Stopford - Covid and Climate Change: Two big challenges to the Shipping Industry

Yesterday listening to Martin Stopford's interesting presentation in a Capital Link event and lengthy Q&A session, it seemed to me that the two major drivers of events shaping the shipping industry today are Covid and Climate change.  They have a number of similarities. They have far ranging effects on world trade and ship technology that will affect the future.

Covid crisis and climate change start with natural phenomena that have morphed into highly contentious political issues due human response to them and the ensuing politics involved, particularly in the EU and US. 

Viruses and microorganisms are as old as life on the planet.  New viruses appear all the time.  Coronaviruses are well known and this is a new strain of this existing family.  We have had virus outbreaks from China repeatedly in the past years like SARS and H7N9.  Nobody panicked  and eventually these new strains took their course through natural means with human immunity and some efforts for vaccine,  Vaccines are simply an artificial means reinforcement of human immunity systems that would otherwise develop antibodies in reaction to exposure to the virus.  Ultimately there is no other way to deal with viruses.  The human race would have long ago become extinct from viruses if there were not biological immunity systems.

What is startling in the case of Covid is the political response to it that was first initiated in China by mass lockdowns/ social distancing of the healthy population and economic shutdown of production. Historically quarantines in reaction to infectious diseases were done by isolating sick people from the general population and holding travelers from infected areas for a certain period before entry into national territory.  

The Chinese government shutdown had an immediate effort on the shipping industry with a reduction of port cargo movement of 20% on the average, affecting the container industry negatively, forced to blank sailings and facing box build ups in Europe from the imbalances produced by the factory shutdowns in China.

Then there was an even more damaging and recessionary impact on the shipping industry with Western Governments collectively adopting the Chinese lockdowns and imposing them on their populations, quarantining large segments of their healthy population in fear of exposure to the virus, something never done before in human history.  

This has caused a great deal of instability for global shipping. There are projections of significant reduction in world trade this year,  Ship operations have become challenged due difficulties to carry out surveys and repairs. Normal crew changes have become a major problem to carry out .  Economic impact varies by sector.  

• Container shipping was looking to recover with Chinese reopening of factories and increase in port cargo volumes in March, when it got slammed by the recessionary impact of the lockdowns in Western economies that created even deeper losses of revenues and blank sailing. Major container lines have been plagued by poor earnings margins for years.  Some were just beginning to turn profits in 2019.  Now all these major liner companies are likely this year to go back into operating losses.  Stopford feels they will eventually muddle through this, depending on the speed that Western government reopen after lockdown and the severity of the global recession.  Stopford feels that large containerships were always a problematical response to the structural problems of the industry.  Globalization is over after Covid and trade is likely to evolve more regionally.  The use of these units will be restricted and the transport needs will be more for regional distribution.

•  Conversely the tanker sector has been enjoying a bull market with record rates.  This in related to failure of OPEC to extend production cuts and a new price war, when at the same time Western mass lockdowns have provoked a significant drop in oil demand.  The system is flush with oil from overproduction.  This has resulted in a surge of demand for tankers both for transport and storage, even backing into product carriers from refinery overproduction.  Ironically this situation will eventually result in obligatory and severe cuts in oil production and a dead tanker market with fewer hydrocarbon cargoes ahead.  Stopford pointed to the inherent weakness of the tanker sector in his presentation.  For now the tanker companies are the darlings of investors and flush with cash and profits.

•  Dry bulk is more mixed and nuanced here.  This sector has not been very profitable for at least 10 years, except for short rate spurts in certain segments.  The large bulk carriers depends on the steel industry,  coal and iron ore cargoes.  This segment had an awful first quarter with BDI indexes going into negative territory. Stopford does not see a very bright future here for these units with a maturing Chinese economy and the likelihood of stimulus spending to be more focused on technology rather than further infrastructure projects.  The smaller units will fare somewhat better. Panamax units carry more diverse cargoes like grain that are driven by other factors than the steel industry. The smaller sizes carry a much wider range of cargoes, including minor bulk trades.  More of this is related to foodstuff and general population needs. These segments will muddle through the crisis but present rates are low.

Stopford sees a secular trend towards regional trading zones with production closer to consuming areas.  He outlined three recovery scenarios.  All this is related to Western governments and how they manage the reopening of their economies.

This is entirely a political issue and it will have big effects on the depth of any recession. The drop in world trade will be milder than drop in GPD, but the effect on the shipping industry will be far reaching.

I see this as complicated political issue, not directly related to the virus. Western governments have taken unprecedented actions imposing drastic restrictions on their populations and curtailing basic civil liberties like freedom of assembly and religious worship.  All this together with significant social and economic cost on their populations that has led to the specter of global recession.

Scientific studies are beginning to indicate that there is nothing novel about this virus.  Infection rates on general population are much higher than originally anticipated despite the lockdown measures.  Death rates are much lower than wildly inaccurate early studies from places like Imperial College.  There is no easy way for the political class to reopen quickly.  They are fearful of the future political cost of their actions.  How this unfolds in the US and EU depends on the boldness of the political leadership and their effectiveness to return to normalcy and limit damages by getting their populations back to work and reflating their economies with the stimulus programs.

Despite the three scenarios, Stopford closed with a hopeful note that by fall, most of this Covid crisis will be over.  We shall see!

Climate change and environment regulation has taken the back seat due Covid crisis but this is a similar case of politics overwhelming natural phenomena and creating considerable challenges.  The earth has underdone significant changes in climate for millions of years. Anthropogenic causes by burning hydrocarbon fuels are a very recent phenomenon.  Carbon is essential for life on the planet.  There is a natural recycling of carbon from plant life back to oxygen.  Science is even more divided over these matters than Covid and human immunity systems.  The climate depends on so many other unquantifiable factors such as solar radiation and tilt of the earth.

