Thursday, September 30, 2010

Two Chinas for growth in steel demand?

Many dry bulk owners invested in Panamax and Capesize tonnage seem to expect that China will follow a path similar to Japan or Korea in terms of steel consumption per capita. The critical question to ask is whether it makes sense to look at China as an undifferentiated entity in this matter. The per capital steel consumption in the coastal regions on a standalone basis already surpasses Germany! It may be less growth potential than most observers are forecasting.

Danish Ship Funds, Christopher Rex, divides China into an urban and a rural economic zone.  He notes that approximately 650 million people, of the Chinese population of 1.3 billion people, live in the urban region. The remainder lives in rural China, where food expenditures account for a relativity large share of the disposable income. In rural China approximately 150-200 million people living are living in poverty (using the internationally accepted 1 US$ per day guideline), There is still a long way to go before these individuals increase their steel intensity to a level close to that of the urban regions.

Rex deems it unlikely that the rural regions will develop their steel intensity extensively as long as food expenditure represents a considerable share of their income. The current food inflation exacerbates the situation and suggests that it will be a long time before the rural provinces increase their steel intensity per capita.

The future potential for Chinese iron ore demand is highly sensitive to this issue. Assuming that the Chinese population, in terms of steel consumers, does not consist of 1.3 billion people but rather the 650 million people living in the urban region, this change would obviously double the Chinese steel consumption per capita from its current level of 320 kg per capita (the same as the US) to 650 kg per capita (larger than Germany).

If Chinese steel consumption per capita is 650 kg, few will expect a massive surge in Chinese iron ore imports.

The only saving grace to this situation has been the financial crisis that has limited capital and increased the cost of bank finance for owners to complete their CAPEX needs. Last year roughly 60% of the drybulk new building orderbook was deferred and there may be similar results this year.

A Chinese rebalancing agreement with its trading partners that results in a 20% currency depreciation over a several years would bring market conditions similar to the early 2000's (when China did something similar with its currency) with considerably dampened freight rates. Despite the sharp drop earlier this year in spot Capesize rates, present rate levels remain profitable for dry bulk operators and they remain in a more comfortable position than their tanker owner peers.

China bubble ahead or beginning of a new economic boom cycle?

Optimism on China and other emerging markets is a major driver in shipping markets this year in all classes of tonnage as well as resumption of new building orders. WTO's Pascal Lamy revealed global trade is now expected to grow 13.5% this year. The future depends on successful trade rebalancing, a highly complex and political issue. China watchers like Michael Pettis and Andy Xie do not believe in the sustainability of the growth model.

Pettis and Xie feel that this system is resulting in increasing asset misallocation. The growth model is based on easy money from domestic financial repression that the government invests in infrastructure projects, SOE's and real estate. China keeps its currency pegged with the US Dollar at advantageous rates to promote exports by massive purchasing of US dollar assets rather than importing their trade surpluses domestically. Internal saving rates are held at very low levels.

Xie has argued that there is no rational pricing mechanism for real estate swapped by local government entities. Pettis is worried about future non-performing loans. He cannot see how the Chinese authorities can boost consumer growth from loss-making infrastructure projects:

"But governments do not cover losses. They channel money from households to cover losses. In other words if the Chinese railroad system turns out to be economically non-viable (i.e. the true economic cost of building it exceeds the economic benefits), households will be forced pay for the net reduction in national wealth. This of course reduces future household income and consumption – the surging of which is supposed to make all these infrastructure projects viable."

Xi Li, a Consultant at State Street Global Advisors, focused in a recent article on the real exchange rate (RER), which is nominal exchange rate (NER) adjusted for inflation rate and is more important in determining a country’s current account balance with another country. China's NER, largely fixed with the U.S. in the last few years, is provoking very high internal inflation. Bubbly housing prices are due to a combination of negative real interest rates, few investment options, and extremely low carry costs in terms of maintenance fees and zero property taxes.

