A Year of Decisions in Shipping

FT DEUCHLAND SHIP FINANCE CONFERENCE

Session 1: Winners and losers – ship finance following the serious crisis

SMM Hamburg,
6th September 2010
Final

“A Year of Decisions For Shipping –

How Will The Markets Develop?”

Dr Martin Stopford, MD Clarkson Research Services Ltd

Figure 1: Jingnan shipyard: a long established Chinese shipbuilder that opened a major new facility

1. The Decision Makers

Good morning ladies and gentlemen. The title refers to "a year of decisions", so
let’s start by looking at who the decision makers are. In shipping there are four
primary groups of decision-makers, and today each faces a very different situation.

Shipowners are at the heart of the equation and they face a wide range of different
problems over finance and investment. Bankers are still struggling with the credit
crisis generally but shipping portfolios have their own problems. The shipbuilders
who are expanding fast are juggling the problems of cashflow; funding new facilities
and managing accounts which cannot meet their commitments. Finally where things
are not going smoothly governments are being drawn into the frame, generally
reluctantly.

In the wake of the great boom these decision makers have plenty to worry about
and my focus this morning will be on getting the facts we know into perspective. But
this is what they are paid to do – worry about the future and in the end its just a job
like any other. Some do it better than others.

I will start by looking at the market trends in recent decades, both as earnings and
return on investment. I will then take a look at those key drivers of the future markets
– the market fundamentals; the world economy, ship building and demolition. Finally
I will pull all this together into some sort of perspective on the dilemmas facing
decision makers in the various parts of the industry today.

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A Year of Decisions in Shipping

2. Freight rates 1980 to 2010

A quick run through the last three decades gives illustrate how previous
generations of decision makers have handled the same sort of decisions we are
struggling with today ( Figure 1). In fact each decade has a different character and
none turned out to be quite what the market expected at the outset.

The Miserable 1980s

The 1980s was a much worse disaster than anyone expected at the beginning.
2008
Figure 1: Earnings of the average ship 1980-2010 $50,000/day
2004
50 $39,000/day "China's present to 
“super cycle  bulk shipping". 
(Clarksea Index is a weighted average of earnings  with rather high 
45
by tankers, bulkers, containerships & gas.) blood pressure”

40 1999
“What a 
1993 miserable 
35 “A year  The great
six 
owners  shipping
C la rkse a In d e x $ 0 0 0 /d a y

months”
30 would 
1995 boom left
rather 
“A  2000 a legasy
forget” $24,000/day
25 significant  “Wow”
1991  upturn in  2001
$22,800/day
1989 $16,000/ the dry bulk  “Back to 
20 1979‐81
“Far  day market” normal”
"Rates  1982‐6
Better!
15 boomed" "Worst 
” $12,000/day
ever"
10
rehearsal

$8,500/day
Dress

Super-Slump Super-Boom
0
1 98 0
1 98 1
1 98 2
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1 98 5
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1 98 9
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2 01 0
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2 01 4
Owners, encouraged by builders who were struggling to fill surplus capacity, made
significant counter cyclical investment at the start. It turned out badly and prolonged
the recession. Governments handled the second oil crisis badly and trade collapsed.
With a large surplus of ships which, for four years in a row, produced earnings which
were barely sufficient to cover operating expenses. By 1986 most shipping banks
were facing problems with most of their portfolios. The strategy of foreclosure just
made matters worse because the sale of ships at distress prices undermined the
collateral supporting bank portfolios. But eventually the surplus was cleared and the
market got back to some sort of normal by 1990.

The Difficult 1990s

The 1990s was expected to be much better, but the result was disappointing. There
was a round of speculative ordering of tankers which turned out to be badly timed.
The shipbuilding shortage which was predicted to result from heavy demolition of
tankers built during the 1970s bubble, never happened. So by 1999 even diehard
optimists were wondering why they soldiered on in the bulk shipping business.

