By Richard Stephenson, CAIA - Executive Chairman at TonnEdge, and Director at Gestion Maritime Group Introduction by Alessandro Sanos, CAIA – Global Director, Commodities at Refinitiv Introduction With its silent efficiency, shipping is rarely in the spotlight. To the uninitiated, this industry could be perceived as a marginal market, but shipping is the backbone of international trade. It plays a critical role in the global economy as it moves over 90% of the physical trade in the world. Shipping is also a very differentiated industry, as the business of moving crude oil and refined products over the “wine-dark Sea” is entirely different from the one of LNG, chemicals, dry bulk, or containers. Listed equity is often the default avenue of choice for investors wishing to allocate to the shipping industry. This approach, however, may not necessarily be the best option. It could add unwanted exposure to idiosyncratic risk when a particular stock is negatively impacted by something happening in the market that positively influences the industry, and to company-related risks such as lack of management talent. Also, investors may be better served by other routes as business models and capital structures of listed shipping companies result in many stocks moving more in line with mainstream equity than with the main shipping benchmarks. Looking at the historical performance of shipping stocks, it is undeniable that most passive investors have run into severe storms, with many listed shipping companies showing extremely negative equity returns over the past few years. Instead of investing in stocks, investors wishing to gain exposure to the shipping industry could follow alternative routes such as passive ETFs, more active FFAs, or by investing with specialist shipping funds that lend money to shipowners secured against vessels, or who employ a data-driven investment manager who adapts best practice from finance and risk to the unique characteristics of the shipping markets. Whichever route one chooses, it is important to understand the dynamics of the industry, beginning with an overview and a historical explanation of the current market structure as well as a breakdown of the two main approaches to the commercial shipping investment management. The Basics of Shipping There are currently 51,500 commercial vessels on the water. They are essentially floating factories that can weigh hundreds of thousands of tonnes and can measure up to 450 metres. They carry most of the materials required to build, power and feed the global economy and are by far the cheapest mode of trade transportation. Without shipping, we would pay more for almost everything. Different vessel types carry different types of commodities or goods. Dry bulk vessels are the largest shipping category and carry non-liquid commodities such as iron ore, coal, and grain. Tankers, the second largest sector, carry crude oil and products derived from the crude refining process. Containerships carry standardised rectangular boxes that contain finished goods, so nearly everything that you buy that is made in China was transported by containership. Each vessel is an asset with fluctuating cash flows due shifting demand for and supply of seaborne transportation – which is called “freight.” Freight demand is a derived demand as it is determined by the demand and supply dynamics of the commodities the vessel carries. Freight supply is determined by the number of vessels available at each auction point. As vessels can take up to three years to build, supply is inelastic in the short term as the market approaches full capacity utilisation. Vessel earnings are determined by freight rates, which are expressed in dollars per day. Freight rate curves have defined term structures out to five years for the most actively traded vessel types. Short term rates, known as ‘spot’ rates, are extremely volatile as they capture immediate demand and supply imbalances, and are often quoted in the press as they make for good headlines. Long term rates are far less volatile. The main shipping derivative instrument is the Forward Freight Agreement (FFA), which is a cash settled futures contract that mirrors the daily rate of the corresponding point on the cash freight curve. FFAs are liquid for the largest vessel types – particularly dry bulk – and are a useful hedge against both earnings and vessel price fluctuations. There is also an active FFA options market for the most liquid contacts. FFA contracts are OTC negotiated, exchange cleared, and are mainly used by commodity traders and hedge funds despite their obvious hedging benefit for shipowners. The vessel price is theoretically the present value of the expected net future cash flows to be generated from vessel ownership, namely average freight rates minus operating and maintenance costs over the holding period, plus the terminal value. However, the market is extremely sentiment-driven and pays little attention to financial theory. Many adjustments, therefore, are required to reconcile the DCF price against market prices. Rational discount rates and forward cash flow estimations are incredibly complex, but using a fixed income ‘curve fitting and offset’ approach is the most logical way to price individual vessels. Vessel prices depreciate non-linearly over time. Newer vessels depreciate faster than older vessels, and are more sensitive to freight rate fluctuations. Vessel earnings also decrease with age, but at a much slower pace than price depreciation based on a scrap value floor. As such, yields for older vessels are higher and downside risk is typically lower. Nonetheless, traditional shipping banks prefer to lend against newer vessels. A Brief Modern History After World War II, the US initiated a system under the Marshall Plan, in which European shipowners would be ‘sold’ US warships. These ‘Liberty’ ships would then be converted into commercial vessels, reopening Europe to global trade. Greek shipowners were the main beneficiaries of the Liberties program, with the Greek government guaranteeing long-term loans from US banks to purchase hundreds of vessels. During the Cold War era, a subset of these shipowners went on to dominate the global oil transportation business, despite Norway being the dominant European oil nation. These ‘Golden Greeks’ confirmed their nation’s ship-owning dominance through a global outlook versus Norway’s early domestic shipbuilding and purchasing policy decision. Moving from the US, to war-torn Germany and Japan, the Greeks ordered numerous increasingly sophisticated tankers, helping to rejuvenate these nations, whilst deepening ties with the Middle East. Driven by a desire for low-cost oil transportation, US Oil Majors encouraged the dominant Greek shipping players to develop offshore structures in which vessels would be registered under ‘flags of convenience’. Panama, Honduras, and Liberia were initially chosen due to either strategic