Alliance concept called into question

The recent shifting in container line alliances – Hyundai Merchant Marine switching from 2M to THE Alliance and Zim tightening its ties with 2M – raises the question of whether the alliance concept and the ownership consolidation of the past five years have actually paid off.

According to Ben Nolan, shipping analyst at Stifel, the results have been disappointing. “Following years of consolidation and bankruptcy which resulted in the top eight liners now controlling 80 percent of the global container shipping trade, consolidation has slowed and a new normal has emerged,” he said in a new research note. “Turns out, thus far the net result of the synergies, economies of scale, etc. is that the companies are still not making any money. In the first quarter, the average earnings for the eight major liners was slightly below net income break-even.”

He noted that despite trade tensions, “container trade in the first half of the year wasn’t bad” although “there are signs for potential trouble ahead.” He pointed out that vessel supply increased by 5.6 percent last year and by 1.9 percent in the first half of this year. “Shipping capacity is clearly growing faster than demand,” he said, pointing to lower freight rates. The Freightos Baltic Daily Index (Global), which tracks the price to ship a 40-foot container, is down 2 percent year to date, 3 percent year-on-year and 14 percent over the past five years.

Rising cost pressures

On top of a still challenging supply-demand balance, container lines face at least two significant cost pressures that could squeeze margins. First, they will see much higher fuel prices following the global cap on fuel sulfur content beginning January 1, 2020. According to Nolan, “Liner companies may struggle to recapture the additional cost of fuel associated with IMO 2020 regulations.” Second, they face higher charter rates for vessels at a time when container freight income is falling. “Most liner companies own half of their fleets with the remaining portion leased from container-ship leasing companies,” explained Nolan.

“Average container-ship leasing rates have increased by 13 percent since the beginning of the year with the very large ships nearly having doubled. With about half of the large container shipping fleet scheduled for emission scrubber installation, the availability of those ships has tightened despite tepid [cargo] demand growth.” In other words, when a liner company’s owned vessels are sent to the shipyards for scrubber installations, they need to rent replacement tonnage, which hikes rental rates.

This is bad news for liner companies such as Maersk Line (Copenhagen: MAERB.C.IX), Mediterranean Shipping Company (MSC), CMA CGM, Hapag-Lloyd (Frankfurt: HLAG.D.IX) and Ocean Network Express (ONE), and good news for container-ship leasing companies including Seaspan Corp. (NYSE: SSW), Danaos Corp. (NYSE: DAC) and Global Ship Lease (NYSE: GSL). Profitability of the container liner business could have been far worse without alliances – there’s no way to know the actual opportunity cost of not doing so – but the fact remains that alliances have not been a panacea lifting the container lines to a position of financial strength. Nolan concluded, “While shifting alliances may help and perhaps even more actual consolidation [could help as well], it appears as though at least for now, the liner business is still going to remain challenging.”

Timeline of alliances and consolidation

The wave of alliances was precipitated by the 2013 proposal for the P3 alliance between the largest three companies – Maersk, MSC and CMA CGM – a concept that was ultimately blocked by Chinese regulators in 2014. That led to the 2M Alliance between Maersk and MSC, which regulators approved and which spurred others to team up. After several line-up changes over the past five years, the two alliances competing with 2M are the Ocean Alliance (CMA CGM, COSCO and Evergreen) and THE Alliance (ONE, Hapag-Lloyd, Yang Ming and now HMM). These alliances, which allow for cooperation on the east-west mainline trades, have been accompanied by significant ownership consolidation via mergers and acquisitions.

In 2014, Germany’s Hamburg Sud bought Chile’s CCNI and Germany’s Hapag-Lloyd merged with Chile’s CSAV. In 2016, France’s CMA CGM closed its purchase of Singapore-based NOL (owner of liner company APL); China’s two largest companies – COSCO and China Shipping – merged; and the container liner divisions of Japan’s NYK, MOL and K Line came together and formed ONE. In 2017, Hapag-Lloyd merged with United Arab Shipping Co. and Maersk took over Hamburg Sud. In 2018, COSCO purchased Hong Kong’s OOCL. Market shares were further concentrated by the loss of a major participant, South Korea’s Hanjin, which ceased operations in 2016 and was liquidated in 2017.

Why alliances don’t equate to profits

Owners in other shipping sectors such as tankers and dry bulk have been saying for decades that if only their segments were much less fragmented, returns would improve. If so, how to explain the container liner business? It boasts an extreme level of ownership consolidation that tanker and bulker owners can only dream of. It also possesses a barrier to entry not found in any other segment: Given the complexity of global container logistics and the economies of scale already secured by the top players, it is virtually inconceivable that a new global liner startup could emerge.

The reasons why alliances haven’t led to higher profits and why freight rates have fallen despite fewer competitors were explained five years ago – before 2M even existed – by former NOL chief executive officer Ron Widdows, who is currently chairman of the World Shipping Council. Widdows gave what turned out to be a remarkably prescient presentation at Marine Money Week in June 2014 on the morning after the P3 alliance was rejected by Chinese regulators.

Driving down the cost above anything else

Explaining why liner companies would focus on alliances and on larger vessels for economies of scale, he said, “It’s fundamentally about driving the costs down now. Cost has become the primary driver. P3 wasn’t about service, it wasn’t about speed, it wasn’t about reliability. It was about finding a way to drive costs absolutely as low as possible, because you can’t control price.”

Widdows continued, “Scale becomes a significant differentiator going forward, more so than it has been before. The winners in this sector will be the ones that find a way to have the lowest unit costs.” He also noted that there is a limit to how low costs can go and how many efficiencies can be found. “The momentum in cost reduction will slow, because there’s only so much you can do to scrape the bottom of the barrel and save your way out of the problem.”

Continuous oversupply

The focus on costs is due to the inability to control price, which is in turn due to persistent overcapacity and the nature of the ownership structures of some of the largest liner players. “We’re going to have an oversupply in the container sector that’s going to go on for a long time, so this is an industry that will have to find a way to price its product to make money even when there’s oversupply,” Widdows said.

He continued, “With the structure of the companies – some of these are state-backed, some quasi-state-backed, some family-owned – the operating philosophies and how they price and how they view returns are different. Those with state backing don’t necessarily have to generate the kind of returns a stand-alone company or a publicly listed one has to generate.”

Widdows said in 2014 that the P3 plan, even though it failed, would likely lead liner companies to “coalescence toward alliances.” He believed alliances would have an “unintended consequence of stronger competition than would have existed otherwise.” He also thought that the business of providing tonnage (the container ship leasing model) would prove to be an easier way to make money than running a liner operation.

Container industry keeps on struggling to be profitable

“This is a sector that’s going to continue to struggle. It’s a better business to be a provider of assets than to be the one operating the assets. The container sector hasn’t made its cost of capital during the past decade, or in any decade you want to look at,” he said. “Going forward, it’s difficult to see this sector on an overall basis generating the kind of returns you would think about from an investment standpoint, and it will remain very difficult to be profitable.” A half-decade later, Widdows’ comments haven’t aged a day.

The liner companies did indeed focus more on alliances, which created more price competition. As Nolan pointed out, the supply-demand balance continues to be tilted toward overcapacity, and leasing companies are seeing more favorable markets than liner operators – both conditions foreseen by Widdows. And as the former NOL boss further predicted, liners remain more focused than ever on cutting costs, and profits remain elusive despite alliances.