Shipping Business Unwrapped

Illusion, Bias and Fallacy in the Shipping Business

Okan Duru

• Publisher: Routledge
• Year: 2018
• Print ISBN: 9781138292468
• eBook ISBN: 9781351864770
• Edition: 1
• Topic: Economía
• Subtopic: Teoría económica

The shipping business is a lesser-known industry, but it is an extremely influential element in the global economy. This book provides a snapshot of the shipping business with micro-foundations from the perspectives of institutional and behavioural economics while uncovering hidden facts about the industry.

Rather than spending a great deal of time reading many books or consulting costly advisors about fundamental issues, readers can quickly and easily find core concepts examined from multiple perspectives. They will certainly enjoy the engaging, narrative-driven content and learn many surprising truths about this fascinating business.

1 The fundamentals of shipping economics

Perfections, simplifications, and the big picture

Neoclassical economics • Behavioral economics

Supply-demand framework • Seaborne trade

Shipping markets • Action-knowledge

The shipping business falls under a particular branch of transportation economics and is a highly specialized field of study. Its technical context makes it highly sophisticated and complex. Newcomers to the industry must first understand the variety of ship types, the market, the applicable national and international legislation, charter parties, the terms and conditions of shipping contracts, and so on just to grasp the basics. It is a kind of entrance exam that eliminates the average person but attracts highly motivated people.

The fundamental economic framework of the shipping business is developed based on the neoclassical economics. The main instrument of this approach is the supply-demand framework: the balance of ships (supply) and cargo (demand). This framework is capable of explaining the broad phenomena and can assist in policymaking and strategy development; that is, the ‘big picture.’

Imagine a masterpiece painted by a legendary artist. If I showed you the entire picture and asked you to copy it, it would probably be an impossible task. However, if I showed you how to paint like they did, the finer points of their brushwork techniques, how they mixed their paints, and so on, it would not be as difficult. Although you may not produce a perfect copy, you might do a decent job. If people were to see it from a distance, it might even seem good. However, the closer they looked, the more inconsistencies they would spot.

This is how it is with neoclassical economics. It can provide us an impression of the business and help us understand some of the common trends. It may be an imperfect perspective, but we can at least see the broader picture. Despite its advantages, though, such a framework is usually not practical for businesses. While such models are quite valuable to those who study the industry, there is an academic barrier between what we find and what is meaningful to people in everyday situations.

The behavioral economics of shipping may fill the gap between practical knowledge and academic theory. It serves as a checkpoint to help decision-makers see the illusory information, fallacies, and, most importantly, cognitive biases in the shipping business.

In the neoclassical economic model, humans are rational actors who collect all information and can distinguish between the signal (i.e. useful information) and the noise (i.e. meaningless oscillations). Of course, this is an oversimplification of actual human behavior.

We do have emotions, interests, a variety of personal characteristics, and even personal biases. Our biased nature seems helpful to survive in daily life. If we were actually rational actors gathering all relevant information, we would become paralyzed by a decision as simple as what to put in our shopping cart. We need our seemingly irrational intuition just for day-to-day survival. Our emotions are particularly valuable when we must make decisions in the face of risk and uncertainty. Professionals in the shipping business need to rely on their emotional intelligence to help them make day-to-day decisions. I am simply advocating that they need to recognize the drivers of such behavior and develop the appropriate measures to deal with them.

Before proceeding to the following chapters of this book, a quick review of the basic economics of shipping would be useful for both beginners and professionals. Therefore, this section will demonstrate the supply and demand framework in brief.

Dynamics of demand

The demand for shipping is simply defined as the amount of cargo that requires transportation. As a principle, it does not refer only to cargo in transit or already shipped. It also covers the ‘agreed demand’ (already negotiated and waiting to be shipped) as well as the ‘prospective demand’ (being negotiated but not yet finalized). As such, accurately calculating demand is difficult. However, we can estimate derived demand from certain leading indicators.