cold war proximity and/or legal similarity with the US. Though this setup provided tax breaks and minimum state intervention, the US was able to exercise control over these vessels at will, enabling US hegemony via tacit policy control. Mainstream Shipping Today Shipping investment practices have remained largely unchanged for much of the industry for decades, despite significant progress in related fields. The data revolution beginning in the early 2000s enabled leading figures in quantitative shipping finance to collaborate with financial risk and investment management specialists and select progressive shipowners to develop new cross-industry insights. This initiative embraced innovations in financial risk and investment management, mapping them to the shipping markets. Currently, two approaches to shipping investment exist. The ‘Traditional’ Shipowner Approach and the ‘Modern’ Financial Approach. The Traditional Approach is adopted by most of the industry, both public and private, and focuses on operational/commercial cost/revenue management, with an instinct-driven capital deployment and income generation process. Traditionalists shy away from the use of derivatives for hedging, and have an informal understanding of the intricacies of best practices in financial risk and investment management. The approach seldom uses data or the tools common to the modern risk-controlled investment management community. The Modern Approach incorporates the latest techniques in quantitative finance, risk and investment management, adjusted to the nuances of the shipping markets. Vessel portfolios managed using a modern approach represent perhaps the largest ‘niche’ alternative investment opportunity in the market today, with billions of capacity and the potential for extraordinary risk adjusted returns. At a time when Preqin estimates that alternative allocations will grow to $14tn by 2023, from $10tn as at Q1 2020, traditionalists continue to pursue an instinct-driven, unhedged approach.  As it stands today, this approach to shipping investment management adopted by the majority of the industry is incomparable with the minimum standards of the alternative investment community. As a result, the two industries are largely disconnected, which is mutually un-beneficial. Unsurprisingly, shipping portfolios managed using a traditional approach have – time and again - exhibited extraordinary levels of volatility and losses. As a result, in numerous banks have withdrawn from the ship lending business, and listed equity analysts have either ended their coverage or have questioned the viability of shipping as a listed asset class. Therefore, for shipping to attract meaningful alternative asset allocations, it needs to break with tradition and modernise. So why does the traditional approach persist? He who controls the data controls the narrative…. Though the Baltic exchange publishes a handful of vessel price benchmarks as well as the main earnings indices to subscribers, the vast majority of data is warehoused by shipbrokers. The largest and most traditional shipbrokers were the first to write accessible textbooks that helped frame the industry’s self-perception. Much of the thinking behind these works was forged in the 1970s and 1980, at the time of the risk and investment management divergence between mainstream finance and shipping. Few had much in the way of shipping data at this time, and pre-internet, informational asymmetry between large and small players was a reality. Like in many industries at the time, larger players had more information, faster. However, with the democratisation of information, this advantage has largely disappeared. The most influential of these texts [was written by Martin Stopford], who is a prominent figure in the shipping world, as he founded the first dedicated shipping research department at Clarksons, the largest and oldest of the shipbrokers.  This non-technical, informative text gives the reader a detailed overview of the shipping market, and is perhaps one of the best textbooks from the perspective of market structure, operation and general market practices. For a financial risk and investment professional seeking to understand the less rational aspects of the industry, Stopford provides a very clear picture of the beliefs of the traditional owner:
- Shipping cycles are completely unpredictable and random, so there is no point in trying to predict them; but long-term standard deviation is a proxy for possible cyclical upside, so higher volatility is desirable. As diversification ‘locks in’ lower returns, it is undesirable.
- Relatively low ‘expected’ shipping returns are brought about by the shipping player’s desire to take shipping cycle risk. Therefore the shipping markets price risk differently in order to potentially get lucky playing the shipping cycle. Some have made fortunes this way, and those lucky few have something tantamount to the ‘x’ factor, which they display by ‘trading’ the shipping market based on gut instinct rather than data. The shipping market views trading ‘like’ an hedge fund as playing high stakes poker, without a formal probabilistic framework or any data. Brokers have all the data, speak to those with the ‘x’ factor and should thus be relied upon to interpret the data for players. Factors such as inflation adjustment and investment performance relative to passive equity benchmarks is of little importance to the traditional shipowner. Shipping is no place for institutional investors because of its relatively high volatility and low returns, based on a passive interpretation of expected risk and return
- A few have it…but most don’t:
"Shipping…. Offers a few successful shipowners wealth beyond the dreams of lottery winners, whilst the less fortunate majority earn enough to survive and to pay their bankers. In effect, the market 'sells' them the volatility which institutional investors do not want because they cannot use it. But shipping entrepreneurs can and as the excitement of the poker table hooks [entrepreneurial] investors, competition continually drives down the return on capital." (Stopford 2009) The traditional view of shipping outlined above contrasts sharply with the practices and experience of the “modern” shipping player:
- The alternative investment market is well equipped to manage the aforementioned risk, and to deliver consistent returns to institutional investors using a data-driven, disciplined framework. By focusing on both the numerator and the denominator of the return equation (unlike the numerator fixation of the traditionalist), and by generating one’s own price and earnings data at an individual vessel level, the Modern approach seeks to capitalise on the heterogeneity of this unique asset class. The asymmetries that exists between vessel of various types, ages and sizes at both a price and an earning level are almost impossible to consistently detect without such an approach.
