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ShipBrief
3 June, 2019
This Edition
● Shipping Market Updates ● Company Focus: Earnings Review - Teekay LNG (TGP) ● Macro Focus: The Major Challenge Facing Dry Bulk
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Market Updates
Dry Bulk:
As of late the dry bulk market has been in a sort of rebalancing mode as the BDI managed to retake the psychologically important 1,000 level and hold over the past couple weeks.
While some are hopeful this represents the beginning of a meaningful correction, it is more likely just the typical ebb and flow of a market
and not indicative of improving fundamentals.
In fact, as we will see in the latest macro report which focuses on dry bulk, the prospects for any sort of a recovery, which greatly hinges on Chinese demand, are fading along with the Chinese economy.
In the past, the Chinese Government possessed enough monetary and fiscal flexibility to carry out massive projects and lending, but as that flexibility fades so to will demand for related infrastructure and housing materials.
The point is simple, the main driver of dry bulk demand growth over the past two decades is fading fast, and there isn’t another nation or region with the ability to negate the damage.
Going forward, dry bulk fleet growth will need to match dry bulk demand growth just to maintain this current precarious balance, but as those two are trending in opposite directions producing an even greater imbalance in the near term.
Short term market hopes are coming to rest more on demolitions and the prospect of slow steaming courtesy of the 2020 Sulfur Cap rather than market fundamentals.
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Crude Tankers:
The crude tanker market continues to outperform 2018 with average earnings well above last years levels.
The upcoming 2020 Sulfur Cap is projected to bring more good fortune to the tanker market as crude runs grow and refinery throughput increases to produce compliant fuels.
The marriage of HSFO and maritime trade over the past years has been one of convenience as refiners, which produce this viscous fuel do so as a by product of normal operations. Therefore, HSFO isn’t going away anytime soon which now brings up the question of how to handle this material.
Andrew Lipow, president of Houston-based energy consultancy Lipow Oil Associates, during an investor presentation by Ardmore Shipping in New York on May 30 estimated that 240 million barrels a year of HSFO will be displaced. With no markets readily able to absorb that volume, excess production will have to go into storage until it is eventually cleared by the market. Onshore storage may provide six months of relief but following that offshore storage may be the call.
Stifel analyst Ben Nolan explained in a client note, “Due to viscosity, the product would likely need to be stored on ships with heating coils, with the expectation that those would be primarily Aframax-class crude or LR2 product tankers.
Asked how long he thought the situation would persist, Lipow answered that it could be “2023 or 2024 before the price reacts and refiners and vessel owners do something about it. One analyst in the room pointed out that according to Lipow’s numbers, if the entire incremental HSFO volume went into floating storage through 2023, “that’s enough to fill the entirety of the global Aframax fleet.”
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Product Tankers:
Trump announced he would slap a 5 percent tariff beginning June 10 against all goods entering the United States from the southern border, a surcharge that would hit millions of products like cars, machinery, fruits and vegetables. Trump promised the tariffs would escalate each month — starting July 1, reaching a maximum of 25 percent in October — unless
Mexico stopped migrants from crossing into the United States.
U.S. goods and services trade with Mexico totaled an estimated $671.0 billion in 2018. Exports were $299.1 billion; imports were $371.9 billion. The U.S. goods and services trade deficit with Mexico was $72.7 billion in 2018.
In 2018, Mexico was the United States’ 3rd largest goods trading partner and 2nd largest goods export market.
With all the talk surrounding the positive benefits of the 2020 Sulfur Cap on product tanker demand, this news brings up a legitimate fear that an escalating trade war with Mexico could jeopardize one of the most important trading routes.
Over the past three months, product tankers recorded 244 journeys from the US to Mexico, making it the third most prolific route and the fourth greatest contributor to ton miles recorded globally.
If Mexico does retaliate with their own tariffs, which is likely if trade talks break down, we may see refined products added to the list either formally, or as China has done, informally, for US energy imports.