The fundamental measures used in the shipping industry are the distance navigated in miles and the volume of cargo transported in metric tons. Together, they form the ton-mile, the standard measure used in maritime transportation. The term ‘seaborne trade volume’ refers to the ton-mile rate of completed shipments in a given period. Although some regard it as measuring the demand for shipping, its precision is questionable at best. Whether shipped, in transit, or awaiting transport, demand as defined here is not helpful for decision-makers. Such a measure may be useful for predicting some future trends, but there are other, more predictive measures.

The major factors in shipping demand are world trade and the overall health of the global economy. The process that drives shipping demand begins at supermarkets, electronics stores, real estate offices, shopping malls, and so on; that is, consumer demand in the retail market. Rose George summarized the size of the maritime transportation industry in the title of her fascinating book Ninety Percent of Everything (2013). Much of the world population is unaware of how most of their goods, serving their daily needs, are made possible by this industry. Nevertheless, our purchasing trends directly result in higher or lower shipping activity.

Think about an automobile. Its steel structure depends on timely shipments of iron ore, coking coal, and steel plates as intermediary inputs. Its plastic components require petrochemicals, its interior section needs textile products, and its tires depend on rubber. The manufacture of just one car requires a massive yet organized transportation system.

Step by step, every consumption trend is supplied by shipping. The resulting seaborne trade volume is the outcome of completed shipping transactions. As such, it is more of a lagging indicator than one showing the current state of the market. Many people use seaborne trade volume as an indicator of shipping demand, but as I have shown, is it neither a useful nor a precise measure. It simply does not indicate true demand. In addition to the issue of time lag, there is also the problem of uncounted cargo sitting in warehouses, being held until the manufacturer receives an order or until the market price is just right. Moreover, there is the issue of mismatched supply and demand. Sometimes, there is more cargo to transport than there is cargo capacity. On the other hand, some ships cannot be matched to cargo and so sit idle, evidenced by the number of lay-ups. Therefore, the seaborne trade volume is never a perfect representative of the demand for shipping services.

It is an illusory measure because it is premised on the assumption of a mature market. In such a market, all ships and cargoes are in equilibrium—that is, there is an implicit assumption that the supply of carrying capacity is perfectly matched to the demand for it. Also, it assumes there is no lost time in searching and negotiating. For all these reasons, seaborne trade volume is useful for analyzing what happened in the past but rather difficult to use in predicting what will happen going forward. This particular challenge is discussed in the next chapter.

Dynamics of supply

The supply side of the shipping industry is defined as the shipping fleet available to transport cargoes. Like its demand counterpart, precise measurement of supply is an illusive goal. At times, it is virtually impossible.

The conventional approach to measuring supply is to take the existing fleet size of the industry, subtract existing lay-ups, and factor in a rough estimation of the ‘slow steaming’ effect.

Every ship is rated according to an optimal speed, which depends on its design and initial test conditions. During peak market conditions, companies tend to speed up operations and therefore increase the speed of their ships as well. During such conditions, the increased fuel costs are marginal compared to the higher earnings. But during poor market times, companies reduce speed slightly (slow steam) in order to save costs. Since it is relatively difficult to find profitable charter contracts in poor markets, there is no rush for ships.

How can we measure such variables? A ship’s speed might be due to slow steaming, but what if reduction in speed was necessary because of the weather? Even if we did have information about all the technical, economic, and external conditions, could we still have any degree of confidence in how we measure supply? The ambiguity involved in measuring transportation capacity is amazing. For these reasons and more, nearly everyone has their own methods of estimating supply.

To find the size of the industry’s fleet, begin with the fleet size of the last time period and subtract demolitions and idle ships (e.g. lay-ups, slow steaming, those in repair yards, etc.). These days, it is quite easy to find the scale of the active shipping fleet by using automatic identification system (AIS) data.

To arrive at the total volume of supply, we need to calculate the maximum carrying capacity for each ship in use as well as the required time for navigation, transportation, and cargo handling. Every ship has an average in-use period, usually assumed as 350 days a year. However, considering all information needed for this arithmetic, it is quite a puzzling calculation.

