Overview
Prior to the Great Recession, a commodity demand boom (driven mostly by China) led to record high rates for many segments. Reactionary owners piled in to newbuilds believing that the more tonnage they had on the water, the more they could capitalize. Shipyards consequently expanded, which was an expensive and time-consuming process, to accommodate what they also hoped would be the new normal.
However, that demand boom proved unsustainable in the long run and shipping collapsed in 2009.
The result was a massive amount of vessel supply that was ordered before 2009 and being delivered as late as 2015 due to the lengthy nature of the shipbuilding process and the backlog in many shipyards which spanned several years.
As the vessel glut across all segments led to historic collapses, these reactionary owners responded by pulling away from contracting orders for newbuilds.
Source: Clarksons SIN
As these vessels were delivered, and new orders failed to materialize, shipyards have been forced to rationalize their capacity or close all together.
Following the Great Recession, we have seen a culling of shipyards, moving from a peak of 934 in 2009 to just 281 as of May 2020. This trend directly correlates with the declining orderbook.
Not only are more likely to close, but this final stage in the rationalization process could be exacerbated due to the current global economic shock. This creates the possibility that this rationalization process may overshoot, and therefore present a new and unexpected market dynamic during the next cyclical phase. One that would take a relatively long time to clear up while having an impact on everything from charter rates to asset prices.
Market Cycles
Recently, I published an outlook on shipping cycles and how this particular transition point may be impacted by the current economic shock. The key concept there as it applies to this report can be found in the conclusion:
“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.”
Now, apply this theory to shipyards. The declining orderbook met with further hesitancy to order (due to economic conditions, consequent business strategies, and other uncertainties) would exacerbate this market rationalization process.
Therefore, not only could this supply side adjustment be pushed out, but the shipyards will feel the impacts possibly through more closures than would otherwise be felt.
Now, take that concept one step further, to where we could see tight or even inadequate shipyard capacity as orders do return. Now, how would the market react? This is where the cycle looks to be headed and here are some potential economic implications which may come as a result.
The well-established cyclical nature of shipping applies to work for shipyards. Therefore, as discussed in the aforementioned report, the trough we currently find ourselves in has been elongated and this will exacerbate the pain for many shipyards.
Those who would have been on the brink during a normal cycle will now face an even greater chance of insolvency – the magnitude of which will be directly proportional to the degree and length of the slow newbuild contracting environment.
If the shock proves strong enough in this context, it leads to the potential for too much shipyard capacity being removed from the equation. This short-term shock response will have medium and long-run will face consequences.
Remember, these shipyards didn’t just pop up overnight during the economic boom preceding the Great Recession. It took between 2003 and 2011 for the number of shipyards to double, and these were radically different economic times.
All this is just an explanation for the potential supply side shift from the shipyards, which will have consequential impacts on newbuild vessel availability and therefore charter rates and asset prices.
Newbuild Prices
While asset prices are often heavily correlated to charter rates, there are other factors at work.
Every bit of shipyard capacity being removed creates a supply side shift. As yard space is curtailed (supply shift) the market price for newbuilds is adjusted upward. This could be part of the reason why newbuild prices have been rising since approximately 2017.
Source: Clarksons
However, it’s noteworthy that over this rise in the newbuild price index, the global orderbook fell from 12.35% to 7.69%. So even while demand fell, the strength of the supply side adjustment could still be a possible reason behind these higher prices.
Fragmentation in an industry often leads to price outliers. As the number of industry participants shrinks those outliers diminish. Consequently, we then see a greater concentration of power in fewer participants, which can often lead to market defining moves in many ways.
Remember, this was an industry that just ten years ago had 934 yards and now sees almost 75% of the orderbook confined to just 64 majors, concentrated heavily in three nations. For an extreme example of how reducing industry fragmentation can benefit participants look to the container shipping Alliances.
Again, what is to stop those on the brink from offering huge discounts? Nothing, but if they are on the brink would you as an owner shell out millions in deposits to a company that is burning cash on building your vessel, and who’s very survival might depend on getting a profitable contract sometime in the next year or so? Probably not.
Shipyard capacity removal, power consolidation, and a preference by owners for well capitalized top tier builders (price premiums) all could have contributed to this move upwards in newbuild prices.
Now carry this forward as we face the most meaningful stage of this final cyclical consolidation which has now been exacerbated and prolonged.
Charter rates
No doubt many might have looked at the newbuild price index chart above and immediately correlated it to the improving prospects in shipping since that time (before C19 hit).
Good, that is correct for the most part as it was likely the greatest contributor. Now, recall that shipping cycles are mostly supply driven. If the shipyard supply cycle is altered to a meaningful degree, the ability for the shipping supply cycle to respond is also interrupted.
Meaning as the market tightens, shipyard capacity may be inadequate to renew and grow the global fleet. Orders may come in, but it could take time to restart yards, train personal, etc.
These delays would further tighten the market, consequently impacting charter rates. Now, this is the point where asset prices would again shift, but in a far more meaningful way, potentially.
Could this happen? Yes. Danish Ship Finance estimates those 64 previously mentioned yards are expected to achieve nearly 80% capacity utilization in 2020. Meaning if these smaller yards are closed next year and we see orders begin to materialize two years from now, we might not have the capacity to deal with them efficiently and delays will begin to mount.
It is really a simple recipe for higher prices down the road: Orders are being concentrated, smaller to mid-sized operations do not have much longer, and utilization levels at these majors don’t suggest a lot of room.
Asset Prices
Which brings us to asset prices, where the logical conclusion is already written on the wall. Capacity rationalization and power consolidation could have a potential impact on newbuilding prices at first. Then the market potentially overshooting the mark when it comes to curtailing shipbuilding capacity could have a medium to longer-term impact on vessel supply and consequently charter rates. This would in turn impact all asset prices.
Conclusion
A trend, approximately one decade in the making, is entering its final stages. Just like many other cyclical industries, the magnitude of a swing one way often creates an equal and opposing swing to a similar degree going the other.
We saw the overbuilding of shipyards to accommodate an unsustainable boom. Now we are seeing the unwinding of those yards, as the orderbook for ships follows its cyclical pattern heading to decade lows following historic highs just a decade earlier.
Just as yard expansion overshot before the Great Recession it will likely overshoot on the way down, and C19 has likely exacerbated this. A key point here is that yards will trail the shipping cycle, and C19 has made the pain they must endure even longer and perhaps greater.
Newbuild orders will likely continue to suffer for a variety of reasons, thereby extending this trough in the shipbuilding cycle.
Once the shipping market does become interested in acquiring tonnage again, the secondhand markets will likely play a role until asset prices there rise or candidates for sale are exhausted.
If tight yard capacity emerges for the next wave of newbuild orders, there will be market impacts. Higher newbuild prices, increasing charter rates, and appreciating on the water assets are all possible.
The longer the current lackluster newbuild environment continues, the more pronounced these impacts could become.
