Domino effect in Dry Cargo Market?

The dry cargo sector started the year badly in 2011 with the KLC bankruptcy and reorganization. The US bankruptcy fillings in NY Federal court name three major previous shipping failures: Britannia Bulk, Armada and Transfield as counterparties, all of which went bust in the wake of the financial crisis. Its collapse created shockwaves in the dry-cargo market with Eagle Bulk, Golden Ocean, Paragon and Goldenport Holdings among those with vessels on hire to the cash-strapped company.

KLC is a major Korean shipping company controlling a large fleet of both tankers and dry cargo vessels. Its dry cargo operation is divided into five groups: Cape team, Panamax team and three tramper teams. They are major charterers for numerous listed dry cargo companies like Eagle, for example, who depended on them for the employment of many of their vessels.

KLC’s needed US $186.94 mio in February to repay debts and meet operating expenses. At the same time its liquid assets totalled only US$ 60.66 mio. Operating income was insufficient to cover these amounts. Its red figure for the whole of 2010 was KRW 328.6 bn (US $291.55 mio), which added to a loss of KRW 584.1 bn in the previous 12 months.

They had tried unofficially to renegotiate some of their charters. KLC earlier sent out 60 to 70 letters to shipowners seeking to revise charter contracts in a bid to stay afloat, but of course, owners resisted. Hard pressed companies like Eagle had little room to give. KLC is already facing six separate legal battles in the US and others are expected to make similar claims. It also has 47 ongoing arbitration disputes. KLC began receivership proceedings in Seoul in mid February a couple of weeks after filing for court protection.

Erik Nikolai Stavseth, an analyst at Arctic Securities, said in his morning note: "In light of the weak market fundamentals and cautious outlook on the dry bulk sector, we maintain our view that more situations like Korea Line are likely to emerge." Platou Markets forecasts utilization and earnings in the dry cargo sector to decline. They estimate a 10-20% decline in asset values depending on vessel type, but note that dry bulk stocks reflect a softer market ahead to a greater extent than tanker stocks. On the other hand, dry cargo owners like Michael Bodouroglou of Paragon maintain up upbeat view that the market will strengthen in the 2nd half of the year and pressure on vessel values will be minimal.

Prevailing forecasts for the world economy in 2011 suggest somewhat lower growth than in 2010. It is therefore likely that seaborne dry bulk trade will also increase more moderately than in 2010. Last year China’s imports grew less than expected, while imports to the rest of the world were significantly stronger. World market prices for iron ore will be of vital importance for how much China will source from the international market. Sailing distances for iron ore, soybeans and forestry products are also expected to increase somewhat due to higher South American exports to Asia. The imbalance in trade between the Atlantic and Pacific Basins will continue to widen. It is also possible to expect slower speed due to high fuel prices and excess ship capacity. All this provides a scenario of stronger growth in tonnage demand compared with cargo volumes in 2011.

What continues to plague the dry cargo market is the huge orderbook overhang and flood of new deliveries into the market, creating a chronic oversupply that depresses freight rates. In 2010, about 77 mio dwt of new ships were delivered from yards and 4 mill dwt of converted tankers entered dry bulk operation. Only 6 mio dwt were scrapped. On a yearly average basis, the active dry bulk fleet grew 12.5% from 2009 to 2010. By segment, the fleet above 100,000 dwt expanded by 23%, while vessels ranging from 60,000 dwt to 99,999 dwt grew by 9%. The 40,000 dwt to 59,999 dwt segment rose by 13%, while the fleet below 40,000 dwt increased by only 4%.

Around 140 mio dwt of new ships are scheduled for delivery in 2011. From previous years, we can assume a 60% slippage, some 85 mio to 90 mio dwt of new ships will start operation. Scrapping is a function of the ships’ earnings, but assuming 15 mio to 20 mill dwt will be sent to breaking, a fleet growth rate in the region of 14-15 percent seems plausible. This far outpaces demand projections of seaborne dry bulk trade increasing by 6% to 7% from 2010 to 2011.

