Description

Pitch

KNOT offshore partners (KNOP) is a way to play offshore oil through the niche shuttle tanker market. KNOP is a market leader with 24% share of the global shuttle tanker market, and is indexed to Brazil (14 of its 18 vessels), an offshore growth driver this decade. Simplistically, as offshore production grows, conditions improve for KNOP.

We see a dislocation in the stock today against the company’s improving end markets. The dislocation was caused by KNOP cutting its dividend almost completely in January from $2.08 to $0.10. The company had been able to comfortably cover the dividend for years at ~1.2-1.5x coverage, but near term contracting challenges pulled coverage below 1x, and forced the board to cut.

KNOP traded at >$15 before the dividend was considered at-risk, vs. a price today of $6.48. We believe this near term turbulence creates an attractive entry point. We expect the global shuttle tanker market to further strengthen, led by Brazil. On the supply side, there are only 5 shuttle tanker newbuilds between now and 2026, while industry estimates point to a global shortage of ~35 shuttle tankers by 2030, compared to a current market of only 74 shuttle tankers.

Increasing production in the already-strong Brazil market will drive shuttle tanker demand, while the North Sea market is showing signs of recovery. Against this backdrop, we expect KNOP to build its dividend back to $1+ over the next 2-3 years, driving a re-rating. KNOP is a MLP with the primary goal of stable cash flows, which are paid out to unitholders through a Form 1099.

Company Overview

KNOT offshore partners (KNOP) operates a fleet of 18 shuttle tankers; 14 in offshore Brazil, and 4 in the North Sea. Shuttle tankers are described as “floating pipelines” – Vessels that shuttle oil from offshore installations to onshore facilities, just as a pipeline would transport oil along the ocean floor. KNOP was an IPO from Knutsen NYK Offshore Tankers (or “Knutsen NYK”), which owns 29% of the company’s common units, and an additional 1.8% of the business through general partner units. KNOP’s fleet has an average age of 9.2 years, with each vessel having a ~23-year useful life.

Shuttle tankers are typically purpose-built, and this specialization means that the 74 vessels globally (46 Brazil, 24 North Sea, 4 Canada) aren’t competing with the conventional tanker market (9K+ vessels), and cost ~40% more than a comparable crude tanker. Shuttle tankers transport oil from a FPSO, or offshore production unit, to a terminal/refinery, while conventional tankers transport oil to and from terminals/refineries. From a newbuild perspective, shuttle tankers are ordered only with a long-term contract, while traditional tankers are primarily spec built.

Shuttle tankers were initially developed in 1979 to navigate extreme weather in the North Sea. Since that time, the value of using a shuttle tanker instead of a pipeline has spread primarily to Brazil given the ultra-deepwater conditions. Relative to traditional pipelines, shuttle tankers offer a less capital intensive solution, flexibility around changing production profiles, and the ability to store and transfer different blends of crude.

Relative to traditional crude tankers, shuttle tankers have two major design differences: Dynamic positioning systems (stabilize the vessel in harsh conditions) and specialized offshore loading systems, which in aggregate increase their cost versus traditional crude tankers by 40%. Today, market estimates for a newbuild in Brazil are $140M and $160M in the North Sea.

KNOP enters into fixed rate contracts with customers that range from 1-7 years (current avg. contract is 2 years as of 6/30/23). Contracts will often also include an option period, which depends on the charterer’s production levels and needs.

KNOP does not disclose dayrates on its contracts for competitive reasons, as a leader in a niche market. The previous CEO summed up KNOP’s pricing approach in a very general way to us: “We never accept anything crazy low, but never ask for anything crazy high. We all compete, but we all have to work together tomorrow.” While we don’t expect a dayrate inflection, KNOP should be able to raise prices methodically over a multi-year period as the Brazilian market continues to tighten.

Current forward dayrates can be inferred by dividing forward contracted revenue by forward contract duration. Inferred forward contracted dayrates have slid from $51.8K in 4Q22 to $47.2K in 2Q23, as this contracted revenue was booked in a less certain environment (most either pre-2020 or 2021-2022). We view any deceleration as near term, and not congruent longer term with the tightening global market (esp. Brazil). For KNOP, the dayrate element to the thesis will take years to play out as the company rolls its fixed dayrate contracts.