The Tight 2000s

The 2000 provided the answer. After a short dip in 2001, the market took off and
for five years from 2003 to 2008 earnings were massively above trend. This was

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A Year of Decisions in Shipping

without doubt the best boom in living memory, and possibly one of the best ever.
One consequence of the boom was very heavy investment in new ships. During the
five years the market committed over $800 billion in orders for new ships. Half of
this investment took place in 2007 and 2008 when new building prices were at record
levels (see Figure 2 which shows the new price of a Capesize bulk carrier on the right
axis).

The Unbalanced 2010s

From my perspective the scenario that lies ahead of us is characterized by a return
of the structural imbalances which characterized the 1980s and 1990s. The formula is
familiar enough. The world economic outlook is patchy because the OECD countries
which still account for half of sea trade, are struggling with unresolved structural
problems. So sluggish trade growth is an issue. Meanwhile the supply side of the
shipping market is drawing ahead of demand and with shipyard output growing fast
the surplus is likely to get bigger over the next couple of years.

This outlook leaves the decision makers mentioned above struggling with several
problems. Firstly some prudent shipowners who remembered the 1970s built up very
substantial cash balances which they are now tempted to re-invest. But they are not
sure if the market has really bottomed out and are anyway are having problems
finding well priced assets. Secondly other investors are committed to substantial new
orders, on which finance was not Figure 2: Investment in new ships & newbuilding prices
always arranged in advance. These B ill $ O the rs Ne w C ap e
O rd e rs C o nta ine r $MM
ships now look very expensive and 120
240 LPG
with prices well down from the peak, L NG
61
220
their collateral value is insufficient to 2 0 0 B ulk 100
support the required loans. Thirdly, as 1 8 0 Ta nke rs 47
the industry built up a track record of 1 6 0 Ne w C a pe $ M M 80
5 42
excellent financial performance, new 1 4 0 40

60
investors were drawn into the market, 1 2 0 28
17
1
particularly in Germany where the 1 0 0 33 105
80 21 9
40
volume of business done through KG 13 28 25 68
60 21
companies grew very rapidly and in 4 0 12 14 16
22
12 9 20
2
11 13 14 55
the United States where public listings 9
32 17 14 11
3
7
7
9
2 0 15 6 503 617 5 43 7 21 21 23
43 39 35
15
0
12
13 13 11 10
became much more common than 0 8 7 5 6
0
previously. Some seem to have
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009

interpreted the 5 year financials in

2008 as “normal” and invested in
structures devised on that assumption. Fourthly, the investment boom went on so long
that shipbuilders were able to drive up prices and had time to plan and build new
capacity. As result today's capacity has drawn well ahead of the requirement
indicated by long-term trading trends. Fourthly second-hand prices increased very
rapidly and seductive arguments about "new paradigms" persuaded bankers to build
portfolios which were often based on collateral valued at levels well above long-term
trends.

3. Return on investment 1982 2010

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A Year of Decisions in Shipping

The returns on shipping Figure 3; Rough estimate of VLCC costs and revenues 1990-2010 4
investment vary a good deal from $120
Co s t $ /d a y fo r Ne w VL CC
VL CC Ea rn in g s (1 2 m o n th a v e ra g e )
one decade to another and this is a $100
3
hood starting point for weighing
up what the next decade might $80 2

$ /d a y e a rn in g s
bring. I made a rough analysis of $60
1
the return on investment for
tankers, bulk carriers and $40

container ships over the last two Chart shows 12 month moving average of tanker earnings (i.e.
$20 $71,000/day is average for September 2007 to August 2008))
decades, based on the sum of
operating expenses; depreciation $0

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and interest on the vessel value.
In recent months the crucial issue
has been the fall in interest rates due to financial easing. This has reduced the "cost of
capital" in the shipping industry to a nominal level, making it one of the principal
beneficiaries of the financial easing policy of governments. It seems likely that this
will continue until a robust economy has been achieved.
Figure 4; Rough estimate of Capesize costs and revenues 1990-2010
4
If we compare to the daily cost 120 Shows 12 Month Average (in arrears) of bulk carrier earnings
& costs
110
with earnings and calculated return, 100 Area 2
which I took as a percentage of the 90 Cost New Capesize $000/day
80 Capesize Earnings 12 Month Av
current new building price. In this
$ 0 00 P e r d a y

