IHS MARITIME AND TRADE The potential of transparency to maximise earnings

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1 IHS MARITIME AND TRADE The potential of transparency to maximise earnings May 2016 ihs.com WHITE PAPER Andrew Scorer Principal Trade Analyst, Maritime, Product Management

2 The potential of transparency to maximise earnings Andrew Scorer, Principal Trade Analyst, Maritime, Product Management Shipping has always been a game of chance, with profits subject to geopolitical forces, boom and bust cycles, and the best guesses and gut instincts of the established families and entrepreneurs who drive the maritime industry, generation after generation. It s a challenging, often unforgiving, environment and there is often little time to make the quality decision. There is another more fundamental transition affecting shipping leadership. The new realities of global interconnectedness, advancing technology, and speeded-up business conditions have heightened the importance of return on investment, residual value risk, and cost of debt and capital. The requirement to understand a company s net asset value (NAV) and the health of its balance sheet has given rise to more sophisticated shipowners and investors. Moreover, the industry must share responsibility with investors for regulations that have eaten away at profitability. Despite these changes, shipping appears not to have learned from its mistakes. History repeats itself with overcapacity and overexposure to risk. This presents a new group of questions. How should shipowners mitigate prices and rates? Is it better to lock in the good returns for a three-year timecharter or take the risk on the spot market? The answers to these questions lie in understanding where the business is in the cycle, helping to manage risk and maximise financial leverage. And in this environment, finding those answers requires data. Lots of data. Oversupply A challenge the maritime industry can face is that outlooks and opinions can be taken out of context by those wanting to portray a particular scenario. Profitability depends not only on how many ships are available but also on the cargo demanded by the industries and countries they serve. These are complicated end-markets, inextricably linked to each other and to the wider global economy. Publicly listed tanker owners face this dilemma at the moment as some potential investors link their earnings potential with the low oil price and NAV, meaning they are consequently undervalued. Supply and demand for cargo capacity is at the heart of the challenge the shipping industry has faced in recent years. It has increased uncertainty at a time of greater volatility. The shortfall in demand left by China s slowdown has not been filled by increased demand in the United States or the European Union, resulting in surplus shipping capacity across the world. Few economists predicted the global financial crisis, and no one appeared to have anticipated 2014 s plunge in the price of crude oil. Some industry players are taking advantage of geopolitical developments to improve their bottom lines. Dirty and clean tankers have seen earnings rise rapidly since the fourth quarter of Underwriting their success has been a low oil price that has increased demand, with China and OECD countries taking advantage of the situation to top up their strategic reserves, together with the stockpiling of crude oil on shore. Companies operating very large crude carriers (VLCCs) have posted stellar earnings for 2015 and anticipate excellent revenue in VLCCs earnings on the Middle East Gulf Far East route wereusd60,000/day in April 2015 compared with USD10,000 a year earlier and breakeven rates in April So far in 2016 the rate has been about USD55,000/day. Dirty tanker revenue has also been helped by a supply-side slowdown. Newbuilding orders have been slow since The picture for these tankers could change in 2017 and 2018, and there are concerns that improved freight rates have encouraged shipowners to return to the shipyards. Questions arise as to whether the increased level of vessel deliveries in 2016 will force the tanker market down into another cycle and what OPEC will do next on production. The table shows that the dirty tanker market can absorb a destructive-looking orderbook over the coming months, but that alone is not enough to justify those orders. It is worth looking at what can be learnt from other sectors experiences of a similar situation. Cover image: Shutterstock 2016 IHS 2 May 2016

