A gathering storm

By Goola Warden& Kang Wan Chern

2040 words
20 October 2008
The Edge Singapore
English
(c) 2008 The Edge Publishing Pte Ltd. All Rights Reserved.

It is dark days ahead for the shipping industry, with plummeting freight rates and
a glut of new capacity as the global economy enters one of the deepest slumps in
decades. Could there be a silver lining?

As he gulps down more diet soda, the affable, charming and fast-talking Frederick
Chavalit Tsao is almost out of breath talking about global shipping. “We have been
offered three shipyards in China over the past week,” says the fourth-generation
ship owner. “Three, in one week,” he pauses for effect. Tsao, 51, calls himself a
hunter. “You’ve got to go out there and hunt. If you don’t, you will be hunted.”
The chairman of IMC Pan Asia Alliance Group says he has seen many shipping cycles.
Indeed, his family has seen more ups and downs than any shipping industry
historian dares to chronicle.

Yet even the hyperactive Tsao readily concedes that the global shipping industry
is going through an unprecedented storm. Freight rates are plummeting, a glut of
new capacity looms as the global economy enters one of the deepest slumps in
decades and shipyards go bust as ship owners unable to raise money in the midst of
a severe credit crunch cancel orders. “Anyone who has been in the business for a
while knows that we are heading for a big bust in shipping,” says Tsao as he
shrugs his shoulders. So severe is the current economic downturn that many
analysts are predicting trade volumes might actually shrink on some routes for
several quarters. “Most companies in the bulk and container market are suffering
because freight rates have collapsed,” says Adam Dupré, managing director of Ocean
Intelligence, a marine industry research group.

Last week, NOL abandoned its US$7 billion ($10.37 billion) bid for German
container shipping giant Hapag-Lloyd, a company that it has long coveted. The deal
would have been one of the biggest marine industry mergers in decades, muscling up
the Temasek-controlled shipping firm into a formidable global force, just behind
global leader Maersk. For NOL, the pullout “is actually a blessing in disguise”,
says Tsao. Anyone planning to buy Hapag-Lloyd right now is “crazy”, he says. “NOL
thought they are a player in the Pacific just as Hapag-Lloyd is in the Atlantic.
But they’d be buying a liability.”

Yet, it isn’t just about falling trade volumes and freight rates or the looming
capacity glut. The biggest problem is that banks aren’t lending to each other and,
therefore, not as many goods are being transported as they normally are. Khalid
Hashim, CEO Of Bangkok-listed dry bulk group Precious Shipping, cites an episode
where one of his clients was unable to cash a Letter of Credit (L/C) with a
leading Middle Eastern bank in Dubai. “Despite having all the required pieces of
paper to cash the valid L/C, our client was told by the bank that it simply did
not have the funds to pay him,” says Khalid, who has heard similar stories from
colleagues about L/Cs being cancelled or recalled in other countries. “American
banks are not accepting L/Cs from banks that they are not comfortable with. As a
result, exports out of the US are falling and exacerbating the already perilous
flow of cargoes.”

Too little cargo

The barometer Baltic Dry Index (BDI) fell a massive 40% last week to 1,506 as
there are now too many ships chasing too little cargo. The BDI is down nearly 88%
from its peak of 12,000. “The average time charter rate for Cape-size bulkers has
reached US$11,580 per day [from US$234,000 per day in June], which is loss-making
even if we disregard the depreciation expenses,” says Johnson Man Leung, an
analyst for JPMorgan in Hong Kong. Defaults are now starting to be an issue —
Ukraine-based Industrial Carriers with 52 bulkers on charter filed for bankruptcy
last week; Noble Group has filed a US$8 million suit against the once high-flying
STX Pan Ocean on the early return of a Cape-sized bulker, Mineral Noble.

“The last time we saw the BDI fall below 1,000 points and reach its lowest level
of 554 points was in July 1986,” recalls Khalid. “At that time, it was the
mountain of new ships entering the freight markets. This time around the avalanche
of new ships has not yet arrived, and may be delayed due to the critical lack of
funding. Yet, the BDI is sinking towards these historically low landmarks.” Tsao
believes “dry bulk is a roller coaster — it’s not for anybody, it’s for the old
hands to play”. Extreme volatility, he says “will get rid of people with no guts
from the business”, leaving it to serious and better-capitalised players.

Container freight rates are plummeting too, though not as fast as dry bulk rates.
That’s about to change, says Tsao. Volumes are already starting to drop. Last
week, China Shipping Container Lines Co forecast container traffic to and from
China could decline 10% next year as global demand for Chinese goods starts to
slow after several years of spectacular growth. Container business depends on
Western consumerism and the bursting of the housing bubble and credit crunch will
hurt global consumption, he says. Asia has long provided the cheap products headed
for discount stores in North America and Europe. It isn’t just falling disposable
incomes and discretionary spending that will likely hurt the global container
trade. Longer term, changing demographics like the ageing population in the West
is another concern. Because of transportation costs, there will likely be more
intra-regional trade rather than inter-continental trade like India selling goods
to Latin America or Europe selling goods to Australia. “North America can produce
in South America, so why would you want to produce everything in China?” Tsao
asks.

