by Alberto Forchielli and Alberto Pagliarini
Its dramatic ups and downs in the last few years (together with its increased importance in a globalized world) have brought the shipping industry under the spotlight of investors, businesspeople and bystanders alike.
It is a fascinating industry with a proud history but one which has changed dramatically in the recent past. One thing that has not changed is its cyclicality, driven by the long-term nature and fixed capacity of the assets that constitute the industry itself, i.e. the vessels.
As an oversimplification, shipping can be divided in 3 sub-categories: dry bulk, wet bulk and container shipping. Each of these 3 categories has different characteristics: -Dry bulk vessels carry iron ore, coal, grains and minor bulk from producing countries (i.e. in the case of iron ore, Australia and Brazil) to consuming ones (China) – Wet bulk vessels (aka, tankers) carry crude oil and refined products from producing countries (i.e. in the case of crude oil, Saudi Arabia and other GCC countries) to consuming ones (US, Japan, etc.) – Containerships carry discrete goods (i.e. non-bulk cargo) from producing countries (China) to consuming ones (US)
The container shipping segment is the youngest of the three. In 1955, businessman Malcolm McLean developed the modern intermodal container: the result was a 2.4 m tall by 2.4 m wide box in 3.0 m long units constructed from 25 mm thick corrugated steel, incorporating a twist-lock mechanism atop each of the four corners, allowing the container to be easily secured and lifted using cranes. McLean gave the patented designs to the industry beginning international standardization of shipping containers.
Such standardization not only allowed shipping costs to drop precipitously (break-bulk shipping accounted for nearly 25% of total cost of product before container vs. less than 1% today), but also meant that shipping became vastly more reliable and simple thanks to the automated process that moves the container from the vessel to the truck/rail. As a result, whereby before the container most cargo transport involved either raw materials or completely finished products; after the container, the majority of cargo became intermediate goods (parts and subassemblies). Container shipping was one of the major drivers of the disaggregation of vertically integrated industry structures and the globalization of supply chains. People refer to the 2002-08 period as “the last super-cycle” as it witnessed an unprecedented bull market for the shipping industry: – Demand boomed (driven by a prolonged expansion in world economy and the spectacular rise of China, especially important in the dry bulk and container trades) – Supply was reduced by the scrapping of the remaining vessels built during the 1970s shipbuilding bubble.
The combination of high demand and low supply led to record freight rates and, therefore, record earnings for shipping companies which, in turn, invested those profits in new vessels (in 2007, the industry ordered new vessels worth US$250bn) creating a record order book (which currently stands at almost 50% of current fleet). The new building binge was also fueled by easy availability of cheap credit from traditional shipping banks but also new entrants (i.e. Chinese financial institutions eager to support the domestic shipbuilding industry). Unfortunately all the elements that supported the sector during the “super-cycle” have disappeared in the post Lehman-bankruptcy world: Demand has dropped sharply as consumers across the globe (but especially in the Western world) de-lever and companies cut outputs.
Supply (i.e. ship orderbook) has never been larger (valued at ~$450 billion with almost 10,000 units on order). Ship owners continue to push for delivery delays and cancellations, but face resistance from shipyards (which figure prominently in the stimulus packages of the 2 largest ship-building nations (China and Korea) which deem shipbuilding a national interest industry)
Financing: the credit crisis has hit the traditional sources of funding for the shipping industry. As a consequence many ship owners will be unable to fund ship orders due to tighter loan covenants and higher funding costs After the Lehman bankruptcy, the BDI (Baltic Dry Index, a broad measure of shipping health) dropped from a peak of 11,793 (20 May 2008) to a low of 663 (5 December 2008), a 94% decline. The reduction was made staggering by financial factors (i.e. the unavailability of LCs to finance the goods/bulks to be shipped).
During 1H2009, the BDI averaged 1,800 showing a poor dry bulk shipping environment but it picked up in 2H2009 (BDI average of 3,100) driven by China’s hunger for raw materials to be used in real estate and infrastructure projects (for example, during 2009 China imported almost 70% all the iron ore shipped globally). Throughout 2009 instead, container shipping was in a slump as the largest consumer of container shipping services (the United States) focused on de-levering after the debt-fueled consumption binge of the last decade.
