The recent headline-grabbing $3 billion takeover of Royal P&O Nedlloyd NV by AP Moeller-Maersk, the world's largest container-shipping company, has put the spotlight on the fantastic boom that the sector has been enjoying. But somewhat obscured is the fact that the whole sector is now facing a potentially vicious cyclical downturn. At the time of writing, for example, the Japanese shipping sector had declined by almost 10% in the space of a week.
"During the past five years, we have witnessed the greatest boom that the shipping industry has enjoyed," says Luke Johnson in The Sunday Telegraph. "The numbers are staggering: the shipping industry generated $57bn in profits in 2003 and $80bn last year on annual revenue of more than $400bn." So, what kicked off this huge boom in the first place? Certainly, surging demand from China was a factor and, says Johnson, "as Far Eastern demand soared and the 1970s shipping fleet was scrapped, decades of over-supply reversed". He reckons "shipping is on the crest of a wave", and recommends Frontline because it "offers an exciting play on demand for crude". The fact that caught Johnson's eye is that the Bermuda-registered Frontline "offers an amazing dividend yield of almost 30% and trades on an historic p/e ratio of less than four. Last year, it enjoyed a net profit margin of almost 50%. If the Chinese economy maintains its momentum, then the bulk and oil-shipping sectors are likely to enjoy good times for a while yet."
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But unfortunately for Johnson and Frontline's super-charged earnings and generous dividend-payout story, the good times are already history. To begin with, rates for tankers have been disappointing this year. Their rates, which are measured in Worldscale points, are about WS95 for eastbound trips fromthe Gulf and only WS85 for journeys in the opposite direction. Last year, rates averaged about WS150, so this represents a decline of 40% year-on-year. Even more dramatic are the drops from the peak rates. "The cost of shipping a barrel of oil from the Persian Gulf to Japan has fallen by almost 70% from its 10 November record," according to data compiled by Bloomberg.
The problem is that, unfortunately, things just got too good. Such huge premiums over costs, which are largely fixed, resulted in rampant profits to be sure, but also attracted competition. As Bloomberg reports, "the demand [for tankers] spurred by last year's record earnings, coupled with rises in steel costs, has driven the price of new oil tankers to record [levels]". The stockmarket is just beginning to get wind of these developments, and Frontline's share price has broken its three-year uptrend. International new tanker capacity increased by 6% in 2004, but is now forecast to leap by a further 11% this year. Meanwhile, demand for tanker volume, which is largely determined by the amount by which Opec decides to raise supply, will probably only go up by 3% this year, although it rose 7.7% in 2004. Too many empty tankers chasing too little oil can't be good for rates. Longer term, tanker capacity is expected to rise by a total of 11% during 2006 and 2007.
Meanwhile, things appear to be no better in the container shipping market, where capacity is set to increase by 13% this year and by a further 16% in 2006. New supply may match the rather optimistic forecast of 12% demand growth this year, but will probably dwarf demand in 2006 when it is expected to slow down to 8.5%. Currently, the world's container ships can handle 7.34 million TEUs (20ft equivalent units). And the new ships that are already on order for delivery in 2009 will have sufficient space to carry 56% of that total again, according to Drewry Shipping Consultants.
Fuel and finance
Two further cost rises have also bitten deep into 2004's record profits. Firstly, fuel costs - what the shipping industry calls bunker prices - have gone through the roof due to rising oil prices. Bunkering costs for Japanese shipping firms, for example, hit an all-time high of $264.40 a tonne in March. Secondly, rising interest rates have cut deep. "Ships are mostly financed with debt," says Johnson, yet he fails to point out that the rate increases since the lows of last year have led to an almost "50% rise in financing costs for a typical shipping-financing deal", according to Citigroup analyst John Kartsonas.
A bleak shore
As ship purchases are highly geared, this dependence on interest rates and vulnerability to the vagaries of global supply and demand, few "have understood the nature and cycles of maritime commerce", according to Johnson. "The banks are the major funders; the key is to find a charter since an idle asset is expensive and the clever game is to play the asset cycles." Well, I couldn't agree more. The only problem is that all the evidence now suggests that the asset cycle is already heading south and shipping's crestof a wave is about to break on to a bleak, and unforgiving, shore. Thisis a sector to be avoided.
James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.
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