Despite this position, the sector remains the most cost-effective means of global transport and therefore further shakedowns to optimise the industry are inevitable in both the immediate and longer term; the sector continues to be highly fragmented and therefore ripe for structural improvement. We have witnessed a number of companies in distress in the past 12 months, including a series of high-profile Chapter 11 filings, and this trend is likely to continue.
In 2008, there was a sudden reversal of an underlying trend of growth within shipping over many decades. That growth was to an extent due to the increasing capacity and efficiency of vessels and ports – a factor that continues to create obsolescence across older fleets – but also due to the increasing significance of growth economies, particularly China. But international sea trade volumes contracted by some 4.5% (and total goods loaded decreased to 7.8 billion tons) in 2009, catching many sector participants off-guard.
Since then, growth has been slow. In 2012, we’ll struggle to see 2.5% overall world growth – even with the help of the Asian economies currently at 5%. Asia itself is set for a slowdown and in any case it is rebalancing towards consumption rather than production for export.
This pattern of continued economic depression is exacerbated by falling margins for the shipping industry – particularly through increased bunker oil costs (over 6% increases for 2012 alone). Add in greater competition through increasingly advanced vessel capacity and efficiency, plus burdening regulation, and it’s enough to see some operators going to the wall. Meanwhile, the specific challenge of long-term capital and finance issues in the form of fleet management overcapacity and the recipe for some will continue to lead to distress and wind up.
Of all these factors, overcapacity is the most significant in limiting the recovery of the sector. There is a further complication that the type of tonnage predominantly on order or most recently put into service is of the ultra-large variety, thereby constraining the operating flexibility of carriers. Since 2008, capacity in the global fleet has grown by 36% during a period when world demand volumes increased by only 9%. Although this factor hasn't affected all segments – tanker, dry bulk, container – equally, most are struggling to cope with the excess tonnage.
The increasing tendency for many owners is either to lay up their vessels to await more favourable economic conditions – over 10% of the global fleet is currently laid up – or to take advantage of relatively high scrappage values. Scrapping increased by 40% during 2012, and while the volume still represents less than 3% of the world fleet, it should help to inject new life into the sector despite the challenges to owners from early write-offs. Of course, the underlying issue with asset redundancy and write-off is the underpinning finance. Global ship financing along with asset financing in general has been severely affected by the disruption to the financial markets and the European debt crisis.
This situation in combination with low freight rates, high bunker oil prices and declining asset values will present significant credit challenges to all shipowner businesses except those with robust balance sheets. The net effect will threaten shipowners' ability to take delivery of their new vessels or to place new orders, and therefore many will be postponing or cancelling newbuilding orders.
With around $1.5bn of syndicated loans due to mature over the next three years, the path to refinancing existing debt is unclear for many. It is extremely unlikely that individual lenders will take on these positions, and the inherent complications presented by restructuring syndicated finance to suit all stakeholders in this economic climate will mean that some operators will lose out on refinancing and face insolvency, while most others will at best be presented with protracted and potentially complex negotiations ahead.
With excess capacity also comes falling time-charter, spot rates and operating margins. Many are now operating at close to or below 'break even' and those with shallower pockets in the form of impoverished balance sheets and limited access to working capital finance are already facing severe financial difficulties. In early 2012, the Clarksea index (the Clarkson Research index for shipping rates) fell by 35% to below $10,000 per day and this trend is likely to continue – at least in the short term and particularly in the bulk carrier market.
The pressure on liquidity for operators is exacerbated by the extreme economic conditions influencing the lending patterns for the traditional sources of maritime debt – European and Scandic banks. All are seeking to protect and limit their exposure to ship loans and many are exiting the sector altogether.
In the current depressed climate, the key issue for most owners is to establish an operating model that minimises the ongoing threats of contraction and suppressed margins while looking for more drastic means to combat oversupply. Already, the aggregate operating losses in 2012 for the world's major container operators runs into billions of dollars.
Most will have already made significant cuts to achieve some operational buoyancy, but this is unlikely to be sufficient given the long-term bleak forecast for the sector – and more can be done to address direct variable costs such as fuel procurement, terminal handling, feeder ships and support transport. Undoubtedly, those with more sophisticated management and access to improved information about the business will be able to outperform others through superior decision making and contracting, but again this will only go so far.