3 Newbuilding summary VLCC Suezmax Aframax/LR2 IHS Fleet Capacity Forecast till end Scheduled as at March 2016 (count & %) 127 (63%) 110 (77%) 162 (62%) Balance that could be ordered Source: IHS Fleet Capacity Forecast 2016 IHS China, which drives so much commerce, can also take it away. The unrestrained growth there that underwrote an increase in shipping capacity over the past two decades may be running out of steam, with increased restrictions on credit lending. The country s growth had been the prime guarantor of investment in shipping. Imports of steelmaking raw materials (iron ore and metallurgical coal) and energy resources (thermal coal, crude oil, and liquefied gas), together with exports of electronic and consumer goods, drove demand for dry bulk, tankers and gas carriers, and for container shipping. The Chinese slowdown is also a headache for Asia-Pacific raw material exporters, which have built up their own extractive economies based on Chinese demand. Now, surplus capacity has depressed freight rates for dry bulk and container shipping and there is little sign of improvement. According to IHS Maritime & Trade, the scheduled orderbook, as at April 2016, for dry bulk ships stood at 14% of the existing fleet, equivalent of 106 million dwt, but there could be a repeat of 2015 s slippages and cancellations affecting about 35% of orders in the full year. Ships are therefore accepting contracts at less than operating cost just to remain employed, but even that will depend on the vessel s age and the route. This tactic makes sense in the short term but digs deep into financial reserves over the medium and long term. The fallout from the dry bulk ordering frenzy means it is now harder for shipowners to structure strategic business decisions, with investors more savvy when it comes to net asset values and the strengths and weaknesses of balance sheets. Does it make sense for dirty tanker owners to buy speculative newbuildings now, especially when shipyards have capacity and prices are attractive? There are two factors to consider: the tanker market may seem to be at the top of the shipping cycle but how do we know this for sure? And when will tanker earnings fall below capital expenditure? From the IHS Crude Oil Freight Rate Forecast below you could argue that the party is over and the slow return to poor rates is here to stay, for at least the next five years. Only time will tell if tankers have peaked, but IHS Maritime & Trade predicts that earnings for VLCCs, Suezmaxes, and Aframaxes/LR2s will be above the typical capital expenditure (capex) amount for the next five years. This assumes that tanker newbuilding deliveries are in line with the Fleet Capacity Forecast. The typical capex is about USD23,000/ day, USD20,000/day and USD18,000/ day for these classes, respectively. IHS Maritime & Trade Dirty Tanker Freight Rate Forecast annual USD per day (TCE) 60,000 50,000 40,000 30,000 20,000 10, TD 3 (Middle East Gulf/Far East VLCC) TD 6 (Black Sea/Mediterranean Suezmax) TD 7 (Intra UK/Continent Aframax) TD 19 (Intra Mediterranean Aframax) TD 20 (West Africa/UK/Continent Suezmax) Source: IHS Maritime & Trade 2016 IHS IHS 3 May 2016

4 IHS Maritime & Trade does not believe tanker owners should order newbuildings speculatively, although there may be a case for strategic orders. This is because the sector seems to be focusing on strategic newbuildings aligned with long-term timecharter contracts to provide stable earnings during what could be a volatile five-year period. Diversified owners will be looking for ways to support those sectors with poor earnings and this may be why tanker owners are resisting flooding the market as they try to negate the traditional shipping newbuilding cycle. Market volatility has traditionally been masked by the rise and fall of business cycles, but times are changing as forward freight agreements (FFAs) and trading models reduce the window within which informed, strategic decisions have to be taken. Moreover, decisions about newbuildings are made more difficult because of increased governance and regulation, along with the demands from banks and private equity as they become more involved in shipping management. Another factor for the apparent restraint is that there are plenty of ships available for sale at the right price. By buying secondhand, companies seeking more tanker tonnage can secure good earnings today rather than in 18 months, when the market could be very different. IHS believes orders will be placed for speculative newbuildings, but not as many as in previous shipping cycles because lessons have been learned. Investment opportunities exist, but buyers will need a robust business plan, complete with exit strategies, to entice investors. Forecasting comes with risk. If we focus the earnings potential for tanker owners in 2016, there seem to be more positives than negatives. If the positives are fulfilled, the year could see rates equal to or better than in The first of those positives is that there is unlikely to be an OPEC/non-OPEC cut in oil production. Second, the expected arrival of Iranian oil may be slower than anticipated, but its looming presence will make any production cut difficult to effect. Third, the tanker market is looking for the widening spread of oil future prices that could provide an incentive for strategic floating storage. Some traders already have options on their spot fixtures to do this, while others are taking vessels on timecharters to have the flexibility when this contango arises. IHS believes there will be strategic floating storage plays this year, but more in the second half because of potentially lower seasonal freight rates and a predicted oil price increase. The main negative for 2016 is always the possibility that OPEC will cut production in reaction to the resilience of US producers and the return of Iran. Brave new world The fact remains that all of the above is theoretical and just the opinion of many within the maritime industry. Who are partners/benchmark in this work of finding, filtering, analysing and predicting? Who will be right or wrong and does it actually matter if the analysts are proved correct or incorrect? Shipbrokers are a significant part of this information equation, but only up to a point. They are the workhorses of the current market, passing information between various parties to help decision-making. But shipbroking is increasingly competitive. Several brokers have merged to secure their survival or future growth. They use proprietary models to understand what they see and what it will mean, with varying degrees of accuracy. But the outcome is just one view or analysis of the situation and could be dangerous to follow if taken in isolation. That said, if enough of these individual opinions build into a consensus, it can be given additional weight. A second opinion, based on independent analysis and insight, can come from external advisers. This can be especially important with the extra governance demands on companies. However, end markets are complex, often opaque. One question to ask is, Does the adviser provide rigorous and advanced analysis that draws on multidisciplinary data and expertise to reflect our interconnected world? In short, the more telescopes and microscopes that are trained on the problem, the more likely the data is to be verifiable, suited to a specific company and market, and with insights gathered from many angles of view IHS 4 May 2016

