Why The Bull Market In Container Shipping Will Continue

Summary

• Container shipping rates have been soaring and stock prices for companies have been rocketing upwards - creating many multi-baggers along the way.
• The demand side deserves some credit but the bull market roots can be traced back to a supply-side outlook that has correctly been forecasting a tighter market.
• Here we examine the supply side in depth, as it typically shapes the medium to longer-term markets, in an effort to understand why this bull market has staying power.
• I do much more than just articles at Value Investor's Edge: Members get access to model portfolios, regular updates, a chat room, and more. Get started today »

Note: This report was originally published on January 23, 2021, on Value Investor's Edge. This report covers the supply-side for container shipping which is relevant to US-listed, including Costamare (CMRE), Capital Product Partners (CPLP), Danaos (DAC), Global Ship Lease (GSL), MPC Container (OTCPK:MPZZF), Navios Maritime Containers (NMCI) and Zim Integrated Shipping (ZIM). The full container shipping demand-side outlook is available on VIE, which compliments this particular report.

Overview

Before 2020 we had been discussing the potential for a bull run in the small to midsized container shipping segment as capacity additions were set to fall below levels needed for vessel replacement and trade expansion.

But as the pandemic set in, and demand destruction at the onset became apparent, container rates fell across the board. As the new 'pandemic economy' emerged over the summer it became clear that demand for services, travel and leisure were being replaced by finished goods, leading to a rebound in container traffic and rates.

This goes on to explain the chart below which saw freight rates tumble at the onset only to see a demand-driven return toward the end of the year.

Source: Clarksons SIN

This rebound is even more impressive when put in perspective.

Source: Clarksons SIN

Notice in the chart above we see not only the steady improvement since spring of 2017 but also at the start of 2020 we were already at highs not seen in almost a decade.

The improvement witnessed from 2017 through 2019 was the result of fairly average trade growth (3.63% average annual cargo mile demand growth for those years) coupled with a tightening supply side, specifically in the small to mid classes.

2021 will likely see a continuation of this trend as I am forecasting approximately 3% net capacity growth against a 5.5% increase in cargo mile demand.

This not only presents the largest gap between the two market dynamics in several years, but it comes at a radically different point than previous gaps this decade as a long-standing supply glut has now successfully morphed into a structurally healthier market with much tighter vessel availability.

Finally, it's important to note that the incoming vessel supply will continue to be unevenly distributed, continuing to favor the small to midsized classes in 2021.

Supply - ULCVs

The vast majority of capacity additions in 2021 will again be in the Ultra Large Container Vessel class which accounts for everything 15,000 TEU and up.

Source: Data Courtesy of VesselsValue - Chart by Value Investor's Edge

With 179 ULCVs currently on the water, the 25 expected vessels represent nearly 14% gross fleet growth. This is a large supply increase for the Asia/Euro route, the primary trade lane for these vessels.

Source: VesselsValue - ULCV Fleet Position on January 20, 2021

However, these ULCV deliveries represent less than 2% total capacity growth for the entire container fleet, which is why this vessel influx will present a greater challenge to this specific class relative to the fleet as a whole.

The first of these vessels was built in 2006, meaning there are still zero demolition prospects for this class for at least another decade and gross fleet growth will likely translate into net fleet growth.

These vessels were built with an expected lifespan of approximately 25 years, meaning we are looking at next decade before we can seriously begin to talk about demolition potential here.

While slippage played a large role in reducing 2020's deliveries it will likely be substantially less in 2021 with 21 of those 25 deliveries expected before Q4 begins.

2020 newbuild orders remained relatively subdued right up till October and November which witnessed 13 new orders. The addition of these contracts led to a thicker orderbook than at the start of the year as total of 21 orders were placed vs. 18 vessels delivered.

One bright spot is that the rising container shipping tide has really started to lift all boats with regard to asset values. Since the start of 2020 we have seen an approximate 10% increase in ULCV values for 10-year-old vessels, according to VesselsValue.

