Tail Risk in shipping recovery still very much present!

Lately there is a lot of capital chasing shipping assets, arbitraging on vessel prices.   Oaktree Capital is one of the high profile leaders.  Wilbur Ross was an early forerunner in the Diamond S. venture, doing the Cido deal in 2011.

It has nothing to do with business plans, building value with companies to gain competitive advantage and market share in transport and logistics services. This is pure and crude asset speculation, betting that we are at the bottom of the shipping cycle, vessel values will begin to move up and a quick profit will be made by unloading these assets on the next company, who in turn riding the cycle will hope to gain themselves on the next leg upwards until the last guy in – like a Villy Panayiotides at Excel with the Quintana merger – gets stuck carrying the candle and goes bankrupt with the losses as the market crashes.

My personal view is that Oaktree and others are desperately looking for yield without many options in the present world of ZIRP.  The FED policy under Ben Bernanke’s reflects today's conventional wisdom, trying to push asset inflation to reflate and get out of the current Great Recession aftermath of the 2008 Global financial Crisis.

Shipping assets have caught their radar.  Putting money in risky assets and companies for yield has not always gone very well in past shipping cases.  Berlian Laju, for example, just months after a massive debt restructuring with US$ 200 million in new funds and repeated earlier high cost lease deals ended in debt default just months later, illustrating the risks involved in this strategy.

Whether the present FED policies will ultimately reflate the world economy depends on future real demand for goods and services that generates cargoes for these vessels, pushes freight rates up and then vessel values increase geometrically on the future earning expectations. Until and when this happens, this speculative money is actually generating more over capacity and prolonging any market recovery in the shipping industry.

Meanwhile, we have increasing zombification of many shipping companies like General Maritime now reorganized along with TORM and Eitzen Chemical now renamed Jason, OSG/ BLT are in purgatory with their ultimate fate still in limbo.  Excel Maritime recently moved into a hopefully pre-packed Chapter 11 reorganization.  Genco and others like Eagle are tottering in the brink. The recent Baltic Trading follow on capital raise seems a back door doubling up for Genco - see my recent piece: "Peter Georgiopoulos tries to regain his lost credibility" http://amaliatank.blogspot.gr/2013/06/peter-georgiopoulos-tries-to-regain-his.html.

Their Bankers are desperately trying to keep the dead alive. In turn, speculative capital like Oaktree and others, are buying up distressed debt to keep the banks themselves alive with an increasing number of zombie banks around.  Warehousing of bad assets has become the fashion.  Commerzbank - basically a zombie institution - recently issued a statement that it does expect to sell any shipping assets because they expect the market will bring the prices up...  So why worry about any 'book' losses at current mark to market price levels, capital (in) adequacy, etc.?

Oaktree seems to have a rather chaotic investment approach with different parts putting shipping assets on their books in a rather haphazard way. After all, did it make sense or show good analysis to invest in General Maritime only months from declaring Chapter 11 and needing even more money in a second round?

Normally, investments are supposed to yield value and then second round financing is done to invest in another leg up in the private equity world.  Here Oaktree was doubling down on a bad position, which is not normally good trading practice.  The normal practice would be to lighten up and reduce exposure.  In the current 'pretend and extend' world that we live in, however, everyone is trying hard to avoid cutting losses and many actively practice 'doubling down'. 

Did Genmar ever really have much intrinsic enterprise value as a shipping company beyond its physical assets to warrant the Oaktree "investment" in recapitalization??? I would say no!

Peter Georgiopoulos  never really thought of Genmar as an enterprise - at least in the sense of a logistics transport business serving customers in carriage of cargo.  Peter G. was and is foremost an asset speculator.  He ignored strategic positioning for Genmar to gain market share, improve earnings margins and generate growth through retained earnings. Employment was just a means of holding his assets rather than serving and building a customer base. His biggest sin was ignoring trends in the tanker market and new growth areas. His mindset was on trading assets.  Others like TK Shipping and his nemesis 'Big John" Fredriksen handily outperformed him and provided superior performance to their investors.

In the case of Petros Pappas, the Oaktree approach is to fund Pappas like a bond trader. Pappas has a successful record in asset trading. Oaktree has Pappas like a stock picker in different vessel classes. Pappas trades largely on his own instincts with his own money on a 50-50% basis with Oaktree. His own skin in the game satisfies Oaktree for the moral hazard. Neither Pappas nor Oaktree are looking to build businesses or really have any business plans at all beyond the asset trading.

