UK: Surviving The Storm - Will Restructuring And Consolidation Help Provide Safe Passage Through The Shipping Crisis?

Last Updated: 18 March 2009
Article by Amir Jahanguiri

Voyage to disaster

For six months now, the downturn has dominated the conversation, the economy and the future of an ancient and resilient pillar of world trade. The short-term outlook for shipping is, indeed, a bleak one.

Scaling in recent times to meet an unprecedented upturn in commodity demand, the industry had no choice but to boost its size and speed to keep pace. As the new superpowers raced to industrialise, and the world's appetite for the goods they supplied increased, the global fleet became a cherished and well-rewarded resource. Tonnage prices soared to new highs, crew were promoted fast and paid well and the shipyards were flooded with orders. The seemingly endless boom would need new ships – and plenty of them. The industry laid down plans to increase in size by an astonishing 50 per cent in just the handful of years it would take to build the ships. Even the early warnings due to instability in the iron-ore market in late 2007, which led tonnage prices to drop temporarily, had only a limited effect on checking the trend of uncontrolled growth last year (see graph below).

Bullish ambition did not last long enough to see much of the new fleet hit the water. The fragility of the world economy, a product of the west taking on unsustainable levels of debt, became increasingly obvious from early 2008. As the year progressed, the gravity of the situation was plotted with gloomy daily updates. Consequently, the shipping industry, by nature cyclical, was to have its next due downturn amplified by a colossal slump in world demand for its services as production growth fell (see graph on the next page). The results now surround and obsess all those with an interest: cancelled ship orders, tonnage prices barely above or below break-even, ports full of idle vessels... these are topics discussed endlessly, with few brave enough to predict the outcome.

The past period of boom and bust in shipping has left the industry stunned. It has also, as with the wider economic disaster, left injured parties sifting over the damage looking for causes and culprits. Unsurprisingly, expansive credit facilities are at the top of the list of things to blame. This is a stance that Tim Jones, CEO of shipbrokers Barry Rogliano Salles, has some sympathy for: 'The defaults have been restrained so far, but there is an iceberg of hidden debt waiting to sink other owners and freight traders. Things could spiral out of control, bringing down even prudent businesses.' The post mortem is likely to be ongoing, though the ultimate verdict given on the causes may already have been reached.

Further trouble ahead

The debt Jones warns of is not isolated. The shipping industry, grimly reflecting US and European economies, is systemically and dangerously over-leveraged. Such widespread exposure is seen by many as a significant problem. According to Richard Haines, senior director of freight futures at independent ship-brokers Simpson Spence and Young, many in the industry are in a precarious position: 'Last year, when charter rates were peaking, a ship purchased in the pre-boom period could have been paid off within six months. At current prices, owners are operating close to or below break-even level, depending on the cost and financial structure of the vessel. That means that many highly leveraged owners are staring at the possibility of having their fleet repossessed.'

The increasingly strained dealings between previously blameless shipping firms and their long-term bankers have been spotted by Lars Westpfahl, partner at Freshfields Bruckhaus Deringer: 'With high leverage comes a change in relations between the industry and its bankers. Friendly arrangements are souring and many industry players have been surprised by the frosty treatment they have received from their banks.'

Although the credit crunch was initially seen by some as a useful checking mechanism that might have encouraged the banks to lend less generously, it has now become clear that many ship owners are not in possession of the cash cows they thought they had bought. The rumblings of impending disaster can be heard – and they are louder for the inherent complexity of modern vessel usage. Haines adds: 'The industry is in a vulnerable position. It is not uncommon to see multiple re-letting of tonnage. A vessel may, for example, be built for and owned by a Greek firm and re-let to a Danish operator on a three-year contract. The Danish company might reasonably re-let the ship again to a Hong-Kong operator for a year – which may in turn re-let to a mainland Chinese operator for three to five months in order to carry cargo for a steel mill. If just one of these businesses were to fold, then the whole chain could collapse like a house of cards.'

There seem to be no corners of the industry free from concern. Ship owners, shipbuilders, operators, crew, bankers... Each group has its own reason to worry. Few in the industry are keen to take a bet on which players are most likely to survive without great loss. It's a point that Tim Jones is aware of: 'Picking who will come out of the downturn unscathed is difficult. Obviously cash-rich firms that didn't make commitments at peak prices stand to suffer less damage. But luck plays a part and even the stronger businesses are exposed to the potential of reneging up and down the chain.'

The assumption that further casualties are a certainty is universally accepted. Indeed, the website of popular industry newspaper TradeWinds is so focused on the downturn that its 'Crisis watch' section is the very first tab available for visitors to choose. Names of those in trouble are clocking up: Armada (Singapore), Transfield Shipping, Glory Wealth... Recent fluctuations in the market seem to have given no more than a fleeting and vain new hope of recovery. The shipping industry is unanimously braced for further bad news and the list watched anxiously by the trade media will lengthen.