We also need to estimate the lifespan of each ship in the fleet. Plenty of them have been in operation for over 30 years. How much more use can be extracted before the ship has to be scrapped? The quality of shipbuilding and the operation of the ship itself play a big part in answering this question. Some ships age more rapidly than others. Some have more technical problems than others. We must also consider the quality of maintenance and repairs. Larger companies with sizeable fleets often keep their ships in better condition than their smaller competitors. All these factors come into play when calculating the supply of shipping economics.

When estimating the economic worth of a ship, there are external factors that also come into play, independent of the physical condition. For certain cargoes, some older ships may remain fully in use even though they have outlived their estimated lifespan. On the other hand, some younger ships are sold for scrap because of their residual value. When the price for iron ore and coking coal go up, manufacturers often turn to scrap metal as a cheap alternative. In times of economic downturn, some shipping companies often use the scrapyards as sources of much-needed capital. The problematic issue that arises with scrapping is whether or not the ship is actually scrapped. Some risk-takers see the value of a ship sold for scrap, buy her from the scrapyard, and put her back in operation. By the same token, some ships are contracted to be built yet never are. Cancellations, exit clauses, bankruptcies, and the like all affect whether or not a contract for construction of a vessel is actually seen through to completion.

While such declared transactional data (ships sold for scrap or contracted to be built) are usually included in estimating supply, we cannot be sure about its reliability. As you can see, the supply side of the shipping industry is just as difficult to calculate as the demand side.

Shipping markets

There are four main markets in the shipping business: the freight market, the new building market, the sale and purchase market, and the demolition or scrap market. In addition, there are other relatively small markets or sub-markets, such as marine insurance, repair and maintenance, ship supplies, etc. The nature of these sub-markets is somewhat different from that of the larger ones, making it difficult to classify them as economic markets per se. For the purposes of this book, we will limit our discussion to the four essential markets.

The freight market concerns prices for shipping services. In general, it usually drives the other markets. Any dramatic change in the freight market almost always spills over into the other markets quickly. For example, if freight rates were down and then recover, asset prices follow and demolition prices decline accordingly. In the neoclassical model we use here, the freight rate would be the equilibrium price between supply and demand. Theoretically, as the volume of supply or demand change, the equilibrium price changes correspondingly. Although the economic model explains the relationship, it is quite difficult to cover all aspects affecting supply and demand, as we have already noted. Using this classical framework requires us to assume a number of ‘facts,’ such as human beings are rational actors and mature markets lead to equilibrium prices.

In the freight market, shipbrokers play a critical role in matching ships and cargoes. For each transaction, or ‘fixture,’ two to three shipbrokers each collect a commission, usually 1.25% of the lump sum freight rate. This means around 2.50% to 3.75% of the total freight service goes to shipbrokers.

A somewhat recent development is that many professional shipbrokers provide not only the matching service but also consulting for ship-related investments as well as independent ship management services. The main benefits of what they sell, though, are their business networks and professional assessments of contracts as representatives of parties.

Returning to the general market, freight rates for different ship sizes naturally vary. To understand the overall trends in the business, we use freight indices aggregated from a number of trading routes and contracts. The Baltic Exchange is a well-known and globally accepted institution that publishes such indices for various ship types and tonnages. As such, its indices, such as the Baltic Dry Index, are widely used. (The motto of the Baltic Exchange is also a common slogan among shipbrokers: ‘Our word is our bond.’ However, the business practices of many opportunists in the freight market devalue this saying.) These indices are calculated by a group of panelists based on declared fixtures or trend basis estimations. As such, the quality of data is questionable, but it at least gives us an indication of the current state of the market.

Another major market in the shipping industry is the sale and purchase market (also referred to as the S&P market or the secondhand market). As is frequently said in the business, asset play is one of the major motives of the industry (for many, it is the sole objective). Therefore, in the S&P market, managing investment timing and shrewdly managing assets is crucial. Shipowners should simultaneously investigate opportunities in the freight market and S&P market to find a way to survive in this risky and volatile industry. S&P brokers are the intermediaries for the market, and their work is somewhat different from freight market brokers. In part because the value of a transaction is much more than that of a charter party and in part because ships are technical assets, the process of S&P always moves slowly.

