Joachim Grieg & Co - Annual shipping report 2012

ANNUAL SHIPPING REPORT 2012

Table of Contents 3

Summary

4

World Economy

11

Energy Policy and Shipping

13

Dry Cargo

20

Tank

25

Chemical

28

Container

35

Gas

42

Shipbuilding

3

Summary

2012 – Faltering economic growth and another depressed shipping year

2012 proved to be another gloomy year, characterized by faltering economic growth and shipping markets still digesting the tonnage burst created during the previous super-boom. The economic slump presumably reached its lowest point in the advanced economies. The European economy contracted due to the ongoing debt malaise and mounting unemployment, while US manufacturing is still in the process of recovering. Allied with this, the developing economies such as China, India and Brazil began to stutter. Chinese growth had to decelerate just at the time the regime was to switch leadership.

It is, however, not all that negative: leaders across the world are more than ever committed to interfering in sluggish economic times: a new 5-year plan in China, US ambitions to restore confidence and a Europe finally increasingly synchronized to bring back growth are just a few factors contributing.

building is an integrated market, prices of specialist tonnage could not escape from the downfall in the tramp segments. Prices for complex ships have been corrected far less since their peak in 2008 as market dynamics proved better. For the LNG market even, delivering stellar freight rates above 120k $/day, prices were hardly corrected. All in all, we foresee that newbuilding values will bottom out in 2013: improved market sentiment in the world economy and the maritime industry leading to more contracting on the one hand while heavily shrinking shipyard capacity on the other hand, would substantiate this view.

The halt in sizable demand growth exacerbated the fleet overcapacity in conventional shipping markets by pushing freight rates further down to often unbearable levels. The shipping industry reacted forcefully: in the dry cargo market, a recordnumber of ships were scrapped. Even with a young fleet following the phase-out schemes in 2010, 2012 saw already significant tanker scrapping bringing down the average scrap age to low 20s. In the container market, supply engineering was the order of the day with more rationalization of liner services, slow-steaming, lay-up and scrapping. 2012 looks set to extend hefty measures in tank and container while the market balance in dry should be reversing. With less of a supply overhang to absorb, the story is different for the specialist segments such as LNG and LPG performing as expected. In chemical, an obvious positive cycle is in the making, inspired by low fleet growth and especially strong demand henceforth.

Besides analyzing ship market behaviour during 2012, careful attention is spent on the fundamental changes that are percolating through in shipping.

The significant changes in global energy policies, especially in Japan (future of nuclear), China (coal production) or the US (shale gas) have substantial ramifications for shipping dynamics. For instance, the massive increase in the availability of cheap unconventional gas in the US is ramping up terminal and plant investments, in turn reshaping the tank, chemical and gas maritime business. The effects are not only related to altering trade patterns; the implications also affect ship construction in terms of size and type. Moreover, the background against which shipping companies operate is becoming more complex: as a result of increasing green energy awareness and the ensuing maritime regulations (e.g. MARPOL emission requirements; EEDI index), shipowners are compelled to choose among alternative solutions, i.e. to install scrubber or compliant propulsion systems (e.g. dual-fuel machinery). It is in this context that we perceive an increasing trend towards differentiated freight markets. Not only shipowners or charterers but also shipyards should be aware of this evolution in product differentiation and timely jump on the bandwagon.

The above dispersed developments were reflected in values as well: both newbuilding and secondhand prices for conventional segments were adjusted further down. This was mainly due to a contracting standstill, a bearish earnings outlook void of any optimism and steel price corrections. As ship-

“2012 lows paving the platform for a new prosperous cycle?�

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World Economy Low growth, uncertainty and questions on how to deal with high debt without jeopardizing economic growth

Traditionally we start the analysis by reviewing the world economy, not only because shipping is a derived product of global trade dynamics but so too because this allows us to paint a better picture of what lies ahead of us. Most of the elements we put forward in our “2011 Annual Shipping Report� still hold, corroborating the consistent view we have been messaging in recent years.

The protracted economic crisis has led to a contraction of the Eurozone as well as weaker than expect-

ed growth in the large emerging economies such as Brazil and India. China has further been driving growth and fuelling ship market activity, but had to slow-down industrial production in Q3, exactly at the moment when accelerated growth in the US came as a surprise to many. The risk, unfortunately, remains on the downside with many problems left to be resolved to tackle the debt crisis in the short and the long run. A change in the traditional growth paradigm that students are indoctrinated with at

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school, could be even harder to deal with; especially when there is no consensus in academic theory on the fastest path to economic recovery. The implications of austerity programs and stimulus packages on economic growth are a matter for such debate.

2012 has supplanted further evidence that advanced economies are stagnating at about 0.9% while developing or emerging economies are growing much more rapidly at about 5-8%, the latest Fitch Global Economic Outlook report informs. This discrepancy in growth path bears, among other things, clear repercussions on global account positions of the United States, Europe and Japan which all are depressing. In contrast, the current account positions of many Asian economies are undesirably strong while still maintaining exchange rates that are undesirably weak. In part, this reflects distortions that hold back consumption within and between trading regions. It also reflects the effect of largescale official accumulation of foreign exchange.

“Currencies in many emerging and developing economies are underpriced, which hold back consumption and worsen global account positions” As much of the talk throughout 2012 pertained to the European debt predicament, we firstly expound on some of the issues taking place in Europe. The bailout package for Greece and its future within or outside the European Union has been a topic much discussed. Many opinions coexist and equally many opinions surfaced on the future of other highly-in-

debted countries like Spain or Italy. Fact remains that Greece will need additional funding at regular intervals, each time raising the question as to how much stimulus can be provided without creating precedents for other distressed EU Members.

Some see a catalyst in the European defragmentation so as to lay down a healthy fiscal framework or integration for the Members. Action is necessary as capital fleeing elsewhere or e.g. escalating borrowing costs for countries in trouble could precipitate disaster. On top of this, there is the danger of protectionism or xenophobic reactions (e.g. Greece) returning that are characteristic of bad times.

The prerequisite of fiscal discipline is one thing, the idea of a banking union is another one as proposed by the IMF. But what does it help to create budget norms if none of the Members (ever) comply and national debt continues accruing? A copy of the FED strategy whereby the ECB would print money to support economies and artificially lower the value of outstanding debt seems out of the question. The European crisis was well-caricatured by the German chancellor Angel Merkel’s drive for austerity vis-à-vis the pro-spending newly elected French president Francois Hollande. Whatever the pursued path, there is no alternative to debt reduction in some form over time. As stated last year, debt financing has some limits as it implicitly assumes that return on the capital lent is higher than the interest rates imposed on the debt. It is conspicuous that this is not always the case, especially not during extended economic downturns. Or, as Keynes (1883-1946) would have put it: the marginal efficiency of capital is not constant over time.

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wards. The domestic side of the economy showed more resilience although manufacturing output saw difficulties in attracting more overseas orders.

The growth of the US economy accelerated in Q3 but market prospects were consistently complicated by the effect of the presidential elections, the Hurricane Sandy as well as the looming fiscal cliff.

“The Eurozone needs strong collective action to safeguard the euro and bring back consumer confidence” The effort of the European policy paralysis became more noticeable during the year. The well-known PMI declined consistently to below 50 corroborating a deep economic retrenchment. Even Germany began to stutter in Q3 as surrounding regions all cut back economic output. Fortunately, there is increasing belief in responsible action from European policymakers. Some proof thereof is the European Stability Mechanism (ESM), established in September 2012, providing financial assistance to Members of the Eurozone in financial difficulty. The ESM should basically be seen as a permanent firewall, coordinating all new bail-out application for the Members.

Also, there is interest in a so-called transatlantic deal where the US and Europe would mutually trade as liberally as possible. In short, we do not expect a double-dip crash in Europe as endured in 2009, but are positive to a slow but definite improvement in the next years with growth catching up to 1-2%.

Economic and seaborne growth USA Latin America West Europe Africa Middle East S. Asia PR China Japan Korea WORLD SEABORNE

2010 2,4 6,0 2,1 4,6 6,8 8,1 10,3 4,6 6,3 3,9 7,6

2011 1,8 4,3 1,5 1,6 5,9 7,0 9,0 -0,7 3,6 2,5 5,4

2012 2,2 2,9 -0,3 4,1 2,5 5,4 7,4 2,0 2,3 2,1 3,3

2013 2,4 4,0 0,4 5,0 4,0 6,4 8,2 1,3 3,7 2,7 4,1

2014 3,1 4,8 1,5 5,4 4,8 7,4 8,4 2,4 5,1 3,5 4,7

By now, we know that the fiscal cliff – defined as the enforced sharp decline in the US budget deficit that could have occurred beginning in 2013 due to increased taxes and reduced spending measures by previously enacted laws – has been avoided by the adoption of the Jan. 1 2013 deal. This deal avoided the automatic austerity measures by moderating tax increases and spending cuts and should be seen as a clear political compromise of current democratic and republican ideology. Although seen as an accomplishment by US politicians, the deal has been heavily criticized as a zero-sum gamesmanship.

Like in Europe, it is de facto the same moral and economic clash that presents itself: budgetary puritans would point to too much government spending being inefficient and self-indulgent, while proponents à la Krugman continue defending the need for more stimulus to bring back growth. As iterated, the truth is still out there. What can be stated, however, is that praising this new deal as an accomplishment is a bridge too far, and feeling like honoring an arsonist for extinguishing his own fire – please note that the fiscal cliff was engineered by Congress 17 months ago after the 2011 debt-ceiling showdown.

“A flexible US economy is already witnessing signs of increasing growth”

(%) 2015 3,0 4,5 1,9 5,3 5,0 7,6 7,9 1,6 4,9 3,5 2,1

2016 2,8 4,2 1,7 5,2 4,9 7,6 7,9 1,3 4,4 3,3 3,4

Source: MSI / Oxford Economics

“World economic growth in China and India, expected to exceed 3% in the next years” The developments in Europe should not eclipse events elsewhere such as the US presidential election or the change in Chinese leadership. The focus in the US has especially been on unemployment which is, unlike Europe, still below double digit figures. The US was clearly recovering in the beginning of the year with unemployment trending down-

As opposed to a defragmented Europe, conversely, the US can move quicker in terms of economic policy. The US is already some steps further in its recovery than Europe. This observation does not only show from key indicators like PMI, consumer confidence or savings figures; it is also inherent in the typical US economy to be more flexible and adaptive to high and economic lows. US GDP figures are therefore estimated to fare in the 2-3% brackets, significantly above European growth forecasts.

In the Far East, economies continue to develop at different speed. Japan is still suffering from a strong Yen (collapse in carry trade, low interest rate in Europe, speculation, fiscal cliff rendering the Yen a safe haven) and languid demand from the US and Europe. Since the 2011 earthquake, it appears that the additional government stimuli have not been providing enough support to the economy.

To counter the ongoing inertia in the economy and risk of deflation as well, the new Japanese Prime Minister Shinzo Abe recently pledged ad-

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ditional stimulus of about 175bio euros destined for infrastructure works and financial contributions to local governments and private enterprises.

What is especially important to monitor in Japan is the energy policy going forward. Will nuclear be effectively phased out by 2040 or not? Opinions remain divided between, for instance, the former ruling party or the new Prime Minister. The reality is that primarily LNG but also crude oil have unceasingly been replacing nuclear power as energy source in the course of 2012. As the restrictive standards from Japan’s Nuclear Regulation Authority are continuously being revised, it seems unlikely to witness a swift come-back from nuclear in the next years.

Hence, even with an economy facing challenges reminiscent to the 90s (deflation, strong currency, no growth), the relevance for shipping is substantial and more than ever influenced by political choices.

“The energy mix in Japan is politically steered and a crucial driver for energy shipping” Fortunately, the economic setback permeating the advanced economies like Europe, the US or Japan is having less dramatic effects on shipping markets than they used to do some decades ago because of the surge of emerging / developing economies like China, India or Brazil.

