Scorpio Tankers (NYSE: STNG) is a product tanker company that focuses on delivering refinery products from refineries to railcars, trucks, and pipelines. Several factors, including sanctions on China's largest vessel company, COSCO, and a game-changing mandate from the International Maritime Organization (IMO) have increased the daily spot rates for product tankers -- lifting the share price of Scorpio 121.4% year to date.

A recent acquisition has created additional capacity to capitalize on price increases, however, several factors increase the long-term risk for Scorpio. 

A short-term opportunity

The mandate issued by the IMO concerns the sulfur content in the fuel that powers the vessels. Currently, ships are using bunker fuel with a sulfur content around 3.5%, which is equivalent to the sulfur dioxide output of 50 million diesel cars per ship. The new mandate requires ships to install scrubbers or use low-sulfur fuel, which will reduce the sulfur output to 0.5%. The due date of January 1, 2020 is around the corner and will ground any product tankers that are not in compliance.   

product tanker ship in the ocean

Image source: Getty images.

In addition, the COSCO mandate has squeezed demand but doesn't seem to affect Scorpio. Scorpio's Chief Operating Officer, Cameron Mackey, stated during the third-quarter earnings conference in 2019 that the COSCO issue isn't material to the product tanker market and is a short-term impact on the industry. Mackey stated that the IMO 2020 issue "may have some impact on volatility, but over the medium and longer-term, it's not really going to have a huge consequence for Scorpio Tankers." 

Because of these two issues, there is a supply and demand squeeze expected in 2020 for product tankers, as the slowing fleet growth, in addition to the global growing refined product consumption, will complement the increase in demand for middle distillates from IMO 2020. Scorpio projects demand for distillates will increase going forward in addition to the consumption of MGO and LSEO blends, which support the compound annual growth rate of 3.8% from 2000 in ton-miles -- the quantity of cargo multiplied by the distance the cargo travels -- which outpaced global GDP during the same time period. 

Increasing capacity

During the third quarter of 2019, Scorpio acquired 19 vessels from Trafigura for $803 million. Issuing 4.7 million shares in Scorpio Tankers at $29 per share for an aggregate market value of $135 million in combination to a $668 million finance lease arrangement with Trafigura, Scorpio increased capacity and decreased the average vessel age of the fleet to 3.7 years -- against the global average age of 15 years. 

The Chief Executive for Scorpio Tankers, Emanuele Lauro, who also controls Scorpio Bulkers (NYSE: SALT), stated during the third-quarter earnings conference that "we are satisfied to have brought the company to this point with the largest, most modern, most efficient scrubber equipped, spot market exposed fleet."

The acquisition increases the current fleet to 124 ECO product tankers in addition to four tankers under construction and 10 bareboat chartered-in vessels. The 19 Trafigura vessels consist of 15 vessels with an average age of 0.5 years and four vessels that are scheduled to deliver in 2020 -- all equipped with ECO scrubbers in preparation for IMO 2020.

This gives Scorpio a scrubbed fitted fleet of 65 vessels currently, which include 50 from Scorpio and 15 from Trafigura. A total fitted fleet of 114 is expected by the second quarter of 2020.

A short-term gain is not a long-term advantage

An increase of $1,000 per day in spot rates would generate approximately $50 million in incremental annualized cash flow for Scorpio. As Scorpio increases vessel capacity while benefiting from an increase in daily spot rates, revenues will follow.

The year-to-date share price increase of 121.4% was from the combination of geopolitical tensions and an industrywide mandate -- giving Scorpio and competitors a leg up as shipping capacity shrank and demand increased. Short-term demand for capacity is unlikely to carry into the long-term gain for shareholders, as the market will provide capacity over time -- washing away the benefit of the short-term competitive advantage. There is growth in distillates as refineries in Saudi Arabia and Kuwait are expected to be online between the fourth quarter of 2019 and the second quarter of 2020, increasing demand for product tankers. 

A forward dividend yield of 1.08%, an average fleet age of 3.7 years, and one of the largest product tanker fleets prepared for IMO 2020 globally give a decent narrative for shareholders to continue holding shares of Scorpio -- prepared to sell shares when the demand shrinks and the daily spot price decreases.

Investors looking to buy Scorpio at the current share price need to be wary as sanctions on COSCO have the potential to disappear overnight -- decreasing the daily spot rates and driving down demand globally. In addition, Scorpio is down 69% from the IPO on March 31, 2010 and has yet to deliver results for investors, generating increased risk. 

The transition period for companies to become compliant with the IMO mandate will stretch into 2020; however, this short-term gain does not give a good narrative for a long-term hold. Shares have the potential to keep rising into 2020. However, the risks outweigh the potential returns.