Maritime industry adapts to the new commodity market

China's economic growth has been a major factor in the expansion of both global trade and the maritime industry in recent years. So the shipping industry has reason enough to be concerned by the drop in China's rate of economic growth, which has heralded the end of a decade-long commodity "supercycle" and overcapacity in the industry. What does the future hold for the maritime sector?

There is general consensus among economists that the decade-long commodity super cycle drew to a close at the end of 2014, due in large part to the slowing of China's economic growth. The cycle's demise was triggered by the fall in the price of oil as well as declining prices for many other commodities that have been trending south for some time, at least since global prices peaked in 2011.

Gross domestic product for the three Asian powerhouses in Q4 2014 saw China drop to its lowest level in 24 years, at 7.3%, while Japan at 2.2% and South Korea at 2.7% both struggle to maintain positive sentiment. Even so, three of the main maritime sectors - dry bulk carriers, crude oil tankers, and container ships - all show growth. The LNG fleet is forecast to show a greater degree of volatility.

As the global economy settles into a new slower growth environment, questions emerge as to the ability of the international maritime industry to respond in a rational manner. IHS forecasts suggest that, given the large volume of commodities carried by sea, the long-term outlook for shipping remains healthy. Short-term interruptions to the smooth flow of trade are part of the business of shipping and can be confusing-which explains why ship owners' fortunes appear so bleak at present-but should not drive long-term investment decisions. Developing a new maritime psyche based on long-term strategies may be the best response to the brutally cyclic commodity market.

Several factors influence global trade. The recent slide in the price of oil has had a direct impact on the cost of fuel and industry charterers have responded by reducing freight rates accordingly. Ship owners have not been able to benefit in the long term. Owners responded to the earlier high fuel price by cutting service speed-referred to as slow steaming-however there is little appetite for increasing speeds despite the lower price.

Neither the benefit of lower fuel prices nor slow steaming can counter the most damaging aspect of the maritime business: overcapacity. This is the natural consequence of ship owners' tendency to seek opportunity to expand in good times-including investment in newbuilding or second-hand ships-even when experience would advise caution.

Given the capital-intensive nature of shipbuilding, and the lead times required to bring a new vessel into service, ship owners are almost inevitably behind the curve when it comes to responding to opportunities brought forth by rising demand. It's akin to driving a car by looking in the rear-view mirrors. The challenge is to accurately forecast demand several years into the future.

This herd mentality-or the fear of missing out-leads to overcapacity, an enduring feature of shipping. Occasionally, as a consequence of conflict, closure of a port or canal, or an outstanding new business opportunity, ship owners with the right ships at the right place in the right time can generate astonishing profitability.

However, leaving aside these once in a lifetime chances, shipping usually operates in a world of marginal profitability and suffers when competition provides more ships than there are cargoes. Exposure can be spread by investing in a fleet that includes large, medium, and small ships on spot and period charters, and in some cases operating ships that cover dry bulk, crude oil, and refined products carriers.

The international nature of the business of shipping brings challenges of its own, with owners located on the other side of the world having a different appreciation of business risk. The common thread is the need for business intelligence at an increasingly granular level. Shipping has traditionally worked through a network of contacts gathered over many years; with the support of advanced analytics, this network can more quickly identify opportunities.

Calibrating capacity

The growth of China's GDP has been an unprecedented experience. In 2007 the country's economy grew by 14%, but then decelerated from 2008 to 2014 slipping from a growth rate of 9% to 7%. Nevertheless, growth remains positive. IHS forecasts that trade in iron ore, metallurgical coal, and liquefied gas all show growth between 2015 and 2020. Indeed, Shanghai's container throughput hit 3.16 million in January this year, a year-over-year increase of 5.3% despite the weakening Chinese economy, according to HIS.

China's dominance in the import of iron ore has stimulated the development of new ports in three southern hemisphere countries and has led to the construction of the largest bulk carriers ever conceived. In 2004, China imported a little over 200 million tonnes of ore, more than half of which came from Australia. Within five years the volume shipped had passed 600 million tonnes, and by 2014 it pushed past 900 million tonnes. Australia now accounts for almost three quarters of the ore shipped to China.

There have been other winners and losers. Indonesia has built a strong trade relationship with China. The emerging Southeast Asian economy has expanded its met coal trade with China from just over 1 million tonnes a decade ago to almost 50 million tonnes in 2014. However, Brazil's share fell from 34% in 2004 to 22% last year, and South Africa's slipped from 8.2% to 5.7% in the same period.

Chinese imports of metallurgical coal have grown from 16.7 million tonnes in 2004 to 100 million tonnes in 2009 and rising to 240 million tonne in 2013. Australia's share has grown steadily from 32% (5.3 million tonnes) in 2004 to 46% (94.3 million tonnes) in 2014.

China's demand for crude oil has surged since 2004, with imports growing from 6% of the world total to 16.5% in 2014. Combined with Japan, South Korea, and other expanding East Asian economies, the region now accounts for almost 46% of the world total crude oil import, compared with shrinking imports by the European Union (11.1%) and the United States (13.8%). The Middle East now accounts for about 50% of Chinese crude oil imports.

Meanwhile, China's imports of LNG have expanded from 6.5% of the 2004 world total to 22.6% in 2014. Forecasts suggest China will overtake the import total of heavyweights Japan and South Korea in 2020 to plateau at 35% in the following five years while its Asian rivals' LNG slip. Even for liquefied petroleum gas, the growing market share of China and its East Asian neighbours seems inexorable. With a share of total imports in 2004 of 43.3%, the current level of 49.5% is expected to stabilise at 48% by 2020.

