It was an article of faith when I was growing up in the Fifties: Dig a hole deep enough in your back yard and you'd get to China. Now it seems that China – and its belated industrialization – is at the bottom of every story on economic and energy policy. But could the gradual addition of China's billions to the global economy really be soaking up virtually every barrel of crude pumped from the ground – and pressing the pedal to the metal of oil prices in the process? Have we finally reached the Malthusian limits of Hubbert's curve? Or, are other forces at work, jacking up quotes on petroleum products to record levels? Processes beyond the "terror premium?" But could we perhaps "simply" be witnessing an orgy of speculation? And it this speculative binge being fuelled by official and unofficial stockpiling, not to mention notoriously untransparent and often inefficient supply and transportation systems? I took my wonderings and musings about the oil market to shipping industry specialist Jay C. Goodgal, who runs a clutch of Pound Ridge, N.Y.-based firms and partnerships sporting "Castalia." Investing in or advising global shippers is central to their games. I interviewed Jay twice in the pages of Barron's, once in 1996 and once in 1998. Both interviews were spectacularly mis-timed.
I have to ask, given our track record. Why agree to talk to me?
That's a good question. Why did you call? Every time you write about me, the shipping market craters. I hope this does not continue the streak.
Seriously, I'm hoping you can tell me what you are seeing in the shipping markets. Especially in the tanker business. Is oil demand as robust as the China bulls would have it? Or is piracy of some sort or another entering the picture?
Literally, of course, piracy is up. But that kind of piracy is not a significant impediment to transporting commodities around the world. No. What's really changed is the nature of demand in the shipping business. It started way back in June of 1992, when China, India and the rest of Asia started to expand dramatically.
That's ancient history –
We are seeing the market impact of China absorbing all of what used to be the world's "excess" crude oil supplies – and many other commodities. China is moving to a high-technology fuel, oil, gasoline and gas. Demand for petroleum is surging in China. It is transitioning to a much cleaner, but higher-priced fuel as its industrial growth gives it the ability to afford it. While long-term this demand from China bodes very well for the shipping industry, it also means that as a society we in the West will have to adjust to higher petroleum prices, long term. Not that there won't be lots of volatility in the pricing, but the long-term macro trend is clearly up.
Let's focus on that volatility, before we get into the nitty gritty on shippers.
The challenge to the shipping market – after what we basically have seen in the last couple of years, which has been an almost perfectly synchronized global economic recovery – will be dealing with an environment in which growth slows or is retarded. China is slowing, but slowing – assuming you believe the numbers – from 9.7 percent to 7-8 percent. Obviously, its growth rate is still likely to be pretty spectacular. The bigger growth problems are in the industrialized world, in Europe and the United States. And they are still by far the larger economies. I believe slower growth in the West is more likely, with higher interest rates and higher costs. And that is before we even consider what a revaluation of the Chinese currency could do to the cost of many products for American consumers.
It wouldn't be pretty.
Allowing their currency to appreciate would clearly lower the cost of their oil imports, which are carried in tankers – and slash the value of their holdings of U.S. Treasuries. But it also would clearly slow U.S. demand for their goods. And those goods are primarily carried by container ships. When will they do it? That's not my area of expertise. Given what the demand function looks like over the next 90-120 days, I can see a truly spectacular tanker market and a very attractive dry bulk market, too, in the short term. In the intermediate term, the outlook for those shipping markets truly depends upon economic growth and especially on the demand function in China and Southeast Asia.
What does long, short and intermediate-term mean to you?
Long-term, to me, is five years and more. Short is 90-120 days. Intermediate is everything in between. And the reason that intermediate term outlook for the shipping markets becomes fuzzy is mostly because there is a lag between the placement of orders for new shipping capacity and actually getting the new ships to float – and that lag falls somewhere in that intermediate stretch. Well, the shipping markets have actually provided an attractive return for investors for a couple of years now. For the shorter-term investor, the opportunities still are very interesting. The question for the long-term investor is in what sectors will these opportunities continue to be most bountiful. But assuming staying power, there's no question I see great opportunities, long-term. It's in the intermediate term, however, that the outlook becomes a bit fuzzier.
The stocks of shipping companies have actually been a lot more volatile this year than the upward trajectory of the day rates in your tables might lead someone to expect.
A lot of investors have been looking at investments in the sector through the eyes of the commodities markets and the physical freight markets. What they've been doing is trading dry bulk stocks off of, say, the Baltic Freight Index for the Dry Bulk Market, and trading tanker stocks off of movements in the Worldscale Index for VLCC [Very Large Crude Carriers] tanker rates, which is an industry standard. And this has greatly increased the volatility of the shippers' shares. See, what these investors don't understand is that those freight rate indices are direct, physical indices that are moved on a daily basis by a wide variety of influences on shipping costs. There just isn't the direct correlation between movements in freight rates, or in the commodities markets, and the shipping companies' profitability that investors seem to be assuming.
There are lead and lag times, surely. But the supply and demand for stuff – and ships to carry that stuff – ultimately has to impact the shippers' profitability.
It's easy to see why people would assume there would be those direct relationships. The simplicity is attractive, but deceptive.
How so?