But the present political consensus like the massive Covid lockdowns is that carbon is bad and greenhouse gasses GHG must be reduced and eliminated.  IMO has adopted GHG targets for 2030/ 2050 for which there is presently no technological means to comply.  The EU dominated by Northern European Green parties wants even more drastic measure such as a carbon tax trading scheme imposed on the shipping industry.  Like the Covid lockdowns, these measures will have negative economic impact on their populations, particularly the poorer classes.  There have been mass protests like the Gillets Jaunes in France in reaction to government taxes on fuel, just as in the US there are increasing protests against the government lockdowns. But generally the political class stands firm on these matters and it is not easy for them to back down in terms of their positions for the political cost.

For the shipping industry, Stopford points out that diesel and fossil fuels are far more efficient technologically than alternative fuels.  There is much higher energy content in the fuel.  It can easily and safely be stored on vessels and it does not take much space.  For these reasons, Stopford feels that diesel propulsion is the only alternative for the next generation of ships with a lifespan of another 20 years. 

The innovations in shipping for less fuel consumption and GHG levels will come from 'smart' ships with messages via CPU modules replacing wires, as Stopford puts it.  I would add this would also dictate more use of digitalization and software maximization programs in the offices linked to the vessels that they manage.  Metis - a Greek software system -based on the internet of things is a good example and a number of leading Greek Shipping companies have adopted it.

Stopford then outlines a growing use of LNG and dual fuel vessels. New technologies like this are more easily implemented in short sea shipping in early stages. Already this is the case for use of LNG in the cruise industry and tanker feeder vessels in Europe, for example.  This will lead to a new generation of vessels that will start to replace the  'smart' diesel/ fuel oil vessels. 

Then rather far out, Stopford sees electric vessels with fuel cells powered by hydrogen, etc. None of this is close to reality today.  The fuel cells cannot produce sufficient power and the new fuels presently can  only be produced from processed that create GHG that must be sequestrated.  Many of alternative fuels are noxious and difficult to store on vessels.

It is very intriguing to note that the same political class that supports decarbonization and vigorous climate change regulation also support with passion the mass lockdowns in reaction to the Covid virus  Many are extolling the positive results from the mass lockdowns on the environment with the drop in air and land transportation and falling demand for hydrocarbon fuel. They are the ones most critical to attempts to reopen economies and get people back to work. They are advocating universal income guarantees and green new deals for stimulus as long term solutions. 

They are not keen to return to the status quo.  They are not particularly troubled by adoption of  restrictions of movement and civil liberties on the general population. They tend to be indifferent to empirical scientific method and how it may evolve over the particular ideology that they promote to support their policies and actions.  They are not especially concerned about the social cost and economic hardship on the general population from their decisions. They place more important on their longer term ideological political goals that they feel are good for society and their political careers.

We will see in the next few months how this political debate evolves and how soon we reopen. The political climate is looking toxic and divisive. Inevitably we are entering a new post globalization era for the shipping industry with far reaching consequences.  Stopford parallels the challenges as analogous to the transition from sail to steam in the 19th and early 20th century.  The political and economical ramifications are huge.

How long will this bull tanker market last?

Despite looming global recession, the tanker sector has been enjoying a rate boom from the oil price war and failure of OPAC+ to agree on rate cuts.  This market boom comes at a time of falling oil demand. The tanker market is being driven by ramped up production. The present large contango in pricing favor physical oil storage, further reducing tanker supply and keeping tanker charter rates very firm.

Many of the major listed tanker companies feel that the tanker industry has entered a new era and will finally be enjoying several years of good earnings.  Frontline's MacLeod characteristically sees floating storage as a 'generational' opportunity.  What is the incentive for build up oil inventories even with wide contango when oil demand is falling in a looming global recession? Is this bull run sustainable and what are the risks for tanker share investors?

There are substantial risks that this could be another false start for the tanker industry, sooner than later.  Even if there are no agreed on cuts in the near future, present production seems so out of proportion to falling oil demand that available storage space is filling up rapidly.  There is the risk that at some point, the storage space will be so tight and expensive that production will have to be physically reduced.  At that point, the tanker market could become frozen for a period with very little demand for oil transport and refineries drawing off oil stocks.

More likely agreed production cuts will come sooner than later and contango spreads will narrow. Negotiations failed this week 15 because Russia and Saudi Arabia are insisting that non OPEC producers like the US and Brazil join in the production cuts. In the US environment, voluntary production cuts are almost impossible legally.  Sooner or later, production cuts seem inevitable.  Physical oil storage has never been sustainable over the long run.  

Maritime consultancy Marsoft predicted in a recent webinar that a significant oil supply cut of Opec, Russia and nine other producers – also known as the Opec+ group – will end the bull runs in tanker markets from July onwards.  Marsoft partner Kavin Hazel estimates that a reduction between 5m barrels per day (bpd) and 10m bpd would pressure tanker rates later this year.  This would lead to a much smaller stock buildup and less floating storage. A rise in oil price from production cuts would narrow the contango spreads. Tanker rates would fall back more significantly in the second half of the year with less oil put into the market.

This view was recently seconded by Cleaves Securities,  who turned bearish and are projecting that Oil Tanker spot rates plummet in concert with asset and share prices. Their tentative VLCC spot rate forecast for 2H20E is now only US $ 15k/d, which is extremely low given 4Q represents high-season, in a tanker note yesterday.

The clean sector also faces challenges with dropping oil demand in  recessionary environment. The jet fuel market, for example, has collapsed with the fall in air travel.  Refineries are trying to change their product output mix to compensate for the collapsing margin spreads in these products. Excess jet fuel can be stored, but unlike crude oil, there is a limited shelf life and the product become off specification and can no longer be used as intended.

At least the tanker markets profitable and building up cash.  Other shipping sectors are not so fortunate with container lines and cruise business burning cash and struggling right now. Dry bulk is showing some improvement but just above water at present.

