Scorpio Tankers Inc

NYSE:STNG

Earnings Call Transcript 2018-Q3

[Operator]

Hello and welcome to the Scorpio Tankers Inc. Third Quarter 2018 Conference Call.

I would now like to turn the call over to Brian Lee, Chief Financial Officer. Please go ahead, sir.

[Brian Lee, CFO]

Thank you, operator and thank everyone for joining us today. Welcome to the Scorpio Tankers third quarter earnings call. On the call with me are Emanuele Lauro, Chief Executive Officer; Rob Bugbee, President; Cameron Mackey, Chief Operating Officer at Lars Dencker Nielsen, Commercial Director; James Doyle, Senior Financial Analyst.

Earlier today, we issued our third quarter earnings press release, which is available on our website. The information discussed on this call is based on the information as of today October 31, 2018 and may contain forward-looking statements that involve risks and uncertainty. Actual results may differ materially from those set forth in such statements.

For a discussion of these risks and uncertainties, you should review the forward-looking statement disclosure in the earnings press release that we issued today, as well as Scorpio Tankers’ SEC filings, which are available at scorpiotankers.com and sec.gov.

Call participants are advised that the audio of this conference call is being broadcast live on the Internet and is also being recorded for playback purposes. An archive of the webcast will be made available on the Investors Relations page of our website for approximately 14 days. If you have any specific modeling questions, you can contact me later and we can discuss offline.

Now, I’d like to introduce Emanuele Lauro.

[Emanuele Lauro, CEO]

Thank you, Brian and thanks everybody for joining us today. For Scorpio Tankers, 2018 has been a year of considerable change. After much work and some difficult decisions, the company now stands well positioned with the reshaped capital structure, appropriate liquidity, a large modern fleet and significant operating leverage to benefit from the much anticipated upswing in the clean product tanker market.

We have spent this year preserving liquidity and strength of the balance sheet. Earlier in the year, through a combination of bank refinancing, sale leasebacks and deferral of the most significant portion of our 2019 convertible bond, we raised over $0.5 billion of liquidity. In the last month, in a challenging market, we completed a capital raise of over $300 million. I'd like to reemphasize that all these decisions were carefully considered, in particular, the issuance of fresh equity is never taken lightly.

Through that transaction, we were pleased to see support from our existing core shareholder group, but also new substantial shareholders, many of whom are with us on the call today. Our straight forward view is that we expect 2019 to be significantly better than 2018. We are encouraged in the expectation by not only the present strengthening of the spot market, but also that of the forward times after market.

I'm pleased to say that with us today we have Lars Dencker, our commercial head who later on the call will share his views on our markets and some of the positive trends we have started to witness in the last few weeks. A few weeks ago, we made a major announcement on the installation of scrubbers on our fleet over the next 18 months. Much internal work has been done on this significant undertaking.

As you know, the shipyard activity coincides with our schedule drydocks for much of the fleet with the consequence that there is reduced additional off-hire time expected. We have been both excited and concerned about the implication of IMO 2020 regulations. We were not prepared to expose our company to the significant risk of sustained substantial and commercially disadvantage post January 2020.

This has been one of the most challenging last 12 months in memory for the clean product tanker space, something which has been both disappointing and to a certain extent surprising to us. Despite that, I can say we now sit with the most rare combination in the shipping sector, a modern fleet, a balance sheet repositioned and reshaped to endure and the spectrum of discernible upswing, driven by the unique convergence of both secular and cyclical factors.

With that, I'd like to turn the call to Lars for his remarks.

[Lars Dencker Nielsen, Commercial Director]

Thank you, Emanuele and good morning, everyone. This is Lars Dencker Nielsen, the Commercial Director for the Scorpio Tankers fleet. I’d like to update you on the current market across the various segments, starting with the LR2s and progressing then to the LR1s, MRs and Handys.

On the LR2s, we have seen rate increase on the Gulf FarEast voyages. Time charter equivalent earnings or TCE have increased from $8000 to $13000 per day. Similarly, the West to Asia naphtha hubs have widened, which translates to time charter equivalents for these Europe to Asia voyages from $6000 a day to $17000 per day.

Looking at the western position list and with an open naphtha hub, we believe this market is poised for further strengthening. Over the medium term, the LR2 will also be leveraging off the strong crude market that now has seen a resurgence to 2015 levels where across trades now are finally fixing Aframaxes up towards $40000 per day and US Gulf Aframaxes are trading at $50000 per day.

This dynamic, we anticipate will provide the impetus when increased exodus of older LR2 to moving into crude and fuel oil and we have now, in the last eight weeks, seen 10 units moving from clean to dirty trade. We now expect this to continue with up to another dozen units actively moving across the dirty, giving the continued bullish crude environment.

