Dry Bulk Transportation Sector Is A Collapse Waiting To Happen

Benjamin A. Smith
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Dry Bulk Shipping ETFs Could Be The Ideal Short Trade Or Portfolio Hedge

NATO can no longer ignore reality. The nation of Turkey—once touted as a primary example of how a modern Islamic country could co-exist with the West—is becoming aggressively petulant. Emerging hostilities are thus leading to a rapid breakdown of maritime security in the Mediterranean region. While we sincerely hope more tranquil conditions return soon, we don’t see that happening. In the meantime, investors may consider profiting from yet another crisis which could deliver the “straw that broke the camel’s back” catalyst which torpedoes the dry bulk shipping sector in 2018.

The latest in a long litany of salvos was delivered again by NATO-member Turkey yesterday afternoon. In a ratcheting-up of military escalations, Turkish warships threatened to sink an Italian drill ship in cypriot waters yesterday. The ‘Eni’ drill ship belonging to SAIPEM had set out to explore block 3 of Cyprus’ Exclusive Economic Zone (EEZ), but was forced to retreat due to Turkish threats. The captain of one of the Turkish warships contacted the SAIPEM (SPM [BIT] – Italian oil driller) and threatened to sink the vessel should it not change its route. SAIPEN eventually ceased and desisted once it became clear Turkey meant business.

This is the second time in the past two weeks Turkey has attempted this type of maneuver.

In isolation, these events are worrying enough. But Turkey’s hostility hasn’t just been focused down south; it has extended westward as well.

Earlier this month, the Greek Defense Ministry announced that Turkey had violated Greek airspace 138 times in one day. Tensions between both NATO members are mounting after Athens accused Ankara of agitating over historically disputed islets. In turn, Turkey accuses Greece of harboring key July 2016 coup suspects.

Previously, a Greek coast guard vessel off the shore of Imia was rammed 10 days ago over one of Greece’s largest ‘disputed island’, over which Turkey now claims sovereignty.

The recent hostility is worrying enough that European Union leaders, in part, will gather in Brussels for talks on diffusing the crisis. Both Cyprus President Nicos Anastasiades and Greek Prime Minister Alexis Tsipras are expected to broach the issue of Turkish aggression with their counterparts. Few analysts believe that portion of talks will lead to anything substantive.

In the meantime, the dry bulk shipping industry can ill-afford yet another shipping lane crisis. While these issues are common to an industry which experiences heightened tensions in the South China Sea, ongoing disruptions in the Pursian Gulf, and nagging African coast piracy, Mediterranean shipping channel disruption is a game changer. The industry is the lifeblood of commerce in Eastern Europe, and provides a primary conduit between North American-southern/eastern European trade.

Consider that shipping is Greece’s most important industry, worth about $9 billion in 2015. That’s a full 4-percent of country’s GDP. If related businesses are added, the figure almost doubles to $17 billion, or 7.5% of GDP. The industry employs about 4-percent of the workforce, or 192,000 people. Greek ship owners still operate the world’s largest merchant fleet, which carry almost one quarter of the world’s oil tankers and 16-percent of the world’s cargo. Major disruption in the region will have spillover effects on consumer prices across the globe.

Keep in mind, we’re only talking about Greece here. Turkey’s aggression threatens to disrupt shipping channels in eastern Mediterranean, from Athens to Tel Aviv, where incidentally, Hamas maritime hostility towards Israel has picked up dramatically.

 

Erdogan’s Neo-Ottoman Aspirations

While it’s beyond the scope of this article to delve too deeply into the reasons behind the turbulence, it’s helpful to understand them. By doing so, investors should come to the conclusion that hostilities aren’t going away. On the contrary: they’re only poised to expand. This trend will heap added pressure of the perennially-dogged dry bulk shipping industry.

In a very broad nutshell, the President of Turkey, Recep Tayyip Erdoğan, wishes to reincarnate the Ottoman Empire. He said as much recently in early February by saying that “modern Turkey is a ‘continuation’ of the Ottoman Empire”, as quoted by the Times of London.

This shocking admission isn’t just some one-off. It’s been years in the making, with Turkey thumbing it’s nose at supposed allies over the years. Whether it’s been threatening to unleash a flood of migrants into the EU (extortion), Turkey’s refusal to allow German MPs to visit stationed troops, or proclaiming “The capliph is coming, get ready“, Turkey’s antagonistic overtures have been well documented. These latest incident only add fuel to the fire.

