Alternative fuels and scrubbers

The only present realistic, technically feasible alternative fuels for IMO 2030/ 2050 carbon emission targets are LNG/ LPG.  All alternative fuels have drawbacks over conventional diesel fuel in terms of energy density, storage requirements and safety.  

The most likely future scenario is dual fuel engines with capability for LNG for the next generation of ships.  All the major marine engine makers - particularly Wartsila and MAN - are ready for this.  Longer term it is likely there will be a range of fuels depending on size and trade of the vessel.  

The scrubber story has fizzled out with very small fuel spreads and drop in fuel prices.  Technically scrubbers are an absurd option:  

• You are burning dirty fuel with heavy residues over a cleaner fuel LSFO that is better for the engine with less wear and lower maintenance costs.
• You have to maintain and operate a complicated exhaust cleaning system that leads to higher carbon emissions from the main engine as well as additional maintenance costs, risks of breakdown and a burden on the crew.

The only motivation was cheaper fuel costs, which presently is nearly zero differential.  Turning off the scrubbers is a no-brainer and scrubbers are a stranded investment for the time being. Obviously, publicly listed companies like Star Bulk and Scorpio tankers, who have been selling the scrubber story to their investors argue that the fuel differentials will widen and their decisions are justified.  Time will tell.

The companies that held back on scrubbers like Euronav or installed them selectively upon charterers request and share in expenses like Safe Bulkers and Danaos have been justified and shown as more prudent management for their shareholders.

Changes in perception of Shipping Risk

We are now well into the fall season. The expected rebound in rates has been tepid. There is growing concern that the slowdown in global growth is structural and not temporal. Integration of economic activity across borders beginning to plateau. The vast pool of low-cost workers in China is no longer available and the credit-driven expansion cycle based on large state-sponsored infrastructure projects has reached its limits. In time, the impact on seaborne demand volumes and travel distances is likely to be profound. There may be a rise of regional production centers that shortens seaborne distances. Commodities prices are softening. Freight rates and secondhand prices may stay low for some years. Risk perception towards the shipping industry is changing, making it harder to raise money in capital markets. Investors playing a short-term asset game may find it difficult to exit with the expected profits. 

 My concern since the 2008 financial crisis is that the central bank policies of low interest rates, quantitative easing and flattening of yield curves is compressing risk premium and distorting asset pricing, which has been spilling over into the shipping industry. Weak commercial bank balance sheets have led to a zombification of the shipping industry, keeping lame-duck companies alive and second-hand prices artificially high.

Current shipping industry environment characterized by:

• Deflation and weak demand, low profitability, frequent credit defaults and limited bank finance availability.
• An inflow of speculative money into shipping assets, searching for yield from resale at marked-up prices with a cyclical shipping recovery. · 
• Preference for new ordering rather than industry consolidation of existing tonnage since asset prices are not marked down and remain stubbornly high in relation to present earning capacity.

To sum this up, zero interest rates together with chronic shipyard overcapacity has caused an inflow of investment money into new building shipping assets exacerbating over supply of tonnage. Weak economic recovery and slowing growth in emerging markets does not generate sufficient increased cargo volume to absorb the tonnage overhang. This puts the shipping industry into a vicious cycle of prolonged secular stagnation. 

The world shipping fleet age profile in bulk commodities dry bulk and tanker tonnage is composed of modern vessels and a dwindling number of scrapping candidates. Useful life of shipping assets is shrinking and ships are now going to the breakers at earlier ages. This has led to increasing asset impairment charges on older second hand tonnage that are highly unlikely to be recouped in current marginal freight markets. Buying older bulk carrier shipping assets is no longer a risk free investment secured by scrap value. 

On the other hand, speculative orders of new tonnage in projects like Scorpio Bulk carries more risk than normally perceived because new building prices may begin to soften again in the next few years. The price of steel has been steadily weakening, making potential replacement cost lower. In the meantime, Scorpio Bulk efforts to develop a chartered fleet for an operating company prior the new deliveries has resulted in operating losses due adverse arbitrage and compressed earnings margins. New deliveries in a period of slack demand and softer replacement cost would create a perfect storm that no one in this venture was originally prepared.

