Earnings Call Transcript - FRO Q4 2022

Operator, Operator

Good day, and thank you for standing by. Welcome to the Fourth Quarter 2022 Frontline PLC Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Mr. Lars Barstad. Please go ahead.

Lars Barstad, CEO

Thank you. Dear all, thank you for tuning into Frontline's fourth quarter earnings call. I know it's been a busy day for at least those of you who are analysts. It's quite a few companies reporting today. I have a feeling some of the questions in the upcoming Q&A will be focused on the termination of the combination agreement with Euronav, but let's, for now, focus on Frontline and the small key markets we've had in the fourth quarter. Although the implications of Russia's invasion of Ukraine caused most of the headlines, we believe, from a tanker market perspective, China was the catalyst to Frontline posting the best quarterly result in over 14 years. We finally fired on all cylinders throughout the quarter and our lean and mean business model demonstrated its effectiveness. Let's quickly look at our TCE numbers on Slide 3 in the deck. In the third quarter, Frontline achieved $63,200 per day on our VLCC fleet, $57,900 per day on our Suezmax fleet, and $58,800 per day from our LR2/Aframax fleet. And finally, the inverted earnings relationship between our segments temporarily reversed. So far in the first quarter of 2022, we have booked 87% of our VLCC days at $58,300 per day, 77% of our Suezmax days at the competitive $72,400 per day, and 68% of our LR2/Aframax days at a robust $63,900 per day. Again, all these numbers in the table are on a load to discharge basis and they will be affected by the amount of ballast days we end up having at the end of Q1. Before I give the word to Inger, let's just quickly jump to slide four in the deck. I'll repeat a few key points from the Frontline fleet composition. Frontline continues to hold one of the most efficient fleets in the industry, and our diversification has proven profitable for all our shareholders during 2022. Scrubber spreads continue to incentivize investments hovering north of $200 per metric ton. We are installing scrubbers on two additional vessels, and only two of these left without a scrubber. The average age of our fleet is a comfortable five years. Frontline is well-positioned in CRI terms and also for the upcoming EU ETS considerations. I will now let Inger take you through the financial highlights.

Inger Klemp, CFO

Thank you, Lars. And good morning and good afternoon, ladies and gentlemen. Then, let's turn to Slide 5. In the fourth quarter, we achieved total operating revenues of $353 million and we had an adjusted EBITDA of $287 million. We came in at a net income of $240 million, which is the highest quarterly net income we have had since 2008. We had an adjusted net income of $215.5 million. The adjusted net income in the fourth quarter increased by $133 million compared with the previous quarter, mainly driven by an increase in our time charter equivalent earnings due to the higher TCE rates that Lars went through earlier in the presentation. This was partially offset by a general increase in expenses. We declared a cash dividend for the third quarter of $0.30 and for the fourth quarter of $0.77, and the fourth quarter dividend gives a direct return of 17% on the share. As of December 31, 2022, we have revised the estimated useful life for our vessels from 25 years to 20 years, which is expected to increase depreciation expense by approximately $59 million in 2023. Then, let's take a look at Slide 6, the balance sheet. Total balance sheet numbers have increased by $227 million in this quarter, and the main drivers are delivery of Front Gaula, revaluation gain on the Euronav shares, increase in working capital, and also the net income that we earned in the fourth quarter. As of December 31, 2022, Frontline had $556 million in cash and cash equivalents, including undrawn amounts under our senior unsecured loan facility, marketable securities, and minimum cash requirements. Then, let's move to Slide 7 and take a look at cash flow potential. We estimate average cash cost breakeven rates for 2023 of approximately $27,000 for VLCC, $21,500 for Suezmaxes, and $17,600 per day for LR2 tankers, with a fleet average estimate of about $22,300 per day. This average estimate includes the start-up of two vessels and one LR2 tanker in 2023, all in the first quarter. With respect to operating expenses, we recorded $8,800 per day for VLCC, $17,600 for Suezmax, and $8,700 for LR2 tankers. We dry-docked two vessels in the fourth quarter, one VLCC and one LR2 tanker. Looking at the right-hand side, we showed free cash growth in millions and per share after debt service. If we look at assumed CTC rates of $75,000 per day with five-year historic spread to be received for Suezmax and LR2 tankers, the annual free cash potential will be more than $1.4 billion or $6.46 per share. And with that, I think I'll leave the word to you again, Lars.