LR1s have enjoyed a positive uptick in rates from all-time lows. The TCE has increased from $8000 to $9000 per day to around $12,000 to $13,000 per day. Rates have increased equally in Western and Eastern markets. MRs have entered endured times. We believe however the market was reached in Q3, the last few weeks have seen MR TCE in the US markets rebound substantially from 6000 per day to $17000 per day.

Whilst we are well positioned in the US markets, we have yet to see a cross funding increase in the benchmark UK Trans-Atlantic, which are currently inversely priced like a backhaul reposition voyage. Trading is only at $5000 to $6000 per day. More importantly, current Atlantic Basin combination earnings has more than doubled from third quarter averages.

In the East, markets are moving upwards, but have yet to move more significantly from 3Q levels. Finally, Panamax vessels trading fuel oil have rebounded from $6000 per day to now trading $16000 to $18000 per day for UKC or current trading vessels and positions our current type. Clean entity is still lagging, but we expect with our modern and high suitable vessels, we’re very placed for the upcoming 4Q-1Q trade.

The message is that markets have moved positively in the last few weeks. In some markets, these moves are quite considerable and more substantial than we have indeed seen with these many quarters. Fundamentally, we’re seeing structural change with increased capacity utilization levels. This will benefit markets positively as we move into 2019 against the backdrop of benign new tonnage supply.

With that, I’ll hand over the call to Robert. Thank you.

[Rob Bugbee, President]

Thank you, Lars. So I just wanted to follow-up a little bit on what Lars is saying there and I think what's really interesting here is to understand that we don’t just have a cyclical and secular improvement in front of us. We are experiencing a very early seasonal upswing too. Normally, this product market doesn't stop to get moving until really mid to late November and it's starting up a very strong platform now in any context at all, even in years where the product market has actually been strong, right to have really been this strong at this point prior to Thanksgiving and the winter season starting.

And we would also, our confidence in that building too is where the crude oil market is traditionally the product market is followed in winter by around 4 to 6 weeks. I think you've got to note also as we’ve given some fourth quarter guidance here, obviously that includes a lot of fixed things that were done in September in the market low. So if you add together logic and what Lars is saying that indicates that the present rate that we’re fixing at are significantly above the fourth quarter guidance levels that we've been given.

In addition to that, outliers, what are outliers in markets? So outliers are important, because in markets that are weak, your outliers and normally lower, so back in September, we had situations where the market average may have been 7000, 8000 a day but your outlying fixtures have been 3000, 4000, 5000. Today, for example, in LR2s, where you are guiding in the present market being, somewhere in the mid-teens or so higher, the outlier, i.e., the highest fixes done in the last week or so is in excess of 25,000. In the LR1s, the highest fixture is around 22.

In the MRs, the highest fixture is in excess of 25,000. And even in the Handys where you’re trading highest class and it’s still pretty early, we've actually got fixtures in the mid-30s. And may even get one shortly in the 40s. It’s not to say that the market average was a mere fact. Across all four sectors, you have outliers that are significantly high. It is very encouraging thing with winter coming and that would indicate that very clearly, the way to risk is on the upside to what happened in the rates here.

If we look at the company as a whole, we've got the bouncing now that allows us to trade in the spot market. We have the most modern fleet, we have taken steps to ensure that it's going to be best positioned in terms of fuel efficiency in the sector going forward to 2020.

Now granted there is a -- we have increased moderately our financial breakeven as a result of the financings and rising interest rate cuts, but we have massive operating leverage here to the upside. We still have remained in a situation where every $1000 a day in rate improvement and as you can go through historically and you’ve seen on the crude, the markets can move in in multiples of thousands, but every thousand dollars a day in rate improvement leads to approximately a minimum of $40 million per annum in actual cash earnings.

And that’s sort of why we're -- it's been a lot of work. There's been a lot of pain, but this company really is prepared and positioned for what is -- what we think is going on right now, which is the change in the actual cycle and you've got a lot of good positive demand catalyst coming in front.

And with that, I'd like to turn it over to questions. Thank you very much.

[Operator]

[Operator Instructions] And our first question comes from Amit Mehrotra with Deutsche Bank.

[Amit Mehrotra, Deutsche Bank]

Hi, everybody. I just want to start with the commercial performance, just given Lars is on the line as well. It seems like the 4Q bookings, to date, the ones you've actually done have just been a lot stronger than maybe what the indexes are reporting or what we're looking at with respect to the indexes. I mean I think scale and the eco vessels have always kind of given the company maybe scale to beat the benchmarks, but it just seems like the 4Q update is just a lot better. And so I was hoping you can help us with that, just given how we calibrate our models and what the sources of that outperformance have been relative to the indexes that we look at at least?

[Rob Bugbee, President]

Amit, thanks. Lars, I’ll let you answer that question. But first, I don’t think you should be modest about it. You guys have done a -- you've got a combination here of a technical side of the really great fleet is helping along with operations. I think you yourself and your team have been bringing along and have been making changes to the way we do things, so feel free to elaborate on those where you can to Lars.