Industry consolidation in mergers like the Oaktree-generated merger of Excel Maritime into Star Bulk is no industry panacea. This is a drop in the bucket in terms of the overall fragmentation in the dry bulk sector and does little to consolidate pricing power.   The speculative new ordering at Star Bulk in open employment positions offsets pricing power.

This is an operation - like Scorpio Bulk - with a highly concentrated position in dry bulk shipping assets. Present returns on shipping assets are low. Profit margins frequently cannot cover depreciation expense. The whole investment exercise depends on the degree and timing of a cyclical market recovery and sufficient financial liquidity to turn over the assets at marked up prices to lock in the capital gains profits on assets.  No shipping investgment can make acceptible returns without asset gain on market uplift in future years.

Case in point is Scorpio Tankers - heavily exposed to the MR product tanker sector and underperforming with the eco-ship argument - where the only appreciable profits have been capital gains from VLCC's sales and potential sale of the Dorian shares from the LPG sector, which has performed well this year.

There are pockets of better quality shipping business in the tanker sector and specialty trades like gas shipping. But there always hangs the Damocles sword of shipyard over capacity where earning margins can be put under jeopardy with new ordering that quickly leads to softening of freight rates. We have seen this in the LNG sector very recently.  Rates are beginning to soften in the LPG sector after a very good run this year.

Sentiment on shipping risk is changing.  Capital market deal volume for shipping transactions is down from last year’s levels. Investment groups have moved on to other sectors. There is increasing discussion about how institutional investors are going to divest of their present shipping holdings in the current climate and how the expected mark up in asset prices for a cyclical shipping recovery may disappoint. 

I have long been skeptical of how this would ever work on any scale to repeat the boom years, not only because of the changed macro-economic conditions with slower Chinese growth rates and chronic ship yard overcapacity, but also because of the finance gap in the banking market needed to facilitate sales at higher prices. What is required is greater demand and exit of the present deflationary environment.  

This is still a work in progress for policy makers and central bankers struggling with an increasingly restless public!

Waiting for September and the fall rebound in freight markets

We are now only a few months away from the fall period and all eyes are on a confirmation of a widely anticipated rate upturn in freight markets from September onwards.  This will be a key litmus test driving market sentiment.  This has been fundamentally bullish since last year, where there was surge of investment in shipping assets on expectations of a cyclical upturn. Expectations continue to be bullish for next few years, when investors will be looking to liquidate their positions in shipping assets with profit and move on.  Likewise there are a number of high profile deals based on new orders in bulk commodity vessel tonnage that will be coming into the water from 2015 onwards. The case of Scorpio Bulk - a dry bulk play from Scorpio Tankers based on a very aggressive booking of dry cargo vessel orders without any owned drybulk tonnage in the water - is a prime example. In an unanticipated repeat of last year, freight markets opened this year with a whimper instead of the much hoped for bang.  There was a premium in period fixture rates, but a downwards correction in spot dry bulk and tanker bulk commodity shipping markets, creating an inverted earnings curve between these two markets.  It was during these inopportune market conditions that Scorpio Bulk entered the market to charter tonnage to build up an operating company in the dry bulk sector until their massive new building orders are delivered. There are two basic issues that may challenge conventional wisdom in recent shipping placements: Chinese rebalancing.  China is presently the single largest contributor to global consumption growth.  This has been a boon to both the tanker and dry bulk markets.  Chinese rebalancing to more of a service economy may be less positive for the growth potential of Chinese seaborne import volumes.  With a leveling of infrastructure projects, Chinese dry bulk import volumes could reach their short-term maximum potential within the next few years.  This year, dry bulk markets have been badly affected by the ban on mineral exports from Indonesia and high Chinese iron ore inventory levels.   US and EU central bank policies of very low interest rates.  Again there are signs of excess asset inflation without support of underlying demand growth.  Shipping markets this year are a prime example where current freight levels do not support the current surge in asset prices.  As long as there is substantial excess ship building capacity and sluggish demand growth at best on par with GDP growth as opposed to being a multiple in the not so distant past, there is likely to be a continued supply glut of vessels, leading to shorter trading life and depressing resale values. Christopher Rex of Danish Ship Fund predicts possible softening of new building prices as early as next year. Meanwhile sentiment in shipping markets is evolving.  The latest monthly update from RS Platou takes a more cautious near term demand growth in the dry bulk markets.  Conversely, Plato is more optimistic on crude tanker demand with growing potential of US crude oil exports, short term VLCC demand from potential supply disruptions with the growing turmoil in Iraq and improved Suezmax demand as European refiners return from maintenance. Soon the fall will be here and then the new year 2015.  With the heavy concentration of long shipping asset positions and new buildings orders coming on stream,  it will be very interesting to see actual investor returns and prevailing asset prices ahead. Personally I am skeptical of a repeat boom of the last decade.  Demand growth in emerging markets seems to be leveling off and there are not the same liquid credit markets anymore that fuelled asset prices and facilitated sales transactions. There is still a lot of shipyard capacity to turn out more vessels at marginal prices.  Apart from cyclical volatility and the noise that it creates, earnings margins in shipping companies continue to be under pressure.  I am concerned that the upturn may be short and poor quality weaked by too much asset arbitraging and current fundamentals. The old Wall Street adage “Sell In May And Go Away” may possibly take on a new meaning, but then again perhaps asset prices will continue to firm as per expectations.

