Earnings Call Transcript - STNG Q1 2022

Operator, Operator

Hello, and welcome to the Scorpio Tankers Incorporated First Quarter 2022 Conference Call. I would now like to turn the call over to James Doyle, Head of Corporate Development and Investor Relations. Please go ahead, sir.

James Doyle, Head of Corporate Development and Investor Relations

Thank you for joining us today. Welcome to the Scorpio Tankers first quarter 2022 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 first 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, April 28, 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 a discussion of these risks and uncertainties, you should review the forward-looking statement disclosure in the earnings press release that was 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 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 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 our 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.

Emanuele Lauro, CEO

Thank you, James. Good morning and good afternoon to everyone. I'd like to start by saying that our sympathies and thoughts are with those impacted by conflict around the world. The times in which we live are particularly uncertain, and the level of tragedy that the world is experiencing is far beyond anybody's imagination. As far as our business is concerned, when we last spoke, I said that our top priority was to position the company to create shareholder value in an improving market and for the next tanker cycle. This remains very much the case. And we felt that the best way to do this is through improving our balance sheet. In order to do that, since January, we have announced the sale of 18 vessels. This sales increased liquidity, reduced overall debt and are a demonstration of the discount that our shares trade relative to an ever-improving NAV. In the first half of the year, we reduced our debt by more than $500 million through vessel sales and scheduled amortization. With a fleet potentially averaging $25,000 a day TCE in the second quarter, should that be the TCE for the second quarter, the company could finish the quarter with $450 million in liquidity. This would result in a reduction in debt of over $730 million in the first half of the year. Last quarter, we said that the catalyst is simple: supplying incremental oil demand with inventory draws is not sustainable in the long-term. The timing is less so but the inflection was near. This became apparent at the end of the first quarter, when the reopening of the global economy from the COVID-19 pandemic increased the demand for refined products, sea-borne exports, and rates on our vessels have reflected that. The mismatch between the supply and demand of refined products and the improving rate environment was apparent prior as well, but further exacerbated by the conflict in Ukraine. Our thesis has not changed, but we are certainly more optimistic given the growing demand and increasing dislocation between producers and consumers. Refined products demand is expected to increase each quarter as the pandemic eases. Given historical low inventories, refinery burns and sea-borne exports will lead to an increase in demand. This will provide a constructive environment for product tanker rates. Product tanker rates increased significantly at the end of the quarter and remain at elevated levels today. We are pleased with our second quarter guidance and excited that the thesis is finally starting to play out. Given our positive outlook, we have no plans to sell additional vessels. We will continue to reduce our leverage naturally through scheduled amortization and opportunistically through vessel refinancings. That said, with a healthy liquidity position and significant operating leverage of the company, in a sustained rate environment, we will be looking to return capital to shareholders in the most value-creating way. For example, by looking to employ our $250 million share repurchase program. There are several reasons to suggest that a sustained rate environment will continue. I would like to ask James to tell us why through our slides.