[Lars Dencker Nielsen, Commercial Director]

Thanks, Robert. I mean, it is obviously a confluence of many different elements here that provides us with the markets, that is the earnings relative to that. I mean, one thing is of course, that we are testing the assets as much as we can. So in terms of how we triangulate the vessels and try and minimize our ballast ones. I think we’re doing a very, very good job of making sure that we focus on the best performing and best earning voyages. We look at – very focused on our daily basis where we see opening on arbitrages, we make sure that we position our vessels in the right areas before the markets move and sometimes, we are right and sometimes, we're not.

But generally speaking, I think through 2018, we've been more right than wrong. It does help a lot that we have a best fleet out there. I mean, the echo fleet that Scorpio had is by far the best in the world and that helps. Definitely, we have a very strong technical team to make sure that the vessels are very well improved. So, we are a partner of choice with most of our clients out there and we see the logistics before anybody else, so we have good chance of being able to position the ships in the right places at the right time.

[Amit Mehrotra, Deutsche Bank]

Okay. It just seems like you're being a little bit more aggressive than on the chartering side, which is great. Just one quick follow up, I guess for Brian. On the cash cost side, you've obviously -- the company's obviously got some pretty heavy debt repayments next year, but plenty of cash to meet those calls now after the equity offering. I'm just trying to think about the timing of the exhaust gas cleaning investments next year and how we should think about the cadence of the cash outflows related to those installations?

[Brian Lee, CFO]

Yeah. We're still looking at what financing is available and will probably – we’ll definitely have an update on that next when we do our next earnings release and maybe along the way, but we're still -- it will be – we’re still finalizing that, but it will be in relationship to the dry docks and so when the five year numbers come up and some other vessels along the way too as well.

[Amit Mehrotra, Deutsche Bank]

Maybe just one, maybe higher level follow-up on that specific topic is, will the cadence of installations follow kind of what you're doing with Scorpio Bulkers, i.e., wait until 2020 comes and then install a bunch after 2020, just so we get a sense of whether it's a ’19 or ’20 event or is it half that?

[Cameron Mackey, COO]

Amit, it’s Cam here. About 60% to two-thirds of the scrubbers will be fitted in within ‘19 and then the remainder in ’20. Bearing in mind of course that we are not fitting our handy sized tankers with scrubbers.

[Operator]

And our next question comes from Ken Hoexter with Merrill Lynch.

[Ken Hoexter, Merrill Lynch]

Good morning and thanks for the introduction. That was a good insight Lars into the state of the market. And I guess to follow on that, rates and Amit’s question, rates look pretty solid for the fourth quarter to date, but would anything change the market. Robert, you mentioned the seasonality that's helping, anything that we should be concerned with that that would go the other way or anything that, in terms of the status of what still needs to be booked that I guess could even get more aggressive, just want to understand kind of what variability we still have left, as we look in to the fourth quarter.

[Rob Bugbee, President]

I’ll take a stab at that first, Lars. So as we go into the fourth quarter, look, a significant thing is tanks. I mean, we’ve been pointing that, we've been massively disappointed with the product market. We didn’t expect that the inventories will continue to be drawn down and down and down, but we always said that once the inventory draw had reached the point where you kind of max that drawer out, but as soon as that stopped the market, it would start change and you would get ups and you get the market functioning in a normal way and that's clearly starting to happen.

You are -- the extended strength of the crude oil market is extraordinary helpful and we’re only just seeing the beginning of that benefit in products and normally for the product market follows four, five weeks behind that, so we should continue as we approach Thanksgiving, have that point where the product market can accelerate a cold northern hemisphere winter would be very, very helpful.

We'd like just to see general economic, we can have volatility around oil pricing, but we’d obviously like to see general economic stability, we wouldn’t like to see the world, economy completely fall apart as a result of any event or political disruption, but generally, we've got quite a powerful headline demand curve here and that's why the risks remain on balance to the upside, because your general inventories are low, you've got dislocation of different things happening, you have a crude oil market that is very strong and everything is going to be dragged towards this 220 position, where people are going to have to start shifting more products around the world, just to get low self of fuel in position.

[Ken Hoexter, Merrill Lynch]

So Robert, how about just finishing on that same thought, any with the risk of tariffs or I guess global trade that could interrupt that from your point of view or would that only aid, given what your thoughts on IMO just increasing demand?

[Rob Bugbee, President]

If things don't trade or tariffs result in a serious crash in the world economy, obviously, that's negative. But the actual, we're not -- it's far more that we're going to continue the demand for products and product related positions that we have this sector shift and winter coming. It's hard to think that, barring something weird happening in the world in terms of winter that you are not going to have that usual lift in demand itself as you approach winter.

[Ken Hoexter, Merrill Lynch]

Emanuele, if I can get a follow-up on, you mentioned the tough decision on kind of finally making the decision on the scrubbers, what finally made the decision for you as you went through the process and kind of how that a little bit longer than some of the others, maybe just your hindsight on kind of going through this process, as you now get started on the actual implementation?

