We’re at the start of higher fleet utilization, so rates will rise

Market Realist

Federal shutdown and sentiment hit dry bulk stocks (Part 4 of 6)

(Continued from Part 3)

Annual capacity growth remains positively in a downtrend

From September 27 to October 4, 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 fell from 4.70% to 4.63%. Year-over-year growth for Supramax vessels fell further from the prior week, dropping from 8.91% to 8.63%, while Panamax vessels also registered a decline, from 10.01% to 9.89%. Analysts use 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.

Annual Capacity Growth 2013-10-09

Why is capacity important?

Analysts evaluate 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 positively 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 2011. 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.

How lower capacity growth contributed to higher rates

As the chart above shows, lower supply growth has a significant impact on fleet utilization and shipping rates. When Panamax and Capesize growth started to fall around October 2012, year-over-year change in the Baltic Shipping Index improved. Of course, stabilizing economic conditions in China helped.

The CEO of Golden Ocean Group, along with other analysts, expects supply growth of just ~3.5% in 2014 and 2015, while historical dry bulk trade has grown at ~5.5%. Note that the 5.5% growth is an average figure, and trade growth can fluctuate widely depending on economic outlook. The current consensus by the IMF calls for a higher growth rate in 2014 compared to 2013. Given the inelastic nature of shipping supply, and the relatively low cost of shipping goods at the moment, even a 2.0% differential will cause shipping rates to grow tremendously.

We’re only at the beginning of a supply tightening cycle

We’re more or less in a cycle where demand is going to outpace supply for some time. The current trend bodes positively for dry bulk shipping stocks like DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM), Navios Maritime Holdings Inc. (NM), and Safe Bulkers Inc. (SB) over the long term.

Continue to Part 5

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