Issued by:
Xuemin Jia, MSc, Seahawk Investments GmbH
Hubertus Clausius, MBA, CFA, Seahawk Investments GmbH
Joshua Politis, MBA, Transport Capital
Septermber 10, 2020
Executive summary
The shipping industry is highly cyclical in nature. The rapid expansion before the global financial crisis has left the industry with overcapacity. Freight rates have broadly fallen since then and the performance of shipping stocks has suffered from low profitability.
However, the boom-bust cycle now seems to reset. The current order book as a percentage of the total fleet has reached all-time lows across almost all segments.
In the present environment certain shipping segments have been surprisingly profitable. After the outbreak of the pandemic industry forecasts have been quite pessimistic for the calendar year 2020. Forecasts have now been revised upwards sharply. The container liner industry will increase profits significantly vs. 2019. OPEC’s oil price war and the subsequent glut of production has led to record earnings of crude and clean Tanker operators . Moreover, paid-out dividends are at record levels.
However, there is still a large amount of uncertainty surrounding the pandemic, value stocks have been out of favour during 2020. The growth stock segment has outperformed significantly. Within the small cap segment, the Russell 2000 Shipping Index is still down -39.90% YTD vs. the Russell 2000 Value Index with a YTD return of -17,73% (31.12.19-31.08.20). Shipping stocks are presently trading with a low average 1-yr forward PE-Ratio of 6.1 vs. 13.56 of the Russell 2000 Value Index. Given the sharp correction of shipping stocks, the Russell 2000 Shipping Index is currently trading at an expected dividend yield of 7.71% for the year 2020 and a low Price to Book Value of 0.65. A more precise measure of the intrinsic value of shipping stocks is the Price to NAV measure. Crude Tanker stocks are currently trading at an average P/NAV of 0.7x, the dry bulk segment at 0.7x and the LPG segment at just 0.4x.
As world economies may be less impacted by COVID-19, world seaborne trade is expected to rebound rapidly in 2021. At the same time, fleet growth is expected to slow as only a small proportion of new builds will be entering the market. For most shipping segments the supply demand balance looks favourable.
New COVID-infections may level-off during 2021 and investors are expected to turn their eye back to transportation stocks, where shipping appears attractively priced.
In addition to that, the entire industry is in transition to combat climate change. The impact of IMO 2020 may be a good example of how new environmental regulations may even strengthen the freight rate environment.
Shipping industry is fighting against climate change
The Shipping industry is responsible for a significant portion of global climate change issues as it accounts for around 2 – 3% of global greenhouse gas emissions, often compared to the entire impact of Germany in relation to the scale of its emissions. The International Maritime Organization (IMO), a United Nations agency which serves as the maritime industry’s global regulator, has recently introduced a number of environmental regulations, including IMO 2020 for Sulphur reduction and the Initial IMO Strategy on the reduction of GHG emissions from ships with implementation targets for the years 2030 and 2050.
IMO’s regulation to reduce Sulphur oxides (SOx), known as ‘’IMO 2020’’, limits the sulfur oxide emissions from ocean-going vessels by 85% with effect from January 1, 2020. The previous maximum fuel oil Sulphur limit of 3.5 weight percent (wt.%) falls to the current 0.5 weight percent (wt.%). The current options for the ship operators to conform to the requirements are as following:
- Continue using High-Sulfur Fuel Oil (HSFO) at the cost of installing exhaust gas cleaning systems (Scrubbers) to the existing vessels to clean the harmful emissions on board
- Switch to Very-Low Sulfur Fuel Oil (VLSFO) or Marine Gas Oil (MGO).
- Adapt to Liquefied Natural Gas (LNG) fueled vessels or other compliant alternatives
The shipping industry has generally moved towards the use of VLSFO: VLSFO fuel sales made up nearly 70% of the total bunker fuel sales for the first half of 2020 in Singapore, while HSFO sales accounted for around 18%. However, due to the oil price collapse, the spread between VLSFO and HSFO has significantly narrowed from a peak of nearly $300/t between late 2019 and early 2020 to slightly below $50/t recently. The VLSFO weakness was initially driven by the output increase from Chinese refiners, as the Chinese government offered a consumption tax waiver and a VAT rebate on fuel oil sales. Moreover, COVID-19 added further pressure to VLSFO prices as the production of gasoline shifted to VLSFO. This was a result of the drop in road transportation demand. The narrowed spread between VLSFO and HSFO has led shipowners to reconsider or delay their scrubber installation plans until the spread widens again. The payback time for scrubber investment will extend from 1-2 years under a spread price of $250/t to 4-6 years under current spread. Although the seaborne trade demand was badly hurt by COVID-19, the weak supply side in 2020 somewhat mitigates the supply-demand mismatch.
