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Outlook 2014: Smooth sailing or stormy seas?

Shipping would appear to be a good investment for pension funds. Ships are expensive, take years to build, last a long time, and earn income from moving about 90% of the world’s traded food, energy, minerals and consumer products around the world. The sprawling ports at which they dock would seem to be well worth investing in as well.

As well as allocating to specialist shipping fund vehicles, some pension funds have invested in the shipping and global trade sector directly, typically through infrastructure or private-markets allocations. The Ontario Municipal Employees Retirement System (OMERS) moved into shipping before the cycle bottomed, through its private equity arm’s 2011 purchase, for $520m, of V.Group Ltd, the market leader in outsourced ship management, crew provision and marine services, which manages more than 700 vessels on behalf of owners. In late 2013, Finnish pension insurer Ilmarinen formed a company with the Finnish National Emergency Supply Agency to buy up to eight tankers in a transaction to ensure the country’s energy supply.

For pension funds the critical decision is which, if any, sectors of the industry fit their specific investment criteria, taking account of the unique supply-demand factors found in major segments like container ships, tankers, and dry bulk carriers, as well as opportunities emerging in shipping energy products stemming from the natural gas boom.

The major distinction in ship investing is between commodity haulers and the container ships of integrated freight lines, says Marcel Saucy, senior partner at shipping investment specialist Fincor Finance, whose firm is forming a private equity fund that will initially target medium-range product tankers, which Saucy says is the first sector that’s demonstrably in an upswing.

Container shipping lines are the better-known, and they typically operate with a more traditional corporate business model, including brand-name differentiation through advertising, long-term contracts with industrial and consumer product manufacturers, and intensive efforts to add value with logistics services that ensure the reliability demanded by such customers.

“Apple is much more concerned about which ships its products are sailing on,” as Saucy puts it.

Commodity shipping is not differentiated by brand name, there is a limited number of charter customers, and the suppliers – typically oil companies, oil traders and commodity producers – are well-known to the users. As long as the shipowner meets price levels and safety standards, transactions are done. But pricing can be extremely volatile: the fortunes of capesize ships, among the world’s largest, are tightly linked to China’s growth and the consequent demand for steel, iron ore and energy. In September, rates moved from as low as $15,000 per day to more than $42,000 per day, ending the month at about $35,000 per day, according to shipping consultants RS Platou and Frachtcontor, reflecting renewed strength in expected Chinese import demand.

And yet one of the most active pension funds in the sector, the $130bn Ontario Teachers Pension Plan (OTPP), sees these assets as part of a multi-billion dollar infrastructure and timberland portfolio that is “designed to generate long-standing, stable returns to pay inflation-indexed pensions” – a natural fit with the fund’s long-term liability structure. The reason is the diversity of its logistics assets. The longevity of shipping port revenue streams, for example, do seem particularly suited to this requirement. Vancouver Fraser Port Authority recently granted GCT a 50-year concession at Deltaport, for example - few assets offer such a time horizon.

Integration
OTPP declines to provide a detailed asset allocation for holdings in the sector, citing the increasing competition among institutional investors for high-quality supply-chain assets. It missed-out by the proverbial razor’s edge on a bid for Port Botany and Port Kembla in New South Wales in 2013, to a group including Abu Dhabi Investment Authority and Industry Funds Management. But the fund’s holdings span the global shipping and logistics chain: SeaCube Container, a global leader in container construction and leasing; Dematic, a specialist in logistics for factories and warehouses; and a group of port terminals held through GCT, a joint venture with a major Chinese shipping family.

Reflecting the increasing integration between shipping and ports, the fund in 2007 formed a partnership with a Chinese family-controlled shipping company, Orient Overseas (International) Ltd, to acquire three ports, TSI Terminal Systems Inc, New York Container Terminal, and Global Terminal & Container Services. Orient Overseas (International) is a holding company with interests in international transportation and logistics, property investment and property development; it’s also the parent of Orient Overseas Container Line, one of the world’s leading container transport and logistics service providers.  Members of OTTP’s private markets and infrastructure groups sit on the board of the new entity, Global Container Terminals, which operates four container terminals with long-standing berths in thriving markets: Global Terminal & Container in Bayonne, New Jersey since 1972, New York Container Terminal on Staten Island, New York since 1955, and TSI in Vancouver and Delta, British Columbia, since 1907.

Ontario Teachers’ broad holdings reflect how shipping is becoming increasingly integrated with other links in the global supply chain, a trend that’s driving reduced volatility at the top end of the shipping market. It’s also leading to a stark divergence in financial performance between large and small carriers, which became apparent when AP Moeller-Maersk reported surprisingly strong second-quarter earnings last summer, says Robert Joynson, a container shipping analyst at Macquarie.

The aqua ships of its Maersk Lines container business make it the world’s best-known shipping name, and perhaps the only real ‘brand’ in the sector. The single largest company in the industry, Maersk achieved scale economies its competitors can’t match by adopting slower steaming speeds, which enable its mammoth ships to load fuel for the Pacific Ocean crossing at low-cost Russian fuel depots instead of in China. “This gigantic jigsaw puzzle has implications for port schedules, customers and logistical chains on a global level,” says Maersk in a company presentation. The implications for financial performance seem clear. Maersk is on course to earn a 10% return on invested capital, while smaller shippers will struggle to get above breakeven.

Though Maersk surprised to the upside, its results were mainly from cost reduction, and the ongoing softness in container shipping took a toll: Maersk has temporarily relaxed its ROIC target to 8.5%, in order to incentivise managers hit the mark without resorting to price-cutting.

Soft pricing remains a threat in the container sector, says Joynson, noting that expectations of a 4-5% volume growth rate per annum are proving higher than the 3% rate that appears likely for 2013. Coupled with ongoing excess capacity and firm new ship orders, Joynson says a deterioration in conditions seems more likely into 2014. He cautions that container lines could increase vessel speeds if industry profitability improves – for argument’s sake, by about 2016 – which could bring significant capacity back to the sea lanes.

As Saucy reminds us, the biggest risk is the basic structure of the industry itself. “Shipping cycles are not driven by demand,” he says. “The over-riding factor in shipping cycles is the growth rate in the supply of ships.”

Struggling
Potential investors overlook this fact at their peril. It’s important to enter shipping markets fairly close to the bottom of a cycle to have a margin of safety against overbuilding, says Cato Brahde, managing director at Tufton Oceanic and manager of its Oceanic Hedge Fund, which has nearly $2bn in assets and a track record going back to 2002. Despite the promise of port and logistics investment, at journey’s end there remains the history of shipping investment: Tufton studied shipping cycles for the past 100 years, says Brahde, and every cycle ended with a negative return on capital.

Brahde says that the latest shipping cycle began soon after China entered the WTO in 2001. As global trade volume increased on the back of that, shipping companies ordered ships: by 2008 inventory under construction swelled to a level that would take up to four years to deliver, ending in a predictable impact on ship prices and shipping rates. From 97% in 2007, global fleet utilisation dropped to 75% by 2013 – even as global trade grew by 5% per annum. Fleet expansion of 40% devastated the economics of shipping.

Oversupply can harm even large players. On the downside from the last peak in 2008, Malaysia International Shipping Corp exited the container business in late 2011, citing high operating costs and the need to invest in ever-large ships to stay competitive at a time of depressed freight rates. MISC had lost nearly $800m over the prior three years, cut its Far East-Europe service and retrenched to intra-Asian routes in an unsuccessful attempt to save the business. Today MISC concentrates on its original energy shipping business.

The bottom line is that container ships are hard to sell because a struggling line usually has to sell ships when demand is weak, and competing lines are not interested in adding to capacity, don’t have the financial resources to buy more ships, or both.

Still, at the moment, says RS Platou, fleet growth appears to be slowing: the firm expects 2013 deliveries of 60m dwt of ships and scrapping of 20-22m dwt to yield 7-8% fleet growth; and 2014 deliveries of 40-45m dwt against scrapping of 15m dwt to produce a 4% fleet increase.

“There’s clearly upside to owning the ships now,” says Brahde, who expects a favorable environment for the next three to five years.

 

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