Lars Barstad, CEO

Thank you, Inger. We are in a market where the potential is substantial. If you move to Slide 8 and recap what happened in Q4 in the tanker markets, have the title here 'sneak peek of what's to come.' I think it's probably not a secret that we are tremendously bullish for the next couple of years. And during the quarter, all segments from Frontline operated performed. It was finally the turn for the VLCCs to shine. The average weighted market earnings for tankers are actually flirting with 2004 highs. And I think, in general, the market hasn't recognized how substantial Q4 ended up being. The average weighted earnings for all tankers, and obviously what's happening with MRs, LR1s, LR2s, FRS, and VLCCs together, has made this possible. We are in market conditions where it's not only the VLCC outperforming; it's basically all segments performing. Chinese imports are back above pre-COVID levels, hovering around 10 million barrels per day, and the VLCC shipments to China are actually at all-time highs. I would like to say the big ships are back. During Q4, we saw the G7 crude oil price cap come into effect on December 6. We have seen a lot of crude oil and fuel oil being redirected from Europe to Asia and the Middle East predominantly. So the effect of the December 5 cap was somewhat muted. We also need to keep in mind that during a mild winter in the northern hemisphere, oil prices were also hovering below or around $80 per day, making Russian crude comfortably priced below the price cap. Let's move to Slide 9 and look at what we believe are the three major themes as we embark on another upcycle. The first is oil demand. As long as we have oil prices hovering around $80 to $90 per barrel, we believe oil demand will continue to be fairly strong. If you look at the chart at the bottom left, this is from EIA—it showcases a lot of volatility going forward. By the end of 2024, EIA expects global oil consumption to be more than 4 million barrels per day higher than where we are now. Asia, particularly China, is expected to be the key driver as it returns from COVID lockdowns. The second big part of this equation is fleet supply. Total tanker fleet growth is set to turn negative during 2024. This has not been seen since 2002. If you look at the middle chart below, you'll see the columns for the various years of growth. As we proceed through 2023, we expect about 3% growth in the total fleet of tankers globally, that will reduce to 1% in 2024 and will actually turn negative during the year. In 2025, the overall fleet is expected to reduce by 1%. A change in trade dynamics may actually accelerate this. Currently, 12% of the tanker fleet is over 20 years old. We've had very limited scrapping, and ships are trading beyond their expected lifespan. Regulatory changes or any initiatives in this respect could accelerate the fleet reduction. The bottom right-hand graph shows world sea-borne trade is expected to grow by 6% to 7% annually over the next two years. This is driven by key demand centers being in Asia, with key production growth coming out of the US and Latin America predominantly. The overall order book stands at 5% or slightly below, and we are looking at delivery windows in 2026. Let's move to Slide 10 and take a closer look at the order books. Last year, we recorded the lowest contracting activity in decades. If you look at the graph on the top left-hand side, you will find no column since 1996 lower than the sum of around 7 million deadweight tonnes contracted in 2022. As we head into 2023, the activity continues to be limited. For our VLCC fleet in isolation, by the end of 2023, there will be 112 VLCCs passing 20 years, that will represent 13.2% of the entire fleet. The order book stands at 28 units, representing 3.3% of the existing fleet. For Suezmaxes, this is even more pronounced. By the end of 2023, 85 vessels will be over 20 years, representing 14.5% of the fleet. The order book is modestly at 10 vessels, representing 1.7% of the fleet. The LR2 market is more balanced; there are a few more ships on order, but they have the same age profile. With about 400 LR2s in the world, 25 will turn 20 in 2023, representing about 6% of the fleet. The order book currently stands at 51, representing 12.8% of the fleet. I would like to mention again on the LR2 that the effective age of an LR2 starts to reduce its trading effectiveness after it reaches 15 years due to several charters limiting chartering activity for vessels beyond that age. If we then move to Slide 11, we will look at some of the key exporting regions and assess the market. I mentioned earlier that the three major themes are oil demand, fleet supply, and distances. In order for demand to be sufficient, we also need production. World crude oil exports are now back to pre-COVID levels, hovering about 42 million barrels per day of ocean-going volumes—that's just north of 40% of global oil production. West Africa continues to struggle but saw modest improvement in the fourth quarter. Latin America is increasingly becoming an important export region, particularly Brazil and recently Guyana as key growth areas. Russian exports are surprisingly resilient and have returned to pre-invasion levels. Some statistics may be influenced by increased exports ahead of the December 5 price cap, but still, Russia seems to find a market for its crude. U.S. exports continue to be firm, and I am particularly surprised after the SPR release tapered off in November last year. The U.S. remains the region where we anticipate production increases, with the bulk of new oil coming online globally over the next couple of years. If we move to Slide 12 and summarize, Frontline reported the highest quarterly net income since 2008, a substantial $240 million. Our cash dividend, which combines Q3 and Q4, is $1.07. We took delivery of the three remaining VLCC new buildings from Hyundai and sold one VLCC and one Suezmax, both 2009 builds. As we see it, China took center stage in the fourth quarter, with imports into China returning to pre-COVID levels. Oil demand continued to recover amid limited fleet supply and increasing ton-mile demand as key drivers for the coming years. We continue to believe that Frontline's efficient and transparent business model will generate shareholder returns. With that, I would like to open up for questions.

