Opportunities in a Wrecked Shipping Industry: LNG Carriers

Opportunities in a Wrecked Shipping Industry: LNG Carriers

By: Michael Molman

This article is Part 2 in a 3 Part series about the investment opportunities in shipping
Part 1: Opportunities in a Wrecked Shipping Industry: Overview

           
            In the first part of this three-part series on shipping, I described how shipping stocks, trading at the cheapest valuations in over 20 years offer investors a unique opportunity to profit off the recovery in the industry. Since then trade tensions have escalated, with the U.S and China on a brink of a full-blown trade war. This has understandably caused investors to be skeptical about investing in shipping, which relies heavily on free flowing global trade. However, some areas of the shipping industry still present huge opportunities despite protectionist rhetoric. One such area is LNG (Liquefied Natural Gas) carriers.

            Natural gas has increasingly become vital to the worlds energy market. Since 2000 the number of countries importing LNG has quadrupled. As a cheap clean burning fuel, it has supplanted coal as the go to cheap energy source. Natural gas is already the most used energy source in the United States and all signs point to its increased use abroad. Liquefied natural gas carriers or LNGC’s are the vessels responsible for transporting natural gas (in its liquefied form) from producing countries such as the U.S or Qatar to energy starved nations in Europe and Asia. LNGC’s represent a very small portion of the worlds commercial fleet but as demand for natural gas explodes and production in the U.S increases, it sets up LNG shipping to be extremely profitable for investors.

            Much like the rest of the shipping industry the market for LNG carriers suffered greatly during the financial crisis in 2008 and the oil crash in 2014-15. These crises significantly depressed the market for natural gas and by extension natural gas trading and shipping. In 2012, the spot price for LNG carriers was an eye watering $143,750 per day, by March 2016 the spot price had fallen to a mere $27,500. Now as the energy and natural gas markets recover LNG carriers are set to make a comeback, by October 2017 spot prices had increased almost 83% from their 2016 lows to $50,250. With stocks in this sector starting to bottom out investors can benefit greatly off the recovery.

Chart showing the collapse and steady recovery in the daily spot price for LNG Carriers from 2011 to October 2017

          To understand the opportunity in LNG shipping it is necessary to understand what is driving the recovery in the market. The answer, simply put, is strong Asian demand for natural gas coupled with steadily increasing U.S production, which has led to a dramatic increase in LNG trading. LNG trading volumes were up 10% in 2017, as Asian countries and China, in particular, begin to replace their polluting and inefficient coal power plants with newer natural gas powered ones. At the same time an unprecedented energy boom is taking place in the United States where shale drillers continue to ramp up production of oil and natural gas, rapidly turning the U.S into an energy exporter. The United States LNG export capacity has jumped to 18 million tons annually in 2017 from just 2 million in 2015. This dynamic of rapidly growing natural gas demand and production might be keeping a lid on natural gas prices but it is a boom for LNG trading, as U.S based surpluses of natural gas are sold to Asian countries which have seen their own gas fields depleted.

            Asia is the end destination for almost 3/4^ths of seaborne LNG volume and the region is expected to account for 50% of all demand growth in the LNG market over the next three years. Growing industrialization and populations have created a growing need for cheap clean energy. Developing countries like Indonesia, Thailand and Philippines all plan to use more natural gas in their energy grids. Chinese LNG imports alone are expected to increase 13% a year, over the next three years as the country continues to battle pollution. This has led to China signing a 15-year deal with Cheniere Energy (LNG) to buy 1 million tons of liquefied natural gas a year and LNG carriers will be needed to carry all of it.

            Proof of greater U.S LNG exports to Asia comes from data collected by the Panama Canal Authority, which manages the vital waterway connecting the Pacific to the Atlantic. The Panama Canal received 60 LNG tankers in the last quarter of 2017 compared to just 43 in the same period in 2016. The Canal Authority expects this number to increase an additional 50% as Asian demand and U.S production of LNG expands. Greater U.S LNG exports to Asia mean LNG carriers have to travel longer distances, this increases fleet utilization (as ships must be chartered out for longer periods of time), which in turn increases charter rates. Higher charter rates lead to improved profits and increased returns for investors.