This viewpoint dovetails with Andy Xie's observation that the global economy is like fried ice cream, where China and other emerging markets are swallowing the US stimulus. Fed easy money policies are putting them on fire with inflation. Li feels that these dynamics will eventually put China in a very precarious position. China will become even more dependent on investments and a current account surplus to grow its economy. It is increasingly cornering itself by reducing the RER of Yuan.

Given the fixation of the current debate on adjusting the NER between Yuan and USD, one day, the continuously exploding trade deficit, coupled with the likely persistent high unemployment rate in the U.S., means that the only outcome will be the threat of trade war, or trade war itself. The U.S., controlling final demand, may finally realize that this control gives it much stronger bargaining power, may end up as the relative winner. If China has trouble, the most commodity driven economies. None of this would be good for commodity shipping.

Pettis recently wrote a lengthy piece on the politics of Chinese adjustment. He notes four ways of boosting the household income share of national income and made a list of winners and losers as follows:

Winners and losers

1.) Raise the renminbi:

Households as consumers, especially middle and lower middle classes
Service industries


2.) Raise interest rates

Households as savers, especially the middle and upper-middle classes
Service industries
Labor-intensive industries
Small and medium enterprises
Capital intensive industries
Real estate developers
Local governments

Capital intensive industries
Real estate developers
Local governments

3.) Raise wages:

Households as workers, especially lower middle classes and urban workers
Consumer and retail businesses
Capital intensive industries with domestic customers
Employers, especially low-income labor intensive companies

Employers, especially low-income labor intensive companies

3.)Transfer state assets:

Households, with the distribution depending on the form of privatization
Government, especially local officials

Government, especially local officials

He notes that the trick for any of the first three adjustment measures (which are the necessary ones for a sustainable adjustment) is to adjust just fast enough so that the employment created by the rise in household consumption offsets the unemployment created by financial distress among the relevant losers. He stresses that Chinese adjustment must be slow because in the short term the negative consequences for employment can overwhelm the positive consequences.

Pettis feels that the pace of China’s adjustment will in large part depend on the pace of the external adjustment. Its trade surplus depends on the ability and willingness mainly of the US and trade-deficit Europe to absorb them. He does not think that the rest of the world is able (especially in the case of trade-deficit Europe) or willing to wait long enough to allow China a relatively easy adjustment.

Accordingly, Pettis interprets the China optimism of commentators like the Sydney Morning Herald's Michael Pascoe and the Financial Times's David Stevenson as the final stages of a bubble. Both Pascoe and Stevenson see a huge rising consumer market in China in the coming years as a major driver in world growth.

The shipping community seems to believe strongly in the robust growth school with Peter G's block vessel acquisition deals earlier this year, Navios's foray into tankers and Evergreen's new order of post-Panamax tonnage. From 10% of the world container vessel fleet in layup in 2009, pundits are now concerned about a future shortage of boxships in view of this massive new growth ahead. All this is all based on continued robust demand growth in China and other emerging markets.

Thursday, September 9, 2010

The Eurozone pact with the Devil and its risks

Peripheral Eurozone countries effectively made a Faustian pact with the Devil foregoing their economic freedom in exchange rates and monetary policy tempted by easy credit and EU transfer money that resulted in consumption and real estate bubbles. The Euro was always a political tool to force European integration rather than sound economics. The EZ created structural distortions increasing divergences. Without an exit mechanism, "Abandon every hope, ye who enter here" as Dante would put it....

The Trilemma in international economics suggests that it is impossible to have all three of the following at the same time:
  • A fixed exchange rate.
  • Free capital movement (absence of capital controls).
  • An independent monetary policy.
A flexible exchange rate and independent monetary policy are means to manage trade balances and promote growth, which is critical in an open market environment and free capital flows - something that EU periphery politicians sadly overlooked.

These hapless countries were reduced to the status of US state governments but without any equivalent of the US Federal redistribution system. EU members in the north like the UK, Denmark and Sweden prudently passed on these risks, preferring their independence. They were unjustly and ruthless maligned by the Brussels elite, but today time has proven the wisdom of their judgement.