China in this respect has provided ample relief in 2012 to cushion freight markets in the downturn, even with growth somewhat decelerating due to the muted recovery in major advanced economies. The same rational applies to Brazil and India. Already in the beginning of the year the Chinese economy was cooling down as exports fell for the first time in years. Housing construction and investment slowed down as well. As widely attested, China’s challenges lay in controlling growth and more in particular the transformation from a developing export-led economy towards a modern sustainable economy in which domestic consumption increases. Most consensus forecasts predicate a 7-8% growth for China in terms of GDP or industrial production, and rule out a hard landing in the coming years. It is positive that China is not afraid to act to avert the evil of inflation or to guarantee healthy growth. Interest rates have been slashed two times in 2012 for instance. A real issue in contrast relates to an undervalued currency which distorts consumption patterns and international trade. We believe in a gradual appreciation of the RMB, a process which started in 2005 but halted when the global financial crisis hit in 2008.

The reason is that China has at several occasions signaled concern about an overheated economy.

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“China to grow by 7-8% in the coming years” The event of the year was undeniably the change in Chinese leadership and the ensuing economic effects this would embody.

More succinctly, following the 18th National Congress of the Communist Party of China, it was Xi Jinping taking over Hu Jintao’s responsibilities as national Communist Party Secretary. Some of the major economic reforms have already been confirmed while other are in the pipeline or being worked, so the international press infers. The current standing with respect to investment stimuli for the Chinese economy already announced can be summarized as follows:

- A committed fiscal stimulus package of about $ 158bio to support investment projects such as highways, airports, etc.

- The pledge of regional governments to support more investment projects, valued at about $ 1.83trio.

- The implementation of so-called eased reserve requirement ratios to push commercial banks to lend more, and to increase liquidity in the banking / market system. A strong monetary easing basically means more focus on growth than inflation.

As absolute figures do not paint a resourceful picture, it is useful to grasp that the first confirmed package would equal to about 2.1% of China’s current GDP. To put in perspective, the 2008 stimulus package coincided with a GDP equivalent of about 4%. More cumbersome to assess is the pledge of local

and regional governments mentioned under point two, namely to accord more than a tenfold of the confirmed package. What we can be sure of is that Chinese governments, be it locally, regionally or nationally, are destined to engulf the country with imposing stimuli measures, exactly as we have experienced during all previous 5-year-plans. It is true that stimulus may not be a replacement for longerrun structural reforms (the creation of a balanced growth economic model), but it will definitely contribute to economic growth in the short-run.

“The growth model in India cannot simply be compared with that of China, but its influence on global and shipping markets is mounting day-by-day.”

Against a background of sluggish consumer sentiment and fragile growth it is self-evident that not only in China but also in the behemoths of Europe, the US and Japan, more aggressive measures are required to combat the perennial downturn to kickstart back the world economy in 2013, exactly like was the case in 2009. Some already put their bets on India to be the next China, but both countries are quite different in many aspects. Apart from the lower level of development in terms of GDP/capita and the lack of an investor friendly environment, opaque clearance procedures and high capital costs (about 12% for credit interest rates at domestic banks) remain one of many problems. To unlock the hidden potential of India, it is acknowledged that quite some fundamental reforms have to be pushed through. These changes could vary from port transformations to, for instance, solving for transport bottlenecks in order to link up rural and urban areas. The latter efforts can quickly affect ship market functioning, as the mounting levels of LPG imports into India throughout 2012 have affirmed.

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Revisiting the banking model?

While the heartbeat of the global economy often dictates the cut and thrust of the shipping demand side, it is the capitalintensive nature of ship assets that necessitates the relevance of adequate finance to manage the shipping supply side.

Despite the lasting weak performance of the global economy and for that matter shipping markets, it is notable that 2012 did not see the many bankruptcies or take-overs many predicted. Different factors may be responsible. Some shipowners are still benefiting from transactions structured during lucrative markets; early scrapping provides some cash; banks prefer to refinance insolvent companies at cheap rates for the going concern alternative is deemed better than Chapter 11 tout court; unwillingness from banks to become shipowner due to stricter banking requirements and lack of good market prospects, etc.

An important reason presumably is that many of the losses have still not yet been fully realized: there are still many expensive ships left in the orderbook, and a myriad of expensive ships have yet to come off their profitable charter.

If the shipping downturn persists for too long a period still, shipowners will increasingly arrive at a situation in which solutions have to be found to redress their balance sheets. This could advocate interesting times for companies pondering consolidation and M&A transactions.

Bearing in mind the stricter Basel capital requirements, albeit delayed, and shipping being labeled as a risky segment, it is unlikely that banks today would be willing to fund massive ship investment programs again as they did during the previous shipping bonanza. Going forward, this would imply that the average shipping company willing to invest through bank finance will have to be more financially sound than it was before the crisis. A direct effect is already noticeable in recent times with more and more companies seeking finance through bonds, more private equity or mezzanine finance. As stated in last year’s “Annual Shipping Report”, banks are indeed becoming less prone to invest in shipping.

It is useful to consider the fact the principal interest rates globally have been cut

down to historically low levels. Following the FED, ECB or bank of Japan, it is fair to assume a regime of low interest rates as long as economies are languishing. At the same time, ship asset prices have collapsed as well, basically reducing the risk that banks would invest in overvalued ships. Such an investment would thus coincide with less risk as in the case where banks would voluntarily finance the same ship, e.g. $ 30mio more expensive 5 years ago. Surprisingly enough, it is exactly in bad times that banks require much higher margins – exacerbated by tighter banking requirements – and more equity although, that in many cases seen from a risk-aversion perspective, margins should become smaller as there is much less price or loan impairment risk over the lifetime of the ship. Banks are of course governed by the global banking model, but this note is worthwhile iterating considering the many distressed ship assets banks are getting confronted with, which were acquired expensively during high tides.

Libor-OIS 3-month spread (%) 4 3,5 3

2,5 2 1,5 1 0,5 0 sep. 02

sep. 04

sep. 06

US

sep. 08

sep. 10

sep. 12

Europe

To obtain an idea of the health of the bank system as well as the price of risk, a welcome indicator to follow is the European LIBOR-OIS spread or the US TED spread. For more information, please check our monthly “Gas Compass” edition from October. The chart clearly indicates that a risky 2012 went in sympathy with mounting bank spreads. As hinted above, it is plausible that banks will be pricing risk (unnecessarily) higher than they did before.

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ENERGY POLICY AND SHIPPING Increasing awareness

As often is the case, the persisting global economic concerns diverted attention from energy policy. The political agenda has been dominated by macro-economic concerns rather than topics such as energy security and climate change.

Energy is relevant in the actual debate and often regarded as an issue: countries in recession consume less energy than countries whose rapid growth (read China) demand increasing energy inputs. It is hence not straightforward to reach consensus in the global quest for decarbonization.

Important to acknowledge is that the subdued economic backdrop still coincided with oil prices above 100 $/barrel despite high global oil stocks and sufficient supply from OPEC. It has been proven many times before that high oil prices negatively impact on consumer buying power, especially in periods of economic distress (lower inflation, tighter budgets, etc). It is important that governments do not oversubsidize the often wasteful consumption of energy

from fossil fuels. In that light, one should evaluate the recent initiatives from, for instance, the German Chancellor Angela Merkel to devise a plan for rapidly expanding the country’s renewable energy supply, despite criticism from within her own government.

The US is already succeeding in diversifying energy supply towards cleaner unconventional sources such as shale gas. The ongoing shale gas revolution is clearly a game-changer for the US: advances in hydraulic fracturing and horizontal drilling as well as increased geological knowledge of the country’s underground have led to shale gas becoming a wide-spread reality. US gas prices have since collapsed as have prices of derivatives (e.g. LPG).

“The US shale gas revolution is prompting many countries to revise their energy mix”

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The North American gas revolution has prompted many countries to reconsider their energy supplies. Plainly copying the US example is tedious: besides a regulatory framework or knowledge, one needs vast areas to extract shale energy in order to justify economic / profitable exploration.

There is general consensus that natural gas dynamics will shape the world energy map henceforth. The question is more how fast the oil / coal-to-gas substitution process will proceed.

The changing energy mix in the US has obviously a bearing on shipping markets, as well does the upcoming expansion of the Panama Canal in 2014/5. The effects of the capacity expansion will be notable on global economics and international trade dynamics. Not only the direct effects (e.g. increased ship sizes used) but also the many indirect effects (e.g. changing commodity prices and trades) need perpending that arise from interlinking the Pacific Basin. It goes without saying that fleet analysis, valuation exercises and investments will have to be put in a changed framework.

Some more in-depth reflections can be found in our monthly “Gas Compass” edition from August.

“The effect of the Panama Canal expansion will globalize shipping markets and profoundly change commodity supply patterns” If 2011 saw the first signs of a greener focus among shipowners, 2012 was a real transition year in which owners and charterers paid increasingly more attention to environmental shipping. The 2015 deadline triggered by the MARPOL annex regulations that frame the maximum SOx exhaust from ships is coming closer, so that shipping companies have begun investigating how they should comply.

Should one choose a scrubber, a dual-fuel set-up or simply ignore these inventions and pay up for more expensive MGO/MDO fuel to comply to (S) ECA restrictions? The answer is not easy and quite often case-specific. The shipping industry is muddling through in a characteristic wait-and-see attitude. Current market observations show that thus far shipowners have been attempting to render the ship ready for whatever solution to keep flexibility as long as possible. Unfortunately, one cannot endlessly delay this decision as there are notably logistics limitations to have ship construction geared for e.g. dual fuel machinery or sizeable LNG tanks below deck. What renders it difficult really are the required assumptions one has to make on future ship deployment as well as input prices for bunkers, read respective oil and gas price levels.

“The shipping industry is slowly but definitely realizing the potential of green shipping concepts” The investment decision is complicated by the matter that regulatory certainty or the longevity of regulations are necessary for a shipowner investing long-term in a specific design. Compliance to regulations is to a predominant extent dependent on decisions taken at design stage. Ship designers or shipowners are, however, no clairvoyants able to guess what the regulators may decide to act upon in the future. It is therefore crucial that policy-makers work on stringent regulations and standards that hold for a long enough period.

“A stringent regulatory framework that is sustained over a long enough time period is necessary for shipping companies to make the right decisions” Although the MARPOL sulphur and NOx requirements received most attention, we should also remind that adherence to the widely contested Energy Efficiency Design Index (EEDI) is compulsory for newbuilding ships delivered from 1 January 2013 onwards. Although the motivation behind the energy index is interesting, much resistance has been expressed by the shipping community on the correct and all-inclusive computation of all the aspects of a ship’s effective energy efficiency. Given its application only extending to new ships, the EEDI influence will initially remain very low. Over time, it is advised to follow the MEPC workgroup meetings to see what modifications may be done on the EEDI as such. At one point maybe, the demanding and tedious task may pop up that a EEDI is to be determined for the existing fleet as well, leading to major measuring issues and further opening Pandora’s box. On top of the EEDI certificate, ships are also compelled to carry a so-called Ship Energy Efficiency Management Plan (SEEMP), expressing how operational efficiency improvements are implemented. Although it is difficult to mandate efficiency measures - as each ship is unique – the IMO eyes to oblige the ‘ability’ to improve efficiency, which is inspired by the conception that each ship somehow can operate more environmentfriendly. The effective implementation of the SEEMP is thus a matter left to the ambition of the individual shipowner: some will embark on effective monitoring of their operations while other will allow each ship to harvest the ‘lowest hanging fruits’.

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DRY CARGO Record deliveries, leading to low earnings across the board and all-time high scrapping Chinese demand and continued scrapping crucial

5000

Baltic Dry Index

4000 3000 2000

1000 0

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2012

2011

2010

“Since its inception in 1999, the BDI index reached its lowest level ever in February”

FREIGHT – With freight rates diving below 2011 levels, 2012 proved another gloomy year with record deliveries leading to dismal earnings and record-scrapping. Setting the stage for a lackluster year, 2012 started off with a freight rate collapse that dragged down the Baltic Dry Index (BDI) levels to 647 in February, the lowest level since its inception in 1999. Spot rates recovered somewhat during Q2, while a lack of optimism in the market underpinned a further decline in TC rates. Freight rates tumbled again in Q3, to subsequently start yo-yoing on the back of forceful iron ore imports in China towards the end of the year.

