Scorpio Tankers Inc. Q2 FY2023 Earnings Call

Hello and welcome to the Scorpio Tankers Inc. Second Quarter 2023 Conference Call. I would now like to turn the call over to James Doyle, Head of Corporate Development and IR. Please go ahead, sir.

Thank you for joining us today. Welcome to the Scorpio Tankers, second quarter 2023 earnings conference call. On the call with me today are Emmanuel Lauro, Chief Executive Officer; Robert Bugbee, President; Cameron Mackey, Chief Operating Officer; Brian Lee, Chief Financial Officer; and Chris Abella, Chief Accounting Officer. Earlier today, we issued our second quarter earnings press release which is available on our website, scorpiotankers.com. The information discussed on this call is based on information as of today, August 2, 2023, and may contain forward-looking statements that involve risk and uncertainty. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the forward-looking statement disclosure in the earnings press release 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 broadcasted live on the Internet and is also being recorded for playback purposes. An archive of the webcast will be made available on the Investor Relations page of our website for approximately 14 days. We will be giving a short presentation today. The presentation is available at scorpiotankers.com on the Investor Relations page under Reports and Presentations. These 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. If you have an additional question, please rejoin the queue. Now, I'd like to introduce our Chief Executive Officer, Emmanuel Lauro.

Thank you, James, and thank you for joining us today, everybody. We are pleased to report another quarter of strong financial results. In the second quarter, the company generated $235 million in EBITDA and EUR 133 million in adjusted net income. The product tanker market has been and continues to remain strong. To put this into context, over the last six quarters, the company has generated $1.6 billion in EBITDA and $1 billion in adjusted net income, during which we have reduced our leverage by $1.3 billion and repurchased $582 million of the company shares. Deleveraging and returning capital to shareholders has been our primary focus. In the second quarter, we repurchased $260 million of the company shares, which is almost half of our total repurchases since July 2022. The increase in share repurchases reflects the progress we have made on deleveraging and refinancing the balance sheet. We view the repurchases as valuable for our shareholders, given that the shares are trading at a large discount to the company's net asset value. Our balance sheet continues to improve. Today, we have $683 million in liquidity. In July, we closed our $1 billion term loan and revolving credit facility. We are in the process of closing a new $94 million credit facility. These new facilities combined lowered the company's interest margin, accelerated the repurchase of more expensive lease financing, and increased the financial flexibility of the company. Looking forward, we expect low global inventories, robust demand, and limited fleet growth to support strong product tanker fundamentals. We would like to thank you for your continued support. And I would now like to turn the call over to James for a brief presentation, James?