Well, take the first half of 2004, when freight rates in the dry bulk market displayed significant volatility. The Baltic Freight Index for the Dry Bulk Market ("BDIY") which ended 2003 at 4,765, hit 5,681 on Feb. 4, but then fell to a low of 2,622 before recovering to close July at 4,048. Watching that, in this year's second quarter, investors dumped shares of dry bulk carriers. What they were ignoring, however, was that dry bulk rates were actually significantly higher than normal, and volumes were still being forecast to grow smartly. The companies were still earning extremely good money, producing exceptional returns on capital. But investors got scared off by the volatility of the physical freight rates. Still, I expect the dry bulk market to continue its upward momentum over the long-term because of the inescapable fact that there are still 700-plus million Chinese who haven't even been touched by the development and growth the other half of China's population has enjoyed in the past decade. China has to grow, or implode. And transportation will be essential; the resources have to be distributed, the goods taken to market. So yes, the Baltic Freight Index has been very volatile this year. But even at its nadir, it was still better than three times its level at the end of 2001.
So you're most enthusiastic here about, what?
I particularly like the handysize tanker market in the long term, because of increasing U.S. import demand for refined products. But in the short term, VLCCs will also do very well. Then again, in the short term, virtually every sector should do pretty well.
But slowing economic growth will float all ships – only until too many new ones hit the water?
Exactly. The dry bulk business, for instance, is all about ton-miles. The higher the number of ton-miles carried by the industry, the more these shipping companies make. In the near term, the sort of incremental demand we are seeing out of Asia, especially China, will continue to keep the handymax dry bulk carriers, which haul steel over pretty good distances, looking very interesting. Likewise, the Capesize, which generally haul coal, and the Canamax, which carry a lot of grain, should do rather well, even with lots of new capacity coming on next year. In part, that's because port congestion has been driving up day rates significantly, especially in China and some other areas of Asia. The charterers have to pay day rates, even when their ships are just sitting at anchor in China, as a result of port congestion. And more ships actually won't help that situation.
But they will drive down rates. What stocks do you like here?
Some of the small dry bulk companies out in Asia, like Precious Shipping (PSL_TB) and Thorensen Thai (TTA_TB) are exceptionally attractive. Precious Shipping sells at four-five times earnings while Thorensen Thai sells around five times. They carry a lot of steel products; both are extremely well-managed, and both survived the "Asian Contagion" of the late '90s, when the Thai bhat was devalued drastically. There are also some very interesting cruise and ferry companies operating in Asia. For instance, a company called Shun Tak Holdings is very well-positioned to benefit from increased spending by Chinese consumers as they take the company's ferries from Hong Kong to Macau to gamble.
You're gambling on a gambling play?
Some of the surer bets in the world are shipping companies linked to the casino business. Their profitability is generally tops in the industry. Now, the company's price/earnings ratio has expanded recently to about 25, but this is also a real estate company. And it closed last year with more than a billion dollars more cash on its books than debt. I don't know of any property companies here in the United States with a net cash balance.
Where is it listed?
Hong Kong. A company that will benefit from the increase in tanker rates and potentially from a revival of the Gulf of Mexico offshore services market is Seabulk International (SBLK). It owns product tankers that are providing exceptional returns as of late. Probably the best-managed transportation shipping company, in my experience, is Noble Group (NOBL_SP). It is actually a trading company that owns some ships, and manages others, but also moves commodities, both on a principal basis and on a trading basis for third parties. It is big in supplying China and the rest of Asia. The stock is trading at about six times earnings, make that seven times earnings; at only three times estimated cash flow. This is a stock on which the total return from March 31, 1999 through the end of September came to 4,500 percent.
Whoa! Then isn't it just a touch extended, perhaps?
No, actually it's got a long way to go. This company just coins profits, constantly, as shipping demand to and from China grows. This company, back in March of 1999, had a net cash liquidation value of 35 cents a share, yet was selling for only six to nine cents a share. You just had to recognize China's growth prospects back then and believe the company wouldn't go bankrupt. I did, and now it's a very large personal holding.
And when China finally comes in for that landing – even temporarily – that we were talking about?
It will be affected. But Noble last year earned $61 million. In the first quarter of this year, it earned $81 million; in the second quarter it earned $45 million. With Chinese growth picking up again in the third quarter, I again expect to see strong earnings from Noble. This is a company to include in a long-term portfolio. Besides, its 4,500 percent gain over four-plus years, really isn't out of line with its peers. The best of those stocks last year was Precious Shipping, which soared a cool 1,700 percent in only 12 months time. Thorensen Thai climbed 900 percent in that same stretch. Of course, the laggard shipper in Thailand last year rose 400 percent. But I've already told you that both Precious and Thorensen look fabulous here.
Excuse me. Did I just fall into a time warp? But that sort of momentum makes it sound like it's 1999 and I'm interviewing an internut.
What tends to make this different than the internet bubble, I think, is that shipping isn't virtual. The government of the biggest country in the world actually needs to grow – and therefore, inevitably, to grown shipping demand – if it hopes to stabilize and placate its burgeoning civilian population.
And visions of limitless growth and endless speculation are dancing in my eyes…
Come on. Haven't I just told you I expect market volatility, both positive and negative, to be higher than normal over the balance of the year as markets digest interest rate fluctuations, actions by the Chinese government to address a hyper-growth economy, logistic issues relating to the movement of goods in Chinese ports, the developing excess crude oil inventories, which will reduce the price of energy, not to mention the U.S. election? And clearly, I expect the value of our holdings to fluctuate, reflecting the market's volatility.
Okay, thanks, Jay.
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co., L.P. Greenwich, Conn. http://welling.weedenco.com
