Overview

Unquestionably, volatility of the shipping market is unprecedented during 2H08 and 1H09. The environment is still challenging in 2H09, however, we expect the situation will become stable with slight upside potential.

Dry bulk market will consolidate

Freight rates rose markedly in 1H09 as China's import of iron ore and coal was surprisingly strong. Slow down of China commodities import and accelerated supply growth will lead to consolidation in 2H09, while the lengthened voyage distances may support freight rates.

Container market is bottoming out

Container operators underperformed their dry bulk peers in 1H09. Nevertheless, as global economy is warming, we believe that they will catch up soon. Supply growth is limited as shipping lines have great extent to redeliver chartered-in vessels.

Forecasts

- BDI will swing in a relatively narrow range

- Container shipping market will improve gradually rather than strongly

Review of dry bulk market in 1H09: The strongest rebound ever seen

Shipping market underwent a turbulent period last year. BDI reached the historical high 11793 pt in May08 and hit 663 pt in Dec08, the lowest level in 22 years just after half a year. Surprisingly, it rose from 774 pt at the end of last year to over 4000 pt in Jun09, nearly sixfold within 6 months.

Reasons for the rebound are as follow:

China iron ore imports surged

In order to mitigate the impact of financial crisis and propel economic growth, China government launched economic stimulus plans which focus on supporting the development of infrastructure and properties. As a result, demand for steel and hence iron ore mounted. China imported 297.3 mn tonnes of iron ore in 1H09, an increase of 29.3% compared with the same period of last year.

Meanwhile, negotiation between China iron & steel association and 3 biggest iron ore miners (Rio Tinto, BHP Billiton and Vale) remain locked in stalemate. China proposed that the long-term contract price of iron ore should be reduced by 40% while the 3 miners insisted a 33% reduction only. The protracted negotiation entices speculation of iron ore price and finally pushes up the spot price. Freight rates of Capesize vessels, which are the major carriers of iron ore, surged under this backdrop. Broadly speaking, BCI is the sole driver of BDI in 1H09.

China becomes importer of coal

Surging demand for iron ore is noticeable. However, the impact of coal import should not be overlooked. China has abundant coal reserves and act as coal exporter in the past few years. In 2008, however, as coal demand slumped after global economy collapsed and many accidents occurred in Shanxi province's coal mines, over 1000 coal mines have been closed, which resulted in sharp reduction in domestic coal supply.

Since China economy became stable in 1H09, electricity generation and hence demands for coal resurged. At the same time, domestic coal supply was still constrained. As a result, domestic coal price was higher than international coal price, which encourage import of coal. China imported 48.25 mn tonnes of coal in 1H09, a 123% ytd increase compared with 1H08, which support freight rates of Panamax vessels, the major carrier of coal.

Less-than-expected supply growth

At the end of last year, dry bulk operators concerned much on supply side rather than demand side as orderbook is very high in the next few years. However, as ship owners aggressively scrap aged vessels, delay new deliveries and cancel orders, capacity of the whole sector only rose slightly in 1H09.

What are the catalysts for the dry bulk market in 2H09?

Both positive and negative catalysts exist in our view, namely i) China commodities import slow down, ii) Supply growth may accelerate and iii) Voyage distances lengthened.

China commodities import slow down

Unlike most of other countries, China frequently uses counter-cyclical economic policies to stabilize economy. When the economy is under recession, the government would stimulate it through a series of expansionary policies so as to sustain GDP growth, and vice versa. As the impacts of financial crisis subside, economy shows signs of recovery. The recent rallies in global stock markets justify this view. Consequently, China government may fine-tune the stimulus plan in order to cool down the economy.

In the meantime, supply of commodities is expected to rise. Coal mines in China will be reopened little by little and domestic coal price will approach international coal price accordingly. Besides, latest data show that the China iron ore inventories reach 71.66 mn tonnes, approaching the pre-crisis level. With the rapid rebound in commodities price and inventories level in China, We believe the pace of import will slow down in China and freight rates will be driven down in 2H09.

Supply growth may accelerate

Cancellation of orders and delay of new deliveries are costly. As the current freight rates are profitable for ship operators, they may halt to curtail capacity temporarily. As a result, supply will grow faster than 1H09 and hence adversely affect freight rates.

Voyage distances lengthened

Traditionally, Japan and Korea are major importers of China's coal. As China becomes importer of coal and the trend seems irreversible, China coal export to Japan and Korea decrease while coal import from Australia increase. The overall voyage distances for vessels in China increase accordingly. As the coal supply from China reduce, both Japan and Korea have to import coal from countries far away from them. These are the phenomena we see since Feb09.

The case of iron ore is similar. As the negotiation between China and Australia miners has nearly broken, there is anecdotal evidence demonstrate that China intends to import more iron ore from Brazil, which imply a lengthened voyage distance for transportation and hence higher freight rates.