Scorpio Bulk: new ground in shipping investments

Scorpio Bulk is attracting massive media attention. It is start-up dry bulk company with no operational history, riding on the name of Scorpio Tankers and their management team. 

Following the tanker fleet strategy, the concept has been to build up a large fleet by aggressively acquiring yard slots. They currently have a fleet entirely on paper that consists of 23 Capesize bulkers, 23 Kamsarmax bulkers and 28 Ultramax bulkers from various yards all for delivery between 2015 and 2016. They have to build an organization for the commercial and technical management of this very large fleet. This amounts to a massive futures position in dry bulk assets that depends on market conditions in 12 - 24 months for employment. It is fairly concentrated shipping risk. 

 It is not surprising that there have been mixed comments about Scorpio Bulk. This venture has a very different history from Scorpio Tankers. Emmanuelle Lauro built the tanker operation methodically concentrating initially on a tanker pool with partners and building up a substantial commercial team. He also had a tanker fleet in the water that he was managing and operating. He then hired Robert Bugbee and organized an IPO to acquire tanker assets. 

This venture conversely is contracting new buildings without any vessels in the water. Indeed prior to Scorpio Bulk that was supposed to be an impossible schema for a public shipping company because investors wanted operating cash flow with vessels in the water before funding any shipping projects with forward deliveries and were not prepared to endure negative cash flow for prolonged periods before the vessels hit the water. Scorpio broke revolutionary ground that had never been done before in public markets. 

What Scorpio wants ultimately to do with this company and its assets is yet to be seen. Bugbee may be trying to replicate OMI and look at an opportune moment to cash in and sell out the company or its assets for profit. Prima facie, however, they are looking to build an operating dry bulk company alongside their tanker operation. 

The key factor here is how the dry bulk markets will be faring when the vessels hit the water. The prevailing school of thought today is that dry bulk markets are likely to be good for the next two years with Chinese closure of domestic mines and increasing imports of coal and iron ore from cheaper and more efficient overseas sources. After two years, this substitution process will have been completed and the surge in demand will level off to inventory restocking needs. This is especially important for Scorpio Bulk since their fleet is larger bulk carriers, where these are primary trade. There are no handysize vessels in their fleet. 

The major investment premise is that the vessels have been contracted at historically low prices and markets have nowhere to go but upwards in the coming years. The vessels are new and fuel efficient. The major risk hypothetically is that Chinese growth rates disappoint and the rebalancing, including Chinese long positions in commodities need to be liquidated at losses. Historically, falling commodities prices has been a negative factor for freight rates. China finds itself in a middle income trap and there is no other source of fresh demand so that shipping markets face a prolonged downturn of low rates. 

