'Heads I Win, Tails You Lose' — Old Dry Bulk Operating Models Go Out the Window

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Ian Staples

'Heads I Win, Tails You Lose' — Old Dry Bulk Operating Models Go Out the Window

Heads I win, tails you lose. That has been a tacit suggestion at some stage from companies that have sat in the dry bulk operating space for any period of time in the past 30 years.

The idea is that a shipowner is ‘long’ come what may if he or she owns ships. Market goes up? Great! Market goes down? Sit tight and hope your ‘relationship banker’ has forgotten about you for a while at least. For charterers, shipping markets go up and down, but the truth is that the cost of shipping is passed onto the buyer/consumer of whatever commodity is shipped. So when the freight market was breaking records in 2008, the steel mills of the world were reporting record profits. Strange, but true.

However, the ship operator has always sat in a different world. This world is inhabited by CEOs claiming that although a high freight market is ok, they can actually make more money in a low market. This statement appears to have been taken at face value for some time, but it turns out that the limited amount of financial accounts that are available for ship operators tell a very different tale. Basically, operators will tell you that they make money through volatility due to their ability to go long and short on the turn of a card. If the market doesn’t move then they cannot make their margins. Again, referring to the financial information available, this really feels like ‘pub talk’.


Turnovers rise and fall in line with the freight market

In fact, the financial accounts generally show that lower freight markets mean lower turnover. This might sound intuitively obvious, but if you refer back to the ‘Operator’s Handbook’ (2001 Edition), it is implied that lower freight rates lead to higher cargo volumes for operators as they can afford to be more aggressive in gaining business, and therefore turnover should not be overly affected. Operator models work on turning over available cash as many times as possible, generating for example 2% a turn. Turn it five times and you make 10%. However, the facts show that turnovers rise and fall broadly in line with the underlying freight market, namely that operators cannot simply grow or shrink volumes to suit market conditions. One nil to those that think the Operator’s Handbook might be a little outdated.

Financial figures also show that margins are largely dictated by market conditions. The returns of an operating company do vary, but are generally between 1-4% of turnover (when profitable). Therefore, in absolute terms lower turnover means lower gross profits (against static fixed costs) and often net losses. This is another hole in the wall of operator agility. Furthermore, the ‘4% years’ are almost always in a stable and firm freight market. One quick point to make here is that 1% of turnover is not impressive, but return on equity (which is often almost zero) is a very nice figure for a company with no assets and little fixed costs other than staff. It is a good business in this respect.


Is market volatility really the operator’s friend?

Market volatility is often quoted as the operator’s friend, but again this might not quite be the full truth. From the accounts that we have analysed, it would appear that a stable, but upward-trending freight market produce the best results for operators. The pattern that emerges is quite different from the market warrior business model that is often quoted. Is it because operating companies have strayed from the original 2000s model? Is it because the companies themselves think they are doing one thing, but are actually doing another? Is it because the tools that they claim to employ either don’t really exist, or don’t do what you think?

I cast my mind back to a presentation from the ‘old’ Navios group, which was a very successful operating company in the original sense. In the presentation was a slide that showed life in the form of a triangle. The three points were ‘ships’, ‘cargoes’, and ‘FFAs’. If you thought the market was going up you took in ships on period charter, if you thought it was going down then you took in cargoes. For anything in between you offset it with long or short FFA positions. What could be simpler? And for many years it was that simple. Klaveness, SwissMarine, Transfield, and so many others used this model to great effect. But remember that everybody in dry bulk between 2001-2008 was a success, whether by luck or judgement. So what worked then may not work when an a long upward trend ends spectacularly.

Things changed at the end of 2008 when the trap doors of the market were opened and everybody tumbled through. Very few landed relatively softly, some came to sticky ends, and some just swung in the breeze, left as examples of what not to do. Every business model worked between 2000-2008 and many fools felt like geniuses. The operator model of old Navios days never really worked fully, but looked like it did because of the market. Certainly the ‘new’ Navios is nothing like the old one.


Can you win on the way down?

Without wishing to sound like a nostalgic raver, thinking back to when the music was better and the crowds were friendlier, it is worth thinking about 2008 in context of the collapse of January 2016 and the collapse of January 2019 to see what is still applicable to look after the health of dry bulk operating companies. Firstly, let’s put the ‘we do better in a low market’ cliché to bed. When the market has surged or been on sustained highs, guess what? Nobody went bust. When the market has been in sustained lows, bankruptcy has gone up. Case closed.

To be positioned to at least be able to cope with a market drop then an operator needs something on the books that makes money when the market is going down. A book of cargo to play with would be one solution. In simple terms, the operator books the cargoes for future dates at one price, then books the ships to carry the cargoes at a later date when the price for ships is lower, thus pocketing the difference. This is the classic ‘we make money in a falling market’ strategy, in theory at least. Our unofficial poll of brokers and operators taken during the research for this article estimated 5-10% of cargoes that are freely available to fix can be booked on forward or COA basis. To put it bluntly, almost everything is spot these days. Bang goes the ‘long on cargoes’ strategy, consigned to the cupboard along with the Sinclair C5 and the iPod.


