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In shipping shipowner trades in four different

markets

 The new building market where we order the new

ships;

 The freight market where we charteres them;

 The sale and purchase market where we try to sell
vessel as second hand

 The demolition market where we finally sells them for

scraping
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  When freight rates rise or fall the changing sentiment
ripples through into the sale and purchase market and from
there into the new building market. The markets are also
linked by cash.

 The relationship is shown graphically in Figure 3.1. Cash

flows back and forth between the industry's bank account
(represented by the circle) and the four shipping markets
(represented by the squares).

 The cash flow into the shipping companies' bank account is

shown by the light shaded bars, while the black bars show
outflows.

 The hatched bars indicate cash which changes hands from one
shipowner to another, but does not change the cash balance
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of the industry as a whole
 Fig 3-1

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  The main cash inflow is freight revenue. This goes up and
down with freight rates and is the primary mechanism
driving the activities of shipping investors.

 The other cash inflow comes from the demolition

market. Old or obsolete vessels sold to scrap dealers
provide a useful source of cash, especially during recessions.

 Investing in a second-hand ship involves a transaction

between a shipowner and another shipowner money changes
hands, but the transaction does not affect the amount of cash
held by the industry. The sale of a tanker for $20 million just
transfers $20 million cash from one shipping bank account to
another, leaving the aggregate cash balance
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  The only real source of wealth is trading cargo in the
freight market.
 In the case of the newbuilding market the cashflow
(shown in black) is in the opposite direction. Cash spent
on new ships flows out of the shipping industry because
the shipyard uses it to pay for materials, labour and
profit.
 Waves of cash flowing between the four markets drive
the shipping market cycle.
 At the beginning of the cycle freight rates rise and
cash starts to pour in, allowing shipowners to pay
higher prices for second-hand ships.

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  As prices are bid up investors turn to the new building
market which now looks better value, they order many new
ships. A couple of years Falling freight rates squeeze the cash
inflow just as investors start paying for their new buildings.

 Financially weak owners who cannot meet their day-to-day

obligations are forced to sell ships on the second-hand
market.

 For older ships there will be no offers from trading buyers,

so hard pressed owners are obliged to sell for demolition.

The whole commercial process is controlled

and co-ordinated by cashflow between
7 Markets
 First: The Freight Market
Four types of contractual arrangement are commonly used:
 Voyage charter, the shipowner contracts to carry a
specific cargo in a specific ship for a negotiated price per
ton.
 Contract of affreightment, in which the shipowner
contracts to carry regular tonnages of cargo for a fixed
price per ton.
 The time charter is an agreement between owner and
charterer to hire the ship, complete with crew, for a fee
per day, month or year .
 Bare boat charter hires out the ship without crew or
8 any operational responsibilities.
  A spot charter is generally a contract to carry specific cargo
from a load port to a discharge port at a per-day rate or a
per-ton carry amount, depending on the agreement.
 Usually, the shipping rate is the current market rate. Under
spot charter contract, shippers pay voyage expenses such as
port, canal, and fuel costs. In contrast, a time charter is
generally a contract to charter a vessel for a fixed period at a
set daily rate. Under time charters, the charterer bears
voyage expenses.
 Under both spot charter contracts and time charter
contracts, shippers are responsible for paying vessel operating
expenses.

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 Time chartering is attractive due to the
following reasons
 First, the shipper may not wish to become shipowner, but
his business requires the use of a ship under his control.
 Second, the time charter may work out cheaper than buying,
especially if the owner has lower costs, due to lower
overheads and larger fleet. This seems to have been one of
the reasons that oil companies subcontracted so much of
their transport in the 1960s.
 Third, the charterer may be a speculator taking a position in
anticipation of a change in the market
 Fourth If the charterer needs a vessel with a special
specifications

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 Second: The Sale and Purchase
Market
 The shipowner comes to the market with a ship for sale. Typically the
ship will be sold with prompt delivery, for cash, free of any charters,
or mortgages.
The shipowner's reasons for selling may vary.
 He may have a policy of replacing vessels at a certain age,
 The ship may no longer suit his trade;
 He may think prices are about to fall.
 Finally there is the 'distress sale' in which the owner sells the ship
to raise cash to meet his day-to-day commitments.
 The purchaser may need a ship of a specific type and capacity to meet
some business commitment.
 Most sale and purchase transactions are carried out through
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shipbroker
 The procedure for buying/selling a ship can be
sub-divided into the following five stages:

1- Putting the ship on the market.

