There was a saying about the airline industry that in order for one to become a millionaire, they had to start with a billion-dollar investment. With the Airline Deregulation Act of 1978 in the US, the regulatory barriers to entry were not stratospheric anymore, allowing for new entrants, like Southwest, to enter the market with a clean sheet, no legacy entanglements (union labor, mostly) and set a business plan – mostly like thereof – to act opportunistically and expand selectively. With an ever expanding fleet, route and plane offerings, the market grew, ticket prices came down, and once upon entering the internet age with its easy price comparisons and choices, competition became cutthroat, and airline companies were after survival by going after market share and covering variable cost. It was a brutal business model with a constant round of bankruptcies where legacy airliners were trying to get rid of their legacy fixed costs, such as pension obligations or get out of leases for obsolete planes, etc. Come the liquidity crunch of the financial crisis that caused the legendary ‘tit to go dry’ of easy lending combined with skyrocketing fuel prices, airline companies had to do a reality check.
In the first decade of the century, the seat mile availability (an industry metric of airline seats available for booking) exploding, while revenue per seat and the financial condition of the airline companies was deteriorating. Once upon having to face reality and deal with a constrained option set, airline companies started shedding off inefficient airplanes, focusing instead on strategic routes and discontinue flying on marginal ones, and, to the detriment of passengers, started optimizing pricing and charging extra fees for luggage and almost anything else for that matter, and … and … In a rare Pauline moment for the industry, the airliners understood that collective, self-imposed discipline was required for survival, and shifting focus from market share (the typical ‘we lose money on the operations but we make it up in volume’) to revenue optimization and maximizing of profit. And to make this clear, today’s Wall Street Journal reports that Thanksgiving-week typical airfare is about 9.4% higher than last year, and Christmas-week traveling higher by about 7.3% respectively; given that seat availability is tight, prices could increase further and no last minute madness sales are expected any more from airline companies trying to fill empty seats at the last minute.
Why one should care about the airline industry’s self-discipline about capacity? As much as we hate such self-discipline as passengers, likely we would have loved it as investors.
In previous postings we have raised doubts about the shipping industry’s fundamental recovery based on the amount of newbuidings that were delivered in the last few years, and mostly about the newbuildings being ordered today. We appreciate the frustration of investors / shipowners from their market point-of-view as buyers being unable to find quality tonnage in the secondary market for purchase at market related prices, since there are few vessels available for sale given that the system is ‘propped up’ all around: central banks and regulatory authorities with their quantitative easing keeping propped up bad banks which in turn keep propped up bad owners which in turn are allowed to keep trading expensive vessels in default (having earned the banks’ tolerance for servicing properly their shipping loans), and thus expensive vessels have an efficient cost basis to compete with more modern and efficient vessels.
Ordering newbuilding vessels is still a rather tempting proposition: prices are still low, especially when compared to peak market pricing, payment terms for newbuildings are favorable and fairly backloaded, and more importantly, newbuildings are better vessels since they are more fuel efficient and may also provide operational efficiencies as well (usually bigger cargo carrying capacity for same dimensions / asset class vessel.) The logic goes that a vessel that is 15% more efficient than an existing vessel, she will crowd out the less competitive vessel; whether the vessel were to be employed under a timecharter (where the charterer pays for fuel expenses) or a voyage charter (where the shipowner pays for fuel expenses), the more efficient vessel will offer a lower transport cost per cargo unit, and thus will have preference over the less efficient one.
That’s at least what we learned in Economics 101. What happens when tonnage capacity doubles, as it has or expected to do for certain segments, and there is no sufficient demand for all the available tonnage? Logically owners will have to accept any charter rate, whether it’s profitable, break-even or unprofitable. What happens when the banks have given up demanding loan servicing from ‘bad’ owners and now these owners – despite their early mistake of ordering peak-expensive vessels – have actually a low cost basis that can remain competitive (only operating cost)? What happens when the ownership and chartering activity is of a very long tail nature, as it is in several market segments in shipping, most conspicuously for the smaller dry bulk vessels? There are jurisdictions and charterers who would accept such vessels that can be kept profitably trading when they are well past their design lives (although clearly top, big charterers would prefer modern, economic vessels, for many reasons.) What happens when shipowners refuse to scrap vessels when they become economically inefficient? (admittedly, selling a vessel for scrap is a very tough, irrevocable decision that never is taken with light heart). Frontline, among others, has recently advocated for the early scrapping of relatively new VLCCs in order for the market to get rid prematurely of tonnage that has not yet reached its design life but could clear the way for more efficient vessels and higher freight rates. As a gesture of setting a good example, Frontline has scrapped earlier than expected a few vessels, and Mitsui OSK Lines over the last year have opted to sell fairly modern capes (sixteen and seventeen year old) for demolition rather than in the secondary market where they could achieve a small premium over scrap. But Frontline has to be a responsible corporate citizen since they are now collectively one of the biggest shipowners in the world and Mitsui OSK Lines is an industrial conglomerate that can absorb losses from shipping; try to explain the logic of early scrapping to independent, trap owners, a long line of them in every sector and in every corner of this planet.
It has been said recently that shipping is not a ‘team sport’ and that certain companies have already been benefiting from the advantages of the ‘first market mover’. No doubt. One of the ‘charms’ of shipping is the renegade attitude of a worldwide market of perfect competition. But again, it’s said that shipowners are their worst enemies where self-discipline is an unknown virtue. Time will tell!
© 2013 Basil M Karatzas & Karatzas Marine Advisors & Co. All Rights Reserved.
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