Structural challenges despite cautious optimism

For the most part, sentiment in the dry bulk market of 2018 can best be characterised as ‘cautiously optimistic’. While volatile, vessel charter rates followed a broadly upward trajectory since the long-term lows of early 2016. Notably, one-year timecharter rates have been higher than timecharter-equivalent (TCE) spot rates across all benchmarks on average, reflecting expectations of further gains in spot rates in the short term. MSI, however, is less confident than this face-value analysis suggests.

Less shock and ore

The modern shipping industry is undergoing a transformative change, buffeted by enormous shifts in the political and economic landscape. For decades, the globalisation of trade and free market economics have powered trade growth, but the future is far less certain. Government policy is taking an increasing role in defining the pattern of trade, notably with regards to environmental regulations and recent US-led tariff disputes.

For dry bulk in particular, critical structural changes are on the near-term horizon for trade, principally related to China, the single most important importer of dry bulk commodities.

Since 2000, international seaborne trade in dry bulk vessels has more than doubled from 2bn tonnes to over 4.6bn tonnes in 2017. Of this incremental growth, Chinese imports account for almost two-thirds.

The principal contributor to Chinese demand growth has been iron ore. Underpinned by a massive commitment to infrastructure expansion, China’s iron ore imports mushroomed from 70m tonnes in 2000 to 1.1bn tonnes last year. MSI now expects this trade will peak within the next two years and will subsequently decline.

This negative outlook is underpinned by flat/falling steel production in China, the near-saturation of ore imports as a proportion of ore consumption, and a sharp increase in the availability of scrap steel.

Meanwhile global coal consumption is facing significant headwinds as governments act to reduce harmful emissions, despite the economic advantages of coal-fired power stations. MSI expects coal trade will be broadly flat over the medium term.

MSI’s expectations for trade in grains and minor bulks trade is more positive. Grains trade will remain volatile but fundamentals are encouraging; increasing populations and progressively grain-intensive diets in regions with inadequate agricultural resources.

For minor bulks, including industrial minerals, there are pockets of strong growth; MSI projects a positive outlook for bauxite trade, for instance, given investment in mining capacity and logistics in West Africa and growing demand for Aluminium in China in particular.

However, the weaker outlook for iron ore trade — and in the longer-term, coal trade — will apply downwards pressure on demand for dry bulk shipping. Importantly, this pressure will come at a time when the global fleet is very young — the average age of the fleet will be around nine years old, down from a historical average since 1995 of between 12 and 13 years old. This will limit the market’s supply-side response through scrapping of vessels.

Limited supply-side response

In the shipping industry, supply-side responses to changes in demand — primarily the ordering of new tonnage in strong markets and the scrapping of tonnage in weak markets — play a significant role in determining market balances. This dynamic has historically promoted a self-dampening cycle for freight rates.

One major exception in the dry bulk market was between 2004 and 2008, when China’s dry bulk imports accelerated; inadequate shipbuilding capacity limited the supply of new ships that could be built and freight rates soared. But in today’s market, excess shipbuilding capacity as a result of this boom means future cycles will not last long and rates will not reach as high, for the next decade at least.

But in a weak market, freight rates are not the only determinant of scrapping. A major driver is the age of vessels – ships younger than 15 years are more likely to be laid up in weak markets than scrapped; this latent supply will provide an instant — and sustained — constraint on freight rate-increases.

Overall, contrary to general consensus, MSI believes we are now close to a peak in dry bulk vessel charter rates. Importantly for cargo shippers, however, this will not necessarily translate to lower dollars per tonne freight rates.

One important policy change on the horizon will place significant upwards pressure on $/tonne freight rates: new fuel regulations imposed by the International Maritime Organization (IMO) starting in 2020. From January 1, 2020, vessels will be forced to either install mechanical systems called ‘scrubbers’ to extract sulphur oxides from the exhaust, or switch from consuming standard 3.5% sulphur content bunker fuel in their engines to 0.5% low-sulphur fuel.

Both solutions come at a cost: scrubbers cost in the region of $1–4m to install while low-sulphur fuel bunker in Rotterdam currently costs $774/tonne, compared with $515/tonne for standard 3.5% bunker fuel.

The financial implications of IMO 2020 regulations are stark. Consider the modern Panamax bulker benchmark vessel used by the Baltic Exchange in its calculation of the Baltic Panamax Index. This vessel consumes 32 tonnes of fuel per day: at today’s prices, the fuel bill would be an additional $8,300/day burning low-sulphur marine gasoil than standard 380cst heavy fuel oil when laden. This compares with the current TCE spot rate for the vessel of $12,000/day.

The uptake of scrubbers has been low – though it has increased in recent months as shipowners bet on falling prices for high sulphur fuel oil after 2020 which they can burn using a scrubber.  Anecdotally, waiting lists to fit scrubbers are long, up to 18 months for one leading manufacturer: accordingly, MSI estimates up to a maximum 15% of dry bulk vessels will have fitted scrubbers by January 1, 2020. It is clear that a large majority will be using low-sulphur fuel.

What does all this mean for shipping costs? This is a complex question to answer but one which MSI’s proprietary market models are designed to tackle, and have been doing so for over 30 years.

Our dry bulk model incorporates analysis of all dry bulk cargos and a projection of the bulker fleet and also incorporates the dynamics of the shipbuilding market which, in itself, is driven by sectors including those other than dry bulk.

The supply/demand fundamentals and a range of operating/capital cost drivers and fleet efficiency factors determine the charter hire rate for a vessel; in addition to vessel charter rates, fuel costs and other voyage factors (including ballasting) determine $/tonne freight rates.

As is clear from the above, fuel prices will be key. Figure 2 shows MSI’s $/tonne freight forecast on an indicative route, coal shipments from Bolivar to Rotterdam, under a number of low-sulphur fuel oil price premium scenarios over MSI’s Base Case for heavy fuel oil, of between 25% and 100%. Clearly, while we believe $/day dry bulk vessel charter rates are near a peak, $/tonne freight rates still have significant room to increase as shipowners look to pass on the higher long-term cost of fuel.

Will Fray is senior analyst at Maritime Strategies International (MSI), a Baltic Exchange member which provides independent market forecasting and business advisory services for shipping, offshore and allied industries. Contact him at will.fray@msiltd.com or by calling +44 (207) 940 0075.

The Baltic Exchange will hold its next Freight Derivatives & Shipping Risk Management course in London on March 11 and 12. More information can be found here.