Our Shipping Market Review – May 2016 is devoted to the fourth industrial revolution. To understand the truly disruptive nature of the fourth industrial revolution, we cannot simply look at the disruptive technologies in isolation. We need to see the new dynamics from the right perspective. It is important to understand that two major tectonic plates underneath the global economy are shifting.
WEALTHY CONSUMERS ARE ABOUT TO RETIRE
The first tectonic plate that is moving is the number of consumers powering the global economy and seaborne trade. The global population continues to rise, but major demographic shifts are changing the underlying forces of the global economy. Wealthy consumers in developed economies and China are about to retire and are being replaced by plentiful but relatively poor emerging consumers elsewhere. This transformation is expected to have a major impact on trade flows and trade dynamics. Still, many argue that this replacement will pave the way for continued improvements in seaborne trade volumes.
THE FOURTH INDUSTRIAL REVOLUTION IS CREATING FEWER JOBS
From a structural perspective, we tend to agree, but we see little to indicate that this potential will materialise within the next decade or two. There are many countries that have vast and unfulfilled demographic potential, but it seems that the fourth industrial revolution is hampering their ability to create the millions of jobs needed for them to become global consumers. We argue that China may be among the last emerging economies to be able to ride the wave of industrialisation to middle-income status through job creation in the manufacturing sector.
URBANISATION MAY BECOME LESS TRADE-INTENSIVE
The second tectonic plate in motion is the supercharger of the global economy and seaborne trade: urbanisation. Clearly, the urbanisation process is continuing, but it is diverging from past trends and is tending to follow new routes that give individual consumers access to more goods using fewer resources (including energy) and requiring less seaborne transportation.
WE NEED TO RESET OUR INTERNAL NAVIGATION SYSTEMS
Global value chains are expected to shorten: from raw materials to intermediate goods to finished goods. Trade dynamics and trade patterns are expected to be redefined. Seaborne trade volumes may stagnate or begin to decline. We need to realise that much of what we think we know about how the world works is about to become outdated. Long-standing trends are being broken since technological innovation has started to deliver on the promises dreamed about for several decades. We are in a period of innovation on many different fronts. To grasp the full potential of the combined forces, we need to reset our internal navigation systems. These new technological innovations are bringing about unparalleled changes to the global economy.
EMERGING ECONOMIES NEED TO LEAPFROG INDUSTRIALISATION
We need to understand that for developing economies that are not yet an integrated part of the world economy, it is not possible to industrialise by technology leapfrogging, as China did. The challenge for the next generation of emerging economies is that they will have to leapfrog industrialisation itself, since large pools of cheap labour no longer represent an entry ticket to the world economy through job creation in the manufacturing sector. Models of economic development will need to feature more investment in education, faster implementation of new technologies and — most importantly — higher rates of local innovation.
LONG-TERM GAINS IN EFFICIENCY AND PRODUCTIVITY
Put another way, the fourth industrial revolution is opening the gates for long-term gains in efficiency and productivity. Transportation costs are expected to remain low, logistics and global supply chains will become more efficient, and the cost of trade will diminish. In essence, travel distances will shorten, trade Danish Ship Finance (Danmarks Skibskredit A/S) Shipping Market Review – May 2016 8 volumes will stagnate or drop, and fleet efficiency could improve considerably.
NEW BUSINESS MODELS WILL HAVE TO BE DEVELOPED
This outlines the first drawings of a new architecture for the shipping industry. Other industries have already seen new patterns of consumer behaviour that force companies to adapt the way they design, market and deliver products and services. A key trend is the development of technology-enabled platforms that combine both demand and supply to disrupt existing industry structures. Similar trends could easily find their way to the shipping industry. It could mean that entire new business models will have to be developed to serve the industry. To us, it seems clear that the fourth industrial revolution could redesign parts of the shipping industry within a decade or two.
NEW DYNAMICS ARE SHAPING THE GLOBAL ECONOMY
This development is playing havoc with forecasts for future seaborne trade volumes that were made simply by extrapolating recent experience into the near and distant future. Many of the assumptions, tendencies and habits that have long proved so reliable have suddenly lost much of their resonance. Our intuition has been formed by a set of experiences and ideas about how things worked during a time when changes were incremental and somewhat predictable. But that is not how things are working now — and it is not how they are likely to work in the future either. If we look at the world through a rear-view mirror and make decisions on the basis of intuition built on our experience, we could very well be wrong. In the new world, we need to scrutinise our intuition from first principles and boldly reset it if necessary.
