of $61 million. We report net income of about $20 million or $0.10 per share and an adjusted net loss of about $5 million or $0.02 per share. The adjustments that we have made in this quarter are different items. We have a $5.3 million gain on derivatives, a $0.5 million loss on marketable securities, a $5.1 million gain on the sale of vessels, the recognition of the distribution from DNK of $13.4 million after tax, and also $1.3 million of amortization of acquired time charters. The adjusted net loss in the fourth quarter decreased by $31.1 million compared with the third quarter. This decrease was driven by an increase in our time charter equivalent earnings due to the higher TCE rates and also a reduction in ship operating expenses. This was partly offset by an increase in interest expense and depreciation due to the delivery of 3 vessels in the fourth quarter. Let's then take a look at the balance sheet on Slide 6. The total balance sheet numbers have increased by about $113 million in the fourth quarter. The balance sheet movements in the quarter are primarily related to the taking delivery of the LR2 tanker from an undisclosed source, in addition to ordinary debt repayments and depreciation. As of December 31, Frontline has $181 million in cash and cash equivalents, including undrawn amounts under our senior unsecured loan facility, marketable securities, and minimum cash requirements. Remaining CapEx, new building CapEx of $437.4 million as per December 31, is fully funded by the $319 million in committed debt and also by part of the net cash proceeds of $68.6 million for the sale of 4 LR2 tankers. The company has no debt maturities until 2023. Then please move to Slide 7, cash breakeven and cash generation potential. We estimate average cash cost breakeven rates for 2022 of approximately $22,700 per day for the VLCCs, $18,900 per day for the Suezmax tankers, and $16,000 per day for the LR2 tankers. The fleet average estimate is about $19,300 per day and includes drydock of 16 vessels in 2022 with an impact of $740 per day. The distribution of the 16 vessels is 5 VLCC, 5 Suezmax tankers, and 6 LR2 tankers. These rates are the all-in daily rates. Our vessels must earn to cover budgeted operating costs and drydock, estimated interest expense, TCE and their higher installments on loans and G&A expenses. We recorded OpEx expenses in the fourth quarter of $7,600 per day for VLCCs, $6,900 per day for Suezmax, and $6,100 per day for LR2, and we drydocked 1 VLCC and 1 Suezmax tanker in the fourth quarter. The graph on the right-hand side of the slide shows the free cash flow per share after debt service and free cash flow yield based on current fleet and share price as alternative TCE base. If we think about the slide that Lars went through on Slide 4, I think it was with respect to how our fleet based on ECO and scrubber adjustments shows significantly higher TCE rates that are also used in this slide. Based on historical tracks in the TCE rates for non-ECO vessels in the period from 2000 to 2021, adjusted for premiums on scrubbers and ECO vessels, Frontline has a free cash flow per share of $2.44 and a free cash flow yield of 32%. The free cash flow yield potential increases, of course, with higher assumed TCE rates and also on a fully delivered basis. With this, I leave the word to Lars again.

