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Firms breaking up fewer tanker ships, is this positive?

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Given all the negative news about crude tankers, including the recent earnings announcement of Frontline, Ltd. (FRO)’s poor earnings due to terminations of long term contracts, investors may wonder what is in store for the rest of tanker companies such as Knightsbridge Tankers Ltd. (VLCCF), Scorpio Tankers Inc. (STNG) and Nordic American Tanker Ltd. (NAT). A metric important to the tanker industry is the rate at which firms retire ships. When companies are aggressively scrapping ships, it suggests stress within the industry.

The rate at which crude tankers are being broken up has decreased from early 2012 (marked by the steepness in the total number of ships being broken up), signaling much favorable supply to demand fundamentals. When the industry faces excess capacity, companies may resort to scrapping of ships to reduce supply. That is what we have seen since January of 2010 when ship construction firms began delivering large amounts of ship orders placed pre 2008. The higher the level of excess capacity, the greater the incentive for firms to reduce capacity through scrapping, thereby increasing day rates for shipping oil.

Slower rates of scrapping also supports other supply and demand metrics. Order levels are showing signs of basing, pointing to a possibility of higher demand for shipping ahead, and construction level is at a historic low (see “Tanker order may be bottoming, opportunities ahead.“) Whilst investors may see continued terminations of long term shipping contracts as customers seek to switch to the lower spot rates in the short term, which will hurt earnings and share prices in the short run, tanker companies may be in for a strong rebound. Several analysts on Wall-St. expect the industry to recover in the second half of 2013.

In the mean time, investors looking to jump into the industry can reduce specific company risks through the Guggenheim Shipping ETF (SEA) which invests in leading shipping companies world-wide and has passed through the issuer’s liquidity test.

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