(FRO) As the Oil Contango Unwinds – Here’s How To Profit From Shipping Rates

January 14th, 2010

by Matthew Weinschenk, Contributing Editor
Thursday, January 14, 2010: Issue #1175

If there’s one thing we’ve learned over the past year or two, it’s that there are plenty of charlatans who’ll exploit any edge they can to make a quick buck.

From “flash trading” to bundling dodgy mortgage-backed securities, these Gordon Gekko wannabes often leave the little guys on the sidelines, while the big institutions skim all the profits.

But today, we’re going to turn the tables on them. Here’s how…

The Oil Contango: How To Profit From This Big Trend Reversal

A year ago, I discussed an intriguing situation in the oil market that was ripe for monster gains.

It’s called a contango – a concept that I labeled “the best buy-and-hold for 2009.”

Simply put, this scenario occurs when the price of oil futures is different from the spot prices. And in this case, it was enough to trigger the interest of well-financed speculators, who bought millions of barrels of oil and promptly stored it at sea in order to earn a profit on the spread between the two prices.

So how much oil is currently bobbing idly on the high seas? An eye-popping 168 tankers – almost 6% of the world’s tanker fleet – are loaded to the gills with 23.8 million tons of oil, according to Bloomberg.

But now that the contango trade is no longer profitable, these ships are going to start offloading oil en-masse. In fact, up to 26% of the oil they currently hold could be unloaded within the next six months.

And the results could allow us to earn some profits of our own.

You see, scores of empty tankers will now return to ports, looking for their next shipments. Trouble is, there aren’t enough shipments to go around…

The Baltic Dry Index: One of the Best Economic Growth Indicators

In short, shipping rates are directly tied to economic activity.

The equation isn’t rocket science…

When consumers buy goods, those products are shipped from where they’re made to where they’re bought.
When the economy is solid and consumers are spending more, more shipping means more oil consumption – and more shipping to move all that oil!

One of the best ways to gauge the strength of the global economy is through shipping rates on the Baltic Dry Index – i.e. what it costs to move raw materials and goods around the world.

In the chart below, you can see what happened to shipping rates when the global economy tanked:

Baltic Dry Index shipping rate drop in 2009

The shipping industry’s response to the global economic meltdown was simple: Companies sent their fleets out to sea. But not in a good way…

Off the coast of Singapore, a “ghost fleet” larger than the U.S. and British Navies combined has been abandoned until the good times return. Almost 500 ships sit anchored, idle and empty, with skeleton crews hoping to carry some cargo before pirates decide they want a piece of the action.

However, with the oil contango trade unwinding, the shipping industry is facing a price crunch. The oil tankers and these “ghost ships” will come back on-line. And the fact that new ships being built will add another 7% to capacity, the market is simply too soft.

Result: shipping rates will suffer. In fact, some estimates call for a decline as high as 27%.

That means the companies that own and operate tankers will be in a major pinch. Here are some ways to play the trend…

How To Cash In On a Looming 27% Drop In Shipping Rates

Frontline Ltd. (NYSE: FRO) estimates that its supertankers need to earn $32,900 a day to break even. The 2009 average was just $23,130, but ships are currently earning about $40,212.

There are two ways to play this:

If you’re a patient contrarian, buy shares of large stable companies like Frontline and rival firm, Teekay (NYSE: TK) for long-term value plays. If you hang on to them for two to five years, I’d expect significant gains.
If you’d like returns over the next few months, consider selling short Knightsbridge Tankers Limited (Nasdaq: VLCCF). Here’s why…

The global economic downturn has hobbled Knightsbridge…

The company used to boast up to $80 million in cash. But declining shipping rates have led to negative cash flow, dramatically eroding its cash horde to just $1.6 million.
In addition, Knightsbridge has $76 million in debt due in 2011. And that debt carries a covenant, which requires Knightsbridge to keep $10 million in liquid assets available. No wonder the firm suspended its dividend indefinitely last year.
Not only that, Knightsbridge only owns six ships and contracts its tankers out to other shipping and management companies. So it’s not responsible for actually managing the bookings and operations of its ships. And those contracts might be dicey.

Knightsbridge currently has two ships under contract to Frontline and three under contract to other firms. One contract will expire in March 2010, with two others expiring in 2011.

Here’s the potential problem, though: All of Knightsbridge’s tankers are 15 years old and need to compete with new tankers built during the boom years of 2006.

With over 83 ships of its own, declining rates in a soft tanker market might persuade Frontline or another contract holder to reconsider its deals with Knightsbridge. And losing the charter on just one ship would slash Knightsbridge’s revenue by 16%.

Simply put, Knightsbridge has a lot of work to do. While it’s branching into dry-bulk shipments, it must re-up its contracts and make headway in a new market, so it can resume its dividend payments.

But with 26 miles of tankers ready to jump in and 500 ghost ships off the coast of Singapore, Knightsbridge has little leverage. It’s a stock I’d bet against in the short-term.

Good investing,

Matthew Weinschenk

View original at: Investment U

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