Dry Bulk Shipping: An Industry In Turmoil

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Includes: DRYS, EGLE, SALT, SB, SBLK
by: Kurt B. Feierabend

Summary

Industry oversupply of ships with a very steep demand curve.

Expectations and hopes that dry bulk rates will recover are repeatedly dashed.

Low oil prices exacerbating oversupply of ships.

Many dry bulk shipping companies trading for around 10% of book value.

The stocks of dry bulk shipping companies have been on a wild ride over the past several years. To say it has been a roller coaster ride would be an unfair analogy to give to investors-it has been more like a log flume ride with a ride up on the lift hill followed by a harrowing dive into the water where all momentum stopped, everyone is wet, exhausted and ready to head for the exits.

Dry bulk refers to dry, granular cargo such as bauxite, coal, wheat and soybeans; commodities which are shipped around the world in the hulls of large dry bulk ships. In a normal environment, producers produce and consumers consume a relatively stable, slowly growing, amount of dry bulk goods every year. As world demand for dry bulk goods increases, the dry bulk fleet can slowly increase to match the demand-the two year time frame to build a ship isn't an obstacle for a slowly changing demand for dry bulk ships.

Dry Bulk Shipping is a fragmented industry with many shipping companies in the space. These shipping companies own dry bulk ships, from just a few to around eighty ships, and they charter the ships out to other companies needing to ship cargo around the globe.

Before around 2008, the supply of ships to transport dry bulk goods and the demand for those ships' services was roughly in balance. However, China's growth in the middle of the last decade threw the industry out of equilibrium. China's impressive growth created a significant new demand for dry bulk goods such as iron ore and coal, a demand the then-current size of the dry bulk fleet wasn't able to handle. As you can imagine, the rates for chartering a ship skyrocketed. At one point in 2008, the daily rate to charter a capesize ship, so named as the large ships which transport cargo around Africa's Cape of Good Hope or South America's Cape Horn, hit $280,000 per day!

As you can guess in the face of the new demand from China and the higher charter rates, the fragmented industry of dry bulk shippers started ordering dry bulk ships. With the incentive of anticipated continuing higher rates, all the shipping companies jumped in at the same time to order new ships. It only took a couple of years until the world was awash with dry bulk ships. The industry over-ordered ships. With the deluge of new ships on the oceans, demand...and charter rates, plummeted.

You see, the demand for ships is highly inelastic-imagine there are two people who need to go to work but only one taxi available; the demand for that taxi is very high. Now imagine there are two taxis and only one person who needs to go to work; the demand for that second taxi is virtually nil. That's similar to what happened in the dry bulk sector. Ships not needed won't deliver cargo so all ships are willing to be chartered for their break-even costs.

With the over-supply of ships the dry bulk industry languished. By 2009/2010, a capesize could be chartered for around $4,000/day, down from the $280,000/day the industry had enjoyed at the high. The rates were below the operating costs of the ships and there have been stories of ships stopping to fish in the hopes of catching a large tuna to sell to Japan to recoup some of their costs. But hope springs eternal and analysts predicted a recovery of try bulk rates in 2012...then in 2013...then in 2014...and to a lesser degree in 2015. Of course they were all wrong and analysts are decidedly less optimistic currently.

So where are we now in early 2016?

In the middle of last year, there were signs that China's robust growth started to slow. China's growth in consuming iron ore and coal are a thing of the past...and there are still too many dry bulk ships. This undoubtedly has been a contributing factor in analysts suddenly growing more gloomy about the sector.

Additionally in the middle of last year, oil prices started dropping. Oil prices had been around $100/bbl which made shale oil production very profitable. Shale oil growth was on the rise around the world. Even the U.S., a large shale oil producer, was on its way to becoming a net exporter of crude. The break-even price for shale started around $60/bbl and worked its way down to about the $40's as shale oil producers became more efficient. Oil supply went up...and ultimately prices went down. Oil currently sits at around $30/bbl, a price point where shale oil producers aren't making any money...but many shale oil producers are still operating because shutting down would be even more costly.

Oil prices do have a profound effect on shipping...and that's because of simple physics. As a ship's hull moves through the water, the energy used and therefore the bunker fuel consumed, increases as the square of the speed. Simply put, twice the speed uses four times the fuel. Ships and companies which use those ships can adjust their fuel consumption to optimize their profits. With fuel being roughly half of the voyage cost of a ship, fuel is a large concern.

The higher oil prices of last year reduced the pain of low charter rates somewhat--Higher oil prices dictated that ships move slower to save on fuel and, since ships spent more time on each voyage, the supply of ships to transport dry bulk goods is effectively reduced. On the other hand, oil prices dropping precipitously over the past six months dictate that a ship deliver its cargo faster. Ships that deliver cargo faster have more days available to ship even more cargo. More available ships put additional pressure on charter rates.

It's easy to do a back of the envelope calculation on the effect of fuel prices on the dry bulk shipping supply. Since fuel is roughly half the cost of a voyage, if the price of fuel is also halved, the company which uses a ship can immediately save 25% by steaming at the same speed with no changes. If you pull out your spreadsheet, you can also see the company can save slightly more, 29%, by increasing the speed of the ship by 40%. It's not hard to see how, with these $30/bbl oil prices vs. last years $100/bbl, there might be 50% more dry bulk ships on our oceans than there needs to be. That's a devastating blow to the shipping industry.

There's a lot for the dry bulk industry to work through so don't expect a quick recovery of rates and if rates try to recover, there is a multitude of factors which will make any rate recovery sluggish.

The stocks of dry bulk shipping companies have, understandably, been beaten to a pulp. Most have a market capitalization which is around 10% of their book value. Star Bulk, for example, is trading for about 1/15th of their book value at this writing.

There will be continued pain in the dry bulk shipping sector, but with the highly depressed stock prices, there could also be opportunity. Going forward, there will certainly be high volatility in dry bulk shipping stocks and there will be a large amount of money made and lost.

Disclosure: I am/we are long SBLK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.