As is typical during market lulls, earnings of small ships fared relatively better, leading to a freight rate compression across segments. This phenomenon is reflected by average TC rates closing in on each other: for example, the inflexibility of a Capesize resulted in annual TC average of 7680 $/day, only a marginal 100 $/day higher than the Handysize obtained.

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Unlike the dirty tanker markets, dry cargo demand fundamentals are pretty attractive and shaped to a large extent by developments in China. 2012 was not different in that respect, although it is logical that China could not escape from the sputtering global economy. Seaborne trade increased by 5.6 % in 2012, down almost 2% from 2011 levels. In the face of December evidencing record iron ore import levels of over 70mio ton, the year in general has been characterized by lower Chinese growth, spreading fear of a tough landing. Indeed, China is key: a 1% point decrease in Chinese iron ore imports corresponds to a 7% decrease in Europe for instance.

Or, of the expected increase in total seaborne trade of iron ore and steam coal the next three years, imports to China would be responsible for more than 90% and 50%, respectively.

“The pace of 2012 dry cargo growth lost almost 2% relative to 2011.”

It is instructive to zoom in on China’s behaviour with respect to iron ore imports. As the chart sketches up, it seems the price arbitrage - namely China and Australian ore price differentials – has become more structural. We notice indeed that Chinese traders and mills are increasingly more favouring imported over domestic ore due to cost and quality differences. It is tedious to determine a static iron ore price floor - something which analysts are keen to relate to – below which Chinese capacity would close down. Important is that a cutback in Chinese industrial growth has caused iron ore prices to fall to 88 $/ton CFR in Q3, the lowest in 3 years, in turn enacting a 40% suspension of domestic operations according to the Metallurgical Mines Associations of China. Prices indeed were much below the ‘guesstimated’ iron ore cost floor of 120 $/ton, hinting that (temporary) mine closures could not stay out.

Iron ore price arbitrage: China – Australia gap ($/ton) 60 45 30 15 0 -15 -30 Dec-08

Dec-09

Dec-10

Dec-11

“Chinese iron ore price arbitrage there to stay?”

Dec-12

With the stimulus package announced in Q3 as well, a change in market sentiment followed suit.

Apart from arbitrage and stimuli measures, it was especially the coldest winter in 28 years resulting in a reduction of domestic production that was responsible for two consecutive record months of iron ore imports surpassing 70mio ton in December. This entailed a massive demand boost!

“The coldest winter in 28 years was responsible for record Chinese iron ore imports of 70mio ton in December” Apart from obvious cost disadvantages, it is the declining quality of Chinese iron ore - currently only about 15% Fe content – that will accentuate the need for more imports. We expect that the share of imported iron ore will increase from 67% to 80% during 2012-2015. In total, we predicate on an average Chinese iron ore import growth of 10% in the next three years.

“Capacity expansions in Australia and Brazil are based on China adding iron ore imports of about 30% in the next 3 years” It is predominantly on this premise that massive export capacity is being planned in Australia and Brazil. Australia, shipping as much as 491mio ton in 2012, is contemplating capacity additions of 299mio ton during 2013-2015. Brazil, in turn, envisages a capacity expansion of 211mio ton over this period.

It goes without saying that adverse weather conditions, or e.g. Vale pushing back long-term expansions plans, swiftly impact on dry freight market conditions. The sudden drastic reduction of almost 40% in Indian iron ore exports was instigated by the government banning mining in two of the country’s major mining states, Goa and Karnataka.

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“World coal trade rose with over 6% in 2012: cheap coal remains a necessary part of the global energy mix” 2012 seaborne coal trade grew by 6-7%, mainly driven by imports to Asia. With China becoming a net coal importer in 2009, the gravity of the coal market has shifted east. Fast-rising imports into Japan, South Korea and Taiwan support this trend.

In spite of its bad image of a polluting commodity, coal remains a critical component in the world’s energy supply. Even in Europe, where natural gas has been priced relatively expensively, do we see renewed interest for cheap coal imports from the US. The US story is clearly different with coal taking a drubbing from all-time cheap natural gas.

“By 2016, China and India will together vouch for 50% of the incremental coal trade” It is generally well-documented that China’s coal supply is constrained by a poor transport network, costly bottlenecks and also ever more quality issues. China’s coal intakes grew by 29% in 2012.

India is struggling to safeguard domestic coal production, and therefore imported 143mio ton coal in 2012, representing a growth of 14% over 2011.

We foresee that China and India together will account for 50% of all incremental coal trade by 2016.

Inspired by its low price, there is still a common belief in growth for coal going forward: Australia, for instance, has been proposing to increase new mine and new port capacity up to 900mio ton per year – no less than three times its current coal export capacity.

“Adverse weather conditions will increasingly shape grain trades” Wheat and coarse grains trade have fallen by a few per cent in 2012. The year still started on a positive note with Australian exports peaking to record levels, but the remainder was more depressing.

The second half of the year was characterized by a severe reduction in northern Hemisphere yields following a sustained period of drought in both the US and the FSU. As a result, US grain exports collapsed to their lowest for 2 decades. US grain became too expensive overnight and was thus replaced by Brazilian and South American grain shipments reaching near-record supplies. The competition is also on in the 270mio ton soyabean market, where Brazil is set to displace the US as the largest soyabean grower in 2012-2013 by planting more so as to meet burgeoning demand from China.

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Seaborne trade in minor bulk side grew by 3-4% in 2012. We especially remember Indonesia’s raw mineral export ban that was imposed in May. By doing so, the Indonesian government forced local miners to process ore into refined metals, thereby forcing the mining industry to move up in the value chain. The effect was impressive: the bauxite trade to China dropped from 6mio ton to only a few 100k ton during May-June, a decline no producing country could make up for.

Because of the incredible expansion of the dry cargo fleet, the positives on the demand side often remain undisclosed. Indeed, a pronounced fleet overcapacity or a nadir in market balance is characterized by freight rates that hardly move. The dry fleet has expanded by no less than 35% over the last 4 years, creating a supply overhang of about 20%. This year alone saw record additions of 107mio dwt, equalling to 16% of the fleet (See chart below). What has been quite remarkable is that Chinese yards have been pumping out dry vessels without the expected delays or cancellations.

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Dry cargo deliveries (mio dwt) 120 100

% of fleet (right)

Dry cargo orderbook (mio dwt) 18%

350

15%

300

80

12%

60

9%

40

6%

20

3%

0

0%

2006 2007 2008 2009 2010 2011 2012 2013 est.

Just as in 2011, with prolonged suppressed market conditions, a hefty reaction can therefore not stay out. With too many newbuildings pooring onto the market, many old ships are simply left without employment opportunities. These vessels are effectively commercially phased out with very little hope of a return.

The chart below fully illustrates the willingness of the industry to rebalance shipping markets: 2011 demolition highs were surpassed and no less than 33mio dwt was recycled in 2012, representing 5% of the fleet. The average scrap age has come down from 30+ to about 25 years. If market conditions fail to improve, nothing should preclude the market sending younger ships to the beach. The early 80s set a precedent in this respect, where modern units were recycled due to a lack of a better alternative. From Q3 onwards of 2012, the scrapping activity was so strong that it surpassed the pace of newbuilding deliveries.

Dry cargo scrapping (mio dwt) 40

32

% of fleet (right)

72%

250

60%

200

48%

150

36%

100

24%

50

12%

0

2006 2007 2008 2009 2010 2011 2012 2013 est.

0%

“The dry orderbook is declining rapidly to below 10% of the fleet”

While the orderbook is still substantial at around 14% of the existing fleet, the annual deliveries are tapering off heavily in the coming two years. In 2013 already, we will experience orderbook % fleet levels dwindling below 10% EQUILIBRIUM – The wide gap between supply and demand created over the last years was painfully reflected through the bleak utilization level of about 80% during 2012. As indicated earlier, the shipping trough has clearly been supply-driven. We believe in improving market sentiment going forward, triggered by a demand side that will outgrow supply dynamics. Dry bulk seaborne trade is forecasted to grow at a record pace of 7-8% (disregarding the 2010 rebound), while fleet growth would be around 8 and 5% in 2013 and 2014 respectively. At these demand levels, loading ports in both Australia and Brazil will have to perform at maximum capacity, which will exacerbate vessel demand even more by at least 1%.

10% % of fleet (right)

8%

24

6%

16

4%

8

2%

0

84%

2006 2007 2008 2009 2010 2011 2012 2013 est.

0%

“2011 and 2012 saw record scrapping levels, reducing the fleet with 4-5%”

“Demand will outpace supply growth in the years to come. Further high scrapping is necessary to mitigate the current slack of 150mio dwt in the market, though” Notwithstanding a positive outlook going forward, the overhang of excess tonnage will keep a lid on a swift market recovery. The market balance would recover more rapidly going into 2014 with utilization in the mid- 80% region. To deal with the supply overhang of about 150mio dwt and achieve a lasting recovery, a regime of continued early retirement for old or inefficient tonnage is a precondition for fortunes to return.

19

“With Cape values in the mid $ 40mio, values are even lower than during the trough witnessed in the 80s if inflation effects are considered” ASSET - Ship values have been under downward pressure the entire year, with a further sharp decline in dry bulk values. Newbuilding prices on average fell 14% through 2012. Only container vessel prices saw larger declines. Last year, we remarked that 2011 Cape values of about $ 50-57mio were revisiting the 90s; this year had values diving to the mid $ 40mio, closing in on values seen in the 80s. It must be said, however, that inflation effects cause todays values to be even more depressed. Since 2008, newbuilding values in the dry cargo market collapsed by about 45-50%, the largest fall across all markets.

This should be seen as a rational price correction as dry values back then were also most overpriced.

Panamax economics 60

$ 1000/day NB in $ mio

Mio cgt 12

Contracting (right)

Panamax 1y TC

2012

2011

0

2010

0

2009

2

2008

10

2007

4

2006

20

2005

6

2004

30

2003

8

2002

40

2001

10

2000

50

NB price

“Declining asset values did not impel large buying interest: too low earnings, lack of optimism or low interest rates are some of the factors interplaying”

The driver of course is the same for all conventional shipping markets in distress, namely that a regime of tumbling freight markets will cause a standstill in contracting of new tonnage. For dry cargo in 2012, this was no different as the charted contracting levels demonstrate. As most of the old ships are small and the fleet overcapacity is situated at the larger vessels’ end, it may be that the investment focus could shift to smaller ships in the future.

On the second-hand market, the low level of transaction volumes seems dictated by abysmal freight earnings and a belief that a market pick-up is not imminent. This lack of liquidity is also not helped by the occasional spikes in earnings that prevent owners from selling at market levels as there is no pressing cash squeeze. Interest costs are obviously very low as well these days, and as long as these are paid banks do not have an incentive to force ships onto the market to be sold at fire sale prices. In the latter case, banks will be losing more than with the temporary ‘wait and see‘ attitude.

Hence, owners of relatively young dry ships have been holding out for prices which at least cover replacement cost or their outstanding debt. Owners of older tonnage as a result have been in a position to take advantage of firm prices to move out some of their old ladies. Under less distressed market circumstances, a regime of declining second-hand prices would propel more buying interest, but this corollary does not hold in times of depression, particularly when coupled with a negative bank lending environment. However, a changing market perception in the course of 2013 could lead to higher transaction prices much sooner than many expect.

Countercyclical investments, dis-tressed asset sales or the eagerness to go for eco-newbuilds can all be factors contributing.

20

TANK Persisting oversupply in 2013 Drastic action required, or will something unforeseen happen?

FREIGHT – The tanker market fundamentals have not changed much over the past year with freight markets struggling due to a substantial fleet overcapacity. It did therefore not come as a surprise that 2012 turned out to be yet another challenging year for tanker operators. Worst was the largest segment with VLCCs earning far less than the smaller segments for most of the year. When considering the higher required rates owners need today due to higher capex compared with previous market lows, it is safe to state that tanker earnings in 2012 have been at an all-time low. The Baltic Exchange quoting negative earnings for VLCCs supports our view.

