Why Shipping Companies Have Been Merging or Forming Alliances - Essay Example

MARITIME ECONOMICS College: THESIS: It is believed that "the mismatch between demand for shipping services and supply of ship tonnage is one of the main factors contributing to freight rate fluctuations in the shipping market" Abstract There are two major reasons why shipping companies have been merging or forming alliances. The first is to access the bigger market share that come with volume and efficiency. The second is to access reduced shipping rates due to ability to match the supply of ships to the volume demand that will eventually assure the liners of economies of scale. The achievement of reduction of rate is the more complex concern for an economist as this has many limiting factors that impact on the commercial volumes. There is also concern that very many ship owners make decision that will impact on the freight rates that have least economic model backing. Contents Abstract...................................................................................................................................1 Introduction............................................................................................................................3 Body Overview of Industry trends...............................................................................................4 Liners Economies of Scale Effects of demand for technology on the shipping rates........................................7 Effects of fixed cost on the shipping rates..............................................................8 Impact of Lower Unit rates on profits...........................................................................9 Impact of concentrated market demands................................................................11 Demand, Supply and Freight Rates...................................................................................11 Conclusion............................................................................................................................12 References.............................................................................................................................13 Introduction In the Shipping Industry, many Ship owners have been resorting to strategies like concentration to sort out the problem that are occasioned by freight rate fluctuation. This concentration has allowed them to maximize their market shared, reduce the cost per volume and remain in competition for the industry leadership. There has been a fluctuation demand for shipping services that is also faced with a fluctuation in supply of the shipping services themselves. (Hoffman, 1998, p. 1) On the demand side, many Shipping firms have believed that the best strategies for concentration will be realized when the merge the ships in order to gain from economies of scale. To that end there have been a series of mergers and acquisition that have lead to an oligopoly of the top 20 leading shippers owning over 50% of the industry business. (Hoffman, 1998, p. 1) The beginning of 1990s saw the formation of Alliances in the World lines. The progress so far has been 10 big groups controlling more than 65% of the volume transport. With a target of lowering the shipping rates, the millions of containers have been criss crossing the high seas from one port hub to the next with the world inflation also at their trail. It has been estimated that the biggest ship can transport more than 8.700 TEUs. The figure in Exhibit 1 below shows the trends of container ship mergers that were lead by motives of economies of scale. (Hoffman, 1998, p. 1) Exhibit 1.Effects of demand for technology on the shipping rates Adopted from Drewry Shipping Consultants, Post Panamax Containerships, London, 1996. Data for 2000 is an ECLAC forecast. (Hoffman, 1998, p. 1) But the main matter of concern has been the realizations that all these merger and acquisition of ship liners in order to gain from economies of scale have not been able to match the demand and supply aspect of the industry. Yet the industry boasts of having advanced ship building yards at Japan and Korea that do over three quarters of the job and has expanded by over two thirds in the last decade. The supply of ship can be verified from the registries to be a conglomerate of top four, Panama, Cyprus, Liberia and Bahama who control over 40% of the total dead weight. (Hoffman, 1998, p. 1) On the other hand the seafaring team is lead by another quadruplet of Philippine, China, Turkey and Indonesia. They do more than 42% of the total routes and are expected to have lead data. A duo of Genstar and Transamerican have stake of more than 50% of the transport lease. (Hoffman, 1998, p. 1) Body: Overview of industry trends With the advent of globalization, it was expected that concepts like concentration would help to stabilize the abrupt fluctuations in the shipping industry rates. Whether this concept has been of any help to the shipping industry remains to be seen. Just a decade ago, concentration mergers worth over US$ 1 trillion were carried out in the US alone plus another US$340 billion across the seas. Yet