Monday, 2 March 2015
Last updated 24 min ago
May 10 2013 | 5:12am ET
By Vladimir Jelisavcic
Founder and Portfolio Manager
Bowery Investment Management
By any measure, shipping fits the definition of a distressed market. In the dry bulk segment, capesize rates averaged $47,000 per day in the 12 years from 2000 to 2011, peaking at over $115,000 per day in 2007, only to crash to below $10,000 in 2012. The average of the 2013 year-to-date Baltic Dry Index, which measures spot earnings of dry bulk vessels, is at the lowest level since 1986.
Source: Bowery Estimates & Pareto Securities Research
Shipping is an operationally leveraged business. Other than fuel, costs to operate a vessel such as crew, maintenance, and financing are essentially fixed. As a result, a shipping company’s profitability is driven by changes in rates (called day rates), which in turn, are driven by three main factors: (a) growth in demand for ships, (b) growth of new ships built by shipyards, and (c) declines in supply as a result of scrapping older vessels. As day rates increase, ship owners are encouraged to compete by placing orders with shipyards for new vessels. The excessive production that inevitably occurs pushes the market to disequilibrium, reduces capacity utilization, and forces day rates lower. Over time, the market gradually moves back to equilibrium as the excess supply is absorbed by demand growth, and older vessels are scrapped.
Types of Vessels
There are three main types of vessels: (a) tankers, which carry crude oil, refined products, and chemicals, (b) dry bulk carriers, which carry iron ore, coal, and grains, and (c) container ships, which carry intermodal containers.
Crude oil tankers have one of the highest barriers to entry as owners and operators face potentially enormous liability in the event of an oil spill. As a result, each ship and ship operator is required to be certified. We view demand for crude oil tankers to be relatively stable, where the current annual growth rate for demand has been approximately 1%. Crude oil is mostly refined into transportation fuels, such as gasoline and diesel. As developing economies grow and mature, there is a greater demand for vehicles and products refined from crude oil such as gasoline and diesel are consumed to service this growing fleet of vehicles. Product tanker day rates are currently at four-year highs. This has been driven by increasing US crude oil production with a longer average ship voyage distance, as refining capacity is being built up in the Middle East (closer to production areas) and capacity is being shut down in the U.S. and Europe (due to being uneconomical). Product tanker demand has been growing at 3%, but is expected to grow over 4% in 2013.
The collapse in shipping spot rates occurred in 2009. The decline was late relative to other asset classes, such as US residential real estate, which peaked in 2006, and began to collapse in 2007. The relative latency of the shipping collapse can be explained by two factors: (a) the peak in WTI crude oil prices in mid-2008, and (b) China’s fiscal stimulus from late 2008 into early 2009 that focused on growing capital and material investment in real estate, infrastructure, and transportation.
Supply & Demand of Product Tankers
Source: Bowery Estimates & Clarkson Research
Demand for Vessels
Demand for bulk vessels has increased each year since 2006, including increases in 2008 and 2009, and continues to grow at an annual rate of approximately 5%. Iron ore, which is used to make steel, is one of the biggest sources of demand for dry bulk vessels. Steel demand is based largely on fixed investment in long-lived infrastructure and inherently more cyclical than demand for crude oil or received products. Demand for ships is driven by secular growth in international trade and the strategic shift by China (which consumes 40% of the world’s bulk commodities) to purchase bulk commodities, while stockpiling domestic resources. China accounts for over 50% of seaborne iron ore demand and we are concerned with the market’s excessive reliance on China. In contrast, China represents only approximately 15% of seaborne crude oil demand.
Supply of Vessels
Another factor slowing the supply of new ships is the availability of financing. Before the global financial crisis, banks were very comfortable making ship loans because ships are hard (albeit depreciating) assets that banks viewed as low risk collateral. If a bank needs to foreclose on ship collateral, there is a global secondary market in which it can sell foreclosed vessels. Banks were willing to make loans in excess of 70% loan-to-value and credit spreads of less than 200 basis points over Libor. Shipping loans were dominated by European banks that were very willing to extend credit on these easy terms before the global financial crisis. European banks are currently reducing their loan portfolios and have significantly reduced extensions of credit to the shipping industry. In fact, European banks have begun selling shipping loans at distressed prices that we find attractive. This financing gap has been partially filled by Asian banks that are encouraged by their governments to support local shipyards. Nevertheless, loans that are still being made are done so on a relationship basis and require more equity (approximately 50% loan-to-value) and at materially higher credit spreads. The overall effect serves to materially reduce liquidity and slow the supply of new vessels.
Time to Recovery
To bring it all together, the time to recovery in any shipping market is a function of four factors: a) the current level of oversupply, b) demand growth, c) the declining amount of new supply coming into the market (orderbook), and d) declines in existing supply (scrapping of older vessels).
Estimating time to recovery is based on observing historical patterns of supply and demand growth. It is also important to track current new build orders and expected delivery dates. With this information, it is possible to estimate when a shipping type may reach equilibrium that will cause day rates to increase to prices that will enable ship owners to earn a rate of return that will justify an investment in new build vessels.
The greatest risk to a “time to recovery” analysis is unexpected growth in new supply triggered by stronger spot rates that send premature price signals to ship owners. This in turn can result in excessive orders for new ships. Increases in shipyard capacity, which have increased 50% since 2007, elevates the risk of excessive new supply growth. As a result of capacity increases, shipyards can ramp up production more rapidly than in prior cycles.
Product tankers are in the process of a near-term recovery in day rates. For these types of vessels, we believe this is an optimal time to invest in distressed debt. Investors can profit in two ways from a recovery in the product tanker market: First, from the cash flow benefits of higher day rates; second, from asset value appreciation driven by higher day rates. Cash flows and asset appreciation will drive the prices of product tanker-related securities higher.
Vladimir Jelisavcic: Prior to founding Bowery Investment Management in 2012, Mr. Jelisavcic co-founded Longacre Fund Management, LLC, 1998, LSE Fund Management, LLC, 2005, Longacre European Fund Management, LLC, 2005 and Longacre Fund Management (UK) LLP, 2005. Mr. Jelisavcic was, until November 1998, a Vice President in the High Yield Department of Bear, Stearns & Co. Inc., where he was responsible for trading distressed bank loans and private notes as well as the identification and analysis of investment opportunities in distressed securities. Mr. Jelisavcic joined Bear, Stearns in 1993. In 1991, Mr. Jelisavcic worked as a law clerk for the U.S. Securities and Exchange Commission in Los Angeles. From 1987 to 1990, Mr. Jelisavcic worked in the Tax Department of Deloitte & Touche. Mr. Jelisavcic is a C.P.A. and the author of articles on trading claims and creditors' rights published in the Journal of Corporation Law. Mr. Jelisavcic earned a J.D. (cum laude) from the University of Iowa College of Law in 1993 and a B.S. in Accounting from New York University in 1987.
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