[Emanuele Lauro, CEO]

Sure, Ken. Well, we broadly came out with our views, Cameron has spoken previously about the fact that it was a difficult decision for us, because we don’t necessarily agree with the regulation per se from a standpoint of the regulation itself. However, what we didn’t want to risk was the commercial disadvantage that disposes on the companies that will not embrace and will not install scrubbers in their fleet come January 2020. So, we took more of a commercial decision than anything else, the financial backed decision than anything else. If we had to discuss the relevance and the value of the regulation, we would need much more than an earnings call and we would probably not come out with the same view on scrubbers.

[Rob Bugbee, President]

I might add. We’ve been waiting for a lot of information to emerge, as the deadlines come closer, given the number of actors involved, not just the political and regulatory actors, but industry actors and bunker suppliers and refiners, everybody has been sort of looking at each other, waiting to see who the penguin is that’s going to be pushed off the ice flow. So we waited as long as we could, knowing that with time comes greater certainty and reached a point where the cost of waiting longer just became inhibitive.

[Operator]

And our next question comes from Greg Lewis with BTIG.

[Greg Lewis, BTIG]

I mean, I guess, I’d like to follow up a little bit on the strength in the market, it’s definitely welcome to see it’s something that we have been waiting to see for a couple of years now. If you could kind of and I think Lars did a good job of highlighting in his prepared remarks, but if we could talk a little bit more about this, is this just a function of hours opening up or is it and Lars, any more detail you could provide on really what’s driving this?

[Lars Dencker Nielsen, Commercial Director]

Greg, look, I mean, we have been waiting this for a long time. I mean, the fundamentals are quite clear and have been clear for a long time what we would expect of the product market and how it's going to play out. If we just keep 2020 aside and look at just share fundamentals, I think it's as clear that the market has always been driven a little bit about dislocations, be it weather or be it geopolitical or be it, let’s say odds opening because of tankages, different places and stuff like that. What we've seen here is that there hasn’t been any dislocation when it comes to weather yet.

There has been none of that. There’s been very limited kind of influence in terms of dislocation apart from maybe the Uranium issue that has changed a little bit of what people discussed on the crude side, but in reality, what we’ve seen is that with the stock draw that has taken place over a very long period of time, that now the market has started moving into an area where you’re just not seeing that there is a bit of a pulse in the market and these are just starting to open and the big wonder you’ve seen over the last couple of weeks is the one that I’ve mentioned in my prepared remarks, which is the naphtha moving East.

Now that is a big influence on the bigger unit, be the LR2s and also the LR1s. And it happens very quickly and I’ll give you an idea that the LRs when we’re dealing with, this standard voyage is growing from the continent after Asia, we’re doing like $500,000 less per voyage over the summer. This is now $500,000 up and is almost like a flick of a switch with some of these, you see these things happen. And we anticipated this to be honest. So we have positioned our ships in the right place and we took advantage of it with four units, in the scope of one week.

We’ve got another three ships coming this week and we’re following and we’re just sitting on the bench because we can see that we’re looking at a position as to, which I also mentioned in my remarks that is very much turning into our favor. And this is something that is moving quicker than I anticipated, we expected it, but it is of course helped and leveraged by the fact that the crude markets are moving so quickly and this is having a big impact now as we move into the fourth quarter.

We’re waiting a little bit on the Eastern markets as they move more slowly, because there is more of an industrial market. But having said that, the benchmarks TCE1 which is the AG to Japan voyages have also moved out form I would say 20%, 25% and you put that into a global context, the LR2 certainly has moved up a lot. The MRs, sorry, the LR1s which have been disappointing in the first half of this year and have been probably all time low are also seeing the benefits of the arbitrage moves.

These arbitrages are also built through a lot of volume that’s coming out through the US now. I mean, that whole adventure is amazing, and we’re seeing huge volumes now being exported out of this space and these are starting to, let’s say, percolate through the different fleets. And I’m not want to believe very much a sentiment driven, but more driven kind of elements of how the markets, they evolve and this dynamic, I can see now is changing within various time, the LR1s have moved up, the MRs in a very big way have moved up in the US Gulf and in the US West Coast market.

Brazil has opened up. Mexico and the West Coast has opened up. So suddenly, we’re seeing a confidence, all these different types are at the same time and without being too, the mojo is coming back with a lot of owners as well, which have some of these have been just accepting and resigning to the fact, but the market has just been weak. So people can see now that there is a [indiscernible] and I think we’re seeing the early stages of this. It’s been increased and accelerated by the fact of what’s happening on crude and we’re just happy for it.

[Greg Lewis, BTIG]

And then just you mentioned about LRs form LR2s, high grading into the crude trade, clearly Scorpio Tankers has a lot of LR2s, is there any thought about maybe putting some of the LR2 in to the crude market to take advantage of this third gen?

