Sunday, August 16, 2009

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.

Sunday, August 9, 2009

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").