HOW TO NAVIGATE THE CHANGING LANDSCAPE
The shipping industry is to some extent navigating in uncharted waters. What actions should be taken? Obviously, surplus capacity needs to be scrapped, but then what? For all of the upheaval facing the shipping industry, a number of powerful megatrends will create unprecedented opportunities for shipping investors to enter new markets and redefine existing business models.
SHIPBUILDING
Overcapacity issues and low freight rates in many of the major shipping segments are burdening the Shipbuilding industry. Contracting declined significantly in many shipping segments during 2015 and the first quarter of 2016, and a large number of existing orders were either being cancelled or postponed, causing some yards in the already troubled industry to suffer severe financial difficulties. Consolidation of the industry is well underway and there are now even fewer yards capable of attracting new orders. In 2015, around 240 different yards received new orders, a significant decline from previous years. It is primarily small and medium-sized yards, many of them in China, that are struggling to secure new orders. Consequently, the number of active yards and total active capacity is falling. We estimate that the number of active yards declined by approximately 70 yards with a combined capacity of 10% of global capacity in 2015. This helped push global yard utilisation up from 68% in 2014 to 78% in 2015. The next couple of years are expected to be extremely difficult for shipyards, as the potential for new orders is expected to remain low. The depressed market conditions, especially in the Bulk, Container and Offshore segments, increase the probability of lower order intake in the short to medium term, as well as more order cancellations and postponements. By year-end 2017, we expect the number of active players to have been drastically reduced.
CONTAINER
The Container industry is continuing to struggle as freight rates stay on their downward trend and ever larger vessels enter the fleet. In 2015, the oversupply accelerated, as the fleet grew by a massive 8% while demand growth weakened to just 1%. Lower European demand in particular was behind the slowdown in overall seaborne Container demand growth, which could be the first sign of more imports being sourced regionally. Despite the weakening demand and low freight rates, contracting in the Container industry continued apace, with a high number of very large vessels ordered. We argue that investDanish Ship Finance (Danmarks Skibskredit A/S) Shipping Market Review – May 2016 9 ments in very large vessels are long-term bets on the geographical location of manufacturing. However, manufacturing and consumer preferences are gradually changing and we do not expect the demand patterns of previous decades to be repeated. As the fourth industrial revolution evolves, manufacturing could become increasingly regionalised, which could redefine trading routes and shorten travelling distances.
Moreover, the emergence of a new, younger generation of consumers is changing the patterns of consumption, which, enabled by new technologies, could reduce the need for physical goods to be transported in the medium term – at least, we argue, on long-haul overseas trades. It seems that the world is undergoing a transformation that could end up redefining the Container industry. The trade patterns of today will persist to some extent, but we expect intraregional trades to grow in importance at the expense of the main east-west trades. This could leave some shipowners with large inflexible fleets unsuited to the future needs of customers, but liners still have the upper hand over tonnage providers.
DRY BULK
The Dry Bulk industry continues to be weighed down by the escalating influx of vessels seen over the last five to ten years. The fact that the industry has relied on China as the primary source of demand for so long has left it vulnerable at a time when China is rebalancing its growth model towards consumption and services and away from construction and manufacturing. In 2015, freight rates reached several low points and in February 2016, the Baltic Dry Index dropped below 300. Despite attempts to shrink the massive order book and stem the inflow of new vessels through order cancellations, postponements and extensive scrapping, fleet growth continued to outpace demand growth and the oversupply worsened. The rebalancing efforts in China left clear marks on the industry and resulted in lower Chinese demand for seaborne Dry Bulk cargoes, primarily due to lower coal imports.
The outlook for the industry remains gloomy. The order book remains large and there is uncertainty over future Chinese demand. Moreover, the global agenda to lower CO2 emissions is expected to put a lid on demand for coal. Urbanisation will continue to drive a large share of demand (i.e. building materials), especially in China, but it seems that the Chinese urbanisation process has been too rapid and that a slower growth period is about to materialise. Several of the steel-intensive industries are struggling with surplus capacity and the Chinese construction sector and real estate market are in the midst of a transition period. The weak demand outlook coupled with a large orderbook will delay the market recovery, putting it back some years. Going forward, scrapping and order cancellations will continue to play important roles in bringing the market more into balance. There will be temporary freight rate spikes on the way to a recovery, but these are expected to be just that: temporary. Previous shipping cycles have shown that occasional spikes in freight rates do occur, even in downward trending markets.