While that is welcome news for owners of these vessels it pales in comparison to the near 100% gain witnessed by the midsized Panamax class for a 10-year-old vessel, proving once again that the smaller to midsized vessels are in a much better position.

Now, some might recognize this as a quicker than usual recap for the ULCV class than previous reports. The simple reason is that market shifts specifically related to this class will be playing less of a role in the overall fortunes of the container market as we move further from the supply influx which peaked in 2018/2019. Furthermore, it means the cascading we have seen in the past continues to dissipate. This has allowed the markets for specific classes to align along current market structures without downward pressure from cascading.

For those reasons our time will be better spent on the mid to smaller classes, which will play an ever increasing role in dictating the overall mood of the container market.

Panamaxes

From 3,000 to 15,000 TEUs the Panamax, Post-Panamax, and New-Panamax classes all appear to be in the sweet spot in terms of market rates as of late.

Source: Harpex

The five-year chart above should put into perspective just how strong these latest rates are, but also the strength heading into the pandemic, which again reflects the tightening market heading into 2020.

Below are the orderbooks for the three vessel classes, which we will soon look at as a whole to get a better idea for the capacity introduction ahead across this broad playing field.

Source: Data Courtesy of VesselsValue - Chart by Value Investor's Edge

The New-Panamax class, which runs from about 10,075-15,000 TEUs continues to see its orderbook shrink, down by over 2% since our previous August 2020 report. Deliveries strongly outpaced orders in 2020 and the latter could have been zero, if not for five contracts placed in December.

That same newbuild ordering trend held true for the Post-Panamax class as the only eight orders inked in 2020 came in the month of December as well.

The Panamax class also saw its first new vessel orders placed since 2013, with a total of five vessels contracted in the month of November - which means the orderbook exists once more, albeit at just 0.7%. Nevertheless, it's noteworthy to see investment enter this space once again especially as it does have the oldest average age among all classes indicating the need for replacement tonnage at a relatively greater rate.

The three classes combined have a total of 16,012,413 TEUs on the water as of January 20, 2021. Their combined orderbook totals 783,520 TEUs or just 4.9%.

For 2021, we are expecting gross capacity additions of 482,908 TEUs, representing just 3%. Remember, this is gross which doesn't take into account slippage and demolitions.

Between the classes there are 190 vessels aged 20 years or older.

Source: VesselsValue

But the number of vessels actually hides the much smaller capacity reduction potential, as the larger New-Panamax class saw the very first vessels hit the water in 2006 leaving the Panamax and Post-Panamax class to account for any possible retirements in the near future.

The average age for demolitions fluctuates with the market, typically adjusting to current market conditions coupled with future expectations.

Source: Clarksons SIN

Notice in the chart above we are currently just under the 24-year mark for the average age. But also take into account how the average age has been steadily increasing as the market recovery gained momentum starting in 2017.

Given the recent market strength we anticipate the average age for demolitions to continue to rise. Nevertheless, there are still some candidates in 2021 as the average age for Post-Panamaxes is 12 years and 14.4 for Panamaxes.

Source: Data Courtesy of VesselsValue - Chart by Value Investor's Edge

While waning demos may be a consequence of an improving market, a very welcome benefit comes in the form of improving asset values.

Earlier we noted the approximate 100% increase in Panamax values as of late but prices still are languishing in comparison to past markets.

Source: Clarksons SIN

These asset values have been backed up by a flurry of market activity centering around these vessels.

Source: VesselsValue

As many know, S&P (Sale & Purchase) activity is a way owners place their bets regarding future markets, and these last few months would indicate that owners are turning bullish on these small to midsized classes.

Small Classes

The Sub-Panamax, handy and feeder vessels all fall into this last category with vessel sizes ranging from 500 to 2,999 TEUs.

Though we typically find slippage to be more prevalent among the larger classes, this past year we saw high degrees of slippage for the Sub-Panamax class as well as the feeder class, leading to 2021's slightly heavier delivery schedule than previously anticipated.

