OSG Ship Holding Group, Inc. (OSG)

Summary:

Overseas Shipholding Group, Inc. (OSG) operates a fleet of vessels that transport crude oil, petroleum, and transportation fuels primarily in the U.S. Flag trade. OSG operates a fleet of 21 vessels (13 owned and eight chartered) with aggregate carrying capacity of ~1.5 million deadweight tons (dwt). One dwt is 2,240 pounds.

Most of OSG’s vessels transport oil and energy products between U.S. ports and are protected from competition from foreign-owned carriers by the Jones Act. That nearly century-old law mandates that U.S. citizens must own at least 75% of a company shipping such cargo.[1]

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As we explain, little is required to make a 50% upside in OSG’s stock price a reality. The company is positioned to benefit from two key industry trends which should not only be long-lasting, but may strengthen:

• The growth in oil production along the U.S. Gulf Coast due to elevated oil prices.
• U.S. energy companies’ desire (think refineries) to source as much of their oil as possible from domestic producers as opposed to Middle East producers whose operations can be significantly impacted by geopolitics and attacks on vessels in the Red Sea.

Why is OSG Cheap:

• OSG’s near-term vessel revenues are highly contracted and, therefore, highly predictable.
• More than 95% of the company’s 2024 available vessel trading days are covered under fixed Time Charter Equivalent (TCE) agreements.[2]
• A drawback to this near-term predictability: OSG’s current rates are below market rates. For example, current TCE contract rates for Jones Act MR tankers, the backbone of OSG’s fleet, are now around $80,000/day, well above the $66,780 average rate that OSG realized in 2023.[3]
• The good news is that even at its current below-market vessel rates, OSG stock is extremely cheap. Its EV/EBITDA[4] ratio, based on projected 2024 cash flows, which reflect these below-market rates, is only about 4x (for context, that is a 60% discount to the S&P 500 Index).
• For every one-point improvement in OSG’s EV/EBITDA ratio, its equity value would increase by about $200 million, or nearly $3 per OSG share, equivalent to a 50% jump in the stock price from current levels.
• Considering the geopolitical and inflationary backdrop, we believe such multiple expansion is likely.
• Even more important, as OSG’s contracts come up for renegotiation, its cash flows will likely increase, implying that its “normalized” EV/EBITDA ratio is well below 4x.
• Another factor supporting OSG’s valuation is a non-binding bid made in January 2024 by OSG’s largest shareholder to acquire the company for a cash price of $6.25 per share.[5]

In our view, the buyout proposal does not provide fair value for OSG’s stock. To date, OSG’s Board has simply said that it is reviewing the offer.

What Could Go Wrong:

A sharp decline in oil prices could derail the OSG story. But, given the extraordinary uncertainty in many corners of the world, particularly in the Middle East, it is difficult to envision how such a scenario could unfold, at least over the intermediate term.

For some more details, please see the following 8 pages.

Company Description

Founded in 1948, OSG Shipholding Group, Inc. (OSG) operates a fleet of vessels that transport crude oil, petroleum, and transportation fuels primarily in the U.S. Flag trade. OSG operates a fleet of 21 vessels (13 owned and eight chartered) with aggregate carrying capacity of about 1.5 million deadweight tons (dwt). One dwt is 2,240 pounds. See Table 1.

Nineteen of the company’s vessels are U.S. Flag vessels, making OSG one of the largest commercial owners and operators of such vessels. The total U.S. Flag merchant fleet is about 175 vessels. See Figure 1.

OSG’s customers include large oil traders, oil refineries, and U.S. and international governmental entities. In 2023, only one customer, Hilcorp North Slope LLC, accounted for more than 10% of OSG’s revenue (14.3%).[6]

Like many oil tanker companies, OSG primarily contracts its transportation capacity over a fixed period at set daily amounts called fixed Time Charter agreements. Under such an accord, a customer pays a set daily or monthly rate for a fixed period to use a vessel. The customer pays all voyage expenses, such as fuel, canal tolls, and port charges. The shipowner (e.g., OSG) pays expenses to physically operate the vessel, including manning the vessel, maintaining necessary certifications, securing insurance, and supplying necessary stores, spares, and lubricating oils.

