Thursday, May 28, 2009

Is Goldman Sach's optimism on the drybulk market justified?

Goldman Sachs was optimistic on US recovery before many others. Now they are taking a bullish stand on the drybulk market based on the China story, which has been driving the market for many years now. Although once considered immune to a global recession, China has had a hard landing due collapsing exports to US and EU markets. Drybulk rates have made a modest comeback this year. One has to distinguish between short-term inventory replenishment and longer term restructuring of the export-oriented economic model. China has considerable productive overcapacity that needs to be reduced and it will take time to create domestic demand to fill the slack.

US fiscal and monetary policy has been focused on increasing asset prices at any cost. The FED now has a vastly expanded balance sheet. The US has been the importer of the first and last resort with very low savings rate and heavy debt burden. The major problem for the US is how to de-leverage. The US response has been for the Federal government to bail out their major lame duck industries by expanded deficits and massive increase in public debt as opposed to reducing it by write-offs and conversions to equity. The looming risks are higher than expected funding rates, currency devaluation and a reduced debt rating. Lately the US dollar has been weakening and long term treasury rates hardening.

The Chinese have tremendous productive overcapacity and sharply declining export markets. They have a high savings rate and hard cash that they have put into domestic stimulus. They are in a more favorable position than the US since they do not have the debt load to carry. Their stimulus programs are likely to be more effective. Longer term, however, they will have to reduce capacity.

The drybulk market depends on steel production and the construction industry is the biggest source of steel demand in China. The Chinese have been renegotiating their supply contracts to reduce prices since demand has fallen and commodities markets have become weaker. It is very likely that they will in the future change their supply chain management and more cargo will be carried on longer-term contracts of affreightment. They may try to channel more of this business to their national fleet.

We could have some improvement in the fall markets but it is also possible that markets will again weaken and remain sluggish throughout 2010 and even 2011.

There is a considerable range of views between economists because of the complexity of these structural economic changes, major disputes on correct policy decisions and untested responses like the FED quantitative easing. The politics that drive these policy decisions favoring certain groups over others does not guarantee the best allocation of resources or most appropriate course of action so we have to expect backing and filling as events evolve.

As a postscript to this article, this past week there has been a surge in demand for Capesize bulk carriers and rates have soared to US$ 70,000 per day for trip charters. Omar Nokta of Dahlman Rose has made the case that the worst is over for the drybulk sector. He sees vessel values rising 20% or more in the second half of the year. This is based on firming Chinese steel prices and rising demand that brings rates up. Others like Drewry do not see sustained improvement in this sector until 2011. Both have reservations on the vessel order book, but Dahlman place much bigger faith than Drewry in the Chinese demand.

We have discussed the China situation in the above article as well as our previous piece. Short term there will be renewed demand from stimulus programs. Long term, there is likely to be some significant restructuring. In the past, Chinese demand has always exceeded expectations. Looking forward, this is harder to evaluate in view of their excess capacity and over reliance on export markets. If the Chinese choose to restructure and reduce capacity, then the demand factor will be less dominant than previous years.

Friday, May 22, 2009

Future Dry Bulk outlook mixed

Whilst dry bulk rates crashed hard last fall, this winter there has been a nice rebound that is now meeting resistance and looking choppy. Some like Omar Nokta of Dahlman Rose think there could be a big jolt in the second half toward the upside based on Chinese stimulus and rising steel prices. Since vessels for 2009 are well advanced in construction, cancelations will play a bigger role in 2010 and 2011. HSBC believes that two thirds of dry-cargo newbuildings penned for delivery next year could be axed or delayed by shipowners reducing the total world order book by as much as one-third. Short-term Chinese stimulus will boost demand but longer term, the Chinese are likely to cut supply. This is likely to mean a longer recession for the dry bulk sector than anticipated despite some short term recovery.

The positive thing about the dry bulk sector is that second-hand values now seem to be in balance with three-year charter rates. Values have plummeted 60% for this result albeit still US$ 5000 per day above long term (1992-2008) average rates. Despite the cancelations, the order book situation is alarming. If 66% of the 2009 and 79% of 2010 orderbook never reach the sea, annual deliveries will still average those of 2008!

