30. OSK-DMG ShippingPrimerDrivers-TheBasicMechanics Sep 22 2011

PP10551/09/2012 (030567) 22 September 2011

OSK Research | See important disclosures at the end of this report 1

MALAYSIA EQUITY Investment Research

Daily

Sector Update The Research Team [email protected]

Shipping Primer & Drivers

The Basic Mechanics

Equal-weight

(Looking for

opportunities, but not

trying to be heroes

amidst a downcycle)

The Primer is a summary of major approaches to tracking shipping and

related markets. We always start with a survey of the dollar, commodities,

before moving to volume drivers and demand growth in excess of supply.

This is no rocket science but basic mechanics, which demonstrates the

difficult environment we are in, and the relative value opportunities. Looking

at value in gold terms rather than in dollar shows that the sell-down is even

more severe than commonly believed. This also illustrates the beginnings of

value. In recent months, we have witnessed further downdrafts in all main

sectors of CONTAINERS, DRY BULK, and TANKERS. But even in this tough

environment, there are strategies to consider while waiting for real value to

emerge. The starting point has to be strong cash flow backed by good credit.

Ports, especially some of the larger and more established, are beginning to

show signs of long term value appearing.

Figure 1: Despite Cautionary Stance, Ship Prices at Low Lows = Opportunity

(in Gold & CHF terms as a way to normalize performance in different light)

Source: Transport Trackers

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See important disclosures at the end

Shipping Big Picture In 2007, our main theme was the artificial feel to the rebound in container and shipping demand following an initial

correction in 2005-06. We could already see the seeds of a [long term] downcycle in the US and containers, with the

epicenter being a slowdown in furniture demand a full two years before the brunt of bank failures. After the big 2008

crash, came a 2009-10 rebound. But during this 2H09-2010 recovery, there were signs that the physical market did not

fully recover in tandem. In containers, our contention is that we face a different run rate to growth henceforth - simply

put from 9%-10% to 5-7% global growth in containers – assuming the consumer is still a little supported by western

governments‟ debt-ridden strategies. We also assume that a boom in China‟s consumer demand would take longer to

materialize, and also that the prices of manufactured goods move sideways and not up. If, in the best of all worlds, for

world governments, central banks truly succeed at printing away, container growth could come in at the high end of

estimates, making container shipping a leveraged play on further bailouts.

Containers still off-balance: A long-term trend in containers carried over from the earlier breakdown post-Asia Crisis is

a trade imbalance that left a large surplus of empty containers returning to Asia from the developed markets. The next

but slow change – of a different kind – is a switch in dominance of drivers from the US and Europe trade growth to new

trade patterns (including the further establishment of recent trade pattern changes in bulk to further emphasis on Asia-

China inbound with respect to commodities, although this summary is simplistic). In short, the holy grail for a container

rebound is the rise and rise of China and China consumption, which is a strong possibility in 5 to 20 years, but which

can still prove problematic in the short run.

Away from containers, the surface impression of many investors has been that shipping is pretty much the same all

around. One might note, after all, that tanker stocks are just as sold down as bulk stocks currently. In bulk, for instance,

a cycle may have similar drivers (US free money policies, and partly, global trade liberalization, etc), while in reality, in

demand and supply terms there are large differences (i.e China‟s industrialization growth is greater than US consumer

demand growth). But further up the capital and asset decision supply chain, most sectors are joined at the hip through

bank lending, shipbuilders, steel costs, and so on. In other words, there tends to be an over-supply of ships of most

types currently.

Tracking companies long term: From a mile high perspective, the main investment decision is to buy into well-run

companies, and sometimes some less well run companies, at cycle lows. In general, the well-run companies had held

on to their recovery-level share prices better, perhaps as far as into 2Q11, while the weaker companies saw a

deterioration of their share price set in early on. The panic selling starting end-July and mid-August for most shares

dealt major damage to transport shares, but offered a glimpse of long-term positioning opportunities. In a longer term

perspective, accumulating after deep corrections appears more obvious than identifying tops to sell into. Value investors

can pick and choose at bottoms and hold. However, we can also be facing a slow moving storm if governments take

years to fully recognize the current problems.

Investors with long dated perspectives going back to the 1970s and 1980s – this can sometimes be seen in shares such

as NOL, NYK, Maersk B (previously D/S 1912, SEDOL 4248754, replaced in 2003) and a few others – recall that the

same general correction in commodities post early-80s also plunged shipping into a multi-year depression.

An initial conclusion is a sector is only as good as its supply-demand balance. Demand is important and can provide

good leading indicators at most times, be it consumer demand in developed countries or oil and iron ore demand in

China. But ultimately the best fit with profitability and share performance comes from understanding forward net

supply surplus and deficits1. Scrapping trends can also be an important indicator.