These are complex matters, but the most worrisome presently is falling global oil demand and depth of the coming recession. The timing and shape of a coming global recovery is critical here. It all depends when the quarantines are lifted and how soon we return to normalcy.

Coronavirus has changed dramatically all forecasts for shipping markets.

Covid 19 is now in a second stage, destabilizing the major consuming economics - US and EU - and unleashing a major global economic crisis of the magnitude of the 2008 meltdown.  It started in China and spread to other Asian countries in the first stage.  China, Singapore and Korea seem to have managed successfully the initial health crisis and contained the contagion, so that people have returned to work, but the problem is that export demand is now under threat due the second stage where the virus has now led to lockdowns that have incapacitated large sectors of the US and EU economies,

In the meantime, a price war has broken out between Saudia Arabia and Russian and oil prices have fallen dramatically.  These low prices threaten the US shale oil industry and many lead to more woe in the offshore sector that was showing first signs of some recovery after a prolonged slump for several years now.

We can make the following observations:

•  The best case recovery scenario is a U-shaped global recovery in the 2nd half of 2020 but lots of output destruction in the 1st half.  Hopefully better years in 2021 and 2022.
•  Scrubbers that seemed a major success story in January this year are now rendered problematic with the low oil prices and very small prevailing spread between LSFO and HSFO.
• The impact on this situation on shipping varies with the sector:

Containerships were badly affected by the factory shutdowns in China, now with the factories coming on stream they face the second wave that is reducing import demand in the US and EU.  Liner companies will face a new bout of financial stress with the weaker liner companies again in jeopard with serious cashflow problems. Likewise, third party vessel provider companies that have legacy debt problems.

Drybulk started the year with very low rates. The Capesize sector was very badly hit and still suffers.  There has been some recovery for the other sizes, but mixed.  

Tankers are experiencing a boom market with the low oil prices, but the first surge in rates has now abated, albeit rates are still very profitable levels. Both crude and products trades are currently profitable. The contango price curve favors liquid storage. With a looming recession, a lot of crude oil and oil products will go into storage.  Reduced oil demand from a prolonged economic slump would jeopardize the current profitability of the sector.   

The severity of this major global recession depends heavily on the ability of governments to contain the virus and get people back to work to restore normalcy.  The most successful cases seem to be Singapore and Korea in this regard.  Whether the US or EU can replicate this success remains to be seen.

The US government is particularly concerned about the need to restart their economy and get people back to work but they are just in initial stages in dealing with the health problems.  The EU is struggling over reflation mechanisms that are lacking in the Eurozone. The health crisis in Italy and Spain is still out of control.

Scrubbers revisited.

Back in October 2018, I published on this blog a somewhat negative article on scrubbers as a means of compliance for IMO2020 regulations.  Today we are close to finishing the first month of IMO2020 in full implementation.  I think it opportune to revisit this subject in view of the experience to date with these regulations now in force.

I always saw scrubber refitting as speculative by nature depending on fuel differentials.  I never liked the concept of making a ship a factory to remove sulphur from heavy residual fuel oil.  I considered direct use of compliance low sulphur fuel oil from the refineries as a more efficient solution.  Also I believe in a level playing ground for the shipping industry and scrubbers create a tiered market for the vessel segments where they are widely used.

In fact, the initial fuel differentials have been much wider than initially forecast.  The actual fuel price spreads are well above projected levels to support the scrubber investment.  This has made the prime movers like Scorpio, Star Bulk and others the winners and substantial beneficiaries on the initial scrubber wager. Indicatively, Okeanis VLCC's are earning a staggering US$ 121 m per day as scrubber savings kick in.  The Greek shipowner says it has already made back 44% of the retrofit bill for its big tankers.

Further scrubber refitting is proving to be an excellent asset play.  Close to 20 modern or resale VLCCs are being touted for sale at high prices in a market that is offering shipowners strong returns.

Looking ahead, we do know yet whether fuel spreads may narrow.  The high differentials may be simply a product of the supply disruption in initial market conditions. Over time, the prices may normalize to lower levels.  Fuel spreads may drop significantly.

One issue to be resolved is the matter of the continued supply and availability of traditional heavy residual fuel oil.  Refineries have ramped up production of low sulphur fuel oil and are earmarking HSFO for other uses than marine fuel.  A smaller supply of HSFO and tighter availability may result in higher prices and also storage issues for the smaller quantities in the market for marine fuel.  Already it is reported that there are availability issues for supply of HSFO in the Far East and ships forced to Singapore to bunker heavy residual fuel oil.

In any case, the scrubber school is presently at the top of the shipping world as the winners in this debate. Some are thinking about monetizing their position by selling the scrubber-fitted units at a premium, but this depends on willing buyers and nobody knows how long present fuel spreads will remain of whether fuel spreads may narrow.

Furthermore, dry bulk rates are very weak and tanker rates are falling, so regardless of whether the vessels are fitted with scrubbers or not, the earnings margins are not improving.

Postscript: Fuel spreads have now collapsed with the dramatic fall in oil prices.  Plans for scrubber installations are now facing massive cancellations, particularly in the dry cargo and containership sectors. We will see in coming quarters whether the wagers made by companies like Star Bulk and Scorpio Tankers pan out in earnings results for their shareholders.

Pyxis reverse merger: an imaginative capital market entry with big challenges

Pyxis marked the first time a Greek managed shipping company became publicly listed via a reverse merger.  They are merging with a San Francisco-based tech outfit LookSmart, already listed.

It was a novel entry to public markets by a small product tanker company, who failed to develop sufficient interest in a previous attempt to do an initial public offering. Will this entry allow them to raise capital in public markets as they would like, or will it prove in the end nothing more a Pyrrhic victory that simply increases administrative expenses for the public listing without any benefits to capital markets access for fund raising?

Present conditions in capital markets this year have not been easy for fund raising in shipping ventures. Enthusiasm and interest among institutional investors to put money on shipping assets has waned considerably over the past two years. Funding for expansion has reverted again to traditional bank financing. The market has become generally very selective on shipping projects.

