Drybulk Fundamentals Remain Healthy

Includes: DRYS, GDOCF
by: Kristian Rasberg

The recent slide in stock prices have left many investors worried about the real strength in the drivers behind the latest year's surge in drybulk rates. In the following article we will look behind the daily stock movements, trying to explain the long-term fundamentals of the drybulk business.

Of the total seaborne trade, drybulk sums up to 36% (2,800 million tons), making it the second largest after the liquid bulk cargoes (38%). The major drybulks consisting of commodities such as iron ore, steam coal and grain.

The Drybulk Fleet

Capesizes are typically around 175,000 deadweight tons (dwt), although both smaller and larger sizes are commonly refered to as capesize. The term is used to describe a vessel that must sail around the capes, instead of using the canals. In this article a capesize will be known as above 100,000 dwt.

The panamax vessel (60-99,999 dwt) is dimensioned to sail through the Panama Canal. In drybulk terms the panamax vessel's trading pattern makes a canal route seldom. Fully loaded one might even experience the panamax to be too deep-draught for the canal.

Smaller sized vessels are known as supramaxes (40-59,999 dwt) and handysizes (10-39,999 dwt). They are more flexible regarding to cargoes, and may carry both major and minor bulks. The smaller sizes are also less deep-draughted, and may enter more shallow water than the bigger tonnage.

The existing fleet sums up to 390 million dwt. In percent of dwt 34% are capesizes, 28% panamaxes, 19% supramaxes and 19% handysizes.

The Drybulk Orderbook

There are currently around 210m dwt in order, though reports are somewhat conflicting the 200-220m dwt range seems likely. This is an astonishing number, and correspond to 54% of the drybulk fleet. 75% of the dwt in order are capesize and panamax vessels. Let us look closer on when these vessels are expected to be delivered:

This year 55 capesizes (10m dwt) are scheduled for delivery, wich adds on to a total capesize fleet of 760 vessels. In 2009 another 23m dwt (130 capesizes) are expected to be delivered, mainly in the second half of the year. And in 2010 there are currently 50m dwt in order, wich is about 285 capesizes. The rest (33m dwt) are scheduled for 2011 and 2012, making the total orderbook 90% of todays capesize fleet.

On the panamax side there are 44m dwt in order for 2008-2012, wich is about 40% of the current fleet of 1475 vessels. 95 panamax vessels (7m dwt) are expected to be delivered in 2008, and another 11m dwt will take place in 2009. As for the capesize orderbook, 2010 is the year for newbuilds, were 16m dwt of panamax tonnage are due for delivery. In 2011 and 2012 another 10m dwt will be delivered, making the total orderbook about 585 panamax vessels.

Too Big Supply Side?

There have been contracted several newbuilds the last year, and the orderbook stands at historical high levels. However the total fleet is growing older, and this is a key factor when looking at the orderbook.

In short 30% of the drybulk fleet is above 20 years, and 15% above 25 years today. 18% of the current capesize fleet is above 20 years (140 vessels), and in 2010 there will be 105 capesizes above 25 years. 22% of the panamax fleet is above 20 years (325 vessels), and an estimated 245 vessels will be above 25 years in 2010. Major charterers are already cautious about taking tonnage aged 20 years, and one may witness major scrapping if rates come tumbling down. This will be a buffer for the freight market when trouble happens. These older vessels experience much more down time in ports than modern tonnage, and they are increasingly expensive due to surveys.

In 2007, China passed South Korea as the largest shipbuilder in the world. A great deal of the Chinese orders have been placed at so-called virgin yards. Many of these yards have not even been built yet, and some are even struggling to get financed. That is the matter of both the yards and the new building contracts, and it is estimated that 68% of the orders still lack financing. One might see that the credit crunch will cut down on financing, or make this very expensive for some owners.

Subcontractors are already experiencing much pressure, and in 2007 about 15% of the orders were delayed because of this. The key question is whether subcontractors can pick up their production fivefold in two years just time too meet yards expectations. Already today motors and hatch covers are very sought-after parts. The situation is likely to be deteriorating the next couple of years.

Orderbooks have been increasing dramatically not only in the drybulk sector, but for the tanker, container and rig sector as well. This has already resulted in an international crew crisis, were the lack of experienced officers are precarious. For the operators this seems to be the biggest challenge going forward.

The Steel Industry

The steel industry is by far the largest driver of drybulk, demanding both steam coal and iron ore, which sums up to about half of the total drybulk trade. The iron ore demand into China have been growing stronger for every year. From 75mt in 2000 it reached about 380mt in 2007, having beated the forecasts year after year. For 2008 the expectations are 450mt, wich is up 100mt from the 2008 estimates made in 2005. By 2010 the current estimates range between 550 to 600 million tonnes of iron ore into China. Looking at the four largest iron ore producers a production increase of 100% from 2006 to 2010/11 is expected to take place.

