^Economic Cycles. Image Courtesy of Singkham at ShutterStock.com
The Big, 70mm Picture
Growth of an economy, any economy – national, local, sectoral, regional and the like – depends on two interrelated factors. These twin governors are the expansion in production and an increase in the velocity of money.
An economy grows when it produces more goods and services. Obvious enough. But this happens only with a proportional increase in the speed of money transactions i.e. the rate at which money is exchanged from one transaction to another. Case for paying your dues on time!
Among the most capital intensive of industries – a tanker comes for hundreds of millions of dollars – shipping is also acutely cyclical. Dependent as it is on the developments in the global economy, something influenced by myriad determinants.
What this means is that a remote development in some distant corner of the world can have far reaching ramifications in the shipping market. Forget the actual event, the mere possibility of such an event can do the same regardless of whether the event actually occurs.
Demand is volatile. Only April weather is more fickle. But supply adjusts very slowly. A turtle would perhaps move faster. Quite a demand-supply gap that can create. Predicting conditions in the shipping market is therefore a near-impossible task that few get right consistently.
There are four shipping markets and the cash flows in these markets trigger the cycles in the shipping economy. In turn, booms and busts alter the cost management strategies of the shipping companies.
A study of the diverse costs involved in shipping and their management is therefore absolutely essential. Plus, we need to place these costs in the wider context of the shipping markets and, of course, the broadest context of the global economy.
Four Shipping Markets
When the global economy is doing well, people earn good money. They spend it to purchase goods and services and thereby create demand for the production of such goods and services. With ships transporting over 90% of international cargo, the global boom hikes the demand for ships.
Such demand attracts investment because freight rates and the prices of new and second-hand ships jump through the roof. But because you can never accurately forecast the precise demand for ships, shipowners inevitably order more than the necessary tonnage.
This over-supply depresses ship prices and freight rates. Shipowners sell their ships in the second hand market. And if they cannot get a bargain, they scrap their ships. How else can they fund routine operations when demand and freight are low and banks are unwilling to lend?
Again, there is over-scrapping because judging the future demand is next to impossible. This lowers the supply to such a point that demand again overtakes supply and the cycle continues.
Four shipping markets are:
- Freight Market: provides ships for cargo transport
- Sale-Purchase Market: offers an avenue for trading second hand ships
- Newbuilding Market: deals with freshly built ships
- Demolition Market: takes care of ships that can no longer run or trade profitably
Shipowners and cash are the two elements common to all four markets, precisely why developments in one market affect other markets as well. Revenue from freight is the chief source of income for the shipping market. Cash from the demolition market comes second.
A fleet with one shipowner typically includes ships of various types and sizes. Moreover, many ship types can in fact replace each other. For example, combination carriers that can carry wet as well as dry cargo mitigated the tanker shortage during the 1967-75 Suez Canal closure.
Such hybrid fleets and interchangeable vessels serve a purpose. For one ships are expensive investments and have an average life of 20-30 years. Fiscal prudence dictates their use for longer periods in order to break even and move beyond.
Then again, the cycles in shipping market are long and tiresome. Breaking even can take years. Plus, demand is extremely changeable and supply is slow to adjust. Interchangeable vessels enable shipowners to profit from a sudden change in demand for a certain kind of vessel.
Provided there is no bank lending, funds from the sale-purchase market do not affect the amount of cash in the market because funds shift from one shipowner to another. The newbuilding market drains cash from this market as funds shift from inside the market to the shipbuilders.
Freight Markets: in here, brokers bring together the shipowner and the shipper i.e. the cargo owner. You can find brokers at major shipping hubs such as London, New York, Singapore, Hamburg, Oslo, Hong Kong and the like.
Charter-Party i.e. the contract that specifies the terms and conditions of the business between the shipowner and the shipper is the most important document when hiring ships.
Professionally drafted charter-parties fix the responsibility for dealing with inherent perils such as mid-sea ship breakdowns, delays, port strikes, congestions and the like.
Through this, charter-parties ensure that either or both parties do not renege on their commitments. Such defaults can cause expensive and time consuming legal disputes that hamper the smooth functioning in this market.
Freight Market Reports provide vital information on the current freight and charter rates for different vessels and diverse cargoes by analyzing market conditions.
Apart from such reports, Freight Rate Statistics are equally important to shipowners, charterers, and cargo owners as they reveal trends for freight and charter rates. Statistics include:
- Voyage Rate Statistics: in $/ton of dry cargo
- Time Charter Rates: in thousand dollars per day for trips of 6 months, 12 months, and 3 years
- Worldscale: in rate per barrel of oil for diverse routes
Baltic International Freight Futures Exchange (BIFFEX) offers a way for shippers, shipowners, and charters to insulate themselves against sudden and unfavorable changes in freight rates.
