Note: This article was originally published August 9th on Value Investor's Edge, a Seeking Alpha subscription service.
Over the past few years, I have had to spill a lot of ink describing the process of a shipping market down cycle, focusing on both market forces as well as the reactionary nature of owners.
Asset values, demolitions, S&P (Sales & Purchase) activity, and newbuild ordering were all influenced in some fashion during this bear market. Other correlations were also observed between a variety of factors.
All cycles share typical traits, but there are also always exclusive ancillary factors that come into play, providing a unique twist to every up and down cycle.
During this past down cycle, I expressed my fears mid-decade that low newbuild prices would stall any first go at a recovery as owners would be lured to the shipyards instead of the S&P market.
These fears it turns out were not unfounded, as in the Capesize market, VLCCs, MR2s, and a few others we saw owners rush to the yards at the first projections of a market upturn, which actually prolonged the existing downturn by adding new tonnage.
But this time around there will be a unique twist as well. One that's not quite as easy to predict, but will almost certainly have a profound impact on asset values, newbuild ordering/prices, and perhaps just how long any bull run can be sustained before owners again become the instrument of their own misfortune.
For those new, or at least not too familiar with shipping, there is an important concept that should be reviewed. That is the role of owners, who behave in a reactionary and collective manner, which creates large supply side fluctuations.
Historically, these supply distortions in the market are often the most profound, overshadowing all but the greatest demand side shifts, and are therefore responsible for the majority of ups and downs.
Therefore, alluding to owners being the instrument of their own misfortune has a solid and long historic record. This will again play out in any bull market, but it should be noted that owners are not the only guilty party.
These boom and bust cycles are aided by the expansion and contraction of credit to shipping firms which also reacts to this cycle.
Additionally, investor interest (and tolerance) often ebbs and flows with market fortunes, making it difficult for public companies to act in a countercyclical manner.
No matter how much we point it out, the market will continue to behave in this cyclical fashion. But retail investors have the advantage of being nimble and able to act in a countercyclical manner.
Knowing when to get in for a shipping market upswing is just half the work, one must be able to spot the warning signs of when to get out.
Bull Markets, Where?
Publicly, I have produced two recent reports highlighting the structurally improving market balance for both LNG and LPG shipping segments.
These shifts were anticipated as described in both reports. This reinforces the notion that shipping markets can be predicted several months and even years ahead with a good degree of accuracy, provided the global market is not subjected to sudden economic shifts of an external nature.
Over at Value Investor's Edge, I have cited another segment with a continuously improving outlook furthering a bullish stance, while two others are showing corrective behavior with bullish potential ahead.
Why All At Once?
Shipping cycles are typically independent of one another and rarely align in such a uniform fashion across all segments. But the massive boom and bust leading up to and after the "Great Recession" created a starting point for this sort of collective cycle.
This unique factor could also play a role in the upcoming bull market according to Ioannis Zafirakis, Chief Strategy Officer & Secretary of bulk carrier operator Diana Shipping, who noted in their latest conference call:
If we are lucky enough to have a thriving tanker market or a container market at the same time, it's going to take longer for the market to go down.
This once again alludes to the reactionary nature of owners who chase markets, which he conceded to in the same call:
If people suddenly realize that there is a lack of vessels or demand is higher than what they should have expected, then everybody is going to be doing the wrong things to destroy the market. We're going to have ordering.
But turning back to why these markets collectively aligned. The economic boom leading up to 2008 led to massive demand for shipping of all types. Owners responded by ordering newbuilds to accommodate for this demand, which sadly proved to be unsustainable in the long run.
Shipyard backlogs kept fresh tonnage coming for years after the economic bust keeping shipping segments saturated with capacity.
Following the downturn, shipyards saw newbuild vessel prices plummet to some of the lowest levels in recent memory, as construction capacity was far too great for the reality of shipping's post bubble needs.