Fixed Time charter rates provide OSG with a more predictable revenue stream than spot rates, which can be highly volatile. In 2023, $353 million, or 84% of the company’s total Time Charter Equivalent (TCE) revenue of $422 million, stemmed from fixed-rate TCE accords. Only 16% of its TCE sales stemmed from spot rate deals. See Table 2.

Probably more important than these statistics is a quote from OSG’s Chief Financial Officer Dick Trueblood regarding the current degree of customer demand for time charters on the company’s 4Q 2023 earnings conference call on March 11, 2024: “Customers continue to show interest in longer-term time charters and entering into new contracts and direct continuation of their existing contracts, often well in advance of the scheduled maturity.”

Distinctions Between Various Types of Oil Tankers

There are two types of oil tankers: crude tankers and product tankers. Crude tankers, which are very large vessels, move unrefined crude oil from the point of extraction to refineries. Much smaller product tankers carry refined products such as motor gasoline, diesel fuel, and jet fuel from refineries to points near consuming markets.

According to the Jones Act, more formally known as Section 27 of the Merchant Marine Act of 1920, any ship transporting cargo between U.S. ports must be owned by a U.S.-based company. Furthermore, at least 75% of the shipping company must be owned by U.S. citizens.[7]

OSG’s Revenues are Heavily Contracted

Table 3 lists details on each of OSG’s vessels and the contract coverage on each. Importantly, OSG has added 116 months of forward fixed price charter coverage since the company last reported contract coverage figures in November 2023. Indeed, management estimates that 95% of its 2024 available vessel trading days are covered under fixed TCE agreements. Available 2024 trading days remain only in 4Q 2024 for the Alaskan crude oil tankers, the Alaskan Explorer and the Alaskan Frontier.[8]

Notes on “Type of Vessel” column in Table 3:

• An ATB, or articulated tug barge, is a tug-barge combination system capable of operating on the high seas, coastwise, and further inland.
• Lightering is the process of off-loading crude oil or petroleum from large-size tankers into smaller tankers and barges for discharge in ports.

OSG’s fixed-rate contract coverage increase reflects the significant strengthening of OSG’s market position over the last few months. Indeed, TCE fixed contracted rates for new Jones Act MR tankers, the backbone of OSG’s fleet, are now around $80,000, well above the $66,780 average rate that OSG realized in 2023. In addition, in 1Q 2024, OSG negotiated new fixed-price contracts for one of its ATBs and its Tampa product carrier vessel. The newly fixed rates increased $20,000 and $10,000 per day, respectively.[9] Consequently, when OSG’s contracts come up for renegotiation, assuming the company’s rates could be increased substantially is reasonable.

Several factors have positively affected the short- and intermediate-term demand outlook for OSG’s fleet:

• A significant recent expansion in the quantity of crude oil produced along the U.S. Gulf Coast has increased the demand for vessels to ship that crude to refineries on Delaware Bay. See Figure 2. The allocation of incremental vessels for that route has, in turn, boosted the market transportation rates in OSG’s key specialized market of moving Alaskan North Slope crude oil to refineries on the U.S. West Coast.

• ConocoPhillips’ Willow and Santos’ Pikka oil projects are expected to increase Alaskan North Slope production to about 700,000 barrels per day (bpd) in 2027 from the current 480,000 bpd rate, per the Alaska Department of Natural Resources.[10] See Figure 3. This suggests a potentially significant boost in long-term demand for OSG’s crude oil tankers. Alaska Class Suezmax tankers, four of which are owned by OSG, are considered the most cost-effective way to deliver North Slope crude oil to refineries in California and Washington state. Suezmax refers to a vessel type with a carrying capacity of 120,000 to 200,000 dwt.