Second-Hand Ship Market: attracts investors and worries bankers on account of its inherent volatility. Please note, ship prices can change by as much as 60% in a matter of few months.
Meyer Werft Shipyard in Papenburg, Germany
Owners sell old ships for a variety of reasons such as obsolescence, availability of good prices for used ships, or distress sale during slowdowns when they need cash to finance their routine expenses.
Prices of different types of ship are closely correlated. A complex blend of market knowledge, procedure, and judgment, valuation is a critical requirement of this market. Brokers usually undertake valuation and banks need a figure before they can process credit.
Ship prices in this market are a function of:
- Age / Physical Condition of Ship: as ships depreciate i.e. lose value with rising age
- Freight Rates: determine the future profitability of the ship. Reasonably good freight rates at present or the expectations of fair rates in the future causes ship prices to appreciate and vice versa
- Shipowner’s Expectations for the Future: for the market can swing from depression to brisk activity within a matter of weeks. Here again, optimistic prospects propel ship values while pessimistic sentiment causes them to tank
- Inflation / Price Rise: affects the future value of the ship
Newbuilding Market: is different from the used ship market. Most yards build custom ships. This process is technically and contractually more complex. And the ship is completed after 2-3 years by when market conditions may have changed.
Located mainly in the industrialized economies, shipbuilding is a technically advanced and capital intensive operation. Demand-Supply equations determine price of newbuilds. Following factors influence the demand for fresh ships:
- Market Expectations: demand rises with positive expectations and falls with negative ones
- Price of Equivalent Second-Hand Ships: low prices of such ships will lower the demand for newbuilds and the other way round
- Freight Rates: better rates spur demand while low rates suppress demand
- Credit Availability: high credit availability triggers demand rise while low availability dampens it
- Financial Liquidity of Buyers: with more liquid assets i.e. assets that are easily converted to cash and cash equivalents, buyers are ready to buy more ships. This propels the demand
Shipyards can supply ships only if they have free berths for construction of new ships and a less busy order book. Delivery schedules beyond three years are useless because conditions can, and usually do, change in this duration.
Supply of ships depends on:
- Shipbuilding Capacity: supply rises with capacity
- Production Subsidies: stimulate production and supply
- Shipyard Unit Costs: greater costs slash supply
Competitiveness of shipbuilding depends on:
- Material Supply
- Shipbuilding Infrastructure
- Skilled Labor Availability
- Labor Productivity
- Wage Rates
- Currency Exchange Rates
You need deft administration in order to coordinate material supply in a manner that the infinite number and type of parts arrive on time and confirm to the required specification.
Demolition Market: when a shipowner cannot even sell his vessel in the second-hand market, he scraps it. India, China, Pakistan, and Bangladesh host most scrapping yards.
In marked contrast to shipbuilding, scrapping yards dot the developing economies. Again, operations are highly labor intensive where labor uses the most basic of tools. Slim margins deter the use of expensive and efficient ship breaking tools.
Relatively lax regulations in the developing world allow the use of scrap steel, diesel engines, deck cranes, generators, and furniture derived from scrapping. This factor locates the industry in developing economies.
Ship scrapping contracts are usually simple. Following factors govern the price of scrap ships:
- Demand for Scrap Metal: rises during booms and falls during slumps
- Availability of Ships for Scrap
- Suitability for Scraping
Costs of Shipping
As mentioned, the cyclic nature of shipping markets presents two critical questions of how to:
- meet excessive demand and cash flow in boom times?
- survive during slowdowns when the market tries to dry out surplus capacity?
Companies with depleting reserves and weak cash flows perish during depressions. Those with reasonable reserves and even modest cash flows pick up gold i.e. good ships at throwaway prices from weaker companies and get set to thrive in the next boom.
