Friday, May 22, 2015

Is asset arbitraging a valid investment theory for the shipping space in today’s economic environment?

Asset arbitraging accounts for at least 90% of all investment in the shipping industry. It is particularly predominant with institutional and private equity investors. Major groups like Oaktree, Apollo and Bayside have taken large positions in various classes of shipping assets. The rationale is cyclical market recovery. This been the bread and butter of many ship owners in the past, but can this work in the current environment of immense shipyard overcapacity, weak global demand and soft commodities prices?

I have never been a warm fan of asset arbitraging as a strategy to build value in the shipping industry. It is another version of the old stock market trading theory of buying low and selling high. The concept is that prevailing shipping assets are somehow mispriced too low. Eventually markets will pick up and the true higher prices will be revealed, when the shipping assets can be resold with a markup.

This viewpoint distorts the nature of the shipping industry, which is a service business to transport cargo. The fundamental driver in this space is cargo volume. The more cargo volume to be transported for the existing fleet available, the better the freight rates. Higher freight rate expectations result in higher vessel valuations in terms of future earning capacity. If you take away the noise from the volatility of the freight markets, long terms returns on shipping assets tend to be moderate and earnings margins restricted.

Costs in shipping are highly dependent on capital and labor. Ships are very capital intensive. They are wasting assets that require considerable maintenance. They have a limited trading life until they are recycled and sold for scrap. Getting in and out of shipping assets depends on class of ship and the liquidity of the resale markets.

I use the term ‘asset arbitraging’ for these shipping asset plays because it reminds us of what this process is and where it leads. Arbitraging eventually evens out market fluctuations. If enough investors see that a class of shipping asset is underpriced and then take speculative positions, then this supplies the market with ample tonnage that provides the end users more than ample vessels for their cargo transport needs and keeps a lid on freight rates. The whole effort is a wash out with no profits.

The dry cargo space illustrates this situation. Several years ago there was an orgy of private and institutional money in dry bulk shipping assets. The purest version of this was Scorpio Bulk (SALT), where they made a massive play in new building orders without even having an existing operating company in dry bulk shipping. All this was predicated on the new building deliveries coming at the time of a market upturn in rates that would lead to significant appreciation in vessel values. Now Scorpio Bulk is trying to lighten up and reduce their position by resales of some of their new building contracts, even possibly some conversions of the orders to tankers.

Unfortunately, the current economic environment does is not supportive of these asset plays:
  • There remains significant shipyard overcapacity.
  • China and emerging markets, which are the main source of cargo volume growth, are slowing down.
  • Advanced economies are still in sluggish recovery and substantial debt overhang.
  • Vessel working life is growing shorter, with both dry cargo and tankers facing age restrictions and trading limitations after reaching 15 years (3rd Special Survey).
Added to these factors is the industry consolidation that is reducing the universe of buyers in the resale markets and the limited credit from the banks available to finance these sales.

So I was not surprised by the recent Tradewinds article on Apollo Global Management putting the 12 Suezmaxes of Principal Maritime onto the market, where some finance sources expressing reservations that it will be easy to find a buyer for an all-cash deal. Also I would not expect the mark up in price to be as much as Apollo was hoping, depending on how much hard cash they can get as opposed to payment in shares from a publicly listed entity.

The other factor is vessel replacement cost. I am not optimistic here. There is an overcapacity of shipyards. Order books are thinning. Steel and scrap prices have been falling. New building prices are more likely to fall in the near future than harden.

Consequently, the best positioned people in these market conditions are freight traders who are asset light business models rather than those heavy in shipping assets. The institutional money in the shipping space has done wonders for end users in providing them more than ample tonnage for their needs to transport cargo, keeping freight rates very low.