Weight of Freight: How will shipowners spend cash in 2021?

Alex: Hello and welcome to "Weight of Freight." In this series, we explore the intricate yet powerful connections between the shipping and commodities markets. And today's episode is all about the money and the money in the shipping market and what is being spent on in terms of the freight investment. The wild year of 2020 has had interesting effects on the cash piles under the shipowners' mattresses. So we shall investigate if there is enough cash in shipping markets like tankers and dry bulk, what it might get spent on, and what does that all mean for the freight rates in both short and long-term perspective. And to guide me through such a complex yet fun topic, I'm joined here today by renowned experts in this field, the one and only Randy Giveans who is the senior VP of equity research at Jefferies. It's good to have you here, Randy.

Randy: Thanks so much. My pleasure, Alex.

Alex: So Randy, 2020 has introduced some outstanding volatility to freight rates. That goes primarily for tanker rates, which had a massive spike to historical highs in the spring of last year, before sliding back to the bottom, of course. And this had quite an impact on the trade routes. For instance, I'm just looking back at the Argus freight data for VLCC route from U.S. Gulf Coast to China. And at certain point in spring last year, the freight costs were equal to over 40% of the WTA price for FOB Houston. These days, it's closer to 4%. So quite volatile and the dry freight enjoyed the recovery in recent months as well, especially in the capesize segment. And hence my first question for you is with all these ups and downs, how are the balance sheets looking for shipowners right now?

 

Randy: Those are great questions, Alex. So at the beginning of the year, starting 2020, the balance sheets for a lot of these crew tankers were very stretched because 2016, '17, '18 was not very good. You also had a lot of debt that was coming due in the near term, you also had a lot of expansion happening in those, you know, prior years leading up to, kind of, the start of 2020. So because of all those factors, you're leverage ratios, your net debt at EBITDA, your net debt to cap, and then your just overall debt that was maturing, your short-term debt was pretty high in numbers.

Now, the fourth quarter, strong earnings helped. But again, not meaningfully. Now, that said, throughout 2020, especially the first 6 months really of 2020, rates were just at these incredible levels, right. So what basically happened was a lot of these tanker owners made more money in six months than they normally do in four years, right, five years' worth. So because of that, as of today, right, balance sheets are much improved. Your net debt to caps are in the 30s instead of the high 40% range. Your net debt to EBITDA has certainly come down pretty meaningfully, because the EBITDA has grown pretty massively, and the net debt has come down, right. So all that said, there was a lot of refinancings that happened, obviously, in this very low interest rate environment that has helped a lot as well. So for now...it obviously will depend on how long this current week rate environment lasts into 2021. But for now, the balance sheets are in very strong shape.

Alex: Is it the same for dry bulk? Because obviously, dry bulk struggled for quite a while with tankers too. But...

Randy: Yeah, yep, currently much better shape as well, especially compared to, like, 2016 when the world was ending for dry bulk you had, I don't know, 6 or 7 of these, you know, let's call it 10 to 12 relatively large, publicly-traded dry bulk companies having to do some emergency, kind of, equity offerings, a few had to file for bankruptcy. So 2016 was just a disaster, right? Balance sheets were incredibly stretched. 2017, '18, '19, things improved a little bit. But again, in 2020, obviously, you had some massive rate volatility there with everything that was happening in Brazil and in Bali, and what have you. That said, currently, those are in much better shape as well. Now, just to compare to tankers, relative not as in good shape as the tankers are, however, when it comes to where you were at the bottom, let's call it 2016, versus where you are today vastly improved.

Alex: Yeah. So that brings a very interesting situation, right? So there is an improved, I guess, cash situation for shipowners in both markets. So as we all know, they prefer, shipowners or ship operators, to spend the investment money on ships, right? That's their prime source of investment targets. And apart from the cash that they already have or accumulated themselves, there's also a question of financing, or sources of capital, sources or getting that extra, extra finance to secure the fleets. How is the situation in those terms? Is it easy to find finance to get investments in the vessels or investors are still cautious about it?

