What keeps the world's ships going?
Global trade is heavily dependent on the world's fleet of cargo ships, which carry everything from oil to iPads. Shipping operators in turn depend on specialized financing to stay in business. Scott Lewallen '89, global head of shipping finance for SEB Merchant Bank, describes how this little-noticed industry keeps globalization sailing ahead.
Q: How does shipping fit into the global economy?
The thing to understand is that shipping is essential. Most of the objects you see around you every day have been impacted in some way by shipping—they have been transported by sea or are made of petroleum byproducts that were transported by sea at one or more points. U.S. retailers would cease to exist if there wasn't a global fleet of container ships, generally operating at more or less breakeven, carrying finished consumer goods that are built everywhere in the world but America.
On top of that, day and night, oil tankers continuously deliver to refineries in the industrialized countries in Europe, North America, and Asia. If for some reason sea transportation weren't available, the transformation would be dramatic and catastrophic in a surprisingly short period of time. That's why there is a possibility for super-profits, because if there is even a hint of disruption there's no price you won't pay for shipping. You have to have it, and you have to have it every day.
Q: So why isn't shipping more visible in the economy?
In terms of the value added, it's a very small part of the cost of goods. Shipping costs are de minimis against the value of the cargo. Even when shipping costs shoot up, it doesn't significantly impact the prices consumers pay to get gas for their cars or a new mattress for their bed.
There are lots of fallow periods when ship owners are operating at breakeven, bouncing along the bottom, but then global economic events intervene. When the Suez Canal was closed, cargo had to go around the Cape of Good Hope, extending the ton-mile demand. There was immediately a shortage of ships, and people would pay anything—if the cost of shipping went up 5 times or 50 times it didn't matter. The surety of supply overshadows the cost of transportation. These extraordinary periods are why ship owners are disproportionately represented amongst the world's wealthiest people.
World events radically alter the demands on my clients. Recently, I've been spending a lot of time working on issues related to Libya, pirates in the Gulf of Aden, and events in Japan.
When the tsunami happened and the nuclear power plants were knocked out, Japan, which is already one of the leading importers of natural gas, was looking at a tremendous need for much more natural gas. Most of the existing fleet has already been committed. The lead time for new ships is two to three years. People with ships available will make fortunes in the tens or maybe hundreds of millions of dollars in the course of the next 36 months as a result of the tsunami.
Q: How does the business work?
One of the things that's notable about the shipping industry is that, to a remarkable extent, the people that were doing shipping thousands of years ago are the same people doing shipping today: the Vikings and the Argonauts—the Norwegians and the Greeks. These two small nations still control perhaps 30% to 40% of the world's ocean-going fleet. It's quite an extraordinary residual element of two millennia of economic growth.
It's also basically an industry with remarkably little technological development. From an engineering point of view, it's a very simple and transparent industry. Oil tankers or VLCC—very large crude carriers—are 350,000 or 400,000 deadweight tons, making them the world's largest movable objects. But they're just basically big steel bathtubs with propulsion. You can practically crew one of these ships with one man, a dog, and an oily rag. Still, they represent large individual, big-ticket assets. A VLCC might cost $120 million. A liquid natural gas carrier could cost anywhere from $80 million to $200 million. Though it is a different industry, big cruise ships can cost $1.5 billion.
The operating costs on a VLCC are perhaps $12,000–$15,000 a day. But the capital cost in terms of debt and amortization of principle is probably another $20,000 a day on top of the operating cost. The current rates for a VLCC are $35,000 or $40,000 a day, just at or above OPEX.
Only two years ago, rates were as high as $240,000 a day. That can translate to $6 million a month profit. If you get that for a year, you might pay for the whole value of the ship, which has a 25-year economic life. Those high times might come once a decade or once in a generation. Shipping is basically a commodity; the only real barriers to entry are financial: having the equity, getting the finance, and then the will to take the risk.
