When Ship Scrapping is an Industry’s Best Hope of a Favorable Wind

Holy Scrap!

When one wants to express strong astonishment, ‘Holy mackerel!’ is a nautical expression that does the trick well. We heard this expression (in British English, that is) many many years ago by a Brit who had beached on the Louisiana coastline in the US Gulf a few decades earlier.

There are a couple of theories for the origin of the expression, but the most plausible holds that since mackerel is a fish that goes bad very fast, fishermen in old England were given extraordinary permission by the church to sell their mackerel catch on Sundays. ‘Guests and fish stink in three days’, the wise Benjamin Franklin astutely once observed, but mackerel is worse than that. And if the church is willing to grant permission to do business on the Lord’s day, there has to be a sacred excuse, and thus the expression.

The expression came to mind while reading a market commentary on the fact that the just passed IMO regulation demanding 0.5% sulphur content in bunker fuel by 2020 will lead to a scrapping wave strong enough to bring a much wanted tonnage balance in the shipping market. In a lousy shipping market, this was a ‘Holy mackerel!’ moment, the way we saw it.

Or, ‘Holy scrap!’ to be more precise; nothing could be more sacrosanct than scrapping in the present market!

The IMO regulation has the potential to be a costly catalyst for the shipping industry, by as much as $40 billion by some estimates. For an industry in distress, additional costs and mandatory investments are the last news one wants to hear about. Complying with the new resolution, a shipowner would have to retrofit a vessel to burn high quality marine diesel fuel low in sulphur, install scrubbers to arrest pollutants and lower emissions or, thirdly, convert the vessel to be powered by natural gas or another low emissions fuel; all pricey solutions that will cost a couple of million of investment per vessel, a tough proposition for a shipowner in a weak market.

Scrapping however is a long shot as an alternative course of action.

Deciding to sell a vessel for scrap is one of the hardest decisions a shipowner has to make, and literally, this is the last decision they will make after exhausting every possible scenario. Selling a vessel for scrap is a terminal and irrevocable decision and quite often entails taking losses in today’s market. Even if there is a ray of hope and an alternative, the shipowner will decide to hold off selling the vessel for scrap. Old age, obsolete design, tonnage oversupply, new regulations, etc are not always definite reasons for scrapping.

With OPA 90, following the grounding of the infamous tanker ‘Exxon Valdez’, single hull tankers were given an expiration date for January 1st, 2015 to be totally removed from the trade. A long lead-time indeed for shipowners to plan for that resolution. What effectively happened was that although there were no single-hulled tanker newbuilding orders since the late 90’s and publicly listed and politically correct shipowners divested off of their single hull tonnage soon thereafter, almost 14% of the world’s tanker fleet was still single-hulled in January 2010, twenty whole years after the new regulation came into place and five years before the final ‘drop dead’ date. Regulations or not, shipowners, worldwide and collectively, effectively kept ‘obsolete’ ships in the market much longer than anybody would had anticipated.

2016-10oct29-holy-scrap-article_graph

Scrapping activity is an inverse relationship of the freight market. Credit: Karatzas Marine Advisors & Co.

The first decade of our century experienced once-in-a-lifetime freight market on the back of China’s expansive growth and easy credit by lenders, which partially explains how single-hulled tankers were kept afloat for so long. Actually, all being equal, the strength of the freight market is a best predictor of the level of scrapping and tonnage withdrawals from the shipping market. As long as freight rates are cash flow positive, ships are not getting scrapped; when the freight market is cash flow negative and prospects for a recovery are poor, then demolition levels pick up. The following graph of the Baltic Dry Index (BDI), the proxy for the dry bulk shipping market, clearly shows the inverse relationship between the index and scrapping activity. There seem to be a two-three month lag, but each time the BDI drastically moves, the scrap yards in Alang, Gadani and Chittagong get to hear about it, one way or another. Earlier in 2016, when the BDI was flirting with all time lows, demolition activity had spiked through the roof, approaching 10% of the world fleet. A few months later with the freight market barely above break even for the dry bulk market, scrapping has more than halved, to the disappointment of analysts and investors who were drawing straight line annual projections based on the activity of the first few months of the year. Scrapping is high still today, to be sure, and comes from many sectors, including containerships, but the moral of the story is that scrapping does not seem to be the convenient and sacrosanct solution that always seem to be.