Blue chip tanker operator OSG posts big losses

US-listed tanker owner Overseas Shipholding Group (OSG) suffered sizeable losses in the final half of 2010 . The net deficit to 31 December was US $134.2 mio, against a profit of US$ 70.2 mio in 2009. The FFA market currently expects VLCC rates in the low 20’s the next two years, yet equity analyst consensus expectations indicate a recovery of the tanker market. It appears that the analyst consensus underestimated the supply side.

OSG is diversified with both crude and product tanker exposure in addition to its specialized US Flag business. 110 ships are operated of which 43% are chartered-in.

The OSG time charter equivalent (TCE) earnings dropped 10% to US$ 853.3 mio over the full year, due to increased spot exposure combined with lower average spot rates. VLCCs and MRs were most badly hit. Average VLCC spot rates were only $17,000 per day in the final quarter, down from $23,900 in the same three months of 2009. Fleet revenue days decreased 2% or 861 days.

CEO Morten Arntzen said: that 2010 was clearly a disappointing year financially but he pointed to debt reduction, a focus on keeping ship operating costs in check and long term charters for two FSOs operated in joint venture with Euronav as reasons to be more optimistic for 2011. He also said the US-flag business has secured new contracts combined with a lower cost base, which should return it to profit.

OSG has high spot exposure and large fixed costs as almost half of the fleet is leased. OSG will struggle with weak cash flows in a low market scenario the next two years. Like most mature companies, OSG suffers from comparatively low returns ratios.

On the other hand, with its strong financial strength, the company could take advantage of new growth opportunities, something that it very much needs to maintain investor interest by improved profitability. OSG had by the end of Q3’10 cash equivalents of US$ 351 mio and a remaining capex of US$ 375 mio which is fully funded. Total liquidity, including undrawn bank facilities was US$ 1.5 bn. In a weaker tanker market, the company could use the opportunity to expand its owned fleet.

Earnings forecasts in the tanker sector are likely to come down as weak market conditions continue to prevail.

Revisiting the impact of the 2008 financial crisis on the shipping industry

The rebound from the 2008 financial meltdown has been the best bounce back on average in the post-war period for large corporations, but most shipping stocks have stabilized at low levels with only a few companies making full recovery. Because their smaller would-be competitors are still having more trouble accessing credit, big companies have done disproportionately well. This is particularly true of the shipping sector and the Greek market.

Back in the fall 2008, tankers were faring comparatively better than dry cargo and containers. Dry cargo staged a remarkable recovery on the back of the Chinese stimulus program in 2009. Tankers, initially supported by storage demands and phase-out were hit hard from the 2nd semester 2010. Dry bulk started to feel some pain in summer 2010. 2011 started very badly for this sector with the orderbook overhang and the Korean Lines bankrupty. Conversely, containers - after massive losses and a dismal year in 2009 - staged a remarkable recovery in 2010 first primed by slow-steaming and then a pickup in headhaul Far East export routes, especially the Asia to the US transpacific route.

Structural changes are evident. The publicly listed company model - strongly resisted by some family shipping die-hards in Greece - proved resilient. Not only did the model offer salvation to laggards by recapitalization through ATM follow-on share offerings to cure bank covenant violations from investing in over-priced vessels and taking on high debt levels, but it also allowed the leaders to raise funds more flexibly and effectively to expand their fleets in a damaged financial system  at lower asset prices and financial cost than their competitors.

Major international shipping banks have tightened on their age criteria for vessels to be financed making CAPEX a higher ticket item for fleet renewal. Smaller companies, especially local Greek operators with older tonnage are dependent on domestic Greek banks and face difficulties in rolling over their fleets and moving to newer vessels as credit has dried up with more bank resources going to assist the ailing Greek public sector rather than productive private investment.

The shipping sector may not be out of the woods yet.  All shipping investments are highly dependent on future growth in Far East emerging economies - particularly China - to bring rates to better levels for acceptable investment returns. Any slow down in the Far East would lead to a situation of attrition for overly stretched financial laggards anxiously waiting for market recovery before the next round of covenant extensions with their lenders.