Baltic tank earnings ($/day) 40 30 20 10 0 -10 -20

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec VLCC

Suezmax

Aframax

MR

“Negative VLCC earnings quoted by the Baltic Exchange for most of the year”

21

The start of the year could hardly be more politically influenced. Embedded fears of Iran closing the Straits of Hormuz, through which around 40% of the world’s seaborne crude is shipped, fuelled the prevailing pessimistic market sentiment in the tanker segment. Freight rates were moving up and down in the first months without a clear direction, a typical feature of the tanker markets. It was not before March-June that earnings were pushed up in all crude segments as tonnage availability was limited and activity to move crude firmed. VLCC earnings jumped to over 20k $/day, the highest observed in 2012. The same freight rate volatility was found in the Suezmax and Aframax segments. In May, for example, Suezmaz earnings doubled on the back of firming levels of enquiry in West Africa compared with a limited availability of tonnage in the region at that time. From the moment vessels were repositioned again, freight rates adjusted to their fundamental lows.

“A US/EU oil embargo in Iran and backwardated oil prices set the stage for distressed earnings in June”

Very often, OPEC production is used as a proxy for oil tanker demand. Most of the global fluctuations in oil supply are accounted for by OPEC while nonOPEC-production is relatively stable and predictable. As the crude tanker market is still stigmatized as being supply-driven, the strong correlation between OPEC production and VLCC rates has for a long time been instrumental in understanding market dynamics. A sudden dramatic drop in 2009 oil production and the structural tonnage fleet oversupply have since broken that correlation. Even the 3mio b/d increase in OPEC production since early 2011 was not sufficient to hike crude tanker earnings.

OPEC production (mio b/d)

33

10 8

Saudi

32

31

6 4

OPEC

(right axis)

Iran

29

2

The VLCC segment has obviously been the segment most affected by the tonnage burst, corroborated by the fact that VLCC earnings have for the majority of the year even been drifting below the earnings in the smaller segments. The situation from that angle was even more precarious than for example the freight rate compression observed in dry cargo. The second half of the year was even worse for the crude sector in terms of market earnings. The problems with the expansion of the Port Arthur refinery were only part of the story; it was especially the introduction of the EU embargo on Iran combined with crude prices in backwardation that announced a regime of sluggish earnings until the middle of Q4. As quite often is the case around November, VLCC spot earnings surged due to a rally in chartering activity in the Middle East.

0 Jan-10

30

Libya Jul-10

Jan-11

Jul-11

Jan-12

Jul-12

28

“Increased OPEC supply was not enough to ignite dirty tanker freight markets” Libyan oil production returned through 2012 to pre-civil war levels. At the same time, Iranian crude oil production diminished severely due to the US/ EU sanctions. Besides Russia and Iraq, it is primarily Saudi Arabia that has been taking over Iranian volumes. 2012 Saudi production has stabilized at a high level after a large step-up of close to 1.5mio b/d in 2011. Most of the growth in crude oil exports over the coming years will be accounted for by the Middle East (4-6% per year) and Africa.

22

It is quite remarkable that in an economic cycle of low global growth, Saudi Arabia has been providing ample supply of crude oil to the market. And even with elevated world stocks in general, 2012 Brent oil prices have been trading at an average 112 $/brl.

Just imagine where oil prices could be heading to in the case of global growth catching up and Saudi Arabia willingly reducing oil output, for instance.

“The US is increasingly producing more oil, exceeding the 7mio b/d mark for the first time since 1993” On the crude import side, the anticipated shifts are materializing: North America, still the largest oil consumer, is set to reduce seaborne imports by some 10% during 2011-2015. Both reduced oil demand and more shale oil supply are responsible. In the last week of 2012, the weekly average oil output for the first time since March 1993 exceeded 7mio b/d, up 1.16mio b/d from the same time the year before. In the “World Energy Outlook” report released by the IEA from November, it is even projected that the US oil output exports will surpass that of Saudi Arabia by mid-2020. By 2030, the US would have become a net US exporter.

Crude oil demand is shifting from the developed to the developing world, and much of the growing demand over the next decades will be absorbed by

Asia. To satisfy the extraordinary growth taking place in the region, both China and India will need all the oil they can get. China have over the past few years become the single largest importer of Middle Eastern crude, taking over Japan/Korea volumes.

In spite of the shorter distances, the significant growth in Chinese imports is still compensating for the loss in crude deadweight demand to the US and Europe, as is illustrated in the chart below. Overall crude tanker demand increased in 2012 by 2.7%.

Crude demand (mio dwt) 120 100 80

60 40 20

0 2000 2002 2004 2006 2008 2010 2012 2014 2016 MEG - CHINA and OTHER ASIA

MEG - US, JAP and EUR

“Chinese insatiable crude demand compensates for the reduction in US, Japanese and European requirements”

23

The tonnage burst in the tanker market has extensively been documented. Followed by the recordhigh tanker rates in 2007, the combined VLCC and Suezmax fleet increased by 7% to 9% per year from 2010 to 2012 – up from an average annual growth of 2% in the years 2002 to 2009. In an attempt to combat this fleet overhang, average operating speed has come down over the past few years, a trend that continued over 2012. Moving tankers into lay-up for instance implies that vessels lose their oil major approvals. Tanker owners are thus generally reluctant to take their vessels out of service as it makes it hard to secure business again once ships are reactivated onto the market. In contempt of supply side engineering, the available tonnage list has been increasing every month with new tankers delivering from the yards. The only option for shipowners consists then of scrapping modern tonnage.

The issue in especially the dirty tanker markets, however, is that fleet dynamics have been rationalized during the previous phasing-out. Hence, the fleet is young and short of obvious scrapping candidates. This explains that the average scrap age for dirty tankers in 2012 was only 21 years.

In the long run, history has proven that product and crude freight markets are integrated due to interdependency and spill-over effects. It is ever more voiced, however, that the product market will develop differently from the crude tanker market in the future because of specific market developments, especially related to the US (cheap feedstock due to shale gas) and China (boost in refinery capacity).

The answer is tedious but the changing role of the US in these two markets has become self-evident.

US refineries have over the past few years become competitive exporters of oil products to the rest of the world. Estimates indicate that 2012 refined oil products exports exceeded the nation’s imports from as recently as 2009. Exports of distillates from the US averaged 10mio b/d in the first 10 months of 2012. Examples of new routes that have lately developed are exports of jet fuel and gasoline to West Africa and naphtha to Asia.

“The gravity of global refinery capacity is increasingly shifting East with the MEG, China and India developing fast.”

Tank demolition (mio dwt) 25 20

15 10 5

0

2000

2002

2004

2006

2008

2010

2012

“Tanker demolition has been high considering the young fleet” It would take us too far to expand largely on the product tanker market. It is fair to stigmatize that while the crude market was chaotic, the product tanker market proved more stable over 2012. MR earnings were relatively stable for most of the year, but made a jump in the Atlantic in October followed by the waiver of the Jones Act after Hurricane Sandy.

On the refinery side, much is happening in the Middle East, China and India. Close to a third of the world’s refining capacity is now located in the AsiaPacific region after a serious expansion of sophisticated refineries over the past 10 years. The position of the Middle East and Asia will yet become stronger going forward with their expected sharing of 44% of global refining capacity by 2015. According to the IEA, almost half of the growth in global refinery throughput in 2012 has been accounted for by India.

In contrast to much of the other Asian refinery expansions driven by projected demand paths in the region, the Indian investments in refinery capacity are largely export oriented. The exciting growth in Indian refineries is therefore expected to significantly fuel demand for product tankers in the region.

EQUILIBRIUM – Notwithstanding growing crude oil production as well as owners attempting to mitigate oversupply, short-term tanker market conditions are expected to remain depressed.

In 2012, tanker supply increased by an estimated 6%, while demand growth was less than half.

“Still large orderbooks need digesting in 2013”

“The product tanker market is changing with especially US refineries exporting cargoes to new destinations like WAFR or Asia”

24

On top of this, the tanker market will still be digesting all the orders placed during the super-boom.

Especially the larger sizes face significant orderbooks. The orderbook-to-fleet ratio for VLCCs is currently 13.9%. For Suezmax and Aframax this number is 16-17% and 5-6% respectively. For product tankers, the orderbook-to-fleet ratio is at 13% for MR tankers, 9% for LR1s, and 5% for LR2s. For 2013, we expect total tanker supply to expand by 4% while overall demand growth will be a moderate 2%. It is only from 2015 onwards that we expect demand to outperform supply growth, be it by a modest 1%. Slow recovery is therefore expected unless drastic supply action is taken. To rebalance 2012 freight markets for instance, 32 VLCCs would need to be decommissioned, while only 10 were scrapped. This number to be decommissioned increases to at least 51 (8.5% of the fleet) units going to 2015. The same logic applies to product tankers, although there is a few per cent of the singleskinned fleet that will have to be recycled by 2015 regardless, when the phase-out draws to an end.

“A young fleet and expensive third survey costs may bring down scrap age below 20 years”

$ 1000/day NB in $ mio

Mio dwt

50

10

25

5

0

0

Contracting (right)

VLCC 1y TC

2012

15

2011

75

2010

20

2009

100

2008

25

2007

125

2006

30

2005

150

2004

35

2003

175

2002

A 5 year-old VLCC at the beginning of the year still valued at $ 63mio saw its value fall by 9% to $ 58mio over the year. Compared to the 32% drop in 2011 this may not seem dramatic, but it still represents a significant loss given the already discounted distress in recent years. Second-hand tanker sales have been at the lowest level since 2009, which render it difficult to know exact price levels. There are large differences between reported prices, and it is challenging to say which levels are correct. Fact remains that the pessi-

VLCC economics

2001

ASSET – With suppressed freight markets and pronounced overcapacity, it follows that values adapt accordingly. Since the peak in 2008, tanker values have been revised down by almost 40%. The corrections implemented in 2012 were fairly limited to around 7-8% as most of the reduction was already discounted in previous years. It must be said that the location of build has become increasingly relevant with for instance Chinese and Korean newbuilding price quotations sometimes even $ 10mio apart.

Another relevant factor that may refrain buyers to acquire second-hand tonnage is the development of a two-tier market due to the much more economic designs being launched these days. Existing VLCCs would hold a significant commercial disadvantage to modern ECO tonnage: fuel savings alone could easily amount to 10k $/day, rendering existing mature tonnage far less attractive on the freight market.

Not only in tank but also in the other markets do we note that owners and charterers are increasingly discounting fuel effects in time-charter contracts.

2000

The average demolition age will likely come down further to below 20 years as the tanker fleet is pretty young. With earnings to remain languid for some time, the waiting game cannot be prolonged endlessly. While the fourth special survey has already started taking its toll with respect to tanker demolition, also the third special survey will be given careful thought as many owners may not expect that a $ 2-4mio investment will pay off over the next 5 years.

mistic expectations in the short to medium term do not propel much buying interest. Sellers are often strong companies with relatively modern tonnage and not keen (yet) to sell off tonnage too cheaply.

NB Price

“VLCC orders dissipating in 2013 altogether?”

Bleak market prospects and struggling tanker operators led to limited crude tanker contracting activity in 2012 in the face of inflation adjusted newbuilding prices at record low levels. Only a handful of crude tankers were contracted in 2012, mostly for Japanese owners. The story was rather different for product tankers: 77% of the tankers contracted in 2012 were product tankers, most of which MR2s.

25

CHEMICAL Marching forward in a positive cycle

FREIGHT – The chemical tanker spot market entered 2012 on a buoyant trend after a flood of styrene, xylene and glycols cargoes shipped from the US to Asia absorbed most of the available tonnage, which in turn created a shortage of available space to South America and Europe. Soaring freight rates over New Year’s is nothing new. For financial and tax reasons, chemical producers often have an incentive to clear out inventories before year-end, igniting chartering activity temporarily. For history to repeat itself, a collapse in activity and rates would be expected in the New Year.