James Doyle, Head of Corporate Development and Investor Relations

Thanks, Emanuele. Good morning and afternoon, everyone. Over the last two years, the recovery in oil demand has been quite resilient, especially when considering that widespread vaccinations only started at this time last year. That said, the recovery has also been bumpy, varied by region, and impacted by new COVID variants and restrictive measures. At any time demand exceeded supply, there were available inventories to draw from. Thus, the improving demand, refinery rationalization, and increasing ton miles that we have talked about so much did not have a material impact on rates until it did. In January, we started to see a steady improvement in MR rates, which was prior to Russia's invasion of Ukraine and driven by increasing demand in Latin America, Europe, the US, and Africa. After Russia's invasion of Ukraine, we saw a significant increase in product tanker rates. But as you can see, it did not have a lasting impact on the LR2s, which increased for two weeks before declining. For the MRs, the highest rate increases were for our vessels that were going from the US Gulf to Latin America, which has less to do with Russia and Ukraine and more to do with increasing demand. While MR rates in the US Gulf declined from their record levels, they have increased substantially in the Middle East and Asia. We have seen a steady increase in LR2 rates over the last few weeks, as Asian demand has increased. As of today, spot rates are higher than currently presented in this graph with eco MR and LR2 rates in the Middle East and Asia trading well above $40,000 a day. The question then is, how did we get here? Slide 8. Diesel demand has been robust and is already above pre-pandemic levels. Despite an increase in refinery runs last year, demand continually outpaced supply, creating an extremely tight diesel market. As you can see by the graph on the lower right, the diesel shortage is not new to Europe. The graph on the top right shows that the shortage extends beyond Europe, including Latin America and Africa, which have similar diesel deficits. We expect the market to tighten further with increased competition for distillate molecules as jet fuel demand returns, and it is also having an impact on gasoline. With refiners running in max distillate mode, we are not building significant gasoline inventories ahead of the peak driving season. This is very constructive for product tankers. As demand grows and inventories remain tight, product tankers will need to be the conduit for filling the global supply-demand imbalance of refined products. Slide 9 please. The situation in Russia and Ukraine has exacerbated the global diesel shortage. Prior to the invasion, Russia exported around 1.5 million barrels per day of clean petroleum products, and the majority of this was 1 million barrels per day of diesel going to Europe. It's unclear how sanctions will play out, but it's hard to see a scenario where it doesn't increase ton mile demand. If European countries were to ban Russian product imports, it's likely that these imports would go to Africa, Asia, and Latin America. To replace the lost Russian imports, Europe will have to source barrels from the US, Middle East, India, and Asia. If this happens, there will be a substantial increase in ton miles, because in every scenario you are replacing a barrel from a location that's farther away. Are we seeing this yet? Slide 11. Well, we have seen an increase in ton miles, but much of this has to do with refinery rationalization. When you factor in the refinery closures over the last few years, it compounds the supply-demand balance in today's market. After a refinery closes, in most cases, the lost output needs to be replaced with imports. For years, we have seen export-oriented refinery capacity additions in the Middle East come online, while older and less efficient refining capacity has been closing in Europe. Additionally, we saw significant refinery closures in the last two years in places like Australia, the Philippines, Japan, the US, and Canada. As demand returns with the global reopening from COVID-19, these barrels need to be replaced. Over the last few weeks, we have seen record refined product exports out of the Middle East and close to record levels of diesel exports out of the US Gulf. This has supported the strong increases we are seeing in MR and LR2 rates today, a demand-driven recovery. Is this sustainable? Slide 12. Yes, but we do think the supply and demand balance for refined products is going to be extremely tight throughout this year. In 2021, seaborne CPP exports were around 700,000 barrels per day, lower than 2019 levels. In addition, there were roughly 500,000 barrels a day of refined product inventory draws. Thus, we were very close. In April, CPP exports exceeded pre-COVID levels by 700,000 barrels per day. Our thesis hasn't changed. Looking forward, refined product demand is expected to increase 4 million barrels a day through the remainder of this year. If 25% of this increased demand is exported, seaborne exports of refined products will increase by an additional million barrels a day. With inventories at historically low levels, there is a limited ability to supply demand from draws and refinery runs will need to increase as well as product exports. This is extremely constructive, and it's expected that product exports and ton mile demand will increase by 5% to 14% this year. Slide 13 please. The product tanker order book is at a record level with 5% of the existing fleet on order today. By looking at the order book, you would 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 tanker orders, but if ordered today, these vessels would not be delivered until 2025. While the order book is at an all-time low, scrapping last year was at an all-time high and we expect this to continue throughout 2022. Unlike other sectors, product tankers were not building mass until the early 2000s. So, scrapping has been minimal and basically everything that's been delivered hasn't left the fleet. Today, there are 255 product tankers, 20 years and older. By 2025, excluding scrapping, there will be 687 product tankers, 20 years and older. That additional new building orders means more than half the fleet will be 15 years and older by 2025. Using modest scrapping assumptions, product tanker fleet growth, net fleet growth, is a little over 1% over the next two years before going negative. However, when we use a scrap rate that reflects the age profile of the fleet, supply growth is essentially zero the next two years before going negative in 2025. Financial highlights. Slide 14 please. To maintain liquidity during the challenging rate environment as a result of the COVID-19 pandemic, we increased our leverage as opposed to raising equity. Prior to the increase in spot rates, our focus was to improve the balance sheet, which as you can imagine, is difficult to do in a weak freight market. Since the start of the year, we have announced the sale of 18 vessels. These vessels increased our liquidity, reduced overall debt, and are accretive transactions, given the discount our shares trade relative to the vessels' sale prices. As Emanuele mentioned, we have no plans to sell additional assets. Through debt repayment related to vessel sales, scheduled amortization, and our convertible bond, we will reduce our debt by over $500 million in the first half of this year. Given the improving rate environment, if the fleet average is $25,000 per day in the second quarter, we could have $450 million in pro forma liquidity by the end of June. This would reduce net debt by over $700 million. In addition, we have refinanced all the upcoming loan opportunities through 2023 aside from one. Given these points and our positive outlook for the market, we feel very well positioned. Next slide please. Slide 15. Scorpio Tankers has tremendous operating leverage. Every increase in spot rates above our all-in breakeven goes directly to the bottom line. So far in the second quarter, the fleet has booked an average PCU rate of close to $28,000 per day, which is close to double the prior quarter. Assuming rates average $25,000 a day for the year, the company would generate almost $600 million in free cash flow before debt repayment or $10 a share, a 40% to 45% free cash flow yield. If you include debt repayment, the company would repay around $4.50 a share in debt and then generate $330 million or about $5.60 a share in free cash, adding $10 a share to the company's earning base. Next slide, conclusion and investment highlights. Slide 17 please. The company owns and operates one of the world's largest product tanker fleets, comprised entirely of eco vessels. We have significant operating leverage; a $1,000 change in product tanker rates equates to $41.2 million in annual cash flow. As you are aware, rates don't usually move by just $1,000. We are in the process of de-leveraging the balance sheet and positioning the company to create value and improve the quality of the investment. We will reduce our debt by over $500 million in the first half of this year. Our shares trade at a steep discount to our net asset value, and we have a $250 million share repurchase program. The market inflection point has arrived and the long-term supply-demand fundamentals suggest we could have an extended tanker cycle as well. With that, I will turn it over to Robert.