Container Shipping: hope emerged under difficulties

Performances of container operators were overshadowed by their dry bulk counterparts in 1H09. Loss in FY09 is the norm in the industry and no survivors should be found. They are still struggling, nevertheless, the situation is not hopeless and we believe that the container transportation market is bottoming out.

Improvement in the US economy

Undoubtedly, global recession has not passed yet, especially in US. Major economic indicators such as GDP and unemployment rate are still deteriorating. However, these indicators are lagging as they are released on quarterly basis. Instead, some weekly and monthly released data foreshadow the recovery of US economy. For instance, initial jobless claims drop below 600000 for 3 weeks consecutively. Consumer confidence index, the widely used indicator to assess consumer sentiment has not further worsened since 2Q09. Existing home sales also stabilized and the price is rising gradually.

Since US is the largest consumer of manufactured goods in the world, the economic recovery in US is critical to container transportation market. China export to US rebound since Mar09, which in line with our view that the worst has gone.

Cooperation but not competition

Generally large firms would try to drive out small competitors during recession so as to capture larger market share. However, it is not the case in current container shipping market. Financial crisis hurt all companies deeply. None of the shipping lines has unrivaled competitiveness since the market is not dictated by few giants. Companies which use tactics such as price war would not outlast their competitors as they are likely to collapse first. As a result, they may choose cooperation instead of competition with others in order to stay afloat. Many shipping lines provide joint services in recent months. Capacities are used more efficiently and cost is saved. Profit margin is therefore maintained.

Rates hike will be proved to be effective

Facing the challenges in current predicament, most shipping lines raise freight rates, bunker fuel charges and peak season surcharges from the start of 3Q09. Doubters are skeptical about the effectiveness of the rates hike during recession. We hold a contrary view as we believe the rates restoration is sustainable. Reasons mentioned above such as economic recovery and cooperation between shipping lines support our relatively optimistic view on container transportation market. China containerized freight index, which indicate freight rates in different routes, also show signs of improvement, especially in Europe routes.

Redeliveries of chartered-in vessels help to curb supply growth

Similar to the case in dry bulk shipping market, large orderbook is the major concern of the industry. However, as nearly half of the capacities are on lease, shipping lines can redeliver chartered-in vessel once they expire. What noteworthy is that the capacities of total orderbook is less than capacities of total chartered-in vessels, which means that in extreme case the supply growth of container vessel can be negative if all chartered-in vessels have been redelivered. In reality it is unlikely as different shipping lines have their own ideal structure of owned/chartered-in vessels. Nevertheless, it shows that supply growth of container ships may be much less than expected.

What do we see in the crystal ball?

Of course we don`t have a crystal ball. However, base on the facts and our analysis, we make a few forecasts for the shipping market in 2H09:

BDI will swing in a relatively narrow range

Volatility of BDI is unprecedented in 2H08 and 1H09. For 2H09, we believe it will not be volatile like previous year as both upside and downside potential is limited:

Downside potential is limited: BDI declined expeditiously since mid-June. Nevertheless, it will not drop to the Dec08 level as credit market has recovered. Moreover, if BDI is low enough, China's import of commodities will continue to rise as low freight rate effectively reduce the actual cost of import. BDI futures indeed give us some clues for the trend in 2H09. Although futures are lower than spot index, we notice that BDI futures remained relatively stable above 2000 pt when the spot rate slumped 25% in Jun09. Therefore we believe that 2000 pt is a good support of BDI.

Upside potential is limited, too: BCI solely contribute to the rise of BDI in 1H09. On the other hand, BSI and BHSI are nearly flat in 1H09. Obviously, the rebound of BDI was merely driven by demand for iron ore and coal in China rather than comprehensive recovery of global economy. As we mention above, China's import of iron ore and coal may not be sustainable and supply growth will accelerate. As a result, BDI is capped without the help of extensive recovery of global economy.

Container shipping market will improve gradually rather than strongly

Stock price of container operators rose starkly in 1H09. However, we believe that it was only due to attractive valuation (PB ratio for CSCL and OOIL had reached 0.2x in 4Q08) but not foreseeing an improvement of business. The current stock price may fail to reflect positive catalysts we mention above, at least to certain extent. We believe good news will be revealed eventually.

However, we don`t think it is a robust rebound. Consumer markets in developed countries are still fragile. Consumers tend to cut spending and save more during recession. Historically, spending pattern will back to normal after recession passed, but this is not guaranteed. The latest saving rate in US reach 6.9%, which is the highest level for a decade. That's why we remain cautious for the rebound of container transportation market.

Overall, we believe that the volatility of shipping market will fall. As we hold the same view for the stock market aggregately, `Equal-weighted` is maintained.

Investment strategy

4 shipping stocks are currently under our coverage. We believe that OOIL (316) is the best choice because i) it is the only one has property investment in China and hence it can be benefited from the robust mainland property market, ii) container shipping business will improve gradually in 2H09, which has not been fully reflected in stock price in our view and iii) Valuation is attractive.

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