Where are we in the Shipping Cycle?

IMIF Buffet Luncheon

Date: 17th June 2013

Host: Peter Stokes, Senior Adviser and Head of Shipping, Lazard

Speaker: Peter Stokes, Senior Adviser and Head of Shipping, Lazard

Subject: Where are we in the Shipping Cycle?

Report By James Brewer

buffet-luncheon-17-june-2013When he had last spoken at an IMIF gathering, in the spring of 2011, Peter Stokes had felt obliged to administer a cold douche to what he felt was premature optimism permeating particularly the dry bulk and container sectors. Making a welcome return to these circles in June 2013, Mr Stokes in the course of a raw up-dated analysis, again poured devilishly icy water over the irrational and possibly deluded thinking of sections of the market.

His plain-spoken survey of the disturbing global financial currents, and the subsequent comments from an array of IMIF members, led our chairman Jim Davis to sum up the abiding frustration of many senior people in shipping and finance with the words: “Where the hell are we going?”

Mr Stokes recalled that the dry bulk market, after a near-death experience in late 2008, was rescued by the massive Chinese stimulus programme the following year, and the restocking of raw materials by the global steel industry in 2010. Container shipping had flirted with disaster in 2009, only to rebound dramatically in 2010. Neither of these sectors, nor the tanker sector, had come close to a sustainable recovery phase, not just because of the structural surplus of capacity, but also because of the continuing broader problems in the global financial and economic environment. His conclusion in his 2011 talk had been: “either way, shipping companies would do well to shore up their balance sheets in anticipation of continued heavy weather.”

If anything, he admitted, he had been insufficiently negative in that assessment. Since then, the vast majority of his time at Lazard had been spent advising lenders on restructuring billions of dollars of distressed corporate shipping debt. “We are now seeing the acute liquidity problems of major tanker companies increasingly being experienced in the dry bulk and container shipping sectors. In all three of the major shipping sectors, 2013 has seen severe renewed weakness in the freight market, imposing liquidity pressures on all but the most conservatively financed of companies,” said Mr Stokes. Yet the view that recovery was just around the corner remained remarkably persistent. We saw it reflected most obviously in the newbuilding market. By the end of April 2013, for example, there had been more ordering of 8,000teu-plus container ships than in all 2012, “although of course it is highly unlikely that we will see any repetition of the exuberance of 2011, the consequences of which are now weighing heavily on the major east-west operators.”

Technical factors were encouraging contracting including the widespread publicity given to the fuel-efficiency advantages of the current generation of newbuildings, but he was”pretty convinced” that the advantages of eco-newbuildings were being over-played.

The advantages of the eco-ship seemed only material in markets which were in broad equilibrium – neither depressed nor over-heated – “and one should never forget that low capital cost will frequently be able to trump superior voyage economics. “

More important was the fact that newbuilding prices appeared to be at or near the bottom, whereas the prices of modern second-hand ships were, in his view, significantly higher than justified by market conditions. “The best defences available against large-scale over-ordering at present would appear to be scarcity of capital and the increasing difficulty of obtaining satisfactory refund guarantees. I hope that they are robust enough to keep the flow of new orders at an acceptably moderate level for the time being.”

Another disincentive to over-ordering would be a collapse in second-hand ship prices to levels consistent with freight market returns and newbuilding prices. Despite the current protracted freight market slump, prices of five-year-old panamax and supramax bulk carriers were more than 80% of newbuilding prices, with capesizes and suezmax tankers at more than 70% and only VLCCs somewhere near more economically justifiable levels at just over 60%. The main reasons for this anomaly, he said, lay in the artificially low cost of money and the extreme reluctance of banks holding billions of dollars of shipping loans to enforce security and trigger write-downs.

Things had gone so far in the direction of easy money policy, that the implications of any reversion to something resembling normal monetary policy would be potentially disastrous for a wide range of asset prices, not least those of government bonds, said the Lazard shipping head. The concentration of outstanding shipping loans in a relatively small number of under-capitalised banks, many of them in the eurozone, had led to extraordinary book-keeping contortions to avoid recognising losses which in some cases would threaten the solvency of institutions.

Mr Stokes described the ramifications of this situation as increasingly bizarre. “Shipping companies which are clearly bankrupt according to any common sense definition of the term continue to operate with stratospheric net leverage multiples, and, if publicly listed, with a share price which indicates a positive rather than a substantially negative equity value. Hedge funds desperate to put money to work in the sector make significant investments in the traded debt of such companies at steep premia to the intrinsic value of that debt in the hope of finding an advantageous way into the restructured equity. And all the while, regulators and auditors are having somehow to reconcile carrying values of shipping loan books with the fact that ships depreciate, which means that playing for time is not, on its own, a viable strategy.”

Shipping companies which are allowed by their banks to continue operating, even though they cannot service their debt, are effectively in run-off mode, said Mr Stokes. They are of necessity takers of whatever freight rate is offered to them in order to generate continuous cash flow and avoid idle time. As the number of these companies increases, their debilitating effect on the freight market is accentuated. As a consequence, we are seeing less impact than might have been expected from the traditional market mechanisms for reducing excess supply, lay-up and scrapping.

In segments of the market where capacity has flattened out or is in decline, there is some belief in selective market recovery within the next 12 months or so, but it should be remembered that no size category is immune from competition from larger vessels or those of a related type.

As long as the political response to the structural problems of the eurozone continued to fall short of radical reforms it was hard to envisage European demand growth coming to the rescue of the supply/demand balance.