Given that pulling out or making major changes to capex planned for fleet purchases is not workable, especially in the

age of free money, easy credit and get-out-of-jail cards for many corporates, capacity growth hangovers can remain

a noose around the necks of many sectors. Only specialty sectors have fared better, with some energy related

sectors proving to be in a different part of the capex cycle than shipping in general. During most of 2011, almost any

analyst or investor would have liked to hang their hat on Offshore and LNG.

In the big picture, whether we have turned to tankers, dry bulk or container shipping, the market has been bingeing on

capacity and needs cooling off and consolidation, in the form of vessel scrapping and restraint by lenders and

governments (including China, Korea, etc). Currently, lending appears to be more limited after a brief rebound in 2010

(China is often associated with more loans, but this is still limited). Ideally, we need it to get softer yet to squeeze out

more marginal players.

1 The longer supply takes to market, the longer „the cycle‟ can last, and the higher the peak during periods of boom demand

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Shipping Drivers and Investment Tenets, circa 2011 1. Investing and Trading: Never sit on your laurels. Never say never. If you‟re in a stock, sub-sector or sector longer

term, be ready for volatility. Be agnostic. Consider that bad/weaker managements can be just as rewarded or

punished by markets as the better companies, due to national or lender support. Weaker companies which at times

may have more leverage, may have more trading upside potential (due to higher beta) from a bottom. There is a

price for everything. Seeking a trade, however, is not the same exercise as seeking a long term investment, to be

sure.

2. Corporate identities: Many China related shipping, transport – and of course other – companies are not

companies in the western sense. Contracts driving revenues can be fixed while costs can have significant related

party transactions. Assets can be transferred in and out, and investors are sometimes/often buying into spin and

concepts rather than clearly identified, independent, cash flow streams. COSCO Group makes an excellent case

study at many points in time, going back to the IPO of Florens in Hong Kong in the early 1990s, as well as the

corporate make-over experienced by COSCO Singapore after the early 2000s, and the COSCO IPO in 2005. Many

Chinese custom designed window companies can be good places in which to park money at cheaper nominal

valuations after or during market sell-offs (and provide some yield). A key issue is to understand the assets and the

parent, as well as potential regulation changes and restructuring implications.

3. Cycles, ‗supercycles‘ and Keynesian distortions: The lesson of the 1980s is that downturns in shipping (and

commodities) can last a long time, while the upstream sectors can hold up/outperform longer. One way to look at

valuations in a transversal perspective, we think, is to normalize the dollar out of the picture (look at the S&P 500 in

gold or Swiss franc terms!). Of course, we could use the Swiss franc (CHF) or the dollar against DXY index to re-

state vessel asset prices or project cash flows. We have chosen to restate long term series to mid-70s in gold

terms, with current prices at 40-year lows. Printing more money and issuing more debt (what “Keynesians” do) has

tended to debase currencies relative to gold, precious metals, commodities over the last decade, which seem

somewhat a repeat of the 1970s. When the tide slows or reverses, this could be positive for ship assets (and for

those with the cash and the patience, some positioning can be taken now). Shipyards also will have to cooperate

by building ships at a truer cost and not simply at variable cost. This is another key part of analysis – floor value.

Scrapping can be an important back test indicator.

4. Understanding USD shifts is key: The dollar has tended to be over-sold against most major currencies, a

phenomenon supported by the Fed and other parties seeking to jump-start the US and global economies. Our work

on long term data series indicates that global trade and growth tend to be stimulated by a long-term weakening of

the dollar, driven by debt issuing western and US consumers. It appears to us that this period is undergoing a major

structural shift in stages since the mid-2000s (the US 2006 housing peak representing a peak of peaks, as well as the 2000

internet bubble peak. The Fed lengthened the 2000 peak and further enhanced nominal growth by lowering rates, which further

hurt the dollar, etc). Currently, world growth has nowhere to go, and this is the big risk. The dollar is down and interest

rates are at zero. Many believe that one of the only tools left is to force everyone to re-set lower through effective

write-downs of debt.2

5. China: China‟s leadership has played the game presented to it almost masterfully, but the level has gotten more

difficult and it too has to take some losses. The RMB has strengthened but is still underperforming commodity

prices. China has driven its own costs higher, and perhaps understood this in the last few years, setting off a wave

of strategic foreign commodity purchases and acquisitions in Africa, central Asia and other parts of the world.

China‟s economy is changing and maturing, with exports becoming a little less central. Ports will benefit less from

export growth but remain important. Inland infrastructure and logistics, meantime, is growing in importance. Focus

on the “go inland” concept long term is more important than infrastructure on its own. Logistics at 20% of or 2x

developed countries‟ GDP levels is telling. But going inland in size will be a challenge for both China‟s leadership

and the supply chain.

2 The US would not only be a paper tiger, but China would be holding too much US paper too, although this was a game China chose to play to grow

its exports, with the winners being Chinese who bought overseas assets.