Laying up vessels is already a strategy for most, but this can only be done in consideration of the full costs of doing so and with regard to the fixed costs that prevail whether ships are in service or not. As noted above, early scrapping is another option, but will be resisted by many lenders who would clearly prefer a discounted return on loans to a significant write-off of secured assets. On the plus side, those lenders who do have significant exposure within the sector will be looking to work more in partnership with owners.
With limited alternatives, it is in lenders' interests to help management teams find the least damaging solution to a distressed position – avoiding expensive restructuring and administration costs where possible. This will mean operators needing to sharpen the quality and timeliness of management information used as the basis for reviewing the current and projected profits and cash flows of the business. Lenders know that many operators are unaware of the true bottom line cost of business and contracting decisions, and are looking for steps to restore confidence that managers can run their businesses more professionally.
Additionally, there is scope for service differentiation within the industry to achieve superior returns from what is otherwise purely commoditised transportation. Some operators already work in alliances – particularly to achieve operational or procurement gains – and this is another tactic to be pursued to the maximum.
As mentioned in our opening comments, there have been a number of recent high-profile Chapter 11 filings in the industry. This and other administration options can seem attractive to vessel owners looking to protect the business from its creditors and trade through the downturn, but the costs and consequences of such action need to be fully understood before pursuing that path.
Applying to the US courts for Chapter 11 bankruptcy protection can be achieved relatively easily for those with US banking facilities or recent trading activity in the US. High-profile filings such as Oversea Shipholding Group (OSG), Omega Navigation, Marco Polo Seatrade and General Maritime Corp have paved the way for other vessel owners. This process can be conducted with the consent of bankers and offer a route to a better 'consensual' negotiation than had previously looked achievable. But the process can be costly, with associated legal and professional fees often running into millions of dollars, and it can require Debtor-In-Possession funds provided as an additional facility to the original principal debt.
The situation facing lenders to the shipping industry is well documented. With depressed rates and falling margins for most operators, many businesses are cash strapped and unable to meet their debt obligations. In regular market conditions, the typical options would involve asset repossession and restructuring of either or both the portfolio of financial support and the business itself. In the shipping industry, however, these are options are not as straightforward as first seems and lenders will need to work closely with management teams and their professional advisers to develop the optimum solution for each business.
This is largely because on the operational side, the costs of restructuring are unlikely to bear sufficient gains to offset the cost of achieving the change, and on the asset financing side, the repossession and attempted sale of assets in a market with depressed resale values and oversupply of new vessels is likely to result in exacerbated losses that are in the interests of neither the owner nor the lender.
Additionally, although Hapag-Lloyd and Hamburg Sud have announced they are exploring a merger – and that deal has been far from plain sailing – the scope for consolidation in the industry is limited. Aside from the naked asset values, most shipping businesses have little by way of intrinsic goodwill to attract premium returns on sale and the much needed rationalisation of the industry is likely to be stalled until operating returns are more attractive.
In terms of options available to lenders when faced by customer businesses in distress, some operational restructuring will work for those businesses that are capable of achieving further optimisation but the costs of doing so – eg through new management and systems – must be carefully considered first. Even then, it is highly likely that such changes will not restore profitability –but they maybe stem excessive losses, stabilise the operation and allow for more in-depth action to be taken.
Such action could involve restructuring debt, but the current options are limited given the financial downturn. Most likely, lenders will realise that given the poor long-term prognosis for the sector, the better option is to stay close to management and weather the storm of underperformance while recommending improvements to operations and management.
As always, lenders need to establish a strong position of leverage relative to owners and operators and be prepared to act early when they see opportunities to protect their balance sheet from preventable losses. For businesses eligible to file for Chapter 11 bankruptcy protection from the US courts, there may be value in working with vessel owners to achieve protection until longer term financial solutions can be established, but the process can be hugely expensive. Elsewhere, other potential providers of capital – such as private equity – have been watching the sector with some interest, but whether this materialises into a viable solution for the capital shortage remains to be seen. It will all boil down to whether asset values fall further and the level of returns PE houses believe can be delivered in the medium term.
The future for the shipping industry will undoubtedly involve consolidation and an industry-wide overhaul to operating and business practices – particularly in the management of the volume and shape of capacity and the requirement for more sophisticated planning and decision making. Such changes are unlikely to be achieved in the short to medium term, however, as the earnings performance for most operators is dire and set on a course to continue for many years ahead – certainly until the current position of oversupply is rectified. The investment or exit strategies for both operators and lenders are limited in these circumstances.