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Containers:
The trade war with China has started taking its toll on trade volumes according to Maersk’s CEO, who believes the spat could shave global box growth by a full percentage point this year.
The initial threat of tariffs brought a significant pulling forward of cargoes as importers tried to beat the clock. But as that pulling
forward has ended transpacific rates have fallen by 50% since January.
Alphaliner stated in its most recent weekly report “Weakening throughput growth in the year’s first quarter, and the expected decline in transpacific volumes as a result of an escalating US – China trade war, have weighed on full-year projections for container volume growth.”
The Ocean Alliance has said it will skip two Asia-US West Coast sailings in June in an effort to maintain rates as the US-China trade war takes a toll on volume.
Now, a fresh round of fears has rightfully surfaced and US/Mexico trade relations have soured following Trump’s announcement that tariffs will be imposed as a consequence for what he sees as Mexico doing too little to stem the tide of drugs and illegals coming across the US/Mexico border.
The root of these tariffs is also great cause for concern as the US/China spat was based primarily on economic factors and disagreements over intellectual and property rights. However, the political and subjective nature of this latest announcement directed at Mexico brings up fears that ideology may begin playing a larger role in global trade decisions.
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LNG & LPG:
LNG spot markets continue to rally after a difficult first quarter with spot rates West of Suez showing exceptional resilience
As of May 30, investment bank Clarksons Platou Securities estimates that average rates for MEGI type LNG carriers are at $74,000 per day, up 10.5% week-on-week and 51.5% month-on-month. One year
time charter rates have also been rising, now at $82,000/day, reflecting strong forward expectations.
Asian spot prices for LNG remained steady at the seven-week low hit in the previous week while inventory levels have moderated from high levels seen during the first quarter.
As many might recall, stockpiling ahead of peak demand season started early last year but even that wasn’t enough to curb the extraordinarily high spot rates seen during the back half of the year.
We expect a similar stockpiling effort from here on out, however, with another strong rise in demand growth over 2018 expected, coupled with significant new liquification capacity coming online (working to keep prices in check) and a miniscule number of uncommitted newbuild deliveries anticipated, the back half of 2019 could see vessel supply even tighter than in 2018.
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Company Focus: Earnings Season Reviews (TGP) Earnings season has now reached near-conclusion. I’ve posted our latest calendar below. We have provided earnings coverage for over 50 firms in the maritime space at Value Investor’s Edge, and subscribers to ShipBrief have also received updates on previously covered firms. Here is the latest calendar of coverage for reference, note there are only 3 firms left to report, including previous covered Tsakos Energy Navigation (TNP) on 6 June.
The rest of this report will focus on Teekay LNG Partners (TGP) earnings results.
Teekay LNG Partners (TGP) Earnings Review
Teekay LNG Partners (TGP) reported a very solid quarter (Link to PR, Link to Presentation, Link to Transcript), arguably posting the best weighted (i.e. including stability of the company and forward prospects versus risks) result in the entire history of the company. Yes, TGP just released the strongest results and guidance in the 14-year company history, yet we sit only a few dollars off all-time record low prices! TGP had traded quite well during 2019, rising off a strong Q4-18 result, but with trade war
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tensions rearing back up, they seem to have fallen ‘easy victim’ for either risk reduction or trader profit-taking. Please reference the YTD chart from Google below:
Source: Google Finance, TGP YTD Quote, annotations added
Specifically, TGP reported distributable cash flow of $0.69/qtr and rapidly rising earnings as well. Their presentation was exceptional, hitting all the key points on valuations:
Source: Teekay LNG Partners, Q1-19 Earnings Presentation, Slide 8
Pick your multiple, either using distributable cash (DCF), earnings (EPS), book value, NAV, or EV/EBITDA and TGP is dirt cheap from any angle imaginable. We're sitting at 9.0x expected EV/EBITDA for 2019. This of course goes even lower (lower is better for EV/EBITDA) into 2020 based on the virtue
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of nearly $100M more in EBITDA and $300M less of debt. GasLog Partners (GLOP), which has a considerably inferior fleet and forward backlog trades in the mid-10s. TGP in the mid-10x EV/EBITDA range is around $30 for 2019, and closer to $40 by mid/late-2020.
