Ship financing and short sea shipping
Roughly speaking, short sea shipping has been operating in survival mode from 2009 to 2019. A first improvement in freight rates became noticeable in the first and second quarters of 2017, with rates increasing as of 2019 and the market staying relatively strong so far. So what is the face of the short sea shipping market today?
After the financial crisis of 2008, there was a decrease in demand for tonnage and the existing fleet was struggling to find employment and fix rewarding voyages. Aggravating the situation at the time was the order book. It stood at about fourteen per cent of existing tonnage. The impact was that a market under pressure had to absorb an addition al inflow of vessels that were surplus to requirement. As short sea tonnage can have an economic life expectancy of about thirty years in European waters, a “normal” orderbook should be around 3.3 per cent in order to sustain the existing fleet. This is, of course, before any improvements in tonnage efficiency in intake, speed or port turnaround times.
From 2017, gradual improvements were registered in freight rates and starting in 2020, an unprecedented spike in rates led to a long awaited boom in freight income. Although a much predicted and anticipated recession is expected, it has not materialised as yet and the market remains good, although an easing of rates is still a likely scenario.
No definition for short sea shipping
As an established definition of short sea shipping is lacking, it can be broadly described as seaborne transportation of merchant goods, taking place over sea. As financiers with a European focus, we have a slightly different description of short sea as a phenomenon compared to the worldwide definition of short sea operations.
At Nesec Fund Management, short sea shipping is loosely described as all cargo carrying vessels under 20,000 DWT, trading between European ports from Russia, going around in Europe, counterclockwise to the Black Sea and all ports that can be called in this range. In addition, short sea ships call on North and Northwest African ports and occasionally they make an Atlantic crossing. And, to make it more confusing, as an exception, short sea ships with specialised cargo or cargo handling features will trade worldwide.
The majority of all short sea vessels have a class notation for worldwide trading, however, trading patterns, lot sizes, products or economics make it unnatural to do so. Short sea shipping has developed from an earlier stage of shipping called coastal shipping, trading up and down littoral places or making short open sea crossings. It is believed that this is the origin of modern shipping and this is where the earliest legal instruments of shipbuilding, shipping and trading come from. These instruments are a shipbuilding contract, shipbuilding finance, bills of lading, time charters and voyage charters. Ship mortgages as security for loans became part of ship lending when government-run ship registers were established in the early 1800s.
hip lending falls into two phases. These phases differ in time precisely around the actual moment of physical delivery of a vessel to a shipowner by a shipbuilder. Very often both phases require financing to the shipowner by external sources like banks or alternative debt providers, such as debt funds.
Providing pre-delivery finance to shipowners is a complex issue for financiers. During the building period, the shipowner has to make stage payments to the shipyard commensurate with the progress that is made on the building of the ship. One of the ways to contract stage payments between shipbuilder and shipowner are five times twenty per cent. Ordinary finance terms may dictate that a pre-delivery loan is available for sixty per cent of the building price, hence forty per cent of the building sum will come from the shipowner as equity. In this example, it comprises the first two stage payments to the yard. The remaining three stage payments will be funded by the pre-delivery loan. By this time, the payments will have been used to build the vessel and liquidity might be an issue.
Generally, the availability of pre-delivery finance to a shipowner falls largely on the financial credibility of the shipbuilder, hence the complexity as this can be difficult to assess. By non-performance or non-delivery of the ship, the amounts paid to the shipyard have to be refunded to the shipowner. Therefore, a bank shall have to issue bank guarantees for the shipyard until delivery of the ship for all stage payments made. Conversely, the shipyard wants to be certain that the shipowner can fulfil his contractual obligation to perform each individual stage payment up to and including the final delivery payment, so the yard is not stuck with an unpaid vessel. Therefore, the shipowner’s financier has to issue guarantees acceptable to the shipyard. Today, banks and financiers can be reluctant to issue guarantees on behalf of shipyards because of stricter (Basel and) internal regulations, generic historical performance of the sector and technological, logistical or procurement issues.
Co-financing and post-delivery finance
Sometimes banks and financiers (such as NSDF, the Nesec Shipping Debt Fund) see the possibility to co-finance the yard together with the shipowner on the basis of making instalments against early transfer of ownership of a vessel (prior to being successfully completed) together with the fulfilment by the yard of certain legal conditions. This finance structure is specific to the Netherlands, albeit there may be similar possibilities in other jurisdictions and it overcomes yard funding issues.
Post-delivery finance is the classic realm of any ship financier and deals with the acquisition of new or second-hand vessels. Typically, sixty to seventy per cent of the value or acquisition price gets financed by lenders with the shipowners being the funder of the remaining part as invested equity in the vessel. In order to obtain finance, the shipowner shall have to put up security for the finance; the most common are a mortgage over the vessel, assignment of earnings and insurances and a (partial) guarantee of the shipowner for the debt.
Loans tend to have a typical repayment profile of fifteen years and the loan duration can be roughly five years. Thus, the loan ends with a balloon (repayment) amounting to the remaining ten years. Normally, this balloon gets refinanced for a next period by the same and sometimes a different financier.