Lars Barstad, CEO

Thank you, Inger. Let's move to Slide 8 and do a recap on the Q4 '21 tanker market. As we see the headwind there, we'll start there. Oil in transit is approaching the heights of 2018 and 2019. If you look at the graph at the bottom, and in particular, the dark blue line where you have a red circle, you'll basically see the dots of volume of oil in transit gradually increasing throughout the fourth quarter. Just a small note, if you look at the yellow line on the left-hand side of the chart, that's actually January and preliminary numbers for February where we are now. Global oil demand was estimated to average 99.7 million barrels per day in Q4, and that's an increase of 1.5 million barrels per day compared to the third quarter. But we continue to draw on inventories, and this to the tune of 1.4 million barrels per day during the fourth quarter as demand continues to outpace supply. I would like to make a comment there, because if we rewind 12 months, when I was sitting here having this call, I was very optimistic primarily due to the fact we expected to stop growing on inventories in August, which basically boded for an interesting second half of the year. Well, that hasn't happened, and we continue to draw way beyond anybody's expectations. Projected demand growth for 2022 will predominantly be non-OECD, if one believes EIA's numbers, and we're going to reach very close to 103 million barrels per day by the end of the year. The current oil price signals tightness in the market. There have been production issues in Libya, Nigeria, Angola, and overall, OPEC Plus is over compliant. This means that when they have kind of pre-decided production levels, they're actually not able to reach them. So basically, the unwinding of the OPEC Plus cuts is going much slower than expected. Nevertheless, oil in transit has continuously risen since October '21 and is now up 20% from those. This could be pretty directly equated to tanker demand. So basically, tanker utilization is improving. Despite increased activity and these growing volumes, we have yet to reach the turning point for rates. Let's move to Slide 9 and look at the tanker order books. This is obvious as vessels are delivering and no orders are being placed, the order book is shrinking. We also have this very unusual situation where 6% of the global VLCC fleet is now above 20 years. 2022 is indeed a large delivery year. But by the end of '22, there will be more than 80 VLCCs due for recycling in the same period. We have a big question mark on net fleet growth in the end as this plays out. Suezmax has the same picture, with 12% of the fleet or 72 vessels either above or passing 20 years in 2022. The LR2 order book is more populated, but again, 15% of the fleet will pass 15 years. The thing with LR2s is that their useful lifetime is far more than 15 years. However, in the clean trade, charters do not prefer a vessel that's older than 15 years to carry a clean cargo, basically due to the fear of contamination. This means that an LR2 above 15 years will normally move or change to become an Aframax. The VLCC, Suezmax, and LR2 order book stands at 8%, 7%, and 13%, respectively, and more importantly, meaningful capacity for new tanker orders has now been moved out to 2025. Now let's move to Slide 10 and dig a little bit further into the current fleet composition. Here, I've been looking at the tankers that we are exposed to, the asset classes that we hold. As you all know, by 2023, the IMO will impose new measures. We like to refer to them as tickets to trade. We're going to get Efficiency Ratings on all vessels in the world. For those of you who looked at those, it's A, B, C, D, E, which is basically the range. You need to be C or better in order to get the ticket to trade. Frontline's own fleet overall weighted carbon intensity rating is A based on the 2021 data. But if you look at the chart to the left, you'll see how many ships in the tanker fleet are challenged. 6% of the fleet is over 20 years old. If you have the ones that will be efficiency challenged basically per facing an EEXI rating that is below C, you can add another 17%. If you look at the non-ECOs that struggle to trade economically in the current oil price environment, you're getting up to another 29%. The CII is mentioned a few times on this chart, and CII is a measure for a vessel's carbon intensity and its average emissions per volume transported. A vessel's carbon intensity is important to charters if you are going to charter the vessel, particularly if they have carbon footprint policies. This is also a relevant measure when we talk about carbon tax and the potential of shipping entering the European ETF trading program. Basically, I think we can all agree that the global fleet of VLCC, Suezmax, and LR2s is somewhat challenged over the next few years. The best measure you can apply in order to reduce your CII, or carbon intensity, is speed. Basically, reducing speed will minimize your carbon footprint. However, in order to deal with EEXI, you would need to do physical work on the vessel. You would need to cap its ability to produce power, which ends up reducing speed as well. It's important to note that the Frontline fleet does not foresee any challenges with regards to maintaining compliance with the IMO trajectory until at least 2025. Next, let's move to Slide 11 and discuss tanker recycling. This has been a missing piece in our market for a while. With record high recycling steel prices, activity is finally looking to accelerate. The last two big recycling years were 2017 and 2018. In 2021, we have seen 2.3% of the overall tanker fleet above 10,000 deadweight, which is a measure for the carrying capacity of the tanker fleet, being reduced by 2.3%. We believe this trend must continue. The aging fleet is severely challenged in compliance spot markets and alternative uses or opportunities for older tankers are virtually non-existent. If you look at the bottom graph of recycling steel prices, I tried to find longer history to see if we've ever been at these levels, but I couldn’t find any in the historical data I could access. So we believe this combination of regulatory challenges, which I described on the previous slide, the very challenging market for non-ECO vessels, and the recycled steel prices should produce a positive outcome for tanker owners. Let's move to Slide 12 and look at Frontline and how we are addressing ESG. As I think I mentioned a few quarters back, Frontline started its project, which we call The Decarbonization Journey towards IMO 2030 and 2050. We started that back in 2019. The first thing we did was to find out where we are currently positioned. This includes digitalization and making ourselves able to record live from every vessel we control and feed that into a database where we can analyze, not only carbon but also speed, consumption, and incidents on all our vessels. After that, we planned how to improve it. We have, in the first place, one of the youngest and most energy-efficient fleets in the industry, and we are obviously at all times compliant with increasing regulations. We are making strategic initiatives toward decarbonization, including successful trials of low-carbon marine biofuel. Frontline targets to reduce our carbon emissions by 3% per year, which equates to about 55,000 metric tons. The reason why this works is that it also automatically gives us an increased earnings potential. We share the UN sustainable development goals and promote Seafarers' wellbeing. We publish our ESG report every year, which I encourage all the listeners to review. We also follow what we refer to as sustainability accounting in accordance with the SASB principles. Now let's sum it up in Slide 13. Demand and supply of oil continues to rise. The Omicron variant seems to have a far more modest impact than we could have feared. Tanker markets have, in fact, recovered since Q3 '21, but obviously to a modest degree, far too modest for our liking. We're still challenged by oil supply, which is not fully at pre-pandemic levels. Tanker recycling, as I mentioned in this presentation, is finally starting to make an impact on vessel supply. There are a lot of moving parts, including U.S. SBR releases, discussions about OPEC strategy going forward, and Iranian nuclear talks, creating some interesting dynamics. Oil in transit continues to rise, energy prices are at record highs, and our oil is now flirting with $100 barrels per day. How this will affect the factors I just mentioned creates a lot of interesting dynamics. Lastly, Frontline's financial commitments are fully funded, and we've managed to do so with reduced overall financing costs. We think we are well positioned as the story of this market unfolds. With that, I think we'll open this call for questions.