What about DCF? TGP reported $0.69/DCF, which means they trade at a 5x current DCF ratio and roughly a 4x forward DCF multiple. These are unheard of multiples for a company of this quality. Even 10x fwd DCF would be quite low, and that's over $30/unit for TGP.
Even if you think 9.0x is the right multiple, then TGP is worth $25 by mid-2021 just by virtue of the deleveraging... And 9.0x is lower than anything in the space. GLOP drops 2nd-rate assets for higher!
Source: Teekay LNG Partners, Q1-19 Earnings Presentation, Slide 9
This level of coverage is unprecedented in the space, with 2019-2021 coverage around 96% on average.
Source: Teekay LNG Partners, Q1-19 Earnings Presentation, Slide 11
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TGP only has 5 assets left to deliver, all of which are fully financed. The final vessel "Yakov Gakkel" is currently scheduled for 25 November 2019. There's only one reason TGP is in the $13s right now instead of clearing $25 and pushing towards $30: the dividend (or lack thereof). Unfortunately these markets are so distorted that a company like GLOP carries a valuation 1.5-2.0 turns higher despite being worse off at every turn.
I've spoken personally with multiple industry analysts about TGP. They all agree that the long-term returns are likely to be very large. But they won't give it a price target of any reasonable respect. Why? Because without yield, they know the units just won't get there anytime soon. Unfortunately they're likely right. But it pains me to see major bank analysts who think that the proper way to value a company is to slap on an 8-10% yield. This just speaks to the heavy distortion of the markets.
The markets are so broken that TGP is unlikely to move past the mid-teens without one of the following things:
1. Major new investors join the space. Actual investors who look beyond current dividend yield. 2. Investors and traders believe that TGP is going to pay out 'huge' in the future.
The 'trade war' is keeping #1 from happening and TGP's uber-conservatism blocks #2 for at least another two years. The "$11.30 of equity value" slide I shared about looks great from a finance perspective, but it's anathema to those hoping to trade around yield jumps.
Unfortunately we're sitting on what seems to be extreme value. But we just can't get there without yield. It's not just shipping either. ArchRock (AROC) and Energy Transfer (ET) are two other examples of unprecedented cheap multiples even while growth is still coming. It's a weird market.
Conclusion: Phenomenal Results & Progress, ‘Fair Value Estimate’ remains $25.00/unit
TGP produced the best results and forward guidance, arguably in the entire 14-year duration of the company. If we use forward DCF or forward EV/EBITDA, even a target of $25.00 is fairly insulting; however, we’re talking about a stock in the $13s as this report is published… Here’s a review of TGP since inception, just to illustrate the extreme dislocation here.
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Macro Focus: The Major Challenge Facing Dry Bulk
Background
Back on December 1st, 2017 James Catlin published a report entitled As Dry Bulk Recovers, Here's What To Watch In 2018, which presented a somewhat contrarian view.
He noted that many analysts were forecasting another year of solid dry bulk demand side growth, but cautioned "the potential for a global economic slowdown can't be ignored."
Instead James used this report to discuss a few demand side factors in an effort to avoid "getting all swept away in the euphoria of this apparently never-ending bull market."
With China being the most important nation to dry bulk demand, a discussion of their economy took center stage.
Here he cited a previously released October 28th, 2017 report entitled Does China's Debt Management Pose A Threat To Shipping? which examined the possibility that China's stated plans to curb the increasing debt load could negatively impact the dry bulk segment, specifically the appetite for iron ore.
This proved to be well founded as iron ore imports recorded a 1% year over year decline for 2018.