Central to the murky outlook is an irrefutable economic reality, explained by Haines: 'The volume of major deep-sea dry-bulk shipping is driven by three primary demands: for grain, coal and iron ore. The first two are moderately stable, of course. But until the market sees an increased appetite for steel from the construction and car-manufacturing sectors, it is unlikely that there will be sufficient demand for bulk shipping to produce a significant revival in rates.'

Money in general is a problem that stems not just from the slump in global demand. Second-hand ships bought during the boom at a premium have shed value, leaving owners with the negative equity all too familiar to subprime American homeowners. In addition, further funding is squeezed in the credit crunch and covenants are being revised.

Non-bulk shipping stands to lose, too. The wet market is flat and tanker demand is likely to suffer as oil consumption drops for first time since 1983. Such a drop will put pressure on operators working out of the Middle East, north Africa, west Africa and the Caribbean. Container shipments of finished goods remain affected by reduced consumer spending in the west. Lloyd's reckons that 135 container ships are idle – and the big lines are slashing their rates across the board.

The unfolding of anguish and loss is hard to watch. But with the World Trade Organization (WTO) estimating that 35 per cent of world trade travels by sea, with some $13.6 trillion-worth of goods shipped annually, this is an industry that must repair itself while continuing to operate efficiently.

Bailing out

Predictions of how long recovery will take are hard to come by, with pragmatic commentators reluctant to take a call on a problem with so many influencing factors and imponderables. Although the majority anticipates gloom for upwards of two years, there is the occasional pundit who sees a chink of light beyond the clouds. The UK's leading business radio programme, Today on BBC Radio 4, was brave enough to suggest in mid-February that the BDI's recent rally may be a first signal that the global economic crisis is starting to heal.

As long as there is sea and people have stuff to be moved, shipping will survive, of course. So if it is accepted that the downturn will not kill the industry, what measures can be taken by worried companies as they strive to weather the storm?

Consolidation is an obvious route. Shipping remains fragmented compared with other comparably sized industries and the fragility of many firms will make them natural targets. The cyclical nature of the business – regardless of the extraordinary prevailing macroeconomic conditions – favours the strength and momentum of larger groups. So this period could perhaps provide a natural opportunity for firms to seek out mutually beneficial mergers and acquisitions (M&A) activity. It may even be the only hope for some stricken smaller players.

Beyond the option of firms gathering together to pool assets and gain strength through strategic union, the general behaviour of the larger private groups may also change. This is a view held by Jan-Holger Arndt, partner at Freshfields Bruckhaus Deringer: 'The likelihood is that the private shipping companies will begin to operate more like listed businesses in a move towards "corporatisation". The downturn in shipping has put the spotlight on the need for rigorous and transparent accounting and reporting – as well as bringing about harsh criticism for past flamboyant speculation. It may well be that this industry, known for self-reliant private and family ownership, will feel compelled to modernise, open the books further and play according to newly toughened rules.'

Traditional market financing fixes are looking beyond reach for troubled players. Although it may be reasonable for a young firm in the good times to consider an initial public offering to raise growth capital, this is not an option in the near future. Dual crunches on equity and credit mean that there is little in the way of fresh money. Indeed, certain publicly traded firms are considering delisting as the market continues to worsen. Neither will banks be likely just to extend credit as cash flow crises move closer.

With WTO estimates that 90 per cent of world trade relies on letters of credit, it is clear that international banking relations are critical to survival. As trust dissolved during the height of the banking crisis in 2008, the cost of credit inevitably rose. Since then, opinion on the effects on shipping has varied. Liquidity is improving and owners and operators should start to feel the benefits through 2009.

It is clear, though, that some firms are reaching the point where financial and corporate restructuring are looking inevitable. Arndt explains: 'The level of debt in shipping and the meagre price of tonnage mean that certain companies are reaching the point of no return. To avoid this, they must think carefully about radical alterations to the balance sheet.'

Another potential outcome of the turmoil Arndt sees is the changing geographical location of shipping finance: 'China and South Korea have made great progress in their transformation into world shipbuilding destinations, but they have, on the whole, stayed out of financing. It may now be a good opportunity for them to progress in this area, particularly construction financing, and increase their attractiveness to the industry. A strategic shift in shipping finance from Europe to the Far East is a real possibility.'

This year may well prove the toughest test ever for this great industry. There will be no quick fix, no painless resolution, no chance of simply muddling through. But with constructive, practical measures, losses can be contained. The firms that move smartly and inventively through this period of darkness will be the pioneers of growth when the time comes. Prepared by Freshfields Bruckhaus Deringer in association with Untitled. Freshfields is a leading international law firm with a global shipping practice. The large, specialist team is drawn from experts in multiple disciplines, including: port development, shipping, M&A, restructuring, financing and fund initiation. The firm is uniquely positioned to offer counsel during the shipping downturn. Untitled is a new research and strategy firm. It was spun off from HEC Paris, Europe's top-ranked business school. Freshfields is a member of the HEC Foundation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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