Today’s article is part of the “Industry 101” series. I have already covered Banking and Gold Mining. So, it’s time to move on to the next one: Shipping 101.
The history of maritime transport is the history of human civilization. The Phoenicians and the Greeks were the first masters of the Mediterranean. Over the centuries, the Italian city-states came in their place. By the end of the 15th century, the Ottoman Empire controlled half the Mediterranean, cutting off the flow of spices and silk from the East.
Western European empires suddenly found themselves without direct access to the riches of the East. Portugal and Spain were concerned. Thus began the Age of Discovery, which was made possible by constant innovation in shipping.
Over the past five centuries, maritime transport has followed an evolution punctuated by revolutionary inventions. The discovery of the steam engine, then the internal combustion engine, and metal hulls made ships the cheapest means of transport. In the 20th century, the size of vessels grew considerably, improving the economy of scale.
In recent decades of globalization, shipping has cemented its significant role in the world economy. It remains the most cost-effective mode of transport. The variety of ship types is enormous, from nuclear-powered icebreakers to supertankers and bulkers to five-star passenger liners.
The shipping industry has its language as we have AISC, probable reserves, cutoff grade in mining, CET1, RoTE, and regulatory capital in banks. The concepts I discuss apply to cargo shipping. Cruise liners and offshore supply vessels follow different business models, which are not the subject of today's report.
Cost and Revenue
First, we start with the costs. Owning a ship is a complex endeavor with many associated costs. They are divided as follows:
· Capital (42% per annum) is the cost of acquiring the vessel. New ships are often financed through bond issues or bank loans secured by company vessels. It is also not uncommon to see financing through hybrid securities issues. Capital expenditure consists of the regular repayment of principal and interest.
· Operating costs (14% per year) are fixed costs without which the ship cannot be operated, whether in service or tied up. Such costs are crew wages, scheduled maintenance, lubricants, and insurance.
· Voyage costs (40% per year) depend on the ship’s operation intensity. This group includes bunkering costs, port charges, canal transit dues, cleaning holds, and cargo claims.
Fuel costs account for 66% of voyage costs, or about 28% of total costs (at an oil price of $65/bbl).
The shipping company owns vessels, which are contracted to the cargo owner. This is how the shipping company generates revenue. There are several widely accepted options for chartering a ship:
· Voyage charter: A ship is chartered to carry a certain amount of cargo between two ports. The shipowner bears capital, operating, and voyage costs. The rate is set daily according to the spot price per ton/mile. With rising day rates, chartering ships under voyage charter is more profitable for shipping companies because the rates are updated with the spot price.
· Time charter - the ship is chartered for an extended period, and the price is calculated in advance. The latter means that the ship is contracted at a fixed price for the duration of the contract. The shipowner bears capital and operating costs, while the charterer bears voyage costs. With declining or stagnating day rates, time charters are more profitable for shipping companies because they have locked lucrative rates for an extended period. Thus, even when spot rates fall dramatically, they remain profitable. Conversely, time charters come with steep opportunity costs during a strong market.
· Bareboat charter - This option is similar to leasing. Shipowner covers only capital costs. The shipping company remains the legal owner of the vessel while the charterer operates it and has full rights to the revenue generated. The charterer contracts the ship for long periods. He bears the operating costs and the voyage costs. This kind of contract has the lowest risk for shipping companies. At the same time, it diminishes earning potential in case of a strong market. It is most practiced by companies shipping dry bulk cargoes such as steel and iron ore. Charterers of their ships include Nippon Steel, Arcelor, Vale, and BHP Group. The periods on such contracts are often over five years and sometimes for the entire service life of the ship (20 years is the accepted norm).
Often, companies owning over 40-50 ships diversify between time charter and voyage charter according to their view of where we are in the cycle. Small shipping companies with 15-25 ships often concentrate on only one of the charter types. The choice of contract type has additional nuances depending on the ships' size, propulsion, age, and region of sailing.
Cyclicality
Shipping follows cycles driven by supply-demand dissonance. Changes in the supply of ships unfold in 18-24 months (the time it takes to build a midsize or large tanker/bulker), while demand for shipping can vary by 10-20% per year.
