Method to the madness

by Michael King
Share This:

Earlier this year, Danish ship owner Norden announced it was expecting a “very difficult year” for bulk carrier earnings but, even so, would still invest many millions in buying new vessels. A bizarre strategy? Norden is not alone.

New orders for bulk carriers in the first quarter reached 106 ships amounting to 10.6 million dwt, according to analysis by Clarksons. Shipping association Bimco, meanwhile, reports that in the first four months of 2013, new contracts awarded for bulkers totaled 14.8 million dwt, up 40% compared to a year earlier, and with the latest figures suggesting the splurge had continued deep into May.

These orders have been placed despite the market suffering from excess capacity. As a result, the Baltic Dry Index averaged 921 in 2012 and has been stuck below 1,000 since January this year.

Given that the breakeven point for most operators based on the BDI is assumed by analysts to be around 1,500 points, or slightly lower for those with a large proportion of ships under long-term contract, are bulk carrier owners engaged in some willful collective act of self-destruction? Not necessarily.

Owners with big enough pockets are being tempted by two factors: first, shipbuilding prices are at historically low levels; and second, fuel costs now make up an ever growing proportion of operating costs. The gamble is that more efficient ships bought now at bottom-feeding prices will still turn a profit over their 20- to 25-year lifecycles, even if money is hemorrhaged in their first few years of operation.

“The driving factors behind the orders are multiple and represent the fact that every single owner has his or her own motives for signing new contracts for tonnage — this is no team sport,” said Peter Sand, chief shipping analyst at BIMCO.

“But among the factors is surely the anticipation or self-fulfilling prophecy that shipbuilding prices cannot go any lower now. Prices for tanker tonnage are still sliding while prices for dry bulk tonnage have moved sideways for a couple of months now. Some broker price quotes suggest that the strong interest in capesize tonnage has pushed prices for those slightly upwards during the latest weeks.”

This is confirmed by the figures. As of April 2013, the price for a new capesize vessel being quoted by Chinese yards was around $47 to $48 million. This is 3% up from a 10-year low but 50% less than peak prices in 2008. With yards in China struggling with a strong Remnimbi and rising labor costs, it is unlikely they will be able to offer such discounts indefinitely.

“The drive for ‘ECO-tonnage’ has also been mentioned as a reason behind the new orders, with some owners highlighting this issue in particular,” said Sand. “If you can get a capesize ship that burns, for example, 10 tonnes of fuel less a day, that gives you an economic upside as travel-related costs are lower than your competitors. In today’s bunker market, where fuel costs around $600 per tonne, that is a savings of $6,000 per day.”

Impact on grain shippers

Voytek Chelkowski, managing director of analyst firm Seamind, told delegates at the 7th Asia Grain Transportation Conference, hosted in Bali, Indonesia in May by a range of U.S. grain organizations, including USDA, that many investors in bulk carriers were willing to take a hit on the front end of their investment in order to buy now while prices for fuel-efficient ships were low.

“Over 15 years they will eventually make a profit,” he added.

So what does this mean for grain shippers? First, owners are expecting rates to increase and they could be right. But when exactly this might happen is far from clear.

Grains constitute around 12% of annual bulk carrier demand. Although the annual loading seasons in South America and the U.S. have a major seasonal impact on demand, much will depend on demand for iron ore (which represents 39% of annual bulk carriage) and coal (23%). Of key interest will be demand growth for iron ore from China, the ebb and flow of which tends to reverberate through all shipping segments even though it is primarily capesize focused. If more iron ore is sourced in Brazil, this adds tonne-miles to demand, for example. But if more is shipped from Australia, which at present seems more likely, then the opposite applies.

Ship buyers are betting on the long-term shipping cycle. They believe that, as with shipbuilding prices, freight rates have been so low for so long that they must inevitably increase at some point.

“Freight rates have already started a slow recovery — stressing both words,” explained Sand. “But the overhang of capacity is significant.”

He points out that a number of factors will determine when freight rates will start to recover as supply comes into line with demand. First of all, demand needs to remain strong. “2013 is the first year since 2008 where demand growth is outpacing tonnage growth,” he added. “So now we are moving in the right direction for the first time in five years.

“Then, supply needs to remain under control and lower than any given demand growth rate. This means that more tonnage sent to the breakers is good news, whereas more tonnage delivered into the market — and new contracts are leading indicators of this — is bad news.”

Apart from high scrapping prices, another factor which is limiting supply-side growth is slow steaming, which many owners are now using both as a means of curbing capacity and reducing fuel costs. But the danger is that any increase in rates could see ships speed up and supply-side reduction gains rapidly eroded.

Most of the newbuildings currently being ordered are for delivery in 2015, and in some cases 2016. If the order splurge continues, then forecasts that demand growth will absorb the current excess of supply over the next two to three years could need to be hastily rewritten.

Moreover, most of the orders placed this year are in the panamax/capesize range. “The new contracting of dry bulk tonnage has been particularly biased toward the larger ship sizes with capesizes responsible for 68% in deadweight terms of all new orders in 2013,” said Sand. “The panamax sector has taken 20%, handymax 4%, handysize 7%, and smaller bulkers 2%.”

This translates into a total of 55 new Capesize vessels ordered in the first four months of 2013 as compared to only 22 during the first four months of 2012

“In comparison with the previous two years, where the combined orders of panamax and capesize accounted for 74% of all new orders in January-April, the interest in larger ship designs has been very distinct in 2013,” added Sand.

The panamax orderbook for 2013 stands at more than 20% of the operational fleet, while in total the 2013 bulk orderbook constitutes around 15% of the existing fleet. Some analysts believe that the expansive panamax orderbook will cap any freight rate gains in the medium term.

While scrapping is currently running at high levels, there is limited opportunity to delete tonnage from the bigger, fastest-growing segments of the market because these fleets are already so young and set to get even younger as more newbuildings enter service.

Significant macroeconomic risks also remain, with Europe lurching from crisis, the U.S. recovery far from secure and growth rates in India and China slowing.

Andrew Lee, an analyst at Nomura, believes spot rates will remain at loss-making levels until the second half of 2014 at the earliest. He points out that, unlike the container shipping sector, there are few mechanisms by which owners can collectively limit supply.

“Although dry bulk capacity growth has peaked, we maintain our cautious stance on the sector given that we estimate BDI to remain below the 1,500 break-even level for the next 18 months, given the time required to absorb the over-supply accumulated since 2008,” he said. “Further, with capesize a key driver for BDI, we remain cautious on capesize rates given the capesize fleet has increased by 114% since end the end of 2007, and we estimate Australian iron ore export growth to outpace Brazil.”

Lee concluded that the BDI would average only around 900 this year. Even a recovery of the BDI to 1,500 would not be of huge relief to owners, according to Chelkowski. He said that while this might help recoup operating expenses, it would not cover capital expenditures on vessels.

With owners under such strain, do shippers and charterers need to be wary about with whom they do business?

“In the current low interest rate environment, financing is not costly to those who get it offered or those who can find money in the capital markets,” said Sand. “But for the less-than-top names in the industry, the risk premium is considerable.”

Andrew Benjamin, manager of ocean freight at Bunge Agribusiness, said that given the poor performance of rates over the last two years, there was ample reason for concern that some owners might succumb to financial pressures in the year ahead.