Whilst the Chinese have hard cash and can cover fiscal expansion without increase in public debt, this cannot keep China running at 8% growth for more than a few years. The big problem is that China is an export-driven economy and EU/ US markets are not likely to rebound quickly. China will have to take measures to restructure and increase domestic consumption. This will not be easy as the banking system is very underdeveloped and there are renewed risks for non-performing loans.

Chinese steel production is down 18% and iron ore demand fell by 22%, Steam coal was the only commodity to maintain momentum in 4th quarter 2008. Global Insight expects China dry bulk demand to hit a 10-year low in 2009. Whilst there may be some increase in demand as we have seen already this year and even unexpected surges due domestic stimulus, the longer term likelihood with Government policy shifts to cut supply and boost domestic demand bode ill for dry bulk shipping even with substantial order book cancelations.

Most publicly listed dry bulk companies are recent enterprises without large reserves from past years. Many expanded their assets bases at top of the market prices in the boom years and took on substantial bank leverage. They been through the first round of renegotiations with their senior debt creditors on loan/ asset covenant defaults. Many have raised additional capital often by 'at the market' issues.

If there is not a robust recovery and the market continues weak over time, pressures will mount for further industry consolidation. Bankers will be increasingly tough on terms and may start to press to liquidate their losses. For these reasons, a cautious approach is still required for this sector.

Monday, May 11, 2009

Lucky George...

After successfully raising US$ 500 mio by selling shares over several months at market levels, DryShips is now planning to sell up to US$ 475 mio shares in its second ATM equity offering of 2009. As long as investors continue to purchase the shares at ever higher values above NAV, the more accretive it is for previous shareholders as it aids net asset value.

DRYS management is reserving the widest range of options for the use of the proceeds: to opportunistically acquire additional dry-bulk vessels in the current market environment, and for working capital, existing capital expenditures, repayment of indebtedness, general corporate purposes and, as needed, to continue to enhance our liquidity and to assist in complying with our loan covenants.

The company remains overleveraged. Whilst there has been some improvement in dry cargo rates, the Panamax-size units, which are the core of the fleet, are probably the hardest hit sector in this market. Some forecasters feel that supply-side pressure is likely to cap the Baltic Dry Index in the next two years. In addition, DRYS has taken a sizeable impairment charge on its oil rig acquisition and has more drill rigs on order.

Continued investor enthusiasm to purchase additional shares of this company may prove that positive expectations can be a self-fulfilling means of recovery for this company. The expectations are largely based on steel producers hiking output ahead of the Chinese government's stimulus measures, and fixing iron ore from abroad to meet their anticipated needs.

Thursday, May 7, 2009

The Liquidationists vs Big Government: mounting public concern

There is a growing debate that the deadwood has to be cleared in the US economy for a meaningful recovery to take place. So far the Beltway has avoided and short-circuited normal bankruptcy procedures preferring back-room deals without much transparency like the Bear Stearns - JP Morgan shotgun marriage or complicated schemes like the Chrysler restructuring where FIAT puts up no money and is taxpayer funded. Concern is mounting that this is not a sustainable or viable strategy.

There is little doubt that the corporatist form of capitalism that has developed in the US is vindicating Joseph Schumpeter's worst nightmares. Schumpeter famously argued that the essence of capitalism was creative destruction, by which new economic structures are born from the rubble of older ones. Schumpeter’s biggest fear was that creative destruction would lead capitalism to collapse from within, because society would not be able to handle the chaos. He was right to be afraid. The response of governments worldwide to the financial crisis has been to give the structure of private profit-taking an ever-growing scaffolding of socialized risk.

