Oil for fuel and thought
The price of crude oil is hovering around the mid 30s per barrel at the time of writing. Not only is it wreaking havoc for oil companies, their suppliers and the economies of oil exporting countries and all the other beneficiaries of the revenue streams: it also raises the question whether recent years’ significant investments into eco-vessels and ever bigger ships have been in vain.
How does Torvald Klaveness as a ship owner and operator think and respond to the current low oil price environment? We try to look at the big picture and explore possible future scenarios, so that investment decisions are robust and include embedded optionality.
Using oil as the energy source for ships started in the early 20th century, taking over from coal driven steam engines. According to Daniel Yergin, the author of notable books on the oil market such as The Price and The Quest, it was the British navy, betting on oil as fuel for its vessels that drove the development of oil fueled vessels engines. Despite not having any domestic oil resources on its own, the Brits thought that access to the newly discovered oil resources in Persia (present day Iran), Borneo and other places would suffice to engine their globally present navy, and to maintain their supremacy over Germany, which also invested heavily in building a deep sea Navy in an arms race with Britain at the time. Today, more than 100 years later, oil is still the king among ship fuels. Alternative fuels, such as hydrocarbon based liquefied natural gas, electricity and fuel cell engines all have major hurdles to overcome before being able to replace oil fully. So, for the next 10 to 20 years, we believe the oil, and the price of it, will be an integral part of shipping.
Often being the single determining factor in optimizing sailing speed or a vessel’s trade pattern, ship owners, operators and cargo owners all need to be on top of the oil market and its impact on costs of transporting goods overseas. Even with crude oil prices below $40/bbl, the cost of fuel still constitutes approximately 50% of the cost of transporting dry bulk goods on Supra- and Panamax vessels. In the foreseeable future, increased complexity and the cost of burning oil at sea will increase with an expected roll-out of a global sulfur emission cap in 2020, reduction in NOx emission in the USA (Tier III regulations) from 2016 and a potential carbon emission tax or a cap-and-trade scheme for international shipping further down the line.
So how does volatile energy costs (i.e. the oil price) impact Torvald Klaveness’ ship operations and ship investments? With fuel costs still being 50% of the total running costs of a dry bulk vessel, speed optimization and vessel performance are highly prioritized. Oil price volatility also impacts the balance sheet: lower oil prices reduce inventory value (bunker on board). This is however more than countered with an increased funding need for net current assets. With 30 days credit from fuel oil suppliers, but shorter credits towards freight customers, falling oil prices actually increases working capital needs. Having hedged oil exposure with derivatives towards clearing houses, there is furthermore increased collateral (cash calls) requirements, draining liquidity. A further effect of low oil prices is that it usually depreciates the Norwegian krone vs. the USD. USD denominated companies with a cost base in Norway, such as Torvald Klaveness, will improve its earnings. The risk department at Klaveness assesses and stress tests the portfolio of freight and derivative contracts to investigate the effects on liquidity and the balance sheet from oil price changes. Identifying natural hedges and how oil price changes could impact counterparty risks (e.g. bunker supplier risk) are also part of the process. To manage the above risks, mandates are in place to limit potential cash calls from clearing houses, and market risk is scaled down if there is a risk of it exceeding the allocated loss absorbing capital.
Although oil prices are low, it is hard to peg where they are going short term. Hence, we still keep our heads down on oil price risk, hedging exposure arising from COA business. Looking into the future, we think that any investments should seek to minimize its carbon footprint. Large reduction in current upstream oil investments, increased geopolitical risk in oil exporting countries, taxation on carbon emission and new environmental requirements for ship fuels will most likely contribute to increasing fuel prices from today’s depressed levels. It is interesting to note that the Norwegian elephant discovery of 2011, the Johan Sverdrup field, is currently just about breaking economically even, given today’s prices (according to Rystad Energy). Hence, when investing in newbuildings, we at Klaveness think that a careful approach to consuming oil on ships will be needed. The future being uncertain, embedding optionality for LNG engines, monitoring the development of scrubbers and alternative fuels are all prerequisites to succeed in propelling a shipping company into the future.