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G.E. Shipping: Research meeting extracts - Views on News from Equitymaster

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G.E. Shipping: Research meeting extracts
Aug 14, 2006

We had recently met with the management of G.E. Shipping (GES) to gain first hand information of the offshore demerger plan, state of the shipping business and expectations from the future. Here are the key takeaways from the meeting. Offshore demerger: GES has filed an application in the Bombay High Court for extension of the deadline for demerger of the offshore business into a separately listed entity – Great Offshore. The earlier deadline had expired on August 2, 2006. Against the earlier scheme of share swap amongst the stakeholders in the proposed two companies of shipping and offshore businesses, the new proposed arrangement does not include this clause. Rather, the shareholding pattern in Great Offshore will be a mirror image of GES. Moreover, the new arrangement will also put to rest worries indicated by the clients of the offshore business on its viability as a separately managed company. The management has clarified to us that the concerns were not in terms of financial guarantee but for performance guarantee, since the business was scheduled to have an independent management. Now, as per the latest scheme of arrangement, it is proposed that after the de-merger is affected, both the companies, i.e., GES and Great Offshore, will be headed by Mr. K.M. Sheth as Chairman and will have identical promoters. Even then, while GES will have no responsibility for the business operations of Great Offshore, the fact that the promoters and Chairman will be the same, might go a long way towards soothing concerns of the contracting parties of the offshore business. If passed, the demerger will be effective April 1, 2005. Also, the process of demerger will take about 6 months from the date of approval by the court.

Changing trade patterns: In our earlier meeting with GES’ management (in September 2005), it was indicated that not the high price of crude but the longevity of the prices remaining high is what can affect the global shipping industry. And, since global crude prices have remained at very high levels during this period (currently hovering at nearly US$ 77 per barrel), we again raised the question of an adverse affect on the shipping business.

This time, while the management has again cited the high crude prices as a big challenge to growth of the shipping industry, it also seemed to draw comfort from the changing trade patterns in the industry.

Readers would do well to note that, historically, crude oil and petroleum products flowed to the markets that provided the highest value to suppliers. Oil moved to the nearest market first, because that had the lowest transportation cost and therefore provided the supplier with the highest revenue. If this market could not absorb all the oil, the balance moved to the next closest one, and the next and so on, until all the oil was placed.

In the case of the US, it has been depending a lot on its Western Hemisphere (WH) neighbors for import of crude. As per the US Energy Information Administration (EIA), against 1.7 m barrels per day (mbpd) of crude that the US imported from the WH in 1973, the quantum increased to almost 5 mbpd (or 50% of total imports) in 2003. Much of these voyages (from WH to the US ports) were of less than a week’s duration, indicated as ‘short-haul’. The North Sea, Mexican and Venezuelan regions also helped the trend toward short-haul shipments to the US.

However, there is a change in trade flow patterns, as indicated by GES management. And this is of critical importance to the global shipping industry. This is due to the fact that the abovementioned regions (North Sea, Mexico and Venezuela) have reduced their crude production in recent times in line with their aim of increasing their reserve accretion ratio (higher reserves of crude to meet anticipated growth in domestic demand). However, this has not led the US to reduce its consumption of oil and, consequently, imports from regions like West Africa and the Middle East have been on the rise. This has led an increase in ‘long haul’ tonnage, thus aiding shipping companies to put their tonnage to a longer duration of use, thus earning more consistent and larger amount of revenues from their assets. Long hauls have also taken off some pressure on freight rates due to the increase in tonnage supply.

This was on the wet bulk front (crude and petroleum products). As far as the dry bulk (commodities) trade is concerned, a similar situation is expected to lead to stable rates going forward. With China not seeing any reduction in steel production and consequently importing large amounts of iron ore, dry bulk rates are likely to stay strong. Another factor working in favour of shipping companies is that this dry bulk trade of iron ore to China has now taken a longer haul route from Brazil. This is because the short haul tonnage from India has been on a decline as the latter has reduced its exports of iron ore to China. As a matter of fact, around 55% of India’s exports to China are iron ore and, with large domestic steel capacity expansions plans on the anvil, there has been a rising need within the country to ensure future availiability of the input.

