Marine Finance Rule #1

by Matt McCleery October 2009
Making sense of the highs and lows of the shipping markets requires, to a large extent, an insider’s understanding. But as Matt McCleery explains, rule number one in marine finance becomes clearer when a Greek ship owner and an Irish American publisher of maritime financial information meet in a New York hotel bar and the following conversation ensues…

“I am getting excited,” the gargantuan, unshaven Greek shipowner sang out as we sat in the 33rd floor bar of the Mandarin Oriental Hotel, staring across the leafless treetops of Central Park last February.

“What are you, sick?” I asked, my face probably contorted in disbelief. “How can you possibly be excited when a capesize bulk carrier has gone from being worth $130 million to being worth $40 million in a period of six months?”

It was hardly news that a five-year bull run for shipping, which began in 2003, collapsed in mid-stride in the second quarter of 2008. Capital, once abundant, had suddenly become scarce. Energy, once inadequate, had suddenly become oversupplied. Asset values, once limitless, were collapsing due to a lack of buyers. Demand growth, once exponential, had become downwardly linear — all at a time when the supply of vessels was increasing due to a record-sized order book. The party was over, the hangover was here, but the Greek was rubbing his hands together with excitement.

“That is exactly why I am excited. Rule number one,” he said. “Success in shipping is 99% the result of your cost basis in a ship. If you buy a good ship at an historically rational price and you don’t overleverage it, you always make money — it’s just a question of when and how much.”

“I thought ‘rational’ and ‘shipping’ were mutually exclusive. Are you aware of the fact that charter rates are lower than operating expenses?” I asked sarcastically.

“Oh,” he smiled. “You are speaking of cash flow? You Americans love your cash flow, but there is a fundamental problem with that.”


“Cash flow is just another way of describing credit risk — because it depends on someone else paying you — and credit risk is not something you want in the shipping industry.”

“Why not?”

“Because when cash flows are highest, ships are overvalued and the strength of counterparties is overestimated. So tell me, why don’t you want to buy an expensive ship?” he asked rhetorically.

“Because of rule number one.”


“But doesn’t cash flow pay down a ship, sometimes even bringing it below the historical average value?” I asked rhetorically.

“Do you mean cash flow from people like Armada, Brittania Bulk, Industrial Carriers, Atlas, Samsun Logix or the dozens of others that have defaulted? That type of cash flow?”

“Those are all dry bulk charterers.”

“The container lines are no better. Mattolaki, the only place where charters help you is in the tanker market where the counterparties are stronger, but even there the only time you want to lock in a charter is when you are using other peoples money and they foolishly require it.”

“You are not a believer in cash flow?” I laughed.

“No, I am a believer in taking on exposure to assets toward the bottom of the shipping cycle and that is where we are heading — and that is why I am excited and why you should be too.”

Karate Studios & Gorse
The story of the rise and fall of the shipping markets has become so mainstream that it’s getting a little boring. How mainstream? To give you an idea, my son’s karate teacher and our landscaper have both engaged me in substantive conversations on the virtues of trading DryShips options. The Baltic Freight Index has been dubbed the Baltic “Fright” Index on Wall Street and one fund client of ours believes that the Baltic Index is one of about five indicators that actually determine the direction of the global equity markets! (emphasis added). This is a far cry from the old days when investors used to ask us questions like, “Where are those Worldscale located and how the heck do you fit one of them giant boats on one?”

For those of you who had the good luck of not being long in the shipping industry for the last 18 months, here is the summary. I will go fast, not because it’s unpleasant for those of us who have been involved with the industry for the last 18 months, but because it’s largely irrelevant at this point. So here is what you need to know if you want to talk successfully about shipping in the gorse or at a karate studio:

Dry Bulk
Capesize rates went from $233,000 to $2,300 per day from June to December of 2008 — a 99% drop. The same vessel went from a value of $155 million to $40 million over the same period. It wasn’t just the capes that got slaughtered. A five-year-old panamax peaked during the summer with a value of $89 million before dropping to $38 million and handysize bulkers dropped from $53 million to $19 million. Two things to remember here: 1.) not everyone paid the high tick for every vessel, and 2.) the prices were ridiculously inflated at their peak.

Thanks to a lot of government stimulus and continued loose credit, industrial production and restocking in China has led to a greater amount of iron ore imports in 2009 than record-breaking 2008. As a result, the dry cargo market has strengthened considerably from the malaise of the beginning of the year with virtually all vessels generating revenue in excess of operating expenses. That said, at least 25% of the fleet will be delivered in the coming months and, as I write this article, China’s appetite may be waning.

Container Ships
It shouldn’t come as a surprise that the container market, which is the shipping sector most closely linked to consumer demand, has received a body blow. The Clarkson Index is currently down 75% from a peak of 171 points in April 2005 and players in that market note that the index has only stabilized at current levels because it approximates the breakeven point below which a shipowner would have a financial incentive to simply put their vessels into lay-up, which is precisely what many are doing.

