Saturday, September 19, 2009

Shipping Market Cycles

Cycles are not unique to shipping. They occur in many industries and in the economy as a whole. Economic historians have devoted much effort to analysing and classifying cycles into categories, usually focusing on their length. Many different types of cycle have been identified. The Kitchen is a short cycle of 3–4 years; the Juglar lasts 6–8 years; the Labrousse can last 10 or 12 years; the Kuznets lasts 20 years, while a Kondratieff spreads over a half century or more.

In shipping the existence of cycles has long been accepted as part of the shipping business. In January 1901 a broker noted in his annual report that ‘the comparison of the last four cycles (10 year periods) brings out a marked similarity in the salient features of each component year, and the course of prices’. He went on to observe that the cycles seemed to be getting longer ‘a further retrospect shows that in the successive decades the periods of inflation gradually shrink, while the periods of depression correspondingly stretch out’.
Although the length of cycles is of great interest, it soon became evident to observers of the shipping business that the cycles were far more complex than a sequence of regular fluctuations in freight rates. Kirkaldy (1913), saw the cycle as a consequence of the market mechanism. The peaks and troughs in the cycle are signs that the market is adjusting supply to demand by regulating the cashflow:
With the great development of ocean transport, which commenced about half acentury ago, competition became very much accentuated. As the markets became increasingly normal, and trade progressively regular, there was from time to time more tonnage available at a given port than there was cargo ready for shipment. With unlimited competition this led to the cutting of rates, and at times shipping had to be run at a loss. The result was that shipping became an industry enjoying very fluctuating prosperity. Several lean years would be followed by a series of prosperous years. The wealthy ship-owner could afford to put the good years against the bad, and strike an average; a less fortunate colleague after perhaps enjoying a prosperous time, would be unable to face the lean years, and have to give up the struggle.

Viewed in this way, shipping market cycles have a purpose. They create the environment in which weak shipping companies are forced out, leaving the strong to survive and prosper, fostering a lean and efficient shipping business.

While Kirkaldy dwelt on the competition between owners and the part played by cash flow pressures, E.E Fayle (1933) had more to say about the mechanics of the cycle. He suggested that the build-up of a cycle is triggered by the world business cycle or random events such as wars which create a shortage of ships. The resulting high freight rates attract new investors into the industry, and encourage a flood of speculative investment, thus expanding shipping capacity: The extreme elasticity of tramp shipping, the ease with which new-comers can establish themselves, and the very wide fluctuations of demand, make the ownership of tramp steamers one of the most speculative forms of all legitimate business. A boom in trade or a demand for shipping for military transport (as during the South African War) would quickly produce a disproportion between supply and demand; sending freight soaring upwards. In the hope of sharing the profits of the boom, owners hastened to increase their fleet and new owners come into the business. The world’s tonnage was rapidly increased to a figure beyond the normal requirements, and the short boom was usually followed by a prolonged slump.

This perception of the cycle suggests a sequence of three events, a trade boom, a short shipping boom during which there is overbuilding, followed by a ‘prolonged’slump. However Fayle is not confident about the sequence, since he says the boom is ‘usually’ followed by a prolonged slump. He thought the tendency of the cycles to overshoot the mark could be attributed to the lack of barriers to entry. Once again the cycle is more about people than statistics.Forty years later Cufley (1972) also drew attention to the sequence of three key events common to shipping cycles. First, a shortage of ships develops, second, high freight rates stimulate over-ordering of the ships in short supply which finally leads to market collapse and recession.

The main function of the freight market is to provide a supply of ships for that part of world trade which, for one reason or another, does not lend itself to long-term freighting practices. In the short term this is achieved by the interplay of market forces through the familiar cycle of booms and slumps. When a shortage of ships develops rising freights lead to a massive construction of new ships.There comes a point either when demand subsides or when deliveries of new vessels overtake a still increasing demand. At this stage freights collapse, vessels are condemned to idleness in laying up berths.

