Analysis of Economies of Scale

Analysis of Economies of Scale GONZALO PARENTE QUESTION 1: ECONOMIES OF SCALE: Shipping is an immense industry requiring huge financial investments and continuous development. Therefore, it has become an ideal game field to find and implement economies of scale. Any minor achievement on this will mean an impressive extra benefit in terms of cost reduction and efficiency gains. However, when economies of scale are managed under wrong market perspectives it can generate catastrophic results affecting for example ports flexibility and their commercial feasibility (e.g. congestion at terminal, hinterland) (P. Rodrigue, 2014). It is important to highlight that different shipping segments require different strategies due to variations on operations and infrastructure. Therefore, it can be found different shipping niches where economies of scale can be applied: Bigger capacity leads to lower costs per unit: Benefits, in terms of costs per unit, increase with ships capacity. If a comparison, in terms of operating costs, is made between a TTT class and a New Panamax vessel, it can be seen that megaships would be 30% cheaper than medium size vessels ($100/TEU) (P. Rodrigue, 2014). Bigger ships carry less fuel consumption: It is known that fuel consumption counts around 45%-50% of operating costs. Modern ships have led to a reduction on fuel consumption turning the shipping industry into a more profitable business. Under normal conditions, megaships consume 164 tons of fuel per day, being 35% lower than a medium size vessel (P. Rodrigue, 2015). Low speed (Slow steaming) also reduces fuel consumption: During the crisis of 2008-9 a new sailing approach came up, Slow steaming, reducing the speed to 18-20 Knots aiming to lower the fuel consumption. It enabled the market to absorb the over-fleet capacity during periods of slack demand, without impact in port congestion thanks to keep the fleet port call frequency. While a Post Panamax consumes 230 tons per day sailing at 24 Knots/hour, at 21 Knots/hour it would burn 150 tons per day (33% less) (P. Rodrigue, 2015). New shipbuilding techniques mean vessels being built rapidly: It has let ship-owners increase their fleets in a much reduced time at very low prices, taking advantage of the market conditions at all times. It is economy of scale applied to ship design. For example the new ships price fall between 2008 and 2009 was due to the appearance of revolutionary techniques offering new ships at very low prices (Stopford, 2009). Vessel ´s specialization leads to market flexibility: Not only economies of scale but also economies of scope are encompassed by ship specialization. Case: In order to fight against the inefficiency generated by bulk carriers sailing in ballast, a new specialized vessel came up called Multi-purpose. In terms of economies of scale, a multi-purposes vessel was an innovated idea due to the wide range of goods that it can accommodate at the same time, adapting it to the market conditions at all the moments without concerning about the port features, season, trends etc (Stopford, 2009). New technology and handling equipment speed up port operations: Operating mega vessels under high levels of productivity/efficiency requires sophisticated handling equipment. TTT vessels can be operated by 7 cranes at once (251 TEU/hour); while NewPanamax vessels need 6 cranes to handle 140 TEU/hour (Stopford, 2009). As a conclusion, the application of economies of scale to the shipping industry has led to a positive impact on the global economy. QUESTION 2: COST ELEMENTS OF SHIPPING: When talking about shipping costs, two main types of costs must be always taken into account: voyage related costs and no-voyage related costs. However, a better way to understand how different costs work in the shipping industry is by classifying them into capital, operating and voyage costs (ICS 2012, 2103; Plymouth university -Mr Adkins, 2014). The capital costs are fixed costs directly related to the vessel ´s purchase. These costs are part of the owner ´s responsibility. Some of these costs are Pre-delivery costs: the cost of transporting the vessel from the shipyard (e.g. japan) to the delivery point (e.g. Rotterdam). Loan repayment: it involves all the money that the shipowner must pay back to the bank. Leasing charges refer to the cost that shipowners must pay to the lessor e.g. TC for capesize, 5 years = $10500 per day. Depreciation: it refers to the decline in value of the vessel or any other infrastructure. Depreciation depends on the cost of the asset, the expected salvage value of the asset, the estimated life of the asset. Vessels life aprox. 