Operator, Operator

We have the first question from Jon Chappell from Evercore.

Jon Chappell, Analyst

Lars, first thing I want to ask you about, you brought it up in the presentation in the press release, is that OPEC is obviously having a difficult time getting to their production quotas, not Saudi Arabia, not UAE, but there are some other countries with probably some more structural issues. As you think about the supply that the tanker market needs to catch up with this recovery in demand and countries in West Africa and other places can't really meet their quotas, where do you foresee this coming from, especially as the U.S. companies try to be more disciplined? And could it be an issue where the inventory drought lasts a lot longer than anticipated, because we can't respond to that increase in demand with global supply?

Lars Barstad, CEO

Yes. I realized it was a question, but you basically answered it a little bit yourself. The obvious answer where you could relatively quickly increase supply is the U.S. But the discipline among U.S. producers has been, so far, well, not good for us, but good for the oil price. If that continues, this is a challenge. Obviously, you still have barrels in the Middle East countries. I would assume, otherwise, we are in a lot more trouble than we’d like to consider. So I think that kind of that's the likely initial phase should we continue to be where we are now or if the oil price should even rise further. I think OPEC will have to basically open the taps completely. Although OPEC would like to maintain a very high oil price, they also have a huge respect for demand destruction, and an oil price significantly north of 100 could put us in a tough position. That's kind of my thinking here. I also think that if we are in a situation where the U.S. doesn’t grow more, the EIA has about 800,000 barrels per day of U.S. production. Regretfully, U.S. demand is also rising quite rapidly, so we don’t know how much will be left for exports. But I think you have a huge incentive to get something done with Iran.

Jon Chappell, Analyst

Well, that Iran situation kind of leads to my second question. I mean, you've been pretty public about calling out the illicit trading fleet, showing a pretty interesting graph in here showing the difference between the non-ECO, the ECOs with scrubbers and then all the nuances around IMO 2023. It seems like there's so much optimism in the market. People are reluctant to scrap older ships because they're fully paid off and they can still generate a good return on the recovery. At what point do either regulations, economics, or maybe more importantly, just vettings and charters, I assume you speak to the biggest ones, really put their foot down and force more removals of 15-plus-year-old ships?

Lars Barstad, CEO

Well, I think we need to speak about two different markets. In the compliant market, the big charters are already doing this. You see, in the compliant tanker market, which we are part of, we are under scrutiny every day, and we are doing all we can to protect ourselves from exposure to sanctioned activities. However, you have a parallel market here that is making a lot of money. The reason they are profitable is that sanctioned crude is discounted crude. As long as that discount exists, there is an incentive to trade sanctioned crude. In my simple analysis, that's how we can address this issue. In the event of, say, sanctions being lifted against Iran, all that volume will need to go onto compliant vessels, because the normal customers of Iran – and historically, that includes places like India, Northwest Europe, Korea and so forth – simply cannot take that oil on a vessel that does not have compliance in order. That would create an enormous trigger for demand for compliant tankers, and I believe that would be the death blow for this shadow market.

Operator, Operator

The next question is from Randy Giveans from Jefferies.

Randy Giveans, Analyst

Looking at your fleet, let's start there. You agreed to sell the 4 LR2s all delivered to the new owners. Thoughts on further asset sales as asset values continue to outperform spot rates?