Easy money had stimulated excessive valuations in stock, bond, commodity, real estate and shipping markets. “If you believe that governments and banks will continue to be able to ‘kick the can down the road,’ then we face the prospect of an ongoing contained depression, in which those industries on which shipping depends for its demand growth will perform anaemically. In such circumstances, the control of fleet capacity will assume critical importance in determining the timing of a recovery in the freight market. And that recovery will not be dynamic.

“I would say that firmness could begin to appear as a sustainable trend in the products tanker market in 2014, in the crude tanker and container shipping markets in 2015 and in the dry bulk market in 2016.

“The alternative scenario, which I am now beginning to view as more plausible, would involve a bungled unwinding of quantitative easing in the United States, leading to turmoil and heavy capital losses in global stock and bond markets. Banks would no longer be able to disguise the true value of their assets, and governments would be forced into a thorough-going clean-up and restructuring of their balance sheets, together with the recapitalisation of surviving institutions and the closure of defunct ones.

“In such a scenario, prices of second-hand ships would collapse to genuine market-clearing levels. The psychological impact of such a market burn-out would, however, be salutary, since participants would regain confidence in the reliability of asset values and recapitalised and restructured banks would be able to contribute to economic growth rather than constrain it. A year or two after such a crash, it would be possible to envisage a more vigorous economic upturn, of which shipping would be a beneficiary. “

At the beginning of this year Greek shipowners took the view that the market was close enough to the bottom to justify the purchase of second-hand vessels or ordering newbuildings. From their point of view, as strategic participants in the industry with a requirement to renew their fleets, this was a reasonable enough step to take. Pure financial investors, however, should logically take a more rigorous view. Eminent investment firms had made misjudgements as to timing and due diligence in placing capital in the shipping industry over the past two or three years.

Mr Stokes summed up: “In my view, shipping will offer attractive opportunities for financial investors over the next five years, but I am not yet convinced that they have manifested themselves in the three major sectors. In the first scenario described above, worthwhile risk-adjusted returns in tankers, bulkers and container ships may continue to be elusive. In the second scenario, the bottom of the asset price cycle will become painfully apparent, but I suspect that most investors will be too distracted to take advantage of it.”

Mr Davis said that, sadly, he did not disagree with a lot of what Mr Stokes had said.

With the question of fuel costs and the concept of slow steaming raised during the ensuing discussion, Mr Stokes described the fuel efficiency argument as an interesting one and not invalid. He reiterated his caution, however. “I think that we have yet to see anything revolutionary in terms of engine design. We have seen various improvements, and you can argue about how significant they may be. Obviously the proponents have been vociferous – shipyards etc – but the important point is if you look at the real comparisons that make a difference (more important in container shipping than bulk shipping) for each individual ship it is the optimal speed and under what market conditions that is interesting.”

In the current market, the benefit of eco-ships over existing ships was significantly less than a lot of people were saying. Ultimately one can buy a perfectly good five year old ship at an attractively discounted cost that will continue to compete against the next generation of newbuildings, particularly as the cost of capital becomes a more important element. At the moment, fuel costs were swamping capital costs.

Another member at the table agreed that it was wrong for banks to keep kicking the can a long way down the road. He went on: “In Germany, it is a big can, and it is a very long road. Banks are not only dealing with the shipping crisis, but with a changing regulatory market… I am wondering, will the banks change from a head-in-the-sand attitude to taking a realistic approach?”

Mr Stokes replied that the key banks realised that “temporary stabilisation, the art of the possible,” only gets you so far. Some had talked more recently about debt to equity conversions. “Reality is forcing its way in. we cannot continue to support these situations without significant write-offs.” Although the forces of inertia were tremendous, there were a number of core banks which fundamentally depend for their immediate survival on where their shipping books are, “and I think we are getting close to a point where the debts have to be cleared, and that is partly political.  It is not just banks, it is governments [involved].”

A further question posed was: “Where has the money been coming from to finance this newbuilding book?” Answer: There has been some money coming in from alternative investment groups, but shipping entrepreneurs had benefited from phased payments. Some of the money came from Greece, some from Norway. A lot of what is reported in terms of newbuilding activity was not necessarily firm orders – for instance John Fredriksen had pulled back from an original announcement (regarding capsize bulkers in China).

Dealing with the role of China, Mr Stokes said that the shipping industry had to accept that China is not going to come to its rescue. The Chinese will be less of a factor than some expect for demand for container shipping. On the dry bulk side a lot will depend on the price of imported materials, and there will be a continued need for crude oil from the west, but whether it would be enough on its own to provide support for the tanker industry was doubtful.

On a different tack, the next question was: “The shipping industry has been first among equals in using tax efficient structures. Do you think this will fade away?

Mr Stokes: “In order to incur tax, you have to make a profit. As and when it starts to be profitable, it is one of those industries which fall very clearly within terms of regulators and people concerned with money laundering, as a classic. So it will not escape, it cannot escape.” There were some companies that pay a lot of tax, including the Chinese and AP Moller Maersk.  “The industry just has to accept that structures that have been put in place in order to minimise and in some cases eliminate any liability to corporate taxation will become increasingly difficult to sustain. That is just another element in the process which is steadily creating a higher and higher return-on-capital barrier to the industry.”

Mr Stokes added: “The industry is obsessed with cash flow but if you are not focusing on return on capital you are losing what it is all about, because you are not creating any ongoing value. I hope that this will force mature shipping companies to factor all these things in together with regulation and control.  The costs are growing and growing of running a shipping business.  That means your hurdle level is getting higher and higher.  People in this industry need to be thinking in these terms, in their approach to doing business.”

Jim Davis wound up the meeting by thanking Peter Stokes for his “predictably excellent presentation” which had led to a very high- level and relevant discussion.  He further conveyed on behalf of those present warm appreciation of the fine hospitality extended by Lazard.