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Sector Views & Data Approaches (what we like and don‘t like)

In general, we like volume data over value data, and unadjusted data over adjusted data. Ultimately, we only ever have 3-6 month forward visibility windows for most global trade patterns (and sometimes less!). In 2011, the weak pattern of container trade (consumer goods) was visible directly after Chinese New Year (and guessed at Dec-Jan). In bulk, demand patterns have been steadier, even if not stellar, with sector problems focused squarely on supply.

Ports and China: Most port data is what we like to turn to first for a read on consumer trade currents. There are only new orders data (which are less aggregated and visible) which can be forward indicating in trade. China has been at the leading edge of data gathering for just about everything in recent years, going so far as affecting historical patterns to bring them more in line with Chinese holidays and events. One example of distortion is the ports‟ own free-wheeling nature to help over-state some data by blurring the definition of what constitutes a container move, for instance. But the value of earlier reporting of port data remains a key contributor to global trade indicators.

Liners: Container shipping lines are great indicators although often managements do not turn on a dime. Managements need to consolidate and be sure of their view, and so often wait a few months to confirm downturns or turnarounds. This has been shown time and time again. The best approach is to drill managements and investor relations on current data points, when it is possible to discuss (i.e not before results). We have found middle management and anecdotal glimpses into core operations often more telling than public presentations by CEOs. This is the nature of data gathering and research. Capacity analysis has become second nature to us; so what we care more about is net supply or net demand balances in terms of impact on rates. And we care more about an understanding of “net rates” or a clean Revenue/TEU figures than gross Revenue/TEU. Ultimately, we care about cost effectiveness, both financial and operational. This proved a miss for many analysts catching margin squeezes in 1Q11.

Bulk: Capacity surplus, especially in capes, trumps everything at the moment. It may be a few more years or longer until the enormity of over-production is digested. In recent years, congestion at load ports and their impact on the Baltic Dry Index and vessel rates in specific mattered. There was even a correlation to track. Now they matter little, until a very strong rebound can be established and load and receiving ports can be turned into parking lots, at which point rates could be driven higher to pay for the right to wait in line. This is related to China‟s predilection in the mid-00s for driving up its own costs of production. In 2003-07 and 09-10, China contributed to commodities‟ over-demand, at risk of higher than needed input costs and increased pollution.

Tankers: The drivers of wet bulk are similar to dry bulk because the financial returns are similar – in both cases we are looking at returns on physical assets to owners for most listed companies. However, the differences widen afterwards. Bulk ownership is more diffuse and tanker market control is more concentrated. And tankers are subject to more environmental and regulatory oversight and therefore carry more financial risk. The potential for a better investment case once a downturn is firmly grasped, as now, is that the costs to stay in the game can be higher with tankers. Burning capital can be that much faster, which can help speed up capacity exit for all but the diehards. But here as elsewhere, distortions from yards and sovereign subsidizers must be held at bay (most recently China had begun making large orders for VLCCs, but the magnitude has yet to be confirmed). A chart on how bad the lay-up process got in mid-80s illustrates the scale of the problem once capacity is too great, and demand falls off. Please refer to the appendix for additional charts.

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Shipping Drivers (when fixed is variable and variable is fixed…) Container ships: Ships are assets first and should be followed from the ship owner perspective first, and from a container demand perspective second (see directly below). Container drivers: Consumer spending (not GDP). Long term growth peaked at 10% long term demand in late 00s after rising through 8-9% long term growth. Growth could fall back to 5%-7% long term if a developed country‟s consumption is curtailed (or lower if there is a severe debt issuance shutdown). China growth inbound will contribute to some rebalance in trade which was lost during the Asian Crisis. Re-balancing could take time and will not contribute to lead (outbound) leg strength in the short term. Capacity: Supply growth was over-stimulated by easy money. China‟s competition to match and surpass Korea (and emulate Korea‟s own experience in surpassing Japan in the 90s) will continue to exert pricing pressures on asset prices and contribute to deflation of transport costs. In this Primer, we discuss briefly the return profile for a new 14,000TEU vessel at about USD125m (about USD8,930/TEU slot cost) Costs: For all sectors but clearly explained in containers is the need to keep costs down. If in general there is a 50-50 split in fixed and variable costs in containers, fixed costs can structurally be kept lower and variable costs can be tactically managed. An 8000 TEU ship that cost USD130m at some point around the peak and USD80m recently can lead to entirely different: i) capital deployment, ii) depreciation profile, and iii) financing and credit outlook. The same apply for most capital equipments. Variable costs, ironically, can be more „fixed‟ as competitors exhibit similar breakdowns. Port costs can be negotiated lower through economies of scale and engines can be made to be more efficient. But the cost of fuel is essentially the same, unless the concept of timing (mismatching) is used to advantage in hedging strategies. Ultimately hedging can be applied to assets, debt, interest, currency, and fuel. Container boxes: Steel prices and the shortage of trained supervisors as well as oligopolistic manufacturer influence have led to record high USD2800/TEU type prices. Containers ultimately answer to container shipping and consumer demand, and tend to lag container shipping. Container ports: Within shipping, ports can be defensive as pricing tends to be fixed. Chinese ports have been strategic given their window status for China trade. However, over-building of container berths has increased the risks. Nonetheless, defensive characteristics remain at the margin. Valuations can be discounted cash flow-based using infrastructure approaches to valuation. Topline drivers originate in shipping, but project structures can be rooted in corporate finance. Bulk ships: Bulk ships ranging from large Capesize and VLOCs to small Handysize should be seen from a shipowner perspective and evaluated from a long-term return potential by ship type, with consideration for some ship types holding greater forward relative cashflow generation capability than others. For instance, a vessel with lower fuel consumption as a result of a better engine can generate vessel operating savings, which can be reflected in a more advantageous vessel charter rate. Bulk drivers: China has been a key driver since about 2003. Even seasonal patterns have been altered from previous stages of the global industrial economy, when Japan and some European countries played a greater role in the industry. Steel and related typically occupies more than 50% of bulk demand, including iron ore, coking coal and steel itself. Please see seasonality chart at the back. Tankers: Tankers range from large crude oil VLCC types to smaller Aframax, and also to product and chemical tankers. As with bulk and containers, larger vessels typically exhibit greater revenue volatility. Long term charter rates have been volatile and generally at or below cost recovery recently. Poten Partners in July estimated break-even at about USD40,000/day, although a lower entry cost can lower break-even levels. In August, a 298,000-dwt 1995 built VLCC was reported sold for USD25m (Apr ‟10 sold for USD49m). Older vessels tend to trade at bigger discounts during downturns. Tanker drivers: China oil demand, combined with Japan and S Korea, make up about 30% of seaborne crude imports of about 40m bbl/day, most using VLCCs (about 2m bbls per vessel). Asia‟s is about 45%.