[Rob Bugbee, President]

I’ll take this question. Frankly speaking, fundamentally, the LR2s that we have are product carriers and they are the best and the Rolls Royces of our industry. We've got a lot of vessels which are much older to look at the overall fleet profile of this and they will move into the Aframaxes and we'll do it cheaper than we would ever do it because the opportunity of cost has to be there.

I’ll remind everybody on the call that you want to move an LR2 into crude, that’s easy. But if you want to move an Aframax, the opportunity of cost today is much higher and prohibitive than it was before. So, you need to have a very strong view that that delta is going to be very wide for a very long time before you would do it. And frankly speaking, I believe very strongly in clean market that that’s going to move as well.

[Operator]

And our next question comes from Magnus Fyhr with Seaport Global.

[Magnus Fyhr, Seaport Global]

Just one question on your thoughts on the LR market versus the MR market. I mean, you still have a pretty heavy delivery schedule next year for MRs and despite market being very weak, you haven't seen that much scrapping, but just want to see there what your thoughts were as far as potential for more scrapping there with the increasing regulations coming in next year in 2020?

[Rob Bugbee, President]

You're going to get effective removals of vessels from the MR market, as they turn 15 from the clean petroleum market. They don't necessarily have to be scrapped to do that. They're going to be aid staffed and Lars do you want to add anything to that?

[Lars Dencker Nielsen, Commercial Director]

I mean, it’s only half of the picture to be honest, because if you look at the age profile of the MRs, you will see a lot of MRs that are growing older in the fleet as a percentage of the overall fleet. And if you look at the ones that are turning 15 or more over the next 12 to 18 months, you'll find that it probably is more balanced approach and so the MR market is not really, let’s say, getting overbuilt relative to what is out there.

[Magnus Fyhr, Seaport Global]

And there's been also a little bit ordering activity there still, do you see still the shipyards getting more aggressive on their pricing or you see pricing firming?

[Cameron Mackey, COO]

Magnus, thanks. Largely, it’s stable to slightly firming. Many of the major yards have been preoccupied with container ship and gas orders, depending on the size you're speaking of. And obviously, they have some cost pressures, so gently firming is how I would describe it, but not a lot of ordering activity on the products.

[Operator]

And our next question comes from Randy Giveans with Jefferies.

[Randy Giveans, Jefferies]

Two quick questions for me. First, so looking at the I guess $337 million equity offering, with rates improving, as you’ve kind of noted in recent weeks going forward, why do you decided to do the offering when you did it and then secondly with a much stronger balance sheet following the refinancing initiatives, why did you decide to raise the 337s instead of maybe 200 million.

[Cameron Mackey, COO]

So if we go back to the beginning of October, the crude oil market hadn’t started moving at the beginning of October and the product tanker market hadn’t started moving either. And there's a degree of uncertainty as to how things would happen and even with a -- even if you had a great improvement at that time, the company would be pretty well, being really bringing to risk the sort of the one covenant that ship owners really don't want to bring into risk, which is the net debt to equity covenant itself and there is a -- we're very confident as you can hear of the actual product market itself now and we've seen the crude oil market move and we've seen the Southeast start to give crude in.

So in many ways, the world has changed a lot in a month, in a short time for the tanker markets. Back in October, you couldn't have rated that sort of quick improvement much more than 50-50. But even with the improvement and without the equity rise, you would have been -- because you’ve already deep in to – you’ve already booked 40% of the quarter, you would have been getting close to that net debt to equity and in either event, you really couldn't have afforded a Mac event.

There is something went wrong. So we’re sort of quite openly saying, look, we think the product market by itself is great that the world economy keeps functioning, probably, it's great. But, in 1997 Asian currency crisis came along or 2001 event came along, the company couldn't take it. It would just be demolished itself and it's very important that we feel that we got such a strong change going on in the market. It was much better to turn this company from a what was really a lottery ticket on immediate improvement to a proper investment thesis on the secular and cyclical change in the market. So that was really why we did the equity raise itself.

The actual number itself, why did the raise come to the level? Well, I think that it's fair to say that everybody involved in the rates wanted to make sure as best as they could, it would be the last time that the company went to the well, but if you're going to rip that bandage off, you do it really properly and you really make sure that that balance sheet is really strong. You’re not trying to skate through the situation and you're trying to really ensure that the company is in a great position.

I would never actually -- I don't think you should put, even though I’m about the word overcapitalized and shipping company in the same sentence, I mean, ultimately if you get a little bit wrong and the market does improve, you can – there are so many things that happen. Your balance sheet just gets stronger earlier. And the shareholders coming into that raise were that they really wanted to make sure everybody wanted to make sure that we had enough.