5k easychems spot rates ($/ton) 120

100

80

60

40

Jan Feb Mar Apr May Jun

Jul Aug Sep Oct Nov Dec

Houston - Rotterdam Rotterdam - Far East

Houston - Far East

26

Q1 spot rates declined gradually indeed, but the expected collapse did not play out. The US Gulf – Far East easychems benchmark rates dropped from around 110 to 95 $/ton during January-March as activity slowed down and more ships came available. This trend unfortunately continued with rates in Q2 and Q3 turning out sluggish in all sectors as well. With subdued demand in China in Q2, volumes from the US Gulf and Europe to Asia slowed.

Q3 was pressured as well with the setback in China obviously impacting on chemical market activity. Except for Europe-Far East and Transatlantic trades going west, spot rates continued to decline.

There is a well-known strong correlation between chemical output and GDP. With the current state of the Western economies, chemical companies in the EU, North America and Japan have in recent years increasingly relied on exports to the flourishing emerging economies. Continued strong economic growth in Asia is thus a vital precondition for sustained growth in chemical shipping.

“Chemical tanker demand grew by 4% in 2012” Overall chemical tanker demand grew by a small 4% in 2012. The biggest consumer of chemical tonnage is vegetable oils, a trade that accounts for 44% of chemical tanker demand. In 2012, the vegoil trade grew by an estimated 5.1%. Close to half of the vegoil trade is palm oil, dominated by South East Asia (Indonesia and Malaysia) exporting 94% of the total. 54% of these volumes are for intra-Asian trade. About 40% of chemical ship demand is for the trade in organic chemicals, which in 2012 grew by 2-3% on account of especially East Asia. This region is becoming an ever more important importer of organic chemicals, with 61% of all 2012 organic chemicals imports sent hereto.

Meanwhile, trade in inorganic chemicals grew by an estimated 5% in 2012. Inorganic chemicals, mainly consisting of sulphuric and phosphoric acid, as well as caustic soda, account for 11% of the total chemical tanker demand. The main driver of the growth in this trade is sulphuric acid exports from North East Asia.

With one of the primary sources of demand being in the processing of metal ores, this trade is also largely dependent on the state of the Chinese economy, as Australian and Latin-American imports of sulphuric acid are dependent on Chinese steel demand.

Feedstock prices 16

$/mmbtu

$/ton

14

1400

1200

12

1000

10

800

8 600

6

400

4

2

200

0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

0

Nat gas US (left)

Naphta NWE (right)

“The US chemical industry is being reshaped due to cheap gas feedstock. Increasingly expensive oil / naphtha elsewhere contributes to the competitiveness of the US” A widely discussed topic in this market is how the cheap shale gas glut is reshaping the US chemicals industry. According to the American Chemistry Council (ACC), US chemicals production is for about 85% dependent on natural gas as a feedstock, while chemical makers outside of North America rely on oil-derived naphtha for 75% of their raw material. The changing dynamics have spurred a wave of new investments in the US. According to the ACC, almost $25 billion has been earmarked by US chemical companies for the construction or expansion of new facilities, which in turn would bolster chemical exports on mostly larger ships serving markets long-haul.

Fleet development (mio dwt) 12

21 %

8

14 %

4

7%

0

-4

2000 2002 2004 2006 2008 2010 2012 2014

Deliveries Scrappings Growth % (right axis)

Orderbook Est. scrapping at age 25

0%

-7 %

27

“The total IMO-fleet was only expanded by about 1% in 2012” Analyzing the chemical tanker fleet is more complex than it may at first seem. Much of the modern product tanker tonnage is IMO classified, and can to some degree compete for the simple chemical cargoes. The total IMO classified fleet increased in 2012 by a modest 1.1%. With an orderbook of just around 200 vessels, the chemical tanker sector has one of the lowest orderbook-to-fleet ratios in the industry, at just 7.6%. If we study only stainless steel tonnage, the growth is even more modest for 2012: this fleet grew by 0.9%, and only counts an orderbook-to-fleet ratio of 5-6%.

Scrapping activity in 2012 was roughly the same as the year before at 2.1mio dwt, coinciding with 2.4% of the total fleet. With a significant 23% of the fleet older than 15 years, maximum age restrictions and more demanding charterer preferences (e.g. fuel-efficient ships) will over time create an expanding part of the fleet that may face employment problems. A scrapping pool is hence in the make.

“Low orderbook, low values and prosperous demand point to a positive chemical shipping cycle” In spite of 2012 demand surpassing supply growth, more time is needed to rebalance the chemical tanker markets. Ship employment rates in 2012 climbed by a modest 1% to about 85%. With the current limited orderbook combined with healthy demand growth, we are confident that the chemical shipping cycle will increasingly get more traction over time.

ASSET – In line with overall suppressed tanker markets, chemical NB values continued to decrease over 2012 by about 5%. Since the peak in 2008, newbuilding values have plunged about 30%. Bearish freight market markets and tight finance have kept a lid on new orders in this segment as well. Contracting activity improved somewhat in the second half of the year with several of the main operators becoming increasingly convinced of the unique opportunity to secure tonnage at record-low prices.

28

CONTAINER Market collapse, continued oversupply that necessitates more creative supply engineering

FREIGHT – With a limited lay-up program and a pre-Chinese New Year trade surge, container freight markets temporarily tightened in the beginning of 2012. The darkening of the European predicament, however, quickly reversed market conditions. As projected, most pain was inflicted on the AsiaEurope trade due to limited cascade opportunities following the plethora of large container newbuilding deliveries that were unable to find found a home elsewhere. It quickly became apparent in 2012 that Panamax rates were mostly slashed as the cascading process eroded their deployment opportunities. This also explains that most of the Panamax overcapacity has been displaced throughout the year.

Freight rates in Q2 trended upwards due to an artifact. The well-known General Rate Increase (GRI) on 1st March materialized and so did further GRIs for April and May. Important for this freight in-

crease was the discipline – read pricing adherence and supply side control - that liner companies were able to enforce onto the market as freight rates in Q4 2011 and Q1 2012 tipped all of the lines deep into the red financially and employment-wise.

It must be said that the traditional undercutting of GRI levels happened, but this time at tolerable levels. To counter fleet overcapacity, lines did suspend a couple of services but the largest effect came from skipped sailings. At one point, Mærsk even had to stop taking orders as backhaul cargo ship capacities reached their limits. In short, liner and charter freight rates across all segment jumped up by about 20-40% from their earlier nadir. It is quite unique for container that this could happen without really a notable increase in trade growth or a slowing of the delivery schedule. The academic notion of ‘quasi-monopoly’ is responsible for that matter.

29

Container freight tariffs $/TEU

2012 container 6-12m TC rates (1000$/day)

2 400

1990=100 180

2 000

150

1 600

120

1 200

90

800

60

400

30

0

2006 TC index

2007

2008 Asia-Europe

2009

2010 Transpacific

2011

2012

0

Transatlantic

Source. MSI

Despite a rebound in the US, in the second half of the year the global economic environment became a lot tougher again, translating into negative margins for most liner companies. There was a pronounced contraction on some major headhaul trades (e.g. Asia-Europe shrinking about 6% in Q3-Q4). Idle capacity did creep up once again, pushing freight rates markedly down. No less than 300 ships were quickly put in lay-up equaling to about 5% of the container fleet in TEU terms.

About 60-70% of these idles units are charter free.

“A collective pessimistic market view prevents owners from quoting even lower freight rates” It is interesting to note that in defiance of such a depressed market, freight rates did not revisit the trough of 2009 again. Engineering the supply side by means of skipped sailings, slowsteaming, lay-up, etc or market consolidation attempts did contribute to a certain extent, but it is rather a long-term collective awareness and belief in market distress that prevents owners from quoting (lower and) lower below cost levels.

14 12

10 8 6 4 2 0

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1k

1.7k

2.75k

3.5k

4.4k TEU

EQUILIBRIUM – As last year, the demand side championed again in diverging trends. It was quite obvious that the Asia-Europe lane faltered (-4 to 6%) and so did the Transatlantic Eastbound trade (-9%).

The growth in the Transpacific (2-4%) was not able to compensate for this gap. The largest growth as expected came from the non-mainlane trades with intra-Asia (5-6%) – although suffering from the bickery between Japan and China – to the fore as well as imports into the Middle East / Indian subcontinent (6-7%) performing strongly. Trades from Asia and the MEG into India expanded by about 7%: for the China – MEG trade leg, even double digit growth was noted, which is very important to utilise the supply overhang of post-panamaxes on. It is relevant too to track the weak performance of Brazil and India when actuals are mirrored against what forecasts were envisaging in recent years. Aggregately, we assume 2012 container demand to have grown by about 5%, as opposed to a fleet growth of about 6%.

“Without drastic action on the supply side, fleet growth will continue to outperform demand growth in 2013 and 2014” Based on past organic growth patterns and economies of scale, as well as global recovery in the world, underlying demand should be stronger and assumed to exceed 6% growth in 2013 and 2014. In 2013 and 2014 we still expect about 8-9% and 6-7% expansion in the fleet, respectively. This widened market balance discrepancy prima facie does not bode promising news for 2013 unless of course shipowners continue to take drastic action.

Several supply measures need acknowledging:

30

- The question of slow-steaming is never far away with grim economic conditions. One reaction could be that ships could start sailing slower on non-mainlane trade legs which thus far have not evidenced the same speed reductions as the mainlanes. Liners may also further work on reducing voyages or artificially influence vessel load factors to avert negative demand shocks.

- Tactics of liner companies could consist of pushing back fleet deliveries in 2014 and 2015 - An understanding of the fleet composition is required. Most of the 2013 fleet expansion will occur in the 12k+ (500k) and the 7.6-12k (500k) TEU segments.

No less than 0.4k TEU will deliver in the 3.9-5.2k TEU segment which is a lot for markets in distress, especially if the Eurozone crisis would intensify (something we do not assume in our base case).

The recent changing attitude with respect to scrapping strategy should be seen in this context. MISC for instance scrapped one 17 year-old 4.5k TEU due to lack of alternatives. Unfortunately, there are still not that many old ships in the container market that could offer enough alleviation to the market although some differentiation is needed.

In 2012 about 5-6% of the fleet below 5.2k TEU was scrapped. The largest segments are also the youngest and lack any form of scrapping flexibility.

- Regardless of how ones put it, there will be a consistent expansion of VLCs that are best suited for long-haul deep sea trades. In case of oversupply, the industry has been cascading tonnage off to smaller trades. This is nothing new in itself, but this strategy has fuelled the awareness of liner companies pertaining to fuel consumption and slot differentials in more detail. Bluntly stated, it is fuel prices and speed that are decisive factors for cascading tonnage to be economical or not. At very low bunker levels, for instance, employing too large vessels would, apart from a lack of bunker savings, lead to distorting trade patterns and underutilization of the ship as well.

A good example of the fuel cost awareness is the strategy Mærsk Tankers

pursued to stem substantial shipping losses: vessels were not only placed in cold lay-up, but were also retrofitted with equipment to save on fuel costs.

“Fuel prices are especially relevant for container operators with respect to cascading tonnage, slot allocation and operating speed” - Due to the ongoing train of VLCs delivering in the coming years, there will automatically be increased transshipment activity. Quite often, this move goes in line with more consolidation and vessel sharing agreements. The Mediterranean will see more transshipment activity to the detriment of direct Asia-Latin-America trades on VLCSs. It is hence important to take account of trades being reshuffled and served differently. It not only artificially affects bilateral growth trade numbers but also renders annual comparisons tedious.

- Further consolidation could also be in the cards due to ever more companies becoming confronted with precarious balance sheets. The MSC/CMA link up and the G-6 Alliance are cases in point. The current talks between two of the biggest tonnage providers in Germany, Norddeutsche Vermogen and Conti Group, forming one chartering shop of 130 vessels are another example of the consolidation bandwagon.

