Note: This article was originally published February 2nd on Value Investor's Edge, a Seeking Alpha subscription service.
Dry bulk shippers specialize in transporting cargos, typically commodities, such as iron ore, coal, grain and other materials around the world.
Companies with exposure to dry bulk include Diana Shipping, Inc. (NYSE:DSX), Eagle Bulk (NASDAQ:EGLE), Genco Shipping (NYSE:GNK), Golden Ocean Group Ltd. (NASDAQ:GOGL), Navios Maritime Holdings, Inc. (NYSE:NM), Navios Maritime Partners L.P. (NYSE:NMM), Scorpio Bulkers (NYSE:SALT), Safe Bulkers, Inc. (NYSE:SB), Star Bulk Carriers Corp. (NASDAQ:SBLK) and Ship Finance International Limited (NYSE:SFL).
It is widely accepted that currently the drybulk market is experiencing supply and demand disequilibrium. This was the result of too many ships being ordered prior to the 2008 crash to supply a commodity demand boom that was unsustainable in the long run. The end result was a massive amount of supply that was ordered before 2008 and being delivered as late as 2014 due to the lengthy nature of the shipbuilding process and the backlog in many shipyards that spanned several years. Thus, the available supply soon outstripped post-boom demand.
This oversupply problem has been compounded by lackluster demand growth for the dry bulk trade which eventually led to a historic lows in the leading economic indicator for the segment known as the Baltic Dry Index, or BDI.
The Baltic Dry Index, or BDI, is a composite of the Baltic Capesize, Supramax, Panamax, and Handysize indices. It is useful in determining the cost to move materials by sea.
Introduced on January 4th, 1985, at 1000 points, this economic indicator had reached a record high 11,793 on May 20th, 2008 and a record low of 290 on February 10th, 2016.
Reviewing The Cause
Knowing the root cause of this historic downturn and where we currently stand is crucial to understanding how and when it will be resolved.
As noted earlier, an oversupply of vessels has been the main culprit behind the historic downturn, and a correction on that front will be key to rebalancing toward market equilibrium.
Last year I authored an article geared towards investors unfamiliar with the shipping market called Trading And Investing In Shipping Part II: Focus On Supply Side. This article attempted to explain the reactionary nature of owners to market rates which contributes to the significant volatility in the shipping market. Of course, these orders take some time to hit the water, so conditions may be different than the period in which those orders were made.
This is exactly what happened leading up to 2008. Chinese demand for raw materials carried by dry bulk ships was nothing short of insatiable. This demand, which proved to be unsustainable in the end, created a boom for dry bulk vessels which saw rates peak in June of 2008 at $233,988. In an effort to capitalize on this environment, owners responded to this boom by ordering more ships - a lot more.
By 2009, when the boom had clearly turned to bust the orderbook for newbuilds stood at a whopping 78%.
Traditionally, 15% is seen as what is required to replace aging vessels coupled with historic demand growth.
As Chinese demand for raw materials returned to a more sustainable level many of these newbuilds that were contracted prior to the bust began to hit the water. This led to a massive oversupply of vessels for a market which was no longer experiencing that insatiable Chinese appetite for raw materials.
As more of those vessels hit the water competition became more fierce leading to lower rates which resulted in a record low for the BDI in February of 2016.
BDI 10 Year Chart
The Invisible Hand
This situation resulted in two important market driven trends.
First, low rates meant that almost all vessels were losing money. This led to the scrapping of older vessels. Overall, it comes out to basic loss projections. Which way would lose the least amount of money. Owners must now take into account time frames and projections. If the bearish time frame looks short, older vessels may keep sailing if a projected recovery means they can still make money over the long-run vs what they will lose in the short-run. However, if the bear market looks to be fairly long in duration, owners may not feel as confident that these older vessels will return to profitability in their remaining life. Even if they think they might get a couple years of recovery toward the end, would it be enough to ride out a 5 year bear market amid record low rates? Probably not.
Second, these reactionary owners did what was expected and cut orders for vessels due to this low rate environment leading to a shrinking orderbook. This thinning orderbook would eventually lead to a rebalancing of the supply side years down the road.
Currently, the vintage fleet (older than 15 years) surpasses the amount of newbuilds on order.
Overall, the vintage fleet is approximately double that of the newbuilds on order.
Many astute shipping aficionados probably will note that drybulk vessels typically have a 25 year life span so the vintage fleet could have some significant time left on the water. Normally, you would be correct.
But a recent mandate out of the IMO (International Maritime Organization) will have a significant impact on the scrapping of vessels. That mandate is the Ballast Water Management Convention and it will enter into force on September 8th, 2017
So what is the BWMC and why does it matter?
Ballast water may be taken on board by ships for stability and can contain thousands of aquatic or marine microbes, plants and animals, which are then carried across the globe. Untreated ballast water released at the ship's destination could potentially introduce a new invasive marine species. Hundreds of such invasions have already taken place, sometimes with devastating consequences for the local ecosystem.
The International Convention for the Control and Management of Ships' Ballast Water and Sediments was adopted in 2004 to introduce global regulations to control the transfer of potentially invasive species. Once the treaty enters into force, ballast water will need to be treated before it is released into a new location, so that any micro-organisms or small marine species are killed off.
Poten and Partners reported that "the prices for these systems vary depending on their type and level of sophistication, but the tanker owners that we have talked to indicate a range of $1.0 million for an MR product tanker up to $2.25 million for a VLCC (including installation) for a top of the line system."
These systems must be installed during the first dry docking following the implementation date.