the benefits as far as the reduction in shipping rates were found to be indirect. (Hoffman, 1998, p. 1) There is a closer relationship between the demand and supply of carriers, ships and transshipment. As the demand for ship sizes increases, the economic need will also follow trend for the containers and vessels. The more the supply of transshipment the more the shipping routes. The shipper who has managed to form successful networks will need adequate initial capital which only the giant firms can access. (Hoffman, 1998, p. 1) The giant shipping firms and transshipment companies will cause the port authorities to spend more in maintenance activities and infrastructure. If this infrastructure is poor and containers take weeks on months to clear then storage cost are going to make the overall shipping rate to increase. On the other hand if the services and infrastructure are well maintained as a public good, then the benefits are lower handling rate which will be yield an average of lower rates of shipping. If this efficiency is there, the ships will take the shortest time at the port and this will encourage more liners to use that port facility. Hence there will be maximization of this public good. (Hoffman, 1998, p. 1) The demand for the average bigger ships has been increasing steadily. This has gone up by over two thirds in the last two decades. The onset of the post-Panamax has seen this demand grow from 950 TEU in the early 80s to over 1600 a decade ago. Their trip is mostly between Pacific, Europe and the East lines. (Hoffman, 1998, p. 2) In order to attain the objective of being able to set the right demand for ship and supply of tonnages, with the accompanying economies of scale, many ships have been merging rather than form alliances as the later has got fairly simple exit strategies while the former has got long time commitments on goals like stabilizing shipping rates to the customers. The other reason why the liners have been merging is the increasing demand that is occasioned by long term contracts. (Hoffman, 1998, p. 2) In the case of alliances, when there was an increase in demand for the services, they were not getting cheaper rate with the ports authorities and this expense was passed on to the customers rates. The multiplier effect is the refusal of liners to make long term commitments with those shippers who are positioned as alliances. In the long run, the Alliance firms will be out competed due to tenure and rates matters. In the long run, only the 15,000 TEU capable ships will be in business. This will result into not more than five hubs, equally spread across the continents. Whether these will remain in perfect competition or act somewhat oligopolistically, remains a factor that globalization is still shaping up. The rest of the players will have the economic obligation of being niches if they want to survive. (Hoffman, 1998, p. 2). The world trade has been expanding more than the world GDP. Despite the lowering of the shipping transport rates, the cost per unit volume has never the less increased. As opposing as this fact may appear, volumes of shipment such as industrial raw material have been on going up in procurement over the last decades. (Hoffman, 1998, p. 3). Increases in demand and shipping liners have resulted in massive growths. Up to this point, there is no justification for concentration. But this boom has resulted in the demand for technology and better infrastructure that will have a direct implication of increased rates and costs. The end result has been ports authorities pushing for deregularization and clamor for liner concentration. (Hoffman, 1998, p. 3). But the intention of governments that harbor major shipping liners is to increase trade volumes demand with cheaper rates of services. So they have been reluctant to regulate maritime sector. The governments have also developed a negative local position when the liners merge due to the global conditions of competition. (Hoffman, 1998, p. 3). (Sutton, 1991, p.) The following diagram in Exhibit 2 below elaborates the patterns of liner concentration. Exhibit 2. Adopted from (Hoffman, 1998, p. 3). Liners Economies of Scale a.) Effects of demand for technology on the shipping rates Operating from some variable like workers wages and fluctuating interest rates, the demand for technology at the ports will cause a variation in the cost of handling goods. The implication will be on the fixed cost more than on the variable cost. The resultant shift in this function will give rise to positive economies of scale. From the supply side, the bigger firms will take advantage and more mergers will take place to cut down the individual payers as the market sets an appropriate equilibrium. (Hoffman, 1998, p. 3). b.) Effects of fixed cost on the shipping rates. In the recent period, the functions of the fixed cost and variable costs have been impacted on by very many issues. These issue range from increased numbers of cranes at hubs, more voluminous transshipment, technology demand, costly but cheaper maintenance ships and e-commerce. The result is that when one secure services for a big container, it will be equivalent to 