Unlike sovereign governments, who can create monetary reserves through their central banks, the peripheral Eurozone members unwittingly exposed themselves to the risk of insolvency and bankruptcy with the illusion of a sovereign guarantee from Brussels that allowed them to rake up public debt in amounts and at rates that they would not normally be entitled. Once the bond vigilantes moved in and popped this illusion, credit spreads started to widen with restoration of proper risk pricing and crisis broke out.

The Brussels elite initially compounded the crisis with their very poor management, blaming the markets for their own shortcomings and policy failures. They were only bailed out with the tacit cooperation of the US, who winked at the unprecedented expansion of the IMF charter by facilitating  them with a financial backstop because the Americans feared the systemic risk. The ostensible mission of the IMF is to support individual countries in trouble, not a badly constructed and questionable currency union. This should have been the sole responsibility of the European Union, not other IMF members collectively.

The unsustainable trade imbalances that this currency union has created have in no way been addressed to date. It is virtually taboo in the EU even to raise the subject. The reason for the lack of demand-side adjustment is that much touted Europe’s internal market is not fully functioning, certainly not at the consumer level. As FT's Wolfgang Munchau points out, Germany entered the Eurozone at an uncompetitive exchange rate and embarked on a long period of wage moderation where it benefited from a real devaluation against other members.  Meanwhile southern European industry lost competitiveness and withered.  Consumption soared and real estate bubbles were fueled by the cheap credit until the bond vigilantes spoiled the party. A large part of the German trade surpluses are reflected in peripheral member deficits.

Over time, these intra-Eurozone imbalances will not only persist, but probably increase. This will make the economic adjustment for Spain, Portugal or Greece even more difficult than it already is. Those persistent imbalances, as well as the alarming build-up of debt, raise cause of concern about the long-term health of the Eurozone. Solvency is defined as the ability to finance debt in a sustainable way, and is affected both by the amount of debt, and future income through which the debt is repaid. Already several EZ members like Greece, Ireland and Portugal are bordering on insolvency.

For the Greek austerity plan, it hard to imagine a realistic estimate of a trajectory that foresees a stabilisation of the Greek debt-to-GDP ratio at tolerable levels. Optimists like Olli Rehn in his recent article 'Greek Renaissance' tend to pull the joker of some massive above-average growth forecasts for the future without explicitly stating where this growth is coming from. Normally in these IMF work-outs the growth comes from exports spurred by devaluation and structural changes. Even Swedish restructuring in the late 1990's resulted in currency devaluation. In Euro Hell, Brussels will not give Greece this option in defense of their sacred cow, the Euro.

The other side of the German exports to weak peripheral members and the resulting trade deficits is the mounting debt crisis. The austerity measures of 'infernal' devaluation is largely a Brussels concoction of untested crank economics that in practice downsizes GDP and deprives the failing country of tax base and income needed to repay and reduce its debt. Coupled with the 'pretend and extend' debt pyramiding of the IMF/ EU 'bailout' facility for insolvent borrowers, this risks bringing the whole Euro currency union down like the Tower of Babel. In the case of defaults, other weak EZ members will be liable for the backstop facility, pulling them under as well.

To guarantee the solvency of the Eurozone’s periphery would require not a few quarters of solid growth, but an entire decade. Where is this joker of massive above-average growth going to come from? Who is going to accept the trade deficit rebalancing?

Presently the Brussels elite seem very much in self denial. They remain unwilling to accept that one day a Eurozone state might either default, or, more likely, be forced to restructure its debt. Not only do they adamantly refuse to accept the principle, but also stubbornly insist on avoiding any institutional preparations for an orderly default of a Eurozone member or departure from the currency zone.

It is as if the Devil has possessed their minds in the hell (with no exit) that they have created with their currency union.... Is it a coincidence that the Faustian legend came from Germany? Can purgatory bring salvation?

