Why is capacity important?
Analysts evaluate capacity growth to see whether it will exceed demand growth, instead of solely relying on indicators such as ship orders and ship prices that reflect managers’ perspective of future supply and demand dynamics. When capacity grows faster than demand, competition rises among individual shipping firms as they try to use idle ships and cover fixed costs. This lowers day rates, which negatively affects bottom-line earnings, free cash flows, and share prices for companies. On the other hand, when capacity increases can’t meet demand growth, shipping rates will rise, which bodes positively for dry bulk companies’ top line revenue, bottom-line earnings, free cash flows, and share prices.
Key takeaway from the latest data
Year-over-year growth in dry bulk capacity, measured in deadweight tonnage (DWT, the weight a ship can safely carry across the ocean) rose for Capesize vessels from October 4 to 11. While annual capacity growth was falling in the past few weeks, dropping to as low as 4.63% on October 4, growth bounced back up to 5.84% on October 11. Panamax vessels also saw an increase from 9.89% to 10.14%, while Supramax vessels rose slightly, from 8.63% to 8.67%. Analysts use year-over-year growth to adjust for seasonality and to make comparisons on a more long-term trend rather than a short-to-medium-term perspective.
Background on capacity growth
Driven by large placements of new ship orders, shipping capacity had ballooned over the past two years, as companies expected global trade growth to continue at a record pace. As they realized what they got themselves into, they’ve refrained from ordering more ships. The overall declines in capacity growth since 2011 show this development. Supply growth remained elevated, however, as trade growth fell with slowing economic growth in 2011. October 11’s increase appears to be driven by a significant drop in last year’s data around October, when rates touched record lows and several companies delayed or canceled deliveries and companies aggressively scrapped vessels.
How lower capacity growth contributed to higher rates
We may not see year-over-year growth fall as much. After all, industry experts expect 3.5% annual growth for 2014 and 2015. But this level should be enough to support higher rates. In fact, it has already done its job. As the chart above shows, lower supply growth helped tighten fleet utilization and supported shipping rates. When Panamax and Capesize growth started to fall around October 2012, year-over-year change in the Baltic Shipping Index improved. Of course, stabilizing economic conditions in China helped.
Historically, the dry bulk trade has grown at ~5.5% every year. Note that the 5.5% growth is an average figure, and trade growth can fluctuate widely depending on economic outlook. The current consensus by the IMF calls for a higher growth rate in 2014 compared to 2013. Given the inelastic nature of shipping supply, and the relatively low cost of shipping goods at the moment, even a 2.0% differential will cause shipping rates to grow tremendously.
We’re only at the beginning of a supply-tightening cycle
We’re more or less in a cycle where demand is going to outpace supply for some time. The current trend bodes positively for dry bulk shipping stocks like DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Navios Maritime Partners LP (NMM), Navios Maritime Holdings Inc. (NM), and Safe Bulkers Inc. (SB) over the long term.