20 smaller ones. The positive implication is that variable cost (VC) reduces with larger ship volumes. The functions of the fixed cost (FC) will then be dragged towards an increase in the total cost (TC). (Hoffman, 1998, p. 3). (Sutton, 1991, p.). This resultant total cost will be irrespective of the increase or decrease of FC, VC, or even average cost (AC). The important issue is the coefficient of FC/VC. If the TC and demand are constant, the lowered VC vs. inflated FC will still motivate concentration. As is evident in the Exhibit 3 graph below, the holding of average unit costs at a constant will only yield a function of FC and VC that favors increased optimum volume per shipper with a long run effect of lesser shippers. Exhibit 3 of Increasing FC and Bigger Commercial Shippers adopted from Sutton, (1991). In the same graph scenario, the AC will be least when AC = MC (Marginal Costs). Therefore the appropriate cost function will be c= + x, with c= TC per shipper; x = no. of TEU in a period, = FC in $; and represents the VC. Also increased fixed costs and pursuit for bigger market share will lead to higher MP (marginal price).Thus the shippers have a short term obligation of meeting the shipping rates. (Sutton, 1991, p.). The implementation of concentration that is demonstrated by shift from Optimum 1 to Optimum 2. As evident, even if AC has gone down, the marginal pricing cannot be hinged on it. This is instead done by consideration of the economies of scale. So that with a reduction in MC, shipping rates will vary as they set their equilibrium with the demand shifts. (Sutton, 1991, p.). Impact of Lower Unit rates on profits The shipping liners have the discretion of reducing the rates through the effects of economies of scales as is evident in the comparison of ship volumes and returns (ROI). But is it noteworthy that there could be externalities that make this function yield such high results, leading to the observation that even if bigger ships have the effects of economies of scale with resultant lower prices, their long term profits stand to drop. This is illustrated in Exhibit 4 below. (Hoffman, 1998, p. 4) Adopted from (ROI vs. average ship size, TUE for 16 main carriers, 1996.) Average Ship Volume and ROI The only form of cost cuts are realized by the aggregate lower rates that will impact on other players including those who did not venture in the expansion exercise. Overall, most shipping firms have been realizing profits because the increased absolute markets. Otherwise, in an analysis of the returns on investment, the profits have been going down relatively. The natural thing to do has been to pass the cost to the customers in order to remain above competition. An assessment of the past trends in relation to the reduced interest rates shows that the ROI is relatively stable. This is illustrated in Exhibit 5 below. (Hoffman, 1998, p.4) Exhibit 5, comparison of interest rate trend yields over the years. Impact of concentrated market demands. There are concentrated market demands in the North and South as well as East Asia, Pacific, Gulf, and South East coasts as these form regional markets. Historically there has been very high fixed cost and lesser collaboration in the shipping industry. This has led to the speculations by the CEOs that the shipping industry is full to capacity. In reality this has no basis. (Hoffman, 1998, p. 4) Consequently, there is less supply of ship liners in the east-west that is occasioned by the rerouting of the medium to large size ship to other areas. This resulted in bigger ships shortage and a multiplier effect of shifting the smaller ships to these markets has also realized a positive growth in most regional markets. South America is an example of positive beneficiaries. (Hoffman, 1998, p. 5). Demand, Supply and Freight Rates So far it has been proved that the shipping industry, need to operate under competitive markets as this will be defining point of the freight cycles. The equilibrium of the supply and demand in the shipping industry is set by the ship firms and shippers. Over the long run, it has been observed that there has been a steady increase in the demand for ships while the supply has been steadily low. The implication has been fluctuating freight cycles. (Stopford, 1992, p. 147-148). There are five major demand dependency factors that impact on the freight rate fluctuation. These are the global economy, goods of trade, mean transportation, political stability, and shipping costs. Since there is a correlation between the various sector producers and the shipping trade, a political instability in a region can come as a reliable indicator of impending demand changes for the shipping firms. (Stopford, 1992, p. 148) Next the kind of goods being traded can also cause a reasonable fluctuation in demand. Taking the example of oil which is a real shipping industry prime mover and shaker. The price differential in the 70s caused changes in demand. (Stopford, 1992, p. 148) The third aspect of demand is the distance to be covered by the ships. The longer the distance the more the demand. Fourthly, the political stability that have been most turbulent in