And then frankly, why did it change to that level, because there was such a high oversubscription at that level. We had -- a lot of people taking that moment. We had a very, very strong equity book. In fact, in all of the raises that I've ever been involved with in my career since 1985, I've never seen a book as strong as the book that’s been built at that point, but everybody was focused in that book and ensuring that the company had adequate liquidity to get through into the middle of 2020, even on a terrible market and not have to come to the well again.

[Randy Giveans, Jefferies]

It’s fair to know a follow-up question for the dividend. How committed is staying to that once the dividend, obviously, now it’s a higher share count, payout is roughly $21 million annually, so any risk to this going away in 2019?

[Cameron Mackey, COO]

I think we’ve done our calculations in the raise, based on maintaining the dividend that we have. I think that there is a benefit going forward in, there is a very strong shareholder group especially in the institutions and the long onlys that would like some form of dividend, however non related it is, I mean, where it’s priced at the moment, it’s pretty much what you get at the, certainly the current accounts on the borrowing and we’ve managed to keep the dividend going through tougher times than what we foresee is going to happen in 2019.

[Operator]

And our next question comes from Noah Parquette with J.P. Morgan.

[Noah Parquette, J.P. Morgan]

So I guess the people that are out there critical of scrubbers, two things that come up are that spread between HFO and maybe the software blends will be a lot lower than it is between HFO and MGO and that there is potential regulatory risk in the future, how did you guys assess those two things when you went through this process.

[Cameron Mackey, COO]

Thank you. Maybe I'll start with the second one first. Just when you look at our industry and tankers specifically, put IMO 2020 in context of a rich mosaic of regulations, local regulations, national regulations, international regulations have been following an arc for decades and will continue to follow that arc. So while the commercial consequences of IMO 2020 are very significant, it is a step, it's one of many steps that the world is taking towards regulating cleaner and safer shipping. So while there are regulatory risks, again put them in context of who can react in that reaction, in general, local bodies react quicker than national bodies and national bodies in turn react much quicker than international bodies.

So when you look at the tempo or cadence of international regulation, it's quite slow and having just gone through another IMO committee meeting this past week, where 2020 was confirmed in terms of time, scope, implementation. We expect some horizon a number of years before that is revisited, but inevitably, it will be revisited or strengthened. In what way, well, the world has decided that sulfur is a serious risk to health, airborne sulfur and so the purpose of IMO 2020 is to address the same airborne sulfur health risk that many of the member states have already addressed on land. It's not to make a perfect regulation, it's to address that very specific risk.

So like I said, we have no doubt that local and national bodies and eventually even the IMO will reassess and modify its approach to this risk, but they all take time and move in a different pattern. And as an aside, overtime, all these regulations in various safety and environmental areas are beneficial to our industry, because very gently, it encourages consolidation. Small weaker players don't have the platform or the appetite to navigate this complex nexus of regulations in their traits. So maybe that’s an answer to the second question.

Now when it comes to the first question, knowing that the world has a problem with sulfur, it's going to be very, very difficult for the refining industry and consequently the bunker industry to reposition itself for demands for much less sulfur. How do we see this playing out? Well, the world is going to be very shortly awash in 3.5% high sulfur fuel oil. It can be stored, but only to a degree. It can be used as a substitute for coal, but that's a long way down in price from where it is now. It can be a repurposed by refiners, but if you look at, for example, look at what Valero just did, they are committing $1 billion in 3.5 years of time to process only 55,000 barrels a day of residual fuel. So all sort of fingers point in the direction of a very difficult time and a very low price for HFO into the future.

On the other hand, the blends are not new, but what they are a very niche cocktails or bespoke products of different refiners. We've been testing blends since 2012 and we continue to test them from different oil majors, but there are two big issues with blends that you need to bear in mind. One is compatibility because everybody’s blend is different and the other is stability, which is these cocktails, you can't assure that they stay in their chemical form, they're very delicate balances of fuel and chemicals and put together, it's not so easy to say that everywhere in the world, you can find a non-commoditized or idiosyncratic blend that works on your vessel or works on the fuel you've previously purchased. So, we are looking at blends, but I'd say they are much more local solution than a global one. Their pricing obviously will be anchored to the more scarce or precious end of the trade, which is the low sulfur trade. Remember, sulfur is very expensive and problematic for refiners to produce. So, we don't see blends occupying or fully being a substitute for either low or high sulfur, they're going to continue to be a niche product for niche players.

[Operator]

And our next question comes from Frode Mørkedal with Clarkson Securities.

[Frode Mørkedal, Clarkson Securities]

I like to switching, as you mentioned. I guess you just talked about the opportunity cost of switching and I’m curious about that since Aframax rates are probably double [indiscernible], maybe you can touch more on the pros and cons of switching?

