MV Wasaborg Cayman, image credit Karatzas Photographie Maritime
At a recent shipping conference, we were asked to present on the topic of smart investments in shipping given the present phase of the business cycle. The shipping industry is ever changing and the so-called investment thesis for shipping investments can change structurally in much shorter periods than in other industries; what looked appealing a year ago can be facing challenging winds now. The opposite can be just as true.
More than $30 billion have been invested in shipping by institutional investors in the last five years, not to mention the commitments by independent shipowners, charterers and cargo interests, shipbuilders – directly or indirectly. For the investors who had in mind a relatively timely and well projected exit strategy, a reality check of their investments in shipping at present rings rather disappointingly; for the investors who had in mind the long term, a marked-to-market analysis is of less importance, but still, unfavorable clouds have replaced, to a certain extent, the optimism of the trade winds for a smooth sailing.
Whatever the goal and the timeframe, shipping investments of the last five years have genuinely been a disappointment.
The Dry Baltic Index (BDI) has been flirting with thirty-year lows and shipping asset prices seem temptingly low, whether for dry bulk, containerships or even tankers (which have been trading much livelier than any other sector.) For certain asset classes such as panamax dry bulk vessels, ten-year old tonnage can be had as inexpensively as twice their scrap value. There is no doubt that asset prices are getting at ‘interesting’ levels. For those believing in the adage ‘buy low, sell high’ it seems that the present asset pricing environment is a no-brainer for outright purchases of ships.
Could ‘going long’ the market be the best way to invest now? Whether investing for ‘alpha’ or trading for ‘beta’ would seem equally obvious choices to ‘play’ the market, since asset prices are historically low.
But again, why would one invest in equity in shipping?
The world fleet in all asset classes is rather new, newer than five years of age in certain asset classes such as the capesize market. A great deal of vessels were ordered just prior to the crash of 2008, and many more were ordered ever since, with a massive newbuilding wave in 2012 and 2013. A relatively young world fleet cannot precipitate an accelerated level of demolitions, and likely the owners of young vessels, however un-economical, would hold onto them for as long as possible. It’s well known to traders than when there is plentiful of ‘inventory’, the probability in price spiking is rather weak.
Looking just beyond the existing fleet, the outstanding orderbook is not negligible either. Since not all asset classes ‘picked’ at the same time, there are waves of varying strength of newbuildings in different asset classes, but still the overall orderbook is a robust at 20% of the world fleet; some asset classes seem better balanced in this respect (containerships and tankers), but still, there are almost no mainstream markets where the outstanding orderbook is nor higher than 10% in terms of the existing fleet in the same asset class. Linking together a young world fleet and a meaningful existing (that cannot be cancelled) orderbook, one has to wonder that tonnage oversupply will always keep a lid on pricing, at least in the next year and possibly longer.
One may be tempted to say that in two years then, when more demolitions will have taken place and the presently outstanding orderbook will have been delivered, it’s a reasonable horizon to aim at for asset appreciation. And, in any event, vessels ordered today likely cannot be delivered before then, within two years, considering that it takes about nine months to physically build a vessel and the existing backlog of newbuildings. But again, shipbuilding capacity, especially for dry bulk vessels, seems to be unlimited;
Chinese shipyards can keep building commoditized dry bulk vessels day-in, day-out, including Sundays and holidays. Yes, some shipbuilders seem too weak financially and can survive; on the other hands, it doesn’t take much to expand shipbuilding capacity for commoditized vessels. And even for bigger sized vessels, Chinese strategic interests like China Merchants (CMES) and with Vale, didn’t seem to be a problem for obtaining fairly prompt slots for VLCCs and possibly fifty more Valemax vessels.
Thus, the world fleet is relatively young, the outstanding orderbook is relatively strong and shipbuilding capacity is potentially there to accommodate a market expansion; all these three factors do not pertain well for the market, at least as equity investments are concerned.
But, if tonnage supply is to expand, is there sufficient finance available?
Private equity funds and institutional investors are still there to consider equity investments in shipping, possibly for ‘doubling down’ on existing investments, or possibly to enter the market with a lower cost basis than their competition or even possibly to feed on the distressed opportunities presenting themselves form time to time. If newbuilding capes (of the eco-type) were a bargain at $58 mil, why newbuilding contracts for capes at $50 mil or even lower cannot offer a better opportunity, especially since additional fuel savings and other improvements can provide an incremental benefit (beyond the price) to the newly ordered tonnage? And newbuilding prices can stand to drop, as commodity pricing (read: iron ore) has been heading south and likely to remain weak; and, China (read: good news for Chinese shipyards) have already produced too much steel plate in the past, so much so that are getting close to formally be taken to World Trade Organization (WTO) by the US for ‘dumping’ steel plate in the international markets below their cost. Private equity funds and institutional investors do have the dry powder to invest, shipbuilders can afford to lower newbuilding prices; and, the low interest rate environment can have a magnifying impact on making many projects appealing when the discount rate for NPV calculations can be awfully attractive.
And, there is always the question on demand!
China, the horse that many an industries and projects are trying to hitch their wagon at, has been at a decelerating growth curve; long forgone are the days of double digit growth; the growth rate of 7% achieved in the last year is expected to reach 5% within a couple of years, and some educated projections are looking for a growth rate meaningfully lower than that.
It seems then that investing in equity in shipping (going ‘long’ the market) is a tricky way to invest, given our litany of factors mentioned hereabove. We think that there are opportunities to invest in equity in shipping and still have a good chance to make money; however, any such play will require expert knowledge of the market, ability to act fast, to select high quality vessels and pay cash; such play would require strong chartering relations, operational expertise, and certainly strong conviction and some luck. In our opinion, such opportunities likely to be few and between.
However, the flip side of our argument, that a weak freight market is likely to persist, then investing in credit may be the optimal way to invest in shipping. For starters, most traditional shipping banks have left or are vacating the shipping industry, leaving behind them a huge gap to be filled. Additionally, the weak freight market generates an ever-increasing need for financing, as shipowners are running low on working capital, to operate vessels on a daily basis and also capital for mandatory capital expenses such as drydocking and special surveys. Such funding needs are never to be considered by traditional lenders, since they entail a balance sheet and the borrowers are typically are of lower credit standing.
There are also the ‘legacy transactions’ where newbuilding orders were placed on speculation with no financing in place, as incredible as it seems now; for such projects, the option set for the shipowner is tight: either default on the newbuilding contracts and lose 10-30% of the down-payments on the original price or borrow (with the vessel as collateral) at hefty rates in order to get the vessels on the water and get to live another day, hopefully a day of strong freight rates to pay for the costly mortgage.
In our business practice, we routinely see shipping projects in need of financing that can provide the vessel as collateral that can allow for 7% return with strong covenants and very favorable loan-to-value ratios; for projects with some ‘hair’, returns for credit investments can be double-digit and can also allow for convertible to equity or upside potential based on market performance.
The question to be asked is why credit investments in shipping wouldn’t be ‘smart investments’? Favorable terms and tough covenants that allow for high single-digit returns with the shipping asset as a collateral, minimal or little market risk, and with the option to convert for the riskier projects. Could ‘debt’ be the new ‘equity’ (or preferred equity) in a weak, risky, unpredictable shipping market environment?
An abbreviated version of our presentation from the conference can be found here.
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