The Emerging Opportunity in Shipping
Issues to be addressed in this research paper
At first glance, the shipping industry looks un-investable. The long-lasting bear market is now in its 13th year and, unlike other industries, most of which have fully recovered from the Global Financial Crisis, shipping has not. Take for example the Baltic Dry index, which measures the cost of shipping goods around the world. As you can see below, after the 2008 collapse, shipping prices recovered modestly from late 2008 to early 2010, but it didn’t last. Prices have been in a near-continuous downward spiral ever since the 2008-10 rally, and we are now millimetres away from the 10-year low in shipping prices (Exhibit 1). In this paper, I will explain why this could be about to change.
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Unlike most other industries where both demand and supply play a major role when products or services are priced, shipping is like the airline industry where demand is relatively predictable. Thus, pricing becomes largely a function of supply, and supply could drop significantly in 2020-22.
The expected drop in supply is mostly a function of new regulatory standards which came into effect on the 1st January. Below, I will briefly describe the new rules, I will review the implications and explain why they could have a major effect on the supply curve. I will also briefly mention various ways investors could take advantage of the new rule set, although more research needs to be undertaken before we can provide a more complete assessment of the opportunity set. Our findings will be provided in a follow-up paper to this one.
One final point before I start: The shipping industry is divided into different types of ships. According to Clarksons Research, there are bulk carriers, crude tankers, other product tankers and containerships. In addition to those four types, in the following, I will also make several references to cruise liners. It is obviously a fundamentally different industry, but the implications of the new rules are the same. Just bear in mind that, when I refer to industry statistics (from Clarksons Research or others), the cruise industry is typically not included in those numbers.
The state of the shipping industry
The shipping industry is in dire straits. Shipyards are closing all over the world, costs are rising (see later), and pricing conditions are, as you just saw in Exhibit 1, very poor. No wonder another shipyard is closing regularly.
According to Clarksons Research, the number of active shipyards worldwide dropped by no less than 62% from January 2009 to July 2017 (see here). Although I don’t have access to more recent data, anecdotal evidence suggests that, if anything, the trend has gathered pace since mid-2017. Although some consolidation has taken place (i.e. fewer but larger shipyards), tonnage capacity is still down about 40% (source: Progressive Capital).
The inevitable consequence is that the number of newbuilds continue to fall. An OECD study from March 2018 revealed that the amount of CGT (compensated gross tonnage) to be added to global capacity in 2020-21 will be significantly below recent years’ levels (Exhibit 2). Likewise, a study conducted by ShippingWatch in October 2019 revealed that the number of orders for new bulk carriers dropped 30% last year and is now near 20-year lows (see here).
A very important reason why the number of newbuilds is so low despite international trade continuing to grow robustly (international trade grows marginally faster than global GDP, and 90% of all international trade is delivered by ships) is the discount buyers of ships are currently offered on used ships compared to the cost of building a new ship. A 10-year old bulk carrier can be acquired at a 30-35% discount and a 15-year old vessel at a 45-50% discount to newbuilt parity (source: Progressive Capital). Such a discount makes it a relatively easy choice, particularly when considering that the average lifespan of a commercial ship is 25-30 years.
The problem in a nutshell & how regulators are addressing it
The shipping industry is the most polluting industry in the world. With climate change having moved to the top of the agenda in many countries, the industry can no longer ignore it. The problem is the type of fuel that most ships burn. That fuel is called bunker fuel. It is the left-over at the end of the refining process. It is quite simply an environmental nightmare. It is toxic, it doesn’t evaporate, and it emits far more sulphur than other fuels. It is poisonous to both fish, seabirds and humans living near ports. If the shipping industry were a country, it would rank alongside Germany as the sixth-largest contributor to global CO2 emissions (Source inews.co.uk).
The world’s largest cruise line company, Carnival Corporation, emitted ten times more sulphur dioxide (SO2) around European coasts in 2017 than did all 260 million European cars that year, a study from Transport & Environment has found. And 15 of the largest ships emit more SO2 and NOx than all the world’s cars combined (source: Enerjen Capital).
Regulators have had enough now and have, as of the 1st January 2020, introduced new rules that should dramatically reduce emissions. Those rules are known as IMO 2020, named after the London-based maritime regulator, the International Maritime Organisation (IMO). IMO is a United Nations agency and has global powers.