It's a hugely cyclical industry, with earnings fluctuating with demand for oil as well as political, economic, environmental, and weather events. There are contracts you can get in to mitigate that risk. Enter into a long-term commitment of 10 years at $44,000 a day and you have no risk. But you've eliminated your chance to participate in these super-profits, because you've locked in the availability of your ship. You're going to lock in an IRR of 8%. It's a bit binary.
Q: Where does the capital come from?
There are enough people with the risk appetite on the equity side, the Greeks and Norwegians, and increasingly, New York private equity firms—Apollo has been a big player in this and JP Morgan has a maritime fund. But on the whole, it's still dominated largely by traditional owners' equity and senior-secured bank debt.
Investment banks have entered the field in the past and a number have lost badly. Shipping finance requires care and attention. It requires a more proactive relationship between the bank and the client. It doesn't standardize or systematize.
Because shipping is capital intensive but not labor intensive or technologically advanced, financing plays a disproportionately significant role. Because of the big-ticket capital nature of it, there's an exceptional opportunity to miscalculate and lose everything.
It's possible, in shipping, that if you order at the wrong time, when the price of the ship is high and the exchange rate is unfavorable, and it's delivered three years later into a weak market, and you secured a higher level of leverage than you maybe should have—which is normally 70% to 80% financing against a first-priority mortgage—then you may only get to operate the ship for three to six months before it breaches the minimum value clause in the loan agreement. You invested $20 million and lost all of it in a matter of months. That possibility rightly discourages quite a lot of people.
The shipping banks have very low loan losses but the margin is generally low too. The old-fashioned house mortgage is a good comparison in a certain way.
There are only 20 or 30 banks in the world that do shipping finance, provide senior debt capital to the industry, as opposed to infrastructure, telecom, or pharmaceuticals where there's probably 200 banks. That is because even though the individual ships are large investments, the total amount of capital for the whole global fleet, perhaps $400 billion, is a fraction of the amount of capital in those other fields, so you don't need that many banks.
Q: Where is the industry based?
Shipping has more international harmonization of legal systems than other industries. This global organization of the system means that you can own and manage a shipping business from anywhere in the world. Once you've got that sort of flexibility then business activity just gravitates to where the expertise is.
Britain built its empire as a maritime nation. But today the UK has virtually no shipping industry. It doesn't build ships. It doesn't operate them anymore. But London remains the preeminent maritime cluster of banking, insurance, and legal expertise.
Building ships is labor intensive and low skilled. In general, it left America and Europe after the Second World War. The Japanese call it kiken, kitanai, and kusai meaning hard, dirty, and smelly. As they moved up the economic scale, it gravitated to Korea. And now it's leaving Korea and being exported to China and India. The only ships that are built in Europe, now, are cruise ships, which are basically floating hotels, so there's a high degree of value added in subcontracting. Outside of LNG [liquid natural gas] carriers and container-carrying liners, the world fleet has seen very little growth over the last 20 or 30 years; really what you're seeing is just fleet renewal.
Q: And this business with ancient ties is facing a resurgence of an old problem. What is happening with piracy?
Something on the order of 400 ships have been seized by pirates. Currently some 100 ships and crews are currently being held hostage. You hear about it every now and then, but it's amazing it doesn't get more note. But even given the relatively small size of the shipping industry, that's less than 1% of the world ocean-going fleet, so for those not directly involved it's not an inconvenience.
From an economic perspective, it continues because the ship might cost $100 million, and it's carrying oil cargo worth $150 million. Not counting the lives of the crew, the pirates have seized and interrupted a $250 million asset, so the ransom is paid. Forgetting the economics, it's not right that people can make such a successful living out of this sort of thing, but nobody has solved the problem. The Gulf of Aden is too big for the various navies to patrol effectively with the ships they have sent thus far. It is like having three police cars cover the state of Nevada. However urgently they respond, there's no way they're going to get there in time.
Interview conducted and edited by Ted O'Callahan.