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Data Relationships as Best Go To References (to start a long triangulation process)

1. Big Picture First. Commodities. Dollar versus everything else: Dollar against CRB Index, dollar vs Gold, dollar vs Oil,

dollar against main currencies. Recently, dollar against Swiss Franc and Gold have been the greatest measures of risk in

the system, but there are so many other relationships to look at;

2. Trade Volumes Second. We think hunting for any volume data can be the most forward indicator of what will later turn to

price. In a second instance we want to know volume against capacity available as well. The best volume indicators in recent

years have been China-related, but include bulk demand, oil demand – and of course - manufactured goods demand

through container ports;

3. Shipping Price Indices Third. General level of Baltic Dry Index (BDI) as additional analysis only, Include

confirmation/non-confirmation from other indices. Much of time we have to be ready for a-synchronous investing

opportunities between bulk, tankers and containers. Our first recommendation is to break the dependence on the BDI – to

dismiss it. Only after looking at everything else can we come back to it and understand what to do with it. In recent years,

the CCFI (China Container Freight Index) has become more used for container freight tracking;

4. Macro. We dislike GDP and CPI data the most, and have found them over-massaged. We prefer almost any raw data over

massaged data for the purposes of understanding the current economic climate. The recent revision of US GDP for 1Q11

was a case in point;

5. Utilization. This is a wonderful indicator, one that is often buried, mis-interpreted or distorted by managements. Take for

instance Asia-Europe containers, which some carriers are able to operate above 100%.

BDI against dollar (commodities to dollar) long term summary discussion

As an example, we look at the dollar‟s performance as seen in the DXY Index. We don‟t say an inverse relationship is always there, although there is a general negative relation of BDI-dollar. There is an ebb and flow nature to the relationship, which is affected significantly by the time to market of the supply response to increased demand, and demand effects from a weaker dollar and stronger currencies. This chart below illustrates the DXY dollar index vs the BDI against the CCI (continuous commodities index similar to CRB).

Figure 2: Roadmap (not Trading Strategy) on BDI, Commodities & USD Correlations, 1985 – 2011YTD

Source: Baltic Exchange; Datastream; Transport Trackers

MEMO: 1) Need to understand rolling nature of correlations; 2) Need to consider events/timing/catalysts for correlation reversals; 3) Peak of peaks 99-00, as seen elsewhere…. All roads lead to internet and US, etc ‘00 bubbles (especially in gold terms)

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Continued discussion on Currencies and freight

