Every day the US imports 10 million barrels of oil, a whopping 550 gallons of crude per capita annually. That’s up roughly 50 percent from a decade ago.

And while the US is the world’s largest importer, the Europeans and Japanese aren’t far behind; Europe imports about the same 10 million barrels of oil per day while Japan, with a population roughly a third the size of the US, imports about 4.3 million barrels per day.

If that import dependence strikes you as all bad news, think again.

The booming global oil trade offers investors a shot at earning dividend yields as high as 25 to 30 percent annually. That’s not a misprint–even with longer-term bond yields well under 5 percent and the S&P 500 offering just 2 percent yields, some oil tanker shipping companies have been paying yields as high as 15 times that of the S&P 500 average.

General Maritime (NYSE: GMR) is our favorite play on the oil tanker shipping business. The company was the first to adopt a novel dividend policy that pays out the majority of the company’s earnings as dividends to shareholders. This new, straightforward policy ensures that shareholders receive the maximum yield possible with General Maritime setting aside enough cash to continue making needed investments to grow the business.

In addition to strong dividend growth, General Maritime offers a high potential for capital gains from an appreciating share price. As we outline below, the company’s exposure to the hot mid-sized tanker market, coupled with a focus on spot shipping contracts, is an ideal positioning in the current shipping market. We’re adding General Maritime to our Proven Reserves portfolio as a buy under 57 (please see “How to Play It” for more on General Maritime).

Frontline (NYSE: FRO) is another well-run tanker firm. The company focuses on a slightly different aspect of the tanker market than General Maritime, a part of the market that’s far more volatile. But Frontline pays a larger dividend yield, currently about 29 percent (more like 35 percent if you count dividends paid in stock). We’re not yet ready to add this stock to the portfolio but we cover an alternative strategy involving Frontline below.

Of course, those large yields don’t come without risk–tanker stocks have a tendency to pull back sharply when there’s a correction in the oil market. And dividend payouts can fall in a weak tanker market.

But we’ve developed a simple strategy for vastly reducing these risks while allowing investors to participate fully in the income potential offered by General Maritime. We detail the company’s dividend policy and our proprietary risk reduction strategy below; first, we’ll cover the tanker industry and General Maritime’s competitive position in greater depth.

Where’s the Oil

Most of the oil we consume comes from countries located thousands of miles away; the source for most of the world’s oil is the Middle East. Every day, roughly 19 million barrels of oil and related products depart the Middle East bound for markets all over the world, accounting for roughly 40 percent of total world oil exports. The US, Europe and Asia also import vast quantities of oil and refined products from places like Venezuela, Africa and Canada.

And the real growth in oil imports is coming from Asia. China, a net exporter of oil little more than a decade ago, is now the world’s second largest consumer of oil and the world’s fastest growing importer.

Tanker ships move as much as 90 percent of that oil at some point. And it’s not just crude that must be shipped, but gasoline, heating oil and other refined products must also be transported.

Tanker companies own a fleet of ships designed to carry oil and refined products; they don’t own the actual oil transported on their ships nor do they explore for or produce crude. These companies charge oil producers what’s known as a day-rate to ship their oil or gasoline–for every day the oil company rents the ship they pay a fee for its use. This fee can be charged either on a spot market basis or through what’s known as a time charter.

Spot market contracts charge companies the prevailing day-rates for leasing tankers. If day-rates rise, the rate charged under spot contracts will also increase. Alternatively, tankers contracted under time charters are leased to oil producers for longer periods of time at a fixed (or partly fixed) rate.

Time charter contracts offer tanker companies reliable earnings–their tankers are leased out at guaranteed rates. But spot rates offer more upside leverage. If day-rates are rising, spot contracts normally offer higher returns for ship owners.

The graph below depicts the “Baltic Dirty Freight Index.” This index is produced by The Baltic Exchange, and is based on spot tanker market rates for a variety of routes around the world. The graph reflects that there’s some clear seasonality to the index–summer demand for gasoline can produce a “spike” in spot tanker rates. But more importantly, this index has been generally rising for the past five years. In other words, the average spot tanker rate for the entire year is far higher than it was a few years ago. The reason for this is simple: The size of the global tanker fleet isn’t expanding fast enough to keep pace with demand for shipping oil.

^{Source: Bloomberg}

Keep in mind that a very large crude oil tanker that can transport 2 million barrels of oil can sometimes be chartered for more than $180,000 per day. To understand the amount of money involved, the breakeven point for a ship like this is around $18,000 per day.

