Scorpio Tankers Inc. Q4 FY2021 Earnings Call

Hello and welcome to the Scorpio Tankers Inc. Fourth Quarter 2021 Conference Call. I would now like to turn the call over to James Doyle, Head of Corporate Development and Investor Relations. Please go ahead.

Thank you for joining us today. Welcome to the Scorpio Tankers fourth quarter 2021 earnings conference call. On the call with me today are Emanuele Lauro, Chief Executive Officer; Robert Bugbee, President; Cameron Mackey, Chief Operating Officer; Brian Lee, Chief Financial Officer. Earlier today, we issued our fourth quarter earnings press release, which is available on our website, scorpiotankers.com. The information discussed on the call is based on information as of today, February 14, 2022 and may contain forward-looking statements that involve risk and uncertainty. Actual results may differ materially from those set forth in such statements. For discussion of these risks and uncertainties, you should review the forward-looking statement disclosure in the earnings press release that we issued today, as well as Scorpio Tankers SEC filings, which are available at scorpiotankers.com and sec.gov. Call participants are advised that the audio of this conference call is being broadcast live on the Internet and is also being recorded for playback purposes. An archive of the webcast will be available on the Investor Relations page of our website for approximately 14 days. We will begin with a short presentation today. The presentation is available at scorpiotankers.com on the Investor Relations page under Reports and Presentations. The slides will also be available on the webcast. After the presentation, we will go to Q&A. For those asking questions, please limit the number of questions to two. We want all analysts to have a chance to ask questions. If you have an additional question, we are more than happy to answer, but please rejoin the queue. Now, I'd like to introduce our Chief Executive Officer, Emanuele Lauro.

Thank you, James, and good morning and good afternoon to everyone. Thank you for your time today. For the last six quarters product tanker rates have remained below our all-in cash breakeven levels. There is no sugarcoating it. The weakness in the product tanker market and prolonged recovery has been frustrating. I would like to thank our shareholders for their support and patience during the past year, which unfortunately has been another COVID year. Scorpio Tankers finished 2021 with more cash on the balance sheet than in 2020. We continue to focus on what we can control. In January 2022 we agreed to sell 14 vessels. These sales increase liquidity, reduce overall debt and highlight both a significant increase in asset values as well as the discount our shares trade to these higher asset values themselves. The decision to sell assets is consistent with our efforts to maintain a strong liquidity position and significant operating leverage in a challenging market. Our top priority remains the same: position the company to create shareholder value in an improving market and for the next tanker cycle. We feel the recovery is close and the next tanker cycle not far behind. As far as demand is concerned, oil demand increased by 19 million barrels a day since May 2020, and is expected to surpass pre-COVID levels this year. At the same time, refined product inventories are at historically low levels and we drew 181 million barrels from January through November 2021. So the catalyst is simple: supplying incremental oil demand while inventory draws persist is just not sustainable in the long term. The timing is less simple to read, but the inflection point is near. In December product tanker rates reached their highest level since the start of COVID. While the spread of the Omicron variant slowed the momentum, there are several reasons to suggest it will return this year. I would like to now turn the call to James Doyle, who has been recently promoted to the position of Head of Corporate Development and Investor Relations. He will now walk you through a brief presentation as he discussed in his opening remarks. James, congratulations, please go ahead.