Robert Bugbee, President

James, thank you very much. Firstly, thank you to all the analysts who have supported us in these months that we've gone through, especially those who supported us during the really dark times, such as last November. First, I’d like to thank all the blog chat rooms, especially tanker data; all you people have been really helpful in providing encouragement and constructive criticism. Now I think James has laid out a pretty conservative but very reasonable position in his notes. We can see that even if that was obtained, there would be substantial value derived in the stock. Emanuele has been very clear that we want to improve the quality of the investment by continuing to deleverage, and to be clear that we have the capacity with the stock authorization of $250 million to make significant inroads into the stock. Now what we don't know is just how much. We don't quite know what the rates are going to be, and we know that there's huge differences and changes. Cash flow is huge even now; it's instantaneously dynamic and transforming. If the company gets cash flow, you can look across and see the container market last year, some companies that went up more than 7 or 8 times from February through January, some even went up more. We’re seeing the dry cargo market companies like Eagle, Star Bulk, and Genco all having substantial rises in their stock value as cash flows came in, and their options came to either increase dividends or buy back stock. For us, while it is a huge difference in NAV at the moment, we would rate our NAV at around 35, 36, maybe even a 37 level. It is very difficult to tell when things are moving up very quickly. There's no question that buying back stock would be the best use of excess capital. And I would counsel everyone to look at the cash flow now. Long-term fundamentals are fantastic. The cash flow right now has dynamics in it that change with trade routes that are really unlikely to change significantly. Every time we look at and answer the question over the last two months, can it be sustained? The answer has really resulted in the market getting stronger. This last week, the market has moved into a new stage, a more global importance, where Asia is driving rates right now in a huge way. And you have the LR2s at the top of the pack that are the most industrial demand sensitive, driving higher into record rates. Just this last week, those rates moved up to the range of $30,000 a day or so. MRs are also strengthening during this period. So don't get fooled by the headlines that all the US Gulf is weakening. Even the US Gulf is starting to strengthen again, but it's a much healthier market to have the natural order events, with the LR2s at the highest rates, MRs in between, and Handys underneath. We are likely to see some weakness in the Handys because the heating season is ending and we're moving into summer, meaning those Handys trading dirty are likely to trade at relatively weaker rates than those Handys that are trading in and between. That said, I’d like to open it up for questions. Thank you once again.

Operator, Operator

Our first question comes from Greg Lewis with BTIG.

Greg Lewis, Analyst

I did want to talk a little bit about the market. However, before that, I wanted to clarify that about a month ago, you did sell off another couple of vessels. I’m curious if you could share any color around that, especially considering asset values have been rising. How are you thinking about the fleet management of your assets?

Emanuele Lauro, CEO

As we stated, we are done with the sales. The market has moved quickly. Whether the fundamentals pointed towards where we are now has happened quicker than we expected, triggering maybe by the geopolitical aspects we are experiencing. However, as you know, selling a ship doesn't happen overnight. The process of selling vessels started months ago and concluded with the last vessel, which you are likely referring to, at a time where we decided to proceed with that transaction because it was the right thing to do. Discussions were already well advanced for us to withdraw from it. Selling one more vessel didn't change a lot from a balance sheet perspective, but we decided to proceed and now focus on the incredible cash flows that are coming in. If those are sustained, which we expect them to be, then we will then discuss how to return capital to shareholders.