At the same time, the energy transition and decarbonization of the world economy has become more important and the maritime industry’s transformation towards ‘’green shipping’’ brings more uncertainties to the supply side. A subdued order activity will ultimately have a profound impact on shipping companies’ profitability.
IMO has established the IMO GHG strategy in 2018, targeting to reduce CO2 emission to 50% of the 2008 level and carbon intensity by 70% in 2050 (40% by 2030). Meanwhile, the European Commission has been working hard on finding solutions to combat climate change. In March 2020, the European Commission published its proposal for a European Climate Law which sets a legally binding target of being climate neutral by 2050 for the EU as a whole. In July 2020, the EU commission has proposed to include the maritime sector in the EU emission trading system (ETS), which would require at least a 40% reduction in CO2 emissions by 2030. If this vote passes the European Parliament in September 2020, each member state will need to ratify the new legislation and it will officially become effective in January 1, 2022.
Some container operators have already responded. The world’s largest container liner shipping company, the Danish A.P. Moeller Maersk has promised to be CO2 neutral by 2050. At the end of June, A.P. Moeller Maersk has announced plans to invest 53 million euros in a research center in which technological prerequisites for decarbonization goals are to be created. Other shipping companies, such as the French CMA CGM, are striving to be carbon neutral by 2050. Hapag-Lloyd wants to reduce its own CO2 emissions by 20% this year and has set itself technological modernization and innovation goals. European integrated oil companies have also set themselves the goal of being CO2 neutral by 2050 including their shipping activities. Equinor from Norway was the first oil company to modify its future charter guidelines which now give a clear preference for chartering lower-emission ships. The global maritime value chain is rapidly adapting to the decarbonization transition.
Global shipping market supply and demand
Seaborne trade accounts for 83% of international trade by volume, with an average growth of around 3.5% over the past 20 years (pre-COVID level), measured in tonne-miles. The world seaborne trade closely follows global GDP growth with an approximate 0.9x multiplier. According to Clarksons, seaborne trade has slowed down to around 0.5% in 2019 in tonne-miles as a result of the US-China trade war. However, the impact was limited: only 1.8% of annual seaborne trade was subject to tariffs, furthermore, substitution effects and variable sensitivities to tariff levels also helped to moderate the overall impact on seaborne trade.
The COVID-19 pandemic has deeply disrupted the global economy. Global GDP is projected to fall by -4.9% during 2020. In 2021 world GDP is expected to increase by 5.4% according to the latest IMF’s (International Monetary Fund, June 2020) estimates. Thus, seaborne trade is expected to see strong growth of 5.6% again in 2021 as per Clarksons, assuming the economic impact from COVID-19 is limited.
As demand is in high correlation with the global economy, the shipping industry is highly cyclical in nature. The ClarkSea Index is a weighted average index of earnings for the main vessel types measured in US dollars per day. The weighting is based on the number of vessels in each fleet sector. The below graph shows the ClarkSea Index development in the past 20 years. Currently, the index is gradually recovering from the lows of the year 2016. At the present point in time, the index is already close to its 20 year average.
In contrast to the global financial crisis in 2008, the shipping industry entered into this crisis with a more manageable supply side: In 2008, the world order book was more than 50% of the fleet capacity while in 2020, the order book is less than 10% of aggregate total fleet. This is a historical low since 2005. The fast expansion before the global financial crisis has left the industry with overcapacity which has taken almost a decade to rebalance. In the meantime, the tightening environmental legislations has created uncertainty over what type of fuel and propulsion system to choose given new technology improvements and evolving regulation requirements. In addition to that, more restricted access to loan financing has led to more muted new order activity amongst shipowners.
Market outlook by segments
Tanker:
Crude oil demand has fallen significantly during the 1st half of 2020. Crude oil prices collapsed in late April. As global oil demand has been gradually picking up in H2, OPEC+ has further reduced their supply cuts by 2 million bpd (barrels per day) from 9.7 million starting in August to rebalance the market overcapacity for the rest of 2020. The global seaborn oil trade is expected to see a year-over-year growth recovery of 4.49% in 2021.
