The Global Shipping Industry: Not Such a Small World After All

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 |  Includes: ALEX, FRO, SFL, SSW, TK
by: Travis Johnson

I don't currently own any shipping companies to speak of, but I have invested in them in the past. Lately, there are some general trends that have peaked my interest again.

Almost every shipping company - whether it is a Jones Act shipper like Alexander and Baldwin (NYSE:ALEX), a big tanker company like Frontline (NYSE:FRO) or Teekay (NYSE:TK), a bulker or even a container line - has risen dramatically over the past couple of years. Some of them, notably the tanker companies, have been extremely volatile, but the general trend has certainly been positive.

So why am I considering investing in them again? Well, there are a few fundamentals that underly the shipping industry, no matter the segment - the global economy in general is certainly one, and the supply of ships is another. In recent years, China has been the real heart of the shipping story. China's demand for oil and commodities has driven tanker and bulker rates higher on the margin, and its increase in exports has driven container rates higher.

This makes me step back and think more about it: Isn't the story of shipping really a story about the world growing larger? It's true, the world has shrunk in some ways due to air travel and globalization and today, no market is truly so foreign that it can't impact the global economy, or is so remote that you can't invest in it in some way.

Nowadays, there are few societies that remain isolated from the world at large. As long as you're willing to pay, you can get a piece of fresh tuna sashimi on your plate in Tokyo less than a day after it was caught off the coast of Maine, so in some ways, the world is shrinking and we're all becoming more connected.

Although, when it comes to big things like tankers full of oil, or container ships laden with flat screen TVs, the world is still growing. You see, a decade or two ago we didn't import allot of goods from China and they didn't use as much imported oil. We used to get most of the oil needed for U.S. consumption from our own wells, and would then make up the shortfall using supplies from neighboring countries such as Mexico, Canada or Venezuela.

But now these markets are truly global. This means that conceptually the world is shrinking, but the distances that shipped materials have to travel have become tremendous.

Some of the recent events that have gotten me thinking about this topic are European imports, Venezuelan and Nigerian oil problems, as well as discussions about free trade between the U.S. and South Korea. I think all of these have the potential to help spur an increase in the demand for heavy shipping, which might make an investment in a shipping company sensible, even after its recent excellent performance.

The first issue is oil. It is transported by massive tanker ships, and because of the high cost of transport, is usually consumed by local populations (which is part of the reason why we get so much of it from Mexico and Canada). In abstract terms, we can pay them less for it than China can, because of shipping costs. Additionally, the U.S. has come quite close to satisfying our oil import needs with countries that are only an ocean away - whether that's Nigeria, Venezuela or Norway.

True, there has always been some marginal importation from the Middle East, but it isn't anywhere near the top of the list, and in a truly efficient market without political concerns, we could probably get by without any Mideast oil (it would all go to China and Europe, and we'd get almost all of the rest). Everyone likes diversified supply, though and this makes things a little less efficient than it otherwise might be.

So what happens if Chavez really does make a deal with the Chinese to cut off the U.S. from Venezuelan oil? Or if the majors pull out of Nigeria because the unrest is too much to handle (or just cut production because they can't keep its pipelines open)? Or if the North Sea dries up even faster than we expect (according to what I read, it seems to be tailing off these days)?

None of these incidents would cause a real shortage of oil, as there is probably enough marginal production and discovery elsewhere to make up for any Nigerian or North Sea shortfall, and Venezuela's production would still be entering the market. But it would mean that the U.S., which is still by far the world's leading oil importer, would need to pull in supplies from farther afield, since those are the biggest exporters that are relatively near our ports.

Since boat owners are generally paid lease rates by the day (in some contracts there are longer terms), and not by the load, every additional knot that a barrel of oil has to travel brings some extra demand for shipping tonnage, and puts extra money into the pockets of shipowners. If it takes just a few days for oil to make it to Louisiana ports from Venezuela, it can take a month for a tanker to go from Kuwait, through the Suez canal, and arrive at the U.S. Gulf's offloading facilities. As you can imagine, even if consumption everywhere in the world remained the same, the mere fact that the marginal oil production comes from Kuwait instead of from Venezuela would make a marked difference in the number of tankers that are needed, and in the prices those tanker owners could expect to receive.

This has long been an understood part of the market, of course - this, along with the scrapping of single-hull ships, has been the driving force behind the tanker market for many years, and it brings spikes when Nigerian oil, or big Norwegian platforms unexpectedly go off line for any period of time.

The fear has been that so many ships are being built and hitting the water right now and over the next year or two that the supply/demand imbalance will swing back the other way. Now I'm starting to wonder if that's too pessimistic, given the fact that China, India and the U.S. are likely to be competing for oil from around the world.

A similar phenomenon has also been coloring the container ship market, which I haven't ever looked at before. While China has been supplying the U.S. with cheap consumer goods, which almost all travel by TEU (20-foot equivalent units, or something like that) containers on container ships (the ones that look like they're carrying giant legos), they haven't supplied Europe to quite the same degree. Now that's changing, and Chinese exports to Europe are climbing.

Why is this so important? Right now it takes 8-10 days for one of these big container to get from the coast of China to ports on the U.S. West Coast, but it would take the same ship more than half again as long to get through the Suez canal and make it to the big container ports of Europe. Chinese televisions are still cheaper than French ones, even with the extra shipping cost, so it would mean more demand for boats, and more money for shipowners.

The world may be shrinking for people and air cargo, but for ships the routes are getting longer and more lucrative as the spread of capitalism, export-led economies, and free trade means that anything can come from anywhere, and be in demand anywhere in the world. And I haven't even mentioned the possibility of expanded two-way trade with South Korea, or the number of deals that the Chinese are making for South American commodities and steel.

So what am I doing with this thought? Not much, yet. The safest bet on these markets is probably the shipowners that lease out its boats for years (and sometimes decades) at a time, thereby making it a bit less susceptible to fluctuating day rates. This would include companies such as Ship Finance Limited (NYSE:SFL), which buys and provides long term leases primarily on tankers to the shipping companies, or Seaspan (NYSE:SSW), which does the same with container ships. Both tend to trade in part on its very nice dividends.

The racier investments would be the operators of the ships themselves- the ones who pay those long term leases, or own the boats themselves, and hold some. or all of its ships for the spot market (this meanings booking journeys one at a time at prevailing rates instead of signing longer term time charters). Frontline (FRO), which runs most of SFL's ships, does this in the tanker business. I'm not sure if there's a pure play on this for containers or bulkers but I expect that there probably is.

It's an interesting business, but one that has been extremely volatile in the past, with cyclical downturns bringing the companies down to well below the book value of its hulls. Whether that's going to change in this new, bigger world, I don't know.

Disclosure: I don't own any of these companies at the time of writing, but may invest in them in the near future.