            Asia is also not the only region desperate for U.S natural gas exports.  Demand from Europe is on the rise as well. European demand for LNG is expected to increase 17% a year until 2020. This demand growth is being fueled by falling domestic production, and a projected decline in pipeline supply from North Africa. Also, Western European countries, historically dependent on Russian gas supplies, may choose to buy American LNG as tensions with Moscow rise. This growth in American LNG exports is extremely beneficial to the LNG shipping business.

Chart showing expected global demand for LNG imports from 2011 to 2020. Demand is expected to grow an average 7% a year over the next 3 years. (Greater LNG imports is good for LNG Carriers)

            The demand picture for LNG tankers is solid but it is also necessary to look at the amount of LNGC’s in and entering the market. If the supply of ships outpaces demand growth, the market will suffer. Delayed deliveries of new ships in 2017 greatly helped the LNG shipping recovery, only 20 ships out of expected 36 were delivered.  This limited fleet growth to 5%, which was considerably below demand growth. A continued recovery will depend on a supply of ships remaining low. In the first 9 months of 2017, 13 new orders for LNGC’s were placed bringing the total order book for LNG carriers to 123 vessels. This is well below the November 2015 peak of 164 and with increased demand for LNG imports the supply and demand balance for LNG shipping should continue to improve. However, the market balance will remain delicate for some time leading to periods of volatility.  

Chart showing order book for new LNG Carriers steadily declining. This is bringing the LNG shipping market back into balance.

                   The market for LNGC’s is steadily improving; investors who want to get involved have the option to invest in multiple different companies. Unfortunately, many LNG shipping companies are in poor financial health following several years of tough market conditions. With that being said, there are a few companies that have seen their stock prices and financial conditions improve along with the LNG shipping market. Some of these companies include GasLog Partners LP (GLOP), Golar LNG (GLNG), and Teekay LNG Partners LP (TGP). All three have seen their stock prices stabilize after several years of declines and all three are either profitable or expected to return to profit in 2018. As such they offer investors a good avenue to gain exposure to these LNG trading and shipping sector.

            Still, even though LNG shipping presents investors with an enormous possibility there are some risks. Chief amongst them is the rise of renewable energy sources threatening demand for natural gas imports as well as the possibility of an oversupply of LNG tankers. These are the greatest risks to the LNG shipping sector but may not be as prominent over the next few years. Renewable energy sources are still too expensive to be adopted on a large scale by smaller developing countries, which will still need access to large supplies of cheap energy, in other words, natural gas. As for the supply of ships, new vessels will continue to hit the market over the next three years but there are not enough LNGC’s under construction to overwhelm the market like in the past. This means LNG carriers, a somewhat niche business within the shipping industry, represent an enormous opportunity to take advantage of the growing demand for LNG imports. Investors who get involved now could see significant profits over the next several years as the market grows.

http://www.talkmarkets.com/contributor/Mike-Molman/

Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor.             

Opportunities in a Wrecked Shipping Industry: Overview

Opportunities in a Wrecked Shipping Industry: Overview

By: Michael Molman

This article is Part 1 in a 3 Part series about the investment opportunities in Shipping

So far 2018 has proven to be a much more difficult year for investors then 2017. Strong gains in January were followed by a sharp and brutal correction in February which brought with it something that has been missing from the stock market these last few years, volatility. Some traders like billionaire hedge fund mogul, David Einhorn, believe value stocks will now begin to outperform their fast-growing counterparts. This new stock market dynamic provides investors with huge opportunities, if they know where to look.

            
The place to look is at industries and sectors that have been underperforming over the last few years and are poised for a comeback, shipping is one such industry. Shipping has been around for over 10,000 years and is one of the world’s most important industries. Over 90% of trade is carried by the international shipping business each year. The business is almost exclusively responsible for the shipping of raw materials from resource rich countries in Africa to factories in Asia and then the finished products to consumers in the U.S and Europe. Shipping’s importance in the global supply chain cannot be understated, however the last 10 years has seen the industry suffer one of its worst ever downturns, which saw freight rates drop an astounding 98% in some sectors. This in turn led to rapidly falling stock prices, bankruptcies and defaults throughout the shipping business. There are signs though, that shipping has passed its cyclical bottom and could be poised for a recovery. With shipping stocks trading at extremely depressed valuations investors have a rare opportunity. To understand it though, it is necessary to know how the shipping business is structured at what caused it to collapse in the first place.

