Saturday, September 19, 2009

Decisions Facing Ship Owners

A shipowner had a difficult decision to make. He had ordered two 280,000 dwt VLCCs which an oil company was prepared to charter for five years at $33,000 per day. This would guarantee revenue to cover his finance costs for the first five years of the ship’s life, but the return on his equity worked out at only 6 per cent per annum. Not much for the risk he had taken in ordering the ships. In addition,the time charter would shut him out from the tanker boom he felt sure would happen in the next few years.He decided to wait and trade the ships on the spot market. To begin with this looked like a good decision, since the ships were delivered into a rising market.Unfortunately the next three years proved to be very poor and the vessels earned only $15,000 per day each. To meet bank payments the owner was forced to sell three old combined carriers. Since there were no offers from trading buyers heeventually sold them to a breaker for $5 million each. Two years earlier they had been valued at $23 million each.In this example the shipowner trades in four different markets:
1.The newbuilding market where he ordered the ships;
2.The freight market where he chartered them;
3.The sale and purchase market where he tried to sell the combined carriers; and
4.The demolition market where he finally sold them.

We seek to explain how the four markets work from a practical viewpoint and to identify the differences between them. How are ships chartered?How does the sale and purchase market operate and what determines the value of a ship? What is the difference between buying a new ship and buying a second-hand one? How did selling the ship for scrap differ from selling it for continued trading? An understanding of these practical questions lays the foundation for our discussion of the economic principles that covers the maritime industry.

Jevons, the nineteenth century economist provided a definition of a ‘market’ which,a century later, still serves very well for shipping. He says: Originally a market was a public place in a town where provisions and other objects were exposed for sale; but the word has been generalized, so as to mean any body of persons who are in intimate business relations and carry on extensive transactions in any commodity. A great city may contain as many markets as there are important branches of trade, and these markets may or may not belocalized. The central point of a market is the central exchange, mart or auction rooms where traders agree to meet and transact business… But this distinction of locality is not necessary. The traders may be spread over a whole town, or region of country and yet make a market if they are…in close communication with each other.

In shipping there are four shipping markets trading in different commodities. The freight market trades sea transport, the sale and purchase market trades second-hand ships, the newbuilding market trades new ships and the demolition market deals in scrap ships. Beyond this there is no formal structure. This is an important point which calls for a warning. We will discuss the economics of the shipping markets. While this analysis provides guidance on how the markets operate, we are not dealing with immutable laws. The fact that market traders have behaved in a particular way in the past is no guarantee that they will do so in future. Because markets consist of people going about their business, the best commercial opportunities often arise when the market behaves inconsistently.For example, ordering ships at the top of the market cycle is usually bad business,but if for some reason few ships are ordered, the rule will not apply. Commercial judgements must be based on an understanding of market dynamics, not economic principles taken out of context.Because the same shipowners are trading in all four shipping markets their activities are closely correlated. When freight rates rise or fall the changing sentiment ripples through into the sale and purchase market and from there into the newbuilding market. The markets are also linked by cash. Cash flows back and forth between the industry’s bank account and the four shipping markets. Cash which changes hands from one ship owner to another, but does not change the cash balance of the industry as a whole.The main cash inflow is freight revenue. This goes up and down with freight rates and is the primary mechanism driving the activities of shipping investors.The other cash inflow comes from the demolition market. Old or obsolete vessels sold to scrap dealers provide a useful source of cash, especially during recessions.The sale and purchase (S&P) market has a more subtle role. Investing in a second-hand ship involves a transaction between a shipowner and an investor. Because the investor is usually another shipowner money changes hands, but the transaction does not affect the amount of cash held by the industry. The sale of a tanker for $20million just transfers $20 million cash from one shipping bank account to another,leaving the aggregate cash balance unchanged.

In this sense the sale and purchase market is a zero sum game. For every winner there is a loser. The only real source of wealth is trading cargo in the freight market.

In the case of the new building market the cashflow is in the opposite direction. Cash spent on new ships flows out of the shipping industry because the shipyard uses it to pay for materials, labour and profit.Waves of cash flowing between the four markets drive the shipping market cycle. At the beginning of the cycle freight rates rise and cash starts to pour in,allowing shipowners to pay higher prices for second-hand ships. As prices are bid up investors turn to the newbuilding market which now looks better value. With the confidence created by bulging wallets they order many new ships. A couple of years later the ships arrive on the market and the whole process goes into reverse.Falling freight rates squeeze the cash inflow just as investors start paying for their new buildings. Financially weak owners who cannot meet their day-to-day obligations are forced to sell ships on the second-hand market. This is the point at which the asset play market starts for those shipowners with strong balance sheets.In extreme circumstances like 1932 or 1986 modern ships change hands at bargain prices. For older ships there will be no offers from trading buyers, so hard pressed owners are obliged to sell for demolition. As more ships are scrapped the supply falls, freight rates are bid up and the whole process starts again.

The whole commercial process is controlled and co-ordinated by cash flow between markets. Cash is the ‘stick and carrot’ which the market uses to drive activity in the required direction. Whether they like it or not, shipowners are part of a process which controls the price of the ships they trade and the revenue they earn.

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