70 3
analysis earnings play an important 60
part, but so too interest rates (which 50
40
I calculated using LIBOR) and new 30 1
2
building prices, both of which were 20
highly volatile. 10
0

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The tankers the 1990s was a
very poor decade (Figure 3).
During the first half of the decade earnings were insufficient to cover depreciation and
interest, and the average over the whole decayed was 2.6% (note that this is after
paying interest costs on the full capital value of the ship at LIBOR). Then in the 2000
is things improved and the return over the whole decayed was 9.8%. In

A during the 1990s bulk carriers did slightly better than tankers, with earnings just
sufficient to cover costs, (Figure 4) leaving a 3.2% margin. That's in the 2000 is the
return shot up to 14.5% over the Figure 5; Rough estimate of 3300TEU Container costs and revenues 1994-2010
whole decayed. This may sound 50
Cost $000/day
low, but remember that until 2003 45 2
40 Containership earnings
returns were very low, and there Shows 12 Month Average (in arrears) of containership earnings

35
was a dip in 2006. 3
30
$ 00 0 P er d ay

1
25
I also included containerships in 20
the analysis (Figure 5), though this 15
market is much less established and 10
the data correspondingly less 5
reliable. However the same 0
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analysis showed a return of 9.4% in

the 1990s and 9.3% in the 2000s,

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A Year of Decisions in Shipping

when the higher return in the first part of the decade was pulled down by the very
poor performance between 2007 and 2010. It is also noticeable that the volatility of
this market segment increased significantly over the period. From this perspective the
recent crash looks less frightening, though structurally the volatility which has been
building up could be due to a structural change as the size of the container charter
market expands and investment control moves away from the service operators, who
controlled all investment until 1990 and had it on their balance sheets, to independents
who are buying ships to charter and now account for half the market.

This analysis the results of which are summarized in Table 1, provides a useful
benchmark for weighing up
the coming decade. The Return on shipping investment (ROI) 1990-99 & 2000- June 201
spread of returns in 1990-1999 2000-2010
individual segments and is % per annum increase
between 2.6% and 14.5%. LIBOR 6 month 5.50% 3.20%
VLCC 2.60% 9.80%
It also demonstrates that
Capesize Bulker 3.20% 14.50%
there are significant Container (3,500 TEU) 9.40% 9.30%
differences in the Note: the ROI calculations based on a new ship depreciated over
performance of different 20 years, with interest charged at LIBOR on the full newbuilding
segments of the market. In price each month and OPEX added. The ROI is calculated as follow
general bulkers did ROIt = ((depreciationtt + interestt + OPEXt) x 350)/newbuilding pric
somewhat better than
tankers, but overall containerships produced the best return -- remarkably close to the
famous 8% offered by KG companies.

Our task is to weigh up where things will sit in future.

4. The world economy

The world economy had a record run between 2003 and 2008, followed by the
most severe recession since the early 1970s (Figure 6). Looking below the surface,
the principal pattern today is that the non-OECD countries are generally performing
well. It's is not difficult to be positive about the performance of China, India, South
America and other non-OECD areas during the coming decayed. These economies
have growing markets and are no longer so dependent on the north Atlantic. In
contrast to the OECD economies are now mature, with demographic problems and
problems in the banking system which are still unresolved.

One of the most striking messages from the history of the last 30 years in the
shipping market is that demand leads the way and fluctuations in demand for more
important in triggering the major developments in the shipping market than supply.
However the demand side of the shipping market is much more difficult to analyse
than supply, because it involves two lares of complexity, first the cycles and crises in
the world economy and secondly the specific developments in seaborne trade. Over
the last 50 years there have been regular "crises" in the world economy - the stories
crisis in 1956 and another in 1967. The oil crisis in 1973 and another in 1979. The
US financial crisis in 1990 to 93, then the dot-com crisis in 2001. Finally we have the
credit crisis which started in 2007. All of these crises are shown in the figure below
which also shows a close correlation between cycles in the world economy and cycles
in seaborne trade.

