With These Stocks, It's Time to Abandon Ship

International marine transportation forms the backbone of the global economy. As the middlemen of worldwide trade, shipping companies move 90% of internationally traded cargo. In 2006 alone, more than $10.5 trillion in imports and exports were shuffled across the oceans, up nearly 60% from 2003. This rising tide has lifted all shipping companies, with pricing, demand, and stock values near all-time highs across the industry.

But could these favorable trends be reversing? In 2006, the carrying capacity of the world merchant fleet reached all-time highs, and with shipbuilders' order books backlogged, this cyclical industry could be approaching oversupply. Can investors expect the excellent returns on invested capital that shippers have generated in the recent past to continue into the foreseeable future? More importantly, what do today's market valuations assume about future economic wealth generation? By diving into the three major sectors of waterborne shipping--tankers, dry-bulk, and container ships--we'll help you navigate this industry's often treacherous waters.

Why Tankers May Be Hit the Hardest
Tanker ships represent 40% of the world's merchant fleet, moving oil (both crude and refined products), liquefied natural gas, and chemicals from production centers to consumption countries around the globe. Over the past several years, growth in oil demand, and consequently tanker shipping pricing, have spiked because of China's emergence as an economic powerhouse. In 2004 especially, oil demand grew at its highest level since 1988, adding 3.4% versus 2003. As a result of this heightened demand and the continued diversification of production countries, the Baltic Exchange's "Dirty Tanker Index," a measure of industry pricing, climbed at a 41% annual clip from 2002 to 2004. However, the index shed nearly 30% per year through early 2007, attributable to both slower gains in demand (closer to the historical average of about 1.5%) and an increasing outlook of ship supply.

Though all three of shipping's major sectors feature robust order books for new vessels, the oncoming supply of tankers looks to be most daunting. The current backlog of ships slated to enter the water before 2010--about 40% of the global fleet--is at a peak that has not been seen for 25 years. While many countries have mandated the elimination of older, single-hulled ships by 2010, several countries in the Far East (where such ships are primarily used) have not committed to this requirement, and we think the elimination of single-hull tankers will extend to 2015. We think that marginally growing demand during a period of starkly increasing supply will drive down pricing over the next several years.

One stock to avoid in this category is  Double Hull Tankers (DHT). While the firm operates a modern fleet of double-hulled oil tanker ships, we don't think the company will avoid continued downward pricing pressure. In an attempt to both stabilize its cash flow and participate in the upside of the volatile spot market, Double Hull has chartered its seven vessels on long-term arrangements that also include profit-sharing agreements. Still, the minimum rates on each ship are more in line with those found several years ago rather than the current lofty average daily prices. If pricing drops below this threshold, Double Hull's returns would be greatly diminished. As further risks, the company's debt/capital ratio is high compared with competitor  Nordic American Tanker Shipping (NAT), and a recently announced vessel purchase is less favorable to Double Hull than its current arrangements.

Dry-Bulk Ships Holding Their Own
International dry-bulk ships--36% of the world's merchant fleet-- move non-containerized dry cargo across three major goods: iron ore, coal (both of which are used in steel production), and grain, as well as other dry cargo such as steel. In recent years, increased Chinese steel production has driven import demand for ore and coal and subsequently export demand for steel. As a result, the Baltic Exchange's Baltic Dry Index--a sector pricing measure--shot up 65% in 2004, on average, before crashing in 2005 and 2006 because of a pullback in worldwide steel demand. In late 2006 and early 2007, however, the Baltic Dry Index rebounded, shooting up to an all-time high because of a resurgence of Chinese steel and severe Australian port congestion (tying up a substantial portion of the dry-bulk fleet for up to a month at a time).

Dry-bulk shipping's constrained supply is amplified by the least-robust order book among shipping's three sectors. Currently, future expected supply is about 25% of the dry-bulk fleet's capacity, but shipbuilders tend to prefer filling orders for higher-margin tankers and container ships. As the substantial orders for these other shipping areas enter the water, slots should open for the building of dry-bulk vessels. We think high prices should continue for the next year, and while increased supply should drive pricing to a more reasonable level, we don't forecast the Baltic Dry Index returning to pre-2003 levels.  

With its vast fleet and hedging strategies,  Navios Maritime (NM) looks poised for continued growth. The company's vessels are currently chartered at lower-than-market rates on one- to three-year agreements, and we expect Navios to capture much of this upside as it renegotiates its contracts. As a result, a dry-bulk market downturn wouldn't be nearly as detrimental to Navios as it could be to its peers. Adding to the company's opportunity, many vessels that Navios leases into its fleet include options to purchase the ships at below-market costs, and the firm's operating costs are amongst the lowest in its industry. Still, shipping can be an incredibly cyclical industry, and Navios is not completely immune from such volatility. We recommend purchasing the stock only with a substantial margin of safety, and we think the stock is fairly valued at today's prices.

Container Shipping Stocks to Suffer
As the smallest but fastest-growing international shipping sector, containerized shipments have become a critical aspect to global trade. If a long train carrying a multitude of giant boxes in all colors has ever held you up, you've seen TEUs (20-foot equivalent units), the same boxes that container shippers send back and forth across the world. In these containers, shippers typically carry finished products from Asia to North America and Europe.

Over the past few years, solid global GDP growth has buoyed demand for container shipping. While growth in marine container shipments isn't outpacing GDP growth as much as it used to, demand remains strong, and we expect 10%-11% annual growth for the next two to three years. Still, fleet growth has outpaced demand, driving down average daily charter prices in 2006 after two years of successive gains. As the total fleet's capacity is slated to increase 42% by 2010, we expect price rates to fall over the next several years.

To mitigate the effect of such a volatile market, the largest container shipping companies, such as A.P. Moeller-Maersk and China Shipping, have chartered-in an increasing amount of outside-owned vessels over the past several cycles. The ship owners--such as  Seaspan  or Danaos (DAC)--will typically agree to a rate that is less than the current spot rate, but over a very long period of time (sometimes 10 to 12 years!). By doing so, the shipping companies can lower their fixed costs while the ship owners avoid violent price movements over many market cycles.

The Bottom Line
Ship owners and operators over the past three years have enjoyed the strongest marine transportation market since the early 1970s. Barring another unforeseen spike in demand, the party seems to be over for container and tanker shippers, while their dry-bulk counterparts should hold on for at least another year. Though waterborne transportation is an integral piece of the global economy, stiff competition among industry participants combined with low barriers to entry and substantial customer power results in zero long-term economic profits, in our view.