Oil Market Report October, 2015

Ask most people on the street to name a volatile commodity market and they will likely talk about oil, or possibly something like metals or coal. Few if any will mention shipping, which is odd when you consider that, with the exception of oil, no other industry affects people’s daily lives so profoundly. In this global economy, people wouldn’t enjoy the benefits of technology, wouldn’t look cool in the latest fashions and certainly wouldn’t eat if it were not for ships. In fact it’s quite staggering that so little is known about this giant industry, when one considers that 90% of world trade depends on shipping and, in the UK alone, over 15,000 containers are loaded and unloaded from ships every day.

The Shipping Market is the ultimate roller coaster when it comes to price movements (see graph 1) and is often characterised by greater volatility than even the oil market. What’s more, shipping and oil almost always move in tandem, rising and falling together. On the surface this seems rather counter-intuitive, as here we have a sector that uses fuel but is not benefitting from a lower fuel price. Surely it should be the other way around? Not so; for with lower oil prices, shipping customers (manufacturers, distributors, resellers) are quick to demand reduced shipping rates and so prices for chartering ships fall away. Furthermore a drop in the oil price is often a reflection of reduced demand for consumer goods around the world, which creates a double-whammy effect for the shipper. Customers demand lower prices because fuel costs have gone down but in the meantime, there are fewer things to ship around the world. The result is the situation we have today, where the Baltic Dry Index (the Shipping World’s equivalent to Brent Crude) is at a 30 year low (see graph 1 again).

Riding the waves of price volatility is nothing new to the Shipping Industry though. From 2000 onwards seaborne freight rates steadily climbed as China’s economy grew (and grew) and shippers enjoyed a halcyon period. A ship starting its voyage in Europe or North America would carry high-end / luxury goods from the developed world to the avaricious Chinese consumer. Once the product was unloaded in the East, a new cargo of cheaper, lower-end material was loaded onto the same ship for the return leg to the West. In freight terms this is the Holy Grail, because the freight “dead-leg” (ie, returning empty to the port of origination) was removed. Happy days then and with demand for shipping freight reaching almost unprecedented levels, so production at the Asian shipyards of Japan, South Korea and China itself (Europe and North America do not engage in mass shipbuilding any more) was also booming. But building giant ocean craft has a lead time of 3-5 years and so by the time the Financial Crisis hit in 2008, many shipping companies were faced with the ultimate nightmare scenario; just when the new vessels were sailing out of the yards, demand was crumbling and a recession was taking grip.

The result was huge over-supply of shipping tonnage, shrinking demand and a short-term crash in freight rates. But demand for shipping quickly bounced back, firstly because this was not a full blown global recession, but a localised US / EU affair. And secondly, the commodity boom slowed up only for a short period before bouncing back and reversing many of the shipping losses from the dark days of 2008-09. But fast forward to the present day and the picture we have is definitely less rosy. By most people’s reckoning, the commodity boom is over and Chinese consumption is no longer booming. Graph 2 illustrates the current situation and also shows the close correlation between oil prices and shipping rates. But what makes the graph really interesting is the comparison between shipping prices for dry goods (Baltic Index) and those for tankers (Capital Link Index).

As you will see, the Baltic Index has dropped very significantly, whereas tanker prices have fallen at a much slower rate. Why so? Well the answer to this lies in the underlying reasons for the falls in oil price. On the one hand, increases in demand for oil are slowing and this is having some downward effect on oil prices, but the overall drop in demand for all types of goods is having much more of a profound effect on the wider, more general shipping market. At the same time, what we know about the recent oil price crash is that this is an over-supply phenomenon (world-wide glut in oil production), ie, it is not really about falling demand for oil. So even though oil prices are dropping, demand for shipping of that oil remains relatively robust. After all production is booming and once the black stuff has come out of the ground, it still has to go somewhere and this invariably involves the use of a ship – even if that ship doesn’t go anywhere and simply sits anchored offshore.

So tanker prices have dropped because owners have to pass on reductions in fuel costs to the customer, but in general a wholesale rout of prices (as per the Baltic Index) has been avoided. That being said, any significant drop in shipping rates has significant long-term consequences and the truth is that both dry and wet goods are experiencing lower prices, albeit to differing degrees. We have already ascertained that building a ship is a long-term course of action and with an average construction cost per vessel of $150m, it’s fair to say that shippers will not be rushing back to build new vessels any time soon. The result will almost certainly be a shipping shortage when we have the next consumer or commodity boom. This shortage will only add to overall inflationary pressure because freight rates will surely rapidly rise and the cycle will begin all over again. Welcome to boom and bust!