 The first step is for the buyer or seller to appoint a broker -
or he may decide to handle the transaction himself.
 Particulars of the ship for sale are circulated to interested
parties in the market.

. .

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 2-Negotiation of price and conditions
 Once a prospective buyer has been found the negotiation

begins. the buyer may have to make a quick decision on very

limited information.

 Alternatively during a weak market, he can take his time,

inspecting large numbers of ships and seeking detailed

information from the owners.

 When agreement has been reached in principle, the brokers

may send a memo summarizing the key details about the ship
and the transaction, before proceeding to the formal stage of

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preparing a sale contract.
 3- Memorandum of Agreement.
 Once an offer has been accepted a Memorandum of

Agreement is drawn up setting out the terms on which

the sale will take place.

 The memorandum sets out the administrative details for

the sale (i.e. where, when and on what terms) and lays
down certain contractual rights, such as the right of the
buyer to inspect Class Society records.

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 4- Inspections.
 The buyer, or his surveyor make any inspections which are

permitted in the sales contract.

 There will probably be a physical inspection of the ship,

possibly including an underwater inspection by divers.

 There will also be an inspection of the Classification

Society records for information about the mechanical and

structural history of the ship.

 Sales often fail at this stage if the buyer is not happy with

the results of the inspections.

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 5-The closing.
 Finally the ship is delivered to its new owners who
simultaneously transfer the balance of funds to the
seller's bank.
 At the closing meeting representatives of the buyer and
seller on board ship are in telephone contact with a
meeting ashore of representatives of sellers, buyers,
current and prospective mortgagees and the ship's
existing registry

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 Price Dynamics of merchant ship:
 There are four factors which are influential:
freight rates, Age, Inflation and expectation
Freight rates are the primary influence on ship prices .

 Peaks and troughs in the freight market are transmitted through into the
sale and purchase market. When the freight rate fell from $8,500 per
day in 1981 to $3,600 per day in 1985, the price fell from $12 million
to $3 million. Conversely, when the freight recovered to $8,500 per
day, the price increased to 15 million.
 This correlation provides some guidance on valuing ships using the gross
earnings method. Analysis of the past relationship between price and
freight rates suggests that when freight rates are high the S&P market
values a five-year-old ship at about six times its current annual
earnings, based on the one year time charter rate. For example
if it is earning $4 million per annum it will value the ship at $24 million.
 In recessions the value may fall as low as three time earnings.

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 The second influence on a ship's value is age
 A ten-year-old ship is worth less than a five-year-old ship. The normal
accountancy practice is to depreciate merchant ships down to scrap
over 15 or 20 years.
 Brokers who value ships take much the same view: a ship loses 5 or 6
per cent of its value each year.
 The slope of the depreciation curve reflects the loss of performance
due to age, higher maintenance costs, a degree of technical
obsolescence and expectations about the economic life of the vessel.
 For a specific ship the economic life may be reduced by the carriage of
corrosive cargoes, poor design, or inadequate maintenance.
 When the market value eventually falls below the scrap value the ship
is likely to be sold for scrapping.
 The average age of tankers and bulk carriers scrapped in 1995 was 23-
25 years, but in protected trades, such as the US domestic trades, the
average scrapping age in the mid-1990s was about 35 years.
 Ships operating in fresh water environments such as the Great Lakes
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last much longer.
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  Figure 3.10 shows the price of a 1974 built products tanker over
the 20 years to 1994. The slope of the depreciation curve reflects
the loss of performance due to age, higher maintenance costs,
a degree of technical obsolescence and expectations about the
economic life of the vessel.

