Don’t worry about near-term capacity growth—think long-term

Market Realist

Why dry bulk shipping shares will rise after a recent fall (Part 5 of 6)

(Continued from Part 4)

Annual capacity growth remains positively in downtrend

From September 6 to 13, year-over-year growth in dry bulk capacity, measured in deadweight tonnage (DWT, the weight a ship can safely carry across the ocean) and published weekly by IHS Global Limited, for Capesize vessels rose from 5.15% to 5.26%, while growth for Supramax and Panamax vessels continued to see declines, from 9.28% to 9.14% and 9.93% to 9.87%, respectively. Analysts used year-over-year growth to adjust for seasonality and to make comparisons on a more long-term trend rather than a short-to-medium-term perspective.

Why is capacity important?

Analysts look at capacity growth to see whether it will exceed demand growth, instead of solely relying on indicators such as ship orders and ship prices that reflect managers’ perspective of future supply and demand dynamics. When capacity grows faster than demand, competition rises among individual shipping firms as they try to use idle ships and cover fixed costs. This lowers day rates, which negatively affects bottom-line earnings, free cash flows, and share prices for companies. On the other hand, when capacity increases can’t meet demand growth, shipping rates will rise, which bodes positive for dry bulk companies’ top line revenue, bottom-line earnings, free cash flows, and share prices.

Background on capacity growth

Driven by large placements of new ship orders, shipping capacity had ballooned over the past two years, as companies expected global trade growth to continue at a record pace. As they realized what they got themselves into, they’ve refrained from ordering more ships. The overall declines in capacity growth since 2011 show this development. Supply growth remained elevated, however, as trade growth fell with slowing economic growth in China. Nonetheless, with construction levels falling, it’s just a matter of time before capacity growth falls even further—especially for Panamax and Supramax ships—which would be positive for rates.

Weekly growth rate continues to fall

Last year, several dry bulk shipping companies had pushed back deliveries—for Capesize vessels in particular—as China’s economic growth fell and rates fell to a record low. This year, delays may not be that significant, as rates have risen above the lows. On September 6, the eight-week moving average weekly growth rate stood at 0.10% for Capesize vessels, which was lower than the 0.11% on September 6. Panamax vessels continue to see weekly growth of around 0.17%, but are expected to fall soon. And the same can be said for Supramax vessels, which were seeing 0.09% weekly growth on average.

Near-term capacity growth not worrisome

Year-to-date, Capesize vessel capacity has grown by 4.59%, Panamax by 7.91%, and Supramax by 5.80%. If the last twelve weeks of average weekly growth carry through for the remainder of this year, Capesize vessels could see 6.19% in annual growth, plus 10.21% growth for Panamax and 7.23% growth for Supramax. There is and has been much debate over whether capacity growth will outpace additional demand this year. Last year, dry bulk trade grew 7%. Capesize rates have risen sharply because of high demand and one of the lowest supply growth of all ship classes. The probability that rates for Supramax and Panamax will increase is lower. But a record output of crop that’s expected to ship to outside the United States in the fourth quarter and lower capacity growth for Supramax could leave some more upsides in rates.

Investors may be wasting their time trying to time everything, though. There’s a wide consensus that shipping rates will recover in 2014, with supply growth only at ~3.5%. So while investors fudge over whether it’s this year or next year that fundamentals will improve, the market would likely continue to support share prices of companies like DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM), Navios Maritime Holdings Inc. (NM), and Safe Bulkers Inc. (SB) with little downside in the near term.

Continue to Part 6

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