25 years. Operating costs can be divided into four groups: crew costs, repair and maintainace, insurance and administration. Crew costs include the seafarer`s wages (Not the same for Philippines, American or Greeks), the travel costs (Not the same from UK to Rotterdam than UK to Italy), crew training (Depends on flag state/ship registries), medical inspections, recruitment process, insurances for crew accidents. Repair and maintenance costs include the maintenance of engines and other equipment, replacement of vessel ´s parts. For old vessels, it counts even 14% of operating costs. Insurance costs: The two compulsory insurances that every vessel must have are the 2/3 hull and machinery and the 1/3 third party liability. Administration costs consists of communication costs agents in port, or shore based administration and management charges. The voyage costs are one of the most important costs that shipowners must take into account when planning voyages. It is usually known as voyage estimation. Fuel charges: include the fuel price, the engine power and efficiency, the design and state of hull and the ship ´s speed. Port charges include the port dues which is the general use of port facilities (depends on volume of cargo, weight of cargo, gross tonnage and net tonnage). Service charges which include the pilotage, towage and cargo handling. Canal charges refer to the price vessels have to pay to ship across these short cuts. Please see below a good example of voyage estimation: (Private data from Shipbroking firm) Vessel: 8.000 TEU Route: Shanghai-Rotterdam (12.000 miles and 100% load factor). Bunker price = $650 Ship cost = $100m Containers = $20m Operating costs = $8.500 Value of cargo = $60.000 per TEU Annual interest rate = 3% Emission cost = $30 per tonne of fuel consumed Freight rate = $800 per TEU A ship is considered profitable when after taking into account capital, operating and voyage costs, still generate profits for the shipowner. This profit directly depends in the market level and freight rates. It is not the same to fix a vessel for WS50 than for WS80.Sometimes, it happens that freight rates vary for the same vessel size. One of the main factors is the geography. Depending on the demand for vessels in those specific markets, some shipowners will be willing to accept higher or lower freight rates. . For example: A vessel operating in Cross-MED for WS50 and a vessel operating UKC-ARA for WS80. In order to make your vessel more profitable, some strategies can be applied to seek economies of scale. Nowadays, one of the most popular seems to be slow steaming. QUESTION 3. WORLD MERCHANT FLEET, STRUCTURE AND COMPOSITION: As seen, shipping is a global industry formed by a sum of different sub-markets. This question is focused on the bulk market and the main differences between three of the biggest segments: tanker, dry bulk and containers. When looking at different shipping segments, it is important to analyze not only the routes of each segment but also the type and vessel size used in each of the markets. For liquid bulk cargoes, the type of vessel used is known as tanker vessels. Tankers are divided in two main groups: crude oil tankers and product tankers (ICS, 2015). Crude oil tankers range from 80.000-120.000 dwt (Aframax), 120.000-200.000 (Suezmax), to 200.000-500.000 dwt (VLCCs-ULCCs). The main routes are AG-USG, AG-China, AG-Japan and AG-ARA-UKC (ICS, 2014). Product tankers range from 10.00-42.000 dwt (Handy), 42.000-60.000 dwt (MR), 60.000-120.000 dwt (LR1-LR2). The main routes are USA-UKC for Diesel, NE to USG-N. America for gasoline and AG-China/Japan/ARA for Naphtha. For the product industry it is important to take into account the refineries location (ICS, 2015). The main features of crude oil and chemical products are that must be stored into tanks, handled by pumping and in some cases can be corrosive and toxic. For dry bulk cargoes, the type of vessel used is known as dry bulk ships. Some of the main features of this cargoes are that are shipped in large quantities and handled with automated equipment like belts and conveyors. The size of the vessel usually varies with the commodity transported. These are the most important commodities in the dry bulk industry (ICS, 2013; E. Branch, 2012). Iron ore: Main routes: Brazil to China-W. Europe (Panamax)- Australia to Japan/China (Panamax). Raw material of steelmaking. Major importers, it changes with countries development. China, Japan and USA are considered the three bigger consumers. Major exporters, Australian, Brazil, India or South Africa. Key players: Vale, BHP Billiton, Rio Tinto, ArcelorMittal, Metalloinvest, Anglo American. Ports/Terminals: Itaqui, Tubarao, Sepetiba, Ponta do Uba, Dampier, Port Walcott. Coal: Main routes: Australia to Japan/W.EU S.Africa to EU (Handymax), Columbia to W.EU (Panamax). Raw material of steelmaking as well as fuel for generating power. There are two main types: Cocking coal and steam coal. Coking coal: Australia is the worlds largest exporter. Steam coal: Australia Indonesia larger exporters. Major coal importers are Europe and Japan (43% of the world ´s coal imports). Grain: Main routes: US to S.America/Japan/Asian countries (Panamax), Argentina to Brazil (Handysize). Wheat, maize, rice, barley, soya etc. They all seasonal and irregular in volume and route. Major importer: Japan, China, Russia, EU, N. Africa, Brazil, Middle East countries. Main exporters: Canada, N.S. America, Australia. The last group are the containerships. Containerships have been positively affected by technologic improvements such as containerization or automization. Vessels range from: -1000 TEU (Small feeder), 1.000-2.000 TEU (Feeder), 2.000-3.000 (Feedermax), 3.000-5.000 Panamax, 5.000-10.000 TEU (Post Panamax), 10.000-15.000 TEU (New Panamax), +14.000 (ULCV) (ICS, 2015). The main routes for containerships are from F.EAST to EU and US (Panamax, Post Panamax), USA to China (Panamax and Post Panamax) and from USA to EU (Post Panamax and smaller) (ICS, 2015). It is interesting to highlight that companies are struggling on the return voyage from West to East. It makes operators to find different ways to optimize the empty containers in order to avoid the loss of marginal profit. QUESTION 4. SUPPLY AND DEMAND AND ITS IMPACT ON FREIGHT RATES: (Based on my dissertation) The shipping industry is a global-scale industry ruled by a combination of factors in charge of determining market trends, market levels and cycles. The supply and demand for vessels will establish the shipping market balance. The mechanism used to link the supply and demand in this industry is known as freight rates. Freight rates reflects the balance of ships and cargoes available in the market at a certain time (Stopford, 2009). Too many ships usually mean low freight rates, and too few ships usually mean high freight rates. Once freight rates are established, charterers and shipowners adjust to them, bringing the supply and demand into balance (Stopford, 2009). The Baltic Exchange is the organization in charge of providing, in co-operation with top shipping companies, daily reports for different markets and vessels sizes (BDTI TD1, TD6à ¢Ã¢â€š ¬Ã‚ ¦). In terms of the shipping market model, 5 supply and 5 demand factors strongly influence the freight rates. On the demand side, one of the most important variables is the world economy and, especially, the global business cycles and local development trends (emerging economies-Nigeria). World economy plays an important role when determining the price of commodities and also when setting the freight rates that buyers and sellers are able to pay to transport them. Another two key factors to achieve economies of scale are the average haul distance and the amount of cargo shipped per voyage. Random economic shocks (2008 crisis) have also a great weight in shipping demand. As these shocks affect demand and people economic power, freight prices are reduced as the demand for these commodities is considerably reduced. And, last but not least, transport costs encompassing capital, voyage and operational costs (ICS, 2015; Stopford, 2009; Lectures given by Jonathan Challecombe: International Shipping and Maritime Management and Markets). On the supply side, the new buildings and scrapping activities are essential to adjust the market balance. New buildings increase the fleet supply, lowering freight rates. Scrapping reduces the fleet supply, increasing freight rates. Fleet productivity is another factor which is focused in vessel ´s efficiency. In a fast pace market, speed and waiting times are crucial for business profitability. The last variable is the freight revenue. For example in markets with strong trends, shipowners may extend their vessel ´s life or purchase second-hand vessels to take advantage of the market; while in markets ruled by weak trends, old ships are scrapped 10 or 15 years before their commercial life ends (ICS, 2015; Stopford, 2009; Lectures given by Jonathan Challecombe: International Shipping and Maritime Management and Markets). For example it is good to understand what is going with the current dry bulk and container markets. The very low freight rates experienced during the last few months are caused by the extreme difference in terms of fleet growth (+) and the fleet demand (-). This situation has led to overcapacity. As a conclusion and in order to become again a balanced industry, shipping companies should follow a new tool developed by BIMCO known as Zero supply growth. It mainly require shipowners to neutralize the delivery of new vessels every year by scrapping an equal amount of capacity from the existing fleet (BIMCO, 2016). Mergers and acquisitions are also great strategies