How things have changed over the last few months. I recall many fund managers and companies reporting that there was clear forward earnings visibility for many as they had contracts in place thereby giving a fair amount of certainty. Some may recall that I addressed this in my opinion piece in Splash last August, suggesting that no one was immune from the fallout and even the existence of a contract did not guarantee future earnings. The piece warned of contract delivery delays, charter rate reduction and contract cancellations as companies moved to shore up balance sheets and improve liquidity. This has come to pass and we now see a deluge of negative sentiment and reporting around the shipping / shipbuilding and OSV markets of late.
The situation has got to the stage that the nuances in the good news / bad news stories have changed emphasis. It is now seen as a positive when an existing contract is scaled back and charter values reduced rather than outright cancellation. I suppose that this is a better result than having the contract cancelled in its entirety, but has now introduced the next battleground as liquidity issues emerge front and centre. My last opinion piece looked at the state of the market, and my recent webcast on the on the Asia markets discussed the decline and possible new niche markets. This article takes these onboard but will focus on what one can expect for the rest of 2016. Whilst the yards in Asia had distinct advantages in shaping their dominance over the sector in the last few decades, those advantages have diminished of late.
Trend one: Ongoing consolidation of the balance sheet
We currently have oversupply / capacity not only in existing vessel fleets, but we have newbuilds entering the market, suggesting market conditions will deteriorate. Consider, for example, that of the world fleet of approximately 5,000 OSVs, 1,300 are not active and there are 500 on order. We now have the situation that in some sectors, such as dry bulk, shipping companies have been forced / coerced into accepting zero charter rates i.e. the charter covers operating costs only. In a sense the dry bulk sector has responded by increasing the pace of scrapping in 2016, with 117 vessels scrapped so far this year as opposed to 81 in the same period of 2015.
Other options that are available to the sector to bring about balance is to reduce the supply of vessels by means of disposals, demolition / scrapping and stacking. Bourbon, the French operator, has adopted the stacking approach with more than 20% of its 511 vessel fleet now out of service. In my view, the only real solution is to increase the level to which older vessels are scrapped. It has been suggested in some quarters that vessels beyond 15 years of age, whilst appearing costly and introducing short term impairment costs, clears the deck for sustained growth going forward.
Another consolidation method that will be attractive is debt restructuring, with the most popular being the conversion of debt into equity transfers to improve liquidity. We are seeing this taking place particularly in the South Korean yards, an example being Hyundai Heavy. Associated with this development in Korea has seen the Korea Development Bank receiving requests from the Korea Shipowners Association to “go easy” on loan to value breaches as values decline. Paragon, who recently disposed of its fleet, offered baby bond holders an exchange of $25 note for 60 shares of Paragon common stock.
Trend two: Increase in mergers and acquisition activity
Whilst not a lot happening right now, I expect that this will escalate over the next six months as companies move to rationalise fleets and services in order to rectify the current supply/demand imbalance. Of interest is the move by Japanese and Korean shipyards to enter creative JVs with countries that can offer lower cost advantages, particularly as shipbuilding is moving towards standardisation and modular construction. Japan appears to have favoured new yards in Myanmar, whilst South Korea has boosted this activity with Vietnam.
There has been further speculation that Keppel and SembCorp Marine will merge their offshore and marine businesses – particularly coming out of the Singapore government’s investment instrument, Temasek Holdings. This has particularly come to the forefront as both are exposed to Sete Brasil to the value of around $2bn and would have significant impairment costs, eroding shareholder value.
Trend three: Offload assets
We are already seeing the evidence of shipping companies and shipyards moving to rationalising their fleet / focus and return to their core business. The most notable has been Paragon that made the decision to offload its entire fleet. Daewoo Shipbuilding has also recently announced that it will be moving away from the offshore / sector and focus on LNG and defence contracts and it is selling off non-core assets. Other examples of companies selling off assets include Transocean and Diamond Offshore, but this option has become problematic when you consider that the price differential between new and secondhand vessels are at an all-time high.
Trend four: Increased legal fees around contract cancellations / renegotiations
Essentially this will become a lawyer’s paradise as we see increased activity in contract reviews and cancellations. In the recent past when demand outstripped supply, contract cancellation / review mechanisms where hastily constructed as there was always a ready customer to step into the breech – whether for a new build or take over a vessel charter. We now have the situation in which the available customer base has shrunk, and any poorly constructed contract terms is a basis to question the sanctity of the contract. Not only are we now seeing delays / postponements in delivery, we have seen an escalation of order cancellations. Examples would include 12 out of the 21 JURs ordered at Keppel are at risk of cancellation, with Transocean delaying the delivery of five JURs. Sembcorp Marine faces cancellation of 6 JURs by Marco Polo, Oro Negro and Perisai and a semi-submersible from West Rigel.
The latest legal proceedings include:
· Bumi Armada Vs Woodside for the cancellation / termination of the FPSO Armada Claire contract
· Nam Cheong Vs Perdana Petroleum over the cancellation of the accommodation barge contract
What is needed going forward is having a sound management teams that has a clear strategy and insight into their markets. Some of the criteria to look at when evaluating a good team include:
· Ability to raise funds by means of a well-articulated business restructure and plan
· Negotiation skills to facilitate debt restructuring including interest payment reductions and debt refinancing
· Contract mediation skills to extend and preserve contracts as best they can and move from a win-lose mentality
· Board structure that shows commitment to the business and not having directors with multi-board roles
There are many companies that do not demonstrate these capabilities, which could well result in a stronger trend emerging in the second half of 2016 i.e. increased business failure and bankruptcies