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A Year of Decisions in Shipping

In Figure 6: GDP recovering OK so far but OECD still weak practice

forecasts % growth
The 42 year 3.9% trend is dragged down by five of the
7%
world crises (roughly but not reliably every 10 years). The regional
This looks like another but pretty severe. balance is
economy 6%
changing
have
little 5%

4%

3%

2%
y = -0 .0 0 02 x + 0 .0 3 97
1%

-1%
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
credibility -- 2 years ago when I spoke at this event, the consensus forecast was that
world GNP would grow at 4.2% in 2008 and 4% in 2009. In fact GDP fell by .6% in
2009. The sad reality is that we just do not know when these cycles will appear.
Today the forecasting agencies are predicting growth of about 4% per annum over the
next two years, but I doubt whether anyone in this room takes these projections
seriously. The truth is we face a very uncertain outlook.

However as far as seaborne trade is concerned, decision makers do not really need
precise forecasts. They just need a sense of what is possible. Over the last five
decades the annual growth of sea trade has varied enormously from a peak of 7.5%
per annum in the 1950s to a trough of .9% per annum in the 1980s (see inset table in
figure below). During the decade 2000 to 2009, despite the best efforts of China,
trade only grew by 3% per annum. In Figure 7 below I have set out four different
scenarios. The lowest is 1%, and reflects the growth rate during the 1980s. The
second 3% reflects the growth rate in the last decade, and the third is 4% which was
the growth rate in the 1990s. Finally I have added a 7% scenario which is the growth

Figure 7: Sea Trade scenarios based on different rates of growth

17 7% scenario
16 Growth of sea trade
15 Period %pa
14
s e a b o rn e im p o rts b illio n to n n e s

1950-60 7.5%
13 1961-70 9.1%
12 4% scenario
11 1971-80 4.8%
3% scenario
10 1981-90 0.9%
9 1991-00 4.1% 1% scenario
8 2001-09 2.9%
7
6
5
4
3 C hina Impo rts
2 W o rld le s s C hina
1 7% i
0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020

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A Year of Decisions in Shipping

rate in the 1950s. I suspect most readers would settle for 3% as a reasonable outcome,
but, when we get to discussing supply, we see that we really need the 7% scenario to
keep the shipping market is buzzing in the way they have done over the last few years.

Unfortunately the 7% scenario is very unlikely because although the Pacific

countries are growing very rapidly, the OECD countries, which still constitutes a very
large proportion of seaborne trade, are growing slowly. On this basis the 2010s are
unlikely to be as good as the 2000s, in terms of the world economy, but a return to the
3% growth trend seems possible. In terms of sea trade, perhaps we 3% per annum
growth would make a reasonable planning assumption.

5. Shipbuilding and the demolition

One of the principal legacies from the boom was the expansion of world
shipbuilding capacity. The yard is delivered 117 million deadweight of ships in 2009
and the trend so far this year suggests 150 million deadweight in 2010, with 140
million deadweight in 2011 (Figure 8). With a fleet of 1.3 billion deadweight,
deliveries are running at around 11% of the fleet.

Figure 8 Shipyard deliveries showing scheduled deliveries & latest

latest estimate (line)

180
O rig in a l s c h e d u le d o rd e rb o o k
160 D e liv e rie s
140 D e m o litio n Stage 2 39
M illion Deadweight

120
100 192 Current
estimate
80 157
Stage 1
60 117

89
40 70 75 80
62 59
50 55
46 46
20 29 33 38 37
24
41

0
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

Today we have a relatively modern fleet and in 2009 demolition was 32.9 million
deadweight, about 2.5% of the fleet. So far in 2010 the pace and demolition has
slowed to less than 2% on an annualized basis. Generally in the past order books
which have been contracted end up being built, albeit a little late. The severity of the
crisis last year made it look as though this might be an exception to the rule. Many
shipowners had not arranged adequate finance in advance, and the credit squeeze
made financing very difficult.

