Tail Risk in shipping recovery still very much present!

Lately there is a lot of capital chasing shipping assets, arbitraging on vessel prices.   Oaktree Capital is one of the high profile leaders.  Wilbur Ross was an early forerunner in the Diamond S. venture, doing the Cido deal in 2011.

It has nothing to do with business plans, building value with companies to gain competitive advantage and market share in transport and logistics services. This is pure and crude asset speculation, betting that we are at the bottom of the shipping cycle, vessel values will begin to move up and a quick profit will be made by unloading these assets on the next company, who in turn riding the cycle will hope to gain themselves on the next leg upwards until the last guy in – like a Villy Panayiotides at Excel with the Quintana merger – gets stuck carrying the candle and goes bankrupt with the losses as the market crashes.

My personal view is that Oaktree and others are desperately looking for yield without many options in the present world of ZIRP.  The FED policy under Ben Bernanke’s reflects today's conventional wisdom, trying to push asset inflation to reflate and get out of the current Great Recession aftermath of the 2008 Global financial Crisis.

Shipping assets have caught their radar.  Putting money in risky assets and companies for yield has not always gone very well in past shipping cases.  Berlian Laju, for example, just months after a massive debt restructuring with US$ 200 million in new funds and repeated earlier high cost lease deals ended in debt default just months later, illustrating the risks involved in this strategy.

Whether the present FED policies will ultimately reflate the world economy depends on future real demand for goods and services that generates cargoes for these vessels, pushes freight rates up and then vessel values increase geometrically on the future earning expectations. Until and when this happens, this speculative money is actually generating more over capacity and prolonging any market recovery in the shipping industry.

Meanwhile, we have increasing zombification of many shipping companies like General Maritime now reorganized along with TORM and Eitzen Chemical now renamed Jason, OSG/ BLT are in purgatory with their ultimate fate still in limbo.  Excel Maritime recently moved into a hopefully pre-packed Chapter 11 reorganization.  Genco and others like Eagle are tottering in the brink. The recent Baltic Trading follow on capital raise seems a back door doubling up for Genco - see my recent piece: "Peter Georgiopoulos tries to regain his lost credibility" http://amaliatank.blogspot.gr/2013/06/peter-georgiopoulos-tries-to-regain-his.html.

Their Bankers are desperately trying to keep the dead alive. In turn, speculative capital like Oaktree and others, are buying up distressed debt to keep the banks themselves alive with an increasing number of zombie banks around.  Warehousing of bad assets has become the fashion.  Commerzbank - basically a zombie institution - recently issued a statement that it does expect to sell any shipping assets because they expect the market will bring the prices up...  So why worry about any 'book' losses at current mark to market price levels, capital (in) adequacy, etc.?

Oaktree seems to have a rather chaotic investment approach with different parts putting shipping assets on their books in a rather haphazard way. After all, did it make sense or show good analysis to invest in General Maritime only months from declaring Chapter 11 and needing even more money in a second round?

Normally, investments are supposed to yield value and then second round financing is done to invest in another leg up in the private equity world.  Here Oaktree was doubling down on a bad position, which is not normally good trading practice.  The normal practice would be to lighten up and reduce exposure.  In the current 'pretend and extend' world that we live in, however, everyone is trying hard to avoid cutting losses and many actively practice 'doubling down'. 

Did Genmar ever really have much intrinsic enterprise value as a shipping company beyond its physical assets to warrant the Oaktree "investment" in recapitalization??? I would say no!

Peter Georgiopoulos  never really thought of Genmar as an enterprise - at least in the sense of a logistics transport business serving customers in carriage of cargo.  Peter G. was and is foremost an asset speculator.  He ignored strategic positioning for Genmar to gain market share, improve earnings margins and generate growth through retained earnings. Employment was just a means of holding his assets rather than serving and building a customer base. His biggest sin was ignoring trends in the tanker market and new growth areas. His mindset was on trading assets.  Others like TK Shipping and his nemesis 'Big John" Fredriksen handily outperformed him and provided superior performance to their investors.

In the case of Petros Pappas, the Oaktree approach is to fund Pappas like a bond trader. Pappas has a successful record in asset trading. Oaktree has Pappas like a stock picker in different vessel classes. Pappas trades largely on his own instincts with his own money on a 50-50% basis with Oaktree. His own skin in the game satisfies Oaktree for the moral hazard. Neither Pappas nor Oaktree are looking to build businesses or really have any business plans at all beyond the asset trading.

A recent Tradewinds interview with Lazard’s Head of Shipping, Peter Stokes, sheds a lot of light on this matter. In fact, I am amazed and somewhat gratified to see someone like Stokes, thinking and saying publicly, many of the same things that I have been saying privately and publically when I was recently a keynote speaker at the Hong Kong shipping forum.