Further adding to the negative impacts of reigning in debt, China made strides toward more efficient steel production (an effort to reduce pollution) while the economy continued slowing. The long term staying power of these factors, which contributed to this import decline, has led to further declines this year.
For the first four months of 2019, China imported 340.21 million tons of iron ore, down 3.7% from 353.32 million tons in the same period last year. April imports fell to an 18 month low.
Additionally, in a March 2nd, 2018 article entitled How Trump's 'Trade War' Could Impact Maritime Trade, the dry bulk segment was specifically cited as being in the cross hairs and the first to feel any pain from an escalating trade war.
Even with a very acceptable 3% net fleet growth over the course of 2018, which would have been easily absorbed in typical years, these demand side factors created a challenging market which was reflected in stagnant charter rates.
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Source: Value Investor's Edge
With all of this in mind it's time again to turn to the Chinese economy as their ongoing challenges present what is perhaps the biggest threat to the health of dry bulk shipping.
China's Importance
Since the turn of the century China has been responsible for the vast majority of seaborne iron ore demand growth. This growth in iron ore imports can be traced to infrastructure investment and construction in China. Both of which are now cooling with further stimulus measures being balanced against an increasingly concerning debt load.
Iron ore composes the largest portion of dry bulk demand over any other commodity.
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Source: United Nations
China imports nearly three-quarters of the world's seaborne iron ore.
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Source: UN
With the capesize class being particularly geared toward hauling iron ore, waning demand out of the world's biggest customer for the key steel making ingredient will weigh on this class especially hard.
Steel
Some might point to the latest steel production figures out of China as an indication that iron ore demand will remain strong.
After all, in the first four months of 2019 China's crude steel output was up 10.1% y/y at 314.96 million tons.
Therefore, it would seem reasonable to assume that the current trend of waning iron ore imports against a backdrop of increasing steel production is unsustainable. But there are a host of factors that might counter that notion.
As iron ore prices break $100 due to supply reductions, a result of the tragic Vale dam collapse, port inventories have played an increasing role.
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Source: Business Insider
Iron ore's last price spike over $100 resulted in extremely low port inventories and there is ample cushion this time around. Though it must be stated that the appetite for high quality iron ore means that much of the low quality port inventory isn't desirable, but not necessarily useless. In fact, blending of ores is always an options as producers try to walk the line between margins and appeasing government regulators concerned about mill efficiency and environmental standards.
This cushion will allow a bit of short term relief but over the long term government policies will likely result in stagnant or even decreased steel output.
Since 2016, China has disposed of more than 1,900 zombie firms and heavily-indebted companies. Additionally, it has eliminated more than 150 million tonnes of crude steel capacity in the past three years.
But a recent declaration showed further government resolve to streamline the sector.
China will tighten approvals of steel capacity swapping between companies and ban all new steel capacity in any form. This means that future output gains will be based mostly on utilization and efficiency of existing mills.
Steel capacity swaps have been seen as facilitating illegal capacity expansions. Approved by local governments under the cover of capacity swaps, these companies move capacity between different regions to reduce the concentration of plants in polluted industrial areas. The new facilities have undermined Beijing’s efforts to reduce pollution and reduced steel capacity.
China will also control steel-making capacity in key pollution-control areas, including the Beijing-Tianjin-Hebei region and the Yangtze River Delta, by imposing more strict environmental, energy, land and water usage standards.
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Steel mills will also be encouraged to launch large-size scrap recycling and processing centers and to adopt electric-arc furnaces that only use scrap metals to make steel and emit less toxic air compared to widely used blast furnaces.
China will provide support to domestic steel mills to set a “more reasonable” pricing mechanism on imported iron ore and study how to boost the development of domestic iron ore miners and increase ore supply in the country.