According to AXA Alphaliner, ships in lay-up went from 210 in January to 303 in February to 452, or about 11% of the fleet, in March. The laid-up fleet is now closer to 15% and the orderbook for new vessels is huge. Thus far major liner companies, such as Hapag Lloyd, Korea Line, NOL, Hanjin, CMA-CGM, Zim, MSC, CSAV and others have been supported by public and private funds, but there it is no clear sense of how long this can and will last. Most container ship pundits don’t think there will be equilibrium of supply and demand until 2013, raising the specter of bankruptcy. Vessel values are now at an all-time low.

Oil Tankers
The tanker market had its second best year on record in 2008, despite the fact that the spot market went fallow in the fourth quarter. Rates started to weaken in the second quarter of 2009 and the industry is now in a full-blown depression. OPEC has reduced output, IEA and EIA have cut demand forecasts and the net fleet growth will be well into double digits in the coming couple years — so you do the math.

It looks pretty bleak. Ships that were worth $45 million last summer are worth $14 million today. As for rates, one tanker friend told me that all tankers are earning $8,000 per day, you can just pick your size. The longer this market remains weak, the greater the likelihood that shipping companies will fail and many believe the fourth quarter will be the beginning of the end for overleveraged borrowers.

Although most in the industry are crossing their fingers with the hope that a large percentage of the newbuilding orderbook will be cancelled, so far absolute cancellations have only been about 10% with another 20% of the orderbook pushed to a later delivery date. Moreover, the governments of Korea and China have implemented stimulus programs, by encouraging corporate lending and providing export-type vessel financing, in an effort to control unemployment associated with shipyards.

Probably the biggest wildcard in the outlook for asset values revolves not so much around the supply of, and demand for, oceangoing transportation. Over time, this will rebalance. It always does. The real wildcard is capital cost and availability. Who will provide it? Will there be enough to absorb the $500 billion orderbook? Or, more pointedly, how cheap will assets have to get in order for shipping to attract the required capital? And can assets reflate to historical levels in a world with a historically inadequate amount of cheap capital?

Commercial bank debt, until 12 months ago a seemingly endless and deflating commodity, has become scarce in 2009. And bank debt is fundamentally important to shipping economics and capital structure. Not only does it account for more than 80% of the $250 billion of capital that is formed each year, it is also the “bedrock” of low cost capital upon which virtually all other types of ship finance relies — 
specifically leasing, public and private equity and bonds.

Single investor, unleveraged shipping leases have never been competitive and it’s unlikely that a private equity fund will hit its hurdle rate on an unleveraged basis unless ships get really cheap — off the charts cheap. Of course, when ships get really cheap, there is unlikely to be any cash flow, which is pretty unappealing to all but the bravest investors but “exciting” to rule number one guys like my Greek buddy. Bonds are like gin: magnificent when diluted with something less toxic, in a ratio of one to five.

So where is the opportunity to invest in shipping? And why is the gargantuan Greek reclined across the table from me so excited? We believe the opportunity to invest in this particular market cycle resides in the Asian shipyards. Here’s why: thus far, sale and purchase activity of secondhand ships has been relatively flaccid. Banks have yet to foreclose on owners because with many loan balances in excess of asset values, there is no real incentive for anyone to do anything but restructure loans so that they can be deemed to be performing. Moreover, most financing that is in place on existing ships is so much cheaper than whatever fresh financing a new buyer could come up with, that vessels are actually more valuable to their current owners than to their prospective owners.

However, shipyards, which are not in the business of owning ships (at least not by choice), are in possession of a multitude of ships that have been orphaned by the companies that originally ordered them — either because the deposits paid to date are less than the decline in the value of the asset, or because the buyers simply do not have enough cash to take delivery.

For established shipping companies, particularly those that currently have a substantial order book of vessels, there are opportunities for converting ships types and changing economics. But for outside investors that team up with shipbrokers that are close to key shipyards, there will be plenty of opportunities as well. Take, for example, Mallory Jones Lynch and Flynn (MJLF) in Stamford, CT. This leading shipbrokerage house identified the importance of newbuilding ten years ago and hired a former employee from Samsung Heavy Industries. Today, they have three former shipyard representatives from Korea and have built a powerful newbuilding franchise unmatched in North America and equal to any ship brokerage in London. In the past two years, they have secured over $7 billion in newbuilding contracts for their clients.

Since October 2008, however, the game has changed and the shipyards have shifted their focus from newbuilding contracts. The team at MJLF has been working with the shipyards to maintain current contracts, renegotiate terms and find new, hidden buyers for ships that have been defaulted on by the former owners. Also, in sync with the trend of new and interesting circumstances that this financial crisis has brought, the brokers at MJLF are supporting the yards by offering employment options for vessels until the asset prices return to acceptable levels.

The shipping markets are weak, but so what? This is just another time-hewn cyclical shipping downturn. Yes, this cycle was magnified with the extraordinary demand created by China, the global asset bubble and loads of available capital, but in the end it is always the same. Strong demand leads to high charter rates, which lead to increased investment, which leads to high value for ships in the water, which leads to people ordering “relatively” cheaper new ships in the future, which leads to new capacity, which invariably arrives when the strong demand has cooled off causing asset prices to collapse — and that’s when the smart money, like my Greek friend, create the real value by following rule number one.

Matt McCleery is the president of Marine Money International, managing director of Blue Sea Capital, Inc and non-executive director of oil tanker owner Omega Navigation Enterprises, based in Athens, Greece.

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