Thank you, Emmanuel. Slide 7, please. We've seen an elevated rate environment since Q1 of last year. As Emmanuel highlighted, over the last six quarters, we've generated a little over $1.6 billion in EBITDA. Since July 2022, we have repurchased $582 million of the company's shares and paid $49 million in dividends. We had 15 vessels on time charter contracts and the remaining 97 vessels operating in the spot market. Slide 8, please. We continue to repurchase vessels under expensive lease financing and have started to refinance some of these vessels under new bank facilities with lower interest margins. To the right, you can see the list of vessels that have been repurchased and are upcoming. As of today, we have repurchased or repaid the outstanding debt on 46 vessels. In July, we closed our new $1 billion term loan facility and we're in the process of closing a new $94 million bank facility. The margin of lease financing ranges from LIBOR plus 350 to 525 basis points and our new facilities have a margin of SOFR plus 170 to 197 basis points. Slide 9, please. We've made significant progress in reducing the expense of lease financing from $2.2 billion to $1 billion today. Timing differences between repurchasing vessels on lease financing and drawing down on new facilities means that at times, it appears increasing. Vessels with lease financing have periods in which they can be repurchased. The majority of vessels under lease financing can be repurchased within the next 12 months and there are additional vessels that we expect to repurchase this year. So, we will continue to reduce our leverage. I just wanted to highlight the timing. Given the strong earnings and proceeds from new facilities, we expect to have an elevated cash balance, but keep in mind, a portion of this will be used to repurchase more vessels on lease financing. Today, as Emmanuel mentioned, we have $683 million in cash. Slide 10, please. While gross debt will increase slightly in the third quarter, net debt has remained around $1.5 billion to $1.6 billion over the last three quarters. As of today, this declined and is currently at $1.4 billion. With no newbuildings on order, we have minimal CapEx and feel very well positioned. Slide 11. The company has significant operating leverage in Q2 so far, including time charters that are averaging $26,000 today. As you're aware, rates have increased significantly over the last two weeks and MRs are now at $34,000 a day and now August north of 40. At $30,000 a day, we generated almost $800 million of free cash flow per year, and at $40,000, close to $1.2 billion. These are certainly exciting times. Slide 13, please. In the second quarter, significant refinery maintenance, lower refining margins, and reduced arbitrage opportunities led to lower trading activity and a decline in rates. MR 2 saw a larger decline as Asian refinery maintenance, limited naphtha arbitrage opportunities, and competition from LPG reduced long-haul volumes going from the Middle East and Asia. MR rates remain much more stable, reflecting the strong underlying global demand for consumer fuels such as gasoline and jet fuel. Despite these headwinds, rates remained well above cash breakeven levels and many of the headwinds in Q2 are in the process of reversing. Refining margins have seen a large increase in July and remain at very strong levels on a historical basis. The naphtha LPG spread has improved and the forward curve suggests naphtha substitution for LPG will occur over the next several months, which is very constructive for the LR2s. Unplanned refinery outages and historically low inventories create a scenario where any supply disruptions will lead to increased volatility and higher rates. Lastly, rates have increased significantly over the last few weeks and we think they're going to remain strong through the rest of the year. Slide 14, please. Global inventories are well below the 5-year average for gasoline and diesel. It doesn't matter what region or what product they're extremely low. Typically, diesel inventory is still in the summer months ahead of a strong winter demand season, and we have seen minimal builds at the moment. This is very constructive for a tight market in the back half of this year and highlights how robust demand has been. Slide 15, please. Forecasts for refined product demand for the second half of this year and next year have been revised upwards. Second half 2023 demand is expected to be 2 million to 3 million barrels a day higher this year than last. In our view, this is one of the most bullish drivers for strong freight rates, with 2 million to 3 million barrels of additional demand year-over-year against historically low inventories. While diesel demand is expected to increase at a slower pace due to lower trucking activity, the demand for gasoline, jet fuel, and naphtha are expected to see large increases. We are seeing this demand on the water today. Seaborne volumes remain extremely high and are averaging 1 million to 1.5 million barrels a day more than 2019 levels. Given low global inventories, increased consumption will continue to be met through imports with product tankers reallocating barrels within the world. Slide 16, please. While demand is above pre-COVID levels, refining capacity is lower and more dislocated; regional capacity changes are structural and