An elegant definition of the cycle as the process by which the market co-ordinates supply with changes in demand by means of the familiar cycle of booms and slumps. However, Cufley is convinced that the cycle is too irregular to predict. He goes onto say: Any attempt to make long-term forecasts of voyage freights (as distinct from interpreting the general trend in growth of demand) is doomed to failure. It is totally impossible to predict when the open market will move upwards (or fall),to estimate the extent of the swing or the duration of the phase.

Finally Hampton (1991) in his analysis of long and short shipping cycles emphasizes the important part played by people and the way they respond to price signals received from the market: In today’s modern shipping market it is easy to forget that a drama of human emotions is played out in market movements… In the shipping market, price movements provide the cues. Changes in freight rates or ship prices signal the next round of investment decisions. Freight rates work themselves higher and trigger orders. Eventually excess orders undermine freight rates. Lower freight rates stall orders and encourage demolition. At the low point in the cycle, reduced ordering and increased demolition shrink the supply and set the stage for a rise in freight rates. The circle revolves.

Hampton goes on to argue that market sentiment plays an important part in determining the structure of cycles and that this can help to explain why the market repeatedly seems to over-react to the price signals.In any market including the shipping market, the participants are caught up in a struggle between fear and greed. Because we are human beings, influenced to varying degrees by those around us, the psychology of the crowd feeds up on itself until it reaches an extreme that cannot be sustained. Once the extreme has been reached, too many decisions have been made out of emotion and a blind comfort which comes from following the crowd rather than objective fact. All these descriptions of the shipping cycle have a common theme. They describe it as a mechanism devoted to removing imbalances in the supply and demand for ships. If there is too little supply, the market rewards investors with high freight rates until more ships are ordered. When there are too many ships it squeezes the cashflow until owners give up the struggle and ships are scrapped. Looked at in this way the length of the cycles is incidental. They last as long as is necessary to do the job. It is possible to classify them by length, but this is not very helpful as a forecasting aid. If investors decide that an upturn is due and decide not to scrap their ships, the cycle just lasts longer. Since shipowners are constantly trying to second guess the cycle, crowd psychology gives each cycle a distinctive character.Yet another reason why the cycles are irregular.

Stage 1: Trough

We can identify three characteristics of a trough. First, there will be evidence of surplus shipping capacity. Ships queue up at loading points and vessels at sea slow steam to save fuel and delay arrival. Secondly freight rates fall to the operating cost of the least efficient ships in the fleet which move into lay up. Thirdly, sustained low freight rates and tight credit create a negative net cash flow which becomes progressively greater. Shipping companies short of cash are forced to sell ships at distress prices, since there are few buyers. The price of old ships falls to the scrap price, leading to active demolition market.

Stage 2: Recovery
As supply and demand move towards balance, the first positive sign of a recovery is positive increase in freight rates above operating costs, followed by a fall in laid up tonnage. Market sentiment remains uncertain and unpredictable.Spells of optimism alternate with profound doubts about whether a recovery is really happening. As liquidity improves second-hand prices rise and sentiment firms.

Stage 3: Peak/Plateau
When all the surplus has been absorbed the market enters a phase where supply and demand are in tight balance. Freight rates are high, often two or three times operating costs. The peak may last a few weeks or several years,depending on the balance of supply/demand pressures. Only untradeable ships are laid up; the fleet operates at full speed; owners become very liquid; banks are keen to lend; the press report the prosperous shipping business; there are public flotations ofshipping companies. Second hand prices move above ‘book value’
and prompt modern ships may sell for more than the newbuilding price. The shipbuilding orderbook expands,slowly at first, then more rapidly.

Stage 4: Collapse
When supply overtakes demand the market moves into the collapse phase. Although the downturn is generally caused by fundamental factors such as the business cycle, the clearing of port congestion and the delivery of vessels ordered at the top of the market, all of which take time, sentiment can accelerate the collapse into a few weeks. Spot ships build up in key ports. Freight rates fall, ships reduce operating speed and the least attractive vessels have to wait for cargo. Liquidity remains high.Sentiment is confused, changing with each rally in rates.

1 comment:

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