The orderbook overhang situation will continue to depress rates. Added to this problem, higher bunker costs from the rise in oil prices are again eroding earnings margins.  Financially stronger, larger companies will be looking to assert their strength and push for more industry consolidation.

Each company and shipping sector must be carefully examined on its merits.

Seaspan eyes Tiger scheme: structural change in Chinese container market

Seapan's move to raise capital by a US$ 250 mio preferred shares together with a proposed US$ 75-100 mio minority stake in a containership venture with Tiger Group are raising eyebrows. Aside from possible Clayton Act violations stemming from Seaspan CEO Gerry Wang also running the new fund which may invest in competitive container companies, the nature of the fund illustrates Chinese policy to maximize its future container transport needs though Chinese-built vessels and Chinese liner companies.

Seaspan announced recently (January 21), a public offering of 9.5% Series C Cumulative Redeemable Perpetual Preferred Shares. The company had been examining for some time alternatives to raise capital to cover their ambitious CAPEX program. The use of preferred shares appears to be a means of raising capital with minimum dilution to shareholders.

The Tiger investment fund vehicle would invest in container shipping assets, primarily newbuilding vessels strategic to China. Seaspan is placing its future in Chinese liner trades, which now represent more than 70% of their fleet employment.

Seaspan told investors:

“We also anticipate that we would have a right of first refusal for some negotiated duration with respect to any containership asset opportunities that are developed by the vehicle. We believe that any investment by us in the vehicle could enhance our ability to pursue current growth opportunities in the container shipping market by leveraging the vehicle’s access to capital and customer relationships. We also believe that an investment in the vehicle would allow us to continue to increase the scale of our business and realize volume discounts for newbuilding orders that we would not otherwise be able to achieve.”

The role of Gerry Wang, the Seaspan CEO who is going to also run the new fund which may invest in competitive container companies is confusing. Whilst Seaspan is based in Hong Kong, it is a US-listed company subject to the Clayton Act.

The Clayton Act states: "No person shall, at the same time, serve as director or officer in any two corporations that are, by virtue of their business and location of operation, competitors..."

The other aspect of these moves is that Chinese policy seems to be moving more to a Japanese "Keiretsu" model of interlocking business relationships and shareholdings and Seaspan is following along with this trend. We have already began to see a similar direction in the Capesize trades, where a growing share of the iron-ore business is going under long-term contracts including transport and less emphasis on spot markets. Key suppliers like Vale are building their own fleets. Further the Chinese are very keen on supporting their domestic shipbuilding industries, who have increased dramatically their capacity over the last few years to become major players.

Finally, this system depend on perpetually high growth rates in the Chinese export model, where money is constantly being channeled into new capacity. Already there are signs of overheating. Seaspan has a franchise on special relations with China, but should there be a downturn where expectations are disappointed, Seaspan will be affected with such concentration in this market.

For the time being the 'smart money' continues to give strong support to this group. Wells Fargo Securities" Michael Webber upgraded Seaspan to “outperform”, calling the company “best of breed” within the containership sector(among vessel providers to liner companies, as Seaspan has no cargo system of its own and depends on liner companies to employ its vessels):

“Seaspan currently has 11 vessels scheduled for delivery in 2011 and three in 2012, which are fully financed and will increase its capacity by 53% to over 400,000-teu,” he told clients, adding: “We believe Seaspan will have capacity to materially increase its dividend and potentially fund additional growth and pay down debt, as we expect Seaspan to generate roughly US $412 mio and US$ 528 mio in Ebitda in 2011 and 2012, up 43% and 28% [year to year], respectively.”

This mirrors the China growth story with aggressive growth and high returns on growth of multiples. The underlying investment returns on DCF with residual asset value are much lower. Seaspan's asset-heavy vessel provider business model with long-term time charters is by nature a low margin business, where higher returns can only be generated by high capital gearing and rapid growth. What makes this especially appealing is that Chinese business is considered virtually "risk free" counter party risk.