Thank you, Emanuele. Good morning and afternoon, everyone. At the end of the fourth quarter, we started to see a material improvement in rates, specifically in December, and it seemed as if the inflection point was finally here. Even with significant inventory draws, rates pushed higher. However, by early January, the rapid spread of the Omicron variant had impacted our markets and rates began to slow. Recently, our smaller vessels, the Handymax and MRs, have shown more improvement because of the demand strength we're seeing in the U.S., Latin America, Africa and Europe. On the other hand, the LR2s have been slower to recover and this is largely due to lower demand in Asia and a reduction in arbitrage opportunities. Since Q3, we have seen 19 LR2s switch from trading clean to dirty, which is the equivalent of about an 8% fleet reduction and creates a favorable supply-demand setup as Asian demand returns. If there's any evidence of the demand recovery in refined products in 2021, it's the draws we saw in gasoline and distillate inventories. From January through November, we drew 181 million barrels of gasoline and distillate. Inventories are now at historically low levels and we feel the headwind is behind us. While Omicron delayed the first quarter recovery, we are optimistic for 2022. So, the question is how close are we? Well, in 2021, ton-mile demand exceeded pre-COVID levels, which may seem surprising when you look at rates. The driver behind the ton-mile demand growth has been refinery closures. Over the last two years, we've seen a significant number of closures. These are often older, less efficient or poorly located refineries. Weak operating margins and maintenance CapEx to keep these refineries operating doesn't make sense. For the first time in 30 years refinery closures outweighed new capacity in 2021. After refineries close, in most cases, the lost output needs to be replaced. The most favorable example is Australia, which closed two of its four refineries last year, and has since increased its product exports by 200,000 barrels a day in November to make up for this lost production. On the volume side, refined product exports were around 1 million barrels per day lower than pre-COVID levels. However, from a demand perspective, when you account for the inventory draws that occurred last year, it's about half that. In other words, without inventory draws we are only about 500,000 barrels a day below 2019 levels. So, will 2022 be the year refined product exports exceed pre-COVID levels? We think so. While jet fuel may take until 2023–2024 to fully recover, the increase in gasoline, diesel and naphtha have offset lower jet fuel demand. Crude oil and refined product demand is expected to increase by 4 million barrels a day this year. If 25% of this increased demand is exported, seaborne exports of refined products will increase by 1 million barrels per day. Also, this excludes the additional demand of around half a million barrels that was supplied with inventory draws last year. Timing is always challenging, but we expect a sequential improvement in demand each quarter throughout the year. Inventories are at historically low levels and have declined as refinery utilization has increased. So, the ability to draw from inventories has reduced substantially. Thus, given the low inventory levels to meet the increased demand this year, we expect higher refinery runs and consequently product exports. Refined product exports and ton-mile demand are expected to increase 6% and 7% this year; one could argue by the end of the year it will be higher. Supply: the product tanker order book is at a record low with 5.3% of the existing fleet on order today. By looking at the low order book, one might think that shipyards are desperate for orders, but it's quite the opposite. Other shipping segments have done so well such as containers that the yards are fully booked. We do expect more product tankers to be ordered, but any orders placed today would not be delivered until 2025. While the order book is at an all-time low, scrapping is at an all-time high. This is due to higher steel and scrap prices, but also the age distribution of the fleet. Unlike other sectors, product tankers were not built in mass until the early 2000s. So, scrapping has been minimal previously because everything that was delivered mostly stayed in the fleet. However, this will start to change and we saw the start of this last year with 48 product tankers scrapped. Today there are 267 product tankers 20 years and older. By 2025, excluding scrapping, there will be 687 product tankers 20 years and older. And this is not including the roughly 1,000 product tankers that will be 15 to 19 years old. Additionally, by 2025 more than half the fleet will be 15 years and older. Using modest scrapping assumptions, product tanker net fleet growth is around 1.3% the next two years before going negative. However, if we use a scrap rate that reflects the age profile of the fleet, supply growth is essentially zero for the next two years before going negative in 2025. Financial highlights: while everyone is focused on rates and liquidity, there's been a substantial increase in asset values. Rising steel and labor costs as well as new building orders from other segments, given limited available yard capacity, are driving prices higher and delivery dates later. Since January 2021, five-year-old LR2s have increased $12.5 million per vessel. We apply this increase to Scorpio Tankers' 42 LR2 vessels and that would increase gross asset value alone of the LR2 fleet by $525 million. It also means our loan-to-value is decreasing. In January, we announced the sale of 14 vessels. These sales increase our liquidity, reduce our debt and crystallize the steep discount our shares trade relative to our net asset value. After the completion of the sales, the company will have over $460 million in pro forma liquidity. As Emanuele mentioned, to maintain liquidity with rates below all-in cash breakeven levels, we have refinanced vessels as opposed to raising equity and also sold some. If we look at the debt repayment schedule, which excludes amortization for the 14 vessels that will be sold, the company has two maturities in the next eight quarters: the convertible bond which will be repaid in Q2 and a credit facility that matures in Q4 2022. In the past, we've seen different comments and figures around the debt that's due in a given period for the company. So, for clarity, if we use the credit facility that's due in Q4 as an example, before this facility matures, we arrange to refinance the vessel in the facility with the new lender. Thus, when the facility matures in Q4 we repay the $16.9 million debt balance and then draw down on a new loan facility. Alternatively, we could sell the vessel, repay the debt and collect the proceeds. If this happens to be in LR2, current prices would generate significant liquidity. If you look at the company's balance sheet over the last six quarters, you will see a significant change. However, our view of the balance sheet is that after several challenging quarters, LTVs have decreased, we have $600 million in pro forma liquidity which creates flexibility in the event of a longer market recovery. We have refinanced essentially all of our upcoming maturities and have minimal CapEx. We will repay $485 million of debt in the first half of this year from scheduled amortization associated with vessel sales and the convertible bond maturity. Given these points and our positive outlook for the market, we feel well-positioned. To wrap it up, the company has the largest product tanker fleet in the world comprised entirely of ECO vessels. We have significant operating leverage: a $1,000-a-day change in product tanker rates equates to $42.7 million in annual cash flow. We know rates don't usually move by $1,000 a day. We have positioned the balance sheet to provide flexibility with increased liquidity and a plan to delever. Our shares trade at a steep discount to our net asset value. The market inflection point is close and the long-term supply-demand fundamentals suggest we could have an extended tanker cycle not far after. With that I will turn it over to Q&A.