Wednesday, September 8, 2010

Chemical war of attrition

The chemical sector experienced some revival earlier this year, but rates softened again during the summer and there remains a great deal of uncertainty yet about the time of a market upturn. Financially weaker operators like Eitzen and BLT continue their optimism, the more established major operators like Stolt and Odfjell remain cautious and see a longer market recovery period.

The chemical tanker sector was badly hit by the 2008 GFC. Cargo volume dropped dramatically in nearly all trades. Markets during 2009 were sustained mainly by US chemical feedstock exports to China, with tonnage swelling in the FE struggling for return cargo. This year after a stronger first quarter, the chemical tanker market saw a pullback. The transatlantic trades slowed, not helped by continued weak petroleum product markets. Reduced requirements for aromatics from China, which sustained the market in 2009, led to less demand for larger commodity parcels (above 5,000 tons) and with plenty of available vessel space as a result. The biofuel market withered with the US putting a 54 cent/gallon import tariff on most foreign ethanol supply and Brazilian ethanol production has been hurt from high sugar prices and heavy rains in 2009.

Stolt has been outperforming its peers with its solid contract base, diversified income from storage and other activities, and its sound financial position with moderate leverage. Stolt was very fortunate in its CAPEX obligations because delays at the SLS Shipyard allowed them to renegotiate price and delivery of their Dwt 44.000 coated newbuildings placed in 2005 for ME commodity chemical trading and they eventually secured full refunds for their Dwt 43.000 stainless orders. STJS cargo volume transported was up 7.6% from 1Q10 albeit freight rates remaining flat. Stolt finished its 2Q2010 with US$ 27.5 mio net profit.  

Stolt's main competitor Odfjell finished its 2Q2010 with a net loss of US$ 64 mio, but much of this was due to their decision to enter the new Norwegian tonnage tax system at a total cost of USD 42 million. Time-charter results per day increased by 2% compared to first quarter. Odfjell is not running any cash losses, but its balance sheet is somewhat weaker than Stolt with higher bank leverage.

Stolt expects a continued weak market for the rest of 2010 and 2011. Odfjell reports falling cargo volume in 3Q2010 accompanied by weakness in outbound voyages from US and Europe. They see increased competition for cargoes.

Ailing Eitzen Chemical with the recent exit of its CEO Annette Malm Justad and failure of its much touted merger with BLT gained reprieve by selling off its 74.3% stake in Eitzen Bulk, which brought a total profit of US$ 60.7 mio for the 2Q2010. Total freight income in the quarter dropped from US$ 31.03 mio to US$ 29.03 mio as the ethylene market remained weak and there were a number of drydockings. Eitzen has had extensive loan restructuring with its senior lenders and has extended its covenant waivers for several years, but it is far more dependent on a quick market recovery than financially stronger competitors. All the more so because it has a weak contract base, more dependence on the spot market and clean petroleum products.

The most optimistic and aggressive chemical operator, Berlian Laju (BLT), was recently down graded by Fitch, who cut its rating on the tanker owner from “B” to “–B” with a negative outlook. It also dropped its tag on BLT’s $400m unsecured notes from “CC” to “CCC”. Its Indonesian management believes fervently in rapid return to bull market conditions and it maintains a very aggressive new building program. This is an unlimited growth mentality similar to that of Seaspan's Gerry Wang, but without the support of long term SOE charterers to underwrite the business. BLT derives less than 10% of its revenues from Indonesian business, although lately it has shown interest to diversify into Indonesian FPSO and more domestic tanker cabotage business.

The weight of the shipowner’s significant capital expenditure requirements led Fitch to concerns that it may breach certain covenants if current market conditions persist. BLT leveraged up its balance sheet in 2007 when it purchased Chembulk from AMA at the peak of the market boom with a sizeable markup from the price that AMA had acquired this Connecticut-based chemical tanker operator from its founder Doug MacShane just a few months earlier in the beginning of the year. Having paid a premium price, the company strained considerably to raise the cash to complete the deal with AMA, selling and leasing back existing vessels in its fleet as well taking on heavy bank debt.

