Waters Remain Choppy for Shipping Stocks

Our view of the volatile marine transportation industry hasn't substantially changed since our last industry outlook, published in October 2008. Although the past eight months have been tumultuous, with customer bankruptcies, canceled contracts, and letters-of-credit issues, spot-market prices have rebounded to their autumn levels after a precipitous fall, primarily due to increased Chinese imports. These higher rates have subsequently boosted vessel values, enhancing ship owners' financial positions.

We continue to believe that China's industrialization will proceed mostly unabated over the long run, and the positive effects of its infrastructure-focused stimulus package don't surprise us. Recent production increases at major world steel mills will likely require additional iron ore--a major dry-bulk shipped commodity. That said, we think China's iron ore deliveries (which comprise nearly 50% of shipped iron ore) are due for a pullback, and we remain skeptical that cancellations within the massive order book for new ships and scrapping of older vessels will fully offset supply increases over the next several years. Vessel utilization has undoubtedly bounced back since its collapse in late 2008, but we expect further boom and bust cycles as supply becomes constrained by short-term factors such as port congestion and shipyard delays. Over the long term, we expect market pricing to stay relatively in line with its current level.

China's Voracious Commodity Demand--Too Much, Too Soon
The dry-bulk shipping market relies heavily on China's appetite for iron ore--a key input for the world's largest steel producer. We estimate that the recent overall shipping demand pickup is mostly due to the country's 40% iron ore import increase through the first five months of 2009 compared to the final five months of 2008. This massive increase partially supports China's 13% steel-production gains over the same period, but also seemingly outpaces it.

Higher shipping demand is primarily explained by the substitution of imports for domestic iron ore production, as foreign iron is of better quality and is now cheaper. This trend is likely to continue; we think recent spot-market discounts will eventually roll into new benchmark prices that are currently in negotiation. We don't think Chinese steel producers will garner the 45% year-over-year discount they're targeting, however, as Japanese and European manufacturers recently accepted price cuts from miners closer to 33%. China's port-based iron inventory has also risen substantially in the past several months, suggesting that iron ore imports will slow.

Dry-bulk ship owners have enjoyed demand expansion with Brazil regaining its position as the second-largest iron ore supplier to China (after losing its spot during Vale's (RIO) attempted late-2008 price increase), increasing average shipping distances.

The massive uptick in Chinese imports has also led to sizable port congestion at the country's coast. Both aspects constrain the amount of vessels available for shipments, artificially reducing supply and driving rates upward as a result. Still, these factors are short-term in nature, and a more meaningful structural change will likely need to occur to prevent continued oversupply.

Supply Side--Cancellations Still Inevitable?
At 65% of the world's current fleet, the gross order book of dry-bulk ships slated for construction is daunting. Some industry participants have recently noted the possibility that 50% of this backlog could never hit the water due to credit issues that will affect both vessel owners and unfinished shipyards. With credit markets slowly thawing and vessel values rising, we think that this estimation is overblown. We peg the cancellation number in the range of 10%-20% due to Asian stimulus packages and improved financing availability. As a result, we think the market will see supply outpace demand in 2010, although we continue to expect short-term boom and bust cycles along the way.

Of course, further credit issues and resulting vessel cancellations would pull forward our assumed even-keel supply and demand. Ship scrapping--practically nonexistent during the supercycle over the past few years--has also picked up considerably and will generate further volatility for owners as the fleet waxes and wanes.

 

Compounding their oversupply concerns, dry-bulk ship owners must also combat direct vessel purchases by previous customers. Vale continues to buy both new and secondhand vessels and recently increased its planned spending to about $600 million from its originally budgeted $150 million (after already ordering ships valued at over $1 billion late last year). The long-distance Brazil-to-Asia route is critical for bulk shipping companies, and Vale's captive fleet threatens to further oversaturate the industry. Still, we expect long-term pricing at around current levels, which is well above break-even levels for owners.

The Curse of Overleverage
We're concerned that some firms may not survive the current downturn. Faced with slackened demand and upcoming ship deliveries, sale and purchase activity amongst dry-bulk ship owners dried up over the past several months. As a result, vessel values fell more than 60% from May 2008 to April 2009. After adding substantial debt to their balance sheets to purchase ships, many of the companies we cover found themselves in violation of minimum ship value-to-loan requirements. Although the companies' lenders have waived these requirements for varying lengths, most firms were forced to reduce their dividend payouts and pay higher interest rates.

In order to recapitalize their balance sheets, some shipping companies have taken advantage of rallying share prices and issued equity.  DryShips  has issued nearly $1 billion in equity year-to-date but still faces near-term debt maturities and financing needs that could threaten the firm's solvency. Other companies such as  TBS International  and  Paragon (PRGN) will see their waivers evaporate at the end of 2009. Vessel values have recently increased, climbing 20% from January to May on the back of increased shipping rates, but we think additional negotiations will need to take place if vessel values do not continue to materially rise. Ship owners may not find their banks as amenable if additional waivers are requested.

A Few Companies Still Worth Watching
While some dry-bulk shipping firms face challenging economic futures, others have seen their stocks undeservedly decline along with the industry. We'd recommend keeping Genco, Navios, and Diana on your radar.

 Genco Shipping and Trading  3 Stars
We think Genco's strong customer base and solid management team will help guide the company through the current downturn, especially as it faces substantial contract renewals through the remainder of the year. The company's low daily operating costs further buoy our positive outlook.

 Navios Maritime (NM) 3 Stars
Although Navios renegotiated its debt covenants, its banks took into consideration the firm's high-quality counterparty insurance when calculating waiver requirements. As a result, Navios was allowed to maintain its dividend and share repurchase program while its peers were forced to cancel payouts. Furthermore, the company's locked-in pricing shields its bottom line from massive industry swings.

 Diana Shipping (DSX) 3 Stars
With one of the best balance sheets in the industry, Diana will likely benefit from its ability to add secondhand ships to its fleet at cyclically low prices. Although a substantial portion of its fleet faces contract expirations through the end of 2009, recently rising shipping rates strongly benefit Diana's repricing potential.