Randy: Right. So it really depends, right, so I'm gonna go into a few different topics here and feel free to, kind of, cut me off or interrupt. But when you look at vessel financing, historically, it has been through European banks, right, Commerce Bank, Nord LB, BNB, ABN AMRO, whomever, and they would give, on average, 65%, maybe 70% loan to value on a ship. So if you're ordering a tanker for $80 million, you can get, I don't know, around $55 million in debt, if you're ordering a capesize for $50 million, you can around $30 million to $35 million in debt. And that's on a speculative new build order without any long-term charters. And they were giving that out.

Now, it was, historically, let's look at the last 10 years on average, probably LIBOR plus maybe 500 basis points. Nowadays, the rates are obviously much improved, LIBOR's down to nothing, right, maybe 30 basis points. Whereas the margins are certainly tighter, right, we're seeing LIBOR plus 250, maybe 300 on the high end, or even 200 on the low end. So your margins have come in as well. That said, a few things have changed, right, your LTV, your loan to value, you're only getting maybe 60%. And then secondly, the banks are being a lot more selective, right? Before, you could have five vessels and get financing for all five. Nowadays, the banks are certainly looking at the scale of your fleet. Obviously, if you're publicly traded, that will probably give you a little premium as well because you have access to public equity in that regard. So it's really a story of, kind of, haves and have nots in this situation.

Alex: When banks do get this, how much are they looking at, let's say, projections of how the freight market is gonna be doing?

Randy: Yeah, very much. Yep, they're certainly looking at, kind of, a discounted cash flow. Now, a lot of times, they'll just use, what is the 10-year average spot rate band, or the 10 year average one-year time charter band, or even a five-year average, right, and, kind of, using these relatively conservative numbers to, kind of, back into that. And again, that is also why they're giving a lower loan to value. Because if you're saying a new build cape, and you're getting $50 million to pay for it, and you're getting, let's call it 60% financing, that's only $30 million bucks, and they're gonna make you amortize that, right? Probably on a 15, if not 10-year profile with a bullet at the end of 5 to 7 years, right? So they're gonna make sure even in a very dire case, even with quick depreciation, that the, kind of, loan to value stays below 100, if not below 80, even in a down market.

Alex: Right. Okay. And in terms of actually these tools that you might have to make sure that you are getting your money back as an investor, is it to mostly make sure that there is a time charter agreement for the vessel which you're getting invested in? Is there, like, any other prime tools, I guess, to make sure that people are good for the money?

Randy: Now, when you say as an investor, are you meaning as a bank who's financing?

Alex: Yeah. Yeah, I mean, as a financier, yeah.

Randy: Okay. Yeah, as a lender, right. You know, you don't necessarily need time charters, right. This isn't LNG carriers or container ships historically, right. Obviously, right now, in the past few months, LNG has just been gangbusters and then container ships are the best market we've ever seen. But historically, you would want time charts on those vessels. So when we're keeping this conversation on tankers and dry bulk, the vast majority of the market is on spot, right, we're talking 65% to 85% of vessels canvassing the world are doing spot cargoes or maybe some contracts of affreightments. So not all on long-term charters. So with that, I don't think you are looking for or need that.

The real issue is just making sure you don't have residual risk. And that's why your average life of these loans has shortened, your amortization profile has steepened, right, has increased, and your loan to value has decreased. So those three metrics make it a very, kind of, you know, reduced risk lending opportunity for the banks. And that's also why you can get such cheap money, right? If you're loaning at a 60% LTV for 5 years with an amortization profile of 10 years on a life of a vessel that usually depreciates over 20 years, that's very safe. So you can get LIBOR plus 200 basis points.

Alex: Yeah. And in terms of investors, since I did misspeak earlier, do you think there are more investors now coming into the shipping market actually trying to invest, let's say, in the fleets and what kind of players those are, I wonder? Especially, I guess it becomes more attractive when you see volatility, and when you see big rate spikes, even short term, and some people may perceive this as the market which could have potential in it. So I wonder what players are getting attracted after 2020 into the shipping market as new players?