The third major market is the new building market. In today’s industry, shipyards have their own designs and optimize their production lines by building identical ships. Shipowners can select from a few designs and have limited options for modifying them.

In the last few decades, new building brokers have begun to help shipowners determine the right ship and shipyard for their new vessel. They rely on their experience and network connections with shipyards throughout the world. However, many shipowners still prefer to deal with the shipyards directly and manage the process on their own.

The fourth and last major market we will discuss is the demolition or scrap market; that is, the market for old ships. At the end of its useful life, every ship is broken down into its component parts and used in scrap-based steel production. As discussed earlier, there is no standard age for determining when to scrap a ship. The decision is based on the experience of the ship’s owner, current market conditions, its physical condition, and other factors.

Breaking down a ship is generally a dirty business, including the risk of asbestos exposure. As such, there are a limited number of scrapyards. Some, though, have strict processes and observe safety and environmental concerns. Obviously, companies with strong green policies prefer these yards.

Models of shipping markets and the hidden forces behind our decisions

There is a strong academic emphasis on modeling shipping markets and predicting/estimating the dynamics of the business. Statistical methods, time series analyses, and econometrics are frequently used for testing models and finding the magnitude of factors within particular markets. Although a large volume of academic literature deals with modeling, it is still difficult to say that we have fully uncovered the big picture. Among the data limitations and assumptions I have addressed, there is one that has been scarcely addressed: irrationality.

Irrationality comprises our emotions, our bodies’ neuroscience, our motives, individual incentives, our personalities and characteristics, and everything else that blends together to form our cognitive biases. As discussed, the classical economic model does not adequately account for our irrationality. That model is not wholly inferior, but it does need some adjustment to more accurately reflect the reality of what goes on in everyday business and even in our own minds.

Sections of our brain play a significant role in controlling how we collect and process information, as well as the decisions we execute based on that knowledge. The studies of neuroeconomics, neurofinance, and neuromarketing were all born from examining the intersection of neuroscience and the other fields, respectively. By the same token, the intersection of psychology and economics led to the study of behavioral economics.

Economists develop models from the application of knowledge; in other words, action-knowledge. Behavioral economics was, in part, the next step in creating an economic model that represented all the actors and influences in business. The so-called heterodox economics (or ‘bad boys’ economics’) shed light on the shortcomings of the classical model of economics, effectively demolishing it as a stand-alone framework. While the classical model provided a good knowledge base for understanding the shipping industry, its time has passed. We must move on to a better way of understanding the market.

Human bein...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of illustrations
• Introduction
• 1. The fundamentals of shipping economics: perfections, simplifications, and the big picture
• 2. The story of the ton-mile: can we really measure demand or supply in the shipping business?
• 3. Ships vs. assets: fleet vs. portfolio
• 4. Garbage in, gospel out: fallacy and freakonomics of shipping statistics
• 5. Information asymmetry: what you know and what you do not know!
• 6. Emotions: neuroeconomics of the shipping business
• 7. Alliance capitalism: solidarity survives
• 8. Cycles: this time, it’s almost the same!
• 9. The anatomy of a shipping crisis: dissection of irrational exuberance
• 10. The shipping mortgage crisis: how ship valuation methods rationalized toxic shipping portfolios and ship covered bonds
• 11. Glaring tycoons: survivorship bias
• 12. The fallacy of ‘expertise-like’: know-whys
• 13. Too big to fail: winner’s tragedy
• 14. About the C-level executives: get the incentives right
• 15. Spot vs. period: risk vs. loyalty
• 16. Too small to survive: uniqueness vs. size
• 17. Seafarers and outsourcing: bundle it!
• 18. Dashboard: visualizing shipping metrics
• 19. The age of artificial intelligence: what computational intelligence needs to be
• 20. Lenders’ stimulus: even bankers can be misled
• 21. The magic of the discount factor: temporal myopia and hyperbolic discounting
• 22. Credit engineering: misleading habits
• 23. Risk vs. uncertainty: swine flu and shipping
• Concluding remarks
• Appendix
• References
• Index