Transportation - Supply-side phenomena

Tanker and dry-bulk markets have positively surprised us year to date. However, both markets face the prospect of a supply overhang in 2009-11. That said, tanker scrapping/conversions could result in positive surprise in 2009-10. Buy GE Shipping; Sell SCI.

Tankers: will the market scrap?
Tanker freight rates in 2008 have, so far, been better than expected. Although we lower our tanker demand growth estimate to 2.7% (from 4.5%), we expect the market to be finely balanced in 2008, on the back of supply-side adjustments. However, Clarksons estimates new-build deliveries at 36.4% of global capacity between 2009-11. Based on our long-term tanker demand growth estimate of 3.6%, we expect new supply to put pressure on freight rates. That said, we believe weakness in the tanker market is unlikely to be prolonged (except for complete demand destruction) as owners remove single-hulls from the trade. In our view, removal of single-hulls could be triggered by: 1) the market’s tendency to be self-adjusting; 2) a widening price differential between double and single hulls; 3) record-high scrap prices; and 4) conversion to FPSOs. So, removal of single-hull vessels could result in freight rates surprising on the upside in 2009-10.

Dry-bulk: order cancellations key for balance
The dry-bulk shipping business is experiencing another good year due to continuing strong demand for dry-bulk commodities and port congestion. We raise our demand growth estimate for dry-bulk trade to 7.7% (from 5%) for 2008, suggesting a tight demand-supply situation. However, Clarksons estimates scheduled new-build deliveries will add 259mdwt (66% of global fleet) to drybulk capacity during 2009-11. Thus, we remain negative on the dry-bulk cycle due to supply concerns. That said, there is wide speculation in the industry about potential delays/cancellations of new-builds at Chinese yards. In our view, order cancellations are a must for the dry-bulk business to see a positive demand-supply balance over 2009-11.

Buy GE Shipping; Sell SCI
In our view, the 100% offshore subsidiary (Greatship) is likely to protect earnings and value for GE Shipping shareholders. We value Greatship at Rs151/GE Shipping share. Adjusting for this, the parent is available at 3.5x PER and 3.3x EV/EBITDA on FY09F earnings. SCI has a capex of US$1.6bn with the bulk of deliveries in FY11-12. However, we believe weaker freight rates and rising capex will result in falling RoEs and disappearing net cash.