Please note the instructions for the question-and-answer session. Our first question comes from Omar Nokta with Clarksons Securities.

Thank you. Hey, guys. Good morning. Good afternoon. James, thanks for that. I think a pretty good run through of things. Clearly liquidity has been a focus for the past year and a half or so. And you managed really to continuously enhance your cash position with debt refinancing. Aside from sale leaseback, actual sales have not been something you've done in the past or recent past. So just regarding the LR1 deal, we've gotten used to seeing when an owner sells ships at a tough earnings environment, especially an unblocked fleet and an all-cash deal, they usually come at a discount to sale price. But your LR1s got a pretty hefty premium, I'd say. Can you talk a little bit about how that transaction came about? And what really compelled you to move forward with it?

Sure. I think the easiest thing to first understand is that, as James pointed out, prices have been moving up and moving up quite strongly. So you've got a quite strong purchase market to start with. Those vessels were sold at a surprisingly high price in the market, and we strongly believe net asset values have been adjusted up significantly. That doesn't just apply to us; it applies to other product tanker companies with modern fleets, those less than 10 years, seven to eight years old. The first thing is we had a market that was very strong. It came about through a very competitive process. We've indicated in a couple of quite large conference calls and in the press that we would be willing to sell vessels as part of securing liquidity. It's a win-win for us because, first, it increases liquidity. Second, it's a rational thing for management to do when you think your NAV is high and your stock is trading at a steep discount to NAV. You believe the fundamentals are very strong, but you have uncertainty on the timing of recovery. First, you remove the worry about liquidity. Second, you put the company in an offensive position: when rates recover above our all-in breakeven, we'll look to return capital, including potential buybacks. Strengthening the balance sheet and putting cash on the balance sheet gives us strategic optionality. That's really how it came about.

Thanks, Robert. Good color there. And I guess, yes, just on the context of being offensive and having too much liquidity, clearly now your cash position is well over $400 million, which I think is the highest in many years. The question, obviously now is, how do you feel now with that position ahead of a recovery? And do you foresee future sales to maybe take advantage of that NAV arbitrage?

At the moment what we see, especially as Omicron seems to be subsiding even faster than some people hoped, is that actual headline demand for products and crude is much higher than many thought. It's incredible that apart from the United States, there's been restricted mobility in many places over the last few weeks, and yet demand for oil and its derivatives has been very strong. You've also got multiyear inventory drawdowns. That sets up a situation where there's a long-term favorable market, and it's just a question of timing. To your second part, we're comfortable with our liquidity position and we would not sell further vessels because we have to for liquidity. However, we could sell additional vessels opportunistically even when we don't need liquidity. If NAVs are high and the market offers attractive prices, selling additional vessels to increase cash and optionality is a rational course. Given our fleet size, selling some vessels does not materially affect our operating capability. We're not married to any particular ship.