[Rob Bugbee, President]

That is the whole point is that we saw your report where you have Aframaxes double. They are not double what our LR2s are making. So I think what Lars was saying was that look, if you have an older LR2, that’s not in, let's say, a bigger fleet with a program and you’re customer preferred, then yeah, the spread is very wide and even if you thought that spread was not going to be maintained for too long, you probably should go and take your fixture at $25,000, $30,000 a day or whatever on an Aframax as opposed to earning whatever was in Europe 13, 14 on a older LR2. But if your LR2 is outperforming your index in the first place and itself is put in a structure where it's fuel efficient in the spread to the aftermarket is less and as Lars said, you have confidence that history says that the spread doesn't actually last too long.

History says that spread that opportunity is taken out, that is very normal to have the crude oil market leading the product market, you would not immediately move your vessel, because you could be sitting in a situation very shortly whereby you would – you’re earning more for a clean LR2 than it would be for a dirty Aframax that it actually swaps the other way in a few -- in a period of time. And then it's really difficult, because it's really difficult then to take your dirty LR2 and put it back into clean. So I guess that right now we're not seeing that bigger odd, because of the way we're programming our ships and because of the quality of our LR2s, but we perfectly understand why somebody who is in a different situation would immediately take that at the moment. And I think that's working to our advantage.

Lars, do you have any more to add to that?

[Lars Dencker Nielsen, Commercial Director]

No. It was very eloquent, Robert. I would agree 100% with that.

[Frode Mørkedal, Clarkson Securities]

Another question on IMO 2020 or about the fuel oil trade. Could you see longer tonne miles in general, what do you think will happen to the fuel oil trade today?

[Cameron Mackey, COO]

I can take a stab at that and maybe Lars, you want to add, but what we understand from our friends in refining is that 2020 has a major impact and differentiating effect on refiners. So, complex refiners in certain parts of the world will benefit because they can readjust their slate and optimize around distillate production. Others cannot make that change so easily and in general, Russia and the Middle East or former Soviet Union and the Middle East are identified as areas that will be very long fuel oil and that fuel oil has to find a home somehow somewhere.

So I think you could see increased ton miles in fuel oil, trying to find that home particularly as the uptake of scrubbers, while it's rapid right now is expected to plateau and storage, floating storage, depending on the outlook. But it's something of a mystery how that market is going to balance in the next two to three years. At some point, I'd expect more investment in coking or hydrocrackers in order to have some sort of alternative destination for fuel oil, but between now and then, I think the world is going to be drowning in the stuff.

[Operator]

And our next question comes from [indiscernible] with Morgan Stanley.

[Unidentified Analyst]

You alluded to it a bit in your prepared remarks that your balance sheet is coming at a cost of your cash breakeven. So just wondering what other levers you can pull there, whether it be SG&A, OpEx, any other ways to decrease your breakeven?

[Brian Lee, CFO]

Look, we're always looking for ways to do that. We've even had a voluntary reduction in some of the fees from the management company to help do that in terms of efficiency of the fleet in operations that are looking to reduce things. I would be remiss in thinking that we should rely on reductions because we are in a cost inflationary environment. It’s going to be, we benefit of course from having a modern fleet. So we have less requirement for dry docking and let’s say maintenance costs. But, crude costs are likely to go up going forward. As on the margin, some of the maintenance costs, that's as the result of a world economy that’s functioning.

[Unidentified Analyst]

Okay. And then on the scrubbers, I know it's more of a -- bit more of a commercial decision it sounds like. But can we go through maybe some of the economic factors, fuel consumption on the ship. Kind of what you're looking out for the spread and did I hear you right that you're not really thinking that blends will be the main solution for people without scrubbers. You see it as a different fuel or a new fuel. Is that correct?

[Cameron Mackey, COO]

That is correct. We don't -- simply because a blend is not a commodity. Fuel oil is a commodity, distillate is a commodity, readily available blends or individual solutions deposited by individual refiners or even refineries. And a lot of testing and homework have to go, not only into the formulation of these blends, but also how they work on vessels and in other -- with other blends, how they're going to be distributed. It's a big open question that at a minimum would take several years to solve.

But back to your first question without getting into the granular detail, of course, we can do that offline, it's quite easy to see that the current spread between gas oil and fuel oil is up around $250 and the forward market today has an opening up to somewhere around $350 in 2020. And if you simply take not the ship on paper, but your actual trading patterns and operating results and consumptions, your payback on a scrubber and we said this many times before, sadly, we don't have 20-year old VLCCs or VLOCs or cape sizes because there the economics are really pronounced, but still the same on our fleet, we get payback on IRRs that are 40%, 50% and above against the capital outlay for scrubbers. So it's incredibly accretive use of capital.

[Unidentified Analyst]

What do you expect the spread between MGL and this new fuel, this new low sulfur fuel to be in 2020, 2021?

[Cameron Mackey, COO]

Well, let me put it to you this way. We do a backward calculation, which is we work off nothing changing from today on the basis that it's a safe bet, even with the amount of scrubbers being purchased and installed. Just assume or bear with us for a second that there's going to be no expansion of the spread today. That's where we run our calculations and that's where we get our assumptions on paybacks. Any widening of the spread for us just makes it much more attractive. So we're not counting on that, but it's certainly what the market is predicting.