Other factors of freight stability: Against its view in April 2006 of slowdown in the global shipping industry on the back of large supply of tonnage, GES’ management now believes of a better than expected second half of the year (July to December 2006). This is on the back of a lower base effect as the US refineries, which are generally shut for maintenance in the final months of a calender year, were shut down in the first quarter of this calender year, which impacted exports from the US during the January to March 2006 period. Consequently, recovery of refineries post the maintenance and expected robust demand for gasoline and jet fuel is expected to push refiners to increase throughput in the subsequent months (this has already been seen in the April to June quarter). This is expected to create sufficient demand for tonnage in the coming months.

The managemnt has also indicated that, due to the ongoing tensions in the Middle East, some of the producing countries have used their shipping vessels as ‘floating storages’ (ships filled with crude barrels floating on the shores). This has led to a sort of reduction in available tonnage and has subsequently led to rise in freight rates in 1QFY07. To be precise, around 9 to 12 VLCCs (very large crude carriers) have been used as floating storages and, if the tensions are to continue, more are likely to follow suit.

Challenges to growth: Apart from the factors expected to bring about some stability (and strength) in tanker freight rates in the coming months, GES’ management outlined two major concerns.

  1. Sustenance in high crude prices and consequent slow down in global crude consumption is what the management is worried about. While some of the company’s clients are estimating per barrel rate of US$ 58 to US$ 68 by the end of this calender year, the managemnt has indicated that a rate of US$ 80 per barrel and above will surely derail growth.

  2. Retaining talent is another major concern for GES. Indian shipping regulations specify that domestic shipping companies, including GES, can only employ Indian seafarers/shipping officers on its rolls. This is leading to a sort of manpower crunch for GES that has been on a part of fleet expansion in the past couple of years. Also, increasing competition for talent from MNC ship-owners, and consequently the need to pay higher salaries to employees as a retention measure is putting some pressure on margins. Further rise in fleet and thus higher requirement of trained manpower will only aggravate the problem.

  3. Increasing bunker rates: Bunker refers to the fuel, such as coal or oil, which is required to run ships. With the rise in global crude prices, GES has seen a considerable rise in the bunker costs and this has impacted margins. As a matter of fact, against 7% of shipping revenues in FY04, fuel costs touched 10% of such revenues in FY05. Now, despite the fact that FY06 fuel cost figures are not available as yet, one can safely assume that considering the spike in crude prices over the last few months, fuel costs must have definitely increased further for GES in the last fiscal.

Global tanker tonnage: The net fleet growth is expected to be around 6% in the current calender year. The current world tanker fleet stands at about 367 mdwt (million dead weight tonnes) with another 110 mdwt likely to come in the next 2 years.

GES’ fleet: GES' current fleet of 74 vessels comprises 40 ships (an aggregate tonnage of 2.87 mdwt) and 34 offshore vessels (20 Offshore Support Vessels, 2 Drilling Rigs, 1 Construction Barge, 11 Harbour Tugs). The company’s current new building order book comprises 5 MR and 4 LR1 product tankers (aggregating 0.51 mdwt) and 5 offshore support vessels. The aggregate committed capex is around US$ 450 m over the next two years.

What to expect?
At the current price of Rs 257, the stock is trading at 1.1 times our estimated FY08 book value per share. The revised offshore demerger scheme has raised expectations of some value unlocking for investors. Also, while renewed expectations of stability in tonnage demand and freight rates during the second half of the fiscal shall soothe some nerves, concerns with respect to consistently high crude prices and talent retention remain our key concerns for the company. On a balance, we maintain our ‘Hold’ view on the stock.

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