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In the 60s film Carry On Up The Khyber, the Brits were at war in Afghanistan (sound familiar?). Unlike our modern lads, the Highland division had a secret weapon, which they kept under their kilts! But when the dastardly enemy captured Scotsman Private Widdle, he was found to be wearing underpants. Armed with this knowledge they set out to discredit the “secret weapon”.

Shipping’s Secret Weapon

The shipping investor’s “secret weapon” is, of course, the market cycle. Since cycles come in all shapes and sizes, “buy low, sell high” makes a great business strategy for investors who “trade ships not cargo”. This philosophy became popular at the end of the 1980s when there were fortunes to be made on trading distressed assets. For example, a VLCC purchased at $3 million in the 1983 was soon worth $20 million. But it’s a tricky business, and investors need to get comfortable with the real dynamics of the “weapon” they are playing with.

It’s Not a Gift, It’s a Loan

The notoriously cyclical VLCC market shows how dangerously dynamic this mechanism can be. The graph estimates the annual “free cash flow” of a VLCC between 1970 and 2013. The cash flow is calculated from spot market earnings less depreciation (not cash, but ships must be paid for some time), interest at LIBOR plus spread, and OPEX.

The approximate “free cash flow” (in $m pa) displays an astonishingly long cycle. Between 1970 and 1973 the VLCC netted $40 million, a fortune on a vessel purchased, for example, for $18 million in 1966. Then between 1974 and 1995 it lost $94 million. Much of this was in the 1980s, but the vessel did not recover full depreciation until the mid-1990s. Then from 1996 to 2010 the money came back again, with investors grossing $90 million over 15 years. Since 2011 the investment is back in the red to the tune of $13 million. It would have been much more if interest rates had not crashed.

Three Lessons

Lesson 1 from this analysis is that the timing of the mega-investment campaigns in 1973 and 2007 could hardly have been worse, requiring deep pockets and patience to survive. Lesson 2 is that spectacular profits are possible but very tricky to achieve. In 1999 a few courageous VLCC investors were on the verge of bankruptcy and sentiment was at rock bottom. However a VLCC ordered for around $70 million, to be delivered in 2000, would by 2008 have earned over $80 million after expenses and the 10 year old ship value peaked at $135 million. Lesson 3 is that investors who didn’t play the cycle made a pittance. The 1974-95 loss of $94 million was eventually recouped by a profit of $89 million in the 2000s. But over the 44 years the net balance was a miserable $23 million.

Cycles Out of Kilter, Captain?

So there you have it. The choice between trading ships and trading cargo is a real one. Investors who opt for trading cargo must, like military leaders, prepare for a long low margin war. And investors who decide to trade ships had better make sure that they’ve got more than just underpants under their kilts. Have a nice day.

SIW1123

SIW1083Currently there is quite a bit of interest in dry bulk carriers, despite earnings which continue to scrape along the sea bed. On the newbuilding front there is a brisk orderbook, with 42m dwt of deliveries scheduled for 2014 and brokers having difficulty finding berths for 2015. Meanwhile, some big owners who saved their cash in 2008 are in the market,“hoovering up” ships. So does that mean recovery is just around the corner?

Dry Bulk Buzz?

Let’s start with the easy stuff, the supply-demand balance. It’s easy because with today’s fundamentals you don’t need a computer model to work out that, despite heavy scrapping, there is a mega-backlog of surplus bulkers. Since 2007 the dry bulk fleet has increased by 85%, whilst bulk trade has grown by only 32%. This has transformed the 6% shortage in 2007 into the bulker market’s biggest ever “surplus” of around 30% (see graph). For comparison there was an 11% surplus in 1998/9 and 10% in 1986, both grim years with rock bottom rates and distressed asset prices.

Three Shades of Gloom

But the investment market does not see it this way. Admittedly the freight rates are perfectly consistent with the grim fundamentals: the spot market has averaged around $7,500/day for Capes and $5,200/day for Panamaxes so far this year, which barely covers OPEX. But asset prices tell a very different story, with the price of a 5 year old Panamax bulker up 9% in the last three months to about $21m and a 5 year old Capesize about $34m. At the bottom of the 1999 recession the Panamax price dropped to $13m and the Capesize price to $24m. So why are today’s prices so firm?
The conventional reasons for optimism are the economic outlook and shipyard capacity. In spring the world economy was deep in recession, but the bounce-back has started. A few years of 6% trade growth would soon soak up the surplus. Meanwhile, by 2014, bulker deliveries will halve. Encouraging, but hardly decisive.

In reality today’s market is not really about fundamentals. There are other factors at work. The fall in the credit worthiness of banks, and in the interest they pay, has left investors seeking investments with long term “real” value. Ships are core assets which (like bank deposits) are not making much today but will do some day. Meanwhile escalating bunker prices have put icing on the cake; slow steaming has absorbed much of the surplus. When the market tightens, the fleet will speed up, and investors with fuel efficient ships will benefit.

Still No Magic Solutions

So there you have it. Frightening fundamentals are maybe the worst ever for bulkers. But with fewer shipyards and a better economic cycle, the surplus could disappear in a few years, leaving investors with ships performing much better than bank deposits. It will take time, but as Shakespeare said “How poor are they that have not patience! What wound did ever heal but by degrees?” Good advice, but don’t forget that some wounds take longer to heal than others!