In an environment of rapidly rising fuel imports and day-rates, we prefer to focus on companies that operate primarily in the spot tanker market. The spot market offers the most upside leverage to rising day-rates. More than 80 percent of General Maritime’s ships are being contracted on the spot market, one of the highest concentrations in the industry. For this reason, General Maritime is extremely well placed to benefit from the strong tanker environment.

The Tankers

There are many types of tanker ship operating in the world today. The largest tankers, capable of holding between 200,000 and 350,000 deadweight tons of crude on average, are known as Very Large Crude Carriers (VLCCs). To put that into perspective, the Titanic weighed 47,000 deadweight tons and the Queen Mary 2, the world’s largest cruise ship today, weighs about 150,000 deadweight tons.

The Front Ardenne of Frontline. Source: www.frontline.bm

And we’re only giving you an average size for tanker ships, as some are much bigger. The world’s largest tanker ship, the Jahre Viking, has a maximum capacity of 650,000 deadweight tons. Sometimes, ships above 350,000 deadweight tons are referred to as a ULCCs, or Ultra Large Crude Carriers.

VLCCs and ULCCs operate mainly on long-haul routes. In particular, these ships are popular for shipping crude from major production centers in the Middle East to distant markets in China, Europe and the United States. These giant floating cities cannot dock at all ports or navigate in all waterways–they’re best suited for open-ocean shipping.

Tanker ships that carry somewhere between 75,000 and 200,000 deadweight tons of crude are also popular. These intermediate-size tankers are generally called Suezmax or Aframax ships. Suezmax ships are named after the Suez Canal–this is the largest class of tanker capable of fitting in the canal. Aframax tankers, somewhat smaller than Suezmax carriers, are based on a standard size set by the American Freight Rate Association.

Intermediate-sized tankers can’t carry as much crude but are far more maneuverable than VLCC tankers. They are more useful in shorter-haul trips, such as across the Atlantic Ocean and between the Gulf Coast states, Caribbean refineries and ports on both coasts of the US.

At the smaller end of the spectrum lie Panamax and Handymax tankers, which can hold anywhere between 10,000 and 60,000 deadweight tons of cargo. These ships are used for the shortest routes or to access harbors that can’t be reached by other carriers.

Companies currently leveraged to the intermediate-sized Suezmax and Aframax tankers are the best plays. Day-rates for these tankers are smaller than for VLCCs but they’re more stable. That means that seasonal weakness in tanker rates has less of an effect on day-rates for Suezmax tankers as compared to VLCC and ULCC carriers. There’s less leverage in periods of extremely strong tanker markets but we’re more than willing to forgo that modicum of upside for the extra stability.

In addition, Suezmax and Aframax tankers depend less on Middle Eastern oil shipments because they are better able to navigate Atlantic trade routes. VLCCs are normally used to carry oil from the Middle East–when OPEC cuts output, VLCC day-rates tend to fall because there’s less oil to be shipped.

General Maritime focuses almost exclusively on the Atlantic basin with its 42 tankers. The company has 26 Aframax and 17 Suezmax carriers in operation and has four Suezmax tankers on order (newbuilds) for delivery during the next two years.

And while the company’s ships are a little older than the industry average, General Maritime has very few single-hull tankers in operation. Single-hull tankers are being phased out globally because they’re more prone to oil spills.

The rupture of a single-hull tanker caused a spill off the coast of Spain a few years ago. That environmental disaster, among others, prompted regulators to call for a phase-out of these older tankers; much of that phase-out is scheduled to be complete by the end of this year. Only 12 percent of General Maritime’s tankers are single-hulled–the four Suezmax newbuilds will replace much of that single-hull capacity.

Frontline is our top pick in the more volatile VLCC market. The company’s fleet consists of 25 wholly owned VLCC carriers and 28 Suezmax carriers. We also like Frontline’s management team, headed by John Fredrickson, one of the most astute CEOs in the oil business and Norway’s richest man. The company, like General Maritime, focuses primarily on the spot market. Frontline offers more upside potential in a strong tanker market than General Maritime but carries more risk–below we set a course to minimize that risk.