Three crucial variables govern financial performance of shipowners:
- Revenue from Operating / Chartering Ships: this is maximized by:
- Promoting Productivity: through advanced dwt utilization and operational planning while minimizing idle times, loading-unloading durations, and backhauls
Deadweight utilization is average load carried by the ship as a percentage of its full load capacity. Backhaul is the return journey when the ship does not carry any cargo and therefore does not make any money
- Improving Cargo Capacity to benefit from economies of scale
- Better Negotiations to get better freight rates
- Cost of Running Ships: include operational, repair-maintenance, cargo-handling, and voyage costs as well as taxes, dividends, and capital repayments
Old ships demand more maintenance costs but low capital costs while new ships involve greater capital and lesser maintenance costs. Flexibly designed ships carry diverse cargo and hike the money-making capacity of ships
- Method of Financing: during depressions, freight rates drop and are normally just enough to pay for operating and voyage costs. The owner often cannot pay the repayment installments
Debt (bank loan) is relatively inexpensive but the shipowner has to make fixed, periodic repayments regardless of whether he makes money. Else, the bank will confiscate the ship
Equity finance (sale of stock to raise capital) is free of such pressures but is expensive. Plus, the creditor (shareholder) is a partial owner and may assume ownership of the ship
Two relationships are crucial to shipping economics:
- Cost-Age Relationship: operating cost rises for older ships because of higher fuel costs, higher crew requirement, and more maintenance costs. New ships use better technology that requires lesser fuel, fewer crew, and reduced maintenance
But the capital costs for old ships are lower because they have paid off all or part of the money raised to purchase or build them. New ships are far from this stage
- Cost-Size Relationship: costs fall with an increase in the size of the ship because capital, operating, and voyage do not increase proportionally with tonnage. Therefore, unit transportation cost falls with a rise in the size of the ship
A simplified expression for the cost of shipping one unit of cargo is:
K: Capital Cost
OC: Operating Cost
PM: Periodic Maintenance Cost
VC: Voyage Costs
CHC: Cargo Handling Cost
DWT: Tonnage i.e. Amount of Cargo the Ship Can Carry
Larger ships however lose flexibility for they cannot carry different types of cargo. Plus, they can enter only those limited number of ports that are large enough to accommodate them
Shipping costs include:
- Capital Costs: interest on debt and dividend on shares (stock) comprises about 39% of the total cost
- Operational Costs: routine costs of stores, crew, routine maintenance and breakdowns, insurance, and administrative overheads. These make up about 25% of the total cost
- Voyage Costs: fuel costs, canal tolls, and port fees, and tugs and pilotage. Fuel expenses make up about 47% of these costs and depend on the vessel’s age, hull condition, and machinery
- Periodic Maintenance Costs: for dry dockings and special surveys. Ships are dry-docked every two years. Ships are also dry-docked every four years for special insurance-related survey / inspection
- Cargo Handling Costs: include the costs for loading, unloading, and cargo claims
Shipowners get more choice in choosing the nationality of their crew. By choosing crew from third world countries, they can minimize crew costs. Not everyone accepts the minimum basic monthly wages prescribed by the International Transport Worker’s Federation (ITF).
Shipping is a dollar-based business, but shipowners typically deal in multiple currencies. Administrative overheads comprise a substantial fraction of the costs for large liner companies.
It was only in the 1970s that shipowners began to invest in fuel-efficient ship designs when the oil shocks skyrocketed fuel costs. When oil prices dropped in 1986, this interest declined only to revive in recent years with global warming and emissions becoming such a hot topic.
Areas that have witnessed significant efficiency improvements include the main engine, the propeller, and the hull. Designers optimize the hull shape and the power plant for an optimum speed. This speed is 18 knots for container ships and 15 knots for bulk carriers.
Slow Steaming is a recent phenomenon that has gathered steam since the global economic slowdown of 2008. Operators deliberately ply at lower speeds to lower fuel consumption and emissions in times when low demand for shipping allows low deadweight utilization only.
It works because fuel consumption drops with a drop in speed. The relation between speed and fuel consumption for a diesel engine is:
F: actual fuel consumption
S: actual speed
F*: design fuel consumption
S*: design speed
Freight rates and fuel costs influence operating speeds. Higher freight rates incentivize full speed operations while higher fuel costs do the opposite. The reverse is equally true in both cases.
Despite the trebling fuel costs in Oil Shock of 1973, tankers and combination carriers operated at full speed because they got sky high freight rates.
Taxation is not a serious expense because most shipowners register their ships with those flag states that levy negligible or zero taxes. Shipping costs are low for bulk cargo because it is homogenous and you can easily load-unload it. That is not the case with general cargo.
Shipowners cannot control the principal cost and revenue items. Clever management within the choices presented and limitations imposed by factors such as age, size, cargo management, and technical flexibility govern the profitability of shipping companies.
Striking a balance between single-purpose and multi-purpose ships, old and new ships, and debt and equity financing is essential. Once made, the company cannot change the choice immediately. And, numerous such combinations have been equally successful.
Our blog makes great reading for those interested in knowing the fundamentals of maritime economics and marine engineering. For a practical on marine fabrication services, marine pipe fitting, and large scale custom metal fabrication, contact Kemplon Engineering.