Finally, the NDRC also said it will encourage mergers and restructuring in the steel, coal and coal-fired power sectors this year, and will eliminate all so-called zombie firms, companies with outdated equipment and debt that are no longer competitive, by forcing them to shut down or merge with other companies by 2020.
In the short run the expectation and final announcement of these Government measures may have contributed to a pulling forward of steel production. If this did indeed play a role in the latest round of production increases the output gains would also therefore be temporary in nature, with any potential hopes of a sustainable gain in related iron ore shipments being dashed as well.
China
Over the past couple years I have made my opinion known that China is on an unsustainable path as they balance a cooling economy with a massive debt load. That debt load isn't confined to just the government, as companies and households also carry a massive burden.
On May 7th, 2019 Bloomberg reported that Chinese companies defaulted on 39.2 billion yuan ($5.8 billion) of domestic bonds in the first four months of the year, some 3.4 times the total for the same period of 2018.
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The pace is also more than triple that of 2016, when defaults were more concentrated in the first half of the year, unlike 2018. The trend is clear: unless something changes, 2019 will be the new high.
State-led, debt-fueled, economic growth must no longer be considered a viable model, as the debt to GDP ratio indicates the necessity for reigning in government spending.
Together, this formula puts the spotlight on a key port town where disruptions in the past have created ripple effects in global maritime trade.
Tianjin, a city with 16 million people, is expecting a third straight annual contraction in fiscal revenue this year and as Bloomberg notes, is "flashing warning signs".
Tianjin sports the highest ratio of LGFV bonds to GDP in the country and has seen several high-profile distressed cases from local state-owned companies in recent years. Recently, Fitch has downgraded a major commodities trader, Tewoo Group, a Fortune Global 500 company, as well as other government-related entities in Tianjin citing growth concerns and debt load.
As policymakers balance debt vs. growth in these state driven economies there will inevitably be sacrifices. Investors are rightfully concerned as evidenced by the fact that the highest yields in the 7.5 trillion yuan ($1.1 trillion) worth of debt sold by LGFVs are found in regions where the public sector dominates the economy.
Over the past couple decades household debt has composed an increasing portion of overall debt.
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While corporate and government debt are often the main topics, Chen Changsheng, director general of the Macroeconomic Research Department of the Development Research Center of China’s State Council, cited household debt as the biggest risk.
A sharp rise in real estate and asset prices had emboldened the Chinese consumer in recent years to carry even greater debt loads. But a South China Morning Postarticle presented a sobering forecast with a comparison to the Japanese asset bubble and following lost decades.
The parallels between China’s current landscape and Japan’s three decades ago are readily apparent, stemming from a loose monetary policy that laid the foundation for the expansion of a housing bubble, said Naoyuki Yoshino, dean and CEO of the Asian Development Bank Institute.
“I’m very much concerned that if land prices keep on rising and if the population starts to shrink along with aggregate demand, then China will experience a similar situation to that of Japan,” Yoshino said.
Of course, stagnant or declining asset prices, particularly real estate, would not just curb consumer confidence and spending but would likely hinder investment in the segment. A cooling housing market would translate into cooling seaborne commodity imports for residential construction.
Wow, Really?
While James has been bearish on China over the past two years, a recent forecast out of J Capital partner and iron ore and steel analyst Tim Murray really took the cake. Speaking on the sidelines of the Global Iron Ore and Steel Forecast Conference in Perth, he calls for a massive decline in Chinese bound iron ore cargoes, dropping 40% to just 600 million tons in five years.
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Monetary stimulus had rapidly driven Chinese property prices beyond the reach of many buyers, he said. Mr. Murray, who lived in China for 19 years, predicted that flatter property prices would reduce construction, and therefore steel use.
While China has pledged to further 2019 infrastructure spending, totaling 2.15 trillion yuan, up from 800 billion yuan in 2018, Mr. Murry added that as the Government winds down its stimulus of an overpriced housing sector infrastructure construction would not replace the property sector’s reduction in steel demand.