Randy: Yeah, so let me back up a step here as well. So there was a big push by private equity into shipping in, let's call it, 2012 to '16, right? Now, in recent quarters, and even months, you've seen this "prexit," right, this private equity exit, out of shipping, so that kind of source of capital is no longer there. And again, as I mentioned earlier, your large commercial banks in Europe have been shedding their shipping exposure as well. So the people who have come in have been, you know, a lot of these sale-leaseback agencies, a lot of these Asian financial institutions with, again, who sale-leasebacks are doing a lot of that activity in terms of new build financing, or even secondhand financing, resale financing. So that is one side of the, kind of, investor, but I would call it more financier lender profile.

In terms of investors, right, you know, we're recovering these common equities. So in terms of common equity investing, you've seen a very diverse group, right? You've seen energy investors, you've seen industrial investors, we've seen value investors, right, where you're looking at, in a world where over the last, I don't know, a couple years, it's been all about momentum, growth, tech, you know, all of these, kind of, phenomenons. Our view is with a higher kind of a likelihood of inflation here in the next few quarters and years. And with more of a switch to value, right, economically sensitive, energy-related, global trade-driven companies, asset-heavy in an inflationary environment, that is perfectly suited for shipping, right? So that's why you've certainly seen a lot of new entrants just here in the last few months into shipping.

Now, when you see these, kind of, crazy numbers back in March, April for tankers, going to 200 plus 1000 a day for VLCC, there's certainly been just any investors just, kind of, coming in. You know, I went on CNBC, and there's been a bunch of tanker owners on CNBC, and it's been, kind of, the mass media has been really catching wind of it back when floating storage was just in vogue and everyone started talking about the contango, right? So that was a huge influx of volumes both in creating...

Alex: Hard times. Yeah.

Randy: Exactly, exactly. Now, that was a big party. And then there's been a big hangover in the last few months because, you know, you had this massive build and floating storage and inventory levels and these other things. So that has, kind of, traded off, as of late. That said, when you take a longer-term view and when you look at, kind of, value, when you look at where we are in terms of asset values being at very low levels, both on tankers and dry bulk...you know, I was looking this morning just to, kind of, compare some of the numbers. And historically, the difference between a new build vessel and a 5-year vessel is about $20 million for VLCC and about, I don't know, $10 million for capesize. Well, now that difference is about $25 million for VLCC and about $20 million for a capesize. So that shows there's a huge gap between a five-year-old vessel and a new build.

And in this environment, we don't see a lot of new builds, right, because of the environmental regulatory uncertainty with IMO 2030, with the shipyard capacity shrinking, with the access to capital, as we've been discussing, shrinking. So I think a lot of people are now looking at, well, the 5-year-old vessels are a lot cheaper, they're already on the water, they're not adding to the order book, they still have at least 10 years of life before they become obsolete. Whereas if you order a new build, you're not getting it until 2023, maybe 2024. So you might have six years of true life. So because of that, we think there will be a big push into the secondhand tonnage, which will push up asset values, which will push up net asset values, which a lot of these tanker and drive oil companies trade on.

Alex: Okay. But since you mentioned environmental regulations, it's a very broad topic in many ways for shipping because these days, we're talking about the new investment cycle, because the industry is facing new decarbonization goals, just as you said, and thinking about the next fuel, which would be applicable globally, probably. And the main problem here is, a lot of players agree, is there seems to be no current solution for long-term decarbonization, decarbonization goals. So whatever investments you make in the fleet is quite a risky bet, whether you go for LNG, or you wanna try things like hydrogen or ammonia, which is much tougher for big segments like VLCCs, or capsize, or anything like that, or any big vessel segment for that matter. So the question is considering all that, the next investment cycle in new tonnage, first of all, when is it gonna happen? And what do you think is gonna be the darling for investment, which type of engine or fuel and which segments in dry bulk and tankers?

Randy: Yep. So great questions there. So we see the, kind of, real near-term push will be on dual fuel, kind of, LNG-powered ships. Like, the infrastructure is there, you can find LNG, obviously, all around the U.S. Gulf, you can find LNG in Asia, throughout Europe. You know, even in the Middle East with Qatar and other producers there, down in Australia, obviously. So you can fill up your vessel if it's running...or if it's using LNG as your fuel source, you can fill it up anywhere. So that's a big component of what fuel will be used. So we have seen in the past probably year or so, and we'll see for sure continued ordering in using this fuel. Now, Wartsila and some other engine manufacturers are certainly building out their proficiencies in these LNG-powered ships. So I think that's gonna be over the next three to five years, certainly your focus on, kind of, hitting these IMO 2030 goals.