Investors have been burned by bad positions in dry cargo shipping companies, where the markets turned against them, ship values have declined and these companies are making substantial operating losses. Even in the tanker sector, which is doing quite well this year with resurgence in freight rates and cargo volumes, investor interest is limited only to a handful of large tanker companies. Conversely, a number of private equity joint ventures are putting their tanker assets on the market for sale to monetize their positions.

Pyxis would probably never have succeeded in their reverse merger operation without the support of Larry Glassberg at Maxim Securities. Maxim is mid-sized investment banking firm that has not only a base of institutional investors but also a substantial base of retail investors. Glassberg has an exceedingly long experience in the investment bank industry and shipping operations.

Pyxis did not attract sufficient interest for an IPO (initial public offering) because it is a relatively small operation with a fleet of six MR product tankers, two smaller chemical feeder tankers and one MR new order yet to be delivered. Vessel age ranges from three units built in the late 2000’s to a small two-vessel MR NB order of which one unit has been delivered.

The company is certainly on the right side of the market in product tankers, but they face much larger peer companies like Ardmore and Scorpio Tankers. Major established companies like BW Pacific and Hafnia Tankers would like to list publicly, but are themselves constrained to wait for improved market conditions to do an IPO listing. It’s only a matter of stock flotation, but also obtaining favorable valuation with their listed peer tanker companies still trading below or close to NAV despite a surge in profits. This was a basic hurdle that Wilbur Ross was not willing to accept in the case of Diamond S going public.

Vessel values have improved but still remain below what would be expected given current earnings. Part of this may also be due to the restricted bank financing market, where loans are given only to existing customers and preference to larger clients.

The true test here will be if Pyxis can leverage their public listing to raise capital to facilitate growth. That is clearly the motivation of Pyxis for the costs and increased administrative expense of a publicly listed company. With a fleet of eight vessels, they will have to absorb additional administrative expenses of at least US$ 800.000 to 1.000.000 annually. Pyxis as a listed company has an estimated US$ 70 million market cap, of which US$ 66 million will be controlled by its principal, Eddie Valentis. The remaining US$ 4 million of stock has traded less than $100,000 per day. Pyxis remains essentially a private company under total control of its owner. It has no trading volume and will not attract any analyst coverage.

Going into the market to raise capital, the valuation issue becomes critical. Pyxis will likely trade at a discount to NAV [net asset value] and to established companies like Ardmore Shipping or Scorpio Tankers. Should investors put a low valuation, what will be the appetite of the principal shareholder, Eddie Valentis, to dilute his personal share holdings, selling his stock to investors at a discount? Of course, there are other means to raise capital. Pyxis could look to bond issues, for example. Financial expense will be higher than a conventional bank loan, but amortization schedules may be more favorable, providing more free cash flow liquidity that could be reinvested in further expansion. They could also consider convertible bonds or CoCo’s that would get around the share dilution conundrum.

At least, Pyxis is on the right side of the market in the tanker sector. They have a relative young fleet. This listing operation may prove a spring board for future growth, depending on the quality of incremental investment that they take to market for investor support and the prevailing market appetite to invest in the shipping sector.

Reversal in Tanker Markets with Crude trades more robust than Clean

Although tanker rates are hardly booming after being the wall flower last year in the shipping markets, this sector has been consistently outperforming the dry bulk sector this year. This contrast is more due to weakness in dry bulk rates and somewhat better tanker rates than last year. The crude sector is showing signs of strength over the popular clean sector. At the heart of these developments are changes in energy sources and trade flows. 

Not surprisingly, the clean tanker sector has an order book that is nearly twice as big on a relative basis. Asset values were broadly higher in the tanker markets in the first half of 2014, but current values do not support the expected earnings environment The vast majority of tanker demand originates from the movement of crude and residual fuels.

Crude oil marine transportation demand for tankers arises from matching refinery raw materials needs with crude oil production. Petroleum product marine transportation demand arises from matching consumption with refined product production in refining regions. More than 50% of projected growth in demand is forecast from China and India. Energy use in the US and EU has been fairly stagnant for many years. Oil market fundamentals suggest a moderation of crude price increases in the near future in the absence of geopolitical influences. Natural gas is the fastest growing fossil fuel, supported by increasing supplies of shale gas, particularly in the US. 

US domestic oil production forecasted in 2015 to rise to the highest level since 1972. Most of this domestic production is light sweet crudes. A steadily increasing proportion of heavy crudes are being imported to the US driven by growing abundance of domestic light sweet grades. The US is likely to restart export of crude oil, but not for several years ahead. This will be light sweet crude. It will be highly dependent on the prevailing level of oil prices and US domestic politics. Meanwhile, the US Gulf has become a major clean product export hub providing robust volumes of gas oil and gasoline to Atlantic Basin. 

Tanker ton-mile demand is likely be modest over the next few years. Ton-mile demand has been falling in the MR sector. Currently LR freight rates are higher for trading dirty cargoes than clean. Further the MR sector is being cannibalized on longer haul routes by larger LR units. The clean sectors are burdened by heavy supply outlook against only moderate demand growth. The MR’s are under the most pressure with the poorest fundamentals. 

The dirty sector tonnage supply is moderate and demand positive. The VLCC sector faces a large number of deliveries in 2015 and 2016, which creates a neutral freight outlook until the 2018 when some increase is anticipated, assuming new contracting is controlled. Suezmax demand growth is somewhat more positive but dependent on continuing demand for this size in longer haul trades. The Aframax sector has been subject lately to high geopolitical volatility especially with the chaos in Libya but order book situation is more favorable. than the larger sizes, opening more opportunity for rate increases. 

