Monday, August 22, 2011

Are shipping markets heading for another leg down?

Recently private equity group First Reserve bankrolled the Diamond S deal in which 30 product tankers were acquired from ship management company CIDO at a significant premium over prevailing market levels. This speculative spirit reminds me of the General Maritime block deal last year. Similar lust for quick profits of shipping in the early 1980’s led to ill-timed, mispriced major investment decisions and a series of major shipping bankruptcies, and period of severe market disruption. Will the Chinese Eldorado and Fed financial engineering save the day for Wall Street flip-over deals or are we at the end of the 1980’s economic cycle and age of asset inflation?

The major growth driver for cargo demand has been emerging market economies. This year started badly and all sectors are presently suffering. There has been lately some interest in containership and product tanker asset speculation. The only sector really making money is LNG where there is a healthy supply/ demand gap.

Despite the dicey economic environment, the shipping industry staged an unexpected recovery in 2009 and 2010. Dry Bulk benefitted heavily from Chinese stimulus infrastructure projects and commodities stockpiling. Tankers benefitted by oil price arbitraging and storage demand. The container sector managed to reflate demand artificially by slow steaming and then benefitted from a pick-up in Chinese exports.

There is nothing ‘miraculous’ or unique about the Chinese growth model. Well-known China observers like former Morgan Stanley star Andy Xie and political economist Victor Shih at Northwestern University have long maintained that the Chinese growth model is an input driven economy fuelled by cheap money through financial repression to increasingly marginal investments subject to diminishing returns.

Everybody is banking on opportunities of a giant boundless consumer market in China, but as Michael Pettis (senior associate in the Carnegie Asia Program, based in Beijing) has recently written: “Low consumption levels are not an accidental coincidence. They are fundamental to the growth model, and the suppression of consumption is a consequence of the very policies – low wage growth relative to productivity growth, an undervalued currency and, above all, artificially low interest rates – that have generated the furious GDP growth. You cannot change the former without giving up the latter.”

China funds almost all of its major investments with bank debt. It long ago ran out of obvious investments that are economically viable, so any marginal increases in investment must be matched by increases in debt, resulting in an unsustainable debt overhang. Meanwhile, with the US economy at stall speed and the EU imploding into recession, Chinese trade surpluses are no longer desirable with its trading partners.

Rebalancing is not an option for China and it is likely to be very disruptive and for a prolonged period of time. All historical precedents are for a sharp down downturn in economic growth. The decline in Chinese growth will fall disproportionately on investment and this will severely impact the price of non-food commodities.

A sharp Chinese slowdown will have a severe impact on cargo demand and freight rates. The drop in steel consumption from the infrastructure projects will adversely impact the economics of emerging market exporters of raw materials. Liquidity will start to dry up in all emerging market economies. Finally, decline in steel prices will adversely affected vessel values. Scrap prices will fall and replacement cost for new vessels will decline. Vessel prices could drop dramatically.

All shipping sectors will suffer. A recession in the EU and US will quash any increase in demand in the products markets. Emerging markets will not pick up the slack. The larger bulk carriers are very exposed with dependency on China and its steel industry. Container overcapacity will again plague the industry. Recent speculative Greek issues like Boxships and Diana containerships riding on hopes of increased demand for feeder services will fizzle as liner companies reduce their chartered fleet. The most painful aspect will be the drop in vessel values.

In such a scenario, it may take years before any recovery, totally changing speculative business plans and discounted cash flows where time is the biggest enemy to profitability. The nightmare of any short-term player is to be stuck with a losing proposition as a long-term investor. In many cases, the best option is to liquidate in timely fashion not to ride the market down to the bottom. That will be difficult with such a large positions. Maybe this is already being reflected in the recent pressure on shipping shares, even large well-capitalized tanker companies like OSG and TeeKay.

On the other hand, depressed market conditions would facilitate industry consolidation and clean-up of over-leveraged, deadwood companies with failed management. Since the 2008 meltdown, there is a growing list of zombie shipping companies swimming in debt and heavy consumers of lease financing at any cost. This would benefit the financially solid long term players and eventually give them better market pricing power. Lower vessel prices would make the industry leaner and more competitive.

Of course, nobody is a prophet. Next year, we could have a booming shipping markets, a new vessel ordering boom, and the Dow back over 12.000…. Imagine DryShips again trading over US$ 100 per share! George Economou has been a leading advocate of the Chinese unlimited growth story.

Wednesday, August 17, 2011

Diamond S. a new business model for shipping?

The Diamond S deal with Cido for a US$ 1 bn block purchase of product tankers has been the talk of the town, especially with the involvement of 'King of Bankruptcy' Wilbur Ross who has decided to enter shipping and bankroll a large portion of this project. From the feel of this venture backed by private equity First Reserve and Ross, it seems more likely to be a flipover asset play rather than an effort to create a long-term shipping business like TeeKay with intrinsic value.

The venture starts with some very positive factors. Craig Stevenson is a successful, proven CEO in the shipping sector with an enviable track record. First Reserve successfully backed the Corbin Robertson venture Quintana, which was sold at a very timely moment to Excel Maritime (who has been struggling under the asset impairment and weight of the purchase debt leverage ever since).

The CIDO assets are young and come with period employment said to be on the average 5-years. The project is well capitalized with US$ 600 mio equity and US$ 400 bank debt. If the market takes a further leg down, they can withstand the drop in asset values on their existing fleet and they have ample reserves to purchase additional assets at lower values. If the market starts to improve, they will reap the benefits of higher asset values so that they can float an IPO at a premium for First Reserve to exit with some profits for the risks and lighten up on its holding.