5 One major issue is whether the maritime industry is ready to embrace the big data or advanced analytics phenomenon. Using just one source of information to validate business decisions could seem naïve, but so too is using multiple sources when you could unknowingly be comparing apples and oranges, as the methodologies and datasets used will be very different. For example, if you asked a panel of 10 brokers and independent companies to provide an annual freight rate forecast for the next five years, some could be forecasting simply at an annual level, while others are forecasting at a monthly level and then aggregating the figures. Which is better to base your business decisions on? Shutterstock Reactive to proactive Big data and advanced analytics are especially valuable because they provide an ability to move beyond what is known and what is predicted. That can enable, for example, business strategists to understand how a target market can be penetrated with flexibility to minimise the risk of illiquidity and liability. The speed of information flow and the amount of external data available is probably far too much for most companies to take in, process, and use intelligently. Yet without the ability to anticipate market developments, businesses are doomed to react to events rather than become proactive like a ship s captain waiting for the storm to hit rather than navigating around it. When looking at data we need to treat history as a guide. Finding reasons and explanations provides indicators and insight, and those indicators can be taken into an assessment of the future. This knowledge is hard to find unless you have the expertise and time within internal teams or external advisers to distinguish between the predictable and the unpredictable. This is important because it filters out the background noise and allows for focus and data refinement. As an example of how data reported by remote sensors a basic ingredient in the data revolution can advance maritime forecasting capabilities, we can look at shore support. This has a major influence on a ship s behaviour. Automated Identification System (AIS) is a good big-data point to start with: it tells us where ships are operating and where they are loading and discharging. Connecting this to ports and bill of lading data gives insight into what commodities ships are carrying and how trade routes are developing. Decision-makers can also use AIS data to optimise routes, taking into account weather, security, and ice, as well as fuel consumption, linked to slow steaming. Technology provides the industry with views of its world that were never available before, with the promise of providing better visibility into the future, whether that is weeks, months or even years ahead. For events that are unforeseeable, the speed at which these forecasters can react and revise forecasts can enable companies to adapt ahead of the competition. By applying pattern recognition and parallel processes to fleet-wide behaviour, new datasets can be created. These tell us in much sharper detail than was previously available which carriers spend more or less time than their competitors in certain ports. It means we can monitor delays in real time at ports and nearby alternatives. Importantly, use of this technology is dramatically improving forecast accuracy. IHS has used these techniques to improve the matching of AIS records to ship records, bringing the number of verified bulk carriers from 69% to more than 90%. This means more port calls are being captured, which improves understanding of trading activity IHS 5 May 2016

6 Risk v reward The shipping industry and its customers should be offered a better grasp of the underlying elements of the market so investment decisions can be made using the best insights and data available. What counts, after all, is not the existence of big data, but what can be done with it. By using data to build and show what could happen to a fleet and potential earnings, customers can develop actionable insights into companies respective strategies. Being able to use a forecasting tool to inform trade route selection should enable companies to compare performance against earnings for routes and whether they could have increased earnings by using different routes. One way the shipping industry is leveraging the potential to maximise earnings is through market consolidation. Consolidation often appears reasonable at a superficial level but it must be asked whether earnings will be increased for the owner or as return on investment for a private equity company. There is no definitive answer yet. However, understanding how a fleet operates within the crude market, now and over the next five years, and whether additional regulations will affect potential earnings, will guide strategic decisions, enabling reactions to unforeseen scenarios to be faster and more accurate than those of competitors. Deciding whether to increase or decrease a fleet s percentage exposure to the spot or timecharter market depends on understanding how a fleet operates. This leads to further longer term questions, such as: Freight rates low but should I sell my ship? Freight rates high but should I buy a ship? What will happen in two years? Which sector looks most promising? Do I have access to cargo? When to invest/cash in? Sea change ahead The real problem for the industry is that much maritime forecasting is stuck in technologies or processes from the past. Some still relies on back-of-the-envelope calculations or, more likely, a combination of instinct and technology, to give shipowners and their clients a view of future demand. While technology is increasingly making shipowners smarter, with such things as onboard sensors monitoring engine performance and fuel usage and tracking cargo containers, it has, frustratingly, not been as influential in the back office, where the forecasts that drive a company s prosperity are made. Enter big data analysis. This promises to improve the fortunes of the industry just as it has revolutionised all others it has touched. Shipowners and their customers suddenly have access to a new set of complex inputs. The variables to plug into the equations are daunting. IHS believes the equation of big data plus analysis plus hypothesis equals a significant competitive edge that few in the industry are yet taking advantage of. For accurate forecasts it is only through a deep understanding of market drivers that companies can analyse the raw data themselves or save hours of work by using the critical insight provided to support forecasts. The story around the forecast is more important than the forecast itself. Simply, if you do not understand how a figure is derived, then how can you trust it? Context is imperative. The pace of decision making can only increase as companies try to enhance their balance sheets, take control of their business, and improve their likelihood of survival in a fragmented and volatile industry. Better forecasting could also mean more investment, as investors and bankers gain transparency into companies and how they operate. Understanding market developments will inform charterers decisions to persevere with high spot rates or try to secure period charters for the medium term. This decision depends on the market conditions expected in two or three years IHS 6 May 2016

