How coronavirus ‘stress tests’ will change ocean shipping

The 2009 global financial crisis was disastrous for ship owners, spurring sudden insolvencies and restructurings followed by years of rolling loan renegotiations. “Ship owners overall are in much better shape now than in 2009 because asset values are much lower and leverage is much lower,” asserted Karatzas.

Ships were valued at historically high levels when the crisis struck in 2009 and banks were providing debt financing for up to 80-90% of asset values. Asset values collapsed and fleets no longer provided the required collateral security to lenders. Today, ship values have much less room to fall and vessels have much less debt coverage, at around 40-60% of asset values.

Karatzas still foresees restructuring ahead, but unlike other industries where fallout is immediate, he expects it to be more of a second-half-or-later event for shipping.

He pointed to private-equity funds that previously purchased the shipping-loan portfolios divested by European banks, as well as private credit funds that provide high-interest debt to owners who cannot access low-interest bank loans.

Such private debt holders “will be much more proactive and hands-on [than commercial banks] and will not allow borrowers much room for error,” he said.

Vessel demand

Asked how the coronavirus could affect future vessel demand, Karatzas answered, “I think the probability of a catastrophic scenario is rather small. It seems more likely to me that there will be a deep worldwide recession in 2020 and a V-shaped recovery in 2021.”

Even under this scenario, he pointed out that coronavirus fallout “is coming after the trade war, and if people think, ‘The world is not smooth anymore, whether because of tariffs or COVID-19,’ and we have nearshoring and deglobalization, it raises the question of whether all those ‘Triple E’ [ultra-large container] ships make sense in the new world.”

Karatzas continued, “You have to believe that the impact of COVID-19 will be negative [for shipping demand]. That’s logical. On the other hand, there will be a lot of experimentation and disruption of existing supply chains and establishment of new supply chains, and this should have a positive effect [on vessel demand] in certain market segments in the intermediate term.”

Vessel supply

Pre-coronavirus, shipping was heavily focused on plans for International Maritime Organization (IMO) regulations to promote decarbonization by 2050. Uncertainty over those future IMO rules reduced future vessel supply by disincentivizing new ship orders; owners were concerned that newly ordered 25-year assets would be rendered prematurely obsolete by yet-to-be-written regulations.

The dearth of newbuilding orders continues, now driven by the coronavirus. “Ordering for the next several months is pretty much out of the question, primarily due to practicalities,” said Karatzas.

Next year may be a different matter. Add 2019’s order drought due to regulatory concerns to 2020’s order drought due to the pandemic and the case to break the logjam and place orders becomes more attractive in 2021. “It will become tempting and I think there’s a good chance the Chinese will provide incentives for newbuildings,” he said.

Evolution of equity markets

U.S. equity markets have been closed to shipping with the exception of a few penny-stock deals. Coronavirus has rendered already weak investor sentiment toward shipping exponentially weaker.

Asked how the industry can ever revive its reputation on Wall Street, Karatzas opined, “The problem is that even for companies with a large number of vessels, it’s about direct market exposure [to freight rates]. They do not provide anything more, so it’s always highly volatile.”

Most public commodity ship-owning companies are pure plays in a single ocean freight sector with a high emphasis on spot employment. There’s little or no share-price premium for management acumen.

Karatzas believes public shipping companies ultimately need to embrace business models that earn a management premium and “provide for more stability in down markets.” Public-company management must “find complementary businesses that provide support in bad markets.”

The hurdle, he acknowledged, is that the private sponsors of public shipping companies prefer volatility and are averse to models that reduce their own potential upside.

Evolution of debt finance

On the debt side of the equation, Karatzas believes banks have generally turned away from traditional asset-backed ship mortgages in favor of lending against corporate balance sheets and charter cash flows. The coronavirus crisis creates the opportunity “for these banks to stress test their shift from asset-backed financing to balance-sheet financing, see what they’re missing and fine-tune their models,” he said.

European lenders — who have already pulled back from shipping over the past decade — will inevitably be hit by losses on their non-shipping portfolios due to the pandemic. These losses are “definitely going to have an impact and should make the banks even more selective with their shipping loans” in the future, he continued.

He’s convinced that ship finance in general will shift even further toward Asia at the expense of Europe and the U.S. That “is not speculative but more of a fact,” he asserted.

Western ship owners have increasingly turned to Chinese leasing houses for capital in recent years, selling ships, taking the cash, and leasing the ships back with either a repurchase option or obligation. The coronavirus crisis will provide an important stress test for Chinese leasing as well.

Chinese lessors could wind up owning a very large number of ships if lessees decline to exercise repurchase options. “That may look bad, but maybe that was part of the goal,” Karatzas speculated. “Maybe they wanted to control a large percentage of the world fleet.”

Chinese leasing houses also have exposure to non-shipping sectors such as aircraft leasing that could be extremely problematic in the wake of the pandemic. What if they face non-shipping financial pressures at the same time shipping lessees can’t make lease payments? Will they “amend and extend” contract terms in the same way forgiving European banks did post-2009, or will they take control of the ships?

In the latter case, what happens with the debt? Chinese leasing houses have often financed the purchase of vessels in sale-leaseback transactions with debt provided by traditional European commercial shipping banks. If lessees default, will Chinese leasing houses make the European lenders whole and take the loss themselves?

“This is the first time we will get to see how Chinese financing and Chinese leasing performs in a bad market,” said Karatzas.

Coronavirus clauses and risk premiums

Yet another coronavirus-induced evolution will involve shipping contract language.

The interpretation of “force majeure” clauses vis-à-vis coronavirus is ambiguous and will be litigated. Future shipping contracts will be written with more clarity on the assumption that outbreaks may recur.

“I am not a lawyer, but I believe that this will be fine-tuned in charter contracts going forward,” said Karatzas. “That will have an effect on the underlying financing by increasing the risk premium. COVID-19 is a low-probability, high-impact event the world has never seen before. People will ask: What prevents a more evolved form of the virus that has even bigger consequences from emerging next year?”

If contract language heightens financing risk, it should theoretically elevate the interest rate on debt financing and the required returns on equity investments. A higher cost of capital implies that freight costs should increase to compensate the ship owner.

“That’s what they teach you in business school,” said Karatzas. “How it will work in real life remains to be seen. Shipping companies have not always been able to pass along extra costs to charterers or end users, so maybe this will turn out to be yet another cost for the industry to absorb.” Click for more FreightWaves/American Shipper articles by Greg Miller