Another risk that the present type of eco vessel is rapidly superseded by change of fuel and becomes obsolescent prematurely. This concerns the general strategy of Scorpio, heavily predicated on the eco-ship story and heavily invested in current eco-designs. 

Most shipping experts are confident that these are unlikely scenarios, but shipping is always unpredictable because trade relations are constantly in flux. Scorpio has undoubtedly considerable new building risk with a very concentrated position. No rewards without taking on risks.

Scorpio successfully pulls off a second public offer for US$ 68,4 mio

Investors snapped up all the 6 million shares of Scorpio common stock on offer at $10,50 each and underwriters grabbed 900,000 over allotments at the same price.  Since the first IPO last year,  Scorpio has been trading in a fairly tight range between US$ 9.80 - 11,90.  It started out at the high level but fell hard to the lower range in later December 2010.   The New York-listed owner is on the brink of booking five medium-range (MR) products tankers in South Korea.

Scorpio has a multi-step plan that includes the above MR new building order with delivery of the five ships in late 2012 with the options to follow a year later if taken, opportunistic second-hand vessel purchases and chartered-in tonnage for its contract book needs.

The company is a pure play product tanker listing. Scorpio is an old company with roots in New York from the Lollighetti family, who moved their operations to Monte Carlo. Scorpio CEO Emanuele Lauro is third generation. During the boom years, he concentrated on building a tanker pool with a strong team of brokerage professionals rather than leveraging up and acquiring tonnage at top of the market prices. He took on ex-OMI management, making Robert Bugbee President of his US operation and bringing to capital markets last year. Bugbee warned investors last year that recovery for the tanker market might come later than expected.

Scorpio lost money in 2010, closing the year with a US$ 2,8 mio loss.   The company reported a loss of US$ 1,4 mio in 1st quarter 2011, reversing a US$ 1,2 mio profit posted a year ago. The result, which amounted to a deficit of $0.06 in basic and diluted earnings per share, was three cents ahead of the consensus forecast. Scorpio said the addition of new ships helped vessel revenue increase by US$ 10,9 mio to US$ 17 mio in the first quarter, but admitted the gain was offset by a decrease in time charter equivalent rates which slipped to US$ 14.997 per day on average from US$ 22.798.  

The product tanker market has been struggling to absorb the large inflow of tonnage seen in 2008 and 2009. This may continue well into 2012. Rates and values remain low as demand fell short of supply in the product tanker fleet. For 2011, distance-adjusted demand is expected to advance 6% and the product tanker fleet is expected to grow by 5%. This might support rates and values, but this all depends whether demand will large enough finally to surpass the growth in fleet capacity, the persistent problem that has been plaguing the product tanker sector for years.

If Scorpio’s newbuilding plan pans out, the company will control a fleet to 22 products tankers in addition to options for the three MRs and a pair of 2008-built panamaxes.

Tough times for the tanker sector

Despite some rate improvement earlier this year and some speculative new IPO's like Crude and Scorpio as well as a large Genmar block acquisition deal; the markets have not met expectations, suffering from low rates and over capacity. Futures and inventories do not support any storage to soak up excess tonnage supply. Scrapping of single hull tonnage has been high. Even bullish analysts like Platou have revised downward forecasts. The future depends on renewed FE emerging market demand.

Recently Oppenheimer's Scott Burk and Cantor's Natasha Boyden have been downgrading major listed companies and slicing rate forecasts into 2011. Boyden reduced next year's VLCC rates to US$ 40,000 daily, some US$ 5,000 a day lower than she had previously expected. She chopped her fourth quarter Suezmax forecast from US$ 37,500 daily to US$ 22,000 daily, with projections for 2011 down from US$ 35,000 to US$ 30,000. For 2011, Burk dropped his rate assumptions to US$ 36,000 daily for VLCCs and just US$ 27,500 per day for Suezmaxes.