As mentioned above, this is a utilization story, where visibility into healthy utilization in 2024 and 2025 will allow KNOP to improve its distributable cash flow, and hike its dividend. During 2Q23, utilization was 99.3%, in line with a historical average of 99%+. The stock gets penalized when utilization is not near that 100% level (excluding drydocking maintenance), and/or when future utilization is uncertain. Today, it’s the latter challenge, where 4 of KNOP’s 18 charters need to be fixed for 2024: The Dan Cisne, Dan Sabia, Torill Knutsen, and Hilda Knutsen. The below outlines KNOP’s fleet contracts:

Fixing these 4 vessels with charters for 2024, and ideally 2025, would go a long way in establishing the visibility needed for the board to begin to raise the dividend. More detail on the outlook for these vessels:

• The Dan Cisne and Dan Sabia: These are relatively small vessels, which are not optimal for the Brazilian market today. Still, Brazil is in short supply of shuttle tankers, a trend that will only continue as Brazil brings online 18 FPSOs (50% of global supply) between 2023-2027. The Cisne and Sabia currently operate under bareboat charters, a lower rate alternative to KNOP’s typical time charter agreements. Note also that based on their carrying costs and expiring current contracts, KNOP took a non-cash impairment charge on these vessels.
• The Torill and Hilda Knutsen: North Sea vessels that are currently chartered with KNOP’s sponsor Knutsen NYK, which should allow KNOP to more easily secure forward contracts for these vessels. The North Sea market has seen a slow post-COVID recovery, though we’re seeing tangible signs of improvement, and expect a shortage of shuttle tankers going forward. 

Once these charters are fixed, we believe the path clears for modestly increasing the dividend in 2024. Investors should not expect the dividend to return the previous $2.08 run rate over at least the next couple of years. Distributable cash flow shouldn’t return to the prior $100M+ range required to support that payout, while we also see the BoD backing off from its previous dividend coverage target rate of 1.1x, as it looks to re-establish credibility in its dividend policy. We think that in 2-3 years investors ultimately see a dividend in the $0.95-1.40 range, marking a conservative policy shift towards a coverage ratio of 1.5x, on distributable cash flow of $50-75M. The more conservative distribution coverage would allow capital flexibility longer term to pursue acquisitions of dropdown inventory from Knutsen NYK.

Market Backdrop

The driver of our thesis is KNOP contracting 100% of its fleet into 2024+ vs. <80% currently, which will allow the company to hike its dividend at a measured pace over the next 1-2 years. As mentioned, we don’t expect a dayrate inflection, but think there’s reason to expect modest pricing gains as the Brazilian market tightens. Brazil will be the global driver of shuttle tanker volume growth, which Rystad expects to be +3.5% annually from 2021-2030 (see graphic below, analysis as of January 2022).  

In addition to Brazil, the KNOP thesis is a bet that the North Sea offshore market will improve, as energy security becomes a higher priority, in addition to comparatively attractive offshore E&P economics. We continue to see evidence of this, as recently as 9/27 when Britian approved the North Sea Rosebank field for development. Management expects continued improvement in the North Sea over the next several years – The Johan Castberg project in the Barents sea is the bellwether to watch here. The project is three oil fields that in aggregate are expected to add 190K bpd over 30 years. Equinor, a large  KNOP customer, owns half of production for the project. First oil from the field is expected to flow in the fourth quarter of 2024.

While these factors are encouraging to the demand side, the supply dynamics of the shuttle tanker market are also attractive. The #2 player, Altera Infrastructure, highlighted in an August presentation a global newbuild shortage expectation of ~35 shuttle tankers by 2030 (see chart below, note this analysis also assumes $60 oil), and a ~61-66 shuttle tanker shortfall by 2040. This shortage becomes pronounced beginning in 2025, and compares to a current industry order book of just 5 vessels.

Knutsen NYK Offshore Tankers

As KNOP’s sponsor, Knutsen NYK brings more than 30 years of industry experience, and controls 4 of KNOP’s 7 board seats. Knutsen NYK has a fleet of 10 shuttle tankers (or 29 incl. KNOP, and incl. ships on order), 25 LNG tankers, 2 floating storage and offloading (FSO) vessels, and 3 product/chemical tankers. Knutsen NYK’s decision to IPO KNOP in 2013 was well-timed, as the mid-2010’s was an extremely challenging operating market for offshore OFS.

Today, we believe the picture has improved for KNOP, and having Knutsen NYK as a sponsor has a couple of key benefits aside from industry experience. Knutsen NYK gives KNOP access to an extensive pool of lenders. Also, KNOP can make acquisitions of Knutsen NYK shuttle tanker vessels to support growth. In the current environment, though, acquisitions from its sponsor have taken a back seat to raising its distributable cash flow and dividend.

Management

Strategic direction at KNOP is determined by the board. They appoint one executive to serve as a joint CEO & CFO, and that CEO/CFO effectively carries out the board’s instructions. The job is more akin to a CFO and IR type of role. KNOP recently replaced outgoing CEO/CFO Gary Chapman with Derek Lowe, who had previously served as Secretary of Telford Offshore since 2018.