Robert Bugbee, President

Greg, I’d like to add that we accelerated our position now, knowing we are really strong. By adding those two ships, we can drastically drop the debt down, clarifying our watershed line. We can then focus on driving the company and driving shareholder value.

Greg Lewis, Analyst

I want to discuss the market. Recognizing it's fluid and evolving daily, could you provide a little more color around what is happening with the LR2s? The recent leading edge scrub rates for LR2s seem to be at their highest in quite some time. Can you talk about that strength?

Robert Bugbee, President

First, Lars is really busy, and he's too busy to be on this call. Normally, he'd be very important for us to have on the call as he’s out in Asia making sure he’s on top of the position and this new change in the LR2 market. It is very, very strong. We had fixtures just in this last week, which have strengthened into the end of last week and have now just moved up virtually every single day. We still have a wide disparity. We have a market that's giving returns between 25 and 75. It will start to fill into different parts as we go through this week and find its level, almost certainly at a higher rate next week. Emanuele?

Emanuele Lauro, CEO

Robert, I was just echoing what you were saying. The market has started pumping on all cylinders, particularly in the US Gulf on the MR side. This has triggered an interest from vessels located in the Mediterranean and Northern Europe to reposition themselves in the US Gulf. As expected, this has raised the European market while adjusting the US Gulf market downwards. When I say downwards, I mean MRs are still fixing at extremely healthy levels with TCE numbers starting with a three. The Middle East long runs between the Middle East and Asia have been lagging, but there has been a constant daily increase in the last 10 days, highlighting the structural demand for LR2s, not only in Middle East to Asia trade but also in the US West Coast from Asia into California. This has balanced out the market dynamics, creating a sustainable upward trend.

Robert Bugbee, President

As Emanuele mentioned, the latest MR fixture lifted subjects this morning was from North Ages to Los Angeles at $72,000 a day. This demonstrates the difficulty in guessing cash flows clearly. We know we are in a strong market, and it's tough to envision the dynamics that would stop this market from firming overall. While it may not average $72,000, there’s not much that's likely to change the dynamic. We don't foresee the Russia-Ukraine situation changing significantly in the coming months, and we’re also entering the gasoline season with diesel and gasoline inventories that remain critically low.

Operator, Operator

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

Ken Hoexter, Analyst

Robert, just to understand correctly, are we supposed to take the $72,000 and put that in our MRs for a model now?

Robert Bugbee, President

No. I mean, you could put $25,000 in the model. That’s an easy hurdle.

Ken Hoexter, Analyst

So walk me through this part. We’ve been excited about rates finally arriving. What is it in three months that we come back to you and either what goes wrong or what's a post-mortem on this that we would have missed?

Robert Bugbee, President

First of all, from your base position, a market that simply supports that the stock should be trading towards its NAV in the mid-30s is difficult unless you encounter an event that no one has foreseen, or an unexpected escalation in geopolitical events. It’s hard because that scenario would require a dramatic drop in demand. What could go wrong? I don’t know— perhaps people are restricted from using vehicles consistently. What you’ve got here is a genuine change in ton mile dynamics that coincides with long-term supply fundamentals due to refinery openings and closures.

Ken Hoexter, Analyst

On a different subject: Emanuele mentioned that you’re done selling, which surely showcased your NAV capabilities to the market. Do you ever consider M&A as you did with your prior firm to gain scale within the sector?

Robert Bugbee, President

We’re at the point of making money with the newest and largest fleet. We are number one in the three remaining categories we are in now, the Handys, MRs, and LR2s. We have no reason to acquire more assets or buy another company. Almost every purchase would create an inferior fleet profile. It’s not even being discussed. That's the beauty of our situation. It's easier to manage predictably since we have no CapEx. We have no new buildings and very little capital expense.

Ken Hoexter, Analyst

I agree; it’s really about waiting for that rate inflection that you’re capitalizing on.

Ben Nolan, Analyst

I'll start on the macro side. James, you mentioned that you expect that at some point people will start ordering more product tankers. Given current prices versus building prices, is there any incentive to order now? I can't see why anyone would do it unless secondhand values come up or new building prices come down.

James Doyle, Head of Corporate Development and Investor Relations

I think you're right on that, Ben. The only thing I would add is you could see certain owners look to order vessels with dual-fuel technology and long-term time charters, similar to what INSW has done. But that's a caveat and I agree with you.

Ben Nolan, Analyst

Is there an appetite for charters to do that for a Handy or an MR? It seems like it’s being done on bigger ships, but a much greater challenge for smaller ships.

James Doyle, Head of Corporate Development and Investor Relations

Most interest so far from charters has really been for vessels on the water in the next few years. This reflects the view that maybe this inflection will lead to a longer-term extended tanker cycle, given the supply-and-demand fundamentals.