If we turn to the proverbial anecdote “ The hare and the tortoise,” the supply side in shipping is the tortoise, and the demand is the hare. This principle is valid for all tangible assets-based businesses. The supply is inelastic, unlike the demand. This dissonance leads to epic boom and bust cycles.
Shipping companies order new ships during a market boom, but they are delivered only after two years, creating a surplus that leads to cycle contraction, i.e., weaker day rates. And so on until the new vessels become old and unprofitable and then go for scrap, thus reducing vessel supply below demand. Then, the vessel shortage arises, day rates go boom, and shipowners go on shopping sprees. Drink, rinse, repeat.
How do we know where we are in the cycle? Bottoms and peaks share certain traits:
Bottom:
Day rates barely exceed operating costs
5Y old vessels are priced close to or even below their scrap value
Ships below 20 years go for scrap
Minimum orders of new ships as a percentage of the current fleet
Banks specialized in maritime financing refuse loans to finance
The consensus among market participants is extremely negative
Highs:
Daily rates exceed operating costs by at least three times
The price of a five-year-old ship (received now) is equal to that of a brand-new one (received in two years)
Almost no ships are scrapped
Multiple new ship orders
Specialist banks are happy to finance shipping companies
Shipping companies are at the center of investor attention
Demand and supply vary between types of vessels, resulting in different cycles. For example, the markets for VLCCs and Capesize ships are in structural deficit, while the markets for VLGCs and Container ships are in surplus. The former two are more attractive due to supportive fundamentals than the latter two.
The four markets
Every shipowner considers four markets before making any decision:
· The market for new ships, i.e. shipyards
· The market for transport services, i.e. charterers
· The market for old ships, i.e., other shipping companies
· The scrap market, i.e., companies buying ships for scrap
In the center is the shipping company. Shipowner strives to balance between all four. Each market follows its cycle. At first glance, this is a drawback. Therein lies our advantage as investors. Remember the inelastic supply and erratic demand that brings the proverbial Alpha.
The market for new ships depends on supply, i.e., on the capacity of shipyards, which follows the demand for new ships but lags by at least two years. Demand for vessels depends on the stage of the global economy. An example is China and major bulks demand. The stronger the Dragon, the higher the bulk carriers' demand, and vice versa.
The second-hand market is a function of the demand for new ships and the demand for maritime freight. With rising day rates, old ships become attractive investments. At a certain point, buying a 5-10-year-old vessel is more lucrative than ordering a brand new one delivered in 2 years. This is also reflected in the price of old ships. In the late stages of the cycle, five-year-old ships that are available now often cost more than brand-new ones with delivery in two years.
The role of the scrap market is to destroy old ships. Vessels over 20 years old are considered such. However, this age is not written in stone. With increasing day rates, ships are often operated up to 23-25 years old. Conversely, even 18-19-year-old ships are sometimes scrapped in a shrinking market.
The examples described are not exhaustive. They are intended to show the interrelationships between the four markets and the shipping company. How to solve this puzzle? By focusing on the supply side.
The supply or where the Alpha resides
Unlike demand, supply changes slowly, allowing us to predict shortages over the next 18-24 months with high conviction. A few metrics predetermine the supply:
· Age profile - what percentage of ships are over 20 years old; what is the average age of the global fleet? From an accounting point of view, the life of a ship is 20 years. However, as you have seen, according to the supply and demand of ships, this age varies. The fleet age distribution suggests a future deficit/surplus. If more than 10-15% of ships are 20 years old within a year, they will be scrapped. Thus, the supply decreases. On the other hand, if old ships are less than 5% of the fleet, supply will remain stable.
· Number of new ship orders relative to the current fleet - how many ships will be delivered in two years? Order book below 10% is assumed to be low. Examples of these are VLCC crude oil tankers, Capesize bulkers, and offshore supply vessels.