The oil price plunge has pushed floating storage demand which drove up freight rates to astronomical levels for oil tankers during March and April. Around 8-9% of oil tanker fleet capacity was used for floating storage between late May and late July, comparing to a peak of 11.5% in early May. As a result of weak oil trade, lower refinery runs and the return of floating storage vessels, crude tanker freight rates have decreased across most routes.
On the supply side, the tanker order book currently sits at a 23-year low of around 8% of the entire fleet, in constrast to around 20% at the peak of the last market cycle in 2015. Furthermore, the global tanker fleet is aging: 20% of the midsize tanker fleet, measured by dead-weight tonnage, is currently 15 years or older and likely to be scrapped in the coming years. The small order book and a relatively high scrapping activity contributes to a low net tanker fleet growth in the near term, which to a certain extent mitigates weaker demand.
Dry Bulk:
According to Clarksons, global seaborne dry bulk trade is projected to decline by 3.9% in 2020, as a result of the severe impacts from COVID-19, while the fleet is expected to expand by around 3%, suggesting a starkly negative supply-demand balance. The rapid recovery in China has been boosting strong demand for iron ore, compensating for the general weak demand elsewhere: global iron ore imports in June were 118.69 million tonnes, comparing to 118.55 million from the same period last year. The supply side seems adequate and healthy too – Brazil’s largest exporter of iron ore, Vale, announced 67.6 million tonnes output in 2Q, up 5.5% from last year at the same time. Australia’s two biggest producers also reported higher output in the second quarter. Seaborne dry bulk trade is therefore expected to be strong in 2021 – a 5.5% increase as per Clarksons research.
In the beginning of August, 0,2% of the dry bulk fleet capacity were under scrubber retrofit to meet the IMO 2020 sulfur emission limits, comparing to over 2% in January, which adds to the total fleet growth. However so-called ‘slow steaming’, an effective way to save fuel consumption, could lend some support to overcapacity in 2020. Looking ahead to 2021, the expected fleet growth will slow down to 1.1%, due to the all-time low order book in the last 20 years. Should COVID-19 fade away, we could expect to see a freight rate increase driven by a supply demand mismatch.
Containerships
The containership segment initially recovered in 2019, however, it suffered from COVID-19 demand shock as well as other segments. Clarksons estimated a decline of 7.7% in TEU (Twenty Foot Equivalent Unit)-miles in seaborn container trade for the full year 2020, although consumer activity and supply chains have been gradually recovering from the deep contraction in Q2. Demand recovery can also be seen from the idle fleet capacity improvements from a peak of 11% in May to 7% by mid-July. Consequently, the freight rates started picking up in late June whilst container trade demand regained the lost ground.
Looking ahead, seaborn container trade demand appears to be as bullish as a 7% rise in 2021, as per Clarksons projection. On the supply side, similar to other segments, the current order book is at historical lows which alleviates the container ship subdued delivery disruption in 2020. Moreover, when we expect a demand rebound in 2021, the slow containership capacity growth could create a supply shortage. The average earnings of containerships appeared to pick up again in July after a sharp dip in May, nevertheless, the increasing operating cost arising from IMO2020 compliance could erode profitability if COVID-19’s negative impact prolonged to 2021.
Equity Valuation
Major shipping segments are currently valued at a significant discount to their net asset value (NAV). The tanker and bulk carrier segments are valued at roughly 0.71x their NAV whereas the LNG and LPG segments are discounted by roughly 50%. Comparing historical price to NAV multiples, we see the current shipping market is valued at a low point across various segments. However, putting together the post COVID seaborne trade demand growth projections and the current all-time low order book, we expect an undersupplied market in the future. Vessels take a long time to build. The large vessels which typically have a more profound impact on the supply side take at least two years to deliver.
Furthermore, we expect future newbuilding activity to be even more muted as the industry is undergoing a transformation which is pressured by evolving environmental regulations, resulting in large uncertainties. The limited access to financing due to bank’s exits from vessel finance and past poor performance is another important factor which limits ship owner’s ability to invest. Putting them all together, we see this supply shortage could create a prolonged earning window for existing ship owners which makes the sector an attractive investment.
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Editor: Hubertus Clausius acts as a tied agent (section 2 (10) German Banking Act (KWG)) on behalf, in the name, for account and under the liability of the responsible legal entity BN & Partners Capital AG, Steinstrasse 33, 50374 Erftstadt. BN & Partners Capital AG has a corresponding license from the German Federal Financial Supervisory Authority (BaFin) for the provision of investment advice in accordance with section 1 (1a) No. 1a KWG and the investment brokerage to section 1 (1a) No. 1 KWG.