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.

Does the CIDO deal mean tanker values are on the upside?

Jonathan Chappell argues that Craig Stevenson's massive US$ 1 bn product tanker acquisition deal to purchase the 30-vessel CIDO fleet is good news for tanker asset values. He estimates a US$ 40 mio price tag per vessel up from his previous US$ 36-37 mio valuation for a three year old tanker. He believes that supply and demand will improve in this sector this year and in 2012 seeing this a 'smart money' deal. I am more skeptical.

We saw last year Peter Georgiopoulos's block tanker acquisition deal with Metrostar at premium prices and how bad timing resulted in drastic fall in the Genmar share price and a dramatic capital injection/ loan restructuring with Oaktree.

The Cido fleet had been up for sale for some time. CIDO has been steadily shedding off assets for months. There were numerous rumored suitors for this deal including Navios. Stevenson's company Diamond S. Shipping was the highest bidder and fixed the vessels at a premium price. Whether this is really a good deal depends on future events.

Until now, Diamond S had no ships in the water. Diamond S currently has eight 158,000-dwt tankers and two 105,000-dwt product carriers on order from yards in South Korea for delivery between next year and in 2012. His ex-OMI senior management - Robert Bugbee and Cameron Mackey - moved to Scorpio. The Cido acquisitions is a transformatory development making it a functional ship owning company that operates 30 tankers.

Scorpio by contrast is not a company that would bet on such a big move. Emmanuele Lauro first built up a cargo operation and then started scaling up incrementally. Craig Stevenson is buying assets before building his commercial or technical management capability.

Presently things in the product tanker market are bad. The transatlantic market is flat and east of Suez is slow. Big ships are in dire straights. Earning margins are poor. Operating expenses are high. Bunkers are capping any returns potential. There is very limited free cash flow to pay debt and dividends.

The product tanker story revolves on new refinery capacity coming on stream in Asia and the Middle East to catalyze CPP exports and boost ton-mile for product tankers. But the timing of this development is dependent on when a major pick-up in demand is seen for gasoline/diesel in the West, combined with the movement in CPP inventories in the latter region. For 2011, distance-adjusted demand is expected to advance 6% and the product tanker fleet is expected to grow by 5%. Rates may not improve meaningfully until 2012 and even 2013.

Whilst there is a positive general consensus on the product tanker market as a good long-term investment, such a notion could change dramatically if the fundamental outlook changes (through macroeconomic disappointments, structural changes in the industry etc).

Omega in bankruptcy: Test case for other weak listed shipping companies

Omega Navigation (NASDAQ: ONAV) is a product tanker play with fleet of 12 vessels plus a joint venture with Glencore (LSE: GLEN) .  Most of its fleet on time charter to Glencore.  The fleet is divided between MR and LR 1 units all built in Korea.  The company only had really one good year in 2007.  It was hard hit by the 2008 meltdown.  It had been filing for delays in publishing accounts, but known to be in protracted debt restructuring and suffering from high leverage.

Since this was a vessel provider business model with a relatively small fleet, it was dependent mainly on fleet growth and favorable market conditions to generate profit and value for shareholders. It has one very large customer, Glencore. It remains to be seen what will happen to the Glencore joint venture companies, which have not been included in the Chapter 11 reorganization filings.

Omega entered the product tanker market in boom market conditions, acquiring assets at high prices with leverage. Its CEO Kassiotis had been  commercial director of Target Marine S.A.  He tried to lock in some benefits of the firm charter rates, but its 2009 accounts show a significant drop in time charter equivalent earnings. Further its capital gearing on book value was already over 70%.

Omega's main senior lender in 2008 was HSH Nord-bank of Germany. Apparently HSH Nord-bank intervened early in the game when cashflow problems first emerged. Omega under pressure reworked its credit facility and prepaid principal owed under the main facility with a second-lien infusion of US$ 42.5 mio from new lenders NIBC Bank of Holland and Japan’s Bank of Tokyo-Mitsubishi NFT. Perhaps they were enticed by the fact that this was a public company, the asset quality and the charters; but second lien lending is a highly risky business. Also, this undoubtedly led to a significant increase in financial expense for the service.

Normally, for Omega to get a second mortgage for NIBC and Bank of Tokyo-Mitsubishi, HSH Nord-bank would require that these institutions sign a subordination agreement, preventing them from taking any action without HSH consent. Meanwhile there is no evidence that Omega tried to sell units to pay down debt. In their September 2010 investor presentation, it claims financing is in place to fund capex commitments.

Omega was too small to benefit with ATM follow on offerings to increase capital. They had to means to take advantage of the downturn in tanker values so they tried to team up with Glencore in a joint venture for this purpose. At this point in Chapter 11, they lack resources and the future of the Glencore joint venture is in question.

No doubt with such attractive assets, other product tanker companies would be interested to purchase them at present market values, but George Kassiotis is hoping to survive under Chapter 11 and keep control of this operation.

TBSI: a dry parcel liner service beleaguered by losses and financial problems

TBSI (NASDAQ: TBSI) has recently been under pressure with operating losses of US$ 16,7 the first quarter this year and senior lender pressure to increase capital by US$ 10 mio coming. When TBSI went public through Jefferies under John Sind`ers in 2005, its chequered history of its 2000 Chapter 11 reorganization surfaced. The company operates a parcel liner service with a large number of tween deckers and heavy presence in Latin American ports, an unusual trade largely superseded by container vessels.