There is a third case of disappointment in scrapping: after the shipping market collapsed in 2008, still cash rich shipowners and institutional investors were aiming at buying dirty cheap ships from shipping banks. When the banks held back from selling at any price, at least then, many a shipowner and especially an institutional investor jumped on the wagon of ‘eco-ships’ being fuel efficient that would make ships held by the banks obsolete. And, a massive wave of newbuilding orders was placed. Fast forward five years later, and we all now know that the fresh deliveries of better eco-ships failed miserably to force older tonnage to the scrap heap. Brand new ships, and modern ships, and older ship, and old ships have kept floating and trading and depressing the freight market for all. The wave of demolitions triggered by the eco-design deliveries crowding out older tonnage, shown in Power-point presentations to Wall Street, has failed to materialize and save the market. Holy scrap was not!

We do not want to discount the importance of scrapping to achieving a balanced market. Actually, at this stage of the cycle, scrapping seems one of the most promising drivers for the market; shipping is so bad, indeed. And the new regulations by the IMO for lower emissions will push some shipowners to the edge, and some ships to the beach. However, likely, in our opinion, scrapping will be a slow remedy that will be more drastic with the level of the pain of the market, that is the state of the BDI and the rest of the freight market.

As they say, pain is beauty!

Holy scrap!

reflection-on-water_propellerrudder_red_piraeus_kpm_jul2015-3

Never easy to say ‘Good bye’ in shipping. Image credit: Karatzas Images


This article was originally was posted on Splash 24/7 under the title ‘Holy Scrap’ on November 1st, 2016.


© 2013 – present Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.

Advertisements

Low and Dry: For how long?

Since the Baltic Dry Index (BDI) established all-time lows in February this year – as per graph herewith, the ensuing negligible recovery has only driven deeper the belief that the dry bulk market (and likely other shipping sectors) may be in a structural market trough. Rates have marginally improved since February, but the truth of the matter is that most types of dry bulk vessels barely earn their variable cost (operating expense), not to mention financial cost, capital repayment and profit. The market has been terrible for almost a year now, meaning that dry bulk shipowners are just bleeding cash; even at a small operating loss, let’s say at $1,000 pd, that’s $350,00 per annum per vessel, and for an owner of ten dry bulk vessels that’s $3.5 mil. This is before interest expense is factored in, repayment of the ship mortgage, etc While for the publicly listed companies their quarterly reports wash over casually over the computer screen as the Red Sea (or sea of numbers in red), it takes a ‘field trip’ and to ‘feel their pain’ of the private owners.

There is telltale evidence of anxiety about the direction of the market. There is anecdotal evidence that many shipowners have been cutting down on their vessel maintenance expense, spare part inventory on-board, and warm lay-up of the vessels. For the vessels that are inspected, there has been an ever growing concern that many vessels have been neglected and that ‘cheap ships’ may just be that: ‘cheap ships’ in need of keep-up. For the few shipping banks still open for business, the dry bulk market is a ‘do not touch’ market segment, irrespective of the prospects. Cyclical thinking and lack of liquidity has kept many buyers away from the market, further depressing asset prices, which in turn causes more owners to default in this death spiral. Asset prices for dry bulk vessels have declined by 20% to 50%; in a glaring example, a ten-year old panamax dry bulk vessel – as per graph herewith – has declined in value from appr. $21 mil in May last year to appr. $10 mil today, a precipitous drop and a halving on one’s net worth and economic value. Looking back at data for more than two decades, this is as low as that this particular asset class has even been, so at least on absolute terms, this is close to the bottom of the market. It’s hard to fathom that a ten-year old dry bulk vessel was once valued at more than $70 mil in 2008, so, if the market ever returns to its previous glory, theoretically, buyers at today’s levels will make a killing. But again, even a small bounce in the market can be a generous return of capital; asset prices and dry bulk freight rates move about fast, and if for some reason there is an improvement in a depressed market, a 10%+ improvement can take place very easily; at the very least, it will be completely unexpected.

