Shipping in the 2020s — Inflation, Infrastructure, and the Price of Steel.
When I was a kid, my dad ran a metal shop. Out back, he had heaps and heaps of scrap steel. Pieces of machines, broken tractors, metal shavings, odd cuts of steel plate. My dad did this because steel prices are volatile, and if he timed it right, he could clear his scrap inventory and realize large gains.
Steel is one of the basic building blocks of modern civilization. We use steel to build modern residential and commercial space. We use it to create factories. We use it to create car frames, both electric and ICE. We use it to create windmills, to create solar panels, to create roller coasters, air planes, cruise ships — nearly everything. Metal is so valuable to humanity that periods of history are named after which metal we were using at the time (Bronze age, Iron age, etc.)
When the price of steel rises and falls, it changes the intrinsic value and reproduction cost of assets. If the price of steel doubled tomorrow, automakers would raise their selling price.
The price of steel is essentially a composite of the cost of the inputs of steel: coal, iron, and the associated mining, transportation, and refining processes.
These processes themselves take lots of steel, lots of oil, and lots of electricity. As the input costs rise, the price of the output increases.
Inflation usually really means just one thing: our currency is losing purchasing power. Over time, fiat currencies (government issued money, not backed by hard assets) tend to lose value.
Since COVID-19 relief started, the federal reserve has conjured nearly 30% more dollars into existence than there were at the beginning of the year. This is an unprecedented dilution of the dollar, and this easy fed policy currently shows no signs of abatement.
In periods of inflation, many financial assets tend to perform well. In periods of hyper inflation, they go parabolic. Consider this chart of the Venezuela stock market rising exponentially, while the country experienced heavy monetary dilution and severe shortages of basic materials and supplies:
Stocks are not alone. Many assets tend to rise in periods of inflation. Hyper inflation, like that seen in Venezuela, bring things to an entirely new level.
Commodities (like steel) also tend to perform well in periods of inflation, and the rise and fall of commodities is closely correlated with inflation.
Pause for a moment here to consider that we’re talking about currencies — not demand. Now consider that most money doesn’t really “exist” — it’s just debt. In a period of severe inflation, the value of assets rise, but the value of the debt is fixed.
Let’s use a simple example. You purchase a rental property for $500k. A period of hyper inflation pushes the value of your property to $1.5M in just a few years. Your loan is still $500k. Rents have also tripled. Are you in a better or worse position than you were three years earlier? Do you feel wealthier or poorer?
Now let’s talk about two very important macro themes:
- The Green New Deal
Due to the pandemic, hundreds of millions of people worldwide are unemployed. The unemployment rate in some countries exceeds 30%. In the United states the number is closer to 7%, with some data suggesting the recovery is stalling and we may see these numbers tick back up. 2021 may bring an unprecedented wave of evictions and foreclosures as well due to lost incomes.
The Green New Deal
You’d have to have been living underground with no communication to the outside world for the past couple years to miss the dialog shift on climate change. Governments and people around the world have been crying for a rapid solution to climate change. They want lower emissions, and they want it now. They want to power generation, power transmission, fuels, cars, planes, and ships, all in one go.
Study after study has been produced to show all of the ways our new society will be “clean”. Tesla shares have exploded beyond all reasonable valuations.
Solar stocks have similarly exploded.
Markets are convinced the future is renewable and the future will be here any day. There’s only one problem: the raw materials and sheer scale of the challenge.
A leading Minnesota think tank recently explored what it would take to redesign their grid to run exclusively on renewables. What they found was nothing short of astonishing.
To summarize their findings, simply converting Minnesota’s economy, a state with just 0.07% of the global population would require:
- 1% of ALL global copper production
- 4.3% of ALL global nickel production
- 43% of ALL global cobalt production
- 0.07% of ALL global iron production
The global supply chain already shows signs of stress for some of these essential raw materials. Even the iron ore requirements, which are roughly perfectly on par with per capita production, would, in the case of Minnesota, require that 100% of current iron ore production goes towards the energy transition.
Many of these commodities are so severely under supplied that it’s almost assured mining operations will need to be scaled up exponentially to meet the demand.
If you believe these projects happen, there needs to be more of this:
More mining. More heavy equipment. More drilling. More big ships. More diesel engines. Steel, the backbone of all of it.
Now I’ve hopefully established two points:
- We’re likely on a path of accelerated inflation
- Any attempt at an energy transition will require far more steel
Though I’m sure there are plenty of other ways to play this, there is one industry I’m very familiar with that would greatly benefit from higher inflation, a more active commodities trade, and higher steel values: shipping.
Let me provide an example. A VLCC (very large crude carrier) contains a bit more than 41k tonnes of steel. The scrap rate as of today is approximately $425/tonne, putting the steel value at around $17.5M. Currently, the scrap value is approaching the value of the oldest trading VLCCs.
If steel were to double, the intrinsic value of a twenty year old fleet would roughly double.
The majority of companies in this space trade roughly between half and 1x the net present value. The largest part of the balance sheet for every company is their fleet.
If the value of steel were to double, owners with middle aged fleets (10–15 years) could benefit from a huge arbitrage in the market valuation of their fleets vs the intrinsic value of their fleets. The steel value would put a hard floor under the value of each trading fleet, regardless of whether or not the ships could even find employment.
I examined two particular companies, both of whom share a similar fleet profile (ships are ~11 years old), Teekay Tankers and International Seaways.
I found that a 100% rise in the value of steel would bring the steel value of their fleet roughly in line with the current trading value.
What I’m trying to say is that the combination of higher inflation and sustained higher demand for steel due to infrastructure projects could push the steel price far beyond the highs from 2008, when ships were scrapping for over $700/tonne, and the value of veteran super tankers was far higher than it is today.
A higher sustained steel price would put a much higher floor under both shipping asset prices and shipping equities. To go back to the house example from earlier, let’s say a theoretical tanker owner has 10 veteran super tankers which today are worth $22M each, and have ~$20M in debt attached. In a few years the value of steel has doubled. Our owner can now sell half of his fleet, pay all of his debt, and keep the rest of the fleet trading. If many owners do this, we can see a dream scenario where the size of the fleet is reduced greatly, the value of a fully depreciated asset rises dramatically, and a smaller fleet enjoys higher charter rates.
Pause for a moment while you consider what I’m saying: regardless of market fundamentals in shipping, regardless of daily hire rates, if the value of scrap steel appreciates sufficiently, the economic fortunes of ship owners, whose primary investment is in steel, will appreciate significantly.
If you have a view on inflation rising and steel demand accelerating, perhaps due to infrastructure spending, invest in shipping.