Like any other commoditized industry, the shipping industry is also very cyclical due to lengthy construction lead time. If demand for tankers is growing at a much faster pace than managers expect, crude tanker stocks will enjoy a period of strong rise in rates. But high rates would encourage many shipping companies to purchase more vessels in an attempt to capture those gains. So eventually, those high rates would have to come down.
Rates for crude tankers have gone through booms and busts in the past. The industry recently faced one of the worst busts when managers placed excess orders of vessels that started in 2005 when rates were very attractive and companies generated returns on assets and equities above 10% and even close to 30%. Expectation of strong demand for OPEC oil was another reason for managers to join the party.
Boom and bust
During this time, shipping construction firms expanded operations rapidly to absorb an increased number of orders. But just when a flood of new deliveries was to hit the industry, the global economic recession that started around 2007 hit global trade. The beginning of a U.S. shale oil and gas revolution was also something shipping managers and other shipping managers didn’t expect. When managers realized they’d ordered too much, order activity died down and the orderbook started to fall.
As new deliveries pushed rates down to levels unseen in 2000, it was time to start scrapping vessels. While scrapping activity used to be minimal, as managers tried to prolong the life of ships as long as they could, it started to rise. Business at shipyards also died down, seeing that very few manages were willing to place new orders and money flowed out of the industry. This also led to declines in vessel prices in the newbuild market and secondary market.
The crude tanker industry is a cyclical business, so buy-and-hold is not the best strategy. If an investor is on the wrong side of the cycle, they can lose significant capital. But for those who still wish to have some exposure, orderbook, vessel prices, and scrapping activity are important indicators that could give investors some color on where the industry is in terms of cycle. Investors buying companies based on high returns must be careful and should ask themselves whether such high returns can be maintained.
© 2013 Market Realist, Inc.