Critical to any meaningful improvement in the tanker markets is a global economy gaining traction to approximately 4% growth needed to underpin the necessary expansion in oil demand and trade. This year, growth projections have been reduced due the poor performance of the European Union with its deflationary policies and China rebalancing with a slowing in infrastructure projects and sorting out losses in the domestic banking system. 

This remains a prerequisite for the freight market to make a return to a moderate level of profitability. Given the number of high profile publicly listed tanker company bankruptcies, the fate of the reorganized companies like Genmar and OSG will turn on when and how soon there will be recovery in the tanker freight markets. 

Earnings margins are likely to remain tight. Trading life of tanker fleets is likely to become shorter. Competitive advantage will come from modern fuel efficient tonnage, good commercial management, and moderate financial expense.

Structural changes in the crude oil tanker sector: failure of companies to adapt may prove fatal!

The crude oil tanker sector faces the double whammy of excess capacity from overinvestment as well as structural changes in trade flows.  It is not a growth industry.  Developed economies have proved successful in rolling back consumption and diversifying in alternative fuel sources.  Marginal demand growth to fill the slack depends on emerging market economies.  The degree of hard landing in China and future level of growth rates in emerging market economies thereafter is very critical in the short and medium term.   Those tanker companies heavily dependent on traditional crude oil transport – VLCC’s, Suezmax and Aframax – without other revenue sources are severely exposed.  Those with high bank leverage are in severe distress.

Spot market tanker rates can be very volatile. These vessels are dependent on one cargo only: crude oil. Demand is driven by inventory levels; futures pricing, oil production levels and underlying oil import needs. Oil production is in part manipulated by the oil producer cartel OPEC and particularly Saudi Arabia as a swing producer, so productions levels play a key role in available cargo volume for transport. Politics plays a big role with the Iran oil sanctions. Speculation plays a role depending on the future pricing curve whenever it is favorable to buy and store the physical commodity in chartered tonnage for sale at a later date, taking this out of the transport market, leaving less tonnage available for lifting cargos to destination.

As the US has been the greatest consumer of crude oil in cargo volume, the VLCC trades were developed as the most economical means per unit cost to transport crude oil to the Houston area for refining from the Middle East. With the China and emerging market boom of the last decade, there was a deluge of new refinery projects in the Middle East, China and India.

Middle East producers wanted to develop a more value-added economy, investing their profits from oil sales into refineries to produce products at source for export. This led to great optimism in the product and chemical tanker sector that jumped the gun in over investment in these sectors. Since the 2008 global financial crisis, some of these projects have been cancelled, some delayed and some progressed and are on stream. Demand was less than expected for the ship owners.

One of the most novel projects from the Middle East was the Motiva refinery. This is a 50-50 Shell and Aramco joint investment of three new refineries in the US Gulf region. It is the reverse concept of the Middle East refinery projects. They transport crude to the US and refine there. This has been a boon to the product tankers trades in US Jones Act cabotage trade; albeit due project delays and a refinery closure due an accident, it has been slow to come on stream.

Conversely, there have been some overwhelmingly negative structural changes that threaten crude oil trade to the US, namely:

• Technological evolution in the production of tight oil and shale gass, allowing more US domestic energy production, together with the Keystone pipeline project facilitating Canadian oil imports. Whilst this is another potential boost to US Jones Act shipping for distribution of products, it is one of the main contributing factors this year to a dreadful international tanker market.

• Expected increased domestic use of energy resources in the Arabian Gulf, making less crude oil available for export. This is developing on several fronts. First, there is the political front with the Iran oil embargo. Second, there was a drastic reduction of Saudi oil exports during the summer where the oil was diverted to domestic use for electricity production. Finally, the above-mentioned refinery project now coming on stream to produce clean products and chemicals for export. After the GFC, about a third of the projects were cancelled and another third in delay, but the last third is now coming on stream and exporting. This means production at source and less crude oil for export.

The rise of gas shipping as a new growth area is also impacting negatively on crude oil transport. The LNG market is dominated by cargo operators and normally done on long period contracts. Historically, returns have been less than desired and tonnage ordering has overshot the market, but the Japanese tsunami provided the catalyst to rekindle this market to profitable rates with attractive returns to investors. The vessels are much more complex to build than crude oil tankers and capital costs are significantly higher, providing serious entry barriers. The limited number of yards that can turn out such specialized vessels has created a two-year window of opportunity for nice run on rates with existing tonnage in relatively short supply.

Increased LNG production as a long-term secular trend means also downstream enhanced prospects for LPG shipping. Together with the offshore sector, these are presently the major growth sectors in the tanker markets.

Conversely, the crude oil tanker market – except for sudden brief demand spikes in refinery restocking – does not seem to offer good long term growth prospects in the face of these secular trends. A number of established tanker operators like BW Shipping have been shedding VLCC tonnage.  BW like Teekay Shipping and major private owners like Angelicoussis in Greece, foreseeing these secular treds  have diversified themselves in timely fashion into other more attractive areas like LNG shipping and offshore, positioning their businesses with profits from these new growth areas that shelter them from the current losses on their tanker tonnage.

Some like TeeKay Shipping have sought to develop a franchise in tanker trades demanding special expertise, namely shuttle tankers offloading directly from oil rigs. These vessels have special mooring fixtures and are equipped with dynamic positioning technology. They require specially trained crews. An extension of this offshore business is the FSO and FPSO business with floating oil storage and production facilities, another current growth area in shipping.

Companies who have been slow to adapt to these developments are generally in deep trouble. General Maritime (GMR), for example, just recently got out of Chapter 11. Peter Georgiopoulos appears to have ignored totally all of these developments. His company was probably the weakest of the large listed tanker operators in terms sound commercial management. Perhaps he was distracted by his ventures into dry cargo. Now he has lost control of his tanker business and is fighting to save Genco and Baltic in the current severe bulk carrier markets correction. What Oaktree gained in taking over General Maritime remains to be seen. Presumably they were attracted by a cyclical asset play because the enterprise value of their acquisition is quite low compared to peer tanker operators.  Oaktree now seems to be ready to do a startup asset play in dry cargo with Petros Pappas of Oceanbulk.  At least this venture promises to have a lower entry and transactions costs than Genmar....