Eitzen and BLT have smaller vessels than Stolt and Odfjell. Particularly, the Eitzen fleet is concentrated in Dwt 12.000 stainless units and also has a fleet of coated chemical tonnage. BLT has some larger stainless tonnage in the Dwt 20.000 range, but this has come from their acquisiton of Chembulk, left largely with the US management. Their Asian fleet are smaller units. Both companies have smaller contract books than Stolt and Odfjell.

The future depends on how the markets play out. A V-recovery and bull market would greatly benefit BLT due its very high operating and financial leverage. A prolonged slack market will benefit Stolt with its resources to pick up distressed opportunities. Clearly Stolt and Odfjell with their stronger balance sheets and customer bases have more staying power than Eitzen and BLT. Eitzen needs very much a quick market recovery before its lenders become restless again and BLT could face loan restructuring with its senior creditors or even worse, be forced to sell off its Chembulk acquisition to raise cash.  

Tuesday, September 7, 2010

Seaspan's China gambit

Seaspan is a non-operating containership owner with a very ambitious fleet expansion plan. They have been struggling since the 2008 GFC to finance their aggressive CAPEX program. Their business plan is highly dependent on continued Chinese export growth. The two top customers are Coscon and CSCL  (70% total revenue) both Chinese state owned enterprises.  90% of their contracted revenue is from China and Japan. The company is highly leveraged and has recently filed a shelf registration for a new share issue.

Seaspan is a vessel provider business model. It owns and operates container vessels with long term charters to major liner companies. It has no container logistical system of its own as do the major liner companies like Maersk, CSCL, MSC, CMA-CGM, Neptune Orient and Orient Overseas. It is largely an asset play backed by long term charter parties with substantial rate discounts and subject to earnings margin pressures over time from inflation, currency fluctuations and increased repair costs as the fleet ages.

It has a very impressive Board of Directors, including Graham Porter (Chairman of the Tiger Group), John Hsu (partner of Ajia Partners, one of Asia's largest privately-owned alternative investment firms), Peter Lorange (former President of IMD) and Peter Shaerf (managing director at AMA Capital Partners). Seaspan's CEO Gerry Wang appears to have very good personal contacts with the Chinese SOE's in shipping. He is always been extremely bullish on Chinese growth prospects.

The container sector was one of the most sharply hit by the sudden and deep economic slowdown in 2008 GFC. The major liner companies suffered heavy losses in 2009, with aggregate industry losses running into tens of billions of dollars. As an effect of industry wide losses, the liner companies heavily cut capacity, idling their own capacity and returned the chartered tonnage to non-operating owners. Normally, most liner companies own approximately 50% of their tonnage and charter in the remainder to cover their cargo volume projections.

These major operators made substantial adjustments in terms of order cancellations and deferrals of newbuilding deliveries well into 2011-2013. There was probably more speculative vessel ordering in the container sector than any other sector of the shipping market. A very large part of the orderbook are the large post Panamax size vessels for long haul routes.

The great attraction for non operating owners' investment has been the term charter cover from the liner companies. The current order book stands at 30% of the current fleet, down from about 55% at its peak in mid 2008. It is important to understand the current order book mix in terms of the owners.  The German KG market and asset providers in non-operating owners like Danaos Shipping and Seaspan constitute greater than 50% of the current order book, remaining is covered by the liner operators like Maersk, APL, and CMA CGM etc, who actually control the underlying commercial business with end-users in the sector.

Seaspan fared well in 2009 closing the year with record profits of US$ 145 mio as opposed to the losses of the two prior years: 2008 (US$ 199) mio and 2007 (US$ 10) mio. They reported no charterer default or renegotiation problems. This year for the 1 H, Seaspan is again in loss position, but due to sizeable changes in fair value of financial instruments resulting in a loss of $223.2 million for the six months ended June 30, 2010 compared to a gain of $92.5 million in 2009. The change in fair value loss for was due to decreases in the forward LIBOR curve and overall market changes in credit risk.