• As a side note, around year-end 2023, OSG reached an agreement for its Alaskan Explorer vessel to begin transporting U.S. Gulf Coast crude oil to one of its Delaware Bay refining customers. This highlights that OSG’s Alaska Class tankers can be effectively used outside the Alaska market as well. Other parties seem interested in structuring similar transactions.[11]

• Increasing quantities of renewable diesel fuel are being transported from Gulf Coast production sources to markets along the West Coast. The growing demand for renewable diesel stems from federal and especially state programs that encourage using that fuel. For example, California’s Low-Carbon Fuel Standard program mandates decreasing the carbon intensity of California’s transportation fuel pool to cut petroleum dependency and improve air quality. Most participants opt for renewable diesel, which is chemically identical to regular diesel, to meet rising renewable fuel targets.[12] Renewable diesel can be used on its own or blended with regular diesel. This incremental demand has translated into higher market rates for Jones Act MR tankers (like OSG’s) to transport the fuel.

• Recent escalations in tension in the Middle East, particularly Houthi high jackings and missile and drone attacks on shipping in the Red Sea, together with the Russia-Ukraine war, have caused many energy companies to source refined oil products from domestic sources as opposed to international ones. Indeed, over the first two months of 2024, Suez Canal trade dropped 50% from the year-ago period.[13] (The April 13 news that Iran attacked Israel with perhaps 300 ballistic missiles and drones likely adds to these tensions.)

• The safety of both the crew and cargo are key reasons for making such decisions, as are economics. This combination of events has created — and should continue to create — a strong market for OSG’s Jones Act MR product tankers. The utilization of and rates achieved by OSG’s Jones Act vessels have increased.

• Many vessels contracted by buyers who favor international-sourced commodities now avoid the Red Sea and make much longer trips around Africa’s Cape of Good Hope. This has increased aggregate ton-mile demand for oil tankers. See Figure 4.

Impressive 2023 Results

OSG’s cash flows soared in 2023. Its operating cash flow reached $103 million last year, up from $73 million in 2022. Likewise, its adjusted EBITDA jumped to $176 million in 2023 versus $143 million in 2022. See Table 4. (Read Table 4 in conjunction with OSG’s revenue detail shown in Table 2.)

Given the improving backdrop for OSG’s business, management sees further growth in 2024. Total Time Charter revenue should reach $450 million in 2024, up from $422 million in 2023. Similarly, adjusted EBITDA should increase 10%-15% in 2024, implying nearly $200 million this year. Also, OSG’s 2024 excess cash flow (operating cash flow minus maintenance capex and $43 million of required loan amortization) should be around $50 million.[14]

OSG’s Heavily Discounted Valuation Makes it a Very Cheap Stock

Factoring in its share price of about $6 and its net debt of $324 million, OSG’s enterprise value (EV) is around $800 million. This implies that its EV-to-adjusted EBITDA ratio, based on projected 2024 cash flows, is only about 4x. By comparison, the average stock trades at an EV-to-adjusted EBITDA ratio of 11x-12x.

OSG’s business is closely tied to global oil prices and, therefore, geopolitics, making it inherently volatile. Consequently, OSG’s cash flow multiple should trade at a discount to that of the broad market index. Still, the current gap appears too wide, particularly given OSG’s high degree of contract coverage and the likely scenario that Middle East uncertainties persist and could cause oil prices to remain high.

For every one-point improvement in OSG’s EV-to-adjusted EBITDA ratio, its equity value would increase by about $200 million, or nearly $3 per OSG share, equivalent to a 50% jump in the stock price from current levels. Given the volatile global backdrop, which suggests that oil prices have limited downside, it is difficult to foresee a scenario where OSG’s current low EV-to-adjusted EBITDA valuation contracts.

OSG appears to have an asymmetrically positive risk-reward ratio.

Saltchuk Bid

Another factor supporting OSG’s valuation is a non-binding bid made in January 2024 by OSG’s largest shareholder to acquire the company. More specifically, Saltchuk, a privately held family of transportation and distribution companies headquartered in Seattle, WA, submitted an unsolicited, non-binding indication of interest to OSG’s Board to acquire all outstanding OSG it does own for a cash price of $6.25 per share.[15] Saltchuk, which holds a 2% stake in OSG, previously proposed to acquire OSG in July 2021 for $3 per share but later suspended discussions because of the uncertainties over COVID-19.[16]

In our view, Saltchuk’s proposal does not provide fair value for OSG’s stock. To date, OSG’s Board has simply said that it is reviewing the offer.