Now, if you ask me in 10 years, it could certainly go to hydrogen or ammonia, right, or battery-powered ships? Who knows. But I think we're at least 5 if not 10 years away from those. Just again, the infrastructure isn't there, the technological know-how isn't there, the cost of those vessels would be much, much higher. So unless you have a willing and able counterparty, like we've seen in the LNG fund where Shell says, "Hey, we need 10 LNG-powered VLCCs," and you have a handful of tanker owners say, "Okay, yeah, we'll do 2, we'll do 4, we'll do 2," you know, whatever the case may be, you have to have some very, very long-term charters with some guaranteed returns to go and build an ammonia-powered ship or a hydrogen-powered ship. And we think that's at least, like I said, 4 to 10 years away.

So we think LNG will be the focus in terms of asset classes. Got to be the biggest ships, right, got to be the VLCCs, gotta be the capesizes. We've seen it already on the very large container ships as well. So the big fuel-burning ships that are going to the big ports, right, the ones in U.S. Gulf, Singapore, Europe, the Middle East Gulf, Australia, where the LNG is, right, to, kind of, refuel.

Alex: But what do you think regarding the longevity of LNG as a solution, especially if you're thinking of the investment? So if you're investing in a dual-fuel LNG-powered vessel right now, and this is a considerable investment by any account, or especially for the big vessels, and then let's say in five years after your new built is delivered, you're facing with the problem of looking for another solution, maybe something more long term for longer decarbonization goals. Do you think people might slow down? Like, just looking at this and thinking about the slow down in ordering LNG-powered vessels and rather wait, run with scrubbers [inaudible 00:20:02.203] something else, until there is a better application of hydrogen or ammonia? Or you still believe there's gonna be quite an investment into LNG after all?

Randy: Yes and no. Like, I think most of the investment dollars will be in LNG. That said, I do not think there will be a big surge in new build ordering, right? At least for the next one to three years, just until people get a little more comfortable with IMO 2030, even IMO 2050. But again, that's 25 years away, even to order a ship next year, right. So even if you order a ship next year, it will certainly be gone by 2050. So the real focus will be IMO 2030. And until we get some more clarity and visibility around that, I don't really see a huge surge in ordering to get ahead of that. So that's why we're pretty constructive on the shipping markets for the next handful of years because the order book to fleet ratios are very low. There hasn't been much ordering, for all the factors we've discussed here, recently, in recent years. So that has really drawn down the order books. And that means that the supply growth over the next few years will be pretty low.

Will there be ordering? Absolutely. And I think most of that ordering will be on the LNG-powered ships, or at least eco-friendly, mostly with scrubbers, all of these things. But until you get some more visibility and some more certainty around the timing of IMO 2030, and other things, and maybe there's a new, like, global speed limit that gets put into place, and you can only go 10 knots or something like that. Obviously, that would be a drastic reduction in carbon emissions. Same thing in your vehicle, you know, if you're driving 70 miles an hour versus 50, you're using a lot less fuel burn. So because of those efficiencies, we do think there will be some slowdown of the fleet as well, which also would reduce the effective supply of the global fleets, which should be bullish for the shipping rates.

Alex: But here's the problem, right? So coming back to the beginning of our conversation, we have shipowners who are sitting on more cash than they used to not so long ago. And time and time again, we've seen throughout at least the last decade, even after like hard times and terrible earnings and everything looking super gloomy, you have been increasing rates for a while, slightly better forecast in terms of it can only go up. And at the same time, you're sitting on a bunch of cash. And times and times again, we've seen shipowners just going for a shopping spree. Yeah, no matter what it is. And that's why I wonder, it all makes sense what you say, but do you think that this psychological sentimental factor might just go in and play a role again, and we might see an increase in orders just from people having more cash than they used to a year ago?