will continue to drive ton-miles and flows for the coming years. The impact of new export-oriented refineries coming online, like in Australia and Kuwait, has led to an increase in exports in the Middle East. We are also seeing the impact of European sanctions on Russia. Europe has increased its imports from the U.S. and Middle East by 600,000 to 1 million barrels. All of these changes are driving an increase in ton miles as ton mile demand increases, investment capacity is reduced, and supply tightens. Slide 17, please. Over the last few months, Russian exports and refined products have declined to more normalized levels. Moreover, our vessels that are servicing Russian volumes have increased significantly to 353 vessels today, of which 277 are Handymax and MR vessels. Vessels servicing sanctioned trades have reduced the supply of vessels in non-sanction trades. The impact of vessels servicing Russia is expected to have a significant impact on the capabilities of the global fleet going forward. Many of the vessels that have moved into this trade are 13 to 15 years old and will likely not return to the premium trades given their age and trading history. Slide 18, please. If you recall, in December, rates reached record levels while the order book was near an all-time low. Over the last 18 months, we have experienced a strong rate environment, evidenced by the volatile blue line in the graph. From a cyclical perspective, hopefully, we are in July 2003 or even July 2004. Historically, as product tanker rates increase, so do the orders for new vessels. It's not surprising that we have seen additional orders. The rationale for ordering—strong spot market, healthy long-term time charter rates, constructive demand outlook, and aging fleet—is a good reason. It's also a good rationale for investing in product tanker companies. Slide 19, please. The increase in the order book has largely been driven by LR2 orders, which have accounted for 49 vessels year-to-date. While LR2 orders are elevated, MR orders are below their 5-year average this year and well below historical averages. Until this year, LR1 orders have been virtually nonexistent, with only 12 LR1s ordered from 2016 to 2022. Therefore, part of the increase in LR2s is to compensate for the aging LR1 fleet, similar to how MRs have largely replaced Handymax vessels. Additionally, within LR2, we have the optionality to trade in the crude market; less than 50% of the LR2s on the water today are trading clean products. There are constraints to ordering new vessels as well; long lead times exist for the delivery of newbuild vessels. Orders placed this year were for the earlier slots at the shipyard; those slots are now gone. New builds are expensive compared to historical levels, and the cost of capital is higher with rising interest rates. A new build LR2 costing $71 million with a 2026 or 2027 delivery date will require a high breakeven rate and needs a constructive market. Lastly, there are still concerns about different propulsion systems required to meet future environmental regulations. All of these factors act as a constraint. Slide 20, please. When thinking about new building orders and fleet growth, the age and trading profile of the fleet must be considered. The product tanker fleet continues to get older and this is important because as product tankers become older, the coatings that make them product tankers develop issues. Every product tanker in the water is not trading clean products; only 60% of the Handymax and LR2 fleets are trading clean products and 70% of the LR1 fleet. Older vessels are moving into trading dirty products or crude oil. Although you may see our newer vessels move into these trades eventually, it does need to be accounted for. Given the age of the fleet, we expect more vessels to move into crude oil trades as they get older, while the increasing number of vessels aging into scrap candidates adds to this. By 2026, the product tanker fleet will have 954 vessels that are 15 to 19 years old and 811 vessels 20 years and older, an increase from 349 today. These changes will have a material impact on the fleet. Lastly, scrapping is at an all-time low, and we do expect scrapping to increase as vessels age and environmental regulations increase. Slide 21, please. Putting this all together, despite the increase in the order book, the order book remains modest. Using minimal scrapping assumptions, on average, the fleet will grow less than 2% a year over the next three years. Using higher scrapping assumptions due to fleet age and upcoming regulation, the fleet will grow less than 1% per year. Seaborne exports and ton-mile demand are expected to increase 4% to 11.9% this year and 3.4% to 6.3% next year, vastly outpacing supply. Additionally, 1-year and 3-year time charter rates remain at high levels, evidence that our customers' outlook is one of increasing exports and ton miles against the constrained supply period. The confluence of factors in today's market are constructive individually; historically low inventories, increasing demand, exports and ton miles, structural dislocations in the refinery system, rerouting of global product flows, limited fleet growth, and upcoming environmental regulations. Collectively, they are unprecedented. With that, I would like to turn it over to our President, Robert Bugbee.