DryShips again in the limelight on possible conflict of interest issues

George Economou’s DryShips caused some surprise announcing a US $770 mio order for six suezmax and six aframax tankers. That was nothing compared to the reaction to market speculation when Morgan Stanley analysts Ole Slorer and Fotis Giannakoulis downgraded the stock raising concerns about increasing potential conflicts of interest between the public and private companies of DryShip's chairman George Economou. Economou had previously announced a firewall between Cardiff and DryShips.

Morgan Stanley Research suggests that DryShips may have overpaid by about US$ 50 mio for the six suezmax and six aframax tankers and warns that it expects tanker prices to further decline. This was a very sensitive remark because of previous concerns back in the fall of 2008 concerning the transfer of some Capesize dry bulk orders from Cardiff to the public company in view of subsequent cancelations and accompanying write-offs.

DryShips’s finance chief Ziad Nakhleh vehemently denied these allegations, asserting that not only were the orders done directly between the yard and DryShips but that Cardiff did not have any tankers on order from the yard in question. According to a well-known shipping publication," the denial sparked thinly disguised incredulity on the part of some, since during 2010 Cardiff was widely reported to have built up an orderbook of at least six aframaxes and five capesizes at South Korea’s Samsung Heavy Industries."

Prior the Morgan Stanley hiccup, DrysShip's shares had been rising on increased optimism about their CAPEX offshore funding and announcements of rig employment contracts. There has been speculation for some time about DryShip's spinning off their offshore activities at a premium for its shareholders.

Since then, DryShip's shares have stabilized at US$ 5.25 - not a very exciting level but still considerably better than the July 2010 low of US$ 3.28. DryShips was a star in the bull markets prior the 2008 meltdown with peak share levels close to US$ 130. In 2009, the company entered into a series of ATM offerings that led to massive dilution to deal with bank covenant issues.

Genmar muddles through

Genmar recently found reprieve in Northern Shipping funds, selling three product carriers and leasing them back for seven years at US$ 6.500 per day that will rise to US$ 10.000 per day after two years. The group has been fighting a shortfall on the US$ 620 mio Metrostar deal for some time and needed the cash to repay a short-term loan. Northern participation reflects increased interest in this financial sector to book shipping transactions.

Northern - composed of mainly ex-NFC (DvB Bank leasing venture, who lost a lot of people in the 2008 meltdown) executives like Sean Durkin and Nikos Stratis - has been looking for leasing business and Peter G/ Genmar is a too big to fail company and ideal client.

Peter G did the Metrostar deal in the spring of 2010 on the euphoria of tanker market revival, taking advantage of the funding window opened in capital markets. He was constrained to do a large block deal for a follow-on offering with investors. Metrostar got a premium price on their units because of the time needed as well as the uncertainly to complete the deal with share underwriting and bank lending. In the end, the Genmar follow on offering was very successful with only marginal discount and their banks happy granted them a large loan facility to support the acquisition.

Since then the tanker markets have deteriorated and values are under pressure. This year the crude market has started badly with a nasty tonnage overhang and slack cargo demand, mainly driven by the Far East and Western economies much weaker. The products market is faring better with firmer rates, but still historically low levels.

The pricing of this deal with US$ 6.500 leasing rates in the first two years reflects current market conditions, leaving Genmar barely above water with two of their units chartered at US$ 15.000 per day and the third unit at US$ 16.000 per day. This is comparatively better than other leasing deals with hard pressed owners where sometimes there is even a burn rate that has to be funded in such transactions whereas Genmar has a surplus. The lease rate structure, however, is probably insufficient to provide acceptable investor return; thus, the US$ 10.000 rate increase in later years. We do not know, of course, how residual value is shared. NFC was normally quite aggressive on this with owners as it is key factor in lease profitability.

