The drybulk shipping and offshore drilling industries

I don’t think that the shipping and drilling industries are great places to look for unusual returns.  Over the entire boom and bust cycle, investors generally do not make much money.  Historically, the way to make money has been to time the boom and bust cycles in the industry.

The pattern is that high profits cause a wave of capital to flood into the industry.  This leads to overbuilding and a oversupply of ships in the industry, causing prices to crash.  The wave of overbuilding tends to take several years to wear off and causes massive losses for years.  This tends to set up the market for a new boom as many investors have little interest in getting burned again.

Capital markets tend to make the boom and bust cycles more extreme.  As investment banks make large profits from underwriting fees, their incentive is to raise capital for new ships even if it isn’t a good idea for investors.  Many investors can justify purchasing these shares since the shipping companies tend to exhibit reasonable P/E ratios and high returns on equity during a boom.  (I’m the kind of person who would do this since I used to own Dryships/DRYS.  I’m not that smart.)  On top of that, the boom phases tend to last for several years and investors may conveniently extrapolate from the past and ignore the bust that came before the boom.

Banks also cause the cycles to be extreme as they lend to the shipping companies and cause more capital to flood into the industry.  When the drybulk shipping industry crashed in 2008/2009, many of the banks (the West German banks) did not seize their collateral even though the borrowers breached their loan covenants.  If the banks did seize their collateral, then they would have to immediately recognize losses on their balance sheets and I guess they didn’t want to do that.  At the end of the day, the banks did not know what they were doing in lending money to shipping companies.  This tends to be a common pattern in the history of banking… they make money in their core activities and find creative ways to lose it in other endeavors.

Drybulk shipping versus offshore drilling

In general, I believe that the drybulk shipping is much worse than the offshore drilling industry.  Drybulk shipping has the lowest barriers to entry since the ships are the easiest to build and therefore every shipyard can build the ships.  Offshore drilling involves more technology and therefore there are fewer shipyards capable of building the ships and fewer people with the expertise of running an offshore drilling company.  This makes it easier for the industry to quickly become flooded with an oversupply of ships.

Another factor is that drybulk rates tend to be extremely volatile and therefore attracts speculative money that chases high returns.  Too much capital flooding the industry causes losses for everybody.

Economics of the industry

Every company’s revenues and expenses will be roughly the same.  I do not believe that any one company operates its ships at a cost that is meaningfully lower than everybody else.

Ships will have higher maintenance costs as they age.  Eventually, there will be a point where the day rates for a ship are equal to or lower than the ship’s operating costs.  In that situation, it can make sense to scrap the ship for its salvage value.  The overall supply of ships depends on how many new ships are built versus old ones that are scrapped.  Ships often last for 20-30+ years and I believe it only takes a few years for shipyards to oversupply the industry.  This tends to make crashes particularly severe and causes the bust cycles to last at least several years as it takes a while for the oversupply to wear off.

Predicting supply and demand

I’m really no good at this.

Predicting future prices is really, really hard as there are numerous factors that affect supply and demand (e.g. closure of canals, wars, politics, regulations, demand for commodities, technology, etc.).  Historically, I don’t think that there have been many people who were skilled at predicting commodity prices and have gotten rich from it.  Even famous macro investors like George Soros and Jim Rogers are wrong much of the time.

Investing in these industries

There are some things to watch out for:

  1. Integrity / excessive management fees.  Many management teams pay themselves too much and/or have dubious related party transactions (e.g. Dryships).
  2. Excessive leverage.  Most of these companies often do have excessive leverage.  History tends to repeat itself as the heavily leveraged companies tend to go bankrupt eventually.
  3. Mind the arbitrage.  Sometimes the stocks sell at a premium or discount to the private market value of the ships and the contracts attached to them.  Some of the smarter management teams out there (e.g. George Economou of Dryships) exploit the arbitrage between the two… though not always to the benefit of shareholders.

With these stocks, you are mostly speculating on commodity prices.  It strikes me as a very hard way of making money unless the industry is at an obvious bottom (e.g. lots of scrapping versus newbuilds).  I don’t think either drybulk shipping or offshore drilling are at a bottom right now.

*Disclosure:  I don’t own any stocks in these industries.

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