The COVID-19 pandemic has created a perfect storm in the dry bulk shipping industry. It disrupted vessel supply, vessel demand, and suppressed the market impacts of one of the most significant maritime regulations in history (IMO 2020). However, as the world fully reopens, the industry will be facing a large supply-demand imbalance that should lead to a sharp freight rate recovery, and potentially, the start of a shipping supercycle.
The Perfect Storm And The Next Supercycle
Dry bulk shipping involves the marine transport of commodity goods such as iron ore, bauxite, coal, and grains. This is an essential industry that faces no obsolescence risk because it is by far the cheapest method of transportation of low price per weight commodities. However, it is highly cyclical and moves closely with global GDP growth. In addition, due to a two-year ship construction time and a 25 to 30 year lifespan, vessel supply growth often does not balance with vessel demand growth. These factors have led to a history of extended periods of low rates followed by shorter periods of enormously high rates – a shipping supercycle.
The last supercycle was during the China economic boom of 2003 to 2008. Freight rates reached unprecedented levels and vessel values surged. To provide some context, the largest class of vessels, Capesize, earned an average freight rate of over $70,000 per day during the late-2003 to early-2008 period. This compares to a roughly $6,000 per day operating cash breakeven. In early-2003, a 5-year-old Capesize could be purchased for about $25 million. By mid-2008, it would have generated over $120 million in cash flows and could be sold at over $110 million. In total, the $25 million investment would have generated total net cash inflows of over $205 million, an enormous gain.
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Unfortunately, shipowners extrapolated this high demand growth rate and ordered too many vessels. The ensuing jump in vessel supply coincided with the post-Global Financial Crisis economic stagnation. And thus, shipping rates have languished at around cash breakeven levels for the past decade as the oversupply needed time to be absorbed.
Adding to the industry’s misfortune, just as rates began recovering in 2018-19, the Covid pandemic led to arguably the greatest negative demand shock in dry bulk shipping history. Many global ports completely shut down, and trade ceased in some regions. Nonetheless, this demand shock has sowed the seeds of what may be one of the most powerful shipping recoveries in modern history.
Indeed, the trend growth for dry bulk commodity demand may have shifted higher than pre-Covid levels due to enormous pandemic relief efforts. Global policy makers have spent trillions in direct fiscal aid and monetary stimulus, and much of the impact of these actions will only be fully felt when the world reopens. In addition, every major economy in the world has launched, or will soon be launching, commodity-intensive infrastructure spending plans.
On the vessel supply side, the current fleet orderbook – newbuild vessels on order as a percentage of the existing fleet – is at or near, multi-century lows of about 5%. Historically, this metric is usually at 15 to 20% of the fleet due to anticipated vessel scrapping and demand growth. Simply speaking, assuming roughly 4-5% annual demand growth (roughly equivalent to global GDP growth) and 2-3% annual vessel scrapping (as old vessels are no longer useable), shipyards must produce 6-8% of the existing fleet in new vessels every year. This net fleet growth of 4 to 5% should roughly match the growth in demand. The orderbook provides color on the next two to three years of vessel supply: 6-8% gross vessel growth per year multiplied by two to three years forward = about 15 to 20% required orderbook.
At about 5%, the current orderbook implies that global vessel supply could start shrinking by sometime in late-2021 to early-2022! This very constrained supply situation is the best downside protection against any unexpected future negative demand shock. But demand will eventually return and supply will not be sufficient to meet that demand in the short-to-medium term.
The Best Positioned Dry Bulk Shipper
Star Bulk Carriers Corporation ($SBLK), is the best-positioned dry bulk shipping company to exploit this market opportunity. The company is the largest publicly-listed dry bulk company in the Western world with 126 vessels across all major size categories. It is the lowest-cost operator amongst its major peers. And it has a very liquid and well-capitalized financial position. All of this is easily verifiable by perusing its financial releases. However, we believe the best proof of its excellence is that it not only survived the recent COVID-induced shipping depression but also it is likely to both show positive GAAP net income in 2020 and announce the restart of its dividend policy in the upcoming 4Q20 earnings release this week.
Now, beyond the supply-demand aspects of this investment thesis are the impacts of IMO 2020. On January 1, 2020, the International Maritime Organization’s marine fuel sulfur rule (“IMO 2020”) came into force. This rule banned commercial marine vessels from using high sulfur fuel oil. This cheap but highly-pollutive fuel was previously used by nearly all commercial marine vessels. Following IMO 2020, the only approved fuels are very low sulfur fuel oils, LNG, or the use of high sulfur fuel oil that has been scrubbed by an on-board exhaust gas cleaning system (“scrubbers”). For further reference, please see: https://www.imo.org/en/MediaCentre/HotTopics/Pages/Sulphur-2020.aspx.