Good morning, everybody. Thanks so much for joining. On behalf of the management, this is a great time to be invested in Scorpio Tankers, and a great time to be further invested in STNG. We're happy with all the buybacks we've been able to do. I'd like to point out a couple of things that I think are really important. First of all, the liquidity and the financing that's being done give us a tremendous amount of flexibility going forward. We've shown during this quarter that we're willing and wanting to sell older vessels to improve the arbitrage opportunity between NAV and the stock price. The other thing is the rates—it's most important where the market is going as an investor, as opposed to where it's been. The market right now is going up; it's inflecting upwards from a very weak period that we've had for a couple of months. The average that we've achieved in our bookings during what is typically the weakest part of the year is fantastic. For many years, that would be a high number. The next part is we're already earning a very large number, as James pointed out, with the mid-30s in the MRs moving into the 40s on the LR2s. The LR2s continue to rise today, which creates a lot of confidence for the company moving forward. I would like to thank you all again and open up for questions.

We will now begin the question-and-answer session. The first question comes from Omar Nokta with Jefferies.

I wanted to follow up a bit on just, Robert, your comments about where rates are. And also, I know James, you touched on this. But it seemed that product tanker rates have settled into the typical summer doldrums we've seen in the past. What we've actually seen over the past, say, two to three weeks is a real resurgence across all product segments. This is happening while we've seen some weakness or further weakness in the crude tanker side of things. I just wanted to ask maybe if you could dive a bit deeper into it. What's been driving the market here recently? What's behind the latest jump? And what can we expect going forward?

Sure, James. I'll go first on this. I think that the first thing we've seen is refinery margins really widened positively here. We've experienced a significant change in sentiment. We moved from a recessionary view on oil and consumer demand expressed by the paper market into the physical market. Demand is going up now, and we are seeing this constant drawdown. As the prices of oil move upwards and the prices of refined products move up even higher than the price of oil, people start to engage in the market. As usual, outside of periods of hurricanes or war, this is demand-led. We had a market that was very tight anyway, as we've explained this week. We saw the doldrums at very high levels with high utilization. As soon as demand increases, that was going to push rates higher.

Thanks, Robert. That's helpful. As my second question as a follow-up, given the market strength, you guys have a sizable critical mass across the LR2s and MRs. In prior quarters, you were able to put away some of your ships on period contracts. How would you think about it now? I think it was 15 ships that you've got on time charter. What does the liquidity look like for that market at the moment given the sort of run-up we've been seeing? And is there appetite for Scorpio to add more?

I think we’ve seen that one of the other encouraging things that supports James’ view of the long-term fundamentals here is that the 3-year forward rate was hardly changed during this period. So again, the physical market is moving through this period, not referencing the paper market. Right now, it’s a very strong move and it has surprised us. We’ve had to act very quickly to respond. We knew that the market would rise; however, it's challenging to pinpoint that exact inflection point. The inflection started happening about 10, 12, or 13 days ago. Right now, it’s not the time to put ships out on time charter. We need to let the market develop, especially as Europe is becoming more exposed on diesel. If we start seeing more movements from the Middle East or products and increasing movements from Chinese exports, then this market could really strengthen as we move into the stronger season. For now, it's not the time to negotiate time charters.

Thanks, Robert. That makes sense. That's all for me. I'll turn it over.

Our next question comes from John Chappell with Evercore ISI. Please, go ahead.

James, I want to tie together a couple of points that you brought up going into the second half of the year, both the low inventory starting point and the 2 million to 3 million barrels of incremental demand. We've been early before with inventories drawing below historical levels. Where is the incremental 2 million to 3 million barrels of supply going to come from? When you think about that from a global map perspective, does it continue to extend the ton miles that we've seen over the last six quarters? Or is there a chance it could be a bit more regional, just given the panic going into winter to meet that demand?

I believe we are in a scenario where inventories are so low that any type of supply disruption—like we saw with some refineries in the U.S. Gulf—will have to be met with imports from different places. It will be a combination of long-haul and regional. If you're considering remaining places with capacity, it's primarily the Middle East and China. Robert mentioned we could see Chinese exports increase if they issue a new batch of quotas, which seems likely. We have also seen capacity out of the Middle East increase. For example, the Al Zour refinery, with two out of the three CDUs fully operational, has had a significant impact on the export market. However, I do believe given the strong demand, this will be a collective effort to meet needs.

Okay. But just to be clear, I mean, you do expect that incremental demand to be met with supply and not kind of further inventory draws below 5-year averages?

The projections we're looking at are very close. For instance, if you were to lose more Russian barrels or there were to be more disruptions in European or U.S. refineries, things could become very difficult. You could see draws. We are also observing significant draws on the crude side right now.

Okay. Second question relates to the fleet. You've sold a vessel recently and I look at the fleet age, there's still a handful that are at or over 10 years old and a larger group that will become 10 years next year. When you think about the arbitrage of the current stock price and asset values right now, should we expect more monetization of the older vessels as we go into the second half of the year?

Yes, as we stated on the last call and as evidenced by the sale of the first one, we’re willing to do that. However, that would be done slowly, and it would be disruptive.

