Saturday, March 16, 2019

The Absence of a Trend can Mark Opportunity...

Marc Faber once wrote that all great commodity bull markets started from a low that was put in place by oversupply. The question to answer is whether the present glut of many commodities will one day be replaced by a tight supply. The Baltic Dry Index is a proxy for dry bulk shipping stocks. It has been plagued by continuous oversupply for the past 10 years. Faber attributes the depressed Baltic Dry Index to continued weak global demand, caused firstly from slowing growth from China’s steel production. As of 2016, the Baltic Dry Index had lost 98% of its value since 2008, marking the lowest level since 1985 [1].

Kopernik Global portfolio manager Mark Kinney offers an alternative theory for the depression in the shipping industry, stating that it is the result of the Fed’s QE programs that have created such an extreme. The toxicity of QE lies in its consequences. Industrial commodities like oil, coal, and iron ore become much cheaper, causing a premature end to the commodity super cycle. Those commodities are transported by dry bulk carriers. Additionally, because money flows into banks and M&A, dividend payouts, and share buybacks, investments for new productive capacity lack financing and liquidity. Quantitative easing also reduces the end user consumption of manufactured goods, leading to shocks all along the value chain.

In 2018, surplus tanker capacity - namely VLCC’s - and weak oil demand - due to production cuts by oil exporting nations - are still persistent. Earnings remain incredibly depressed, with an average about $6,000-$10,000 per day [2]. Meanwhile, the average break-even cost has risen to around $2,200 per day [3]. How did earnings become so depressed in the first place?

Rewind to the period between 2002 and 2004. Freight rates were increasing leaps and bounds in tandem with increasing commodity prices. As a result, container companies were cash-rich and highly profitable. Bankers, seeing opportunity to make returns for themselves and their firms, egged on the shipping boom by lending to shipping companies at artificially low rates. Emerging markets, led by China, were hooked. Lending increased profitability for the shipping companies themselves in the form of new container shipping orders. In the 1990s, the average ship earned roughly $10,000-15,000 prepay. By 2000 the average was around $24,000, $39,000 in 2004, and $50,000 by 2008 [5]. Many shipping companies were investing heavily in ship building projects at the height of the boom in late 2006 and 2007. (Note: for reference, new tonnage takes about 2-3 years to deliver) By the time the ships were being delivered in 2008, demand had already crashed.  Without adequate revenues from ships [4], shipping companies were unable to service their bank loans, leading to bankruptcies and the contraction of credit.

Similar market peaks in 1967, 1970, and 1973 triggered investment bubbles with resultant structural imbalances in supply and demand, which took 20 years thereafter to clear. In 1997, demand finally caught up with supply. What seemed to be a recovery was soon postponed by the Asia Crisis and the crash of 2001. As the average ship approached 30 years of age, the shipping industry entered the boom in 2003 with investment hardly sufficient to replace the remaining ships built in the 1970s bubble. The carrier building boom was driven by China’s steel production. Shipyards with little to no orders led to new building prices to double. Capacity expansion was undertaken at a very short notice, with the order book increasing from 15% in 2002 to 47% of the fleet at the late 2007 peak.

Given historical cycles, it could take anywhere from 10 years (which have already elapsed) to more than 20 years. Though monetary QT would serve to reverse the depressed cycle into a recovery, this is highly unlikely at this point. Instead, an inflection point will probably come from real interest rates rising, causing an increase in prices of commodities. Only then could we see a rise in the Baltic Index. For now, it remains both cheap and undervalued.

Source: CNBC charts

[1] Bulk Shippers Hit by Perfect Storm, Fortune (2016)
[2] Overcapacity Threatens to Capsize Global Tanker Market, WSJ (2018)
[3] A Storm is Gathering Over Container Shipping, WSJ (2018)
[4] The Financial and Economic Crisis and Impacts on Shipping, Journal of Social Sciences (2016)
[5] The Great Shipping Boom 2003-8, Stopford (2008)