Ben Nolan, Analyst

You now have a lot of liquidity and you've been able to monetize some assets. Given the discussion around returning capital to shareholders, isn’t it better to spend some time and capital to deleverage the balance sheet?

Robert Bugbee, President

Ben, I think that's correct, but we have caveated this with sustained superior earnings. You're not going to be sitting at $17 a day before stock buybacks. But with superior earnings, you'll have room to pay down a reasonable amount of extra debt along with amortization while also taking opportunities to buy back stock. Each month makes it safer. The leverage is very high off this. It's nearly $40 million for every $10,000 improvement.

Magnus Fyhr, Analyst

You have painted a strong demand picture and limited supply growth ahead. Where's the additional supply from refineries coming from, given that they’re all running at pretty high levels?

James Doyle, Head of Corporate Development and Investor Relations

Magnus, you're correct that in the first half of this year, we are looking at a very tight refined product market. We expect refineries to increase capacity by 2 million to 3 million barrels a day, which adjusts for a loss in Russian production, with incremental supply coming from Asia and the Middle East as those regions come off maintenance.

Magnus Fyhr, Analyst

What are the conversations you’re having now with charters regarding securing tonnage? With high rates now, is there an appetite for longer-term charters?

Emanuele Lauro, CEO

We're seeing substantial increases in interest with what was previously a 12-month interest now shifting into the 24- to 36-month range. These signals usually suggest a durable view from oil companies and traders. We expect to see action in long-term fixing going forward in the product tanker space over the summer. We anticipate that end-users will start covering their books for probably 36 months ahead.

Magnus Fyhr, Analyst

From your point of view, would you prefer to stay spot or are you considering longer durations for charters? A 12-month charter doesn't do much.

Emanuele Lauro, CEO

There’s always a magic number we’re not going to disclose for negotiations. A minimum of 36 months would be required to attract our attention. We’re starting to see those numbers being mentioned, which would prompt us to look into covering a portion of our fleet. Ideally, we’d hope to fix vessels at numbers that are too conservative if the thesis gets stronger than expected.

Operator, Operator

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

Liam Burke, Analyst

You've paid a dividend consistently through the cycle, even through the last six quarters. With the business getting stronger, is there thought that dividends could come up in the cycle from its current levels?

Emanuele Lauro, CEO

I believe it’s premature to discuss this now. However, in the cycle, for sure, we will consider adjusting dividends upward looking at the tankers cycle ahead. It's part of capital allocation to shareholders. We need to see the market sustain for a few months before contemplating an increase in dividends.

Robert Bugbee, President

Currently, it’s not even a discussion point due to the gap between NAV and stock prices. It’s massive. Traditionally, we did not increase dividends when this gap was large until it began to close, which may lead to increases in dividends proportionate to shares bought back.

Cameron Mackey, COO

No, we aren't having any difficulty in getting high sulfur fuel.

Chris Robertson, Analyst

Robert, you mentioned companies like Genco and Star Bulk that have clear dividend strategies. Is that something Scorpio would consider for the future, perhaps moving to a more formulaic approach?

Robert Bugbee, President

It's a long way off; increasing dividend policy isn’t being discussed at this point. The future could differ, but we are not considering that now.

James Doyle, Head of Corporate Development and Investor Relations

The average fleet all-in cash breakeven is around $17,000, including debt. Without debt, it would be around $11,000 per day. This is well above those rates. We wouldn't be looking to buy any ships right now. We're focused on low CapEx to maintain maximum cash flow for repayment and stock purchases. The idea of buying ships is off the table. However, there are purchase options in some of the leases, and we could make financing more efficient by exercising some of those options and replacing them with conventional bank debt.

Omar Nokta, Analyst

With increasing sanctions on Russian-owned vessels, are we seeing any effects on the supply side of the market, particularly for products?

Robert Bugbee, President

On the product side, the product tanker fleet hasn't been greatly affected by sanctions simply because there aren't many Russian product tankers. The sanctions are more impactful on crude starting from the Aframaxes upwards. The impact on those sanctioned vessels has already trickled down; while it may affect the crude market significantly going forward, it’s difficult to predict exactly.

James Doyle, Head of Corporate Development and Investor Relations

As far as I know, there are only two MRs scheduled for delivery in 2024, and only six LR2s. So it’s very few. Thank you. That's all I had.

Emanuele Lauro, CEO

No particular remarks. Thanks very much for being with us today. I look forward to speaking with you all in the coming days and months. Thank you.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. You may now disconnect. Have a wonderful day.