We constantly come back to the US dollar level. Looking over long term data series we often see an inverse relationship between commodities and commodities related (ie, FREIGHT) and the US dollar. But understanding how i) breakdowns occur, or ii) reversals of correlations developing are more important to us than looking at just the movements themselves. One – understanding breakdowns This is relatively easily put down to the nature of capacity growth in excess of demand, which currently is seen in most sub-sectors in shipping and related, ex offshore and LNG. Two—Correlation reversals Often we cannot point to a specific reason except a catalyst from one above. Once started, we often see a rolling nature to correlations. When the dollar is falling against commodities, it does not simply remain there. It waxes and wanes, despite a long term trend to a negative correlation. Our conclusion, after plowing through hundreds of data series is the dollar has been often used and abused, brought down in value longer term, either by conscious or sub-conscious design, with the aim of stimulating global trade and growth. This is where we have big differences with many strategists and writers (Thomas Friedman comes to mind first). The dollar‟s decline has been a key part of US leaders‟ strategy, right and left, as an attempted cure-all. We can go on, but the point is that has been used as a policy tool, knowing that it could. We recommend reading up on the topic of Seigneurage, with reference to Paul Craig Roberts. Please see http://en.wikipedia.org/wiki/Paul_Craig_Roberts for an introduction. A fear we harbor with respect to global trade is if a dollar rebound managed to work its way through the global system (rather than just competing devaluations against gold), that this would present yet another blow to global trade and create yet more excess capacity. The silver lining is that this would speed up the process we have been awaiting, which is the exit of marginal capacity in containers, bulk and tankers. We are aware that an exit of tonnage is something that can happen in a partial manner, particularly due to excess capital in the system.

http://en.wikipedia.org/wiki/Paul_Craig_Roberts

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Navigating Price Performance and Value Ranges Share Performance

Share prices and asset prices need much context in order to understand where the value is. In the case of NOL, a P/Book chart tells us something, but not everything. The issue with NOL is that the book itself was not too stable during certain periods. The PE has been irrelevant for most periods, and EV/EBITDA as well as other metrics have also been misleading much of the time. At the end of the day, P/Book still manages to capture the essence of understanding where value is (although over shorter term periods, this may not equate to share trading gain). In the case of OOIL, the share price was initially dormant during a long period of ignorance until the first phase of the “big China boom 2002-2007.”

Figure 3: NOL Price/Rolling Book, 1983 – 2011 YTD (at least 6 entry points since ‘83)

Sources: Datastream; company data; Transport Trackers

Figure 4: OOIL Price/Rolling Book, 1994 – 2011 YTD


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Figure 5: NYK in Perspective – The Counter Has Been Making New Lows for 20 years (in JPY terms)


Asset Cashflow (container ship) and Price Performance (bulk ship) Another way to drill down is to go behind the companies and understand how their assets are performing. First, we look briefly at a cash flow profile for a new, state-of-the-art 14,000TEU USD125m container ship long term charter, which we assume in the mid-40s (ie, more than USD43,000/day and less than USD47,000/day) on an initial 10-year charter backed by about 70% financing at about 5% money for a good credit (assume repayment begins after year 5 and evenly amortized to end). We ran a few versions, including one beyond a standard 25-year lifespan, but illustrate below a 17-year project with a sale at end of project using a straight line (of course it might sell above or below if at a particular point in the cycle). Generally, what we found was the unleveraged hurdle rate of around a conservative 6-7% for the project (we used to talk of 9-11% a few years ago, and perhaps some can still seek to go as high depending on cost management, asset cost and other timing and scale issues), based on ever lower charter rates after the initial 10-year charter period. Cash flow multiples ex financing and “PE” multiples are all over the map. In general we believe the 14,000 TEU vessels will be core workhorses in the Asia-Europe trade in the coming years, if for nothing else then per unit capital and operation costs will be lower than the previous workhorses in the 8,000+TEU group.

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Figure 6: 14,000 TEU Project with a 17-yr Lifespan (DCF of $125m equates to 6-7% discount rate)


It‟s not only about the cashflow profile, but also the opportunity costs around price asset entry ranges. We often bang our heads against the wall or jump on tables and shout that tracking performance in dollars is misleading, as it has been used as the currency of choice to show price moves and profits, when in reality it has fallen in price faster than many other currencies. A more accurate gauge would be a basket made up of {USD+CAD+CHF+JPY+EUR+XAU…}. We showed the performance of a Panamax (mid-sized bulk ship) between 1976 and now on front page, and below we show a few more vessel types. Figure 7: 5-yr Old Bulk Ships in Gold Ounces, 1976 – 2011YTD


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Ship Store of Value Functions and Price Movements of Various Series

Historically ships have been used as store of value. The Shanghai region‟s Chinese families were and are large owners pre and post the 1949 founding of the PRC, with ships as movable store of value. Greek families have been well followed large owners, as are the Scandinavians and Japanese. And the City of London, where an entire class of “economic” migrants has settled, remains a shipping center despite the nexus of trade having long since moved away. And let‟s not forget Switzerland, also a strong backer of international shipping via private bank feedback loops stemming from corporate and trading division sourcing

3. Hong Kong and

Singapore, of course, have been at the center of trade and have made much effort to growing the use of their flags of convenience, and providing a low tax environment for ship owners. It is a key concept to understand ships for many classic owner families as floating properties, which we also like to call floating DCFs. Vessels are movable in terms of domicile and in terms of earnings power; some more than others. Some vessels also exhibit more stable cash flow streams while others, often larger vessel types, tend to exhibit greater volatility. Over the last 20 years, we have developed many ways of tracking relative and absolute vessel value, as well as volatility. We have looked at price moves and price inputs in USD, JPY, KRW, CHF and Gold. Currently our short cut presentation to illustrate the value picture is to translate vessel value into gold terms

