Shipping industry is a primary means of international transportation of any essential commodity. Around 80% of the cargo moved today is seaborne and almost 100% of hydrocarbon is transported through ocean. The global shipping industry can be broadly classified into wet bulk (like crude and petroleum products), dry bulk (like iron ore and coal) and liners (like containers and others). There are various benchmarks that determine freight rates for these segments. The prominent amongst them are Baltic Freight Index, Baltic Handymax Index (for dry bulk segment) and World Scale (for tankers).
The capacity of Indian shipping industry is estimated at 8.6 million grt (gross registered tonnage) with a fleet size of about 686 ships. The average age of Indian shipping fleet is 17.9 years compared to the world average of 19 years. Let us take a look into the demand and supply drivers for the shipping sector and also discuss the key factors that investors need to consider while investing in stocks from the sector.
I. Trade growth
World GDP growth: Shipping is a global industry and its prospects are closely tied to the level of economic activity in the world. A higher level of economic growth would generally lead to higher demand for industrial raw materials (like oil, iron ore and coal).
Oil demand/Supply: The tanker market cannot exist without the demand for oil and in particular how much of the demand is met through domestic production and stocks. Besides demand, oil supply (which mainly comes from OPEC) is also of significance. The quantum of oil produced by OPEC has a direct impact on the tanker market. For instance, if OPEC cut downs its production in February 2007 (to keep oil prices at desired levels), shipping industry might be left with surplus capacity considering that the tanker fleet is already growing at a rate faster than growth in demand for tonnage.
Oil inventory levels: The amount of oil held in storage which can be drawn upon to meet future requirements also impacts the demand for oil tankers. Generally, consumers hold stocks and levels are drawn down in winter and replenished in spring.
Steel production: Iron ore and coal together represent about 42% of the total global dry bulk trade. Since iron ore and coking coal are key inputs in the production of steel, steel production plays a significant role in determining the demand for dry bulk carriers.
II. Trade patterns
Refinery locations: Before it can be used for final consumption, crude oil needs to be refined into products like petrol, diesel and kerosene. Since refineries are generally located away from the places of production, crude tankers are used to transport crude oil from producing countries to refineries. Tanker transportation is generally more viable for inter-regional trades while pipelines are preferred for intra-regional trades. To distribute the refined petroleum products to places of consumption, product tankers and pipelines are used. Varying levels of capacity and the sophistication of refineries' processing capabilities also play a role in oil markets. Many refineries are located in consuming regions, facilitating response to weather-induced demand spikes and seasonal shifts.
Sourcing areas: The distance between the place of origin and the place of destination is an important demand driver since a shift from a shorter haul movement to a longer haul one (for the same amount of cargo) is likely to result in increased tonne-mile demand for vessels.
Regional grain production: Grain, along with iron ore and coal represents a significant portion of the total dry bulk trade. In case of a drought in a particular region, arrangements are made to import food-grains from countries with surplus production. This, in turn, influences the demand for dry bulk vessels.
Shipbuilding capacity: The number of vessels that a shipyard can build and the time taken to build a vessel plays an important role in determining the growth in tonnage supply. Since new capacities take time to set up, shipyards are unable to cope up with any sudden increase in demand. This impacts the delivery of ships and thereby acts as a supply constraint. Considering the huge order backlog of global shipyards, especially those in the Asian regions of Korea and Japan, ship owners are currently being quoted deliveries that will be beyond 2011.
New building prices: In case of high new building prices, shipping companies are likely to slow (or defer) their new purchases as the break even becomes higher. Similarly, lower new building prices can lead to increased orders (assuming that companies are expecting demand to pick up in the future), thereby increasing the total tonnage available in the market.
Economic Life: Higher the age of the fleet, higher is the expected scrapping and lower the net fleet growth. Economic life differs across vessel category (crude tankers have a relatively lesser economic life than dry bulk vessels). At present, the average age of the global shipping fleet is 19 years.
Regulations: Statutory regulations on age and safety norms set by International Maritime Organisation and the European Union may place restrictions on particular kinds of vessels, thus affecting fleet augmentation. For instance, the International Maritime Organistaion (IMO) has stipulated that all single hull ships be scrapped by 2010.
Over and above these fundamental demand and supply parameters, freight rates can witness spikes due to short-term events. These could be natural catastrophes, accidents or political upheaval in the form of strike/war, or even as basic as port/canal congestion.
Shipping stocks: Key considerations
Management: The ability of the management to foresee trends and alter the fleet mix accordingly to improve realisations is of high significance considering the volatile nature of the shipping industry. Since freight rates are highly volatile, it would be prudent for shipping companies to maintain sufficient revenue coverage through time charters. The company thus insulates its earnings from the highly cyclical nature of freight rates, thereby increasing its revenue visibility. Even though this comes at a cost of losing out on substantial upsides in case of attractive spot freight rates, the company can alter its mix of time charters and spot rates depending upon their outlook on freight rates.
Fleet mix: As mentioned earlier, shipping companies operates in different segments viz., tankers (crude and product), dry bulk, gas, containers and offshore. The segment in which a particular company operates, and the freight outlook in that segment, will ultimately determine the future prospects of the company. As compared to the dry bulk and crude segment, the offshore business provides higher visibility and lower volatility. Oil rigs provide long term visibility to the company's revenues and with the rise in exploration and production (E&P) activities, the demand for offshore support vessels is likely to remain strong.
Valuations: Shipping is a highly volatile business and freight rates are determined depending on global supply and demand. Therefore, valuing a shipping company on the basis of price to earnings may not be meaningful. However, considering the asset intensive nature of the shipping business, price to book value (P/BV) would be an appropriate method of valuation. Though the book value does not indicate the market value of the fleet, book value capture the essence of the balance-sheet strength of the company. It has to be remembered that when freight rates are higher, the asset value of the fleet increases and vice versa. If the company declares the net asset value (NAV), investors could use that as a very good indicator. Otherwise, we suggest investors to value a shipping business on the basis of P/BV. For offshore companies, price to earnings would be an appropriate tool as the revenue visibility is higher and also less volatile.
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