Our next question comes from Randy Giveans with Jefferies.

Howdy, gentlemen, how's it going?

That's a great question. The market is all over the place and you can see extreme volatility. You actually had a lot of activity last week in MRs, for example, which we're starting to trade quite firmly out of the U.S. West of Suez and was starting to pick up speed in the East. We're even starting to pick up a couple of jet fuel cargoes; we loaded a big jet fuel cargo for the first time in many weeks out of the Arabian Gulf on one of the big ships. You have this inventory situation and a very turbulent market, so it's difficult to know the exact timing of a sustained upward spin. It's tight. Whether the next 50% move is the same, worse or materially better than the last move is quite difficult to predict. I think we can be confident that overall our rates will be above, let's say, $10,000 per day, and that adds to NAV value as long as vessel prices don't decline. We see it as a matter of time now. These markets are tight as the winter has shown and the trajectory is upward. By saying we don't know the exact timing, I wouldn't take that as a negative view.

No, that's fair. Hard to prognosticate from here. Second question: following the vessel sales, which would certainly be accretive if you use those for share buybacks, your fleet is still massive, obviously, and a little of your operating exposure has been reduced. So, with that, are you looking to charter-in vessels to increase spot exposure, or on the other hand, are time charter rates too high and you're actually maybe looking to charter out some tonnage to secure cash flow?

We're not looking to charter out. To be clear on this call: we are very bullish—extremely bullish. We are always looking for charter-in opportunities. So far, we've been disappointed because charter-in rates and purchase rates for good quality ships are quite firm. There is clearly broad bullishness in the market. There's a very strong S&P market and despite Omicron, you've had pretty strong fundamentals. We'll continue to evaluate charter-in opportunities, but we are not chartering out vessels to lock in rates.

Thank you, Randy.

Our next question comes from Jon Chappell with Evercore.

Thank you. Good morning. Hey, James, you laid out a good profile of what's going on with the inventories. I think Robert said something important, which was that the U.S is basically the only country where we're seeing kind of normalized flying. Age has been the big growth area for a long time now. What are you seeing there as it relates to inventory versus OECD flying activity and other modes of transportation? Is it possible that we're so focused on the Western world coming out of the virus that Asia can continue to be a drag, and that's one of the reasons that the recovery continues to get pushed to the right?

No, I think what's happened with Asia is that over the summer with the Delta variant and then Omicron this winter, stricter travel restrictions were imposed and that impacted mobility and consumption. When you restrict mobility, demand goes down. Asia, though, prior to Omicron was starting to be quite strong again. For the current time, you've had Omicron, winter, New Year and the Olympics—so there are short-term impacts. I do think Asian demand is going to come back. There's also a complicating component with rising natural gas prices that has affected refineries differently and led to volatility. Looking at the demand side: jet fuel is probably 1.5 million barrels away from where it was pre-COVID, but on the seaborne side it's probably only around 200,000 barrels. So I think we will see the return; it's just hard to nail the timing.

I would add, Jonathan, that you put out a very interesting graph recently showing the real drawdowns in inventories. Those drawdowns mean there are a lot of missing barrels in demand for both products and crude as a result of these inventory draws. That can't go on forever. If inventory draws stop—forget about rebuilding multi-decade lows—you would expand demand even in Asia very quickly. So the inventory story is central.

Thanks for highlighting that. I think the inventories are the most important thing to watch right now. James, for my follow-up, you get the promotion, you get the hard questions. I think there's this view that an Iranian sanctions lifting could be positive for crude but maybe not clear-cut for product. Also, if there were a geopolitical event with Russia and Ukraine, it could be good for tanker ton-miles, but that doesn't take into account a rising oil price effect on demand. Any work or thoughts on those two geopolitical events and what that could do to the timing of the recovery or the magnitude?

When it comes to Iran, the benefit would be increased condensate exports, which would benefit the LR2s. It depends on the scope of sanctions relief, but certain LR2 vessels will carry that cargo and there are South Korean petrochemical plants designed to run that condensate as feedstock. That could be somewhere around 300,000 to 400,000 barrels a day of exports for the LR2 fleet, which would be beneficial. Regarding Russia and Ukraine, it's hard to say what will happen, but Russia is a large exporter of crude oil at about 4.2 million barrels a day and refined product exports probably around 1.5 million barrels a day. Most of this trades to Europe and Asia. If there were a conflict, we would factor those numbers into our analysis and consider the implications for flows and ton-miles.