“2013 will see more consolidation in the container sector” Regardless of the above measures that can relax market oversupply, it seems that more lay-up in early 2013 is unavoidable. The lay-up of postpanamax ships is one of the main variables liner companies can control. On the main trades there is some control with vessel sharing agreements etc.

But on smaller trades this is less the case so that additional overcapacity and cascading heralds quite some further pressure on e.g. the Transpacific, Asia-MEG and Asia-Latin-America trades.

We also believe there are limits to cascading as, for instance, the Transpacific trade has already been engineered and optimized to a large extent. The marginal benefits of cascading in the coming years will thus become smaller in the coming years.

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“The marginal benefits of cascading are diminishing, so that owners need to pro-actively take the correct supply measures”

can market utilization be influenced; temporary speed reductions are nothing new in shipping history and are frequently used to both reduce fuel costs and artificially reduce market slack.

It is therefore imperative that the supply side of the market pro-actively participates in supply measures to restore market balance. If not, the risk is that more losses may be piled up so that 2013 will be governed by a regime of continued freight / price wars and probably container companies defaulting. It might sound strange but the worse container market conditions would fare in 2013, the stronger the rebound in 2014-2015 might actually be. The motivation is that more drastic measures would be implemented in the coming year in order for many container shipping companies to survive.

However, if freight rates over time recover, the new freight rate gains of sailing faster could outperform the bunker savings so that in turn the fleet on average increases speed again. The underlying message is that, in case freight markets would actually begin recovering, many liners may be keen to increase speed again or unwind the effect of previously installed supply measures. This should not be ruled out as we foresee strong freight rate improvements a couple of years from now. A regime of expensive crude or high bunker costs will of course also affect the eventual strategy undertaken.

“It is pivotal to contemplate whether changes in sailing speed are structural or only short-term tactics” One factor shaping every market balance outlook is the tricky variable of slow-steaming, which needs correct perpending. Lots of academic work has been carried out on this subject underlining the important assumption on whether speed reductions are there to stay or not. Only if vessel speed reductions are implemented structurally,

ASSET – While 2011 saw container prices rising thanks to some big contracts placed at Korean yards, newbuilding prices of container carriers were sharply corrected down. With Q1 rates locked to their floor, this downwards price trend from Q3 2011 continued uninterrupted into 2012. The market acted pretty rationally and initial price slides were strongest for the Panamax class, suffering dearly from freight rate compression. In line with dry and tank, the container Panamax ships were seeing prices slides to even about 50% of their net replacement costs.

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“Shipping theory works: contracting, prices and rates in sync!”

Even the sudden freight rate upheaval as a result of the GRI increase, could not unleash improvements in values as newbuilding prices were forcefully weighed down by further newbuilding price declines in other shipping markets. The global economic slump continued so that contracting levels basically dissipated. It is exactly these price declines that companies like e.g. Evergreen have been waiting for. Their long wait for prices to fall further has paid off as corroborated by Kiamco’s (later switched to Enesel) order for a string of ten 13.8k TEU vessels at HHI on the back of a tenyear-charter to Evergreen with purchase options.

“In contrast to rising 2011 prices, 2012 saw sharp price corrections in container asset prices of about 15-20%” Correspondingly, the bearish market conditions and falling newbuilding prices spilled over forcefully to container second-hand values, which literally collapsed in Q1-Q2. Especially striking were the widening price ideas between willing buyer and willing seller, running at least 20%. True, there was limited trading volume although it is quite clear the KG market has been under pressure for some time, which increases the likelihood of more distressed sales.

As indicated earlier, things got worse again in Q3 with a reappearing market imbalance, that exacerbated the ensuing stand-still in contracting.

The correlation between earnings and ship ordering is generally well-conceived - this is the core of shipping economics and what shipping theory is based on – but the formidable extent to which this premise holds in both high and low freight container markets is striking. Further ordering will likely come from Asia due to the obvious over

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Q4 newbuilding prices have arguably fallen a few per cent more supporting the view of an overall price decline throughout the year. The above chart details the newbuilding price corrections over time: since their peak in 2008, prices have come down about 40%, 15-20% of which occurred in 2012 alone.

It is a relatively new phenomenon that China and even the Philippines are heightening competition in large container shipbuilding, hence, putting more pressure on Korea to lower prices. It remains to be seen whether Korean shipbuilding can go much lower to face off the aggressive pricing cuts China may implement. The ‘quality difference’ argument may still be valid now but with China increasing its reputation over time, Korea might simply loose more market share in the container segment.

“With prices having fallen more than in dry and tank, an interesting investment opportunity presents for container” What is interesting to consider is that for agnostic investors container investments might be not that bad a deal. Prices, if indexed since 2004, have fallen relatively more than in dry or tank. Moreover, given the consented regime of high bunker prices going forward, most fuel savings can be reached in container shipping as ships sail much faster than dry, tank or other merchant ships. Or, a container eco-newbuilding will largely outcompete its second-hand compatriot by many thousands dollars a day, differences of which are much bigger and certain than small and unpredictable freight rate movements.

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“Price adjustments of about 50-60% have been observed in the second-hand market since 2008” Even more so than container newbuilding prices, second-hand prices have been pushed down to unseen levels as freight revenues are basically nihil.

The above chart plots 10y old values across sizes and illustrates adjustments of about 50-60% since 2008.

For last year alone did we observe asset price changes of about 30-50% - drastic cutbacks! There is also a significant disconnect in the adjustment process across sizes: the larger the ship, the less the corrections tend to be. The pursuit for scale-effects and the older small fleet being out-phased are main drivers.

It is positive for market functioning that liquidity in the container market has increased with over 20% more asset transactions – remember last year’s mismatch of price quotations and seller’s / buyer’s price ideas causing a slump in number of asset transactions.

Most transactions have obviously been done in the smallest segments, which are subject to shorter TC periods and usually more charterers’ redeliveries.

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GAS Lucrative freight markets with fear of over-contracting future tonnage requirements

It is virtually impossible to compact gas shipping in a few words given that the different niche segments constitute separate freight markets. The LNG market is separate in nature from the LPG / ammonia and petchem markets. The latter markets in turn too are subject to their own particular market fundamentals.

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“Lack of supply and changing trade patterns conducive to soaring freight markets”

LNG – The LNG freight market continued its burgeoning stretch from last year with rates consistently exceeding the 100 $/day mark. For most of the year, short-term TC levels have been hovering around 145-155k $/day, while spot rates were averaging about 125-130k $/day. The inferior spot levels are more so reflective of near-term vessel availability and volatile Europe-Asia price spreads rather than fundamentally shifting market conditions.

Strikingly enough, many shipping analysts last year forecasted even higher rates mirroring heavily skewed fundamentals. The fact that this did not happen in retrospect is that the expected increase in volumes during 2012 did not manifest at all – only an increase of about 1-2mio ton over 2011 from Pluto coming on-stream yielding a total of 243-244 ton. The reason for still record freight rates achieved in 2012 is owing to an absence of net fleet growth – only 1.6% in 2012, opposed to 3.5% and 13% in 2011 and 2010 respectively measured in cbm – that went in keeping with constantly shifting trade patterns inspired by price dynamics rather than organic growth.

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“2012 LNG volumes went up in the Far East but were sharply corrected in Europe, causing a standstill in growth”

combined with a lack of manpower and equipment. This implies that additional LNG must be sourced from the Atlantic basin or from the US.

The LNG market for the time being is still directed by developments in the Far East and more specifically the increased import requirements from Japan.

Still suffering from the previous quake and tsunami that hit in March 2011, Japan saw a surge in LNG imports of about 9mio ton for 2012. As stated earlier, the nuclear debate in Japan continues but will undeniably have ramifications for shipping. A swift nuclear restart seems almost impossible, so we foresee continued strong LNG imports into Japan.

“US terminals will receive more export licenses for LNG: our guesstimated US LNG exports oscillate around 50-80mio tons in the coming 5 years”

The rampant demand growth in Japan was basically offset by reduced European intakes of about 8mio ton. Especially Spain and the UK took in a few mio ton less. One of the reasons is that e.g. in Qatar – UK volume contracts, it is stipulated that European buyers can be passed over if the Far East is prepared to pay more for the product. Given the wide AsiaEurope LNG spread of about 5$/mmbtu, still caused by the Japanese disaster, quite some volumes were (re)sold to Eastern buyers. Structural product shortages in the East contributed to this reselling spree.

“A structural LNG shortage in the Far East, pricing dynamics and delays in LNG output are continuously shaping trade patterns” Even more, it is interesting to realize that Middle East product, until now responsible for most of the Far East LNG volumes, will probably not boost exports in the coming years. To solve for the structural deficit of LNG in the Far East, others sources of supply need be called for. Additional LNG could come from Australia, Russia, Nigeria or the US. Obvious delays in Nigeria (Brass project, OK LNG project) and Russia (viability Shtokoman) are one source of concern. The other one is of course the myriad of Australian projects which are unlikely to deliver timely because of cost overruns,

The US remains the center of attention these days, as vast amounts of discovered shale gas would be available for exports at cheap price levels. An equal amount of different opinions exists as well pertaining to the scale of future exports and the future pricing of LNG, both regionally and globally. Today the reality is that along with Sabine Pass, only 6 other export projects have secured an export license. BG has already signed up to market a large portion of Sabine Pass, which has a potential capacity output of 16.5mio ton per year. Based on our analysis, we estimate that US LNG exports could soar to about 50-80mio ton in the coming 5 years at max, which compares bleakly with the 200mio potential tons that are sometimes quoted in the market. Based on the many idle import terminals in the US, we believe that the US government will give green light for more LNG exports. It may actually be against international trade regulations (GATT) that an outright ban would be imposed.

However, it is rarely seen that volumes increase by monumental amounts given market reactions and a demand side that does not follow in linear fashion. Also, most of the export licenses would apply for countries the US has a Free Trade Agreement (FTA) with. China, evaluated as a major import source for LNG henceforth, does not (yet) hold a FTA with the US. On top of this, checking the DOE and NERA reports, it seems that there are quite many lobbyists pointing to the negatives of the shale gas bonanza. There would be negative effects from hydraulic fracturing used for shale gas extraction; LNG should be used for domestic requirements first and even for displacing oil, etc.

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“Contracting LNG carriers on speculation was considered very risky 10 years ago” A positive element for the LNG market is that contracting has remained relatively modest in 2012.

About 20 LNG carriers (5% of the fleet) have been contracted, far less than the 45 units from 2011. Of the entire orderbook, half of which on account of western independent owners, it is remarkable to observe that about 50% still remain unfixed. The latter evinces the evolution in the market towards shipping practices as we know from the other tramp markets. Going back 10 years, it was considered a huge risk to order LNG ships on speculation. The activity in the FSRU space was equally strong with 6 tenders awarded in 2012. Another 7 tenders could be awarded in 2013 that will probably be accompanied by fresh newbuilding contracts.

less, the Baltic Gas Index climbed in May to over 70 $/ton to only collapse in October to end 30s $/ton, providing owners a fairly long period with prosperous spot earnings. TC levels for VLGCs were correspondingly crossing the 1mio $-mark. The ending of the traditional stock-building period in Q3 and reduced MEG LPG exports pressured spot rates to remain below 40 $/ton for the remainder of the year.

Middle East LPG exports (mio ton) 3.9 3.6 3.3 3.0 2.7 2.4 2.1 1.8

“2012 LNG contracting was modest: the total orderbook seems manageable for the time being, but there is embedded fear of over-contracting in the coming years” With an orderbook currently standing at 80-85 units (21-23% of the fleet), and a forecast requirement of about 90-100 units going to 2016, we are confident that, with an assumed LNG volume growth of 7% next year, 2013 will be another very strong year for LNG shipping. Going further to 2016, it is important that the shipping industry refrains from an additional ordering spree. If, let’s say, another 40 units are contracted in the next years that do not follow tendering business, it seems unlikely that freight markets will be able to hold out above the 100k $/day mark. To substantiate this, we can just highlight the upcoming order of China Shipping and MOL of about $1.5bio as a means to have a strong footage in the LNG sector.

