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VLCC earnings are boosted by a tumbling oil price, at the same time contango players are back with a bang enjoying their profits. 

GOOD NEWS FIRST
Despite omnipresent news of a virus spreading worldwide updated almost every quarter of an hour, and stock markets reaching lows in the same frequencies, there are also some good news these days. At least for tanker owners. Earnings for crude carriers are climbing even faster than the oil price tumbles. Beginning of this year, we saw TCEs returning to a modest level after last year’s spike following the Cosco ban. After that, a rally sat in, with TCEs reaching almost USD 300k/d for voyages out of the Arabian Gulf for some days (see graph below).

SUPPLY SHOCK: PUTIN AND THE PRINCE
But what has happened? At first sight, it seems to be quite simple, a low oil price triggers demand for black gold at least to fill up any strategic oil 
reserves all over the globe. But why has the price for oil fallen to such historic low levels? Beginning of March, OPEC discussed extending their production cuts to support the oil price due to the estimated demand recession in China and under the condition that Russia would participate in such a move. However, Russia was unwilling to bear their share of the burden. It ended with Saudi Arabia announcing to increase their output by 2m bpd to 13m bpd. This increase equals two percent of global oil consumption as of year-end 2019.

HISTORY REPEATING
For some time Saudi Arabia has tried to force Russia and the US shale oil producers to lower their production by threatening them with significantly increasing their output. In the past, however, oil price wars rarely achieved their goals. One example dates back to the 1980s when the OPEC cartel launched a price war against the North Sea oil producers, beating the price down to USD 10/barrel. OPEC hoped the North Sea producers would come to Vienna begging for mercy - but they never did. Within a year, the cartel was forced to change its tactic and to stabilize the oil price again.

WHO IS GOING TO BENEFIT?
It is debatable whether this time the bet will bear fruits in the long-run - in the short-term, it has already worked well (see graph below). By looking at the pure economics of oil drilling, production costs per barrel are far higher in the US shale oil industry and Canada’s tar sands than in the Arabian Gulf region - and in Russia. Of course, the Saudis are cutting their own skin as well as they need the revenue from the oil to finance their national budget. At least, Russia has asked for reconciliation - and was turned down. Currently, Saudi Arabia and the US are reported to be in negotiations about the Saudi’s supply surge. In the end, President Trump might pull a rabbit out of the hat in face of the elections later this year.

DEMAND SHOCK: CORONAVIRUS IMPACT
The latest estimates from research houses forecast a steep drop in global oil demand by about 8m bpd due to coronavirus-reduced transport and consumption. In total, the daily oil supply exceeds the daily oil demand by around 10m barrels.
This means that each month, 300m barrels of oil need to be stored. We do not know the maximum global storage capacities. Some analysts estimate oil storage capacities to be fully utilized even within less than two months. Just to give some food for thought: One month of excess supply of 300m barrels would theoretically fill-up 150 VLCCs as floating storage out of an operating fleet of nearly 900 VLCCs. The current contango situation in the worldwide oil market supports TC rates between USD 60k/d to 80k/d for periods between six to 12 months. Such exaggeration even tops the situation back in 2014/2015 when Saudi Arabia flooded the oil market. Back then, the VLCC TC rate averaged USD 50k/d in 2015.

LET US DO SOME CONTANGO MATHS
Assuming a charter rate of USD 60k/d for a VLCC capable of carrying 2m barrels of crude, such charter rate would cause transportation or storage costs of USD 0.90/barrel per month. At an assumed oil price of USD 25/barrel, the vessel will have a total cargo value of USD 50m on board. This cargo needs to be financed with 5% p.a., thus the cost of capital would amount to USD 0.10/barrel per month. In total, the cost for loading 2m barrels of crude on board a vessel is USD 1.00/barrel per month. For three months, this cost accounts for USD 3.00/barrel and for six months USD 6.00/barrel. Any spread between the future and the market price above this level gives the trader a positive return on the deal. This is what is happening right now (see below graph). As of the end of March, the current curve justifies charter rates of USD 60k/d to USD 80k/d.

A five-year-old VLCC currently is valued at USD 77m, according to ship brokers. Starting with 60% debt on the vessel, we calculate the equity to amount to USD 30.8m. Assuming an asset depreciation of 15 years and OPEX of USD 12k/d, daily costs are estimated to amount to USD 26k/d. Altogether, this results in a net profit of USD 33k/d. If the aforementioned charter rate of USD 60k can be maintained for one year, the RoE would be roughly 40% p.a. This is not bad at all.

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