Since the rule change, most ships use low sulfur fuel but a select few companies decided to install, at a large expense, scrubbers on their ships. Star Bulk was one of the very few companies that decided to install scrubbers on nearly every ship they own at great cost of capital and time. The investment case for pursuing this aggressive course of action was when the demand for low sulfur fuels relative to high sulfur fuels increased, the price spread of the two fuels would significantly widen and give the company a large competitive advantage.
In the early months of 2020, prior to COVID’s full arrival, the spread of the two fuels surged to over $350 per ton from a historical average of over $200. This sharp jump equates to over $300 million in EBITDA for Star Bulk since it burns roughly 1 million tons of fuel per year. It appeared their approximately $200 million investment in scrubbers would be handsomely rewarded. Moreover, this fuel spread advantage would last for the full lifespan of the vessel since the scrubbers are long-lived and the cost of producing high sulfur fuel oil is substantially lower than that of low sulfur fuel oil. This huge scrubber gains would not only provide a competitive advantage for Star Bulk but more than double their 2019 EBITDA of about $200 million.
However, with the arrival of COVID, the fuel spread collapsed to a historic low of about $40 per ton by the summer of 2020, significantly diminishing the earnings from the scrubbers. An unfortunate quirk of the pandemic was the collapse in air travel which destroyed jet fuel demand, a competitor for the specific molecules in low sulfur fuel oil. This unusual drop in demand for jet fuel caused the price of low sulfur fuel to drop relative to high sulfur fuel.
Nonetheless, as the world recovers, the fuel spread is once again widening and is currently around $130 per ton. At these levels Star Bulk is making over $100 million in additional EBITDA and demonstrating the strategic logic of installing scrubbers. Currently less than 15% of the global dry bulk fleet has scrubbers and few companies have scrubbers installed across nearly all their vessels. It is likely that the fuel spread will return to its historical average of about $200 per ton when air travel normalizes. This would add nearly $200 million in annual EBITDA to Star Bulk on a go forward basis.
Valuing The Company
In valuing the company, we assume that shipowners will not order new vessels until rates are sustainably profitable. For Capesize vessels, this would be roughly $20,000 per day, the long-term historical average (excluding the supercycle rates of 2003-08). At $20,000 per day in revenues and about $6,500 per day in operating costs, Capesizes would be generating an unlevered cash flow of about $5 million per year or about 10% of the cost of a newbuild vessel. For the smaller vessel classes, an equivalent rate would be about $12,500 per day.
Since Star Bulk’s fleet is composed of about 1/3 Capesize and 2/3 smaller vessels, its blended daily rate in a sustainable scenario is $15,000 per day. Net of daily all-in cash operating costs of $5,600 and a 350-day operating year, Star Bulk’s EBITDA from vessel operations is over $410 million. If we conservatively assume an IMO fuel spread of $150 per ton going forward and a 75% capture of this fuel spread, then scrubber EBITDA is about $115 million per year. Therefore, the combined EBITDA is $525 million per year.
Assuming a 10% cost of capital (based on bank debt at sub-5% levels), the fair EV/EBITDA multiple for the company is 8x. Please note, shipping companies do not pay corporate tax and maintenance capital expenditures are included in all-in cash operating costs. So, the valuation of the company is:
- Enterprise value = 8 x $525 million = $4.2 billion
- Net debt (Est. YE21) = $1.35 billion
- Equity value = $2.85 billion
- Equity value per share = $28
Currently, using the forward freight rate curve and IMO fuel spread, Star Bulk should generate over $450 million in EBITDA in 2021 on an enterprise value of about $2.9 billion or a 15% unlevered return. With about $250 million in debt service costs (interest and principal) in 2021, it could pay nearly a $2 per share dividend or about a 14% dividend yield on its current $14 share price.
The Quality Play
On a qualitative-basis, Star Bulk has demonstrated high standards of corporate governance during the long downcycle unlike many of its peers. It has not paid its management egregious fees or had any instances of self-dealing. In fact, the management has strived to maintain their status as the lowest cost operators in this industry. And finally, the insiders and Oaktree Capital remain the largest shareholders with over a 50% ownership stake aligning their interests with minority shareholders.
In conclusion, let us emphasize that the future path of freight rates is unlikely to be smooth – it never has been. More likely, as the market recognizes that there is a growing shortage of vessels, rates will far exceed the levels needed to encourage new vessel orders. And if this higher demand occurs simultaneously with stimulus-driven inflationary pressures, a supercycle in freight rates and vessel values may develop.
Overall, Star Bulk Carriers is a well-capitalized, low-cost, and well-run company in an essential commodity industry that is exiting a long downcycle with favorable supply-demand dynamics. In the current monetary liquidity-driven mania, we believe this company is favorably positioned for significant appreciation.
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