            
Although shipping is considered a single industry it is subdivided into many different parts. Different companies operate different types of vessels for different types of uses. There are three main types of commercial vessels; Dry Bulk, which are vessels designed to transport bulk commodities such as iron ore, coal, grains or scrap metal. Container vessels, which are ships designed to carry loads in containers (the ships in the picture above are examples of this type of vessel), and tankers which are ships that carry crude oil or refined products like gasoline. Each one of these categories is further broken down, for example, within the category of tanker vessels, there are ships designed to exclusively carry oil and those that are designed to carry only liquefied natural gas. Each different type of vessel has its own unique freight and spot market which determines how much each type of vessel makes a day when it is being chartered out. In many ways, the shipping business is like the commodities business in that when there is a large supply of ships freight rates are low, when there are too few rates are high.

            
In the years leading up to the great recession in 2008, international trade was booming, growing at an average rate of 5.4% a year. Emerging market economies, especially China, were growing rapidly and consuming more and more of the world’s raw materials. Meanwhile consumers in the U.S and Europe were enjoying a time of easy credit and were consuming record amounts of finished goods. At the same time, free trade agreements opened borders like never before which added fuel to international trade. This type of environment led to unprecedented prosperity in shipping. From October 2001 to June 2008 the Baltic Dry Index (a leading indicator of the shipping industry which shows the cost of shipping raw materials by sea) surged over 1200%. With the cost to charter a ship at a record high, owning a commercial vessel became extremely profitable. At one point in 2007 a 5-year-old 180,000 dead weight ton ship which hauled iron ore or coal cost $160 million. Freight rates for container shipping were equally high with the cost to ship a single container from Asia to Europe at over $2,800 (the current rate is about $1,200).

Chart showing annual growth of world's commercial fleet from 2000-2016 (Percentage Annual Change)

With charter rates soaring along with the prices of commercial vessels, shipping companies began to order new vessels on mass. As the chart above shows, annual growth for the worlds commercial fleet went from just over 1% in 2000 to just under 10% in 2011. The party came to an end in 2008 when the great recession hit. Consumption in developed countries came crashing down, which in turn led to less demand for raw materials in industrializing developing countries. International trade went from growing over 5% a year to less than 1.5%, suddenly there was not enough cargo to go around. In June 2008, a Panamax class bulk commodity freighter commanded a daily charter fee of over $64,000, by December 2008 that fee had dropped to $11,000 if the ship was lucky enough to have a charter at all. Container shipping hardly fared better with the sector losing at least $15 billion in 2008 alone. The Baltic Dry Index which had been soaring for years up to the financial crisis crashed an astounding 94% in 6 months.

The shipping business much like most other commodity related industries, is known for its volatile boom bust cycles. The difference was this time there was no recovery. Banks, which had been eager to lend to shipping firms for years, began to pull out of the business, due to heavy losses on shipping loans. With freight rates at unsustainable levels and no credit, shipping companies suffered, during this time the average shipping stock fell 80%. This hardly reduced the overcapacity in the industry. Due to a backlog of ship orders placed before the crash, new ships continued to hit the market until 2011, only worsening the supply glut, which has continued for the last 10 years. A brief recovery in global trade in 2013-2014 saw ship owners begin placing orders for new ships again, hoping to take advantage of the revival. This “comeback” was sunk by a slowdown in the Chinese economy and the commodities and oil collapse in 2014-15. Leading to a shipping market that continued to be oversupplied, and another 5 years of poor returns and steep losses. 

Chart showing Baltic Dry Index from 2000-2018, freight rates fell as much as 98% from highs hit in 2008 to all time lows set in 2016

Over the last decade, the shipping industry has struggled to deliver returns to investors amid consistently low freight rates and oversupply of ships. However, certain segments of the shipping industry are beginning to see improvement. Most publically listed shipping companies trade below book value, so even a moderate recovery in freight rates could lead to outsized returns for investors.