Stokes sees two basic scenarios ahead (see "Bungled QE exit could 'burn out' ship values" http://www.tradewindsnews.com/weekly/w2013-06-21/article319083.ece5)):

• Scenario A: - conventional wisdom ‘muddle-through’ recovery in the next few years that is likely to be subpar in quality, partly because of so many trying to ride the coat tails of same scenario.  If everyone is arbitraging, then each is cancelling out the other in any meaningful price action.  Further this self-defeating over time in creating over supply with a new wave of speculative ordering that will grow with any upwards price movement.  There is too much speculative money and too much yard overcapacity.
• Scenario B - complete collapse with another leg down, where investment firms like Oaktree, shipping banks, etc. experience painful and unavoidable losses. The zombie shipping companies finally die. Assets are written down to true values and finally there is a proper shipping recovery based on an industry shake up where only the fit survive: much dreaded Joseph Schumpeter’s ‘creative destruction’. 

A  preview of scenario B is the recent reportage in Tradewinds about an apparently unsuccessful attempt by Wilbur Ross, First Reserve, etc. to float an IPO in the Oslo capital markets for their Diamond S venture that was built on a huge block purchase of product tankers from Cido a few years.  My previous two pieces on the Diamond S venture make interesting reading in retrospect: 

• "Does the CIDO deal mean tanker values are on the upside?" - http://amaliatank.blogspot.gr/2011/08/does-cido-deal-mean-tanker-values-are.html.

• "Diamond S. a new business model for shipping?" - http://amaliatank.blogspot.gr/2011/08/diamond-s-new-business-model-for.html.

Obviously, the latter Scenario B would be a devastating setback for governments (especially the European Union political elite) and many financial institutions.  Such an outcome might ruin their careers and threaten the integrity of their institutions. On the other hand, they are slowly running out of resources for the constant backstopping. “Pretend and extend” credit policies with the massive socialization of losses is far more costly than they are representing to their voters.  So far little of this has proved helpful to an economic recovery. Only the US has had some relative success, but their boost in energy resources may be a more substantive driver in this tepid recovery than FED financial engineering pulling on strings.

The two key elements ahead that may affect shipping asset prices are the US and its tapering to wind down the FED asset purchases and the Chinese restructuring, given that the Chinese marginal rate of investment is unsustainable and the losses are corrupting their banking system. The US and Chinese both realize that this needs to be done and it is unavoidable, unlike their EU counterparts with their “muddle through” theories, eternal dissention and dream-world mentality resembling Mann’s Magic Mountain novel.

Admittedly, I am strongly influenced by my friend Michael Pettis in China. I believe Chinese growth will ultimately disappoint.  The volatility concerned that Pettis expresses about the very large Chinese speculative position in commodities worries me given the potentially negative impact on shipping markets. So I would not be surprised about Stoke’s concern about further drop in shipping asset prices, driven by lower replacement cost in steel, etc. All this shipping investment is predicated on Chinese growth reflating the markets again – lots of very concentrated risk if this does not pan out.

See "Crunch Time: Why low growth is China's new normal" http://www.foreignpolicy.com/articles/2013/06/27/credit_crunch_time_china_low_growth_new_normal

On the other hand, the politicians, particularly the EU elite – our PM Samaras with his never ending Greek success story being the success story of the Eurozone – and Oaktree Capital are really betting the house that the worst is over and there will be happy days again with a robust recovery in just a few months.

Former colleagues of mine like the present Head of National Bank of Greece, Alex Tourkolias, saying that a shipping recovery will lead Greece out of its crisis and John Platsidakis of Intercargo, saying that two years from now the Greek debt crisis will seem like a bad dream gone away are lately exhibiting lots of boosterism.

In Hong Kong, by contrast, the shipping circles were subdued and cautious about a quick recovery in the markets.  Some companies like Pacific Basin have been aggressingly buying newer second-hand units, but these purchases are to renew their fleet and backed against a substantial cargo book, not the kind of overt and open speculation mentioned above by the likes of Oaktree.

So who knows? Stokes and I could be incorrigible pessimists and totally wrong. All I can say is that I still see a lot of tail risk around in shipping and elsewhere.

TeeKay in share buy-back

TeeKay's shares recently soared on announcement of a share buyback plan. TeeKay is one of the shipping sector's major success stories. Despite being mainly a tanker operator its share price is at record pre-2008 levels. Since early 2009, it has been making a steady recovery. The company operates a diversified fleet of Aframax, Suezmax, VLCC's and product tankers. It also has a presence in LNG and LPG vessels as well as the FSO/ FSPO market. It is a major operator of shuttle tankers.