Whilst demand from the East has remained strong, it has not compensated for drop in demand from the major oil consumers in the west, which remains weak. The onslaught of tonnage supply has further pressured rates, with the pace of newbuilding deliveries accelerating and floating storage counts coming down. This year there has even been some resumption of ordering. The prospects of a significant rebound in 4Q look bleaker by the day.

Natasha Boyden recently bumped down Overseas Shipholding Group, General Maritime and Tsakos Energy Navigation from 'buy' to 'hold'. Share prices have taken a beating. Peter G's General Maritime, which was a star in the spring with its massive Metrostar deal raising over US$ 200 mio from the market with little or no discount to complete the deal, is currently trading at US$ 4.03 today down from a peak of US$ 8.80 at the time of the deal frenzy. Such is the fate of investors in current markets who trust their underwriters, albeit perhaps the longer-term will eventually bring expected appreciation.

Genmar recently sold two of its VLCC to Pareto. Although claiming other reasons, this may have been a financial move to get the units off their balance sheet. Their US$ 620 mio block deal was financed with a US$ 372 mio loan facility from DnB NOR bank.  At the time of the share offering, the company leverage was approximately 70%; so if market conditions continue soft in 2011 with declining vessel values, they could have loan coverage covenant problems.

Crude and Scorpio have held their share value more successfully than Genmar despite the weak spot freight rate environment. Their business model is based on less debt but Crude has substantial spot market exposure and limited operating history. Scorpio has a very strong chartering and management team providing more more inherent value than Crude, but the clean sector in which they focus has been a market laggard for some time.

Clean products have much better forward growth demand projections than the crude sector. The long term OECD trends are negative for crude oil and the only growth comes from Far East emerging markets, whereas new refinery projects in the ME will lead to structural market changes with more production at source and less export of crude oil. Unfortunately, however, the clean tanker sector order book has overshot realized demand growth and created currently a nasty over supply situation.

Scorpio's CEO Robert Bugbee, ex-OMI CFO, was one of the first major tanker executives to warn investors of coming market turbulence.

A hedge fund's losses are a gain for a privately held shipping company

The financial crisis is leading to a regrouping in the shipping industry where publicly-held companies are in retreat with massive declines in share price and shrinking capital markets. This is illustrated by the recent move of Robert Bugbee and Cameron Mackey from Ospraie, a major NY-based hedge fund, to a subsidiary of the Monte Carlo-based Scorpio Group.

The Scorpio group has chosen a value-added commercial approach building a tanker pool rather than the asset expansion/ vessel-provider model of most publicly listed shipping companies. Ospraie was a major capital provider for NY publicly-listed companies. They had a sizeable portfolio of shipping shares. They have been obliged to reduce their their holdings in this sector. With listed shipping companies rolling up losses with order cancelations and impaired asset values from acquisitions made at the top of the market, sound privately-held companies stand to make a come back in the industry.

Scorpio Shipmanagement is an old established player in the tanker market. It is closed family-held business of several generations.

Contrary to most publicly listed shipping companies, Scorpio concentrated during boom years in building a tanker pool. They have a very fine group of brokers and a solid commercial base with end-users. They gave priority to investment in human resources to expand their commercial and operational capacity rather than massive scaling up in assets at bloated price levels. They did not concentrate on making quick profits nor double digit investor returns overnight. They had longer term business plans.

Where they did expand their asset base, they used cheaper European finance sources. They did not have the high transaction costs or restrictions to their business plans imposed for raising capital in US financial markets.

Presently as seen in the Bugbee move from Ospraie to a new Scorpio subsidiary in Stamford, Connecticut, hedge funds like Ospraie who have been major equity providers for NY-listed shipping companies, are now in retreat. Their massive portfolio losses due to the drop in commodities prices have forced them to start to liquidate their shipping holdings and restrict their capacity for new business.

Private players like Scorpio have a bright future in this market downturn. They are well positioned with a strong commercial base. They are not saddled with expensive asset acquisitions at top of the market prices.

They will have the opportunity to scale up with new vessels at lower prices that will give them a long term competitive advantage to many publicly listed companies.