Earnings, Valuation Expectations, & Competitors

Between 2017-2021, KNOP’s adjusted EBITDA averaged $203M, while distributable cash flow averaged $100M. Distribution coverage averaged 1.4x, allowing the company to comfortably pay out a $2.08 annual dividend (~$72M). KNOP traded at a 6-10x EBITDA range over that period, vs. 6.5x today on cons. FY23E EBITDA, and a 9x average since its 2013 IPO.

Compared to 2021, when revenue was $281M, adjusted EBITDA was $203M, and distributable cash flow was $89M (1.2x coverage), 2023 is undoubtedly a different operating environment. 2023 interest expense is running ~$45M higher on SOFR-linked interest rates, while vessel operating expenses are running ~$25M higher on a variety of inflationary headwinds. Revenue is only expected to be up +LSD% from 2021 (or $9M), and so our estimate for distributable cash flow for 2023 nets out to ~$30M, when also considering higher replacement capex & drydocking costs.    

We think distributable cash flow would need to return to $110M+ for KNOP to return its annual dividend to $2.08. That’s a ways off from current, but we think the stock has been overly penalized. Prior to the dividend being almost completely cut in January, this stock had been owned by yield investors, and the price was driven in large part by indicated yield. Since its 2013 IPO, KNOP has traded at a 10% avg. indicated dividend yield.

We think the company can return to a normalized distributable cash flow of $50-75M, allowing management to establish a $0.95-1.40 dividend. We believe the board will back away from its post-IPO target of a 1.1x coverage ratio, and err more conservatively towards 1.5x coverage. If the historical average 10% yield holds, and KNOP returns to a $1.18 dividend (midpoint of $0.95-1.40), then the stock should trade near $12. It’s reasonable to assume investors will want a higher yield in this environment – At a 13% yield, the stock should trade closer to $9.

We don’t think it’s reasonable to assume KNOP re-rates back to its historical 9x EBITDA average, given the current rate environment, and gradual pace expected for the dividend increase. However, visibility should increase over the next year, and a re-rating from here to 7.5x on cons. FY24E EBITDA of $186M implies a ~$15 share price.

At 6.5x FY23E EBITDA, KNOP earns a premium to its public tanker peer group (TNK, INSW, NAT, STNG, ASC, DHT, FRO, TNP) trading at ~4x EBITDA, due to limited shuttle tanker supply, and duration/security of KNOP’s contracts. Its closest peer is private shuttle tanker operator Altera Infrastructure, formerly Teekay Offshore Partners (TOO). TOO had similarly struggled in the mid-2010’s (see ThatDuo04’s VIC writeup in Feb 2018 for additional context). Ultimately TOO was acquired by Brookfield in Jan 2020, rebranded as Altera Infrastructure. Altera then filed for chapter 11 in Aug 2022 and emerged in Jan 2023.

As mentioned before, Knutsen NYK/KNOP collectively have a fleet of 29 shuttle tankers (39% market share), including 2 ships on order. Altera’s shuttle tanker fleet is 19 vessels (26% share), AET Offshore has a fleet of 17 shuttle tankers (23% share). Following these three, no one else in the industry has a fleet above 6 vessels. We expect this oligopolistic market to operate with capital discipline.

Balance Sheet

KNOP carries $1.0B of debt, all secured by its vessels, while leverage is 5.2x, near its historical average. In June, KNOP refinanced a $240M Sep 2023 maturity out to a May 2028 maturity (final payment of $85.4m in May 2028). Payment schedule for reference below. Having Knutsen NYK as a sponsor reduces KNOP’s refi risk, though the business is certainly harmed by increases in SOFR going forward.

Other equity issues:

• 3.5M Series A preferred units senior to the common units, which KNOP pays a $7M annual dividend on. Distribution to these units is 8% on a liquidation preference of $24/unit and any unpaid dividends.
• 252K Class B Units (all owned by Knutsen NYK). Not entitled to receive cash distributions in any quarter unless common unitholders receive a distribution of at least $0.52.
• 640K GP units owned by KNOT, which represents 1.8% ownership of KNOP.

Risks

1. 5x leverage.
2. Any major delays to the Johan Castberg project would put thesis at risk, along with any other signs that the North Sea offshore market was weakening.
3. Recent shelf filing – While the filing could be perceived as the sponsor readying a stock sale, We spoke with IR, who confirmed to us that this was a more procedural filing than anything, and to not read the filing as any type of intent.

Catalyst

1. Visibility into 2024/2025 contracts
2. North Sea market improving
3. Dividend recovery