Paying Dividends

General Maritime estimates that it needs approximately $100 million in 2005 for basic expenses such as ship maintenance and docking costs. In addition, General Maritime would set aside some cash to pay its interest expense. Management has committed to paying out all of its earnings before interest, taxation, depreciation and amortization (EBITDA) to shareholders above and beyond that $100 million reserve and any interest expenses.

The beauty of the policy is that it allows shareholders to participate directly in the tanker business. Most companies arbitrarily decide on dividend payouts on a quarterly or annual basis; General Maritime’s policy assures that dividends will rise and fall with the fate of the tanker business.

According to company estimates, in 2004 this policy would have resulted in about $5.42 in dividends for the first three quarters and $3.94 in the booming fourth quarter tanker market–$9.36 for the full year per share. That’s roughly equivalent to an 18 percent yield based on current prices.

General Maritime also highlighted an estimate for 2005 dividends. Based on analysts’ estimates for about $391 million in 2005 EBITDA, $100 million in fleet expenses and $35 million for paying interest, General Maritime should be able to pay around $6.74 in dividends. That’s equivalent to a yield of roughly 15 percent based on current prices.

Finally, even in the company’s worst operating year, it generated nearly $250 million in EBITDA. That equates to roughly $3 per share in dividends, or a dividend yield of around 6.5 percent.

2005 will be a much better than the average year for tanker companies. Analysts have been ratcheting up their 2005 estimates for oil demand–eventually this will trickle through into higher estimates for EBITDA. General Maritime could easily see a per share payout well above the projected $6.74.

The actual dividends will be announced quarterly when figures for EBITDA are finalized. And the reserve set aside for ship maintenance and docking (about $100 million for 2005) will be reviewed every year and altered according to the company’s needs.

How to Play It

General Maritime is in the sweet spot of the strong tanker market. The company’s dividend policy is also extremely beneficial to shareholders. But there’s one problem with General Maritime–it can be volatile, especially when there are big moves in the crude oil market. One of the pillars of the Proven Reserves portfolio is to preserve capital and minimize volatility.

For this reason, we’re recommending that you short an equal dollar amount of OMI Corporation (NYSE: OMM) when you buy General Maritime. In other words, if you buy $5,000 worth of General Maritime then you should also short $5,000 worth of OMI. The trade is being added to the Proven Reserves portfolio.

OMI is focused on a broadly similar market to General Maritime. The company owns a fleet of Suezmax carriers and some smaller Handymax and Panamax vessels. The company also operates mainly on the spot market.

But we don’t like OMI management’s dividend policy. OMI’s annual dividend currently stands at less than 1.7 percent. And in the company’s fourth quarter conference call management made it abundantly clear that it’s not going to follow General Maritime’s lead on the dividend front.

The company stated that it’s looking at share buybacks or possibly acquisitions. This makes absolutely no sense. In a strong tanker market, OMI would likely have to pay top dollar for any acquisitions–such purchases would be tough to justify on a financial basis.

Despite strong fourth quarter results, OMI’s stock didn’t react particularly well to the company’s conference call. The market is looking for dividends and, therefore, will continue to prefer stocks that pay higher (yet sustainable) yields.

Even better, by shorting OMI and buying General Maritime, you reduce your overall exposure to volatility in the tanker market. If day-rates moderate, General Maritime might pull back. In such an event, we’d also expect OMI to sell off–gains on our short in OMI will offset losses in General Maritime.

In the meantime, however, we’ll be able to pull in huge dividends in General Maritime. When you short a stock, you have to make dividend payments on it. But this is of no concern because General Maritime’s dividends are well in excess of those paid by OMI. By pairing this long and short position, we can significantly reduce volatility without giving up much of the income potential.

To illustrate this comparatively stable spread, check out the graph “General Maritime/OMI Spread” depicting the value of a position (not including dividends) with $5,000 invested in general Maritime and $5,000 short OMI. It’s clear that this spread is fairly stable over time.

^{Source: Bloomberg}

Recall the above discussion of Frontline, a tanker firm that focuses on the VLCC market. This stock offers even bigger dividends than General Maritime. We’re not yet adding this stock to the portfolio. But if you like the Frontline story and are willing to take on a bit more risk, consider buying Frontline and shorting Overseas Shipbuilding Group (NYSE: OSG) in equal dollar amounts.

Overseas Shipbuilding Group also has a large focus on the VLCC market with more than 21 VLCC tankers. But the company pays a dividend of only a little more than 1 percent. The stock would make an ideal hedge for any position in Frontline.