While some segments did have the prospect of a recovery mid-decade, the low newbuild prices kept a fresh flow of tonnage hitting the water.
All this finally took its toll as losses mounted over 2016, 2017, and 2018. Owners finally reacted in a positive way by curtailing newbuilds in 2017 and again this year leading to the thinnest collective orderbook in over two decades.
Additionally, newbuild prices have rebounded as excess shipyard capacity has been curtailed while M&A activity has rationalized much of the remaining major capacity.
Therefore, I expect that much of the impetus for skewed newbuild ordering has been curtailed and the market up cycle will be defined by an attraction to second hand vessels over that of newbuilds.
Second Hand Vessels
Why an attraction to second hand vessels in a market upswing?
Owners have limited capital and must allocate it in a way that provides the most accretive return over the expected duration of the investment.
During the recent period of low newbuild prices owners were subjected to a less than stellar charter market, and a longer term outlook (20-30 year life span) factored heavily into their decision on capital allocation favoring newbuilds, especially given the fire sale at shipyards.
However, currently, we are seeing rising rates YoY in several markets and a structurally improving supply/demand balance favoring an even tighter market ahead. Expectations of higher charter rates in the near term will encourage owners to pursue second hand vessels over that of newbuilds.
They will do so as they seek to place as much tonnage on the water in the near term to capitalize on the improving market - knowing full well that things can be very different when an expensive newbuild hits the water 2-3 years in the future.
This will have three significant impacts:
It will raise S&P activity by increasing second hand vessel demand prompting asset value increases.
In fact, there is a direct correlation between the strength in rates and asset values.
VesselsValue's COO, Adrian Economakis notes:
As demand and supply reach equilibrium, any positive demand shock has significant upwards effects on earnings and vessel values. (this) spike in rates causes owners to get excited and start buying secondhand vessels at higher prices.
However, it's noteworthy that newbuild values are largely left out of this rally during the early stages of an upswing, as owners favor the second hand market over shipyards.
Equally important is the fact that these same second hand assets experience declines on a greater level during market downturns, with the magnitude of that drop in value correlated to age.
It will further keep newbuild orders subdued until the S&P market is displaying exhaustion.
Historically, during times of rising rates, S&P transactions rise along with the market. However, at a certain point the S&P market slows and interest in newbuilds begins to grow. This can be attributed to a lack of candidates for sale or a simple pricing issue where the second hand market has become too hot compared to more subdued newbuild pricing.
Notice that the S&P activity building from 2000 through 2006 where it reached an acme, the same year that newbuild orders jumped and posted sustained activity until the crash in 2008/2009 as S&P activity declined.
The prospect of a market recovery was touted by some from 2012 through 2014, which led to not only a great deal of S&P activity but also led owners to shipyards to capture that aforementioned fire sale pricing. Who could blame them? After all, record charter rates were still fresh in their mind and Capesize vessels were practically half price compared to peak pricing just a couple years earlier. However, this collective action not only killed any hope of a market upswing, but led to a historic low point in the segment.
The point here is that now we have an extraordinarily young fleet across the board with ample S&P candidates.
This can actually have a very beneficial impact on maintaining the bullish impetus behind the market. As noted, the S&P market becomes exhausted either through a shortage of sale candidates and/or second hand prices becoming too high relative to newbuilds.
Having a high degree of relatively attractive S&P candidates could not only prolong activity in the second hand market, but serve to keep a lid on prices. Both would ideally inspire owners to stay clear of the shipyards for a longer period of time.
The idea could be applied across all segments in shipping as they all experienced the same recent influx of vessels to some degree.
As Ioannis Zafirakis noted earlier, having multiple good markets will hopefully inspire capital allocation in a sort of dispersed manner, as opposed to a single bull market in a segment that would therefore receive an inordinate amount of attention and investment.
It is therefore fortunate that not only do we have multiple bull markets forming but that there are ample S&P candidates in each and every one.