4. Something tycoons did not count

on 20-30 years ago was the extent of the decline of the US dollar. To add a bit more detail, and with a hat tip to an old friend for additional insights, the Shanghai shipowners in large part came from mercantile families, particularly bankers, which very much viewed ships as floating assets where they had had landlocked assets expropriated, and by moving to Hong Kong, were living in a borrowed place on borrowed time and perhaps didn't know where they would go next. Tokyo shipowners evolved to serve a resource poor country with imperial mercantile aspirations. But with exceptions, these were zaibatsu-oriented shipowners. Of course, in the past 40 years, a good many small shipowners have also been said to be linked to gangsters and the yakuza. While some very old Greek owners came from mercantile families operating in the eastern Mediterranean (eg. Niarchos-Coumantaros), a very large number of the modern Greek shipowners had merchant marine backgrounds as ocean-going ship officers, who saw the largesse offered by the US government in the wake of WWII and seized the moment (pooling personal and family funds) to buy very cheap ships being virtually given away in the late '40s and into the '50s. The real old line Scandinavian shipowners were in many cases whalers who then downstream integrated with ships to carry whale oil, evolving into petroleum products. Of course, at one point or another, the lives of almost all these groups were disrupted by wars and/or threat of totalitarian regimes to recognize the subsidiary virtue of ships as floating assets. But one has to remember that these same people have also been through tough times. The Suez Crisis of 1956-57 was a period of great volatility that was punctuated by a short-lived tanker boom around a half-year closure of the Canal. The more memorable crisis – and bigger drop off on the charts – is in the wake of the second Oil Shock of the 1980s. These are two such times we can think of when the so-called floating assets became floating liabilities. The 1980s were the quintessential post tanker boom periods, where tankers were found in lay up in the fjords of Norway, Eleusis Bay (Greece), Trincomalee (Sri Lanka), Johor River (Malaysia), Labuan (Borneo, Malaysia), etc. We need to consider another such period, or variant for certain/some/many ship types, especially if globalization is eclipsed as an economic ideology. The painful thing this time around might be the greater sophistication of ship equipment leading to greater vessel deterioration and damage, with problems not only of sagging crankshafts, but also damaged electronics.

3 The general mechanism is for a high net worth family with an operating fleet of vessels to receive lending and trading activity support from a bank in

return for a total relationship, including private bank deposits. This is considered quite traditional business activity. In a 2007 newsletter (27/8/07; Dorothe Enskog; Financing of Ships, a Lucrative, Growing Business), Credit Suisse gave the following description: “Credit Suisse opened up its ship financing operation back in 1943 under the name Swiss Ship Mortgage Bank. The unit, now named Credit Suisse Ship Finance, belongs to the 10 largest players in terms of exposure... About 500 vessels are currently financed by the bank, with its largest exposures being in Greece, Italy, Germany, Hong Kong, UK and Russia. Credit Suisse counts most of the internationally renowned shipping lines among its client[s]. A majority of these shipping lines are still in the hands of high-net-worth individuals, „Thanks to Credit Suisse‟s global structure, these clients can easily benefit from our bank‟s private banking, investment banking and asset management expertise…‟ ” 4 We don‟t consider gold in a bubble, and selling off would not be the bursting of a bubble, per se either. Gold is simply a money equivalent which

“balances the equation” of too much debt and paper issuance. Issue less paper and the need to chase gold declines…

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End Game Best Sector and Asset Entry Points In short, we want to see the whites of the shipping downturn‘s eyes to mark an entry point into re-investment in the sector. We are not there yet, but it is getting interesting and worth evaluating the opportunities. We are tracking and want to understand, and in 4-D not 2-D, as best we can: i) vessel scrap and price action, ii) vessel scrapping in terms of tonnes by vessel types, iii) new vessel orders and by type, iv) government subsidies and private investment patterns, v) ship prices for new and old and the relationship between the two, vi) volume drivers and cargo pricing around supply-demand responses (and pricing of cargo to ship, just for interest).

The dynamics of understanding scrapping are changing, with for instance less than 10m dwt of single-hull VLCCs to scrap (and even fewer Suezmax and Aframax), which implies that tanker scrapping from now on will focus on more modern double hulls. (But also refer to our 1980s lay-up chart in

Appendix III.)

Ultimately we need a level of capitulation by investors, who have been all too eager to trade back in at every opportunity. And share ―trading‖ in or out represents more short term trends, which we see a few times a year. So far, none of these have been ―the big one.‖ Holding back a bigger correction, on the order of what we saw in 2008-1Q09 (and perhaps more and/or for longer), has been the existence of too much cheaply available capital, which has encouraged low quality investment decisions in the sector. Flushing this out would be one of the biggest positives longer term. The risk of putting too much capital to work now is we get a 1980s-type downturn in some or all sectors. The risk here is we don‘t get a black and white denouement in the coming years, as that excess money never leaves. Given this scenario, we have to quote the Architect in the Matrix: ―There are levels of existence we are prepared to accept….‖

The greatest risk is failure all the current machinations to kick start growth, leading to a reversal of globalization. This is our worst-case expectation, which investors should consider and have a contingency plan for even if they don‘t believe it can happen.