For the global trade in iron ore, metallurgical coal, crude oil, LNG, and LPG, China's economic expansion has changed not only the volumes shipped around the world but also the direction of trade. Ten years ago, crude oil shipments to the developed economies of North America and the European Union accounted to 40% of the world total; in 2014 the combined total was 26%, and it is forecast to slip below 25% by 2016. Large tankers emerging from the Persian Gulf used to set course east for Asia and west for Europe and the United States in equal numbers: now two-thirds head for Asia. Ten years ago, iron ore shipments to China, Japan, and South Korea stood at 290 million tonnes, 64.6% of the world total; today the combined total of 972 million tonnes is a massive 86% of the global trade.

While trade in the major commodities has focused on East Asia, the sources of supply have become concentrated on two or three major exporters and five or six minors. This has significance because of the shortened distances involved, and therefore the reduced ship capacity required. The long-haul ore route linking Brazil's Tubarao port with Qingdao in China is 11,200 nautical miles, taking 33 days at service speed; Saldanha Bay in South Africa to Qingdao is 8,000 nautical miles and takes 24 days. The distance from Port Hedland, Western Australia, to Qingdao is just 3,500 nautical miles and takes only 10 days. Indonesia's Balikpapan coal terminal is even closer: 2,700 nautical miles from Qingdao, just eight days' steaming.

The new normal

While strong growth was the norm from 2004 to 2014, the rate of expansion was not consistent: signs of weakness were evident in 2012 and 2013. Many investors had argued that a spectacular expansion was unsustainable in the long run, so a managed decline in the rate of growth would ensure stability over the longer term. Dry bulk trade remained strong, fuelling crude steel production levels that remained close to historic highs. Daily steel output of 2.2 million tonnes requires an iron ore import volume of 3.3 million tonnes every day, carried in 18 Capesize ships each capable of lifting 180,000 tonnes of ore - day after day.

Certainly for Chinese steel manufacturing there has not been a dramatic downturn in output rapidly reducing the demand for vessel capacity. And yet charter rates for Capesize bulk carriers in Q1 2015 stood at little more than $4,000 per day, hardly enough to cover the cost of operating the ship. Low iron ore prices on the world market have improved profitability for local steel mills, but there is no demand for a steep increase in production of steel.

Year-on-year growth in trade for China, Japan, and South Korea in 2015 is forecast to be 4.5%, 2.3%, and 2.2% respectively, falling to 3.7%, 0.96%, and 1.6% in 2018, according to IHS. Even so, the shipping industry believes continued low demand growth is the chief cause of very low profitability. One London shipbroker observed in March that "demand [for iron ore] is insufficient to create profitable freight rates." However, IHS data suggests the real cause lies not in demand for ship capacity but in supply.

In 2013, spurred by an improved projection of trade volumes, dry bulk freight rates rallied. Ship owners responded by signing contracts with shipbuilders - many in China itself - for newbuilding Capesize carriers. About 140 of these ships are scheduled for delivery in 2015, for an active fleet of about 1,600 ships. Few Capesize vessels are expected to be recycled in the Indian Subcontinent as prices offered have plunged over the past year. In spite of trade volumes remaining at a high level and even though many iron ore cargoes are available for shipment to China, the increasing number of Capesize ships is the reason why charterers are under no pressure to lift charter rates.

This is the story of the dry bulk shipping market in the second half of the decade. Of a total 6,251 merchant ships on order, approximately 940 bulk carriers of more than 10,000 deadweight tons (dwt) are scheduled for delivery in 2015-2016. These will add capacity despite weakening demand from China and other major importers, which can only dampen freight rates. No wonder shipping companies' annual reports are anticipating another challenging year ahead: not because the decade-long dry cargo supercycle has come to an end but because the supply of shipping capacity has exceeded demand.

One possibility would be for a significant increase in the number of ships sold for recycling. This would have to be on an epic scale - about 50 million deadweight tons, a level never seen before in the dry bulk sector, would have to be removed from the existing fleet to balance the 70 million dwt of dry bulk capacity scheduled to be added this year. A 0% growth in the fleet would pave the way for improved charter rates in 2016 or 2017 if the forecast weakness in China's imports of ore and coal is accurate.

The tanker sector has been unsettled by increasing shipments prompted by lower prices of Brent and West Texas Intermediate crude oil, and now half the trade moves towards the East Asia region and away from shrinking demand in the US and European Union. Some relief was offered by the prospect of a small fleet of large tankers removed from the trading lists to store oil in the hope that prices for delivery in the future is higher than the price on the spot market. Reports in January suggested that floating storage had reached 25 million barrels held on 12 very large crude carriers.

IHS Maritime and Trade's newbuilding ships orderbook has 773 tankers on order of 10,000 dwt or bigger, 95of which are very large crude carriers (VLCCs). With Asian demand remaining healthy for the next two or three years at least, according to WTS forecasts, it is perhaps surprising yet encouraging that vessel owners have not rushed to shipyards in Asia to place orders. This restraint across the tanker business has been supported by the sale for recycling of older, less fuel-efficient ships, especially in the Suezmax and Aframax sizes, which have a wider trading range than the VLCCs.

Richard Clayton is chief maritime analyst, and Dalibor Gogic is principle analyst, both with IHS Maritime & Trade