TBS focuses on multipurpose tweendeckers and smaller dry bulk carriers varying from 17,300 dwt to 45,500 dwt that are able to navigate and efficiently service many ports with restrictions on the size of vessels. It has attempted to create niche markets  focusing on trade routes, ports and cargo that cannot be efficiently served by container and large dry bulk vessel operators. It offers regularly-scheduled sailings along with local teams of commercial agents and port captains who meet regularly with customers to tailor solutions to their logistics needs.

TBS CEO Joseph Royce has a ship brokerage background. He then served as President of COTCO, a dry cargo pool of over 45 vessels before founding TBS in 1993.

Having this parcel liner service means fixed costs and bunker exposure that most dry cargo operators do not carry. Whilst break bulk is a higher cost service than inter-model container feeder competitors, TBS tries to focus on cargo with special handling needs and personalized service. The company also has some handysized bulk carriers in their fleet. They appear to have some of their tonnage (approximately 25%) on time charter, which adds to earnings stability.

Clearly. they have suffering lately from lower freight rates and higher bunker expenses albeit their cargo volume increased slightly over last year. Another problem is the heavy off-hire and repair expenses for the ageing 1980's built tween decker fleet with a need to drydock 17 vessels, requiring about 546 days out of service. Tween deckers today are largely vintage tonnage no longer built. TBS has ordered a new series of Dwt 34.000 tween-deckers for fleet renewal.

Although TBS debt to book value ratio is not high, they have been having serious problems paying their debt and in protracted loan default/ restructuring discussions. Lenders have demanded a US$ 10 mio increase of capital to which Mr. Royce has paid in US$ 7,58 mio of his own funds. They are also planning a rights offering to increase capital. Their financial expense has soared to US$ 8,7 mio in 2011  from US$ 5,5 mio last year aggravating losses.

A major New York investment house is forecasting that the dry cargo sector with its substantial order book overhang will be the slowest to recover. On the other hand, smaller handy size units have been outperforming the larger Capesize and Panamax units in current market conditions.

Greek economic crisis in a nutshell

The Greek crisis is a toxic mixture of politics and economics. The show case Eurozone project is in jeopardy by the looming sovereign default of one of their members.

Greece made a Faustian Pact with the European Union that allowed its political elite to freeload the system, using EU transfer money and cheap credit for local political patronage rather than building a sound goods and services economy.

The Euro destabilized the balance of payments. Local production waned and imports soared. Price inflation led to pressure for wage increases. Greece lost competitiveness. Public debt mushroomed to finance never ending public sector deficits. For many years the EU blinked.

The EU elite fearful of the Lehman precedent and protective of their scandalously undercapitalized banking system have chosen a contradictory approach of debt bailouts to cover creditors by musical chairs and wage and price deflation austerity.

The Devil is now seeking its due. Greece is locked into an ever growing debtor's prison with a shrinking GDP causing its tax base to implode and a rising mountain of debt that is currently 140% GDP shortly to rise to 170% with the next bailout loan on the pyramid. Unemployment is skyrocketing, shops and businesses are closing. The government cracks the whip cursing its own people every time its unrealistic tax revenue projections fall short, creating ever more draconian penalties for tax evasion. This climate seeds an increasing flight of capital and lack of investor confidence.

EU policies are terrorizing periphery countries with deep recessions and mounting unemployment, creating disorderly default risk from rising social unrest. Northern European taxpayers are also growing restless and upset over ever growing demands for bailout money from Brussels, as the periphery sinks under the growing debt overhang. They are concerned that these are stealth transfers with growing doubts that the periphery has the capacity ever to repay the money.

Nobody in the EU is happy. The more EU voters see Brussels asking taxpayer money to bail out banks and socialize losses, the angrier they get. This causes growing discontent with the whole EU system. The EU elite seem smugly sure of themselves, appointed with secure positions rather than democratically elected. Politicians in member countries face a rising storm. Few however have the courage to express openly their discontent from fear being ostracized by the Brussels elite for daring to question them.

So far the EU elite refuses to discuss rationally successful restructuring techniques in past emerging market crises. The markets presently see 80% prospects of a Greek default. Their emotional outbursts against default or debt restructuring are directly related to their exposure to sovereign toxic debt and weak balance sheets. After their own meltdown in 2008, the US authorities want to keep this mess under the rug as long as possible, basically turning over the IMF to them as a European bad bank.

As it stands presently, there are basically two trends of thought. The EU elite seem intent on the EU public sector picking up an ever increasing share of Greek sovereign debt. In a few years’ time, there will be one sole public creditor with the private creditors paid off and Greece will have a very high debt GDP ratio, likely in excess of 200%. There is no clear plan thereafter what to do about this mountain of debt. There is a vague hope that somehow Greece will grow its way out of the debt. Structural reforms have been discussed for the last 20 years in Greece but the many stakeholders in the present system create substantial resistance to change. Locked into a hard Euro and compulsory wage and price deflation, it is hard to see from where this growth will come.

The other school of thought comes from mainly American economists like Simon Johnson, Nouriel Roubini and Paul Krugman, heavily influenced by the disorderly Argentine debt default and emerging market debt restructuring. They have support from German economists concerned about Greek debt sustainability and capacity to repay. They are calling for orderly and coercive debt restructuring as soon as possible to remove the default risk and provide relief from the huge debt overhang. Such action may make the structural reforms more palatable, gaining the good will of the Greek public with burden sharing and allowing more gradual adjustment. Both structural reforms and debt renegotiation are necessary conditions to resolve the Greek debt crisis.

Unless the EU elite realize that they must meet periphery needs, the divergence between the core and periphery will grow so large that it may lead to a breakup of the currency zone. It may take generations to restore the credibility of EU institutions after such an aftermath. Moody's in the latest downgrade of Portugal cited poor EU crisis management as a major risk factor, angering many EU politicians. The truth frequently hurts.