7 The present disconnect between owners and charterers expectations for three- to five-year spot rates and newbuilding prices suggest the freight rate is not expected to maintain its current high level. Owners see lucrative potential earnings if they can charter a ship at the right rate at the right time. Conversely, charterers want a rate that is less than their competitors at the time of fixing. Today s market is rarely a good indicator of profitability in five years. IHS Maritime & Trade is in an exciting period of evolution in how investment and planning decisions are addressed at a commercial and strategic level. One solution is the Freight Rate Forecast, which offers a transparent methodology and explanation of the drivers of freight rates, considered at a monthly level for up to five years ahead on a routespecific basis. The arrival and acceleration of big data in shipping signals a sea change in how the industry and its customers can plan for the future. As forecasts become more accurate, shipowners can run more productively, by choosing ideal routes, more efficiently, by using best-priced fuel, and more competitively by understanding what competitors are doing. Meanwhile, customers are helped to ship products or raw materials in the quickest time possible at the most cost-effective price. And for investors in shipping, big data reduces exposure to risk and makes business operations more visible, encouraging further investment. For the industry in general, data-driven insights into business cycles allow players to pursue their strategies with more confidence, whether in terms of building or reducing capacity, turning to the spot market, or delaying or rerouting a shipment. Big data will not end the cyclical nature of business or remove all the geopolitical uncertainties, for example with oil embargoes, but it will allow players to look with more confidence at future events and act proactively to turn challenges into opportunities. Getting and using data Big data, advanced analytics, forecasting, and market information can all bring some transparency into the market. But how can the maritime industry go the next mile and would it want to? Certain sectors of the maritime world are already more transparent than others, and are thriving. The VLCC market is one example. Owner Tanker International s fixture mobile application or app shows real-time fixtures as their status is confirmed. This means owners, charterers, and brokers are informed of the true market, rather than their sense of market sentiment. Some industry players may not like this, but it certainly allows quick benchmarking of freight rates. If owners see the market increasing during the day, they will be in no rush to fix at the last-done rate. In the same situation, charterers try to lock in a rate quicker than if the market was steady or decreasing. By comparison, other sectors rely on the Baltic Exchange assessment at the end of the day and broker information. Shutterstock 2016 IHS 7 May 2016

8 This VLCC example is, for me, the start of a slow but exciting transition to a stock market model. There, deals, bids, offers, and market information are seen in real time and are used to maximise earnings and manage risk exposure. Not everyone trades on online platforms, as some prefer more traditional methods, but it provides an option for quicker decision-making through transparency. The pace of business in the maritime industry is speeding up, as noted earlier, yet the way most of it trades or fixes a vessel has not changed. There are online brokers and charterparty providers, but there are no obvious reasons why the industry cannot create a stock market model for the entire industry so businesses have one source for the actual picture, without having to rely on sentiment. It is not about changing the status quo of the parts of the industry: all will still be needed. But using advances in technology, individuals could negotiate and conclude a deal while out of the office by using a mobile device. It would make it much easier and quicker. In other industries you can use a mobile device to place bets and cash out at any time, or buy and sell stocks, so why can owners, charterers and brokers not do this in our industry? 2016 IHS 8 May 2016

9 About the Freight rate forecast data product Freight Rate Forecast from IHS Maritime & Trade is an online tool offering insight on freight rates in the short- and medium-term, enabling users to strengthen the balance sheet, gain tighter control of the business, and secure a stable platform in a volatile shipping market. Visualize, download and integrate IHS information via a simple user friendly interactive interface. The service currently covers Crude Oil and Dry Bulk commodities. Freight Rate Forecast Drivers Industrial factors Commodity prices Production Consumption Economic factors Industrial production Wholesale production prices Retail prices Financial factors Bond yields Short-term interest rates Long-term interest rates Supply factors Ship evailability Ship utilization Fleet Capacity Forecast Exchange rates Watch our latest video and download the IHS Maritime & Trade Freight Rate Forecast brochure at IHS 9 May 2016

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