At the other end of the spectrum, we think there is almost always room for well thought out strong credits. For instance, strategic projects ranging from energy related to bulk, and even containers, can be structured for investors to participate in. Most projects are not open to equity investors but some strong corporates which participate can be listed companies. We think also during selloffs, some port companies can be seen as defensive. Ultimately, equities after selloffs require the same commitment as private equity opportunities, and may offer opportunities often open only to specialized investors.

. Figure 8: Scrapping Eventually Has to Peak at New Highs, or… (a peak in 80s, and then again later…long discussion)

Sources: Clarksons; Transport Trackers Note: Recent single-hull tanker scrapping increased…but was not a peak; needs discussion

OSK Research



APPENDIX I Global Trade, Free Rides and Keynesians5… (Key Long Term Issues To Address)

Government use of capital is less efficient than private use…yet the government has crowded out private.

Despite an attempt to be recalcitrant after the fact, Greenspan failed at a very deep level. The crime was

he was conscious while committing his errors (contrary to belief by some that he somehow symbolized Ayn Rand, we

believe he had little to do with her in practice, as soon as he became a politician).

Greenspan was not alone: Certain bank executives and government officials had structurally over decades,

taken advantage of the consumption power of Americans and others, and their power to consume above their

budgets to support some supra-national concept of democracy (in earlier days, it led to fall of the Soviet Union. But

as a machine, it over-stepped its bounds. The Wal-Mart and related effects were wonderful, but post Asian Crisis we could

see physical trade imbalances move to a new level. (See the container imbalance chart in Appendix III.)

The Federal Reserve, central banks and money center banks took the easy way at every turn, leaving the

dollar to slide among most currencies as well overall against gold/commodities. A weak dollar was used to

stimulate global trade. The evidence was pretty clear that trade and global growth benefitted from a weaker

dollar, and tended to be hurt when the dollar rebounded. (Please don‟t hesitate to ask for long-term trade to FX charts)

Ultimate power corrupts absolutely – and what has been corrupted is capitalism. We could say other ages

have said „this time it‟s different‟ and that the nature of capitalism is distorted differently in different epochs.

Technology and internet leveraged the bubbles. Fixed assets, commodities, ships… all went on the ride.

China State Capitalism has almost shown it can be more focused and better in some ways, although

much is hidden behind a screen of silence and privilege.

Most current systems are built around structural debt growth. Mercantilist concepts were perhaps thrown

out hundreds of years ago; de-pegging currencies from gold/silver, allowed for excess trade, debt, money – and

trade growth. A discussion is excess versus balance (and back to absolute power) and if mainstream thinkers

truly think there can be balance within excess, or whether tethering the world to gold or other relatively finite

quantities is simply what luddites only would do.

Keynesians control the air waves and balanced discussions are difficult to have within the mainstream.

Free rides in transport, included i) a declining dollar, ii) artificially low interest rates, iii) over-stimulated growth.

DECLINING DOLLAR: Stimulated Asia and exporter growth and turbo-charged European demand for dollar

based production areas from exporting centers. But in recent years, it has still not been enough to rebuild US

exports post Asian crisis declines, at least not yet. We had consistently seen the weak dollar stimulate trade up

to 2007. In transport and shipping, this used to assist high net worth entities (note: ships are floating assets)

preserve value in dollar terms. Think Onassis…in simplified terms.

LOW INTEREST RATES: The Fed‟s „crime‟ and unpardonable support of politicians, though many show the

Fed has never really been impartial since its creation, is to represent, ultimately, the interest of the banks. We

do not fully know the real rate of “inflation” (to use the term as mainstream uses it), but the there is a non-

consensus view that it has been understated. GDP, GDP deflators, CPIs have all been of limited use to us. Real

interest rates may have been more negative than believed. To hold cash is a crime; to issue debt is glorious.

OVER-GROWTH: Over-stimulated growth attempts, all during a period of declining western competitiveness in

the US and many parts of Europe. Simply put - mascara on the ageing face of the OECD.

OUTCOME: We advocated gold not as an end in itself, but as good defense. Was gold‟s general price rise a

reflection of the rise in the stock of {debt + money} issuance? We think so. If debt and money growth were too

linked to each other, was it not expected that ship prices should make new modern day all-time lows in gold

terms during the deflation period? Nonetheless we have to find links to steady credit backed cash flows, which

does not mean high-priced charters which can default, but low-cost assets with low operating costs within

conservative corporate structures. At the other extreme, and with care, also over-sold state-linked assets, which,

though representing the root of the problem, nonetheless offer protected cash-flow streams if there is a national

interest in continuing such streams. China needs more assets to control its own supply chain. Entry prices important.