Overseas Shipping Group (OSG) was too little and too late in these structural market developments and left with heavy crude oil spot exposure. It appears to be heading to Chapter 11. Whereas their peer colleague Peter Georgiopoulos by contract proved timely and diligent bringing in Oaktree to support his company, OSG management also appears to be failing with senior lenders in prompt action in debt restructuring. Hopefully, OSG management ultimately will prove adequate to the circumstances.  I have always felt that their age and career path has made it very difficult for them to adapt to crisis management. The OSG Board made a good decision to appoint outside advisers.

In these cases, it is not only the over indebtedness of the companies, but also the failure of the business model that put these shipping groups in their present predicament. Conversely, the successful operators like TeeKay Shipping have outperformed peer tanker operators because they adapted in timely fashion their business model to anticipate structural market changes and have much better business models.

Will Omega Navigation come out of Chapter 11 as a going concern or be liquidated as per the Marco Polo case?

This week a glimmer of hope surfaced for Omega Navigation (ONAV) in an article in the Tradewinds, where Aaron Kelley reported the signs of a deal where George Kassiotis puts in an additional US$ 2,6 million equity into the company and the company rolls out a rights offering that would give general unsecured creditors and junior lenders a chance to secure a stake in the reorganised company and has agreed to a cash distribution of 10% to unsecured creditors “over time: provided they accept the plan.  Talk of Omega coming out of Chapter 11 with a reorganization plan by November this year.

I have expressed pessimism in the past over Omega, as I saw George Kassiotis’s refuge to Chapter 11 more an defensive act of desperation with his lenders to buy time rather than a serious effort to recapitalize the company. Unlike the successful example of General Maritime (GMR) there was neither any private equity firm ready to provide substantial new funding nor any pre-agreement with senior lenders for a support package. To the contrary, Kassiotis had openly broken with his lenders with a nasty, high profile lawsuit in Piraeus seeking damages.

For Bracewell & Giuliani, Omega’s US attorneys, this was a show case to attract other shipping firms to US bankruptcy court, giving the US legal profession a franchise in maritime bankruptcy. For Jefferies, Omega was a source of badly needed fee-earning business given the collapse of fresh shipping placement deals in capital markets. Hamish Norton, who heads the marine business in Jefferies has a stellar reputation as a knowledgeable and serious investment banker with a high level of integrity and a history of well-structured deals.

Despite this support for Omega, the company financial woes are very challenging with limited room for maneuver. As a smaller listing, Omega lacked the scale of its peers to leverage capital markets and quickly fell behind its peers. The Principal, George Kassiotis, has limited personal wealth from other ventures that he could draw upon to support this Omega. In fact, he seems in an even weaker position than Antonio Zacchello of Marco Polo. All this puts Omega on the same path with a similar fate: move to Chapter 7 liquidation as their senior lenders, HSH Nordbank have already filed for and have been urging.

Meanwhile, whilst Omega has some high powered advisers, they are also some of the highest paid, so there is the specter of mounting costs and legal expenses that are the Achilles Heel in Chapter 11 proceedings. Peter Georgiopoulos had everything in place even before filing in the case of Genmar, to minimize the time and cost in this procedure.

Whilst unquestionably a sign of good faith on the part of Kassiotis, the sum of US$ 2,6 million is a paltry amount for recapitalization of Omega. I am especially intrigued by the rights offering for general unsecured creditors and junior lenders. Is this going to be the main source of funding for company recapitalization along with the sizeable ‘haircut’ to unsecured creditors with promises of the remaining 10% amount paid “over time”? Is not this a sign how bad the situation is?

Who are the largest unsecured creditors? What are liabilities of their advisors Jefferies and legal counsel Bracewell & Giuliani as credtiors. Are unsecured and junior creditors going to be asked to put in new money in this rights issue or will this be a conversion of debt for equity? Why would junior lenders like NIBC and BTMU put more money out on Omega that would in fact benefit HSH Nordbank, who has priority over their position?

Why is not HSH Nordbank sharing the pain in an exchange of debt converted to equity as RBS accepted in their loan restructuring in the case of Eagle Bulk? Would not that give some comfort for a rights offering? Finally who is providing this new restructured senior debt and working capital facility? Has HSH Nordbank changed tack here?

Unquestionably, it would appear that Omega has substantial debtor’s leverage here with creditors in serious jeopardy of severe losses for this formula to be workable. Perhaps it is the magnitude of losses that makes them hesitate to move for the dissolution of the company?

Frankly, the Tradewinds article opens more questions than answers. My reaction is that this tentative agreement is likely still fragile. I am troubled that I do not hear anything about a clear and substantial source of recapitalization for Omega to come out of Chapter 11 as a going concern.

Let’s see what happens by November!

OSG in the doldrums: Is Morten Arntzen really one of the worst CEO’s in any industry?

Overseas Shipholding Group (OSG) is a blue chip tanker company that is currently in crisis with 13 quarters of operating losses, plummeting share value, rating downgrades (CCC+) and ominously its unsecured bond debt trading far below nominal value. Morten Arntzen claimed in the recent 2nd quarter earnings conference that OSG defensively drew to the maximum its current US$ 1,5 billion liquidity facility. With current market fixation on this facility expiring in February next year to be replaced by a smaller US$ 900 million facility, Arntzen did not provide much comfort to investors. To add insult to injury, Motley Fool named him one of the worst CEO's for the dismal stock performance and sizeable investor losses over the past year.

OSG is one of the oldest US tanker listings. It was founded back in 1948 by the Recanati family and listed in the US stock exchange in 1973. The Recanati are American Israeli with origin from Italy where they took their family name. Two of the Recanati family remain on the Board of Directors: Ariel and Oudi Recanati. Aside from shipping the family has a long tradition in banking and finance, having founded the Israel Discount Bank.