Teekay plans to resume buying back its shares under an existing $200m share repurchase authorization. They feel that their shares are currently trading at a 40% discount. They moving into a period of excess cash flow and they see this as a compelling investment opportunity.

Teekay has a number of spin off companies in tanker and gas vessels. Its down stream company, TeeKay Gas Partners, has outperformed peer shipping shares, recovering all its pre-2008 value. It was a tremendous value play in 2009.  Just recently Teekay LNG Partners announced plans to acquire a 50% interest in two Exmar LNG carriers for an equity purchase price of about US$ 70 mio. Exmar will retain a 50% ownership stake and continue to operate the two ships.

The ships are the 138,000-cbm Excalibur (built 2002) and the Excelsior (built 2005), a specialized gas carrier which can both transport and regasify LNG onboard. The two ships are expected to generate distributable cash flow of about $10m per year for Teekay LNG Partners over the firm period of the charter contracts.

TeeKay made news earlier this year with its loan to Nobu Su's TMT for two VLCC's for which they used a pre-2008 credit facility taking advantage of the sizeable loan spreads.

TeeKay LPG Partners (TGP) and its prospects

TGP is a spin off in Wall Street fashion the last few years. OSG and FRO have also done spin-offs. In this case, the parent company is very much in control.TK is a major world player in the tanker sector. They shun the VLCC market. Their concentration is Suezmax and Aframax units. They are also active in the product sector. The gas business is a relatively new segment of their operation, started in 2004. TK is also in the offshore business. In TGP, their concentration is in LNG units and secondarily LPG units (mainly small vessels on order). They have combined this fleet with a flush of 8 Suezmax tankers.

The LNG market traditionally has been plagued by excessive expectations. The saving grace is the high entry cost and needs for operational expertise that keep the number of players restricted. Nearly all the vessels are on long term charter. The spot market is very small but expected to grow to about 30% of the fleet over the next five years. The charterers are major oil companies so counterparty risk is minimal. The spot market is small.

LNG ships are immense capital investments. The LNG industry is based largely on a series of virtually self-contained projects made up of interlinking chains of large-scale facilities, requiring huge capital investments, bound together by complex, long-term contracts, and subject to intense oversight by host governments and international organizations at every state of the process.

Global LNG demand and demand projections generally remain strong, with base case demand projected to grow by more than 70% from 2007 to 2012, and supply projected to grow by more than 80% over the same period. Average annual trade volume growth to 2012 is 9% for low case, 12% for base case, and 16% for the high case scenario. In the short term, the limiting factor on LNG trade continues to be tight supply. LNG supply project development might be slowed down by this financial crisis. The large amount of new liquefaction capacity is scheduled to come online in 2009-10 and there is danger of excess supply, hopefully of short duration but subject to the fall out of the current economic mess, plunging energy prices and spreading recession.

2008 will set a new record for LNG tanker fleet growth, with 55 or 56 newbuilding deliveries. Most 2009 delivery slots are filled, and yard capacity is becoming tight for 2010 deliveries as well. We can assume moderate additional ordering of up to 4 million m3 capacity (20 vessels) for delivery in 2010, and slightly more for 2011. These are exceptionally difficult contracts to cancel.

So far tanker rates have not suffered the catastrophic plunge of the dry cargo and container sectors. In fact, tanker rates are currently firming with seasonal demand. The LNG/ LPG rates are also steady. What has plagued the sector and particularly TNG is inflation in operational expenses (crew costs and repairs). Whatever the external environment, most of TGP’s fleet is contracted on period rates with escalation provisions for operating costs. Also important is financial expense with their large capital commitments. TGP management seems to have done a good job in containing these expenses and planning their FCF; but in the current financial turmoil, this is an area of risk.

Last August, S&P dropped Teekay’s corporate credit rating from “BB-plus” to the next lowest rating of “BB”, signalling that the company faces major long-term uncertainties but is less vulnerable in the near-term. Not unexpectedly, it is the LNG and Offshore business that is the major source of this debt due enormous capital requirements.

In TGP, there is both bank debt and lease commitments. TGP has a very conservative employment profile matching the debt obligations with long-term employment contracts with first-class charterers. They also have negotiated a very good debt profile as well as covered their financing needs for their newbuilding commitments. They seem to have reasonable margins for debt coverage obligations and in any case, it is less likely that these specialized units will be prone to the same collapse in value as commodity tonnage like bulk carriers. The real risk in asset depreciation is the thin resale market especially in distress situations should the contract commitments be impaired – which is the case for all specialized tonnage.

All in all, TGP has an attractive fleet, good employment and management. Shares are trading at very low levels. The major risk is the impact of the financial crisis on future product demand, especially in view of the fall in energy prices. It is also a potential M&A candidate given the entry barriers in the sector.