Eagle/ Kelso partnership: constraints and options

Eagle is presently limited at best in its ability to acquire new vessels, even at distressed levels with constraints to pay half of any future equity raises to reduce debt. By the Kelso partnership, Eagle CEO Zoullas will work with Kelso to pursue vessel purchases on a private basis but will pay commercial and technical management fees to the public company for any bulk carriers acquired. Eagle will have right of first refusal on any bulker the private venture wants to buy.

Eagle has fared relatively well in the crisis so far but not without some setbacks. The block expansion deal with Alba Shipping at the top of the market prices put them into this crisis with the pain of overvalued vessels, some charterer defaults, some order cancellations and over-leverage putting them in violation of their senior debt covenants.

Management did its housekeeping to put things in order. It raised last month US$ 100 mio cash by share sales, which represents a modest share dilution compared to some other peers. It amended its credit facility with lender Royal Bank of Scotland (RBS). The non-amortizing facility has been reduced to US$ 1.2 bn from US$ 1.35 bn, with Eagle also shouldering a higher margin of 250 basis points over Libor, plus the above-mentioned obligation to pay half of any future equity raises to reduce debt.

The Kelso agreement appears fairly structured in terms of interest conflicts. Eagle has right of first refusal on any bulker the private venture - called Delphin Shipping - wants to buy. It also gets a "first look" at any bulkers Delphin acquires and decides to place on charter. Whilst probably a good thing for Kelso and Zoullas, it is neutral for Eagle.

The China Conundrum

A great debate rages over whether China's economic model is sustainable. Western economists often express fawning admiration of the success of this state capitalist model, some of the most virulent critics are Chinese. There are issues of asset bubbles in real estate, massive export production overcapacity, missallocation of resources and a banking system riddled with non-performing loans.

The Western conventional wisdom is that Chinese stimulus has been more effective because it is state-directed and financed by trade surpluses rather than debt. There is a general confidence that rising domestic consumer demand will save the day in the end.

Back in 1994, Paul Krugman wrote an article: "The Myth of Asia's Miracle", where he compared rosy Western projections of Asian growth with cold war projections of Soviet growth rates. Krugman maintained that the rapid growth in output could be fully explained by rapid growth in inputs: expansion of employment, increases in education levels, and, above all, massive investment in physical capital. He pointed to two basic implications:

• The willingness to save, to sacrifice current consumption for the sake of future production.
• Future limits to their industrial expansion - in other words, economic growth based on expansion of inputs, rather than on growth in output per unit of input, is inevitably subject to diminishing returns.

We know that the Soviet system fooled most Western intellectuals and eventually imploded. Are today's China watchers any smarter?

Sceptics like Andy Xie and Martin Hutchinson argue that most statistics out of China are misleading and false. China remains a repressive, closed society with little transparency and lots of corruption. The state corporate sector is still gigantic and supported by state-owned banks. Savers are not permitted to take money out of China, and their huge savings prop up an overvalued stock market and a bond market that is comparable in size to the freely flowing international bond market. Private sector companies are either youthful fly-by-night operations or dubiously privatized state behemoths. Prices are still largely administered, and investment flows mostly to the politically connected rather than the economically attractive. Education is relatively poor outside the main population centers, and land ownership is still restricted.

Even though China has had three decades of high growth, few companies are globally competitive. While China is experiencing weak exports now, the weak dollar allows China to release the liquidity saved up during the boom worrying about currency depreciation.

Xie stresses that there is tremendous over capacity in the construction industry. The pricing structure is highly distorted. State-owned enterprises borrow from state owned banks and give the money to local governments at land auctions, so everything turns around the big Government pocket. Further the rapid urbanization and one-child birth policy will have a very adverse effect on demographics that will create a train-wreck situation. "China’s wealth inequality is already very high. A sizable or even the majority of China’s population may not have meaningful wealth even after China’s urbanization is complete."

Xie argues that the party in China will be over when the US dollar starts to appreciate again. The risks are that prevailing FED easy money and massive increase in US sovereign debt will lead to higher inflation, obliging the FED to raise interests rates as they did in the 1970's.

Of course, there are two divergent aspects in this argument. Easy money and massive FED liquidity are already putting some renewed pressure on the US dollar. Higher interest rates, however, are only foreseeable when and if inflation rises in the US. Right now that is unlikely with only the slope of GDP decline improving, but the massive overleveraging and debt overhang in the US opens the temptations to debt monetization down the line. Already treasury yields are starting to harden. Should the FED be obliged to raise interest rates as they did under Paul Volcker, then Asia could be in deep trouble.