Lars Barstad, CEO

Yes. No, this is obviously an ongoing discussion. As you're all aware, we have done some investments on the VLCC side over the last year. We need to explore various avenues for raising equity for that. We've completed two sales, as we believed it was a very good opportunity at the time. We will continue to look at various opportunities. But I would say this was potentially a very favorable deal structure and timing for us. This shouldn't be regarded as a complete change in how we think about the market. We would ideally like to retain as much earnings potential as we can, but we do believe we have historically achieved the best returns in the VLCC market. However, right now, we don't have any immediate plans for further sales of LR2s or Suezmaxes, for that matter.

Randy Giveans, Analyst

Got it. Okay. And then regarding your quarter-to-date rates. Suezmax and LR2 are above breakeven, VLCC is still below. Any thoughts on catalysts to really move those higher? In the meantime, while we wait for the spot market to improve, are you looking to maybe sign some 6-month, 12-month time charters to secure some cash flow?

Lars Barstad, CEO

I'll address your second question first. We are of the opinion that freight markets are mean reverting and history shows us that they are. Each peak and trough has different durations, and obviously, we are currently somewhere in between. We don't see this as a time where you secure cash flow by entering long-term charters. If we are to pursue that, it will be at a different point in the cycle. Additionally, we don't feel compelled to do it because of our solid financial position. We also have a fleet that provides us comfort in these challenging market conditions. Regarding the different earnings across asset classes, this is highly related to the specific trades in the oil market. What the Suezmax shows is that oil has largely been trading relatively short. I won't delve too deeply into details, but a consequence of the energy crisis in Europe with natural gas has put pressure on refinery margins when dealing with high sulfur crude. This effectively means that the natural home for U.S. barrels has been in Europe, which is primarily a Suezmax trade. This circumstance then negatively impacts the VLCC trade. Additionally, the VLCC market is exposed to the fact that the majority of OPEC's recent increases are coming from the Middle East. Being that Middle East is closer to the primary market in Asia, ton miles has essentially suffered from that.

Operator, Operator

The next question is from Magnus Fyhr from H. C. Wainwright.

Magnus Fyhr, Analyst

Just a question on the dry dockings first. You mentioned 16 ships due for dry docking in 2022. Should we expect them to be dry-docked evenly throughout the year? Or do you try to speed up the dry docking given your positive market outlook?

Inger Klemp, CFO

The plan is to dry-dock 4 in the first quarter, 5 in the second and third quarters, and then 2 in the fourth quarter. That is the plan, but we can certainly adjust based on market conditions.

Magnus Fyhr, Analyst

Okay. I think you mentioned about $740 per day for dry docking. Is that around $20 million for those 16 vessels?

Inger Klemp, CFO

Yes, it's a bit less than that; it's about just below $18 million.

Magnus Fyhr, Analyst

Very good. I have a question for Lars. The rates you booked during the quarter appeared to be very strong, partly due to revenue recognition. Moving forward, considering the premiums you mentioned compared to non-ECO, are you achieving similar rates now as you did in the first quarter? I'm aware that the market has been weaker in January and February, so I'm looking to understand if that premium is still present.

Lars Barstad, CEO

For the VLCCs, no, regretfully. So one must appreciate that. On the Suezmaxes, yes, and the LR2s are a bit mixed, I would say. The Suezmax has shown some promise over the last week, week and a half.

Magnus Fyhr, Analyst

Good. And with the market being slightly different this year, have you seen the seasonality play out? With the second and third quarters typically being the lowest, do you expect a steady trajectory into the fourth quarter this year?

Lars Barstad, CEO

That's actually a very good question because, as you know, in our industry, we typically follow seasonality. It is rare that we actually move out of it. A lot of the challenges we have in the tanker market can be traced back to the extremely tight supply situation in the oil market. In theory, we could quickly find ourselves in a typical market due to the fact that an OPEC increase more than planned occurs, something takes place on the Iranian side, or we continue to grow from inventory. Observing the oil curve makes it quite clear why. Crude today is as expensive as it has ever been compared to crude delivered, say, in May, indicating a steep backwardation. Should there be a rapid change in the oil curve, we could see inventory begin to build again. It is concerning to look at the political tension between Ukraine and Russia, especially when the rest of the world is operating with such low inventories. When you're in the bag, there is potential action against one of the largest oil producers in the world.