All of the above is common practice in ship financing and has been for many years. Of late, there are a number of developments that affect ship finance. Short sea shipping is a versatile part of worldwide shipping. It is the backbone of intra-European bilateral mercantile trade. It is less volatile and cyclical than deep sea shipping (however, it does share these characteristics).
It has logistic aspects in the sense that it is part of production pipelines and schedules, and a sizeable part of transported volumes is contracted through contracts of affreightment. This means that shippers contract certain volumes divided in certain lot sizes with shipowners or operators over multiple nominated vessels with designated loading and discharge ports for a fixed price per tonne for a defined period. Around these contracts, owners and operators weave sequential spot voyages. This makes income levels somewhat less volatile, however, it also makes freight and income levels of ships and owners less transparent.
Contrary to what is often the case in deep sea shipping, there are no defined ship types or routes like panamax or aframax vessels with certain trading patterns that can be incorporated in the income indices like Worldscale or the Baltic Dry Index. Therefore, widespread data on income for vessels and trades is scarce. It makes investment analysis and credit analysis more complex for a number of stakeholders.
Although all shipping investments are capital intensive, short sea ships involve smaller lending amounts. The combination with relatively higher handling costs and lack of data can make short sea shipping an area where the bigger banks and lenders shy away from. As a result, there is also less widespread knowledge of the sector and its dynamics and also, very important to lenders and funders to the sector, there is a lack of credit default data.
Credit default data are the numerical outcome of an assessment of the performance of credits to a large number of similar borrowers over an extensive period of time. Typically, funders tend to data analyse defaults, being non-payment of repayments or interest for periods exceeding ninety days and the loss that occurs in the event a default has taken place. Preferably, these data series will stretch over a period that is considered long enough to go through shipping cycles at least twice. In shipping, borrowers can be very similar and the type of security, mortgage and pledges of earnings and insurance are also very similar, in this way, sufficient data points are available.
Ship types, however, and their generation of cash flow can differ, therefore, debt service will differ. These characteristics can be used to build up portfolios with uncorrelated market characteristics as an internal hedge to overexposure to risk of a particular shipping sector. Alternatively, it enables ship financiers to cut out ship types or owner types that are notoriously more prone to defaults and/or losses.
The credit default data can be enhanced by making periodical snapshots of clients’ and ship credit score card data. This rates the client and ship and aims to correlate these data over a longer period from loan acceptation to final repayment or, worse, final settlement. On the basis of these data, new loan engagements or the build-up of ship lending portfolios can be designed and modelled. In some environments, these models can also be used for stress testing and in some cases, provisioning for bad debt. An extension of several risk assessment systems is the ability for financiers to price their loans in accordance with the perceived risk of a transaction, taking into consideration quantities as ship type, age, commercial operation, financial solidity and market cycle, for example.
Forecasting models to project compliance
A further development in today’s financing of short sea ship finance are the upcoming regulations with respect to emissions. Having dealt with the statutory obligation to deal with waterborne emissions by way of installation of ballast water treatment systems on board all sea going vessels, further regulations will address more impactful airborne emissions. As of January 1 of this year, it is mandatory to calculate the attained Energy Efficiency Existing Ship Index (EEXI) of a vessel (with a GT exceeding 400) to measure its energy efficiency. In addition, the collection of data is initiated for the reporting of vessels’ annual operational carbon intensity indicator (CII). The first ratings will be assigned in 2024.
Carbon intensity links greenhouse gas (GHG) emissions to the amount of cargo carried over distance sailed. The measures are part of the International Maritime Organization’s strategy on reduction of GHG emissions from ships (with a GT exceeding 5000) by forty per cent in 2030 compared to 2008. From the early 2020s, shipowners, class organisations and ship financiers alike have made forecasting models to project the compliance or non-compliance of their vessels with applicable and upcoming regulations regarding these emissions. The obvious reason for owners and financiers alike being the avoidance of stranded assets; assets that cannot fully trade or at least trade until the end of the period required to service its debt. In the same fashion, ships that are not able to trade (or to their full capacity) will generate a less favourable price in the second-hand market.Today, some financiers are able to project the capacity to trade a vessel into the future and simultaneously project what measures can be taken to stay compliant. Models can simulate technical measures, operational measures, energy source choice and Emission Trading System (ETS) rights implications for various ship types and trading patterns. In these scenarios, various price and investment scenarios are run and economic viability and payback periods are calculated in order to prevent financiers from pitfalls in the various emission choices that come with vessels and assess the likeliness of a vessel being able to perform its debt service over its remaining lifetime or at least the period that a loan is outstanding.
In general, it can be expected that short sea shipping will see a lot of dynamic in the forthcoming years. The period from 2009 to 2019 was a prolonged phase with relatively poor income levels. Few newbuilds were ordered and innovation and design challenges were more focused on the cargo configuration side of a vessel. The foreseeable period will require a lot of inventiveness from owners and, hopefully, from a lot of young people that choose a carrier in shipping because of these challenges. The profitability of the short sea sector over the past two years can enable these new initiatives.