the Middle East and parts of Asia. These have a tradition of affecting trade negatively. The last but not least factor of demand is the shipping costs. This will define the long run demand. (Stopford, 1992, p. 148) The supply factors that impact on the freight rates are also five. These are the available world ship fleet, how productive the ships are ship construction rate, depreciation and finally the freight rates. The number of ships and fleet size is determined by the firm owners who write of older fleet and decide when to replace these and by what standard of construction. They are guided by the prevailing rates. (Stopford, 1992, p. 148) The ship firm owners will determine the market speed based on when they are turned around. Speculations have overtaken the place of the annual guide book in determining when and how many ships to supply for transportation. This has however turned out to be very hasty in reliability, considering that the same information is supposed to be used in deciding when to write of ships, construct new ones and order for the coming times. (Stopford, 1992, p. 148) The equilibrium of all the supply and demand factors is set up at some freight rates. Thus, when there is shortage of ship supply, the shipping rates will go up. The implication for the ship firms is to provide more to the seas. The reverse effect happens when the shipping rates fall. The most important aspect in this balance is the timing to set the rates. At the spur of the moment, all ships that are strategically docked at hubs are already creating a competition for available goods of transport. This is defined as the momentary equilibrium. (Stopford, 1992, p. 148) Other shorter equilibrium are realized when ships have enough time to go about the world at regulated speeds. In this industry, the duration of 2-3 years which is normally what it takes to deliver a new ship is the setting of along time equilibrium. Following the economic analysis, both supply and demand graphs will adopt short run J-Shape for the supply as the short run demand will be a characteristic inelastic. These are elaborated by Exhibit 6 below. P SA Dd S D Q However the freight cycle take 7-8 years to turn around. These freight peaks and cycles are realized from the demand movements on the supply curve. Then a demand movement on the kink of this curve will lead to fluctuation the freight rates. This will take time to stabilize and give a better ROI in the long run as shown in Exhibit 7 below. P D D S Q Conclusion From the above analysis, the shipping industry is facing various demand for ship TEU and routes that are supplied in various tonnages all over the regions with the positioning as a strategy of concentration. The fears of market power and monopolistic behavior which were always thought to be the main causes for freight rate fluctuations have actually little effect. In essence there is also oligopolistic behavior. (Hoffman, 1998, p. 8) In the end everybody gains in the whole process that sways the demands, supply and fixation of rates. The worst case scenario are shipping lines that end up in niche markets but stand to gain in the long run as markets expand. There is evidence that the rates for transport per container have reduced but the end product price at the shelf has still increased. The regulation tendency has been rather lax in the wake of international competition. (Hoffman, 1998, p. 8) On the contrary, there are explicit pattern of transport supply cartels that have favored mergers and acquisition. The overall bids have been to increase the volumes of the ships to lower the rates and subsequent costs. The concentration trends are likely to reduce the individual number of suppliers but increase the volume available for customers. There is a very stiff competition that is impacted on by several externalities such as rising inflation, regional financial pressure, regulations and clamor for fewer ships. (Hoffman, 1998, p. 7) In the quest to lower the rates in the shipping industry, concentration has been the focus from a break even analysis. This process has raised FC with TAC. (Total Average cost). E-commerce has been attracting a lot of investments in to technology and infrastructure at the port. The implication is that the FC will increase when compared with the base MC (Marginal cost). In the end, the size of the aggregate market, the speculations in the industry and the externalities have lead to mismatch of demand of ships services to supply of tonnages and a less optimal management of freight rate fluctuation in the industry. (Hoffman, 1998, p. 8) References: Hoffman, J., (1998). Hoffman, J., (1998) Concentrations in Liners Shipping: Its Causes and Impacts For Ports and Shipping Services in Developing Regions, ECLAC, LC/G. 2027, Adopted from World Sea Trade Service Review; Volume 1, Third Quarter 1998. p. 68- 74. Sutton, J. (1991). Sunk Costs and Market Structure: A fundamental work on the relations between Cost functions and market structures. MIT Press. Kite-Powell, H. (2006). Economics of Marine Transportation Industries: Market Economics. 2.964 p. 1-9. Available at . 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