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

This is Nathan Ho dialing in for Ken. I just wanted to follow up on Omar's original question regarding the bifurcation between the feed and the product tanker markets. Over the quarter, we have heard of some tankers dirtying clean product vessels. Can you give us comments on the economics there and how we should consider the capacity tailwind that represents for the product tanker market?

Sure. A lot of the switching from LR2s started in Q4 last year. I'd estimate at least 20 vessels have moved over to this trade. The Aframax market has benefited from a lot of new capacity coming online from Latin America, Africa, and the U.S., which benefited the smaller crude vessels, increasing ton miles. However, the clean side has had its challenges due to the naphtha arbitrage and lower distillate volumes, but we expect those to reverse. Looking forward, we expect both markets to remain tight, especially on the product side, which we know more about. We have been a little less focused on the crude side.

Got it. As a follow-up on capital strategy, how is the team looking at deleveraging from here? There has been a lot of debt shed over the past year and prior quarters. Is there a target leverage level, or is this more of a target vessel breakeven TCE goal that we're trying to achieve here? Also, can you update us on where that $17,000 level could potentially trend in 2024?

So James, why don’t you handle the $17,000 part and I’ll address the other questions.

Yes, we expect the breakeven to come down, though it’s probably a little higher than the $17,000 because of the timing of lease repayments. We are required to give notice, and there is a specific period or time of the year to repurchase the vessel. Although we’d like to repay those vessels today, we can’t yet. The good news is that most of the lease debt, around $1 billion, and those vessels can be repurchased in the next 12 months. You will see continued announcements from us that will provide better insight into how many vessels and the timing on that. For now, we haven’t formally disclosed it, but we do expect breakeven to decline. We must also factor in higher interest rates during this period.

Regarding the debt level, that's not a question we are ready to answer. As you can see from the terms we've obtained—historically, the debt level is relatively low. However, we will continue to consider how we can reduce the debt levels, as we've mentioned, including the potential further sale of vessels. Our confidence in the rate environment going forward also plays a role. I believe these combined factors will lead to our ability to both reduce debt and pursue other initiatives.

Our next question comes from Sam Bland with JP Morgan.

I've got one question with two parts. First, can we touch on the disruption and market tightening from the Russian sanctions impact? Is the impact now done, or have we seen the full effects? Or is there potential for more market tightening related to Russia that may come through, whether it's from the dark fleet or anything else? Second, regarding the ton-mile demand forecast of 6.3% in 2024, where do you think that comes from? Is it general global growth, or is it related to Russia?

Yes. The next year's forecast for ton miles indicates that about 3.4% of the total increase can be attributed to exports, while the remaining 2.9% relates to ton miles driven by Middle Eastern exports and new capacity coming online—along with potential closures in Europe and emerging market demand. This does not factor in any displaced Russian volume. There is still more upside to the dislocation and conflict impacts from Russia and Ukraine, but we have mostly seen the effects. The major contributor will be what happens with the gray fleet over time. We’re talking about 10% to 11% of the MR fleet serving this trade, which may have a long-standing impact on fleet supply and trading dynamics.

Our next question comes from Frode Morkedal with Clarkson Securities.

Good presentation on the questions so far. Yes, the key word has been demand, which you mentioned, and you've highlighted many moving parts. The question really is which one is the most important one or should have the greatest impact in the near to medium term?

I would say headline demand. The headline demand creates confidence among all players and urgency for those who may be short. If we keep moving from recession fears to comfort with headline oil demand and product demand, it creates an environment where if you are short, especially diesel in Europe going into winter, you better start purchasing. That is undoubtedly the most critical factor as it forces the market to act cohesively. It’s difficult to predict the exact source day-to-day of this demand; it could be coming from the Middle East or China, but I would prioritize headline demand.

My second question is on the Russian trades. Our peers report crude exports are coming off, but what’s the situation for products now?