In any case, with the US consumer shopped out, overleveraged and coming prospects of higher tax load, it is certainly not evident that there will be a quick revival of consumer export markets. The EU is also likely to recover slowly. This is likely to lead to a permanent structural rebalancing of Chinese export surpluses. It is not obvious that Chinese domestic demand could absorb the production overcapacity, especially considering what was said above. The stimulus is not workable for an indefinite time period.

Shipping markets are highly dependent on China as the main demand driver against a massive order book built up in recent boom times. The construction industry accounts for approximately 50% of Chinese steel demand so it is closely related to coal and iron ore imports in the dry bulk sector. Massive container ordering was predicated on unlimited export market potential to the West. There have been substantial refinery projects in the ME for export to the Far East as well as huge refineries built in China for the tanker business.

The China story still excites Wall Street investors and already this year, China has again brought a revival in the dry cargo market. Should reality further down the line not meet these expectations, then truly hard times could fall on this industry.

Will there be any distress deals in shipping?

Since the fall 2008, public policy response to the financial crisis has to reinflate asset prices by flooding the markets with massive central bank liquidity. Banks have not been aggressive in covenant breaches. Some major shipping players feel that asset prices are artificially high. ATM share offerings have enabled public companies to bail themselves out. All eyes are presently on the quality of the future recovery in 2010 and beyond.

Last fall shipping markets plunged with the outbreak of the financial crisis. Shipping had enjoyed unprecedented boom times, riding globalization, outsourcing and the rise of China as an economic superpower, following the footsteps of Japan in the 1950's and 60's.

This year's notable recovery of the BDI - mainly in the Capesize sector - is due to a new surge in Chinese inventory building in coal and iron ore after several months of market penury with rates below breakeven levels. Chinse importers were renegotiating supply contracts down to the lowest possible prices and drawing down stock. There is a great deal of debate whether this is the beginning of a new bull market for dry cargo or it is simply temporary inventory hoarding for speculative purposes and concerns of more US dollar weakness ahead.

After a period of relative out performance, the tanker markets took a nose dive. Early in 2009 there was big demand for storage due the extreme premiums in forward oil futures over prevailing spot prices. The rise in oil prices changed this situation. Clean petroleum markets have been hit the hardest. Chemicals are somewhat better off with a surge in Chinese feedstock imports, but most other routes are slack with significant drop in cargo volume. Containers continue very weak, often below operating costs, except some feeder trades.

Despite substantial fall in asset prices and high senior debt leverage levels of many publicly listed companies from the popular fleet block vessel acquisition/ merger deals at the top of the market, few companies have gone into serious default, leading to liquidation. In the relatively few cases of foreclosures, banks have tried to transfer assets to new entities, hoping to position themselves for recovery.

The financially weaker companies have been aggressively issuing new shares, mostly sold slowly in small lots over the market. George Economou has pioneered in this technique raising nearly US1 billion for DRYS. Initially there was brisk investor enthusiasm until the market started to perceive the massive increase in share count. Lately even some of the worst performers like TOPS with a bad record in share value and continuing restructuring negotiations with senior lenders have found ready new money from a standby facility that Yorkville - a New Jersey-based financial firm - offered them with open arms.

For these reasons, Peter Georgiopoulos argues that "While that's [sic governments have supported the banks and banks essentially have returned the favor by supporting clients] good in some ways, it has kept the market artificially high".

So far, this downturn in the shipping markets has been different from some of the historic collapses. Meanwhile the war of attrition continues and the issue ahead will be the quality of the recovery as well as the sustainability of the Far East growth model (see my accompanying article: "The China Conundrum").

Is Wall Street optimism over reaching rational expectations?

PIMCO's Bill Gross argues that median GDP and capital stock returns have been based on 5% PA whereas the government policy efforts to re-inflate the economy have hidden costs and restraints that will reduce median GDP and capital stock returns to 3% PA. This means a new period of sluggish growth and high unemployment where people will have less disposable income.

I have argued in the past that we risk a period of prolonged sluggish growth with high levels of public debt that become a permanent drag on the US economy. The major ideological battle of the new Obama administration is over ultimate control of the US economy between government and the private sector. President Obama is committed to government control as the superior solution. I believe that these policies will result in a poorer country than Americans have been accustomed in the past with lower competitiveness in global markets.

