Watching for Overcapacity in the Shipping Business

In investing, the good returns of the past may not always bode well for the future. The reason is that high returns and high margins attract competition. And competition drives prices lower which eats into margins and profits.

Unless of course, your business is protected by an economic moat (we will get into details of moats in another post). Most businesses aren't.

Shipping oil in oil tankers is one such business that has no moat. All it requires is a shipping vessel, a crew and more demand for oil in a place than there is local supply for. There are no barrier to entries since anyone can operate an oil tanker after passing a regulatory compliance check.

Since the supply of oil is pretty much concentrated in a few places on Earth and demand is everywhere, shipping is a business in demand. But demand for oil is not infinite. So one of the main things to watch for in an oil tanker business is the supply -- not of oil, but of tanker ships.

If there are too many tanker ships in the market and a steady demand for oil the freight prices will come down and so will the profit margins, given that the cost of transporting the goods is determined by the distance to be navigated and the cost of fuel.

All told, the economics of an oil shipping business depend mostly on three items:
  1. The cost of operating the fleet.
  2. The price of oil.
  3. Amount of competition.
In the cost of operating the fleet we must factor in the debt such companies have. Most need a lot of debt to finance buying their tankers, which are expensive and require regular maintenance.

The price of oil influences both the cost of the fuel used in the trips and the price received for each trip, since tankers usually get paid a price proportional to the value of the goods transported. Recent high oil prices have been a boon for tanker companies.

Finally, the number of ships available in the market can drive prices charged per trip up or down.

Consider Nordic American Tanker (NAT). NAT owns and operates 15 crude oil tankers. Only one of them is on a long-term contract while the others operate on the spot market. That means they fetch whatever rate is available at the time.

NAT has no debt, which puts it singularly at the top of the shipping business quality. By having no debt they can better weather recessions or otherwise slow business activities. They are also less sensitive to pullbacks in the price of oil given that their servicing costs are lower than that of their competitors. At the end of the day, NAT will have an easier time providing the lowest cost service.

NAT has good profitability compared to its peers. It churned its assets 3.5 times more than the industry's average (asset turnover is an important efficiency metric for asset-heavy industries like oil shipping).

NAT also pays a juicy 6-7% dividend.

But that leads us to the main point of this article: overcapacity. NAT, as well as its peers, will see an increase in tanker supply in the coming years. An increase in the number of ships of 39% is expected by 2012, given the current backlog. This is certainly a red flag to watch out for. The oil tanker business will likely not be as profitable in the future as it has been in the past.

And oil prices coming down from recent record highs only adds more downward pressure on companies like NAT.

The bottom like here is that when profitability is high, watch out for incoming competition.

Disclosures: No position in NAT at the time of writing.

Related: Shipping your dollars away, by Saj Karsan.

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