although will lead to a more monopolized market. QUESTION 6. RELATIONSHIP BETWEEN GLOBAL ECONOMIC DEVELOPMENT AND SEABORNE TRADE: As a derived demand, maritime shipping is shaped by worldwide macroeconomic conditions. Although shipping market is very complex we can say that there are five major factors which rule the demand for shipping: transport costs, seaborne commodity trades, average haul, random shocks and world economy, which is the most important one (Stopford, 2009). World economy impacts on the demand for shipping mainly through the business cycle and the trade development cycle. Business cycle lays the foundation for shipping cycle, so that fluctuations in the rate of world economic growth cause a cyclical pattern of demand for shipping. There is a close relationship between the growth rate of shipping and the world GDP, what becomes clear if you see how both parameters have closely changed over the recent history. It is not surprising given that world economy generates the most of demand for shipping by importing raw materials for manufacturing or exporting manufactured products. Another side of the relationship between macroeconomics and shipping is the seaborne commodity trades, which can be divided into short-term and long term. Seasonality of some trades is an important cause of short-term volatility. For instance, many agricultural commodities are linked to seasonal reasons, caused by harvest. But in the oil business there also is a cycle that reflects the seasonal fluctuation in energy consumption in western countries. Seasonality has a great impact on spot market (Dry and wet bulk) (ICS, 2015). The flows of raw materials (mainly ores and crude oil) follow a shipping pattern from developing countries towards developed countries. Transports terminals in developing countries are specialized in loading raw materials while developed countries unload are focused on unloading. On the other hand, the flows of manufactured goods mainly concerned developed countries, but it is changing due to the effects of globalized manufacturing processes. We have a new geography of global trade, which can be depicted quite accurately by maritime shipping routes. Developing countries are no longer just the suppliers of high volume-low value raw materials, but instead now also import large volumes of oil, iron ore, and participate in global value chains and the globalized production of manufactured goods (Stopford, 2009). As a result, developing countries are emerging as major world exporters and importers. They have also become main players in globalized manufacturing processes. As an instance we can mention that the growing energy needs of developing countries and the expansion of South-South trade are contributing to recharging tanker shipping and trade maps, supported by the US strategy to get its energy independence. QUESTION 7. ESTIMATING AND FORECASTING It is said that information is the most important variable that make shipping companies win or lose. Currently, technology has enhanced companies to get information from the market, global economy and many other factors in order to make an accurate market estimation and take advantage of it (Stopford, 2009). However, it is said that not all information is reliable, creating uncertainty among shipping players. It is why not only shipowners but also charterers, traders, operators and even brokers must have a clear network to get daily outlooks of what is going on in the market at every stage. Some of the most common information sources are: Shipping institutions: BIMCO, IMO, ICS, BALTIC EXCHANGEà ¢Ã¢â€š ¬Ã‚ ¦ Broking companies: PLATEAU DAILY REPORTSà ¢Ã¢â€š ¬Ã‚ ¦ Newspapers, magazinesà ¢Ã¢â€š ¬Ã‚ ¦ QUESTION 9. RISK MANAGEMENT: A popular strategy used in the shipping industry to reduce the effects of volatile markets is known as bunker hedging. It consists in a fuel price analysis and it is used with the purpose of reducing the company ´s exposure to volatile bunker costs and eliminating the risk of companies ´ bunker budgets getting out of control (Mercatus, 2016). Swap is one of the most popular uses when bunker hedging (Mercatus, 2016). It allows the buyer to hedge his bunker exposure by fixing the price he pays for fuel at a predefined level, over a predefined period of time. Two different scenarios can be found: Scenario 1: It is when fuel prices move from below the swap execution price. As a financial compensation, the shipping company has to pay back the difference between the market price and the swap price to his trading counterparty in order to offset low prices in the market (C, Cheetham, 2013). Scenario 2: It is when fuel prices move above the swap execution price. As a financial compensation, the shipping line has to receive the difference between the market price and the swap