You've seen similar to crude; products have also returned to a more normalized level. Part of that is probably due to OPEC. The increase we observed right after sanctions in March, where exports were at 2 million barrels a day, have normalized as their ability to export at such levels isn’t sustainable, especially with refinery maintenance schedules. Similarly, in the U.S. Gulf and other export regions, high utilization isn’t sustainable. Thus, I believe refined products will remain at these normalized levels.

And this is impacting the market?

Yes. Frode, it will be interesting to watch Europe as the situation develops. Last year, they managed to pre-stock ahead of Russian sanctions during a mild winter. If we enter this winter with lower inventories than last October, it will be much harder to build up stocks given the current Russian dynamics.

Our next question comes from Sherri Elmaghrabi with BTIG.

First, drilling down on what's going on with Russia, there’s potential for more upside. With Russian oil crossing the price cap, are you seeing some tankers return to other trades due to the rates looking favorable? Or is it too soon for that type of shift?

I think it's too soon for that. It's challenging to take a crude ship and pivot it back to clean trades. Given the current spread, the older the ship is, the more difficult it becomes, and many vessels that have traded to Russia won't be accepted by charters in the free market for clean petroleum unless they undergo a significant cleaning process.

As a follow-up on vessel sales, the pace of new build orders has really picked up in recent months. How are you thinking about fleet renewal at this time?

We are not focusing on new builds at this stage. That notion is low down on our list of capital allocation priorities. It’s much more advantageous to invest in our own stock rather than ordering vessels that won’t be delivered until 2026 or later. Additionally, it’s crucial to recognize that the timeline for new building orders has been extended significantly. While there are more orders now, they have shifted the delivery timelines for 2023, 2024, and the first half of 2025. If we simply take a dollar, investing in our operations that yield immediate benefits is much more favorable than a far-off new build.

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

Back on capital allocation, you've been clear about debt reduction and your buybacks earlier. Just last quarter, you bumped your dividend from $0.10 to $0.25. Is this a dividend you anticipate paying through the cycle? Or are you reconsidering that payout?

Much depends on where the stock price is right now. At this particular point, I believe investors would want the company to use cash flow for stock buybacks rather than paying out a dividend that would be taxed. The dividend can wait; we believe it wouldn’t be right to increase it now, especially with the stock trading at such a dislocation to the fundamentals.

That’s fair enough. And I guess this is for James. Things are improving significantly at the macro level. We’re seeing a creeping order book emerge here. While some of this could be offset by recycling, what will get that activity moving? We haven’t seen that in a few years.

That’s a great question. The number of vessels aging into the 20 to 25-year-old category over the next two years is staggering, which will result in many vessels vacating secondary markets or trades and being scrapped. Environmental regulations will understandably play a part in this. The sheer number of vessels, around 900 to 800 that are forecasted to be 20 years and older by 2026, is considerable, up from 350 today. We anticipate scrapping will ramp up, and the aging fleet will cause additional vessels to shift into crude oil trades.

Great. As a follow-on, as your vessels age into that category, do you foresee a need to consider a trade-off between selling to achieve NAV or displacing them into the crude market?

That’s what we are currently doing, and we will continue to do so.

Our next question comes from Christopher Robertson with Deutsche Bank.

James, you outlined minimal CapEx coming in this quarter and next. I’m curious how this translates into off-hire days. Are there any utilization factors regarding ships moving in and out of the pools in the coming quarters that could impact operating days?

Sure, Brian. Yes, the off-hire days are minimal. We don’t have many dry docks scheduled in the next half of the year and the upcoming two quarters. As seen in the table in the press release, fiscal '24 will see more activity due to special surveys. That’s why CapEx is minimal in the coming quarters.

Okay. In terms of utilization, will there be any impact with ships moving in and out of pools?

I wouldn't say that’s material.

My second question is around the step-up in vessel OpEx from Q1 to Q2. Do you see any further cost inflation or pressures expected for the remainder of the year?

I think Q2 is going to be a more normalized run rate for the remainder of the year compared to Q1.

This concludes our question-and-answer session. I would like to turn the conference back over to Robert Bugbee for any closing remarks.

Thank you, everybody. We appreciate your support and your interest. Enjoy the summer, and we look forward to speaking to you again in the near term. Thanks very much.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.