Can the historical growth in steel demand really be sustained? The urbanization of China, India and the Middle-East leads to increasing per capita consumption of steel. South Korea and Japan being at 1.3t and 0.9t per urbanised capita respectively. India and China are currently at 0.15t and 0.6t, despite China being the largest steel producer. The Chinese steel production has grown with 15% annually for the last 12 years, with an increased pace for the last five years. From 100mt in 1996 the 2007 steel production reached about 450mt. This is ten times the production witnessed in India, though production is picking up there as well. Even if the pace should increase less than recently, the added volume will still grow at historical levels. The world steel production is expected to grow from todays level of 1,200mt to reach 1,485mt in 2010. Asia accounting for 860mt of this production, and the US at todays level of 135mt. The main steel consumption is also expected to take place in the emerging markets. For 2008 about 60% of the steel demand will come from Asia.

Increasing Coal Demand

Chinese coal-fired power plants have been adding to the upside in drybulk demand growth. The biggest coal plant in China, situated in the Zhejiang Province, needs 12mt of coal per year. China is expected to build 500 coal-fired plants the next 10 years. This will require 400mt of coal per year in addition to todays level. The fact China becoming a net importer early in 2007, much of this increase will have to come from distant sources. However the Chinese are trying to increase their own coal production, but this has to be shipped as well. 75% of the Chinese coastal trade relates to coal transport. This trade is growing fast, and is estimated to need 75m dwt in additional tonnage within 2010. This equals to 100 panamaxes, or about 17% of the global panamax orderbook.

In the recent years coal have become significantly cheaper than oil per kwh. Even when including cost of transport, coal is about 0,4 per kwh versus oil. In Japan one has even witnessed a swap from uranium to coal. Many of these power plants can be fired on several commodities, and one may expect more coal-fired plants to be built in the future.

New Trading Patterns

Much of the recent increase in demand for tonnage is a consequence of a changed trading pattern for some of the key commodities. The main driver has been taxations on Indian iron ore, forcing China to import bigger volumes from Australian and especially from Brazil. The increased distance every tonne has to be transported, has lead to a dramatic increase in tonne-mile demand. Tonne-mile increased an estimated 8% last year, and the trend is expected to continue as more iron ore and coal needs to be shipped from increasingly distant sources.

Australia is still the biggest exporter, accounting for 127mt into China and 109mt to other Asia. Iron ore from Brazil to China is currently 80mt and 53mt for other Asia, and have been increasing dramatically the last years. On the top of this China becoming a net importer of coal, with the surrounding countries coal exports in decline. Australian coal miners are experiencing capacity pressure, and a larger part may come from South Africa or even the US. When these increased sailing distances are added up, the effect on drybulk rates are significant though hard to estimate.

The increased demand for commodities have lead to higher congestion in the ports. Currently there are 150 drybulk vessels waiting outside Australian ports, 60 of these are capesize vessels. In most cases the owners are being paid by the charterers despite of this congestion. The rates have been positive influence by these problems, since a larger part of the fleet is retracted from the market. Though trying for years to expand ports, little has changed. One might wonder what will happen if the orderbook is released into this market, only increasing congestion overall. As long as there is lacking infrastructure to the ports, it does not matter how many more vessels entering the market. They will all end up in a vessel queue waiting.

The Drybulk Stocks

How much is anticipated in the stocks at current levels? The latest slide in the stocks can mainly be attributed to the sharp fall in the freight derivatives market [FFA]. This is the traded forward rates, commonly used for hedging physical positions (e.g. spot vessels). The fall in the FFAs have been up to 25% short term, triggered by port repairs and miners pulling back cargoes. On top of this the annual iron ore price negotiations have lead to increased volatility in the markets. FFAs have mostly been in backwardation the recent years, indicating that rates will come down. This has not been the case, and rather the oppsite has taken place. In June of 2007 the panamax 2008 forward rate was traded around $32,000, today the actual panamax rate being $62,000 on average. Today the panamax 2009 forward rate is traded around $36,000. A further fall in the rates is already priced into the shares, with forwards even lower in 2010 and 2011. It is this highly inaccurate market that in large influence the short term movements in the stock market.

An important fact is the disconnect between actual physical rates and the forward rates. Comparing the time charters (T/C) to the FFA market there is often a 25% discount to actual rates. One might get $60,000 for a two year T/C in the panamax market, but the average panamax forward rate for the same period is only $45,000. How long can the stock market ignore actual earnings?