The stimulus plan is based largely on government programs. Efforts to promote 'Cap and Trade' policies and universal Health Care represent the transfer of an increasing share of the US economy to the US government. Already a large share of the banking industry and the US auto industry has been transferred to the government. The FED has a vastly expanded balance sheet.

All these programs are rife with hidden costs and restraints. Further the expansion of US sovereign debt has been substantial. There are rising risks in currency devaluation and higher interest rate exposure. Little has been done to address the problems of over-leveraging . There is no additional resources to assist the underlying goods and services economy.

As Mr. Gross puts it:

"Investment conclusions? A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

A corollary of this is that the US financial sector is far larger than warranted and needs considerable downsizing.

Financial instruments turn a first half loss into a large profit for Exmar

Exmar is battling drooping revenues from waning freight rates to post the healthy result in poor market conditions. Earnings have fallen the most in the VLGC sector and less sharply in midsize gas carrier.

Exmar has three 150,900-cbm LNG newbuildings under construction at Daewoo shipbuilding & Marine Engineering (DSME) for which financing is yet completed.

LPG export volumes from the Middle East have declined sharply and the lack of long-haul trading opportunities resulted into a substantial fleet surplus. Overtonnaging in the VLGC sector has been evident for a number of years.

The midsize gas carrier fleet is also hurting with substantially reduced ammonia movements gradually increasing pressure on this segment during the first half of the year.

Exmar hopes to secure financing the first two vessels on order fairly shortly and will begin working on the financing of the third vessel in the course of the fourth quarter 2009 with an objective of securing commitment by the first quarter 2010.

It is not clear when market improvement in the gas sector is likely to come in the current economic environment.

Energy player inks 10 bulkers/ Exporters and steel mills seek long charters

With the fall in dry bulk vessel asset prices, Chinese players have been avid buyers, looking to take a larger share in Chinese-related transport trades. In this case, coal player Lanyue Energy Development signed up for 10 supramax bulk carriers at Xiamen Shipbuilding. This trend is likely to put Western competitor companies at a disadvantage.

Lanyue is one of the top coal transporters in Guangdong province. As aChinese company it benefits from advantageous domestic financing as well as preferential connections for employment contracts. Major London brokerage firms have been saying for sometime now that they feel the Chinese will be moving closer to the Japanese system of covering their transport needs by long-term contracts of affreightment with their own domestic shipping companies.

Notably, Vale's recent deal with NYK comes amid a rush of fixtures by iron-ore exporters and steel mills looking to secure tonnage long term (http://www.tradewinds.no/weekly/w2009-07-17/article540938.ece). Will the Chinese start to follow suit?

NY-listed dry cargo operators will find this tough competition in the future. Many of these companies expanded in large block deals at top of the market prices and leveraged senior bank debt. They have both higher capital and operating costs in comparison to their Chinese competitors.

The issue in the future is the quality of the recovery in shipping for which the dry bulk sector - especially the larger Capesize units - seems to be taking the lead so far.

Is the Handymax sector as good as conventional wisdom claims?

From the outset of the crisis in shipping markets, conventional wisdom has praised companies in the Handymax/ Supramax sector and castigated the Capesize sector. Analysts based their arguments on the record order book for larger bulk carriers and the high age profile of the smaller sizes suggesting need for fleet replacement. Yet the smaller sizes have not been immune to decline in asset value. On the other hand, the recovery in cargo demand this year has favored the Capesize sector.

Secondhand Handymax-bulker values have fallen between 70% and 85%, according to a review of the market by DVB Bank. Shipowners who invested in Capesize bulkers got the best value for money last year, according to research from a top shipbroker, Lorentzen & Stemoco (http://www.tradewinds.no/weekly/w2009-07-17/article540873.ece) and are likely to keep the lead this year.

Whilst most shipping analysts remain focused on supply and demand, they tend to overlook matters like operating margins and leverage as well as investment returns. The larger-size units benefit from lower unit costs. For example, crew cost for a Capesize unit is far less analogous to a Supramax or Handymax on a per Dwt basis, but the freight market for the larger sizes is a lot more volatile with significant profit potential.

Of course, the order book situation for the larger sizes is troubling, but the higher age profile of the smaller sizes is due to the traditionally lower investment returns for the smaller sizes whereas the money for new tonnage follows the higher investment returns.

So far Far East demand has once again smiled on the larger bulk carriers despite order book concerns. The question is whether this is sustainable over the long run? The debate between the smaller and larger bulk carriers is a bit like the Tortoise and the Hare.

Will the analysts backing the smaller sizes laugh last and best?