            
The most obvious bullish sign for shipping firms is the recovery and growth of international trade. Global trade grew 3.6% in 2017 compared to just 1.3% in 2016, most of this recovery came from a recovery in Dry Bulk. A comeback in the industrial commodities coupled with increased demand for raw materials in China increased demand for dry bulk vessels. The Baltic Dry Index jumped over 300% since bottoming out in February 2016. Higher freight rates have led to increased revenue and for the first time in nearly 10 years, profits at some shipping firms. Maersk (the world’s largest container shipper) posted a $541 million profit in 2017 compared to a $376 million loss in 2016.

            
Higher freight rates and profitability have increased interest in shipping. According to a survey by accounting firm Moore Stephans, confidence levels in shipping are at the highest point since 2014, driven by increased cargo demand amid a growing global economy. This growing optimism helped facilitate an increase in the sale and purchase of ships. Ship trading increased almost 30% in the first 3 quarters of 2017 compared to the same period in 2016. About 1,630 ships worth $19 billion were traded in 2017, the highest total since shipping peaked in 2007. Increased ship trading helped boost the price of some types of commercial vessels as well. The same 150,000 dead weight ton dry bulk ship that cost $160 million in 2007, was only worth $24 million when the market hit bottom in early 2016. Since then prices have recovered slightly and in 2017 the ship fetched about $33 million. (Prices of second hand ships are determined by the economic lifetime of the vessel and its future earnings potential).

Chart showing the average price of second hand ships from 2010 through 2017. Ship prices increased on average 21% in 2017 due to increased market sentiment

With market sentiment improving along with freight rates and ship prices, some hedge funds have decided that now is the right time to begin investing in shipping. Throughout the latter half of 2017 hedge funds poured over $675 million into the industry. One hedge fund, Tufton Oceanic which manages about $1.5 billion, put out a statement saying, “shipping stocks are trading at the lowest valuations since the late 1990’s and could increase 50-100% over the next 1 to 2 years.” Besides just increased speculative and institutional buying of shipping stocks, speculation in other forms of freight derivatives has also increased. Freight derivatives are financial instruments which derive their value from speculation about the future value of freight rates. According to leading ship broker SSY Futures, speculation in freight derivatives soared to $16.5 billion in 2017 compared to just $9 billion in 2016. This could signal that many large speculative and institutional investors are worried about missing the chance to invest at the bottom of the market when asset prices and freight rates are lowest.

Unfortunately, similar indicators occurred during the brief shipping recovery in 2013-14. Hedge funds invested hundreds of millions into the sector at the time based on forecasts of improved global economic growth. Unfortunately, the recovery was derailed by not just an emerging markets slowdown and commodities crash, but also by shipping companies over ordering new ships. Many shipping companies began ordering new ships before the market had recovered to get a jump on rivals when freight rates bounced back. This only increased the oversupply of ships in the market and caused another industry downturn.

This time though there are far less ships on order and according to analysts at major banks and consulting firms, the amount that there is, is unlikely to depress the market like in 2014. According to ship consulting firm, Danish Ship Finance, shipbuilders saw their order books decline by over 15% in the first 3 quarter of 2017. New deliveries of ships far exceeded new orderings which has caused many ship yards to close entirely. At the beginning of 2018 ship building capacity was 10% lower than a year prior. Globally there is 3,000 commercial vessels on order, which is the lowest amount since 2003. The lack of new ships on order, means that as global trade continues to increase (as it is expected to) and increases demand for shipping, there will be less supply in the market. This is a recipe for a shipping comeback. 

Despite the bullish signs coming from the shipping industry investors must be careful about which companies and sectors they invest in. Many segments of the shipping business such as off shore vessels (ships supporting offshore drilling), container ships, and oil tankers continue to suffer from oversupply and low freight rates. These segments might one day prove great opportunities but in the current market investors ought to focus on sectors of the shipping business that are already on the road to recovery. The areas of the shipping industry that offer investors the greatest opportunities are dry bulk shipping, LNG and LPG carriers as well as American close shore shippers. Investors hoping to invest in a shipping recovery without choosing individual companies have the option to buy into Guggenheim Invest Shipping ETF (SEA). This ETF is made of the largest shipping companies in multiple segments of the shipping industry. With that being said, the best returns will be had by investing in undervalued individual companies operating in segments of the shipping industry that are set to recover and thrive over the next couple of years. These specific opportunities will be described in greater detail over the course of the next two articles in this series on shipping.

http://www.talkmarkets.com/contributor/Mike-Molman/?uid=50272

Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor.