Shipping’s Long Game

Overview

During 2009-2018, shipping was defined by a massive bear markets which saw fleeting bull runs.

But shipping is highly cyclical. This cyclicality hit a tipping point in 2018, when we began ushering in a new dynamic. One with bullish overall market fundamentals which would likely serve as the backdrop for brief bear dips over the course of the coming years.

Well, the C19 economic fallout is that bear market dip, only it’s a pretty sizable one and likely won’t be as brief.

Does that mean it’s time to cancel all hopes of this long-term cyclical bull run?

Not quite, in fact, this economic catastrophe, occurring at this point in the shipping cycle, could strengthen the upcoming bull market.

Here I will make the case for why a little pain now may bring greater benefits later on in the cycle.

Key Concepts

To understand shipping markets, and where I am going with this report, we need to touch on some key concepts.

First, shipping markets have both long and short run cycles. This is how we can find ourselves in a bear market (which may last for months) within a multi-year bull market backdrop. The magnitude of these short and long-run cycles is what is important.

Right now, C19 presents a massively bearish short-run development, just as the long-term market was still transitioning to bull. This temporarily overwhelmed the initial strengthening phase which is still in its infancy.

Second, supply side cycles typically set the tone of the long-term market with rare exceptions. Owners are the ones who control the supply side through vessel ordering and demolitions. Collectively, they create these cycles.

Third, owners and market participants are highly reactionary. For a segment that should be approached in every way with a contrarian investment strategy, those participating in it do a really bad job.

It is not limited to just owners. During bull runs we see banks generously extending credit, private equity joining the party, and investors bidding up these stocks to frothy values. During pullbacks we see the exact opposite reactions. All this plays into the cyclical formation of shipping markets.

Fourth, vessels take a long time to build. While some vessels can be built in as little as one year, the larger vessels, which typically have the most profound impact on supply dynamics, often take two or three years.

Fifth, supply side dynamics also impact shipyards. During times of low activity capacity (space, equipment, personal, etc.) is curtailed. During boom times there is not an infinite ability to expand immediately. This means an onslaught of newbuild orders must still reckon with shipyard capacity adjustments, which do not shift on a dime.

Sixth, because of all this the supply side macro outlook for shipping moves slowly.

Taken together, these above principles have set the stage for why I believe the temporary bearish demand shock we are experiencing will result in a more profound bull run later.

A Full Cycle

Where we are in the cycle will have an impact on related market response brought about by unforeseen events. This is another key concept we must accept before we move on.

To elaborate, let us start with a full market cycle.

Source: Clarksons SIN

Above we see a full cycle in the LPG shipping segment over the past decade. We start with a crossover point where the level of deliveries does not keep pace with ongoing demand. This tighter market results in higher charter rates.

Even as rates are climbing, the orderbook continues to drop for a couple years before hitting rock bottom. This occurs as owners exploit the secondhand market to capitalize on current conditions by placing as much tonnage on the water as possible.

As the S&P market becomes tired with vessels commanding a premium over their newbuild counterparts, owners inevitably turn to shipyards and place orders. Those orders pile up, forming a thick orderbook which will soon see the supply of vessels outpace demand, leading to a decline in rates.

As rates decline, we see owners back off from ordering, but the damage is done due to the long-term nature of shipbuilding. Now we must wait for the orderbook to rationalize and the market to absorb excess tonnage before we can even begin to hope for a bottom.

In the chart above, notice that 2018 marked the year where the LPG segment was forecast to, and did consequently, establish a market low. But the rate climb in 2020 was impacted due to demand destruction from C19.

Now, consider the shipping orderbook as a whole, which continues to edge lower.

Source: Clarksons SIN

Transition points

Market shifts bring new market strategies from these reactive owners.

Imagine if we hit a peak in the bull market and rates begin heading lower. However, the orderbook continues to build. Not only would this exacerbate the upcoming downturn, but it would also likely prolong it.

Conversely, if we have a bear market shift to bull, we expect reactionary market activity to correlate with this move. This is the S&P/newbuild activity we spoke about earlier.

But what happens when an economic shock, of great magnitude, disrupts this market at a transition point? If the short-term shock overwhelms the market backdrop, as it has here, it will induce reactionary behavior along those lines.

If this reactionary behavior runs counter to the behavior we were expecting during this crucial transitioning phase, we will see market consequences which play into our future forecasts.

So, at this particular point, we are seeing the C19 demand destruction force a variety of behaviors which run counter to how a normal market would be unfolding.

These include, but are not limited to, balance sheet preservation, increasing demolitions, slow newbuild orders, low S&P activity, and risk aversion at large in the industry (loans, credit, investors, owners, private equity, etc.)

During any other part of the cycle other than a transition phase, these reactionary behaviors would induce a short cycle later on, due to the fact that macro moves slowly (see, there’s a reason I listed all that in the beginning).

However, what happens when it occurs during the transition phase? Well, if the type of behavior being induced by the shock runs counter to predicted market behavior during the transition phase, it will exacerbate the market swing upon normalization and be longer in duration.

Conclusion

These general reports are not only designed to describe current market conditions, but also impart key concepts regarding shipping markets. With over 400 years of documented research regarding shipping cycles, these ideas are not merely an economic theory, they are an established reality.

There are always unforeseen circumstances that seem to play with shipping markets. But these short-term events are followed by the market reestablishing its fundamental direction.

The direction for many segments (tankers and LPG in particular) had been clear starting in mid-2018. But this short term, C19, shock disrupted that. However, some pain now may be setting up for some gains later.

Supply side adjustments have been pushed out several months now, and likely will be for several more – possibly a year plus.

This brings with it the growing prospect of economic normalization being met with a lagging supply side, leading to a tighter market than previously anticipated for a period of time. That future strength and period duration depends on just how long these current supply side adjustments will be pushed out.