However the shipyards have got over the last 12 months successfully, and output
has continued to grow. Some of their clients have had difficulties in raising finance,
and we must expect more problems in future as the financial pressures build up, which

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A Year of Decisions in Shipping

seems inevitable despite low interest rates and the best efforts of banks to keep the
wheels turning (which if the fundamental purpose of financial easing). But potential
investors are "circling the wagons". These are the liquid investors, either shipping
companies who held back from investment during the boom, or non-shipping
investors looking for "kick the tyres" assets at bargain prices. The problem so far has
been lack of investment liquidity -- nobody wants to sell their ships cheap and the
market has been benign enough to minimize mandatory sales. When we look at the
trend in freight rates I described in the early part of this paper, it is clear that thanks to
low interest rates and the continued growth of cargo into non-OECD countries, many
companies have been able to survive.

In short, the shipbuilding industry is rolling forward, and still has close on 500
million deadweight of ships to deliver. In my view it would require a better than
average decade to soak up those ships without inflicting some pain on the industry.

6. The market fundamentals

I do not have time to go into great detail, but it is useful to pull together the supply
and demand trends (Figure 9). This is always a precarious business, but in truth we
are talking of very broad issues. In recent decades sea trade has grown at around
3.5% per annum and even during long the boom 2003 to 2009 it grew by only just
over 5%. However we have deliveries running at well over 10% of the fleet, and a
relatively modern fleet which will limit scrapping. The shipyards have survived the
most difficult year, and there seem to be enough potential customers to prevent major
cancellations, provided "the price is right". So the fundamentals trend is one of
growing surplus. My
Figure 9 Shipping supply and demand scenarios
own feeling is that Bill. Tons
provided the non- M. Dwt Fleet Cargo
OECD countries 1600
11
perform effectively 1400 W orld F leet (Dwt) 10
and there is not a Sea Trade
further collapse in sea 1200 9
1% pa 8
trade, the situation
has more in common 1000 3%pa 7
with the 1990s than 800 4%pa 6
.
the 1980s. 7%91 5
600 4
7. Conclusions 3
400
So let me pull all 2
of this together. I 200
1
started with the four
0 0
key decision-makers,
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013

shipowners; bankers;
shipbuilders and
government and
pointed out that
historically shipping has been a highly volatile business and that these for decision-
makers are, essentially, paid to find ways of dealing with that volatility. It's the sort
of business that is likely to appeal to people who in their spare time practise extreme
sports, maybe mountain climbing or skydiving.

Martin Stopford, Clarkson Research 8 9/10/2010

A Year of Decisions in Shipping

One of the consequences of this volatility is that some decades are much better
than others. We might as well accept that, but we must also be aware that we never
quite know what is coming next, so flexibility is essential.

Today the economic outlook is mixed, and although China, India and other
emerging countries are growing rapidly, the heavyweight OECD countries are
struggling. They still have a financial crisis which is largely unresolved. So we
cannot expect high levels of global growth in the coming decade. 3% per annum
would be a good outcome, though in the disastrous 1980s sea trade grew by only 1%
per annum.

Meanwhile the shipyards have sufficient capacity to expand the fleets by 7% per
annum, after allowing for scrapping. In the past it has been very difficult to damp
down shipyard capacity once it has been put in place. So fairly rapid supply growth
seems probable.

Pulling these together, I think that we should be l viewing the coming decade as
one in which returns will be in the lower end of the spectrum (which ranges from 1%
ROI to 15%) my own feeling is that 5% to 7% ROIper annum would be a good
outcome.

Martin Stopford
3000 words
September 4th, 2010

Martin Stopford, Clarkson Research 9 9/10/2010