The main purpose of IMO 2020 is to reduce SO2 and SO3 in the air. The new rules limit the sulphur content in marine fuels from 3.5% to 0.5%. Ships can comply with the new rules in a number of different ways. They can either install a sulphur emission filter – a so-called scrubber – or they can switch fuel-type. The most obvious alternatives to bunker fuel are low-sulphur (sweet) oil, LNG or methanol.
According to Clarksons Research, by the end of 2019, 14% of the world’s shipping fleet – measured by dwt (deadweight tonnage) capacity – had a scrubber fitted. That number is expected to reach 19% by the end of 2020. A scrubber costs on average $3 million and takes c. 45 days to fit. Until now, scrubbers have only been installed in newer ships, and I would expect that trend to continue. As far as older ships are concerned, the payback time on the capital cost of a scrubber may exceed the expected life of the ship.
Instead, I would expect – and this is the most important reason why I think an investment opportunity is presenting itself – a significant number of older ships to be scrapped (demolished) over the next 2-3 years. Fitting a scrubber on older ships makes little economic sense. Nor does it make much sense for many of those older ships to switch fuel type. Consequently, scrapping or non-compliance are the only options, but port authorities are on their toes. I learned recently that more and more ports, particularly European ports, use drones to monitor emission levels, and early signs are promising. Compliance levels are very high.
As you can see below, Clarksons Research have reached the same conclusion as me, i.e. that more ships will be scrapped over the next few years. After a number of years where scrapping levels have been on a decline, Clarkson now expect the number of demolitions to double this year – from 18 dwt in 2019 to 36 dwt in 2020 (Exhibit 3), and they expect that number to rise further in 2021-22.
Sources of supply cuts
Obviously, if fewer new ships are on order, the supply side will be constrained, but a lower number of newbuilds is far from the only reason the supply side is weakening. Allow me to explain:
In the past, when conditions in the shipping industry have been tough and shipowners have been forced to save on costs, the first line of attack has always been to slow down the speed of the ship. Slowing down the speed will save money and pollute less, but it will also impact the supply curve. As you can see below, the average speed is down 15-25% (depending on type of ship) since the Global Financial Crisis (Exhibit 4), and that slowdown is most likely a function of global oversupply. According to Clarksons Research, a decrease of as little as 0.25 knots in average speed across a year absorbs 2-3% of the global supply of bulk carriers, tankers and containerships, so the impact is meaningful.
Bearing the significant cost of IMO 2020 in mind, shipowners have a very good reason to further reduce the speed of their ships in 2020-22. It is estimated that, globally, the container shipping industry will spend as much as $24Bn in 2020 to ensure compliance with the new rules (Source Shipping and Freight Resource) and, confronted with those costs, shipowners may decide that other costs must be reduced. One single containership company – Maersk Line – have estimated that the cost of compliance will exceed $2Bn in 2020.
As fuel costs account for about half of total operating costs in the shipping industry, slowing down the ship is a quick fix and can have a meaningful impact om profitability. I suspect that (many) shipowners will opt for this solution first before the ship is scrapped, making it almost impossible to predict precisely how many ships will end up being scrapped and when.
Adding to that, as already mentioned, it takes c. 45 days to fit a scrubber, i.e. ships going in for a retrofit will be out of service for a meaningful amount of time. Clarksons Research estimate that to absorb another 0.4% to 1.1% of global supply in 2020, depending on the type of ship.
Finally, as far as demolitions are concerned, let’s assume Clarksons Research is correct and that 36 dwt will be scrapped in 2020. The 18 dwt of additional demolitions in 2020 compared to 2019 levels would be equal to reducing the growth in the global fleet in 2020 by 0.8% (1.1% across bulk carriers, 0.8% across tankers and 0.7% across containerships).
That question – how much capacity will be scrapped? – is effectively the unknown in the equation. Unquestionably, shipowners will consider other options first (such as reducing the speed) but, ultimately, scrapping the ship may be the only way forward. I would therefore expect the total amount of dwt that is scrapped to rise significantly in 2021-22.