Others can say, well, blends might cut that future spread in half or say other things, we don't think so, but even if it does, our sensitivity analysis, our investments still makes it a very attractive investment of the marginal CapEx dollar.

[Operator]

And our next question comes from Jon Chappell with Evercore.

[Jon Chappell, Evercore]

Just two quick follow-ups. The first one covering Robert’s answer before about the, where we were in the beginning of October and where we are now and the 1000 a day and the EBITDA you can contribute, the balance sheet may be improving a lot quicker than you would have thought at the beginning of this month. So, what are the use of proceeds then in that type of environment, given Lars’ optimism, could it be the dividend first, could it be more assets, buybacks, how would you think about going from a position of strength as opposed to a position of weakness just a month ago?

[Rob Bugbee, President]

I mean you know, we're already just on that operating variable there ahead of where we thought we would be a month ago quite considerably. But I think right now, I don't know if you further noticed, the thing you want to do is to lower those breakeven point that you increase. So the most effective way to do that is to lower your debt.

[Jon Chappell, Evercore]

And then Lars, it’s good having you on the call, a lot of good insight. I'm just curious as we think about the prior 12 months versus the next 12 months, I think most people on this call, both from where you're sitting and from where we're sitting and most investors really expected ’18 to be better than ’17, certainly not to worsen, but it did, so what do you kind of attribute the weakening in 2018 too and then what's different in 2019 that gives you more confidence that the recent strength that we’re seeing can continue or even strengthen further next year?

[Lars Dencker Nielsen, Commercial Director]

I mean I think it is fair to say that 2018 was a big disappointment than we had anticipated. A lot is down to fundamentals in terms of stock draw, vessels coming on stream, but ton miles, not expanding as much as we expected. Crude being as weak as it had been on the different markets and I guess, you see the market in 2018, where there's been a lot of digestion going on. And there has been a huge difference in scrapping as well that has taken place, if you look at overall from a shipping perspective, obviously with scrap prices going up as much as they have, be it, the amount of scrapping that has taken place in 2018 has been substantial. But what we have seen as well is at least in the second part of ’18, a much greater increase in export from the US.

That ton mile has now started to move across the different segments and we’ve seen also the different segments as well, age profiles playing in to the spot market. You’ve seen some segments where age is becoming more prevalent of an issue, where vessels are staring to move towards the ’15 age mark, which on the product market had an impact, especially on the smaller sizes. And so these dislocations are coming to fruition, if you will and I think in the medium term, as the vessel starts moving, volumes are starting to pick up, the odds are starting to open as we talked about a couple of times. All these elements played part of a overall picture of what makes shipping interesting, because there is never really just one thing.

What happens is that you have one particular thing that suddenly happens and it starts kicking off the whole market and the crude market definitely is good to that and we’ve seen that happening as people start thinking about what weather is going to happen in the fourth and the first quarter. It’s going to be very interesting to see what will happen fundamentally with the markets as well. But we’re starting to see it. I mean, capacity utilization level which is something that people talk about theoretically and as an issue of where the market is going to start to move and when does the pulse in the market start and we’re starting to see that and I think capacity utilization is starting to hit 85%, 86% as we are seeing now and certainly with dislocations and something have, the crude markets move 50 points in one day, but I mean, we haven’t seen that all of ’18, certainly that happens in week.

And then certainly the next type things happen, you got the markets in the US Gulf moving to $60000, $70000 a day for doing, I mean that certainly has a Suezmaxes moving across for that. You have shift balancing on the Aframaxes to the Gulf, so that’s not normal trade. So these dislocations are feeding into the overall kind of fabric of our business and on the clean part, we’re setting and looking at this now and that under the gulf market which has been so poor for all the third quarter, much weaker than we anticipated, down to because of Brazil being close no exports, no imports taking place there, all of these things, we’re just waiting for.

We now -- it’s going to happen, and then suddenly within one week. The markets in the US Gulf move up and in my prepared remarks, we can see that it was moving from $6000, $7000 a day and we’re now doing $17000 a day and we’ve got fixtures, as Robert said, outliers doing $23000, $25000 a day and that goes also to the Handys. So all of these things are happening at more or less at the same time, but fundamentally what we’re seeing is all the things that have been set over the course of 2018 coming into play now and it doesn’t require very much, we’re starting to see bigger swings which we anticipate.

[Operator]

Thank you. Ladies and gentlemen, this concludes the Q&A portion of our conference. I’d now like to turn the call back over to Brian Lee for closing remarks.

[Brian Lee, CFO]

Thank you and I thank everyone for joining us today. We look forward to speaking with you soon. Thank you everybody. Have a good day.

[Operator]

Ladies and gentlemen, thank you for attending today’s conference. This does conclude your program and you may all disconnect. Everyone, have a great day.