Morten Arntzen became CEO in 2004, coming from a banking background in New York. He ran the global transportation group for Chase Manhattan and Chemical Bank. Then he served as CEO for American Marine Advisers, a boutique NY marine merchant bank group with close associations with OSG and the Recanati family. Arntzen and the OSG finance director, Miles Itkin are mature executives both getting on in age and this is probably the first time that they ever been in an underdog crisis situation. Their strategy so far seems to have been to ride out the storm, hoping for a market improvement rather than making any serious sacrifices. At time goes on without market improvement, OSG’s alternatives get more costly and unpleasant so it is a difficult wager.

On the other hand, with over US$ 2 billion in debt, OSG has considerable debtor leverage. Given lenders accommodative stand towards lame duck shipping companies like Eagle Bulk and Berlian Laju Tankers, a “blue-chip” lame duck like OSG should merit equal or better treatment. This may be a fact that Arntzen is playing strongly behind the scenes.

OSG compared to peer tanker operators was slow to diversify into higher growth alternative marine investments like LNG or the offshore sector with better profit margins. To his credit, Arntzen succeeded early on as CEO in a merger with Stelmar that allowed the group a sizeable position in the product tanker sector in addition to their large fleet in crude oil. OSG’s investments in LNG and offshore have been timid and very conservative. In both cases, they opted for joint ventures and their position is relatively small. In fact, OSG has staked a lot in the US domestic tanker market, which until recently was making losses and limited in prospects.

Under US cabotage, the market is sort of an oligopoly with a limited number of operators, but several of them barely eking out an existence struggling with Chapter 11 reorganization. Lately with the Motiva Refinery project in Houston and US shale oil developments, the US domestic market has started to pick up, but Motiva is now shut down due construction problems.

OSG is counting on substantial MARAD Title 11 money for their US fleet that has been delayed. This subsidized loan money cannot be commingled in their overseas operation, but it is a very valuable resource in an exceeding difficult credit market conditions. Indeed, MARAD created recently some stir by its rejection of rival American Petroleum Tankers' (APT) application for Title 11 loan guarantees despite the company backing from Blackstone.  With the difficult conditions in the OSG international fleet, however, the profit from the US flag operation is unlikely to compensate and cover for the losses even with improved rates.

There is a lot of optimism for a turnaround in the product tanker sector. OSG is concentrated mainly in the MR size with focus on trans-Atlantic trades, but this sector has underperformed expectations. In the end, if new refinery projects come on stream and there is an increase in tonnage miles, it is possible that the LR size will benefit more than the smaller vessels.  Both Blackstone and the Prime/ Perella Weinberg Partners are concentrating on these larger units.  So is Scorpio Tankers, a financially much healthier company than OSG.

Otherwise, OSG share price currently around US$ 5 is not an attractive level to raise fresh equity and this would likely entail substantial share dilution in current Wall Street conditions. A bond issue would be expensive with OSG’s credit downgrade and require security given the current discount on its unsecured bond debt. OSG could sell and lease- back some of their unencumbered units, but this will be very expensive and the lease payments will weight on their cash flow and liquidity. Finally OSG could sell out its share in its LNG and FSO joint ventures.

Is it any surprise that Arntzen stresses over and over again that the tanker markets have reached their floor? He could be correct and in fact OSG 1st quarter results gave some comfort in this direction, but losses widened in the 2nd quarter.

Undoubtedly, it would be a big blow for Arntzen and Itken with their stature and age to be compelled to actual sacrifices, should tanker markets continue in the doldrums and OSG liquidity dries out. I believe, nevertheless, that OSG still has substantial support from its lenders, who will bend over backwards to keep them afloat until better days come.

Whether it is a profitable to own OSC common stock or take a position in its unsecured debt right now is another story. This depends on how quickly one expects a global turnaround in shipping markets. If freight markets remain at present levels into 2013, OSG will face some stressful times.

Is Frontline headed for Chapter 11, following Genmar?

Frontline bills itself as the ‘world’s largest tanker company.” This is definitely not the place to be these days with tanker earnings barely covering operating expenses. After the General Maritime Chapter 11 filing, attention has turned to Frontline and its dismal Q3 results: a loss of $ 166.47 million. Frontline, however, is quite a different story that Genmar. The John Fredriksen shipping empire has far more resources than Peter Georgiopoulos.

Unlike General Maritime, Frontline has not yet run out of cash, but the odds of cash crunch in 2012 are substantial. Most market experts don’t expect a significant recovery until 2013. Platou Capital Markets projects accumulated capex totals of $451 million by the end of 2013 with only $147 million bank debt committed. The group is highly leveraged with term debt of $ 1.163 billion and capital lease obligations of $ 1.173 billion but total equity of only $ 557 million. Frontline’s fleet market value is just at par with the term debt and the trend is downwards on vessel values. Frontline’s operating losses in Q3 (net of substantial vessel impairment charges) were $14.4 million with an interest expense of US$ 32.5 million uncovered.

Ironically, the Frontline Suezmax vessels that created its asset impairment charges were ex-Top Ships vessels that Fredriksen had purchased just before the 2008 meltdown in mistaken hopes of an expanding market for this category of tanker. This transaction saved Top Ships from bankruptcy at the time. They were first generation double hull tankers without transversal bulkheads that raised controversial stability problems. Bulkheads are critical for tanker stability.

The Frontline fleet has a large number of older 1990’s-built tankers that are currently at scrap-level prices. Major oil companies have tightened their age criteria to ten years, creating pressure on these older units. This was reported to be one of the factors that led to the departure of Frontline from the TeeKay managed Gemini Suezmax tanker pool. Frontline and Nordic America had older units and they have now gone off to create a pool of their own.