Operator, Operator

Now we're going to take our first question from Omar Nokta from Jefferies. Your line is open. Please go ahead and ask your question.

Omar Nokta, Analyst

Thank you. Thanks, Lars. Thanks, Inger, for the update. Clearly, a lot of positive themes developing here. You touched here on the last slide, Lars, about the new building for our brand now being officially complete with the delivery of these final three VLCCs. You did sell a couple of older tankers, the Suezmax and the Aframax. What are you thinking about Frontline's fleet here strategically as we move forward with asset large scale M&A? How do you think about the fleet from here? For the first time in many years, I would say that you don't have an order book. If you look to sell more ships in this market, do you replace the ones you sold? How are you thinking about that?

Lars Barstad, CEO

It's a very good and timely question. What we are observing is that asset prices are moving a bit ahead of the markets. To defend investing in, say, a new build, look at the VLCCs: you need closer to $50,000 per day of earnings consistently for the next 20 years to achieve a 15% to 20% return on the investment. So we feel that asset prices have moved ahead of time charter and spot rates. Therefore, we are not comfortable. Similarly, due to the lead time to receive a new building, you probably wouldn't get it until 2026. We are facing 2.5 years of substantial asset price risk should something happen to this market. On the retail side, prices continue to be elevated, and again, the spot TC market doesn't give us the returns we're looking for. Hence, we have some assets in our portfolio, but we are considering selling them due to high asset prices. The earnings potential remains high on these more mature assets, so we are somewhat split. Are we going to continue and harvest these units on as long as they are profitable or are we going to utilize this opportunity of elevated asset prices and take profits? All our assets are actually still quite satisfactory from a CRM perspective, so we are not too nervous about that. But I think the question you raised here is probably one that most ship owners are asking themselves.

Omar Nokta, Analyst

Yes, that's an interesting one. Yes. Lots of different ways to look at this. But as expensive as you mentioned, the return profile needed for new builds at least. So maybe, as you alluded to early on in the call about the discussion of the combination with Euronav; to the extent you can say anything about this. But clearly, a lot changed over the past several months. When it comes to Euronav, for instance, can you envision revisiting that combination or that merger if for some reason CMB were no longer involved or were no longer an obstacle? Just wanted to know, as you think about the termination of the agreement with Euronav, is that solely because of the CMB situation or is there something else?

Lars Barstad, CEO

Okay. The last part first, which essentially answers the initial part of your question. It was not solely the CMB blocking position that triggered the termination; there were also certain legal requirements that were in place. So, I think the blocking position was one of the major reasons our Board decided to terminate, but there were other legal factors in play as well. As it stands now, a combination with Euronav is off the table. However, a scenario in the future where that discussion may come up again cannot be ruled out. But as it stands currently, there have been absolutely no discussions with Euronav since the termination.

Omar Nokta, Analyst

Got it. Well, thanks for that color, Lars. I appreciate your time. I'll turn it over.

Lars Barstad, CEO

Thank you.

Operator, Operator

Now I'm going to take our next question, which comes from Jon Chappell from Evercore ISI. Your line is open; please ask your question.

Jon Chappell, Analyst

Thank you. Good afternoon. Apologies for the nature of this question, but it's pretty important. So your dividend policy is back to paying dividends. I think with the ruling on February 7, all-in costs are off, and you can do whatever you want to do with your cash. If we look at the third quarter and the fourth quarter distribution based on adjusted earnings, it appears to be about an 80% payout ratio. So the first thing I wanted to confirm was if there is an actual payout policy that we can model on 70% to 80% of adjusted earnings. And then the second part of it is this depreciation reset that you're doing when you're adding $59 million in annual depreciation. That's not cash, but it is earnings. So does that mean that the payout would be potentially pegged to cash as opposed to EPS going forward because of this depreciation reset?

Inger Klemp, CFO

Let's take the first part first. There is actually an offset payout policy in place; if that's what you mean. I would say you can use the 80% that we have been paying now for the last quarter as a good estimate. However, it will ultimately be the Board that decides going forward. Regarding the depreciation policy, I wasn't sure if I understood your question; could you please repeat?