This sort of dispersed capital allocation in the second hand market would ideally delay the exhaustion effect and work to keep second hand prices under control, therefore prolonging the conditions behind the bullish upswing.
The high number of prime aged vessels is a unique feature about this particular market cycle and therefore presents a bit of a wildcard.
Bull markets have a tendency to distort the demolition patterns. Higher charter rates can often offset increased operating costs for an aging vessel prompting owners to keep them on the water.
There is a direct correlation between charter rates, demolition numbers, and the average age of vessels sent in for scrapping.
Notice in the chart above that as charter rates across the board continued to move up ahead of the eventual "Great Recession" so did the average age of vessels scrapped as the number retired fell. This was a direct response to charter rates where owners sought to maintain as much tonnage on the water as was economically efficient for the given market.
Additionally, notice that after the onset of the "Great Recession" the average age of demos began to fall and scrapping activity picked up considerably as charter rates experienced a significant drop across almost all segments.
Typically, an upcoming bull market would lead me to predict that scrapping trends will remain subdued, but the 2020 Sulfur Cap has thrown an interesting twist into the mix.
2020 Sulfur Cap
The 2020 Sulfur Cap is expected to increase retirements as older vessels face increasing bunker costs, which might not be sustainable even with higher charter rates.
I maintain that the degree of retirements induced by this mandate will be directly related to the cost of bunker fuel and older vessel maintenance balanced against any rise (or fall) in charter rates.
Scrubber investments on older vessels are not typically deemed economically viable or of the highest importance, so many will be running on more expensive 0.5% sulfur bunkers, which are more expensive.
Normally, the rise and fall in charter rates would be enough to shift demolition patterns, but the addition of increased bunker costs throws a major unknown into the mix.
Bunker rate increases have also been cited in potentially promoting slow steaming, which if even by a knot collectively would have a material impact on the market.
So, one main question surrounding this issue centers around bunker price.
In their Q2 2019 Earnings Conference Call, Anastasios Margaronis, President of DSX stated:
We're led to the conclusion that there will be plentiful supply of low-sulfur fuel available around the world from January next year onwards.
He opined that eventually the market would see a reduction in the price differential between high and low-sulfur fuel.
This falls in line with my position that disruptions will be minimal. Astronomical price gaps will not materialize, or if they do will be shortlived and likely regional in nature. Arbitrage traders have been gearing up for this shift months ahead of time and will opportunistically pounce ensuring market efficiency. Ample product (cited above by Mr. Margaronis) will ensure these trades are carried out quickly.
Additionally, the constant downward revisions of global crude demand by both the IEA and EIA , courtesy of the slowing global economy, look to provide more feedstock than previous anticipated for IMO 2020's needs.
Remember, it was just last year when Morgan Stanley predicted $90 crude due to the 2020 Sulfur Cap. Now we see estimates of $30 crude out of BoAML with the start of the mandate right around the corner. This will likely serve to keep a lid on bunker prices as there is a direct correlation between the two.
Source: Ship & Bunker
The Red line indicates MGO prices, while the other shows Brent prices. Yes, there may be a disconnect due to the demand shift, with MGO tracking higher than historical averages for a bit, but the correlation cannot be ignored.
Prior to the oil price crash in late 2014 and 2015, or HSFO, was trading upwards of $600/ton. Looking over bunker price fluctuations since the beginning of the decade, I could find very little correlation between demolition activity and bunker price spreads, though admittedly there was quite a bit of white noise to tune out when sifting through this data as demolitions have proven correlations to other factors.
Nevertheless, HFO bunker prices of $600 did not appear to materially influence demolition patterns and these prices were taking place in a less than ideal rate environment for many segments.
As of August 2, Ship & Bunker's Global Ports Average for MGO shows a price of $637/ton. Since OPEC began curtailing output in 2017, MGO prices have ranged between $786/ton and $493/ton, for a spread of $293/ton. The average price over that time has been $626.5/ton.
