In Like a Lion Out Like a Lion

Observations:

March was eventful on many fronts. From the first Twitter-fueled bank run to significant changes in government guarantees for bank deposits, we exit the month with debt and equity markets that are radically different from those at the beginning.  Fed policy changes monthly as Jay Powell veers between not wanting to be Arthur Burns and wanting to be Paul Volker.  Currently Powell’s challenge is disintermediation in the banking system, since investors can get significantly higher returns buying treasuries than leaving their deposits with banks.  Market participants now are pricing in interest rate cuts to save the banking system.  Like generals fighting the last war, investors have been buying large cap tech and bonds aggressively on the basis they will benefit from falling interest rates, while selling cyclicals, energy, and industrials regardless of facts or fundamentals.  Volatility can be painful short-term but creates significant opportunities in the medium to long-term.  Markets are assuming the banking problems are fixed, while in our view regulators addressed an outcome, while not addressing the cause.  No one knows with certainty the Federal Reserve’s next steps, just as none of the CNBC or Bloomberg pundits predicted the failure of Silicon Valley Bank (SIVB) in February 2023. 

We responded to this month’s volatility with significant portfolio repositioning.  We added to positions in dry bulk and in tankers.  Investors sold shipping more or less indiscriminately as they continue to view the sector as cyclical.  While we agree the sector is cyclical, it is driven more by activity in China than the West.  Tanker rates are counter seasonally high.  VLCC rates have risen 25.8x year-over-year from $3,919 per day (TD-3 Eco Scrubber Fitted, 3-23-22) to $101,119 per day (3-23-23) as China imports more crude oil from the US Gulf.  Given that cash breakeven rate for spot VLCCs can be low as $14,200 per day, we expect 1H 2023 to set profitability records.  We suspect the tanker cycle may last longer than investors anticipate since the order book is low and ton mileage has increased due to Russian sanctions in addition to aggressive Chinese buying of oil. We continue to search for businesses with competitive moats.  In March, we were attracted to Jones Act product tanker transportation. The Jones Act requires any cargo shipped between U.S. ports to be carried by US vessels with American crews. The Jones Act is supported by unions, the few remaining US shipyards, and the US military. The business had fallen on hard times after the US lifted the crude oil export ban in December 2015, as Jones Act ships are three to four times more expensive to buy and operate when compared with international competitors.  The fleet aged out and vessels were retired.  With the advent of energy transition mandates on the West Coast, a new trade has arisen.  Currently the West Coast is committed by law to renewable diesel as a key component of carbon reduction activities.  California has set a goal of reducing its greenhouse gas emissions to 40% below 1990 levels by 2030.  In Oregon, the Clean Fuels Program requires a 10% reduction in the carbon intensity of transportation fuels by 2025, compared to 2015. Similarly, in Washington, the Clean Fuels Standard requires a 10% reduction in carbon intensity of transportation fuels in 2028 compared to a 2017 base line.  Refiners are building significant West Coast renewable diesel processing capacity, although demand in the near term exceeds supply. Renewable diesel is being supplied to the West Coast by Gulf Coast refineries and taken through the Panama Canal to California, a 40-day voyage. Approximately 23% of the US Jones Act product tanker fleet is now in US renewable diesel service, significantly tightening the market.  We don’t understand how it makes environmental or energy sense to grow soybeans with nitrogen fertilizer in Iowa, crush them, ship the oil by rail to the West Coast and then refine the soybean oil.  We do expect these environmental mandates to result in higher gasoline and jet fuel prices as traditional refinery capacity is reduced, along with increased food inflation and starvation due to policy-induced global vegetable oil shortages. In the meantime, Gulf Coast refiners are helping to meet West Coast renewable diesel demand.   When the facts change, so do we.  The Jones Act product tanker business had been an awful business and has been transformed by West Coast legislatures into an attractive one.