Craig Stevenson sold OMI and lost his key people for which he is now busily trying to rehire. It is unlikely that he is going to have any trouble in building a new shipping organization.

Stevenson openly states that he means to keep the product carriers on period charter for secured income and will put his larger Suezmax newbuilding to the spot market to take advantage of spot market volatility.

The only case where this venture could disappoint is with a double dip recession that delays significantly the timing of a market recovery. The premium paid on the Cido assets will begin to seem a liability and the investors will face time and opportunity losses on their position unable to liquidate according to plan. Flipping the business over for a quick profit would start to feel illusory.  They might find themselves as long term investors that they had not anticipated.

It is still far too early to tell how this venture will fare. Personally, I am not sure that asset speculation and quick flip-over deals are good for the long term health of the shipping industry. In the past, this has led to chronic overcapacity and low rates. The companies that purchase the marked up assets usually have problems unless the timing of the deal is very early in the cycle so that they can ride a further leg up.

NewLead in forced asset sales

NewLead is reported to be offloading the 135,000-dwt Newlead Spartounta (built 1989) and the 34,700-dwt Newlead Prosperity (built 2003) after breaching a loan with FBB-First Business Bank. They recently hired the Moelis & Company and Fried, Frank, Harris, Shriver & Jacobson to help it fight its debts, which stand at US$ 581.9 mio. The bad news adds to an ever longer list of struggling shipping companies: TBSI, Omega, Top Ships, Zachello, etc. selling assets or fighting with their creditors.

Initially I was not a fan of the GrandUnion - Aries merger, posing a number of questions. Thereafter, I felt sympathy to the efforts of Michael Zolotas to clean up the mess at Aries and make a turnaround in NewLead.

The basic issue is that Aries was always a big lemon. I pleaded with Stephanie Kasselakis and John Sinders at the time of this controversial IPO and offered in good faith to assist Jefferies. The facts are that their investors got badly burned from this IPO and now the successor NewLead is in jeopardy. I always felt strongly that this could have been avoided.

Looking back at the time of the GrandUnion merger, really no one else would have accepted to take on Aries. Certainly not Scorpio Tankers, which is healthy company with conservative management, who forthrightly warned investors last fall of coming tanker market turbulence.

Aries suffered from horrible technical management, lousy assets and overleverage. GrandUnion was not a strong company in terms of its ability to recapitalize Aries from its losses. They financed the merger with drop down assets and more debt. They made a valiant effort to shed bad assets, clean up the technical management and restructure, but the losses continued. They had no advantages of capital market access to dilute with additional equity or to refinance existing debt with a bond issue, but all the administrative and reporting overheads.

When the dry cargo market started to collapse this year, they were badly exposed with their elderly Capesize tonnage and high debt levels. Their current debt load is crushing. Senior lenders are forcing sales to reduce debt.

It seems to me that NewLead is going to face a difficult fight for survival. The issue for them is to save as much as they can of the GrandUnion resources put into this merger. The risk of two weak companies merging is that this drives both of them to oblivion.

Wednesday, August 3, 2011

Does the CIDO deal mean tanker values are on the upside?

Jonathan Chappell argues that Craig Stevenson's massive US$ 1 bn product tanker acquisition deal to purchase the 30-vessel CIDO fleet is good news for tanker asset values. He estimates a US$ 40 mio price tag per vessel up from his previous US$ 36-37 mio valuation for a three year old tanker. He believes that supply and demand will improve in this sector this year and in 2012 seeing this a 'smart money' deal. I am more skeptical.

We saw last year Peter Georgiopoulos's block tanker acquisition deal with Metrostar at premium prices and how bad timing resulted in drastic fall in the Genmar share price and a dramatic capital injection/ loan restructuring with Oaktree.

The Cido fleet had been up for sale for some time. CIDO has been steadily shedding off assets for months. There were numerous rumored suitors for this deal including Navios. Stevenson's company Diamond S. Shipping was the highest bidder and fixed the vessels at a premium price. Whether this is really a good deal depends on future events.

Until now, Diamond S had no ships in the water. Diamond S currently has eight 158,000-dwt tankers and two 105,000-dwt product carriers on order from yards in South Korea for delivery between next year and in 2012. His ex-OMI senior management - Robert Bugbee and Cameron Mackey - moved to Scorpio. The Cido acquisitions is a transformatory development making it a functional ship owning company that operates 30 tankers.

Scorpio by contrast is not a company that would bet on such a big move. Emmanuele Lauro first built up a cargo operation and then started scaling up incrementally. Craig Stevenson is buying assets before building his commercial or technical management capability.

Presently things in the product tanker market are bad. The transatlantic market is flat and east of Suez is slow. Big ships are in dire straights. Earning margins are poor. Operating expenses are high. Bunkers are capping any returns potential. There is very limited free cash flow to pay debt and dividends.

The product tanker story revolves on new refinery capacity coming on stream in Asia and the Middle East to catalyze CPP exports and boost ton-mile for product tankers. But the timing of this development is dependent on when a major pick-up in demand is seen for gasoline/diesel in the West, combined with the movement in CPP inventories in the latter region. For 2011, distance-adjusted demand is expected to advance 6% and the product tanker fleet is expected to grow by 5%. Rates may not improve meaningfully until 2012 and even 2013.

Whilst there is a positive general consensus on the product tanker market as a good long-term investment, such a notion could change dramatically if the fundamental outlook changes (through macroeconomic disappointments, structural changes in the industry etc).