In that context, allow me to add a couple of observations. As far as scrubbers are concerned, there are three different types being fitted today – open loop scrubbers (74%), hybrids (23%) and closed loop scrubbers (3%). I have noticed that, for environmental reasons, more and more ports ban ships with open loop scrubbers. Apparently, they discharge the washwater from the scrubber back into the ocean, and a rising number of ports won’t allow that.
The implications are still unknown (to me) but, with three-quarters of all the scrubbers that have already been fitted being open loop, it could spell further problems for the shipping industry down the road. I would strongly recommend that further research is allocated to this particular topic.
The net result
Admittedly, there are still many unknowns in the equation. The scrap rate may rise dramatically. Alternatively, shipowners may try to pass the costs of IMO 2020 to their customers. Given how difficult it is, generally speaking, for companies to increase prices at present, I doubt such a strategy will succeed, but a combination of somewhat higher prices and cost cuttings (mostly by slowing the speed down) could potentially work. We just don’t know yet.
What we do know is that, almost whatever happens, supply will drop. More ships in dock to have a scrubber retrofitted will affect the supply curve negatively. Shipowners reducing the average speed to save on costs will affect the supply curve negatively. More older ships being scrapped will affect the supply curve negatively. The only factor that will affect the supply curve positively is more newbuilds and, as you saw earlier, that is not going to happen any time soon.
In that context, I would add that raising finance for newbuilds, following years of the industry having suffered negative returns, is no easy task. I cannot prove this, but I have been told that the average bank manager is struggling to take shipowners seriously when they come knocking on his door.
Therefore, as I see conditions in the shipping industry change over the next few years, the critical question to address is how negatively will the supply curve be affected? The bad news is that, in reality, that question is virtually impossible to answer at this early stage, only weeks after IMO 2020 was introduced. For that reason, I am not going to speculate wildly as to the upside potential when investing in shipping.
Having said that, after years of bleeding, the shipping industry is not on the radar screen of that many investors. The global blue chip in the containership industry, Maersk (A.P. Møller) of Denmark has gone nowhere for almost 20 years (Exhibit 5). The stock traded around DKK 8,000 at the turn of the century, and it still does, meaning that, when investors begin to realise that conditions could be about to change, the impact could be quite powerful. Admittedly, the last 20 years have offered a number of trading opportunities. Having said that, buy-and-hold investors have paid a high opportunity cost.
As followers of my work will be aware, I am not convinced global economic conditions will be plain sailing over the next couple of years. A recession in one of the major economic regions, should it happen, will almost certainly affect global demand for a period of time. Just look at the damage the coronavirus is currently doing to global GDP growth. If GDP weakens across the world, international trade will decline, which will affect the shipping industry negatively. That said, over the long run, international trade has proven very resilient (Exhibit 6).
With the exception of recessionary periods, international trade almost always grows faster than global GDP – 2015 and 2016 being the exceptions to that rule (see Exhibit 6 again). Declining commodity prices in 2015-16 combined with a strong US dollar explain the unusual trend during that period. That said, generally speaking, international trade should continue to grow robustly, and that is despite the populists amongst our political leaders desperately trying to achieve the opposite.
Investing in shipping
Identifying suitable investment candidates in shipping will be covered in a follow-up note. Simply put, we are not ready yet. Nevertheless, allow me to make a few points. So far, we have identified four different ways to engage in the shipping industry:
- Actively managed long-only strategies.
- Passively managed long-only strategies (ETFs).
- Actively managed long/short strategies
- Special mandates
Given our concerns about the overall economic environment, we would be reluctant to go long-only at this stage of the economic cycle, so we would eliminate (1) and (2) pretty much straightaway. Both (3) and (4) offer attractive opportunities, though. There are long/short managers who invest in shipping more generally, and there are investment managers with a specific focus on IMO 2020.
As far as (4) is concerned, in this context, I will mention only one opportunity. I have been introduced to an investment manager specialising in shipping. Although the investment manager in question offers some limited equity upside, most of the return has come from, and will likely continue to come from, an annual dividend yield of about 7%, i.e. it is almost like a corporate bond. In the current environment of skinny bond yields, 7% is not bad at all, but I will leave it to my research team to ‘undress’ this investment opportunity.
Niels C. Jensen
11 February 2020