 For a specific ship the economic life may be reduced by the

carriage of corrosive cargoes, poor design, or inadequate
maintenance. When the market value eventually falls below the
scrap value the ship is likely to be sold for scrapping

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 Inflation
 Inflation affects ship prices . The development of a second-hand price for
a 35,000 dwt bulk carrier built in 1965 is shown in Figure 3.11. The
graph was calculated by taking the reported resale price of the ship in
dollars, deflating it to remove the effects of inflation using the OECD
consumer price index and fitting a linear trend to the deflated data.

 The trend line thus presents a rough estimate of what the resale price of
the ship would have been if there had been no market cycles and no
inflation during the life of the vessel.

 However, inflation seems to have a very significant effect and, as time

passes, the market price line moves progressively further above the
deflated price line. After a few years, even during depressions the market
price does not fall below the book value.
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22
 Expectations
 The fourth and in some ways most important influence on
second-hand prices is expectations. This accelerates the
speed of change at market turning points.

 For example buyers or sellers may first hold back to see what
will happen, then suddenly rush to trade once they believe
the market is 'on the move'. The market can swing from deep
depression to intensive activity in the space of only a few
weeks,

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 Valuing merchant fleet
Valuing ships is one of the routine tasks undertaken by sale
and purchase brokers. There are several reasons why
valuations are required:

 Banks lending against a mortgage need to value the collateral

and will probably continue to monitor the ship's value over
the term of the loan

 Prospectuses for public offerings of equity generally include

a valuation of the company's fleet,.

 Finally, leases often require a view on the 'residual value' of

24 the ship at the end of the loan period.
 Valuing a merchant ship involves a mixture of
procedure, market knowledge and Judgment

 First the broker consults his records to check the physical

characteristics of the ship and recent sales of similar vessels.
 He will pay particular attention to the ship type_, size, age,
yard of build, survey status, equipment and specification. Most
of these are self evident, Equipment is sometimes important.
 Bigger ships are generally worth more than smaller ships but
the relationship varies with the freight cycle.
 Shipowners prefer ships with standard machinery, so any ship
with an unusual engine or auxiliary equipment is likely to be
discounted. Some ships are better specified than others and
owners are keen to see this reflected in the valuation.

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  Physical condition affects the price of a ship, but this is
something which brokers are not in a position to
evaluate. For valuation purposes the ship is generally
assumed to be 'in good and seaworthy condition'.
 The responsibility for establishing the physical condition
of the ship lies entirely with the purchaser/ owner/
banker.
 if the ship is old a special survey will be taken into
account. Although the valuer does not know how much
the ship will need spending on it, he knows how the
market treats ships in this situation, and will take that
into account.
 The ship is normally valued at what it would sell for
today

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 Third: The New Building Market
Although the shipbuilding market is closely related to the sale
and purchase market, its character is quite different. Both
markets deal in ships, but the new building market trades
in ships which do not exist. They must be built. This has several
consequences:
First, the specification of the ship must be determined. A few
shipyards sell standard vessels, but most merchant ships are -
designed, at least to a certain extent, to the buyer's specification.

Second, the contractual process for such a major undertaking

is more complex.

Third, the ship will not be available for 2 or 3 years from the
contract date, by which time conditions may have changed.
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 The purchaser entering the new building market
may have several different motives :
 He may need a vessel of a certain size and specification and
nothing suitable is available on the second-hand market.
 Second hand prices may even be higher than the price of a new
building.
 Another possibility is that the ships are needed for an industrial
project. Steel mills, power stations, and other major industrial
projects are generally developed with specific transportation
requirements met by new buildings.
 Some large shipping companies have a policy of regular
replacement of vessels but this is less common than it used to be
years ago when British shipping companies would replace their
fleets at10 or 15 years of age.
 Finally, speculators may be attracted by incentives offered by
shipbuilders short of work - low prices and favorable credit are
examples.
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 Pricing
 The negotiation is complex. Occasionally an owner will
appoint a broker to handle the new building, but many owners
deal direct.
 One common procedure is to invite tenders from a selection
of suitable yards. The tender documentation is often very
extensive, setting out a precise specification for the ship.
 Once tenders have been received the most competitive yards
are selected and, following a detailed discussion of the design,
specification and terms, a final selection is made.
 This whole process may take anything from six months to a
year. Buyers compete fiercely for the few available berths and
shipyards set their own terms and conditions. Often shipyards
take advantage of a firm market to insist upon the sale of a
standard design.
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 Contract
 The contract negotiation can be divided into four areas on
which negotiations focus:
the price, the specification of the vessel, the terms
and conditions of the contract and the new building
finance offered by the shipbuilding.