Much of the slide in stock prices may have to do with the fear of US entering into a recession. When looking at the larger macro picture concerning steel prices, iron ore and coal shipments, one will discover that the US only accounts for 10% of drybulk demand if not less. As a result of the decrease in cargoes short term, the BDI has come off its highs as well. This rate index is purely based on todays situation. One needs to look at each specific commodity, and what is likely to be taking place at the supply and demand side. As we have seen above the picture is still bright, but short term volatility must be expected at todays fleet utilisation.

Many of the drybulk stocks are also trading below their Net Asset Value [NAV]. Though rates have come a bit off lately, the vessel values are still firm and supported by the steel price and T/C rates. A conservative three year time charter rate still gives 18% annual return for a five year old panamax (market price), and 22% for capesizes using the same variables (both unleveraged). If leveraged the return will be even greater. Let us take a look at two different drybulk companies:

DryShips Inc. (NASDAQ:DRYS)

DryShips owns five capesizes, 29 panamaxes, two supramaxes and eight newbuilds to be delivered the next two years. The company have a Net Asset Value of $73.3 per stock based on the current market value of the fleet. The newbuilds may rise further in value when closer to delivery.

The CEO and main stockholder, George Economou, is spot oriented with currently 75% of the 2008 capacity in the spot market. The time charters are mainly one year deals to expire at the end of 2008. Today these time charters are 25% above the current spot market rate.

When calculating earnings based on the time charters and 2008 freight derivates for the spot fleet, one might expect an EBITDA of $750m in 2008. Using the current one year T/C rate on the spot fleet, EBITDA amounts to $940m. These estimates equals to $20.7 and $26.0 respectively. DRYS is currently trading around $61.5 per stock, with P/E multiples between 2.4 and 3. Looking at 2009 one has to discount rates further. The 2009 FFAs gives an EBITDA of $505m or $14 per share, but based upon the current two year T/C level one might expect an EBITDA of $760m or $21 per share. This equals to a P/E between 2.9 and 4.4.

Regardless of calculation method, there seems to be an upside in the stock. The currently low multiples reflects the higher risk, regarding DryShips' charter strategy. A trigger for the share could be more revenues locked in for the long-term, or a more aggressive dividend policy. Last week DRYS announced a regular dividend of $0.20 per stock, which arguably is low when considering its free cash flow going forward. However this must been seen in line with the company's outspoken growth strategy.

Golden Ocean Group Ltd. (OTCPK:GDOCF)

Golden Ocean have a different approach to the drybulk market, both in regard to vessel owning, charter strategy and dividends. Currently they own two sailing capesize vessels on long term time charters, and 31 new buildings (11 capesizes and 20 panamaxes) to be delivered the next three years. In addition to this Golden Ocean have about 30 panamaxes chartered in short or long term. 13 of the chartered vessels have a purchase option of about one third of the vessels current market value.

Considering the company's opportunistic market approach, they have already sold 11 of the new building contracts making a profit of $380m. These profits are expected to be recorded on delivery of the vessels, about $220m in 2008 and another $100m in 2009.

Looking at earnings per stock for 2008 and 2009, based up on current time charters and using the FFA market on the spot fleet, one may expect $1.55 in 2008 and $1.0 in 2009. When estimating earnings based solely on the T/C levels, $1.8 and $1.35 per stock would be possible for 2008 and 2009 respectively if revenues were locked in today. In addition one must expect further sale of vessels, combined with leases, and the effects this may have on the earnings figures. Current estimates equals to a P/E between 2.6 and 3.0 for 2008 and 3.4 to 4.6 on 2009 earnings, not estimating further vessel profits.

In November of 2007 the company announced a change in dividend policy, from now on all cash flow would be divested to the stockholders. A quarterly dividend of $0.5 was declared and expectations of similar amounts were made. This was later confirmed in press release statements such as to "increase dividend capacity going forward" have been mentioned several times. The stock is trading at $4.60 currently, making it a true high yield stock expected to pay $2 in 2008. This is in the high end of the stock market, but not unacquainted when looking at the main stockholder's dividend history from Frontline (NYSE:FRO).

Drybulk is a highly fragmented business world wide. The ten largest owners controlling only just 20% of the world fleet. As witnessed in the tanker industry, one should expect further consolidation in drybulk. I believe these two picks may play a part in this ongoing consolidation.

Disclosure: Long in GDOCF.PK at time of writing (13th January 2008). No investments should be done based on this article, remember to do your own research.