As of their annual report filed last March, Seaspan had contractual CAPEX obligations on an additional 26 containerships over the next 30 months over an in addition to the existing fleet of 42 vessel in operation. Whilst there have been rumors of possible new order cancellations, Seaspan so far has maintained its orderbook.  It appears that they are highly dependent on COSCO in chartering this new tonnage. The employment contracts with their two Chinese SOE charterers are subject Chinese law and dependent ultimately on the Chinese legal system for enforcement. Indeed, this year, they turned aggressive and also added one additional new acquisition chartered to United Arab Shipping Company for two years and Gerry Wang has made statements about opportunities to pick up units in the troubled German KG markets.

Considering the industry environment with the major liner companies cancelling orders and lately reletting larger post-Panamax tonnage, this represents a remarkable contrarian business strategy with backing from a BoD of major industry figures, who apparently believe strongly in a robust world economic recovery with shipping markets bouncing back to former levels in the near future, ostensibly driven by renewed Chinese export growth and internal infrastructure development as a return the pre-2008 GCF situation.

Financing this program has not been easy. The total purchase price of the 21 vessels was estimated to be approximately US$ 2.6 billion. The remaining five units were covered by leasing arrangements with Peony Leasing Limited, or Peony, an affiliate of Bank of Scotland plc and Lloyds Banking Group. As these units were contracted during the market boom, Seaspan faces a valuation problem with the decline in prices for new orders today. They have "gearing” covenants in their senior debt that prohibit them from incurring total borrowings in an amount greater than 65% of our total assets. Further they were blocked from drawing the remaining approximately US$ 267 million available under their US$ 1.3 billion Credit Agreement on which they were relying heavily to support their CAPEX program.

In May 2010, Seaspan issued 260,000 Series B Preferred Shares for US$ 26 million to Jaccar Holdings Limited, an investor related to Zhejiang Shipbuilding Co., Ltd. of China ("Zhejiang"). These preferred shares are perpetual and not convertible into common shares. They carry an annual dividend rate of 5% until June 30, 2012, 8% from July 1, 2012 to June 30, 2013 and 10% from July 1, 2013 thereafter and are redeemable by the Company at any time for US $26 million plus accrued and unpaid dividends. This appears to be a shipyard-extended credit facility for their reported two orders in this yard.

Compare this to established liner-owner operators like Neptune Orient Lines (NOL) and Orient Overseas (OOIL), integrated logistics players with proven container shipping capabilities available at attractive valuations. For example, OOIL's three principal business activities are segmented under International container transport and logistics services (OOCL, OOCL Logistics, and China Domestic), Ports and Terminals (Kaohsiung and Long Beach) and Property Investments (Wall Street Plaza in New York and Beijing Oriental Plaza in Beijing). OOIL’s container shipping operations is amongst the most cost effective in the container shipping industry with the Company consistently outperforming its peers with the highest profit margin among major container line operators.

OOIL has always had one of the most conservative and strongest balance sheets in the container shipping industry and has consistently kept the net gearing to the lowest. The company has no major issues in meeting its capital commitments and capital expenditure. At the end of FY 2009, OOIL had vessel capital commitments of US$ 712 mio and US$ 1.27 billion in free cash. It's capital gearing is 58%.

Seaspan's second quarter earnings conference presented a very rosy picture of a company with a low debt ratio, impressive built-in future growth revenue of US$ 7 billion and fantastic compound annual growth rate (CAGR) of 40%. Suffice this to be based entirely on their assumptions of a V-shaped world economic recovery and deeming their situation a few years ahead. . Their present leverage is very high and they would be not going through the trouble and expense of a shelf registration if they were not concerned about the need to raise equity to maintain their covenant obligations and cover their CAPEX needs. Indeed, one can presume it likely that this is an exercise to woo potential interest for a possible IPO offering.

The issue is whether peer companies like NOL and OOIL offer more value to investors because of their integrated logistics business models, their diversity of revenues sources, and their stronger balance sheets. All this is in the context of an uncertain environment in terms of economic recovery and rebalancing of trade flows. All these companies are dependent on continued emerging market growth in the Far East.