Northern is counting on a revival of the product tanker sector in later years, which is probably a reasonable bet. With Western governments pushing the 'green' energy revolution and adopting policies hostile to offshore drilling and domestic refineries, the main growth in the crude sector is coming from China and the Far East, but the products markets may get a substantial boost from the numerous Middle East refinery projects, where Gulf Oil producers are looking for more valued-added content in their economies.

Producing oil products at source will give them a big competitive advantage. The shift to longer trading routes will hopefully result on more tonnage soaked up to resolve the supply overhang. The product tanker orderbook situation is only slightly more favorable than the crude sector, but there is a lot more growth potential in the product sector.

The product tankers in this package are handy-sized where there has been the most ordering recently, but also more potential for scrapping due the age of the existing fleet (older, smaller units) and the larger cargo lots. Genmar had previously been trying to market a sale-lease back deal with Pareto for several VLCC's, but this did not work out well with the collapse in the spot market for this tonnage class.

Note that Genmar investors have been lately taking it in the chin with a 53% decline in market value in 2010 (not including follow-on offerings during the year) according to a recent Dahlman Rose study. TeeKay was one of the best performers among listed tanker operators with a 44% increase in market value. Teekay's business model incorporates more added value and is less dependent on asset speculation for profits. Genmar has higher financial and operating leverage making them an attractive turn-around investment should there be an unexpected and early revival in the tanker market.

Genmar capitalization, however, is closer to US$ 310 mio rather than the US$ 188 mio figure in Dahlman's study because of their follow on offering. Genmar's shares are presently trading around US$ 3,25 whereas investors purchased at double these levels in the follow-on offering so they have been badly burned in the transaction.

Genmar's scaling up proves poor timing decision

Peter G was the star of Posidonia earlier this year with his US$ 620 mio block tanker deal for the Metrostar fleet (five VLCCs and two suezmax newbuildings). He succeeded to raise US$ 195.6 mio in net proceeds from the sale of 30.6 million new shares plus allotments with a minimal 4.75% discount in a highly touted deal. One cynical hedge fund manager said at the time that the deal was a means to raise equity with minimal dilution for an already belabored operation suffering from high leverage.

The leverage reduction was only 5% with a drop from 75% to 70% by this equity raise on hyped expectations of a tanker market recovery. A number of major brokerage firms were bullish on tankers at the time. Several analysts upgraded Genmar, which facilitated the issue.

These shares represented 50% of the companies market valuation. There was both market and dilution risk in this operation, yet well-regarded analysts like Cantor's Natasha Boyden ignored the risks arguing that the acquition was accreditive and encouraged investors to buy. Unfortunately, the tanker market disappointed and Genmar's share price has been heading southwards since. Investors got badly burned.

In the fall, Genmar announced a US$ 165 mio sale and leaseback deal with Pareto for two VLCC's (Genmar Victory and Vision Dwt 312,000 both built 2001). This transaction looked like signs of financial trouble with leverage and liquidity. Genmar was facing a 15 December deadline to carry out asset sales. Pareto struggled to rally investors to put in US$ 43 to US$ 63 mio equity to close the deal.

Generally sale and lease back deals raise cash at the expense of future cashflow. In the case of poor markets, this can create further problems. On the other hand, they enhance operational leverage should there be an upturn.

Under these circumstances, it is not surprising that Standard and Poor's (S&P) has just slashed General Maritime Corp’s (Genmar’s) long-term corporate credit rating from B to CCC+. S&P cited lack of current borrowing ability, low levels of cash and significant intermediate-term debt obligations as the rationale.

Wells Fargo Securities analyst Michael Webber said: "given that Genmar's best options to avoid a covenant breach include: additional waivers, which would indicate continued dependency on its lenders and a potentially higher interest burden; asset sales, which could imply material [net asset value] NAV downside if forced on to the market; and an equity raise (which would be significantly dilutive); we believe shares could continue to face downward pressure over the near-to-intermediate term.”

Many feel that tanker markets will improve in 2011. The question is the degree of recovery since the fall in rates has been substantial and the winter season so far has had lackluster results.