Current MGO prices are not that far off from previously high HFO prices just a few years ago, which did not bring about a significant increase in retirements.
But as noted, MGO prices are expected to increase due to an expected demand shift.
This brings into focus a timeline which all owners must consider when scrapping their vessel based on the 2020 outlook. First, to what degree will prices rise? Second, how long will they stay elevated?
If you are like Mr. Margaronis and believe there will be no shortage of compliant fuels, then the first question is answered and the second one is moot.
However, if you are like me and see the potential for disruptions, albeit on a very minimal scale compared to what many have proposed, there will be a price increase at the onset. Turing to the second part of the question, refiners are notorious for chasing margins, and they will seek to capitalize on the situation in a number of very clever fashions. Many have already made adequate preparations to do so. Therefore, I see it as a temporary situation which will be resolved in a matter of months on a global scale.
As noted above, less than ideal rates were seen during the previous cycle of high oil and bunker prices.
Heading into 2020, many segments are expected to have a significantly better outlook aided by a very thin orderbook, which is roughly half the size of 2014's.
Higher charter rates will have an offsetting impact for bunker price increases when it comes to demolitions. In fact, the correlation between demolitions and charter rates is a demonstrable fact, while the correlation between bunker prices and demolitions (over the period studied), has proven inconclusive. Therefore, charter rate moves and forecasts would seem to have a more meaningful impact on demolitions.
Remember, this discussion is set against a backdrop of potentially lower crude prices as well.
But, What If?
The above reasoning holds only if we avoid a massive shock to bunker prices. If we do see a massive spike, of say over $1,000/ton, it would likely produce a level of retirements and slow steaming at the onset much greater than anticipated.
However, this would alter the vessel supply balance and contribute to material higher charter rates.
This direct correlation isn't lost on owners, and many will likely not want to be the first mover in terms of scrapping. There is no real benefit to being an early mover unless you are bleeding red or if you expect scrap prices to fall from a wave of demolitions.
Furthermore, owners must take into consideration timelines once again. If they do find themselves temporarily in the red with older vessels, will an improving rate environment coupled with expectations of lower future MGO prices be enough for them to push off demolitions for a bit to see how the market unfolds? Unless they are in dire straits, it might be tough call to scrap a vessel that could be profitable in the near future.
Rising Asset Values Vs. Demos
Several segments have seen solid year over year improvements through the first half of 2019, and with that comes a corresponding rise in asset values.
In two charts above we showed the correlation between rates and a five year old asset which closely traced each other due to the ability to immediately capitalize on a current market with an "on the water" asset.
Earlier we also talked about how newbuilds lagged in price gains compared to on the water assets during bull cycles, not only because they would fail to capture some of the bullish upswing, but also because of market uncertainty surrounding a possible 2-3 year build time.
Now, here is another correlation that some may find interesting, and could be prohibitive to demolitions if rates continue to show improvement.
Asset values (outside of the value for recycling) for much older vessels are solely dictated by short term market forces. Their few remaining years are locked into whatever market they may find themselves left with.
Younger vessels see more conservative asset value shifts based on the long term expected averaging, which insulates them from short-term markets to a greater degree.
The point is that a short term bull market could inspire owners considering demolitions to test the S&P market. Why? That new owner buying the vessel, knowing that he at least has the security of the demolition value behind the vessel, might be more than happy to risk a small additional sum for this vintage ship in an attempt to capture some market strength over the foreseeable future. Once the market fades the vessel is retired and demo value collected.
The strength of a market often inspires owners to bid up these vintage assets to a greater degree, as they represent a way to risk less capital with a fairly established resale price to scrap yards.
It may already be happening to a degree.
The above chart shows the S&P market for VLCCs. The selection of VLCCs was intentional as they were cited by more than one analyst at the onset of the 2020 Sulfur Cap to see a wave of demolitions with practically nothing above 15 years old spared.