· Shipyard capacity - what available slots do they currently have, and with what type of ships? Shipyards specialize in ship types, following trends in shipping demand. They will focus on high-demand vessels and then adapt their production capacities. However, this is happening slowly (at least two years). In the meantime, the supply-demand balance may change, so other vessels become a hot commodity. However, the shipyards cannot meet the demand because it will take a long time to transform yard production lines again.
The three variables are interrelated and should not be considered in isolation.
Importance of propulsion
Propulsion is a decisive factor when we evaluate the vessel supply side. Environmental regulations add more requirements for air emissions. Shipowners must act accordingly, ordering vessels with compliant propulsion.
In this chapter, I provide more nuances on propulsion. My intention is to emphasize the importance of being familiar with ship specifics.
All investors have access to (almost ) the same information, so the informational edge is non-existent. However, we can develop an analytical edge by knowing intricate details about the business we are interested in. So, let’s discuss some marine propulsion stuff.
Unlike conventional cargo ships like bulkers and tankers, which rely on classic propulsion (two-stroke marine diesel engines), LNGs use sophisticated propulsion plants. These plants share some similarities with passenger ship plants, like diesel-electric installations.
Until early 2000, steam turbines were the only viable solution for propelling LNG ships. However, steamers have fallen out of favor in the last several years. The reason is EEXI, Energy Efficiency Existing Ship Index. It measures ships' power plant efficiency. Despite their advantages, like simple design, steam turbines are among the most inefficient power plants. LNG carriers with steam turbines can’t meet EEXI requirements and have been redelivered from contracts.
Dual Fuel Diesel Electric (DFDE) propulsion plants gained traction at the beginning of the century. They consist of four-stroke diesel engines coupled with alternators that generate electricity for electric motors that drive the ship's propeller. The layout is the same as on cruise ships. The graph below shows a DFDE propulsion design.
DFDE can run on HFO, MGO, or BOG, so they are sometimes referred to as TFDE. BOG stands for boiling gas. It is the losses occurring during the storage of LNG. Due to the external heat, some slight evaporation occurs in the cargo, equal to 0.10%- 0.15% per day. BOG is reliquefied and used as fuel for the main engines.
XDF and MEGI/MEGA have become more prevalent in the last decade. XDF means low-pressure dual-fuel diesel engine. It is a two-stroke engine that runs on HFO/MGO/BOG. MEGI (mechanically operated, electronically controlled gas injection) is an updated version of XDF. The difference is in the injection pressure of BOG. MEGA engines are the newest modification of MEGI. They are 41% of the total orders. MEGA/MEGI engines emit 40% less Nitrogen oxide (NOx emissions) than the engines running on HFO. Greenhouse emissions are also lower (by 22%) compared to HFO power plants.
Like scrubber-equipped ships, vessels with MEGI/MEGA engines are more favorable than those with DFDE or steam turbine power plants. At the end of 2023, there were 709 LNGs globally and around 370 in the order book. 61 steam turbine vessels, 8.6% of the existing fleet, are expected to be redelivered in the next three years (24 only in 2024). The extinction of steam turbine LNGs will boost the demand for MEGA/MEGI LNG carriers.
Shipping investors triad
There is always a trade-off. In shipping investing, this is the impossible triad. There is no way to obtain all three: A-grade fleet, low LTV, and low P/NAV.To get two of those, we must sacrifice the remaining one. We can buy a top-quality fleet with a relatively low LTV at a high PNAV. Or we can pick low LTV and a considerable margin of safety, though we sacrifice the fleet quality.
The top section shows the fleet specs, types of vessels, and average fleet age. The following lines are dedicated to NAV and LTV formula inputs. The bottom part gives the company’s PNAV and Gross LTV.
The shipping investor triad is a robust framework that helps analyze shipping companies holistically without focusing only on one variable.
Today’s write-up is far from exhaustive. There are specifics we must consider depending on the vessel type. That is why I added a section on LNG carrier's propulsion to emphasize the importance of the details.
The article aims to decipher shipping terms in an understandable and, most importantly, actionable way. If presentations of shipping companies make sense after reading Shipping 101, I have achieved my goal.