Got it. Thank you, James and Robert.

Our next question comes from Greg Lewis with BTIG.

Hey, thank you. Thank you and good day, everybody. My first question is around the refinery closures that occurred throughout the pandemic in places like Australia and parts of Europe. Those closures were expected to create dislocations and increase ton-miles. Has the full benefit of these refinery closures been realized? Do we think global product tanker seaborne ton-mile demand already reflects those closures or is there more to come?

Not yet. Part of it has been realized, yes, but when you draw 181 million barrels of global gasoline and distillate inventories, everything is muted. Overall demand is slightly below pre-COVID levels. We have certainly seen the impacts, for example in Australia and U.S. East Coast imports after certain Canadian refinery closures, but I think we will really start to see the full impact as demand returns to pre-COVID levels and that effect will act as a multiplier to those demand gains.

Okay, great. And then just one more: congrats on the vessel sales previously announced. One question we always get is around the depth of the S&P market. Beyond the actual buyers, how competitive was that process and can you quantify how much interest there was from the broader industry for the vessels that were eventually sold?

The competitive process was broad. As Robert mentioned, we were vocal about being willing to sell ships and that stirred interest from many parties. There were pockets of buyers interested in MRs, LR2s, a few on the Handys, and more interest than expected on the LR1s. We chose the LR1 transaction with Hafnia because it was a clean transaction with a natural buyer that appreciated the design features of our LR1 fleet—modern ECO wide-beam vessels with features they did not have in their fleet. When negotiating with Hafnia, it became apparent early in the process that it was a good fit for both companies and we executed the transaction with them.

Okay. Thank you, Emanuele. Have a great day everybody.

Our next question comes from Ken Hoexter with Bank of America.

Hey, good morning and good afternoon. On the sale of vessels you mentioned you get a few months runway of cash and some repayments. Rates here are starting off a bit weaker than you might have expected. Emanuele, you were more sanguine to start the call. Robert, you're very bullish. What is getting you that bullish here? Is it the setup of lower inventories? It doesn't seem to have monetized for years. We've been talking about drawdowns and low order book. What needs to happen here to start seeing rates move above cash cost and stop worrying about refinancing and debt pay down?

I'll start. I think James mentioned this earlier: mobility is affecting product tanker demand and that is the main catalyst we are waiting for. All the fundamentals—demand, supply and inventory—are pointing in the right direction. Mobility needs to increase for the market recovery to materialize.

Ken, to add: two years ago at the beginning of 2021 the stock was over $40 and rates were moving strongly. We expect a return to that demand level and in fact higher ton-miles because headline demand is expected to be higher and refinery changes will increase ton-miles. Supply is constrained due to regulation, a lack of order book, aging vessels and scrapping. Therefore, demand growth against limited supply is a favorable setup. In the weak market with inventory draws against us, rates were low; in the recovery, asset values have also increased because yard prices have risen. So both earnings and asset value perspectives point to a bullish stance.

Yes. It always seems to be there; we just need mobility up. So a minor balance sheet question, Brian: accounts payable seem to be going up significantly while accounts receivable changed only slightly. Is that seasonal or anything to highlight on the balance sheet?

It's timing differences, Ken. Also, to clarify the runway comment: if we look at the lowest rates a company like ours has ever had—about $10,100 in Q3 of 2020—and compare those rates to our breakevens, we would get about eight months of runway. If we look at current liquidity levels and current rates, we get almost 17.5 months. So it's more than just a few months. The additional liquidity from the vessel sales increases our runway quite a bit.

Okay. Great. Thanks for the time.

Our next question comes from Ben Nolan with Stifel.

Hey guys. First, congrats, James. It's quite a step up. Also nicely done on the presentation. My first question goes back to the LR1 sale: it seemed opportunistic. Just confirming, there was nothing structural about LR1s that led you to prefer LR2s or MRs—this was just where the best buy interest was, is that fair?