CRUDE TANKER
Crude Tanker freight rates have declined recently in response to lower seasonal demand and higher vessel availability. Nonetheless, freight rates are still at high levels. It could be argued that Crude Tankers are currently thriving because of the overcapacity in the oil and oil refining industries. The combination of few new vessels being added to the fleet and artificially strong demand for crude oil has lifted freight rates out of the doldrums. Excess production of crude oil has caused crude oil prices to halve, which in turn has stimulated refineries to increase their crude oil intake and the industry to build up reserves. These dynamics, amplified by the addition of new refinery capacity, have been inflating seaborne crude oil volumes above global end-user oil demand, which has resulted in infrastructural bottlenecks. In turn, the infrastructural bottlenecks have lowered the productivity of the fleet and contributed to the perception that supply is inadequate.
A very large amount of tonnage was contracted during 2015, causing a massive inflow of new vessels in 2016 and 2017. The market is expected to be in balance for most of 2016, but it is important to keep in mind that underlying oil demand grew by 10 less than 2% in 2015 and is only expected to grow modestly in the coming years. The large influx of new vessels due in 2017 is expected to tip the effective balance between supply and demand. The nominal overcapacity that has been building up in the shadows of the low crude oil price and high refinery intake is expected to come to the fore. Freight rates and secondhand values may begin to decrease as early as during the first half of the year. While it is the case that additional refinery capacity is expected to open, we are sceptical about how much more demand can be generated by increased industrial overcapacity. The global climate agenda, which aims to reduce the dependence on fossil fuels and to lower CO2 emissions, frames the outlook for Crude Tankers. This, in combination with the recent success of renewable energy and energy storage, including electric and hybrid cars, provides little indication that global end-user oil demand will spike unexpectedly in the medium to long term.
PRODUCT TANKER
Product Tanker freight rates have recently halved since their peak in the summer months in 2015, but average earnings remain fairly high. We argue that Product Tankers have been riding a wave created by temporary demand factors rather than end-user demand. Fleet growth has been high while end-user demand for petroleum products has been fairly lacklustre. Freight rates have been supported by remarkably high trading activity reflecting regional refinery imbalances, surplus production of refined petroleum products, and significant arbitrage trading. In addition, infrastructural bottlenecks have forced Product Tankers into floating storage. This has lowered Product Tanker productivity and kept fleet employment artificially high.
The influx of new vessels is expected to remain high during the next two years while the young age profile of the fleet leaves few scrapping candidates available. The fleet is expected to grow by 5-6% in 2016 and 2017. Seaborne demand is expected to absorb fleet growth of up to 4% in 2016, which will leave a larger part of the fleet unemployed and put downward pressure on freight rates unless scrapping picks up accordingly. Strong seasonal winter demand could provide temporary respite, however, and potentially postpone the pressure on freight rates into 2017. Moreover, new refineries are set to come online, although their impact on freight rates is expected to be limited, given the continued high inflow of new vessels. Increased production capacity is not necessarily a sign of high underlying demand. From a longer-term perspective, we see fundamental risks building up brought about by more widespread decarbonisation in most sectors and sustained high fleet growth. The petrochemical sector may be a bright spot and demand is increasing rapidly. But risks are building up in this sector too, with increased focus on recycling and material design.
LPG TANKER
VLGC freight rates have plunged almost 80% in nine months, from a peak of USD 129 per tonne in July 2015 to USD 27 per tonne in April 2016. The strong demand growth was simply swamped by the massive inflow of new vessels. Seaborne demand grew by 10% in 2015, while the LPG fleet expanded by 17%. In a flashback to the Dry Bulk market in 2008, we recall how the Baltic Dry Index plummeted by more than 90% in seven months, from index 10,844 in May 2008 to index 743 in December 2008. How could something similar happen to VLGCs? The large increase in supply was clearly the main factor tipping the balance, but the sudden increase in fleet availability and fleet productivity, driven by relatively mild weather, low naphtha prices and the unexpected closure of the arbitrage window between the US and Asia, intensified the pain. Now, the segment is faced with an uphill battle. In the years ahead, demand is expected to grow strongly, but the massive inflow of new vessels is set to continue. The fleet is relatively young, with more than 60% of vessels younger than ten years, but there are still scrapping candidates available.
Freight rates and secondhand values may come under pressure if fleet productivity is not reduced. A large-scale return of arbitrage trading between the US and Asia, enabled by higher oil prices, could lower fleet productivity and reinforce the balance between supply and demand. Still, we expect freight rates to remain at relatively low levels for the next two years. Secondhand values will clearly be impacted if the market continues to be low over a sustained period. However, we take some comfort in the fact that the secondhand value of a five-year-old VLGC is currently 20% below its peak in 2006, although earnings have recently been record-high. The lowest value recorded for a five-year-old VLGC is USD 48 million, only 40% below the current level. The point is that we foresee less short-term downside risk in secondhand values than for other segments.
Source: Danish Ship Finance | Hellenic Shipping
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