Randy: Yeah, yeah, no, there's a few things. One is...you know, you say that, and that has certainly happened in the past. But there's a few factors that are certainly at play now that haven't been at play in the recent, kind of, supercycles of rates and of new-build activity. You know, shipyard capacity is lower now than it was 3 years ago, 5 years ago, 10 years ago. Access to capital, as you mentioned, is lower now than it was 5 to 10 years ago. You have this IMO 2030 uncertainty, you didn't really have that 5 or 10 years ago. And then I think the bigger thing is, you also have investors saying, "Look, don't buy new builds, go and buy secondhands." And you've seen this, right? You've seen this. We cover 30 different shipping companies in our coverage universe and I think, I don't know, 4, maybe 5 have ordered new builds in the last year, a lot have bought secondhand vessels. So you can still expand your fleet.

Again, going back to my point where the five-year asset value is at a big discount to the new-build price bigger than it's been in a long time. And those vessels are on the water immediately, right? You don't have to wait 18 months, 24 months to get it. So a lot of the expansion we've seen has been via secondhands. And then, especially on the public shipowners, people are looking for dividends now, share repurchases now again, which we've seen, again, out of the 30 names we cover, I think 5 or 6 started a new dividend in the last year that hadn't paid dividends in the last 5 years, right? And I think 17 of the 30 or maybe even 18 now have repurchase shares in the last 12 months. Again, something you didn't see in 2016 to 2019.

So it kind of shows that there is some capacity discipline, some constraint. Will there be ordering? Absolutely. But again, when your order book to fleet ratios are 10%, on average, currently, with the 5-year average at 15%, with the 10-year average at 20%-plus, yeah, I think the order books will take up a little. But again, a lot of that will be replacement tonnage. Look at all the vessels that were ordered in 2003, '04, '05, '06, '07, '08, right? So those vessels are about to be turning 20 years of age in the next 3 to 5 years. So a lot of those will have to...you know, they're inefficient, they're big gas guzzlers, you know, the design is far inferior to where current ship designs are.

So even if you do get that order book complete ratio getting back to 15%, which isn't huge, we also think scrapping could go up to 3% if not 5% per year, right. And that 15% order book is spread out over 2, 2-and-a-half years. So let's just conservatively say it's spread out over two years, that's 7.5% gross fleet growth. But if you're taking off 4%, on the scrapping, net fleet growth of 3.5%, that's fine.

Alex: Okay. But let's then circle back to freight rates themselves, right, to finish this up. Considering all that you said, and we, like, might see this discipline in the ordering and more scrapping potentially, we still have a situation where the demand in both tankers and dry bulk is still quite uncertain. We live in wild times, right, where anything can happen at any time, and recovery, for instance, in the world [inaudible 00:26:46.777] demand is not near the pre-pandemic levels yet. And when will this actually have a long-term sustaining effect on the freight rates? So are we gonna see some proper change in 2021 for tankers have sustainable growth or for dry bulk, instead of going up and down, again, having sustainable growth as fleet supply drops in growth and the demand recovers? Or are we talking three years, or five years?

Randy: Yep, we think it will be a gradual thing, right, with higher highs and higher lows. There will certainly and always be seasonality, right? So rates aren't just gonna go up and to right, you know, sequentially. Now, we think year-over-year, they could go up and to the right over the next handful of years. So we think the, kind of, rate stabilization happens this year, if not last year, right, following just the complete craziness, especially in tankers last spring. But we think rates, kind of, stabilize and just slowly and steadily keep improving. Now, there will be these, kind of, demand spikes that shoot rates up and then, you know, the market stabilizes and rates come back down. But just looking at, kind of, quarterly averages on year-over-year comparisons, we think the next, I don't know 12 to 16 quarters, the vast majority of those should be up on a year-over-year basis.

Alex: Great. Thanks, Randy. That was very insightful and a pleasure as always. And to everyone who listened, you can always go and check more episodes of "Weight of Freight," content series on Argus website.

Randy: Thank you so much, Alex. And yeah, if there's any other follow-up questions, audience can reach out to me, Randy Giveans, it's rgiveans@jefferies.com. So thanks again.

Alex: Thank you.