Jon Chappell, Analyst

Yes, sure. So if your payout policy is based on net income, adding $59 million in depreciation is quite significant. So, does this mean that the payout would potentially shift to cash rather than EPS moving forward because of this depreciation reset?

Inger Klemp, CFO

It means that probably $0.05 to $0.06 a quarter less in NOI. Hello?

Lars Barstad, CEO

I think we lost you there, Jon.

Inger Klemp, CFO

We believe so.

Operator, Operator

Thank you. Now we will take our next question, which comes from Amit Mehrotra from Deutsche Bank. Your line is open; please ask your question.

Chris Robertson, Analyst

Hi, everyone. This is Chris Robertson standing in for Amit. Thanks for taking our questions.

Inger Klemp, CFO

Hello.

Lars Barstad, CEO

Hi, Chris.

Chris Robertson, Analyst

Hi. You spent quite a bit of time in the presentation discussing the older fleet, and it's an important question moving forward. Do you think the owners with vessels over 20 years of age will simply ride out this current cycle and then exit the market, or do you think these owners will engage in fleet replacement ordering at some point in the future? In other words, how much of the older end of the fleet is likely to be replaced at some point versus simply going away forever?

Lars Barstad, CEO

Yes, that's again a very good question. If we start with the older portion of the fleet, we have two brackets of fleets. We have the absolute dark fleet, those that have gone completely off the grid and are trading Benjamin crude, which is a fairly large portion of the 20-plus-year fleet. They probably will not reinvest in modern tonnage at any point—they are likely to just ride these assets as long as they float. Then we have the more mature ships around 17.5 years old, which we now refer to as the gray fleet. A significant portion of this fleet is currently involved in trading Russian crude and products. In the future, hopefully, with peace in Ukraine and normalized trading patterns, I envision some of these owners exiting the market altogether and likely not replacing much. Therefore, replacement activity will likely be seen from standard shipowners, like ourselves, who have assets reaching age. We aim to be in this industry for the long haul, meaning we'll be here for the next 20 years as well. So it'll be the active ones like us who might contribute to the order book at some point. But again, returning to Omar's question earlier, the economics need to work to make that financial decision. We have seen inflation on asset prices, while wage inflation in certain nations struggles to attract workers to shipyards. What we really need now is inflation on rates, as the rates are simply not high enough to justify those investments at this time.

Jon Chappell, Analyst

That leads me to have an essential follow-up question. You mentioned the yards and labor shortages. My understanding, and correct me if I'm wrong, is that limitations on shipbuilding capacity at the moment is more related to a lack of specialized labor than it is to a lack of infrastructure. In your opinion, what is the likelihood of certain governments either engaging in stimulus to revitalize their shipbuilding industries or incentivizing labor training to help offset this situation in the future?

Lars Barstad, CEO

I think that's very likely. Particularly in China, it's net short hydrocarbons. They have a strong incentive from the government to revitalize the shipbuilding industry. We are already seeing some yards in China getting back online to a modest degree at this stage. Orders that can be placed in 2025 are predominantly in Chinese yards. For Japan, it’s a structural issue; I recently learned that the average age of a Japanese shipyard worker is 67 years. At 60, it gets challenging to cut steel. In Korea, they are highly efficient and technologically advanced but have a higher margin in building LNG carriers than VLCCs or container ships. It is a complex issue; I can’t give you a straight answer, just providing the context I have.

Jon Chappell, Analyst

That's a really interesting perspective. Thank you for that, Lars. I'll turn it over.

Operator, Operator

Thank you. Now I'll take our next question from Greg Lewis from BTIG. Your line is open; please ask your question.

Greg Lewis, Analyst

Hi, thank you. Good afternoon and good morning, everyone. Lars, could you talk a little bit about the market? Some questions we've been hearing from investors focus on the VLCC market's strength, particularly as recent strength has come despite lower crude exports from the Middle East, especially Saudi Arabia. We value that China is absolutely importing more crude oil. But we're wondering if there's a zero-sum game in there where if China imports more, it means another Asian producer or consumer is consuming less. Any color you have around market strength despite OPEC gradually ratcheting down production would be helpful.

