Shipping is a fickle business. Investors who have been burned in the past argue the sector is too distressed to be profitable due to oversupply and lack of demand for container and bulk vessels over the past few years. In particular, alternative-asset investors have had a difficult time selling container ships even at relatively low prices.
It can take years for the shipping cycle to turn and for investors to see their money back. Catching the right window of opportunity, therefore, is key.
One niche sector within container shipping with a particularly attractive risk-return profile is the feeder container ship segment — smaller-scale vessels with a capacity of 1,000 to 3,000 TEUs, or 20-foot equivalent units. Prices for second-hand vessels are at a significant discount to newbuilding parity — greater than 30 percent — meaning the price for a 10-year-old second-hand vessel is more than 30 percent below the implied value of a new ship after 10 years of depreciation. Many distressed sellers, mainly European banks with capital tied up in shipping that need to offload to comply with the regulatory capital rules under Basel III, provide the opportunity to acquire vessels at such attractive rates.
The high number of undervalued assets on the market for sale at low prices coincided with a market situation in which the feeder segment started its recovery because of low supply and high demand growth for these vessels. Liner companies have focused on building larger vessels instead of feeder vessels, and the industry has moved to scrap older, less-environmentally-friendly vessels. At the same time, intra-regional container trades with high-demand feeder vessels are seeing strong trade volume growth.
Considering the healthy market expectations going forward, feeder vessels have never been cheaper.
DISTRESSED SELLERS, COMPETITIVE PRICES
European banks were lending at record levels to the shipping industry before the global financial crisis. In fact, European lenders had a total of $375 billion in shipping, according to Petrofin Research. At the time, Germany, the biggest lender in the shipping industry, had loaned $154.4 billion.
Then the shipping market crashed along with the rest of the global economy during 2008–2009.
The crash, combined with European Central Bank (ECB) capital requirements, meant lenders were pressured into quickly offloading as much capital-intensive investment as possible to comply with Basel III banking regulations. Total European lending to the shipping industry dropped to $221 billion in 2016.
The pressure on European lenders, especially German banks, to free up capital is likely to continue. Only this past year did the ECB announce plans to focus on banks’ shipping loans. Banks are under more pressure than ever to sell risky shipping investments.
The distressed selling of vessels and the lack of capable buyers means second-hand vessel prices are at historical lows. Those that are able to buy inexpensive, quality ships will be poised not only to buy low and sell high, but also to generate revenue by chartering out tonnage at increasing rates.
BUYING FEEDERS FOR THE WIN
Investors who are able to buy feeders at these historically low prices are in an advantageous position due to the expected shortage and high demand. In general, the container shipping industry is recovering from its prolonged downturn, thanks to a strong global economy and moderate growth of the total fleet capacity in recent years.
In the feeder container sector in particular, ordering of new tonnage has been very low in recent years because container liner companies have focused on building increasingly larger vessels to reduce unit costs on long-haul routes between Asia and Europe.
The deployment of large vessels that cannot enter smaller regional ports has, at the same time, supported the growth for feeder services from larger hubs to smaller ports within the different regions. As a result, demand growth in intra-regional trades — e.g., intra-Asia — has outpaced other trades in the industry and is expected to continue to do so in the future, further supported by trade generated through demand from growing middle classes, particularly in Asia. About 75 percent of feeder vessels are deployed on intra-regional trades and, therefore, benefit strongly from these developments.
The risk for feeder vessels to be replaced by larger vessels in the intra-regional trades is limited. In addition to the physical restrictions of port size and infrastructure (only smaller vessels are equipped with cargo cranes needed in less-developed regions), there are commercial restrictions as well. The intra-regional trades are characterized by a large number of port calls in relatively short time periods, making the use of larger vessels uneconomical, as they require more time to load and unload containers in the port.
Besides strong demand and low newbuilding activity, the aging fleet of feeder vessels provides another reason to expect a shortage of feeders by 2020. The feeder fleet includes a high number of vessels reaching the end of their expected lifetimes over the next few years. In addition, new regulations such as the International Maritime Organization’s limit on sulfur in fuel oil used on board of vessels might result in accelerated scrapping of shipping vessels, including older feeders.
The upside for new feeder owners is they are able to charter vessels to liner companies at rates that are expected to increase significantly based on the supply/demand imbalance.
Liner companies charter about 50 percent of their operating fleet to maintain flexibility with regard to changes in demand and trading patterns. Additional reasons liner companies rely on chartering vessels are balance sheet restrictions and their investment requirements for very large vessels, container boxes and digitalization, among others. Hence, a long-term business opportunity exists for companies with a strong balance sheet and access to capital to act as a container tonnage provider for liner operators.
REAL ASSET VERSUS EQUITY PLAY
Not all is well in the shipping industry, however. At any given time, trade wars could shake up the industry or the shipping cycle could turn. However, intra-regional trades and demand for feeder vessels would not be subject directly to the impact made by import tariffs. It is mainly the longer-haul route segment, such as between Asia and North America, that could be hit hard by the potential tariff war. Changing trade patterns are more likely to affect feeder vessels to an extent that is harder to forecast. Feeder investments are a niche real-asset sector that requires support from partners experienced in the industry. Investors that require more liquid investments might turn to equities as a viable option for exposure.
Constantin Baack is CEO of MPC Container Ships.