The World Shipping Industry - Term Paper Example

? Topic:  Marine Finance Contents Introduction 3 The Shipping Industry 3 Role of Financial Management in Risk Mitigation of shipping Industry 4 Examples of two marine industries and their approach in risk management: 6 Recommendations for UK shipping industries 7 Conclusion 8 8 Reference 9 Introduction The marine industry in general comprises of those industries which are involved in the activities of design, construction, and manufacture, maintenance of vessels and shipyards or deals with other marine based services. The marine industry basically comprises of the following sectors: Services – mainly concerned with the shipping industry and tourism Resources- mainly concerned with fishing industry Manufacturing Industry- It is concerned with manufacture of equipments for shipbuilding and oil and gas industries. Research – Mainly concerned with providing research work on marine industry. The Shipping Industry The shipping industry comprises of the largest marine sector. However there has been a decline in the shipping industry since 1974. This can be primarily attributed to cyclical developments which got worse with the structural changes in the shipping industry and the world trade that made adjustments a time consuming and complex process. The extreme changes in the revenues, cash flows and values of assets during the present financial crisis have bought in difficulties in the regular order of financing shipping companies. While bank loan will continue to be an important source of finance, the newly regulated environments are forcing the shipping banks to shift their risk from balance sheet to capital markets through instruments of loan securitization. Due to this shipping company will look for capital markets as a source of external debt. Risk management will be a key issue in the shipping companies under the current situation. The other changes witnessed by the shipping industry is that traditionally it was structured by function and performance but now it is undergoing drastic changes as traditional functions are now merged with number of other services. Another major change witnessed by the shipping industry is involvement of the government in its ownership, operation and regulation. Thus the shipping industry has evolved over time from traditionally being an owner operating, free trading, and unregulated industry towards a public oriented, highly regulated and institutionalised industry (Frankel, 1987, pp. 1-15). Role of Financial Management in Risk Mitigation of shipping Industry The shipping industry encounters a number of risk namely changes in equity prices, interest rates, exchange prices, commodity rates and the changing freight rates. The risk of the changing freight rates will be discussed at length in this section. This is a kind of marketing risk the shipping industry faces on a regular basis. The freight rates historically have proved to be very volatile. The effect of unpredictable geo-political events and slow adjustment of supply to demand has resulted in drastic changes in the freight rates. In financial management the best used risk assessment model is the Value at-Risk Approach. It was developed by JP Morgan’s Chairman Dennis Weatherstone. In this approach he asked his staff to provide him with one page report on a daily basis popularly known as the “4:15 report” which indicates the risk and potential loss in the next 24 hours in the bank’s portfolio. The approach used the estimates of standard deviation and correlation between the returns of different traded equipments. General methodologies of estimating the Value at Risk Approach are analytical methods, Historical Simulation and Monte-Carlo Simulation. This very approach is used in the assessment of freight rate risk in shipping industry. This approach first considers freight rates as risk factors which are assumed to follow random walk and are modelled using stochastic processes. These stochastic processes reflect some of characteristics of freight rate dynamics. The cash flow forms the key measurement of risk. For freight rate scenario the future cash flows are recomputed which includes debt repayment and other cost items. Thus the entire distribution of future cash flows is constructed and based on that the value-added risk type conclusions are made on the basis of a specified confidence level (Skjetne, 2005, p. 11). One of the other forms of risk borne by the shipping industry is known as the pure risk. This is the risk of reduction in the value of the ships due to physical damage, human error and technical failure etc. The financial management tools suggest that the best way to mitigate suck kind of risk can be achieved through the purchase of insurance contracts. As pure risk is firm specific in nature the insurance company who underwrite these risks can reduce their exposure through diversification. The high volatility of the asset values in the shipping industry is also a major source of concern. However the derivative markets offer the mechanism by which the demand and supply of the asset is bought to alignment both for the present as well as for the future. The derivative prices in the financial markets make current and expected prices of the assets more noticeable. This availability of financial information helps in making the industry more transparent and provides guidelines for the shipping industry to determine its production and consumption levels. The credit risk in shipping industry is also high. The regulatory environment of banks makes it difficult for banks to bear the risk involved in the shipping industry. Kjell Nordal, senior advisor in research department and Haseeb Syed of Financial Markets Department of Norges Bank developed a Backtesting model which could predict the credit risk effectively. In this model is to perform stress test in which macroeconomic variables are used that predicts the financial results of balance sheet items (Norges, 2010, p. 25). Examples of two marine industries and their approach in risk management: Wilhem Wilhelmsen