Lars Barstad, CEO

Of course, Greg. What we witnessed during 2022 was a smaller segment beginning to perform, starting with the MR Segment, followed by LR1s, LR2s, and then the Aframax demand. Suezmaxes began flourishing in Aframax stems and VLCCs started trading on Suezmax stems. You are correct that currently, much of the demand for VLCCs is actually what would normally be termed Suezmax trade, from the US Gulf to the UK. We have seen robust activity and a considerable number of fixtures in which VLCCs are stepping in. Earlier in Q1, when the West African market for VLCCs started showing shakiness, the VLCCs quickly began capping Suezmax earnings. To simplify, the situation around crude being redirected from Russia into Europe, which is moving to the Middle East and Asia, has drawn both Aframax and Suezmax ships into that trade, limiting the number of large vessels available in those compliant markets. This has created opportunities for VLCCs to secure good returns as well. Thus, it is a scenario where various asset classes are encroaching on each other's business segments. While there may not currently be sufficient oil for traditional VLCC trade to engage the fleet fully, I believe this will fluctuate in cycles moving forward. Encouragingly, we have seen how everything bottomed out in the first quarter while still remaining solidly above our cash breakeven points when the market turned.

Greg Lewis, Analyst

Okay, great. That’s very helpful. Another inquiry from our investors revolves around the dark fleet. Clearly, there’s significant conversation around sanctioned cargo movements. So, I’ll ask it this way: Do we have any sense of how many vessels—excluding the Russian flag fleet or Russian-owned fleet—could potentially be in that market? Regarding vessels in that segment, how can we assess what their utilization might be? If I’m trading in the dark fleet, I’m assuming those are likely less efficient. Any insights you might have on this would be helpful.

Lars Barstad, CEO

Unfortunately, this is largely guesswork. However, first, regarding the gray fleet trading Russian crude, it remains good quality and compliant with IMO rules, although they may face age challenges. On the dark fleet, I've seen estimates indicating that 5% to 6% of the VLCC and Suezmax fleet are engaged in that trade. In terms of efficiency, one could argue a compliant modern VLCC is 100%. In contrast, older ships not properly maintained might operate at roughly 30% efficiency. We've previously modeled VLCCs along these lines. A gray fleet trading Russian crude may achieve 50% to 60% efficiency due to limitations in the compliant market lacking Russian history. Meanwhile, the modern compliant VLCCs like ours would remain at full efficiency. If executed accurately, this exercise highlights that the overall capacity to freight oil globally is diminishing as time progresses. The dark fleet, consisting of vessels trading listed barrels, isn't growing as it did in previous years, which is encouraging. However, they are becoming bolder, leading to potential environmental concerns.

Greg Lewis, Analyst

Thank you very much for your time, and have a great rest of the day.

Lars Barstad, CEO

Thank you.

Operator, Operator

Dear Mr. Jon Chappell from Evercore. Now we’re going back to Jon Chappell from Evercore for additional questions. Your line is open; please ask your questions.

Jon Chappell, Analyst

Thank you. Sorry, I don't know what happened there. Just to revisit that topic again. I know it’s only $0.07 a share—.

Lars Barstad, CEO

We lost you.

Inger Klemp, CFO

We believe so.

Operator, Operator

Thank you. Now we’re going to take our next question, which comes from Amit Mehrotra from Deutsche Bank. Your line is open; please ask your question.

Chris Robertson, Analyst

Hi, this is Chris Robertson again. I would like to sneak in one last question related to Chinese demand. There has been impressive demand recovery thus far. How much further do you think this can go based on post-COVID recovery? With respect to the upcoming new refinery additions that are in the pipeline, how do you imagine overall Chinese import demand will shape up in the coming 12 months?

Lars Barstad, CEO

I'm not certain about employee Analysts, to be honest. However, we have seen China act aggressively in periods where they believe the oil price is discounted, preparing for increased domestic demand. The highest sustained imports recorded from China was around 13 million barrels per day. Presently, there is considerable oil export growth, but China still hasn’t reached pre-COVID levels in domestic demand. They have a huge and high-consuming airline market internally. As we move towards summer, with Europe set to recover and consumers traveling, it will be interesting to see how that plays out given that production levels haven't considerably risen while we are catching up from years of demand growth, historically 1% to 2% annually. Thus, I support those forecasting bullish oil prices for the latter half of the year and express concerns about the supply and demand picture. Remain mindful that China is also exporting a significant volume of products, which will likely change as domestic demand catches up.

Chris Robertson, Analyst

Yes, definitely very interesting. Thank you for that. That’s all from my end.

Operator, Operator

Thank you, Chris. There are no further questions at this time. I would like now to hand the conference over to Mr. Lars Barstad for closing remarks.

Lars Barstad, CEO

Yes. Thank you very much for dialing in and listening to our Q4 presentation. Frontline management is always available should you have further questions over the coming weeks. I would like to obviously thank the Frontline organization for a fantastic result in a fantastic quarter. Thank you.

Operator, Operator

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