Mitigating a falling market

It is just about possible to mitigate a falling market by not having anything on the books that is falling in value. This means that the operator takes a ship on time charter for a period and relets it either when the market goes up, or very quickly as he or she senses the market is going down. Two parts of this strategy make it a bit harder to execute. The first is that the operator has to know when the market is cheap to take in tonnage, near the top to relet. The ship has to be a good one somewhere convenient, with enough time left on the charter to make a relet possible. And you have to hope that only you have seen the market like this, because if others sense it too then your ship will be one of many and you will be dropping your price fast. These days, after the chaos of unpicking the daisy chains of relets (up to 10 different relets on a single ship during a single charter), many charter parties state clearly ‘No Chains’. So the walls are already closing in. Lastly, the operator has to find a credit worthy idiot that has not worked out the market is going to tumble and is prepared to ‘catch the piano’, which is a phrase describing those willing to buy in a collapsing market. Again, all of this is perfectly plausible, but incredibly tough to execute and, judging by the financial returns of operators, is more like spotting a harpy eagle than a sparrow.

The alternative to all of the above is basic in its simplicity: have no ships if you have no cargoes. Have no ‘delta’ and you have no problems. But then again, you have no risk and therefore you might have no losses, but you will likely have nothing to show for it either. This is often referred to as ‘back to back’. Again, it all sounds good, but the discipline and lack of return makes traders want to stray from this plan very quickly. You can’t be a lion tamer without any lions. So in truth all operators, whether they admit it publicly or not, will have ships and to some extent will judge growth, success and power by the number of ships that they control on charter. Certainly brokers and news outlets will focus on those that have the largest fleets rather than those with the stingiest risk management strategies. The more lions you have the more brilliant lion tamer you are, but the greater the chance that one sneaks up behind you and takes a bite.


The true cost of operating ships in a falling market

Much of the strategy that was set out for operators in the early 2000s relied on finding a stooge onto which unwanted risk could be dumped. The assumption was that charterers didn’t know much about shipping, and smart shipping executives could sneak up on them and bash them over the head with badly timed COAs and forward cargoes. Not surprisingly, in 2019 this is about as far from reality as imaginable. Why it is now like this is a wholly broader debate, but it seems that operators can occasionally pull off smart moves for sensible risk adjusted returns, but in general the smart guys end up having to sell freight at the dumbest guy’s price. In short, operating ships in a falling market is selling 10 dollar bills for eight bucks or less. You have the ship, you need the cargo, so does everyone else, so you drop the price to get the cargo, so does everyone else. Now not only have you added weight onto the offer, you still haven’t fixed your ship. “I’ll do it for breakeven” is a phone call that is made more and more frequently these days.

The last point of the old Navios triangle was FFAs. The FFA market for Capesizes at the start of December for a Q1 contract was a mid-price of $12,300. Today February and March are around $7,500, with Q2 trading at only $8,500. This would have been a useful hedge for sure. But, and there always is a ‘but’, the spot market was $13,000 at the time, having dropped from over $20,000. So selling $12,300 took some courage and it also required the foresight that things would go lower (which the FFA market clearly didn’t think was the case). If the operators were interested to sell the levels of December they would have needed to have ships to put the FFA against, or it would be pure speculation. The December market levels were a long way off the top prices in all sizes, so required operators to be very bearish, but also have ships. Then it would lastly require cash. FFAs require initial and maintenance margins. Hope does not require a margin. In short, at the start of December the market seemingly believed that the prices were at, or close to, the bottom. They were not. Considering the operator’s requirement for superior market timing, generally they will not sell whatever the price is just to hedge and will ‘refine’ their hedges. Cue a collapse of rates, cue a huge headache for operators.


Market throws lifeline to operators

It does all sound a bit bleak for operators, based on what is likely to be going on behind the scenes, namely idle ships costing money and no cargo. But largely the operating sector managed to come out of the all time market lows of January 2016 intact. They survived, although didn’t exactly thrive. It appears that the market itself throws a lifeline to operators. In light of all of the above, less and less ships are taken on long periods at fixed rates. Today index-linked and shorter term period charters mean that if the operator can endure a couple of months of pain then that pain will go away as the charter runs out. Ships return to owners and the operator can recalibrate in whatever the new market conditions may be. There is always the final act from the operator in pain, the early redelivery, which is not uncommon either.

So while these sharp declines in the dry bulk market cost money, the bleeding is shorter, less rapid and easier to staunch. If the operator has a little cash, then it can head into hibernation if all else fails. The results posted by the companies will be lower, the general positions not enhanced, but if they can sit tight then they can go again. Just don’t believe anybody still quoting an out of date operating manual. The challenges of today are unique to today. Shipping remains like the British weather insomuch as nothing lasts for very long, but even on the sunniest day, always have an umbrella handy.

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Published on 15 Feb 2019

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