Source: Data Courtesy of VesselsValue - Chart by Value Investor's Edge

In the charts above, readers likely spotted the 65 vessels expected in the Sub-Panamax class as well as the 44 in the feedermax class since they present a pretty strong departure from previous trends.

But the market was already looking pretty tight for these particular classes as evidenced by the miniscule number of idle vessels.

Source: Clarksons SIN

This relatively small influx should do very little in the way of disrupting the stronger and established market trend.

Source: Clarksons SIN

Before we move on readers might want to note the inverse correlation between charter rates and idle vessels, which is easy to see when comparing the two charts above.

Finally, since we're talking charts, note how demolition trends were influenced by the market over the course of 2020, showing a direct correlation to idle vessels.

Source: Clarksons SIN

Getting back on track, it's important to note that these low numbers of idle vessels come as the 3,000 and under fleet reversed a long established trend of a shrinking fleet.

Source: Clarksons SIN

The once shrinking fleet was due to the impact of the Great Recession followed by a massive supply influx of larger vessels which cascaded down to the smaller classes.

Side Note: A quick trip to the demand side before we continue as it seems like an opportune time to introduce this tidbit; below we see the impact of that cascading on cargo miles for the three classes as a whole. But as that cascading wanes cargo miles have stabilized and are even growing again as this past December's totals were higher than the previous four years.

Source: VesselsValue - Sub-Panamax, Handy, and Feeder Containers

While 2021 is likely to add to the fleet size, 2022 and beyond are in question as newbuild orders remain slow and the prospect of negative fleet growth again surfaces.

Source: Clarksons SIN

2019 had been the slowest newbuild contracting year in quite some time, but 2020 eclipsed that in a very big way. The chart above brings us up to speed for 2021 as no new orders have surfaced yet for any of these classes.

It's noteworthy that this particular scenario, a slow year for newbuild contracting coupled with expected high deliveries, could lead to the orderbook to shrink even further over the course of 2021.

That would keep gross fleet growth in check and with a fair amount of demolition candidates moving forward this should keep net fleet growth at a favorable figure, even for the Sub-Panamax class.

Source: VesselsValue

Approximately 24% of the fleet is now 20 years old or older. Remember, incoming replacements only number 175 vessels and with 2,629 vessels on the water, that breaks down to a very thin combined orderbook of just 6.7%.

With 23-24 years being a historically fair average to use for demolition ages we can see that this older fleet will need to see newbuild orders pick up or they will see a significantly tighter market in the medium to long run.

Source: Clarksons SIN

Asset Values

We briefly touched on asset values but it's important enough at this point to warrant its own section.

Below is the change in asset values for various container classes at fixed ages, starting from January 1, 2020 through January 19, 2021.

Source: VesselsValue - Container Fixed Age Values January 1, 2020, through January 19, 2021

Note to beginners: This chart can also serve as a reference to the approximate TEU size (in black italics) for the class names I use, hopefully making this report easier to digest.

The rise in vessel prices has a consequent impact on a company's Net Asset Value, or NAV, which is a key valuation gauge in determining stock prices for some analysts.

Therefore, the rise in charter rates (what these vessels earn) coupled with the rise in NAV (what these vessels are worth) are the two key metrics responsible for the recent stock price rally.

But as shipping aficionados know, asset values typically lag behind market rate shifts.

Source: Clarksons SIN

This particular class was selected for the chart above as it's among the largest sizes to be involved in the last full market cycle with 10-year-old vessels on the water at the time, but also because it was the one to already experience a near 100% rate increase.

If history is a guide, and it often is with shipping cycles, even taking into account that significant increase over the past year we appear poised for further gains in 2021 as asset values play catch-up to this recent rate spike.

History also shows that during extreme market shifts, older vessels typically see the greatest movement in asset value as their remaining life is tied more closely to current and near-term markets.