price from his trading counterparty in order to offset high prices in the market (C, Cheetham, 2013). A great forecasting job must be done before entering into a bunker hedging agreement. Shipping companies need to be sure in terms of future bunker prices trends. Related factors such as new oil fields, global trade and international regulations must be always taken into account. When properly managed, bunker hedging can lead companies to generate bigger profits as the exposure to fuel prices fluctuations is removed. A freight derivate contract is defined as a financial contract between two different parties, where future prices for transporting goods by sea are agreed. Freight derivate contracts are usually divided into two main groups: Forward Freight Agreement (FFA) and Freight Swap Agreement (FSA) (Baltic Exchange, 2016). These derivate contracts are used by charterers and shipowners in order to hedge against fluctuations in freight rates. The main difference between the FFAs and FSAs is the assumption of risk. With FSA risk for both parties, with FFA risk assumed by the counterparty. FFAs cover the route, settlement date, contract size and contract rate. Lastly, the main difference between hedging and speculation is that speculation involves an activity to make profit and hedging only attempts to reduce economic business risk. QUESTION 10. OTHER SEGMENTS AND SPECIALIZED CARGOES: LNG stands for Liquefied Natural Gas and it is considered the third major energy source carried by sea, after oil and coal. It is one of the most environmentally friendly energy source which is mainly used for power generation and for the domestic use. LNG is considered a hazardous cargo which requires coated tanks and isolated facilities at port in order to safely handle its extremely low temperature (ICS, 2015; Stopford, 2009; Energy Annual Reports, 2016). LNG is usually transported by Very Large Gas Carriers for very long voyages. LNG can be also transported via pipelines, although for that liquefaction is needed. The transport of LNG includes four different activities: Transportation of LNG from gas fields to plants, via pipeline. Methane gas is separated from other substances and stored for sea transportation. LNG loaded into ships. Receive and store LNG at delivery terminals. The LNG costs are divided in the following proportions: 15% production, 40% liquefaction, 25% sea transport, 20% regasification. It is important to highlight that LNG trade is conducted with long-term contracts (Bareboat or Time Charters) with fixed prices. Main exporters: Iran, Qatar and Russia in less scale: Africa, Asia, North and South America and the EU. Main importers: USA, EU, Japan, S. Korea and China. QUESTION 11. PORT DEVELOPMENT: In order to better understand how ports and terminals develop, it is fundamental to focus in a specific port. In my case, the Port of Rotterdam has been chosen as it was one of my research topics at university. As shipowning companies, ports and terminals are in continuous development process where technology and efficiency improvement are always sought. Time reduction when loading and unloading, port accessibility, hinterland connections and the ability of create economies of scale in terms of cargo handling and cargo storage are some of the main reasons why ports have evolve from individual specialized terminals to huge multipurpose shipping hubs where not only shipping but also logistics activities are carried out(Notteboom and Rodrigue, 2004). It has led to improve the supply chain and the instalment of strategies such as JIT (Just in time). Spatial relationships between terminals are key points in port competition. In order to explore how terminals should interact with each other, two main concepts are highlighted: centrality intermediacy (Notteboom and Rodrigue, 2005). Centrality places terminals as a point of origin and destination traffic. It involves intermodal activities and gene rates economic activities in its vicinity. Intermediacy sees terminals as an intermediate point in the flow of freight. It could also be a good point to exploit transshipment (Notteboom and Rodrigue, 2005). The main reasons why some ports stop developing when they reach a certain stage are: lack of green fields to build new terminals (Eg, Southampton Port or the ICTT Terminal, Vallarpadam-India) and the strong competition from terminal global terminal operators such as Dubai Ports World and APM (Venugopal, 2014). For example, the Port of Rotterdam has been working for a long time in two main expansion projects. Firstly, Maasvlakte I which was completed few years ago, and Maasvlakte II which is still on-process. In terms of space, the Port of Rotterdam will gain a total of 20%-22% extra space to allocate the forecasted rising number of containers and enhance