The worst affected are shipyards facing order cancellations because ship owners
can’t raise money from banks or capital markets to pay for the vessels they’ve
ordered. Shipping is a capital-intensive business and ship owners are normally
fairly heavily geared. As credit suddenly dries up, the entire shipping chain is
starting to freeze. Indeed, Ocean Intelligence’s Dupre says “no one can borrow;
bank financing is frozen. We are at crunch time.” Dupré says there are supposedly
11,900 ships currently on order at shipyards around the world. “If they all come
onstream over the next few years, it would be a very serious problem but contracts
are being cancelled,” he says. “We could see a dramatic drop in the number of
ships being delivered compared with ships ordered, which would theoretically
positively affect the supply side and help the shipping industry.”

‘I don’t need the ship’

Tsao, who was offered three bankrupt shipyards for sale last week, says capacity
is being taken out because shipyards are going belly up. “Nobody is extending
credit and everybody is panicking,” he says. Moreover, the shipping industry has
managed its capital fairly inefficiently until recently. “People were throwing
money at shipyards to build ships,” says Tsao. “They took the deposit but instead
of hedging steel costs, they used the money to start building the shipyard. They
know that steel price has gone up and since they haven’t covered themselves they
take on more orders to pay for the steel to secure the cost. Then suddenly, the
steel prices dropped. Now they’ve ordered the steel, and machines, and halfway
through, the customer says ‘you can have my 20% deposit, I don’t need the ship’.”
At Yangzijiang Shipbuilding’s new yard in Jiangsu province, however, it is
business as usual. Yangzijiang’s chairman Ren Yuanlin tells The Edge Singapore his
firm has not had any order cancellations so far. But even he concedes that
cancellations are “a problem for the smaller yards who may not have secured proper
downpayments from customers who have run into financing problems or those who may
not be able to source for and cover the costs of materials”. Ren says his firm has
secured a 20% downpayment on orders and another 20% first instalment to cover
material costs. “We believe that it is highly unlikely that our customers will
cancel orders due to bad financing. Unless the banks themselves go bust.”

Jin Xin, chairman of JES International, another China-based shipyard listed on the
Singapore Exchange, tells The Edge Singapore he is well aware of the gloomy
economy “but our motivation is still to continue building and delivering vessels”.
He adds, “we believe our adequate cash balances and strong order book will keep us
going.” JES International has about RMB1.1 billion ($238.35 million) in cash. “We
are continuing to spend on the new yard with money derived from the IPO proceeds.”

For his part, Tsao sees a silver lining in the gloom and doom. “The good news is
that this capacity would have been bad because the new shipyards in China would
have built lousy ships and they would have stayed for a long time in the market,”
he says. “These ships would be polluting our environment. The shipyards which have
no idea how to build ships deserve to be punished.” But Tsao believes that an
induced bust that the shipping industry might now witness will likely reduce the
real impact of a bust.

Still, with the credit squeeze unlikely to let up anytime soon, there is a real
chance that banks which have lent to highly geared ship owners and shipyards might
end up owning ships. This would be better than triggering an outright meltdown
that might see ship values collapse and freight rates collapse even further,
leading to forced scrapping of unneeded capacity. During the shipping recession in
the 1980s, European and US banks became reluctant owners of ships they had
repossessed from defaulting customers. That led to the emergence of third-party
ship management companies which managed ships on behalf of financial institutions.
“If you’ve got a situation of negative equity and the lender had to repossess the
ship to recoup funds, the bank would simply have to trade the ship until the
values rise and then sell it,” says Dupré.

Underlying demand for cargo still strong

What would shipping look like when the current downturn is over in two to three
years? In container shipping, clearly more consolidation is in order. But in the
dry bulk and tankers arena, the market will likely be even more segmented, says
Tsao. “There will be owner operators, speculators, trade suppliers like the
Japanese, indeed a whole range of players,” he says. “There will be industry-owned
shipping companies like in the 1970s — chemicals, oil or bulk like [Chinese steel
firm] Baosteel coming into shipping; [oil giant] BP has gone back to shipping and
so has [mining giant] the Rio Tinto group. In the old days they got rid of
shipping, but industry owned shipping is making a comeback. Still, that won’t mean
an end to shipping outsourcing. Companies will have the full range of tools. They
can outsource, own, subcontract, ally, lease, be a financier — a whole range of
products. You can be in container or dry bulk, but there will be a choice of many
roles. You can be just a charter, shipping fund, trust unit.”

Khalid of Precious Shipping is another one who sees a silver lining in the dark
picture ahead. “The underlying demand for cargo is still very strong as the
fundamental drivers of an increasing population, rapid wealth creation, changing
diet, rapid urbanisation and infrastructure growth are all still very much in
place and remain resilient and undaunted by the current financial crisis.” The
crisis may have dampened these factors for a while, he concedes, “ but it can’t
hold them back for long or forever”. Dupré couldn’t agree more. “As soon as the
buyers come back, China will be ready to feed the whole shipping food chain again
with its goods and its ships. “It might not be as bad if shipyards go bust quickly
and new capacity is taken out that way,” says Tsao.