Inelastic vessel supply
Shipping rates are essentially driven by industry supply and demand. When the supply and demand balance tightens, shipping rates rise, and vice versa. As the chart below shows, vessel supply is really inelastic in the short run when utilization is tight.
First, it can take up to five years to build a ship. Second, there are a few options available to the industry to accommodate higher ton-mile shipments. These include using less efficient and older vessels or increasing transportation speed. But because these vessels are costly to run, shipping rates must rise in order to operate them. Aside from these options, there isn’t a whole lot the industry can do. Customers, on the other hand, are willing to pay up because there are few economical and efficient alternatives to transport bulk liquids across water. Plus, as a percent of oil price, shipping fees make up just ~1% to 2%.
Note that the supply curve is flat towards the left side of the chart, because it reflects the break-even cost to operate newer and more efficient crude tankers. If rates fell below this cost, shipping companies wouldn’t make a profit.
Inelastic demand curve
We can view the inelastic nature of the demand curve as both positive and negative. When vessel supply is reduced, due to weather and logistical bottlenecks, for example, shipping rates could rise drastically. But when such bottlenecks are no longer there, or new vessels are delivered to the market, shipping rates could fall substantially as increased fleet availability competes for unbudging demand.
Upside and downside volatility
Volatility can be a positive and a negative. The inelastic nature of the shipping industry’s supply curve is positive when utilization is tightening, but it’s negative when utilization is falling, since moving vessels out of service can be costly due to the fixed-cost and capital-intensive nature of the industry. As long as rates are above fixed costs, companies will try to find employment, pushing rates down.
When crude tanker companies said volatility was a positive sign, they were referring to tighter utilization (see the two bubbles above). Read the rest of this series to see what drove recent increases in shipping rates and utilization and how these factors have affected crude tankers such as FRO, NAT, TNP, TNK, and the Guggenheim Shipping ETF (SEA).