a more viable multimodal system. Economies of scale are achieved by the great number of containers that it is able to handle. Thanks to its dimensions, total costs are divided over more than 11.5 million TEU they handle every year. The provision of customer focused services as well as 24/7 cargo handling and storing activities enhance the port to provide a reduction on vessel ´s turnaround times what leads to better productivity. Last but not least, the proximity of the dry bulk and tanker terminals to key production and storing points give the port an important comparative advantage. It minimizes costs and increases safety and effi ciency in terms of time. The great connections with the hinterland and foreland makes this port a global shipping choke point (Notteboom and Rodrigue, 2004). In order to remain globally competitive, attract foreign trade and increase the total volume of exports and imports, countries have to encourage private operators to invest in national ports infrastructure including port configuration, handling equipment and port connectivity. QUESTION 12: THE CONTAINER SHIPPING MARKET: Over the years, container shipping lines have placed increasing amounts of hope in the notion that the trading growth being experienced in emerging markets would improve the demand of containerships. However, as a large number of Super-Post Panamax containerships (ULCV) of size between 13,000 19,000 TEUs being introduced to the market, increasing the current total capacity of world containership in service to 18.2 million TEUs; the overcapacity issue looks set to continue in 2015, although less severe than year 2009. Currently, the largest containership recorded in the industry are the sister vessel MSC Oscar and MSC Oliver with the size of 19,224 TEU (Lloyds List, 2016). The market is expecting to see more of such vessels magnitude being built and deliver in the near future. In terms of global trends ruling the container`s supply and demand, some facts can be highlighted: 1. Container ´s overcapacity: Timing is one of the main factors when referring to the shipping supply and demand. As great expectations were placed into the current market, many shipowners purchased bigger and more sophisticated vessels, which nowadays can ´t be employed. 2. Emerging economies power demand for shipments: Containerships owners can still find a glimpse of light for this market in emerging economies. For example, Nigeria will see its population grow by 275 million by 2050. It gives an idea of the shipping potential of this emerging economies/countries. 3.Cargo adaptation to the container shipping method: containerization. Cargo can be directly shipped from the mill to the consignee, or even to the customer, making the shipping industry more efficient and safer. 4.Sustainability and environmentally friend: New trends have come up concerning about environment issues. It has radically affected the cost for carriers and consequently the vessel ´s supply and demand (CSR). 5.Customer focus and new technology: Development in technology mainly seeks compliance with new regulations and cost-efficiencies. The current lack of transparency along the supply chain can affect either supply as demand due to wrong market forecast or unforeseen constraints. The East-West trade is mainly driven by the import demand of products from China and India to Europe. However, companies are struggling on the return voyage from West to East. It makes operators to find different ways to optimize the empty containers in order to avoid the loss of marginal profit. In order to remain competitive, operators will have to follow some tendencies which will shape the container industry (ICS, 2015) Cost reduction and vessel optimization can be achieved through forming shipping alliances between containership operators. The alliance agreements generally cover areas such as the type and size of vessel to be employed on each route; itineraries; port rotations, chartering of ships; feeder services and the coordination of inland services. 2M, O3, G6 alliance and the CKYHE. Slow steaming can be also applied (Lloyds List, 2016) Another way is the slot chartering: By leasing out part of the vessel ´s slot during the return voyage from Europe to Far-East, operators can obtain optimum efficiency of fleet operation and to maximize slot utilization (Lloyds List, 2016). And last but not least, cost-savings measure adopted by operators is through the use of longer routes in the East-West trade. For instance, instead of using the Suez Canal, ship operators may choose to travel by a longer sea route through the Cape of Good Hope enabling operators to accommodate additional ships with a similar frequency of port calls and reducing the overcapacity issue. 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