No, that's fair. In terms of valuation there was buying across the board for modern tankers. For us, the LR1 sale allowed us to address the balance sheet while also preserving strategic flexibility to create value later. We are leaders in Handys, MRs and LR2s. In LR1s we didn't have that same leadership position. The sale to Hafnia allowed consolidation in that segment by placing the vessels with the number one owner-operator of LR1s. That consolidation in the LR1 market helps strengthen the overall product tanker market dynamics.

Okay, that's clear. Thanks, Robert. My second question: you continue to add scrubbers, especially on the MRs. With fuel spreads widening, I imagine others are also looking to install scrubbers. Are you running into issues getting shipyard space for repairs and installations, or equipment supply chain problems? Any chance of delays or inflation in that respect?

As you know, Ben, yards for new construction and yards for repair/retrofit are fundamentally different. There's not a lot of overlap in capacity with the yard tightness seen in containers and dry bulk. There's capacity available for retrofits. Regarding supply chain and inflationary pressures, they are modest at best. There are always risks, but scrubber manufacturing is largely located in Asia, specifically China, where many shipyards reside, so we don't currently see major risks in logistics or inflation for scrubber installations.

All right. Thanks, Cam.

Our next question comes from Magnus Fyhr with H.C. Wainwright.

Good morning. I agree with your bullish view. But is there something we're missing here besides another Omicron variant that could derail the recovery? For example, oil prices have crept up to multi-year highs—could that eventually eat into refinery margins and user demand, or is there something else we're missing?

It could be. There are many variables—geopolitical events, for example, can have different effects. Traditionally, conflict has been good for the tanker market in the short term, but if it led to something wider and more disruptive, that could be negative. What we are basing our view on is observable behavior: when Omicron passes, people become more mobile, travel more and consume more. That recovery in mobility is the main catalyst. Other macro factors could impact margins, but the primary observable driver is mobility and the current low inventory base.

Thanks for that color. Just on near-term outlook: the IEA has demand picking up each quarter. Is seasonality playing out differently this year than usual?

You could see seasonality be muted in the normal weakening period if increased jet fuel and gasoline demand kicks in off the low inventory base. So the typical spring weakening may be less pronounced given seasonal demand growth combined with the tailwind from Omicron subsiding and people becoming more mobile.

One area we haven't mentioned: petrochemical demand, especially in North America, is strong. Could that surprise on the upside?

Yes, petrochemical demand strength is encouraging. On the margin in a weak market, you don't want petrochemical tankers shifting into the product trade, so stronger petrochemical demand is supportive.

Our next question comes from Liam Burke with B. Riley.

Thank you. The operating cash flow for the fourth quarter was very strong in conjunction with the sequential step up in rates. When you're looking to buy back shares, are you anticipating being able to generate internal cash over the course of 2022? Or would you look to borrow to buy back shares opportunistically?

The only statement we've made is that buybacks would be considered and strongly considered once we see visibility of rates at $17,000 per day or above. We wouldn't telegraph detailed buyback strategy or specific thresholds beyond that. Historically, when we've done buybacks, the priority was to buy shares as low as possible without placing expectations or restrictions on timing.

Fair enough. And James, you mentioned an aging fleet as a competitive advantage. How does the percentage of vessels over 15 years old that are not scrapped benefit you? Or is that neutral?

Certain customers have rules around vessel age and won't take ships older than 15 years, which affects employment in some trades. Structurally, older ships are often deployed in tertiary markets or in trades with lower contamination risk, like certain cabotage trades or dirty trades. With a super low order book and a continuing increase in scrapping, older vessels moving into dirty trades and yards being backed up will constrain future supply; that dynamic benefits modern fleets like ours.

Great. Thanks, James.

That concludes today's question-and-answer session. I'd like to turn the call back to Robert Bugbee for closing remarks.

Thank you very much. I think we've covered everything we need to cover and, as Emanuele said, we appreciate everybody's support and patience. Management looks forward, as much as our shareholders do, to an earlier recovery in rates because that's what is required to set this company and the valuation of the stock to create value. It's simply about opening up mobility, demand, and thereby rates. Thank you very much again.

This concludes today's conference call. Thank you for participating. You may now disconnect.