LPG / NH3 / SMALL GAS – As LPG is a by-product from oil and gas production, the positive effects from more LNG output are immediately conveyed to the LPG markets. We did, however, not witness the same Middle East supply boom as last year, which added 4mio ton of LPG exports. The US sponsored sanctions explain the decline in Iranian LPG exports of about 500k tons for instance. For 2012, we only count an additional increase of about 1mio ton. Neverthe-

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“MEG LPG exports expanded by less than 1mio ton” There were a few interesting factors that overwhelmed the VLGC market in 2012. Saudi Arabia, traditionally considered as a player of waning LPG importance given its pledge to direct volumes to its petchem complex, chronically increased the available spot cargoes to the market. Instead of the 100 VLGCs spot fixtures the market was used to a few years ago during 2004-2007, the number of fixtures in the course of 2010-2012 has been globally increasing from about 150 to 250. The major expansion of the fleet is one element; relevant as well is that with rewarding spot markets, charterers do not want to commit long-term to high TC rates.

VLGC owners, sometimes desperately in need of cash, were also happy to maximize short-term earnings in the spot market. An additional factor was also the many East-West arbitrage opportunities during the year with elevated US Gulf shipments of course pretty in place. It has even come to the point that the arbitrage out of the US is open all the time following the glut of cheap shale gas.

It is the logistics side and the congested Houston

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ship Channel, however, that cannot process all the VLGC cargoes. The knock-down effect was interesting during the year. The US even sent cargoes to NWE or WAFR, while WAFR in turn redirected more volumes to the Far East, especially China.

“More spot fixtures and arbitrage in the VLGC segment” On the import side, the rise of Indian imports to over 5mio ton in 2012 is worthwhile mentioning.

Imports have for a long-time been stable but the country does undeniably herald a huge potential if LPG could penetrate the countryside. Making forecasts is difficult as the role of the Indian government with respect to subsidies remains key.

“Making forecasts for LPG shipping is more difficult than ever given the many uncertain factors and a possible transformation from supply- to demand-driven LPG markets” In contrast to the last 10 years, the future direction for the VLGCs is cumbersome given the likely changes that will occur. On the one hand, there is the US which is set to have LPG exports growing to an estimated 9mio ton, with potentially more LPG shipped to the Far East by VLGCs with a beam of +36m once the Panama Canal opens up for that tonnage. Also the Middle East, WAFR and Algeria have plans for more LPG exports. On the import side, it is especially China that has informed to import much more LPG again to satisfy their shortage of currently overly expensive propylene through the fashioned emergence of so-called PDH (PropaneDehydrogenation) plants. Some even argue that the spate of new LPG sources will transform markets from supply- to be demand-driven.

2012 VLGC supply dynamics were limited with only a few ships entering the market. The topic of the year was of course the substantial Frontline order of 4 units with 2+2 options, and the unconfirmed Oriental Energy’s contract for 6-16 VLGCs. The total VLGC orderbook comprises about 20-30 units depending on the options materializing. Hence, for freight market balance to remain lucrative, quite some additional LPG will need to be pumped out in the next years.

As in 2011, the LGC/MGC market performed well and benefited from the VLGC market momentum. TC rates oscillated between 750 and 950k $/month, with LGCs commanding a premium again over MGCs – more long-haul LPG trade and Atlantic trade are responsible. At the end of the year even, we saw many brokers quoting higher rates for LGC than for VLGCs. “Profitable LGC / MGC markets in spite of a status quo in ammonia markets” Usually more relevant for the midsize are the ammonia market drivers, as about an average number of 20 MGCs more carry NH3 than LPG. Ammonia trade levels were fairly status quo compared to last year but nevertheless healthy compared with the years preceding. We noted some marginal improvements in NWE and US exports. FSU, MEG and Caribs exports declined in contrast, according to Fertecon. On the import side, it was predominantly the US (more shale gas driven domestic production) and Europe absorbing less ammonia. In short, we can detect a trend that more ammonia is finding a home in the Far East which adds miles to the balance.

The fleet supply side did not really have a marked impact in 2012: only one MGC from Eletson was delivered. Moreover, the MGC orderbook has not been enlarged drastically, counting about 10 units on account of mainly established players. Unlike the VLGC segment, we will thus not face an equivalent burst of activity on the supply and the demand side. The LGC and MGC markets will to a large extent be subject to today’s market regimes with some improvement in trade and some replacement of tonnage rather than firm fleet expansions.

“The Handy gas segment saw TC rates increasing to over 900k $/month” The small gas segment, comprising vessels below 23k cbm, had a better year than 2011. Especially the Handy segment fared well. The old 15k semi-ref segment on average earned about 100k $/month more than in 2011. For 20-22k semiref units, the difference amounted even up to 140k $/month. The ethylene segment performed equally strong both for spot and TC earnings.

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TC rates in the pressurized markets were also congruent with 2011 levels, although some divergent developments need perpending. It was quite clear that spot earnings for pressurized tonnage employed in the West declined to abysmal levels towards the end of the year as a sign of overcapacity in the West and a piling up of redelivered tonnage by charterers and traders. While spot levels of about 430k $/month were still reached in 2011, then earnings of about 140-150k $/month by year-end do not bode well – remarkable, since the tradition has that modern tonnage usually employed in West-Europe commands a premium over tonnage employed East.

“Divergent freight rates in the small gas segment following different trade and fleet developments”

should not be forgotten. The fact that ethylene rates were not equally booming was, among other things, due to a lack of Iranian export volumes.

A limited number of new Handy gas carriers added to the market performance. In total, only about 39k cbm semi-ref and 31k cbm small ethylene additions were observed. The pressurized market in contrast had to deal with 122k cbm of additional capacity, explaining their suppression in rates. The pressurized fleet is still young and has only one year of sizable orders to absorb, whereas the semiref / ethylene industry has reached its first scrapping cycle, especially for the smaller sizes below 8k cbm. There is still a clear focus in gas towards ever bigger vessels, corroborating the many projects discussed for large ethylene and Handy tonnage. The Navigator purchase of the Mærsk Handy fleet does at least confirm belief in this segment.

Middle East LPG exports (mio ton)

“Over time, the role of the US as a new major exporter for not only LPG but also petchems should not be disregarded”

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“Reduced MEG ethylene shipments because of the Iranian cutback” It was obvious in 2012 that the Handy 15-25k cbm segment proved to be the best candidates to take care of the long-haul healthy petchem trades of C4 and ethylene, which compensated for the possible reduction in propylene trades.

Also, the popularity of this segment for LPG

Concerning the future prospects, we believe in more petchem trade on the back of global growth returning, which in turn will outperform the increasing share of product being directed to downstream petchem production. Some of the rising downstream derivatives demand will indeed remove part of the feedstock volumes from the export market, but this is something that has been argued for a long time. The long-term prospects for cheap feedstock in the US clearly favor refinery economics and more petchem trade. The abundance of ethane will over time certainly contribute to more seaborne ethylene trade – or, for that matter, create increasingly more ethane trade for dedicated gas carriers.

The trend of specific type of multigas carriers (LNG / ethylene / ethane / LPG) is a good example of the increasing product differentiation in gas shipping.

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“Marginal price corrections for LNG carriers: further price reductions for other gas tonnage” ASSET – For 2012 values, we have to distinguish between the LNG market and the other gas markets. As expected, the continued optimism in the LNG market saw hardly any corrections in newbuilding prices. The LNG freight markets, governed by ever more short-term freight rate contracts, was simply too rewarding so that values were sustained throughout the year. The few second-hand transactions we were able to observe rendered it clear that owners were not keen to sell off profitable tonnage cheaply. It may be that the building of an ever larger LNG fleet will enhance liquidity and in turn lead to more asset transactions. In this context, the plan of the online valuation platform VesselsValue.com to extend its reach to LNG and LPG-carrier sectors as well is more than welcomed.

“Chinese shipyards as the new price-setters for LPG gas carriers is closer by than many think” The other gas markets were not able to resist the price pressure permeating the conventional segments of dry, tank and container. It must be stated, however, that price corrections were much lower for gas freight markets correspondingly fared better. In addition, at this very moment, it is not easy to assess what price levels the market is guided by.

Disregarding Japan, Korea has for a long time been the price-setter but the recent action undertaken by China to engage in VLGC ship construction at far lower levels has created a possible two-tier structure. The Frontline order done at Jiangnan is a case in point. It should not be ruled out that over time, China will become increasingly large a player in this market. Do also not rule out Japan, which has been exhaling in invention through shipping history.

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SHIIPBUILDING Prices close to bottom, more rationalization of the sector’s oversupply & more product differentiation

As became clear through the previous sections, the travails of the global economy have obviously left their stamp on ailing shipbuilding markets in 2012. With the pace of newbuilding price decline still about 2-3% each quarter in 2011, this negative trend accelerated to 3-4% during 2012. As anticipated, the imminent fall in newbuilding prices crystallized by the ongoing train of new ship deliveries opposed to a lack of new orders. Especially the plethora of dry deliveries and the absence of notable delays or cancellations added to the precipitated price fall throughout the year. Arguably, newbuilding prices had been kept artificially high in 2011 triggering a catching up maneuver in 2012.

As the below charts articulate, newbuilding prices have especially been corrected for the conventional segments of dry, tank and container with declines recorded a rato 30-45% since their 2008-peak. To compare, the adjustments noted for specialist ship segments were about half as large. Two explanatory factors stand out: conventional tonnage was shaping the previous shipping / ordering boom and was relatively overpriced. The resulting oversupply today is the major cause for their lackluster freight markets and dismal contracting levels. The niche segments with LNG on top in contrast are performing well and are still seeing orders placed, which is in itself responsible for smaller price revisions.

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the huge Frontline order at Jiangnan for a series of VLGCs were far below traditional Korean prices, providing a new price floor for VLGC tonnage. It is too early to refer to a Chinese LPG price but it is ever more common to have prices reflecting the location of build. The latter basically points to the region’s price setting power which is logically shaped by the amount of newbuilding contracts that Japan, Korea or China are able to capture.

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Some scrutiny demonstrates that competitive market forces have been at play in 2012 with prices across merchant ship segments fairly synchronized again - cfr. container ships overpriced in 2011 - something we forecasted last year to happen. The calibration process in asset prices has been percolating through so that real price differences across ship segments are limited. With ‘real price’ differences, fundamental price differentials are referred to for a particular ship in terms of age and newbuilding / second-hand values. In general, container and tank prices have strongly realigned.

For bulk ships, the gap remains if 2010 values are used as a starting point. For investors of course, a regime of fair prices for assets implies that the opportunity to benefit from relatively underpriced assets in a particular one segment is greatly reduced.

“2012-balanced prices across major merchant segments reflect market fundamentals properly at work” An increasingly difficult task in shipping is that pricing NBs has become tedious because of both a lack of contracts placed and widening price dislocations across regions. The mounting influence of China is being felt in ship pricing, and with prices close to building cost relative price differences become more relevant. ‘What is the benchmark price for a specific ship?’ has been a question echoed more than once. For container, LNG and LPG ship prices still remain dictated by Korea as perceived quality differences still matter. Dry for instance is both priced in Japan and China as benchmark, as equal amount of 2012 dry contracts were placed in these countries (see chart further on). Price differences, however, between both regions have been running at about 5-15% for dry ships. The few representative orders placed in the dirty tanker market render it cumbersome to know e.g. what VLCC newbuildings would go for, and especially what the price difference between a Korean or a China order would be. Relevant too is that intensified competition can affect ship prices, regardless of actual ship market fundamentals as such. For example, the prices for

“The rise of China has triggered more price differentiation in shipbuilding” It is interesting to check how contracting developed during 2012 to understand their regional differences afterwards. As charted, 2012 orders plummeted to the lowest in 25 years shipping – even the lowest tout court if account is taken of the size of the fleet.