Therefore, as the market improves and owners look for a way to capitalize, two main strategies come to mind, having the most tonnage on the water to capitalize on current charter rates for free cash flow and purchasing targeted tonnage and seeing the value appreciate which would add to NAV.

This investment dynamic will be part of the reason why newbuild activity should remain subdued, especially relative to S&P activity, for a time even as the market continues to exhibit improvement.

Newbuilding

The longer we continue to see this low newbuild contracting environment, the greater the intensity of newbuild orders needed to upset the future market.

Not only are we very far along this path already, but there is little impetus to shift the market.

Source: Clarksons SIN

In fact, there are market forces conspiring to keep these orders low such as a lack of PE/investor interest in shipping, banks shy about extending credit to shipping companies, and smaller companies which often own smaller ships suffering the brunt of woes surrounding the 2016 bear market and have yet to fully see their balance sheets recover.

But perhaps the most discouraging factor regarding newbuild ordering has been the prospect of IMO 2030 for these energy (load) intensive vessels. Containerships often have the heaviest consumption of bunker fuel per nautical mile traveled, making any sort of clarity regarding future environmental regulations (what fuel will be used, how, and any sort of pollution mitigation devices needed, etc.) more important to this segment as opposed to any other.

Upon gaining clarity regarding IMO 2030 we expect some newbuild orders to materialize, but given the years of drought it would take a torrential downpour of orders to really upset the longer-term outlook for these medium to smaller classes.

Furthermore, given the decreasing yard capacity all over the globe, any onslaught of orders brought on by IMO 2030 clarity would likely be accompanied by orders for other classes and segments, forcing the completion timeline for these new orders to be spaced out in accordance with other shipbuilding demands.

Conclusion

The forecasted supply side correction in small to midsized vessels was leading to a tighter market as we entered 2020. The pandemic created a short run disruption in this part of the cycle, but the structural outlook remains intact as the economy enters the normalization phase.

In fact, an argument could be made that the longer run was likely improved as an aversion to newbuilding was sustained for several months while demolitions responded to the short-term rate environment.

Source: Clarksons SIN

This reactionary demolition activity permanently removed 'on the water' tonnage beyond what would have typically happened in a normal market. Additionally, lack of newbuild activity translates into a similar removal years from now for tonnage that will never come to be, or was at least pushed back by a year or two.

In this regard, the short-term shock of the pandemic likely had some longer-term impacts on the supply side, meaning we are facing an even better structural supply side outlook for the smaller to midsized vessels than when we entered 2020.

Except for the ULCVs, the container segment will be benefitting again from a very manageable number of deliveries combined with adequate demolition prospects. This should continue to support the supply side driven trend of higher rates we have witnessed since Q2 of 2017.

Source: VesselsValue

Owners have jumped back in the S&P market with an eye on these classes causing asset values to rise significantly. While we saw some impressive gains in 2020, we should see further asset appreciation this year as vessel prices have likely yet to fully adjust to the recent and rapid charter rate rebound, which has led to multi-year highs. This also implies that asset values have yet to take into account 2021's projected improvement.

Newbuild activity among these classes remains subdued and if it does begin to pick up those new launches several years from now will be met with a very accommodative market thirsty for tonnage. Let's also not forget that the Post-Panamax class may not have many demolition prospects now, but just a couple years out things begin to shift pretty drastically in that class placing dozens upon dozens of these larger vessels into retirement-eligible territory.

Similar to the LPG shipping segment, the small to midsized container segments are now a few years along on their supply-side-driven market correction and (with the exception of the pandemic) things appear to be progressing as forecast. Best of all, both the LPG and container segments are now offering current confirmation of age-old shipping cycle market dynamics, providing some much-needed confidence following such horrific bear markets.

As long as these supply-side dynamics remain favorable we can expect the market to continue the current path it is on - provided the demand side holds up its end of the bargain.

Analyst’s Disclosure: I am/we are long CMRE, DAC, NMCI, ZIM. 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.