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Holy scrap!

Holy scrap!

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When one wants to express strong astonishment, ‘Holy mackerel!’ is a nautical expression that does the trick well. We heard this expression (in British English, that is) many, many years ago by a Brit who had beached on the Louisiana coastline in the US Gulf a few decades earlier.

There are a couple of theories for the origin of the expression, but the most plausible holds that since mackerel is a fish that goes bad very fast, fishermen in old England were given extraordinary permission by the church to sell their mackerel catch on Sundays. “Guests and fish stink in three days,” the wise Benjamin Franklin astutely once observed, but mackerel is worse than that. And if the church is willing to grant permission to do business on the Lord’s day, there has to be a sacred excuse, and thus the expression.

The expression came to mind while reading a market commentary on the fact that the just passed IMO regulation demanding 0.5% sulphur content in bunker fuel by 2020 will lead to a scrapping wave strong enough to bring a much wanted tonnage balance in the shipping market. In a lousy shipping market, this was a ‘Holy mackerel!’ moment, the way we saw it.

Or, ‘Holy scrap!’ to be more precise; nothing could be more sacrosanct than scrapping in the present market.

The IMO regulation has the potential to be a costly catalyst for the shipping industry, by as much as $40bn by some estimates. For an industry in distress, additional costs and mandatory investments are the last news one wants to hear about. Complying with the new resolution, a shipowner would have to retrofit a vessel to burn high quality marine diesel fuel low in sulphur, install scrubbers to arrest pollutants and lower emissions or, thirdly, convert the vessel to be powered by natural gas or another low emissions fuel; all pricey solutions that will cost a couple of million of investment per vessel, a tough proposition for a shipowner in a weak market.

Scrapping however is a long shot as an alternative course of action.

Deciding to sell a vessel for scrap is one of the hardest decisions a shipowner has to make, and literally, this is the last decision they will make after exhausting every possible scenario. Selling a vessel for scrap is a terminal and irrevocable decision and quite often entails taking losses in today’s market. Even if there is a ray of hope and an alternative, the shipowner will decide to hold off selling the vessel for scrap. Old age, obsolete design, tonnage oversupply, new regulations, etc are not always definite reasons for scrapping.

With OPA 90, following the grounding of the infamous tanker Exxon Valdez, single hull tankers were given an expiration date for January 1 2015 to be totally removed from the trade. A long lead-time indeed for shipowners to plan for that resolution. What effectively happened was that although there were no single-hulled tanker newbuilding orders since the late 1990s and publicly listed and politically correct shipowners divested their single hull tonnage soon thereafter, almost 14% of the world’s tanker fleet was still single-hulled in January 2010, 20 whole years after the new regulation came into place and five years before the final ‘drop dead’ date. Regulations or not, shipowners, worldwide and collectively, effectively kept ‘obsolete’ ships in the market much longer than anybody would had anticipated.

The first decade of our century experienced a once-in-a-lifetime freight market on the back of China’s expansive growth and easy credit by lenders, which partially explains how single-hulled tankers were kept afloat for so long. Actually, all being equal, the strength of the freight market is a best predictor of the level of scrapping and tonnage withdrawals from the shipping market. As long as freight rates are cash flow positive, ships are not getting scrapped; when the freight market is cash flow negative and prospects for a recovery are poor, then demolition levels pick up.

The following graph of the Baltic Dry Index (BDI), the proxy for the dry bulk shipping market, clearly shows the inverse relationship between the index and scrapping activity. There seems to be a two-three month lag, but each time the BDI drastically moves, the scrap yards in Alang, Gadani and Chittagong get to hear about it, one way or another. Earlier in 2016, when the BDI was flirting with all time lows, demolition activity had spiked through the roof, approaching 10% of the world fleet. A few months later with the freight market barely above break even for the dry bulk market, scrapping has more than halved, to the disappointment of analysts and investors who were drawing straight line annual projections based on the activity of the first few months of the year. Scrapping is high still today, to be sure, and comes from many sectors, including containerships, but the moral of the story is that scrapping does not seem to be the convenient and sacrosanct solution that it always appears to be.

2016-10oct29-holy-scrap-article_graph

There is a third case of disappointment in scrapping: after the shipping market collapsed in 2008, still cash rich shipowners and institutional investors were aiming at buying dirty cheap ships from shipping banks. When the banks held back from selling at any price, at least then, many a shipowner and especially an institutional investor jumped on the wagon of ‘eco-ships’ being fuel efficient that would make ships held by the banks obsolete. And, a massive wave of newbuilding orders was placed. Fast forward five years later, and we all now know that the fresh deliveries of better eco-ships failed miserably to force older tonnage to the scrap heap. Brand new ships, and modern ships, and older ships, and old ships have kept floating and trading and depressing the freight market for all. The wave of demolitions triggered by the eco-design deliveries crowding out older tonnage, shown in power-point presentations to Wall Street, has failed to materialise and save the market. Holy scrap was not.

We do not want to discount the importance of scrapping to achieving a balanced market. Actually, at this stage of the cycle, scrapping seems one of the most promising drivers for the market; shipping is so bad, indeed. And the new regulations by the IMO for lower emissions will push some shipowners to the edge, and some ships to the beach. However, likely, in our opinion, scrapping will be a slow remedy that will be more drastic with the level of the pain of the market, that is the state of the BDI and the rest of the freight market.

As they say, pain is beauty.

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Basil Karatzas

Basil M Karatzas is CEO of Karatzas Marine Advisors, a maritime consultancy and shipping finance firm based in Manhattan, New York.

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