Yet, owners seem to have a different opinion and are placing their money where their mouth is with a clear focus on vintage tonnage, with many in the 15 year old and greater age group.
In fact, the latest sale of the Nave Electron shows an interesting trend in terms of asset to demo values.
Notice the divergence between demo and asset prices, indicating increasing optimism regarding a strengthening market in the near term.
Could this purchase simply be an attempt to capitalize on another expected strong Q4 before being sent to the scrapyard? Perhaps, but, notice that this latest sale came in well above demo value (around $9.5 million), indicating this is likely an investment over the coming years, and not one season.
Playing into the boom and bust cycles is the expansion and contraction of credit for industry players.
Recent years have seen historic bear markets, unprecedented bankruptcies, government bailouts, life-saving consolidation, and plummeting share prices dominate shipping headlines.
Asset values suffered along with charter rates forcing reassessments of LTVs and other covenants for some companies.
Private equity fled, credit dried up, and a recent wave of shipping analyst dismissals from major firms that historically covered the industry have all been the reaction.
The historic degree of market capitulation ushered in an unprecedented reaction from creditors and investors - a collective aversion to all things shipping on a magnitude which matched the downturn.
This will play into the next shipping cycle.
Tepid newbuild orders have been attributed to, among other things, this contraction of credit.
This isn't a problem that will be corrected overnight. The degree of market capitulation is not only correlated to the contraction in credit, but likely determines a timeline for risk appetite to return by those extending the credit.
Therefore, during a potential near term upcycle, creditors will likely begin apprehensively re-approaching the market with a more discriminating eye leading to a potentially slower growth in the collective orderbook.
This could also play into the S&P market, as credit is needed for these purchases as well. If S&P sales proceed at a slower clip because of the rightfully more circumspect approach from lenders this reduced S&P demand could play into keeping asset values relatively at bay - as activity would be muted compared to a normal market.
VesselsValue's COO Adrian Economakis provides this insight:
This clear cyclicality is what the most successful owners bet on to outperform the market. Average returns in shipping are fairly low, especially versus risk profile. Therefore, owners know that timing is everything and make their exceptional returns by buying near the bottom of the cycle and selling near the top. This can be as simple as buying when values are in the lowest observed quartile of valuations and selling in the highest. However, the trick here is finding the money to buy in bad markets, as that is when most lending has disappeared. Ironically, lending tends to appear again in high markets, exactly when owners should be selling and not buying.
That final statement plays perfectly into how almost all bull shipping cycles are eventually destroyed. Too much credit extended to reactionary owners who chase markets and eventually put too much tonnage on the water, becoming the instruments of their own misfortune.
Second hand asset purchases put no new tonnage on the water, therefore transactions there are neutral as "on the water" vessel supply remains the same.
As noted, after the second hand market is exhausted, owners turn to shipyards, However, the bull cycle has been gaining intensity at this point. Investors are cheering, creditors are smiling again, and shipyards begin signing deals on a large scale once more.
However, as these newbuilds begin hitting the water, we see net fleet growth begin to grow. Once net fleet growth begins to exceed ton mile demand growth, we see that negative impact on charter rates.
While owners may back off ordering at that point sensing a contraction, it is too late. The orderbook is set years ahead and the market will inevitably feel the reverberations from the all to typical reactionary behavior of industry players, as another bear market cycle sets in.
The proper way to prepare for this cyclical industry is through countercyclical behavior. But the nature of the beast makes that easier said than done.
Learning the various stages and their impacts on different aspects of the market provides a significant advantage for anyone participating in this industry, from the CEO to the average retail investor.
While these cycles share similar traits there are unique aspects to each one. This particular cycle will be defined by an ample number of young to middle aged vessels, collective and relatively uniform cyclical behavior by several segments, and the onset of the 2020 Sulfur Cap.
How these factors interact with the market will be interesting to watch, but inevitably our eyes will turn to the orderbook in an effort to seek out signs of impending oversupply, and consequently the next peak in the cycle.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.