Frontline Chairman John Fredriksen, nevertheless, has resources that he can bring in to restructure Frontline if he wishes. He remains the wealthiest man in Norway (although he has now taken Cypriot nationality for tax relief). Indeed his investment interest had been waning in the Frontline for a few years as he focuses on more profitable ventures like Golar LNG. The related downstream company Ship Finance International, which leases tonnage to Frontline, is invested in a variety of shipping sectors as well as off-shore drilling rigs.

Already Frontline is selling older vessels to raise cash. Like Eitzen, which was initially in trouble in 2009, Frontline is currently airing a number of alternative restructuring ideas. It is considering splitting the company by separating the trading fleet from the new building orderbook. There is also talk about renegotiating the lease payments to Ship Finance with lower payments now and larger payments in the future.

Generally, “Big John” seems relaxed about the situation. The market is counting on Fredriksen to come up with a creative solution to restructure the company.

Capital profit disappoints, so why is Evercore pushing this stock?

Since Jonathan Chappell moved to Evercore from JP Morgan, he has been touting the virtues of Capital Products Partners and the management of Evangelos Marinakis. Chappell even went so far as to replace Teekay Tankers in Evercore Partners' conviction buy list. Despite my high personal regard for Chappell as an analyst. I find this viewpoint to be misguided. Recent financial results seem to corroborate my reservations.

Stripping out all of the noise, Capital’s bottom line stood at US$ 1.7 million, well short of the US $6.6 million the market was expecting from vessel operations. Most of its profit was made up of an accounting gain on the takeover of Crude Carriers.

Capital’s CEO Evangelos Marinakis holds the conventional view that the products market is amongst the most attractive in shipping right now. The theory is that this class of vessel, especially MR (medium range) tankers, has less of an order book overhang and will see more demand growth from new refinery projects than the crude sector.

Not everyone shares this viewpoint. DvB Bank, a transportation specialist, warns that product tanker values could fall by a fifth if the European sovereign debt crisis negatively affects all global economic markets and creates a significant drop in demand to ship refined oil products. DvB expects product tanker fleet utilization to remain less than 90% until 2013. Platou Markets - who normally have a fairly positive bias - also do not see relief in tanker markets until 2013. Recent large losses of TORM, an established top tier product tanker operator are ominous for this sector.

What confounds me is why Chappell sees Capital in a more favorable light than methodical players like TeeKay or Scorpio which both have greater depth of management? Compared to these peers, Capital is a relative newcomer without much intrinsic value. It was only last year that Capital began its foray as a listed pure play product tanker company.

By contrast, TeeKay has a proven track record and has made every effort to build intrinsic value in its business. It has a strong presence in higher margin niche businesses like shuttle tankers and LNP and in its cargo book operations where it has built up tanker pools. Scorpio invested in an exceptional chartering brokerage team as well some ex-OMI senior management. It also built a cargo book before entering into capital markets to acquire tonnage.

Marinakis has been more of a Greek wheeler and dealer with his Olympiakos football team involvement. I do not see the same management depth at Capital. Does it belong in the same league as the above mentioned peers? Marinakis tends to be very mercurial in his decisions. After launching his pure product tanker play, he then used company funds to buy a bulk carrier that he chartered to Cosco. A year later, he decided to merge his crude tanker listing into this venture, adding VLCC’s and Aframaxes with significant spot exposure.

Although Chappell is cautious in his market projections in both dry and tanker sectors, there seems some irrational exuberance in betting on Capital over other peer companies with more solid management.

Omega Navigation appears to be insolvent

Omega Navigation senior lender HSH Nordbank filed a petition to dismiss Chapter 11 reorganization proceedings or convert them to a Chapter 7 liquidation. With his back to the wall, Omega CEO and major shareholder George Kassiotis has launched offensive lawsuits in Greece claiming bad faith by his lenders. Simple math indicates that his company is insolvent with negative net worth. This legal fight makes any recapitalization hope Omega had look very unlikely.

HSH Nordbank obtained an Omega fleet valuation from CW Kellock at $ 239 million for their court filing. From recent sale reports, I would charitably value Omega’s eight mortgaged units (six LR - Long Range product tankers built in the mid-2000’s and 2 MR -Medium Range) product carriers built in 2006) at US $270 million maximum. This still does not cover Nordbank’s total outstanding loan of $ 278.7 million. (HSH is owed US$ 242,7 mio plus another US$ 36 mio owed to NIBC Bank and Bank of Tokyo as 2nd mortgagees).

The debt dynamics look poor. Omega has not been servicing its debt as interest payments and legal expenses are mounting. The mounting interest liabilities are eating into Omega’s weak net worth.

There is no cushion for inevitable transaction expenses that would reduce the realized value. There are the imponderables of trade debt, unpaid crew wages and maintenance level of the vessels. Second mortgage lenders like NIBC Bank are in a precarious position.

Omega has been clamping down on financial information since their dispute with lenders, which is not helpful to their investors. Yet Omega was profitable in 2009 and declared dividends, so it is hard to understand exactly how relations broke down with their lenders.

We would guess that HSH Nordbank pressed for additional equity, but George Kassiotis, out of personal resources after his previous cash infusion, decided to balk. Presumably he was unable to inspire private equity or distressed asset investors like Oaktree or unwilling to accept their (Oaktree) conditions for participation, provided that he explored alternatives for recapitalization.

Omega is hoping to raise an additional US$ 30 million from the sale of the remaining share of the Megacore joint venture with Glencore. The senior lenders are contesting alleged diversion of funds from their cash flow to fund this project. They do not feel the amount is sufficient to secure their debt and turn the company around.

It is difficult to see at this point how the parties are going to come together. After the lawsuits, the senior lenders would likely not wish to support and work with Mr. Kassiotis any further. It seems unlikely that a private equity firm like Oaktree would be willing to step in to offer substantial recapitalization plus oversight of Mr. Kassiotis management, but that seems to me the only way that might allow an orderly reorganization.

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.

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.