Gibson Shipbrokers offered this insight: "The announcement yesterday that the Ballast Water Management Convention will finally enter into force from September 2017 will have an impact on the older ships where many may not be considered viable to retrofit in terms of costs versus age and earnings potential. In all probability, next month we will learn from the IMO the timing of the implementation of the new global sulphur cap for marine fuels. Many stakeholders believe the global maximum permissible sulphur limit on marine fuel will be 0.5% (lower limits for the ECAs) and implementation will be brought forward to 2020. Both these pieces of legislation will impact on owners in terms of the expenditure required to comply with these regulations. We believe that the impact of both directorates will enhance the prospects for increased scrapping. Once again legislation will have a huge impact of fleet numbers going forward, similar to the impact of the introduction of double hulls in the 1990's."
When this news first broke I wrote an article on the impact the BWMC would have on the tanker market, but the same holds true for almost all shipping segments. Here is a brief part of that report:
Special surveys are done at regular intervals to ensure the safe operation of vessels. However, as a ship ages, more care must be taken to ensure the integrity of a specific vessel. Remember, tankers usually have about a 20-25 year life span so as it nears the end of its life the inspection process grows more complex, expensive and time-consuming.
One of my favorite Seeking Alpha contributors, Stanislav Oleynikov, CFA, described this situation perfectly in a recent article on Nordic American Tankers, which has an aging fleet.
Mr. Oleynikov states: "When a tanker reaches 20 years, the shipowner must make significant investments to undergo the special survey required to continue using the vessel. If the market is weak and is not expected to rebound during the next year, such investment does not make sense. In 2.5 years, another significant investment will be required. That is why, it is economically better to scrap the vessel."
Costs become increasingly prohibitive, especially in a low rate environment which we are experiencing now. But adding to the decision to scrap in the short run is a bump in prices for demo candidates.
Intermodal noted in its week 36 report that "vessel demo candidates keep flooding Indian subcontinent region and prices offered across the board keep climbing at a rather impressive pace for yet another week, the demolition market is currently witnessing a rather unexpected performance compared to the one most of us expected up until very recently. Although we still think that this is not a rally that can last for too long as fundamentals have not materially changed in such a short period of time, it seems that a few things have been supporting the market lately. From one side local scrap steel prices in the Indian subcontinent seem to have brought back the appetite of breakers in the region, while at the same time it seems that part of the demand might have been in place all this time but was kept on the sidelines up until a more clear direction was taken by the market. Either or, the surge in prices is more than welcome by those owners determined to scrap and it seems that many of them are taking advantage this window of opportunity before the rally stalls."
It stands to reason that those owners facing special surveys amid low rate environments may want to take advantage of this unexpected increase in demo prices especially as they face further costs in the form of retrofitting ships for the soon to be implemented Ballast Water Convention agreement which has now been adopted by several prominent nations.
It is noteworthy that demo rates are slightly more attractive now then when I wrote this back in September of 2016.
While much of the very old tonnage has already been removed from the global dry bulk fleet, given the high costs of surveys, the expense of Ballast Water Management installation, and the continuing low rates we should see for a couple more years, it is likely we will see a wave of demolitions as we head toward this implementation date and beyond.
Additionally, the IMO has implemented new sulfur emissions guidelines which call for a move to 0.5% sulfur content bunker fuel from 3.5%. This goes into effect in 2020. So while this isn't an issue that must be addressed immediately it will still factor into an owners decision to scrap or spend money on a aging vessel for the BWMC.
In short, the reduction from 3.5% sulfur to 0.5% could mean significant cost increases for bunker fuel. Estimates place the potential impact anywhere from 44% to a 100% price increase.
But those estimates are based on traditional pricing. With demand side dynamics being severely altered there is the potential that refiners may face extreme difficulty in meeting the demand.
Furthermore, while major bunker centers like Singapore and Fujairah will be able to supply 0.5% sulfur fuel oil, smaller ports may not have the infrastructure and blending components which could create a shortage.
Of course, a demand shortage, whether from port availability or refining capacity, will inevitably impact prices.
Depending on the type of vessel, bunker costs compose anywhere from 40% to 70% of total 'on the water' operating expenses.
Three more quick points.
First, we must all acknowledge the discounting nature of the stock market which often moves ahead of fundamental shifts in actual markets.
Second, we must take into consideration seasonal demand by the Chinese market which is the largest market for dry bulk vessels. Typically that market sees a soft spot right around Chinese New Year.
Source: Allied Shipping Research
Third, the futures market for dry bulk shows a recovery picking up as the year moves on as well as into 2018 and 2019.
Over the past years that I have been covering shipping on Seeking Alpha I have been an absolute bear with regard to the drybulk market. But my tune may be slowly changing for a variety of reasons.
The orderbook is thinning, contracting for newbuilds remains practically non-existent, and mandates are set to take hold which should accelerate scrapping. This should lead to a rebalancing of the fleet.
Though let's be honest about where we stand right now. I estimate the market is still approximately 20% oversupplied and it will take some time for that to work out. This situation isn't going to correct overnight. But the good news is that a correction appears to be on the horizon and I am able to forecast, for the first time in years, that a recovery may be setting up in the long-run.
What we need is for owners to refrain from newbuild orders and scrap vintage tonnage in advance of these mandates. The degree of both will have a direct impact on the speed and magnitude of a potential recovery.
Once again, this is a long-run outlook which will take several months or perhaps a year to begin to come to fruition.
Thank you for reading and I welcome all questions/comments.
If you would like to stay up to date on my latest analysis, I invite you to follow me on Seeking Alpha (click the "Follow" button next to my profile picture at the top) as I continue to cover all aspects of maritime trade.
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