2009 saw, therefore, an oversupply of ships which was accompanied by shipping companies’ bankruptcies, vessel lay-ups, and depressed valuations for asset sales. In early 2010, Korean shipyard Hanjin Heavy sold a 6,500 teu container ship that CMA CGM had been unable to pay for to DryShips’ George Economou (the vessel has been order at a valuation of US$100MM in 2007 but Hanjin Heavy sold it for US$41MM)
2010 started very similarly to how 2009 had ended: strong dry bulk, moderate wet bulk and negative container. Then, in a strange reversal of fortunes, dry bulk and container switched their relative positions. Rates for container shipping kept on increasing driven by improving consumer sentiment in the US and Europe and by an unprecedented display of discipline by the liners (which have adopted slow-steaming in unison and still keep approx. 8% of total container capacity idled). On the other hand, the dry bulk outlook has started to deteriorate driven by deliveries of new ships and reduction in iron ore shipments to China.
The Chinese government’s actions to slow the real estate market (together with the ending of infrastructure projects financed by the RMB4tr stimulus package) may have decreased demand for steel (and therefore iron ore). There are, in fact, reports that several medium-sized mills have recently shut their furnaces under the pretence of maintenance work. Additionally, the Chinese government is promoting a process of consolidation of the domestic steel industry to guarantee environmentally sound production standards and improve the industry’s margins. Finally, iron ore (a key driver of dry bulk shipping demand) has recently shifted from an annual to a quarterly pricing system, which has also enhanced volatility (as Chinese mills may decide, if they deem the current quarterly price too high, to run down their inventory and wait until next quarter to order new ore).
Eventually Chinese demand will come back to the market but probably not at the level of 2009 (a level inflated by the unsustainable development of the domestic real estate industry and by stimulus-funded infrastructure projects).
As the dry bulk sentiment deteriorates, there may be clouds on the horizon for the container shipping industry too. In fact, the container industry boom (2002-08) has relied on the relationship between China and the United States (what Harvard professor, Niall Ferguson calls “Chimerica”). After China’s accession to the WTO (11 December 2001), the value of Chinese exports to the US increased from US$125.2Bn (2002) to US$337.8Bn (2008) therefore fueling an impressive demand for container shipping services (which rose even more when congestion at Los Angeles and Long Beach ports drove some shippers to send goods from China to the US westward through the Suez canal). Today 26% of all containers originate from China (which hosts 3 of the 5 largest container ports: Hong Kong, Shanghai and Shenzhen).
Now, China’s exports to the US have started increasing again at the beginning of 2010 but they are predicated on the growth of the US economy and many (including Fed Chairman Ben Bernanke) are starting to be cautious. In fact, US economic growth during 1H2010 was driven by: Replenishing inventory (which unfortunately has a 1-time effect) The projects funded by the US$787Bn stimulus.
Incentives on real estate (US$8,000 tax break on real estate purchases and low interest rates as 96% of newly issued mortgages in the US are backed by Fannie Mae and Freddie Mac) Quite a few commentators and economists seem to believe that a bottom in US housing prices is still to come (when tax breaks and artificially low interest rates disappear and when the substantial supply of foreclosed houses comes to market). That, together with a stubbornly high unemployment rate, may make the surge in consumption short-lived and therefore reduce the need for container shipping services.
Shipping is, by definition one of if not the most global industry: it will rise and fall with demand (driven in general by economic activity but in particular by the behaviour of many different segments and geographies) and supply (driven by the sentiment of ship owners, the capacity of shipyards and the availability of financing). It can give us an insight into the health of the global economy and also, because of its extreme cyclicality, provide incredibly good and bad investment opportunities.
Alberto Forchielli is President of Osservatorio Asia, an Italian Think Tank based in Imola, Italy, while Alberto Pagliarini works for Barclays Capital in Hong Kong. The views expressed in the article are those of the authors and in any way not those of Barclays Capital.