US policy makers have lately done their utmost to promote the demise of creative destruction. Their vision is a corporatist capitalism that is government funded and guided by public policy. This system as exhibited by the US financial industry that has been operating for years now on a system of political patronage and expanding government involvement in credit allocation primarily in the housing markets, which the Obama administration appears to be expanding on all fronts. Certainly with the massive stimulus programs, the moral hazard for political cronyism is on the rise. This system risks potentially creating a web of ever more parasitic relationships between the public and private sector.

Whilst market discipline would force organic industry reform for businesses to survive the market place, the buzz word of government bail outs give the favored a free ride. The path of the least resistance is to follow the government instead of facing market risks. What is inducing FIAT - a foreign automobile company - to jump into Chrysler, as opposed to putting their own funds and starting a US operation on their own? What keeps large US banks from their breaking themselves up and creating more economically viable and manageable units?

In effect, the US government under the mantra of saving jobs and temptation of expanded political patronage is impeding a natural clearing of the deadwood in the market place. The emerging US economy from this crisis is likely to be debt ridden and uncompetitive in a global markets.

The risks are that the declining productivity will weigh negatively on US government tax revenues, dashing hopes of paying down the surge in public debt. If the US State governments are any harbor to the future, even a small rise in interest rates would create a crushing burden leading to even larger federal deficits. What was originally envisaged as public debt levels of 80% GDP could reach over 100% GDP.

There are growing signs of broad-based concern. This ranges from the 'tea-parties' on the grass roots level to high level figures in the business community like Warren Buffett and Charles Munger.

Is there a showdown coming between the banking industry and the US Treasury?

The US has embarked on an unsustainable course, keeping its financial industry alive by massive bailout schemes and financing it by budget deficits and mounting public debt. Many like Warren Buffett are getting worried about the aftermath of these policies.

Some like Simon Johnson have called for an end to these policies and reversion to a straightforward cleanup and pruning of the banking system. They see a surge of crony capitalism on the Beltway.

Recently Buffett's proxy, Charles Munger, added to the fire. The probabilities are that sooner or later the Treasury will be compelled to move, but so far they resisting hard for political reasons. There is no telling that there is going to be a V-shape recovery. It could also come as an L or U recovery. It is certain, however, that the US will not be competitive globally with high public debt and high taxes. There may be no other recourse but to deflate the debt by monetization.

Berkshire Hathaway Inc. Vice Chairman Charles Munger, whose company is the largest private shareholder in Goldman Sachs Group Inc. and Wells Fargo & Co. said banks will use their “enormous political power” to prevent changes to the industry that would benefit society.

“This is an enormously influential group of people, and 90 percent of that influence is being spent to gain powers and practices that the world would be better off without,” Munger, 85, said yesterday in an interview with Bloomberg Television. “It will be very hard to accomplish the kind of surgery that would be desirable for the wider civilization.”

Munger said policy makers should seek to impose limits on banks that are deemed “too big to fail” after financial institutions worldwide suffered more than $1 trillion in losses. The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the recession.

“We need to remove from the investment banking and the commercial banking industries a lot of the practices and prerogatives that they have so lovingly possessed,” Munger said. “If they are too big to fail, they are too big to be allowed to be as gamey and venal as they’ve been -- and as stupid as they’ve been.”

As for dealing with the aftermath and mountain of debt, this depends on the position of the foreign creditors. As long as China needs US markets to sell its goods, the Chinese government will not be in a strong position to demand tough terms, but if they become more independent and self-reliant on domestic consumption, then things are likely to turn nasty. Chinese authorities are clearly getting concerned about US sovereign debt and a possible US Treasuries crisis.

There is great revival of Keynesian thinking in the US, but this economic theory developed prior open, global markets. In those days, the US was a creditor nation and a major center of production. Today, the US is the world's largest debtor and has outsourced much of its productive capacity to lower cost producers. In today's environment, these expansive policies are likely to result in currency devaluation and higher interest rates.

Many EU countries have tried similar Big Government/ high public debt policies and failed. Since the 1980's, they were all obliged to embark on privatization plans. The heavy public debt created a permanent drag on their economies. After being so badly burned in the past, the EU declined the Geithner invitation to follow similar expansive US policies, rolling up public debt.