Frontline Treading Water

By Stephen D. Simpson, CFA | June 01, 2011 AAA

Oil prices are persistently hanging around $100 a barrel, so it must be good days to own an oil tanker, right? Not so fast. While oil demand has indeed been strong throughout most of the world, tanker operators continue to take delivery of more new capacity and the spot rates for crude oil tankers have plunged as a result.

That leaves Frontline (NYSE:FRO) struggling and ill-equipped to do much more than dog-paddle its way through current troubles. In point of fact, Frontline is one of the better-run tanker companies out there (albeit very focused on crude oil transport), and yet controlling shareholder John Fredriksen is not really looking for a better shipping environment until 2012.

Stock Basics

A Tough Quarter as Rates Weaken
While Frontline reported that total revenue fell 29% from the year-ago level, net revenue was actually down about 40% (flat sequentially) as tanker rates plunged 45% on an all-in basis. While shipping rates are weak, there is no such weakness in operating costs. Consequently, Frontline saw adjusted EBITDA essentially cut in half from the year ago level while adjusted operating income fell almost 77%.

A No-Win Operating Environment
By the company's own admission, its cash breakeven rate for its VLCC (that's very large crude carrier) is a day-rate of $29,700, above the average spot rate of $27,200 the company saw in the first quarter. Worse still, spot rates have continued to drop precipitously - nearly touching $10,000 a day for some routes.

This is not just a problem for Frontline. Other tanker operators like General Maritime (NYSE:GMR), Teekay (NYSE:TK) and Nordic American (NYSE:NAT) are facing the reality that day rates for crude tankers are in many cases not even high enough to pay the operating expenses. Where Frontline does have more of a problem, though, is in its relatively high spot rate exposure (over 70%).

More Capacity Means More trouble
Frontline reported that another 18 ships were added to the VLCC fleet in the quarter, bringing the total to 566. Moreover, shipbuilders like Daewoo, Hyundai and Dalian all seem to expect to continue delivering new vessels this year. On a more positive note, though, it seems like new order intakes are declining; it seems hard to imagine that it is easy to find the funding today to build a new boat when day-rates are so low and the industry suffers from overcapacity.

It's not impossible to think, though, that some of that capacity could come offline. There are still old ships in the fleet, and the combination of low day-rates and high prices for scrap steel may encourage some operators to take vessels out of operation and send them to scrap. After all, if operators of relatively new vessels are struggling to make a profit, it stands to reason that operators with old fleets have it even worse as these boats are typically much more expensive to run. Strange as it may be, then, companies like Nucor (NYSE:NUE) and Steel Dynamics (Nasdaq:STLD) may very indirectly be a friend to the shareholders of companies like Frontline.

The Bottom Line: Tune in Later
Frontline is arguably the "beta play" among tankers, as the company has such high exposure to VLCCs and Suezmaxes, unlike a company like Teekay or Overseas Shipholding (NYSE:OSG) where there is more diversification into markets like LNG and offshore drilling. With that in mind, it's fair to expect that Frontline will outperform when rates rebound and crude shipping becomes lucrative again. (For more, see Not All Shipping Is Sinking.)

With that said, investors should probably keep an eye on John Fredriksen. Fredriksen is a multi-billionaire who built his fortune from the tanker business. If he doesn't think a rebound is likely until 2012, most shareholders probably don't want to take the other side of that trade. There will definitely be a time to consider Frontline again, but in the meantime new investors might be better off thinking of names like Ship Finance International (NYSE:SFL) - a company with much less direct exposure to day rates, a healthy dividend and relationships with many major operators (including Frontline). (For related reading, see Has Dry Bulk Reached Low Tide?)

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