 In a weak market buyers will seek to extract the maximum

benefit from their negotiating position in each area.
Conversely in a strong market the shipbuilder will negotiate
for the maximum price possible on a standard vessel, with
favorable stage payments.
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 Price is the most important. Usually ships are contracted for
a fixed price, payable in a series of 'stage payments', which
spread payment over the construction of the vessel.

The shipbuilder's aim is to be paid as he builds the ship, so

that he does not need working capital and will aim for stage
payments along the lines shown in Box 3.4

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32
  The pattern varies. In a seller's market the builder may
demand 50 per cent on contract signing. In a weak market
the buyer may insist on payment on delivery.

 The specification of the vessel is also important, because

modifications to the design may add 10-15 per cent to the
cost.

 There are many negotiable elements in the contract,

 Finally, the provision of finance by the shipbuilders is a

long established way of securing business, especially by
shipyards who are uncompetitive on price, or during
recessions when customers find it difficult to raise finance.
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 The shipbuilding Contract
 a 'letter of intent' is often drawn up as a basis for
developing the details of the design and the construction
contract.

 The shipyard contract is often drawn up on a standard

form. Two commonly used forms are the AWES
(Association of Western European Shipbuilder) form and the SAJ
form.

 The AWES form runs to thirty pages containing a

preamble and nineteen articles. The brief summary in Box
3.5 provides an insight into the problems which can arise
during the construction of a merchant ship.
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35
36
 Shipbuilding prices
 Ship building prices are just as volatile as second hand prices
and are closely correlated with them. They are determined
by supply and demand. However, in this case the sellers are
not other ship owners, but shipyards.

The key factors are

 freight rates,
 the price of modern second-hand ships,
 financial liquidity of buyers,
 the availability of credit and,
 most importantly, expectations.
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38
 Fourth: The Demolition Market
 The fourth market is demolition. The mechanics are simple enough. The
procedure is broadly similar to the second-hand market, but the
customers are the scrap yards rather than shipowners. An owner has a
ship which he cannot sell for continued trading, so he offers it on the
demolition market.

 Usually the sale is handled by a broker and large broking companies

have a 'demolition desk' specializing in this market. These brokers keep
records of recent sales and, because they are 'in the market', they know
who is buying at any point in time. When he receives instructions from
the owner the broker circulates details of the ship, including its
lightweight, location and availability to interested parties.

 The ultimate buyers are the demolition yards, most of which are located
in the Far East, for example in India, Pakistan, Bangladesh and China.
However the buying is usually done by cash speculators who act as
intermediaries, buying the ships for cash and selling them on to the
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demolition yards.
  Prices are determined by negotiation and depend on the
availability of ships for scrap and the demand for scrap metal.
In Asia much of the scrap is used in local markets where it
provides a convenient supply of raw materials for mini-mills,
or cold rolled for use in construction.
 Thus, demand depends on the state of the local steel market,
though availability of scrapping facilities is sometimes a
consideration. Thus prices can be very volatile. The price also
varies from ship to ship, depending its suitability for
scrapping.

 As offers are received, the price firms up and eventually a

deal is made. Although a standard contract such as the
Norwegian Sales Form is sometimes used, so few of the
clauses are relevant to a demolition sale that brokers tend to
use their own simplified contract.

 On completion the purchaser takes delivery of the ship and,

if he is an intermediary, makes the arrangements for
delivering the ship to the demolition yard.
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