While he acknowledged that such a quick decline was not a common view, other research had predicted the same fall but over 10 years.
Trade War
As the trade war drags on, and the collateral damage mounts, leaders are under increasing pressure to exact concessions worthy of the pain. But with both sides digging in their heels, the latest escalation seems to confirm that an end is nowhere in sight.
For dry bulk the pain came in the form of seaborne agricultural products, particularly soy exports from the US to China.
Freightwaves reports:
These statistics are particularly ominous when viewed through the prism of ton-miles, because voyages
are getting much shorter. The distance from the U.S. Gulf grain terminals to Mexico is minimal; the
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voyage to Europe is less than half the sailing distance to China; and Argentina is just over half the
distance from the U.S. Gulf as China.
While increasing Brazilian imports into China provided some relief, total soybean imports for 2018 came to 88.03 million tons, a drop of 7.9% year over year, and the first contraction since 2011.
The worry is that some of this US grown soy may never find its way back to China as importers form stronger ties with Brazilian exporters and farmers shift the feed mix for animals. In the near term an incurable African swine fever has killed millions of pigs in China further curtailing demand.
Talk of increasing commodity purchases by China, as a component of the trade war's resolution, has stoked hopes of another uptick in demand for dry bulk. But not only are we seemingly still a long way off from any sort of agreement but the debt concerns outlined above make any sort of major purchases by China, outside of what is essential for their economic needs, seems highly unlikely.
Therefore, if those commodity purchases are part of the agreement, it would likely not result in increased demand, but most likely represent a shift in trading patterns. Therefore, the real benefit for shipping (or drawback) from any trade deal involving commodities will come in the form of ton mile demand shifts.
For example, coal sourced from Indonesia might instead be substituted for that of US coal, which would benefit ton mile demand. This doesn't just hold for dry bulk as LNG, LPG, crude, and refined products all make for solid candidates. The good news is that, with few exceptions, any trade flow shift involving increasing US cargoes to China will likely benefit ton mile demand.
Conclusion
As feared, China's economic situation has become an increasing concern for maritime trade, particularly dry bulk, as the days of debt fueled infrastructure and real estate investment are coming to an end.
The unsustainable nature of the Chinese economy has reached a tipping point and policy makers are tasked with balancing the increasingly precarious debt load vs. the economic reality of being a still somewhat government driven growth model.
Cooling demand for dry bulk related commodities will be met with an ambitious government effort to prop up domestic iron ore miners, end further steel capacity growth, curtail outdated and inefficient capacity, and increased use of scrap which should all play into a reduced need for iron ore imports over the long run.
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While China's importance to dry bulk shouldn't need repeating at this point here is a visual reminder of just where the capesize fleet does business.
Source: VesselsValue
Iron ore cargoes are loaded in Brazil and Australia with Indonesia being a coal exporting major. The demand epicenter is focused in China and SE Asia.
A cooling real estate market will likely play into further weakness. Chinese home prices softened at the start of this year and S&P Global Ratings expects the property sector to contract by 8%-12% in 2019.
Not only will a cooling housing market take its toll on dry bulk demand but it will likely eat into the confidence of a highly leveraged consumer.
The vast majority of Chinese steel production is used domestically, and cooling demand gives rise to the potential for greater steel exports. This naturally brings back memories of 2014-2016 where a glut of Chinese exports destabilized global steel prices causing global margins to suffer. If this begins to happen we can naturally expect global output cuts correlated with weak margins. This would bring further pressure to seaborne iron ore demand.
For now, it looks as though China, the main driver of bulk demand growth over the past 20 years, is cooling and some serious market adjustments are likely to result for the dry bulk trade, being most pronounced in the capesize segment.
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All information copyright by ShipBrief 2019
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Note: This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. While ShipBrief believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and ShipBrief’s views as of the time of these statements. Readers should consult with appropriate tax and investment advisors as applicable before making any investment decisions.
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