- The extent to which vessels hold their value over time is identifiable through accurate internal vessel pricing systems, which must account for stale pricing and must use a combination of market and quantitative methodologies.
- Entry point, downside risk measurement and management (FFAs) are key performance drivers, so be mindful of the ease with which pro-cyclical credit flows into the market. The capital market operations of ‘traditional’ listed l companies are of particular importance given their propensity to expand forward supply when capital is available to do so.
- Monitor vessel relative values and liquidity volatility and industry behavioural biases, incorporating observations into the risk and investment process whilst mapping all investment decisions to a defined return target and timeline.
As freight rates, vessel values and credit availability from banks are all positively correlated, the non-data-driven traditionalist, drawn toward growing larger fleets to increase their personal standing within the industry, tends to ride the wave until the downside risk far outweighs the upside. They invest based on price momentum, placing new orders when earnings are increasing, overestimating demand and price persistence and underestimating the competitive response. By contrast, the aim of the shipping investment modernist is to be a confident contrarian, using a robust, data-driven framework containing a vast array of stylized investment tools. Conclusion The shipping industry, a vital component of the global economy, should be an essential element of any alternative investment portfolio. It is important, however, to differentiate between a passive asset exposure and an active investment management process. Though the vessels themselves may be considered alternative investments in their own right, the techniques and processes used to manage them at a portfolio level has a meaningful impact on overall investment performance. Both the investment management process (i.e., vessel segment, type and age selection, portfolio construction, hedging, leverage, liquidity monitoring, vessel employment and exit decisions) and the asset management process (i.e. technical and commercial management), must each be managed within a robust, data-driven framework. Passive or undisciplined ad-hoc shipping exposure managed by those using a traditional gut instinct approach will continue to exhibit deeply volatile and unreliable returns over time. The traditional approach that currently dominates the shipping market floods the news cycle, due to its downside risk and disappointing returns, turning capital away from the industry unnecessarily. Breaking with tradition and moving to a modern approach provides tremendous opportunities for investors seeking uncorrelated, high risk-adjusted returns. Simultaneously, such a paradigm shift would enable the industry to move confidently to Shipping Investment Management 2.0.  The containership market is highly concentrated, with a small number of large listed players competing over market share. This article will focus on dry bulk and tanker markets that have low concentration and active secondary markets.  The continuous ‘catch up’ process between supply and demand is a major component of the shipping cycle, and the orderbook for new vessels to be delivered (new supply) is reasonably transparent.  The staggering volatility seen in spot freight rates for very large crude carriers (VLCCs) in March and April this year due to the OPEC+ supply war is a good example. Spot rates were elevated for a few months when crude contango was extreme and floating storage demand peaked. When an agreement was reached, freight rates crashed, but this volatility was not experienced at the long end of the freight curve.  This is mainly due to losses experienced during the 2003 – 8 China WTO market rally, when these contracts were traded purely OTC and were used by shipowners to establish synthetic long positions. Counterparty credit risk has now been largely mitigated due to exchange margining “Shipping Derivates and Risk Management” (2009) by Amir H Alizadeh and Nikos K Nomikos is the reference textbook on the subject of shipping derivatives”.  Numerous factors affect the rate of vessel price deprecation. With a large and accurate vessel level pricing data set and the right framework, one can structure exposures to exploit these variations.  Short term spot earnings are far more sensitive to cargo proximity than to age. As such, the impact of vessel age is more pronounced for the longer term period charter market. Shipping banks seem to prefer lending against newer vessels out of tradition rather than CVaR. In some cases, there is a political motivation linked to bank support for shipyards and the building of new vessels.  These offshore structures were some of the first of their kind, and paved the way for offshore tax industry that dominates the alternative investment management industry today.  “Shipping and Globalization in the Post War Era. Contexts, Companies, Connections” (Palgrave Studies in Maritime Economics) (2019).  Preqin Future of Alternatives 2018 and Alternatives 2020.  Shipping information is far more accessible today, but is fragmented and disorganised. It must be collected and structured in order to be systematically useful.  Maritime Economics, 3rd edition 2009  ‘Waves in Ship Prices and investment’. Greenwood and Hanson. NBER 2013. Alessandro Sanos, CAIA is heading the global sales readiness function of the Commodities, Energy, and Shipping business of Refinitiv on the holistic offering of market insights, analytics, data management, and technology. Alessandro the Chapter Head of the CAIA Association Geneva Chapter. Richard Stephenson, CAIA serves as Executive Chairman of TonnEdge - a shipping investment data and analytics company, as Director of Gestion Maritime Group - a Bulk Shipping company, and as co-Managing Partner of Gestion Maritime Investment Advisors – focusing on (Dry and Tanker) Bulk carrier data driven risk and investment management.
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