A recent Tradewinds interview with Lazard’s Head of Shipping, Peter Stokes, sheds a lot of light on this matter. In fact, I am amazed and somewhat gratified to see someone like Stokes, thinking and saying publicly, many of the same things that I have been saying privately and publically when I was recently a keynote speaker at the Hong Kong shipping forum.

Stokes sees two basic scenarios ahead (see "Bungled QE exit could 'burn out' ship values" http://www.tradewindsnews.com/weekly/w2013-06-21/article319083.ece5)):

• Scenario A: - conventional wisdom ‘muddle-through’ recovery in the next few years that is likely to be subpar in quality, partly because of so many trying to ride the coat tails of same scenario.  If everyone is arbitraging, then each is cancelling out the other in any meaningful price action.  Further this self-defeating over time in creating over supply with a new wave of speculative ordering that will grow with any upwards price movement.  There is too much speculative money and too much yard overcapacity.
• Scenario B - complete collapse with another leg down, where investment firms like Oaktree, shipping banks, etc. experience painful and unavoidable losses. The zombie shipping companies finally die. Assets are written down to true values and finally there is a proper shipping recovery based on an industry shake up where only the fit survive: much dreaded Joseph Schumpeter’s ‘creative destruction’. 

A  preview of scenario B is the recent reportage in Tradewinds about an apparently unsuccessful attempt by Wilbur Ross, First Reserve, etc. to float an IPO in the Oslo capital markets for their Diamond S venture that was built on a huge block purchase of product tankers from Cido a few years.  My previous two pieces on the Diamond S venture make interesting reading in retrospect: 

• "Does the CIDO deal mean tanker values are on the upside?" - http://amaliatank.blogspot.gr/2011/08/does-cido-deal-mean-tanker-values-are.html.

• "Diamond S. a new business model for shipping?" - http://amaliatank.blogspot.gr/2011/08/diamond-s-new-business-model-for.html.

Obviously, the latter Scenario B would be a devastating setback for governments (especially the European Union political elite) and many financial institutions.  Such an outcome might ruin their careers and threaten the integrity of their institutions. On the other hand, they are slowly running out of resources for the constant backstopping. “Pretend and extend” credit policies with the massive socialization of losses is far more costly than they are representing to their voters.  So far little of this has proved helpful to an economic recovery. Only the US has had some relative success, but their boost in energy resources may be a more substantive driver in this tepid recovery than FED financial engineering pulling on strings.

The two key elements ahead that may affect shipping asset prices are the US and its tapering to wind down the FED asset purchases and the Chinese restructuring, given that the Chinese marginal rate of investment is unsustainable and the losses are corrupting their banking system. The US and Chinese both realize that this needs to be done and it is unavoidable, unlike their EU counterparts with their “muddle through” theories, eternal dissention and dream-world mentality resembling Mann’s Magic Mountain novel.

Admittedly, I am strongly influenced by my friend Michael Pettis in China. I believe Chinese growth will ultimately disappoint.  The volatility concerned that Pettis expresses about the very large Chinese speculative position in commodities worries me given the potentially negative impact on shipping markets. So I would not be surprised about Stoke’s concern about further drop in shipping asset prices, driven by lower replacement cost in steel, etc. All this shipping investment is predicated on Chinese growth reflating the markets again – lots of very concentrated risk if this does not pan out.

See "Crunch Time: Why low growth is China's new normal" http://www.foreignpolicy.com/articles/2013/06/27/credit_crunch_time_china_low_growth_new_normal

On the other hand, the politicians, particularly the EU elite – our PM Samaras with his never ending Greek success story being the success story of the Eurozone – and Oaktree Capital are really betting the house that the worst is over and there will be happy days again with a robust recovery in just a few months.

Former colleagues of mine like the present Head of National Bank of Greece, Alex Tourkolias, saying that a shipping recovery will lead Greece out of its crisis and John Platsidakis of Intercargo, saying that two years from now the Greek debt crisis will seem like a bad dream gone away are lately exhibiting lots of boosterism.

In Hong Kong, by contrast, the shipping circles were subdued and cautious about a quick recovery in the markets.  Some companies like Pacific Basin have been aggressingly buying newer second-hand units, but these purchases are to renew their fleet and backed against a substantial cargo book, not the kind of overt and open speculation mentioned above by the likes of Oaktree.

So who knows? Stokes and I could be incorrigible pessimists and totally wrong. All I can say is that I still see a lot of tail risk around in shipping and elsewhere.

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.

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.

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).