Magnus Fyhr, Analyst

You mentioned that most of the barrels from the U.S. have gone to Europe, since OPEC has been supplying Asia with crude. If OPEC starts struggling to increase production further, can you see a scenario where U.S. shale production increases more, and that incremental barrel is going to the Far East?

Lars Barstad, CEO

Absolutely. I know where you're coming from, and we view this as a little bit ironic. We've seen a correlation between U.S. SBR releases and U.S. exports. Those exports tend to land in Asia. When you release from an SBR, you make crude available in local U.S. markets, which allows players in the U.S. to export more. This indirect supply into strategic inventories, such as in Japan, China, or even Korea, has been the backbone of the VLCC trade in Q4 and, to some extent, into January.

Operator, Operator

The next question is from Chris Tsung from Webber Research.

Chris Tsung, Analyst

I wanted to touch on your presentation from Slide 4, showing that in your fleet, there are 3 non-ECO vessels in the chart on the right that show a significant premium with non-ECO vessels with scrubbers. Is there a plan to install scrubbers on these 3 vessels? Or perhaps would you look to sell them, as it appears the average TCE in Q4 for non-ECO vessels is still below cash breakeven levels?

Lars Barstad, CEO

This is an ongoing discussion. Obviously, having non-ECO, non-scrubber vessels poses a dilemma: do we sell them or do we install scrubbers to improve their position? I can't give you a definitive answer on this call, but it's certainly a valid question and being discussed. The scrubber spread between high sulfur fuel and low sulfur fuel has widened immensely in the past five to six months, making it very economical to install a scrubber. However, practical considerations come into play when taking a ship out of the market. Additionally, we need to find a shipyard and plan the timing for installation. But I assure you this is extremely high on our agenda, particularly for those vessels.

Chris Tsung, Analyst

Great. One more follow-up on the six VLCC new builds. Do you have an updated timeline or schedule? Just trying to get a sense of the cadence for the deliveries.

Lars Barstad, CEO

Yes. The first one will be delivered in Q2, at the end of Q1, early April. The rest will follow in the second half of the year, delivered as pearls from a string.

Operator, Operator

We have the next question from Greg Lewis from BTIG.

Greg Lewis, Analyst

I apologize if this was already asked, I was having trouble getting on. Given Frontline's exposure and ownership of scrubbers, clearly, the spread between high sulfur and low sulfur is widening. Are you hearing or seeing any concerns about the availability of either grades as oil demand has picked up, or any color you could give around that and how you're thinking about that through the rest of the year?

Lars Barstad, CEO

We haven't encountered any major availability issues, but there have been occasional challenges in certain ports that necessitate booking further ahead. This situation largely stems from bunker market players not wanting to hold inventory in a steep backwardation, meaning they will limit what they hold and wait for an order to be placed for a certain amount of bunkers. While we are experiencing some difficulties, we expect this to improve as we move out of winter in the Northern Hemisphere. Tightness in this market has been caused by straight-run fuel going into the power generation pool due to high gas prices. While high sulfur fuel is difficult to come by in certain locations, we anticipate this situation will ease as we enter spring.

Operator, Operator

We have the next question from Robert Silvera from Silvera Associates.

Unidentified Analyst, Analyst

My question is this: at what level do you see rates having to go to before you will re-initiate or initiate a cash dividend?

Lars Barstad, CEO

That's actually a difficult question to answer. Historically, we don't have a fixed dividend policy; it is more at the Board's discretion. However, history shows that whenever Frontline has a meaningful positive net income, we will distribute dividends. You need to look at our cash breakeven levels, which are all-in cash breakeven, to guide what levels you should look for. That's $19,300 on average over the fleet, but the minute VLCCs start earning meaningful amounts above $22,000, $23,000 a day, and around $19,000 for Suezmax and $16,000 for LR2 and Aframaxes, that is when we would be positioned to start distributing funds.

Unidentified Analyst, Analyst

Do you feel that it would be like 10% above those levels when you might initiate the dividend again? Or would it be only 5%? Can you give us some color on that?

Lars Barstad, CEO

I wish I could to be quite honest. However, if you look at Frontline's historical consistency, we will strive to pay out dividends. We've had instances where we paid out dividends in a quarter with minimal profits because we foresaw strong earnings in the following quarter. I would discourage going into a percentage discussion on that.

Inger Klemp, CFO

So do we.

Operator, Operator

There are no further questions at the moment.

Lars Barstad, CEO

Okay. I think we'll wrap it up. Thank you very much for listening in, and have a good evening and a good day to everyone.