An important fact that caused a fall in prices was the drought of container and big tank orders in the first part of the year. The complete stasis in VLCC contracting was quite remarkable in 2012. In Q3 the lowest yard operating rates were reported following abysmal freight earnings – the lowest in 25 years - and a slow-down in Chinese growth that led to a further standstill in contracting. On top of this, the European distress and the awaited Chinese change in leadership fed the pessimistic view among shipowners that the trough had not yet been reached.

Add to this the decline in steel prices towards the end of the year and it is understood that shipowners envisaged additional price revisions in the make.

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To properly analyze the future of shipbuilding markets, we have to detail contracting levels by region and vessel type so as to compare with the shipyard capacity overhang everyone is talking about. It shows quickly that contracting levels were not by far sufficient to fill up capacity. China / Korea saw placed orders of about 9.5 / 7mio Gross Tonnage (GT) compared to an estimated capacity of 18.5 / 16mio GT respectively. For Japan, it seems more harmonized with 7mio GT orders for a maximal possible output of about 8.5 mio GT. 2012 newbuilding contracting levels (mio GT)

tentially launched by the government are deemed insufficient to keep many yards alive for long. The problem is not only limited to China: Korea as well is confronted with substantial overcapacity with contracting levels being a fraction of recent output levels. Offshore orders are a relief indeed but oneoff orders are not good enough to keep yards floating long time. The only difference with China is that in Korea the low share of tier 2 yards is obvious. In Japan opposingly, even with less pronounced overcapacity, it was quite striking that the majority of the (dry) orders went to three yards only – Oshima, Universal and Imabari. How will the other yards be able to survive?

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“The unexpected timely delivery of the orderbook has aggravated the output – capacity gap for shipyards. Only China saw some delays of tramp deliveries”

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“2012 contracting levels in China and Korea are far below yard capacity estimations: massive closures in China and Korea are unavoidable.”

The inspection becomes more valuable if we consider the industry structure as well. China is mostly dispersed with the 10 biggest shipbuilding companies only representing about 40% of the Chinese orderbook; this number equals to abt 80% for Japan and almost 100% for Korea. However, by scrutinizing the orderbook, we observe that the top 20 yards in China took about 80% of the 2012 orders. Many people target especially the small yards going down in China. But it is important to note that they only represent a few mio GT output at max. It is especially medium-sized yards that are clinging on for the time being. Once their ships have delivered, it remains to be seen how long that they can subsist.

The same result is obtained if tier 1 and 2 yards are analyzed. The tier 2 yards succeeded in clinching many tramp deals during the boom, but they are not even close in obtaining a significant share of the orders placed today. The orders are not only lower in total; also relatively seen, owners prefer to place their new orders at reputed and well-known yards, hence, explaining the predicament for tier 2 yards.

One course of events could be that China will follow the blueprint set by Japan at the time where some yards are closed while other ones are merged leaving a few major super-yards, a process supported by the government. Even the rumored massive newbuilding programs (be it in tank or LPG) po-

The output capacity gap has actually been aggravated by the fact that shipyards in general have been pumping out ships on time. Especially, the timely delivery of Japanese and Korean orders was noteworthy which would affirm that postponing or cancelling orders is more difficult than many think. The further we proceed in the delivery of the expensive delivery program contracted a few years earlier, the less likely that cancellations or significant delays will occur as most of the ship has been constructed and paid for. We do note some dislocation in the Chinese scheduled and actual deliveries but far less than that was forecasted 3 years ago: for 2012, we anticipate that over 40mio of the 50mio GT orderbook has been delivered.

“Newbuildings can now be constructed in 1-2 years” We have already witnessed clear indications that the output gap is affecting shipbuilding practice.

Ever more early delivery slots have become available, and the lead time in ship construction is no longer 3-4 years as during the boom but closer to 1-2 years. Some yards converted to shipbreaking, while other shifted focus to specialist segments or even started up ship-owning subsidiaries.

“A so-called inversion in price methodology is part of the shipyards’ strategy”

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There is also an interesting inversion in price methodology. During the boom, owners were prepared to pay high premiums above contract price for newbuilding resales to tap into sky-high earnings.

Now discounted price schemes are offered so that yards can bridge gaps in near-term schedules, read fill empty sloths in the short run. Owners are prepared to pay premiums for late delivery, inspired by the collective consensus that freight rate recovery is further ahead in 2015 and 2016. Also, owners can then better prepare for the new MARPOL emission regulations effective from 2015. Yards, now able to build ships much quicker than during the boom, are hence compelled to offer price discounts to 2013-2014 newbuilding activity. Arguably, a strategy yards attempt to play out is to advance different payment structures. Long-term deliveries will have to be paid according to the traditional 5x20% method whereas early newbuilding deliveries often obtain huge pre-building credit – e.g. 10% payment on signing and up to 80% on delivery of the ship. The above explains that especially from Q3 onwards tanker and dry resales were priced at discount (5-10%) to newbuilding contract prices.

None of these measures, however, will be enough to mitigate the collapse in ship ordering. It has become mainstream knowledge that shipbuilding is in for a painful capacity adjustment process, probably somewhere close to pre-boom levels. Without adjustments, further newbuilding price falls can probably not be avoided unless cost-push factors provide some support.

“Shipbuilding history learns that capacity could be adjusted to pre-boom levels. State aid has returned as well” Shipbuilding has faced similar crises before where boom-bust cycles follow. The last huge capacity correction was in the mid-80s as a consequence of deindustrialization tendencies in Japan and WestEurope. The many closures of yards in Europe were not really inspired by a crisis in shipbuilding as such. This time the yard overcapacity is especially linked to exuberant contracting of merchant ship tonnage as well as the China boom fuelling both ship contracting and shipyard expansions. Subsequent reactions are well-known: reductions in capacity on the one hand but also the resurgence of State aid. The latter has notably been reintroduced under the form of state-backed finance. The partici-

pation of import/export bank or the establishment of ship investment funds are just a means to offer attractive finance schemes to potential newbuilding buyers. The Korea Finance Corporation, the KDB/ KAMCO Shipping Fund Programs or the Japanese Ship Investment Fund are just cases in point. The Chinese backing might be more opaque but the goal of the latest 5-year plan is clearly aimed at fore fronting shipbuilding as a pivotal strategic segment.

“Ship contracting and shipyard capacity adjustments are governed by strong short-term overreactions, which imply that capacity thresholds are met sooner than often expected” It is useful sometimes to take step back and see whether there are long-term tendencies. Doing this would reveal, among other things, that shipbuilding is governed by overreactions: each time contracting activity flourishes for a period of years, shipbuilding capacity will be expanded drastically. The capacity expansion takes time, so that when contracting falters again later on, the effect of overcapacity gets exacerbated. Over time, markets recover and shipbuilding capacity has often been adjusted down (too) much by then, so that a contracting bonanza meets capacity thresholds again. The capacity withdrawal of 30% in the mid-80s over 3 years exemplifies this mechanism.

We are now again amid a period of chronically adjusting shipyard capacity, and foresee up to 50% capacity reductions over a 5 year perspective.

Such process happening would see shipyard utilizations increase more rapidly than many expect, so that prices would significantly be marching up again and possibly peaking a few years from now.

Besides the possible ramifications of State aid, a modeled supply demand framework alone does not tell enough on the actual costs of building ships. It is not possible to determine a cost floor for ship construction as this is of course a complex yard and ship specific variable changing all the time. But the below chart, plotting newbuilding against average steel plate prices, provides nevertheless decent support on cost implications.

As current newbuilding prices are close to bottom, following steel price trends may be a useful exercise to do. We would have to go back to the 80s to find such low prices in relation to steel price levels.

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Newbuilding vs steel prices 120

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0

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VLGC ($ Mio)

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Cape 150-180k ($ Mio)

Another cost factor that eclipses a supply demand approach on ship prices, relates to currency developments. The effect of currency developments was limited in 2012 as the relevant currencies under consideration were stable: the Yen remained expensive in the 76-87 USD/Yen range, while the won did only mildly oscillate in the 1064-1186 USD/Won range.

As signaled earlier, there is some consensus that the Chinese RMB will (have to) appreciate relative to the USD going forward. A weaker Yen opposed to a stronger RMB for instance, ceteris paribus would render Japan again more competitive vis-à-vis China.

Avg steel plate ($/ton) - right axis

“An inspection of newbuilding prices in relation to steel prices underpins the view that newbuilding prices are historically low, especially when inflation effects are accounted for.”

It is true that steel prices have been pushed down in 2012, but it is not the fall that many envisaged in view of the global economic slump. 2012 saw increasing signs of oversupply in steel plate production that went in tandem with diminishing steel demand at e.g. Korean yards due in part a shift to smaller high-spec ships. It must be kept in mind that the global steel industry has been structurally oversupplied for a long time now, and still prices have been firming. Among other things, it is the formidable development in China that has caused steel prices to remain stubbornly high. Specialist steel forecasters like MEPS still foresee a negative outlook for steel prices going into 2013 but, as per usual, caution should be in place when it comes to commodity forecasts. With a global belief in recovering global economies, it remains to be seen as to whether prices will actually fall (significantly). We should also note that global inflation has been soaring since the previous market downturn of around 2002.

Any price benchmark today with previous market lows should properly reflect inflation adjustments.

“It remains to be seen whether steel prices will fall (significantly)”

“The influence of currency developments on shipyard competition has been limited in 2012: a strong appreciationof the Chinese RMB could change this” Weighing all the factors, our shipbuilding analysis points to 2013 being the year that newbuilding prices will bottom out. Given the protracted crisis, the depth and the trough of a regime of depressed newbuilding prices have somewhat been delayed.

Regardless of the aforementioned capacity decisions at shipyards, there needs to be new orders placed before a regime of higher newbuilding prices can be orchestrated by yards. We have reason to believe that interesting times be ahead of us with respect to shipping investments. The ‘new’ demand may strike for various reasons such as: - exploiting low asset prices and countercyclical ordering; - industrial players that want to commit tonnage long-term at low cost; - investors that see shipping adventures merely as asset play and money machines; - capitalizing on technological advances, namely eco-designs that offer lower fuel consumption; - increased product differentiation instigated by location of build and by the new design of ships to accommodate to new maritime legislation; - Chinese stimulus shoring up economies and inciting shipbuilding activity and domestic orders;

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Studying the above market and shipbuilding implications, which strategies should the shipping community follow? This is more than ever a challenging question. Following the new maritime legislation and increasing global energy awareness, one is almost forced to paint a picture of the future. Time will tell whether the impact of green shipping would reveal as drastic as the steam revolution, the scale increase after WOII or the containerization growth in recent decades. We believe, for that matter, that the impact in the coming 10 years will be mind-blowing: oil may not or no longer hold the monopoly of fuel, and LNG will sooner or later become a more widely accepted solution by the maritime community. It is in this context that we acknowledge the new phenomenon in shipbuilding of an increasing trend towards product differentiation. Not only traditional ship construction will be changed (e.g. mixed LNG / ethylene / ethane / LPG carriers), but also the corresponding pricing of ships as well as a possible heterogenization in a ship’s running cost.

Today’s shipping markets already see the discerning trend where investors weigh the pros and cons of newbuildings and second-hand ships against one another. Clear-cut conclusions on such comparisons do not exist because of both different evolutions in fuel-economics by ship type/size and the evolution in asset values. As a result from the upcoming MARPOL sulphur requirements taking effect, the selected speed and the variable employment of the ship are also to be factored in investment decisions. The technological spur for newbuildings is definitely on with food for thought for the creative minds among us! Consider in addition that, with yards forced to aggressively fight for market share again, price imbalances may soon pop up again. It is therefore recommended to follow shipyards’ pricing formulas in close detail, especially for ships that are lacking transparent pricing due to a lack of transactions.

Steve Engelen Finn Engelsen Nina Willumsen Grieg Ivar Sandvig Thorsen

www.joachimgrieg.no jgresearch@grieg.no Bergen - C. Sundtsgate 17/19 PO Box 234 Sentrum NO-5804 Bergen Norway Oslo - Karenslyst Allé 2 PO Box 513 Skøyen N-0214 Oslo Norway London - Sussex Mansions 37 Maiden Lane WC2E 7LH London UK