For those not aware, the The Ottoman period spanned more than 600 years until its demise in 1922. It was eventually replaced by a more secular Turkish Republic leadership on alliances with various successor states in the region. At its height, the Empire encompassed most of southeastern Europe to the gates of Vienna, including present-day Hungary, the Balkan region, Greece, and parts of Ukraine. Included were portions of the Middle East— including Syria, Israel and Iraq west of the Tigris river. In short, tensions could hamper regional trade beyond shipping.

Unlike the Ottoman Empire of the past, there appears to be overt religious overtones fueling the madness. This fact all but guarantees hostilities won’t be abating anytime soon. But further exploration of this topic is beyond the scope of this article.

If indeed Turkey is flexing its militaristic muscle to recapture ‘lost’ lands, shipping could be among the first industries affected. By disrupting exporting routes, Turkey leverages its ability to cause economic hardship to arch opponents in the region. Remember that Greece is still embroiled in a glacially-slow austerity program as it attempts to pay back 75-percent of its debt by 2060.

There’s no better way (short of invasion) to disrupt that process than by hitting Greece biggest industry—shipping.

 

A Sick, Sick Industry

With or without the current strife hammering the region, dry bulk shipping stocks look awful. Perhaps no other sector has completely missed the recovery like maritime shipping stocks. While the S&P 500 has rallied 35% since July 2014, the Dow Jones Global Shipping Index has lost about half its value! To say the sector under-performed is a gross understatement.

You don’t even need indicators to see under the hood. The dichotomy between both assets couldn’t be more apparent. Keep in mind that this negative price action has transpired in an era of historically cheap credit, roughly coinciding with lows in U.S. Treasury yields. Low rates are an absolute necessity for highly-leveraged and under-capitalized bulk shipper to thrive. Rising U.S./global interest rates along with the inevitable global recession could provide the double gut-punch needed to send dry bulk stocks reeling even further.

Aside from a precarious near-term economic outlook, a major industry headwind has just gotten started.

The shipping industry faces the stinging regulatory requirement to install costly ballast-water treatment systems which began last month. This is to be followed by low-sulphur fuel requirements that take effect in January 2020. Builders will be required to cough up between $5 to 20 billion of mandatory capital spending they don’t have to upgrade existing fleets.

There is a silver lining in the darkness. Under new Basel IV regulations, shipping loans will become much more capital intensive for banks. Instead of the usual 90%+ loan-to-value construction finance schemes of the last decade, prospective new vessel orders may require to cough up as much as 40% equity financing. That will help boost pent-up demand as ship builders delay constructing new fleets. The extra regulations mentioned above will lead to more vessels being scrapped in an attempt to avoid costly upgrades. This will help boost bulk rates, as available cargo lags aggregate demand. The shipping industry is highly sensitive to demand/supply imbalances, so expect headwinds to turn to tailwinds in the future.

But this won’t happen right away. At least, not this late in the global business cycle. More likely, stagnant/declining cargo capacity will provide a powerful catalyst for the dry bulk shipping industry somewhere near the apex of the next global recession.

In the meantime, expect the inevitable recession, higher interest rates, and friction in Europe’s historical shipping cradle to take it’s toll. The likely result: individual dry bulk stocks (do your own due diligence), and ETFs like the Guggenheim Shipping ETF (NYSE: SEA) to be ideal long portfolio hedges and short sell candidates.

 

Conclusion

The dry bulk shippers may very well be investment worthy—but not yet. Not until containers demand really capsizes, interest rates crest, and a new business cycle is born. This isn’t a sector that will squeeze investors out of positions. The selling is real, unrelenting and logical.

Expect more of it as global business winds down, bringing with it lower capacity usage.

Benjamin A. Smith

Benjamin A. Smith

Ben is a research analyst and capital markets professional with nearly 20 years of experience. His areas of expertise are broad-based, and include extensive knowledge of macro economics, stock/derivative trading, commodity complexes, cryptocurrencies and technical/quant analysis. He also maintains an particular affinity for U.S. politics and the macro-regulatory environment facing...
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