Panamax Bulker 10yr old prices_KMA_JUN2015

Historical Prices for 10yr-old Panamax Bulker (Karatzas Marine Advisors & Co.)

Actually, there are ‘smart money’ out there that are thinking just about that. The dry bulk market is in very bad shape and the mood is terrible; not sure if the proverbial ‘blood in the streets’ describes the present bottom of the market, but definitely it’s a buyer’s market: bad prospects and confidence (for instance, almost nil interest for long term charters, indicating that charterers do not believe in a strong market recovery, etc), more sellers than buyers in absolute terms, more motivated sellers than buyers in ‘soft’ terms, consensus that prospects are terrible, no easily found debt financing or any type of financing, many institutional investors are putting their own pressure on the market as their premature investments in shipping are turning out badly. However, newbuilding orders have come to s screeching stop and fewer than thirty dry bulk vessels were ordered year-to-date. On the other hand, close to two-hundred bulk vessels were scrapped; as per attached graph, so far this year, the world’s dry bulk fleet has gotten smaller as more ships were scrapped than delivered, signifying that actually tonnage supply is contracting which is exactly what this market needs; and tonnage supply is one of the major drivers for asset pricing as we all know from Econ 101.

Tonnage demand and movement of cargo has been increasing all along; of course there have been revisions by OECD that world economic growth is slowing and that China has moved away from stock piling raw material inventories that used to spike the market on occasion. Volumes to be traded are still available and ton-mile is still increasing, thus demand is still there. Thus, the underlying fundamentals are still positive, it’s only a matter of timing that there is a mis-match of tonnage supply and demand.

Dry Bulk Feelt Development_KMA JUN2015

Historical World Dry Bulk Fleet Development (Karatzas Marine Advisors & Co.)

The smart money wonder whether the market swing has moved too much on the ‘half empty’ camp, with owners giving up on hope and charterers being too exposed to the spot market (with little long term coverage, thus making them trigger-happy once the market start moving the other direction). This can become a catalyst to magnify any market move to the upside as charterers will rush in to charter vessels (whether spot or short term) and driving artificially high tonnage demand with pent-up demand. With every weekly report of high demolitions, one can almost feel the collective deep breath of relief as this definitely helps the market find an equilibrium sooner than later; the news that no newbuilding orders are placed is delightful news both in terms of actual constraining of tonnage supply, but also it has the ‘sentimental’ value that at a time of crisis, no new ships are ordered, which is what is supposed to expect in a situation like this (and in 2002-2013, of course, but then between the eco-design and structural recovery and institutional investors rushing in, it didn’t happen). While tonnage supply can definitely increase over long term, at least for the short term, one can see that vessel deliveries are well known and accounted for, and likely to surprise on the downside (as some owners delay accepting delivery or push backward to the delivery deadlines). With every passing week of weak freight rates, more and more owners are making the decision to scrap vessels instead of drydocking and scrapping is not a stigma or more easily justified when the neighbors are doing it as well. Tonnage demand in the interim is constantly there and growing providing a support for the market; and the market has already been discounting bad news, thus leaving more surprises on the positive, that can move the market upwards substantially in the next year, especially if there is an unforeseen event that can drive the market strongly.

Yes, the dry bulk market is terrible. As we mentioned in a previous post, this terrible shape of the market may actually be a good thing over the long term; the smart money have started thinking that this weak market is a good thing in the short term as well.


 

© 2013-2015 Basil M Karatzas & Karatzas Marine Advisors & Co.  All Rights Reserved.

IMPORTANT DISCLAIMER:  Access to this blog signifies the reader’s irrevocable acceptance of this disclaimer. No part of this blog can be reproduced by any means and under any circumstances, whatsoever, in whole or in part, without proper attribution or the consent of the copyright and trademark holders of this website. Whilst every effort has been made to ensure that information here within has been received from sources believed to be reliable and such information is believed to be accurate at the time of publishing, no warranties or assurances whatsoever are made in reference to accuracy or completeness of said information, and no liability whatsoever will be accepted for taking or failing to take any action upon any information contained in any part of this website.  Thank you for the consideration.