is a Norway based marine company established in 1961. Through joint ventures and acquisitions this industry fully or partly owns three areas namely maritime services, a fully owned port agent- Bari l. Wilhem Wilhelmsen practises a wide range of risk management tools from hedging strategies to diversification, acquisitions and strong network collaborations. The latter strategies are mainly used for risk minimization. The most prominent risk management approach followed by the company is that the interest rates and foreign exchange exposures which are managed via hedging and derivatives (Haarstad, 2006, p. 66). Thames Water is one of UK’s largest shipping companies. The company in order to meet the regulatory requirements of asset and risk has a build up a Geographical Information System in which a central repository is integrated to have access to all geo referenced network. The company heavily depends on its geographical Information system to mitigate risk. Through this model the company can observe whether there is any environmental issue associated with proposed intervention of particular asset. During the present economic crisis the company does not issue any debt. Thames Water Utilities Finance Ltd a financing subsidiary of Thames Water Utilities Limited has passed on all its financing obligations and transactions to the parent company by way of an inter-company loan. As a result the Retail Price Index risk associated with the debt was transferred to the parent company. When any RPI swaps is taken out by the company, the risk involved is hedged by the inter company arrangement with Thames Water Limited. The principal risk and uncertainties of the company is integrated with the principal risk of the group. One of the other risk management strategies of Thames Water is involvement of supply chain in future investment. It will make use of an alliance model for delivering a significant portion of its 2015 and 2020 capital investment plans. This is done with the objective of keeping the bills low and upgrading the infrastructure of the Thames Service area. Thames Water has been using its own risk models. In this model weather forecast model is used to track leakage and demand etc. This has led to a better understanding of the company’s asset base, the potential of the company to optimise resourcing and also enables improvements in risk management. These models can be used for making operational resourcing decisions, cost savings and also to manage risk in water distribution network. On another kind of model is the burst model. This model makes use of weather forecast information and estimates the number of burst across a particular area, allowing network managers to target resources in areas of high risk. They estimate the effect of weather conditions on leakage and make use of weather scenarios to estimate changes in loss of water and also allow the company to verify their management plans (Menadue, 2012). Recommendations for UK shipping industries For the revival of the shipping industry in UK the examples of two shipping companies namely Wilhem Wilhemson and Thames Water can be considered. In order to surpass the present economic downturn and its effect on the shipping industry the shipping industries of UK can resort to several hedging strategies or go for diversification. They can also try making efforts in building a strong network. In particular they can also manage their interest rate and foreign exchange exposures through hedging and with help of the derivative market. The companies can also install a geographical information system. This system is used for the purpose of capturing, storing, analysing, managing and presenting all types of geographical information. By having a more centralized access to all asset and security data one can more accurately trace and coordinate vessel movements. This tool proves to be very beneficial in risk mitigation. . Secondly the company can have its own risk mitigation models designed; this can be build by including the entire risk parameters specific to the shipping company. Like Thames water has used the weather forecast model and burst model for better understanding of its asset base and also led to optimising of its resources and also improvement in its risk management technique. Thus by the examples mentioned above the shipping companies of UK can show resilience to the current financial turmoil. Conclusion Under the current circumstances risk management is key issue to shipping companies. Shipping company can manage their risk by modifying their current operations, by employing vessel and price derivatives or by making adjustments in their capital structures. To maximize the value of the firm from the combination of these three methods, they must carefully decide what kind of risks to be bearded internally and which needs to be transferred to the capital markets. These decisions are very crucial for the shipping industry and the financial manager needs to consider the effect of each risk on the value of the firm, have a thorough understanding of its contribution to the total risk and determine the most cost effective method of limiting the risk to an acceptable level. Reference Frankel, E .G., 1987. The World Shipping Industry. Routledge. Haarstad, L. F., 2006. Which Risk Management Processes are evident within Maritime Economics ?. [Pdf]. Available at: http://edissertations.nottingham.ac.uk/542/1/MA06lixlfh.pdf. [Assessed on 19 January, 2013]. Menadue, J., 2012. Before The Storm. [Online]. Available at: http://www.utilityweek.co.uk/news/news_story.asp?id=197564&title=Before+the+storm. [Assessed on 19 January, 2013]. Norges-Bank. 2010. Economic Bulletin. [Pdf]. Available at: http://www.norges-bank.no/Upload/80115/EN/Credit_risk_model_BUL_1_10. [Assessed on 19 January, 2013]. Skjetne, R. A., 2005. Applied Financial Risk Management for the Shipping Industry Using IMAREX Derivatives. [Pdf]. Available at: http://brage.bibsys.no/nhh/bitstream/URN:NBN:no-bibsys_brage_22841/1/Skjetne.Thesis.Master.pdf. [Assessed on 19 January, 2013]. Read More