5 We use Keynesians as loose term for establishment thinking and any/most officials and executives who believe and who act as such, usually through un-questioned assumptions, on spending above saving, creating money without identifying assets or positive cash flow streams behind money creation. Mainstream has gotten so use to thinking of Keynesians as one school, and without noting that the entire system is framed in spending and debt creation above net accumulations of capital. In addition to Wall Street, banks and governments growing in size as part of the process of levers in negative capital accumulation – accumulation of debt – trade has also benefitted immensely.

OSK Research



APPENDIX II Quick Reference Shipping & Transport Terms We recommend looking at http://www.marad.dot.gov/documents/Glossary_final.pdf for a full glossary of shipping terms

Key Units

TEU: The main unit for container shipping for popular consumption. A TEU is a twenty-foot equivalent unit; holds about 27cbm; weights about 2 tons empty

FEU: The main unit for container shipping for most industry players. Forty-foot equivalent unit (or 2 TEU); holds about 56 cbm; weighs about 4 tons empty. Specials Special container sizes and types include tank, high cube, 45-footers, etc and can contain chemicals, Autos, etc. Today, most large retailers and logistics players seek to maximize use of high-cube 45-footers and FEUs

Dwt (or DWT) Deadweight tonne: Most often used to measure cargo carrying capacity of vessel. It is a measure of the ship as it is dead in the water when loaded. Most often a tonne refers to 1,000 kg and can also be referred to as metric ton, as opposed to a long ton of 1,016 kg and short ton of 907kg. We often, in general discussions, use “tonnes” or “tn.” Vessel draft and loading (as well as speed and displacement) will all be affected by water types and temperatures (fresh water is less dense than sea water; warm water is less buoyant that cold water). Please refer to Plismsoll Line references such as http://en.wikipedia.org/wiki/Waterline

CGT: Compensated gross ton for measuring level of shipbuilding output in value adjusted terms

Cbm: ...in LNG transport:, 1 cbm = 0.425 - 0.475 tonnes LNG (1 cbm LNG = about 21.8m btu)

Popular cargo movers

10,000+, 13,000+ all the way to 18,000 TEU: Transport Trackers have written a number of pieces on these developments and recommend a longer discussion. Please begin with http://www.worldslargestship.com

8,000+ TEU: Still useful but will be obsolete for Asia-Europe trade soon (up to 10,000+TEU) in post-panamax fleet

5,500+ TEU: Old workhorses of East-West trades, formerly efficient. Biggest of the late-90s. Price had risen to $87m 2005.The 4500+ TEU were the first gen of the big mamas that took off after the mid-90s

2,000+/- TEU: Workhorses of regional trades. But 5,000 TEU ships types have been cascading (shifting down) to Middle East and India, etc trades for awhile. Smaller vessels more likely to be 'geared' for self loading. Smaller vessel role will remain for smaller ports not enlarging basins, approaches, and/or not able or willing to upgrade

VLCC 200,000+ dwt: USD150+m (pre-07 old:120+m) peaks. Carries 2+m barrels of oil. Modern tankers are double-hulled. OPEC to Asia is main trade

Aframax 90,000+ dwt: USD75+m peaks. Workhorse of regional trades. Also used, after adjustments, offshore rig shuttles or lightering in US Gulf

Capesize 170,000+dwt. USD90+m (USD145m re-sale) peaks. VLOCs= “Valemax”… Baby Capes are 120,000+dwt. Main transporter of iron ore, though Handymax 40-50,000dwt popular shorter haul India-China. New classes of bulk ships have emerged blurring the lines for what is a Panamax (which can range from 60-80k dwt) , which has long been a liquid, well followed mid-size bulk vessel. Supramax at 50-59,000 dwt. Kamsaramax at 82,000dwt. Size categories can shift by source, time period and source

LNG carriers: Workhorses were in 125 - 145,000cbm range, but recent upsizing for longer haul to above 200,000cbm. Trade dynamics are evolving…

Air Cargo Basics

Load factors: For Air, RTK/ATK; for sea TEU/TEU capacity. Often 80-100% full on outbound leg and 50% or less full on return leg

Yield (airlines): Air cargo = Cargo revenue/FTK; Overall yield = Cargo + passenger revenues/RTK. For RTK conversion from passenger to cargo equivalent, use about 11

FTK = Freight ton Km; ATK = Avail ton Km

B747-400 ERF: Best cargo freighter with popular loading cargo to about 110 tons recent versions. Lowest oper cost/tn mile. USD80-190m pre 9-11, USD130-150m post 9-11, USD150-200m mid-00s, and currently estimated above USD200m. Freighter lifts 124 tonnes air cargo (ie, 2x most) 4450 nautical miles. B747-400F (1st delivery in 1993) and B747-400ERF (1st delivery 2002) http://en.wikipedia.org/wiki/Boeing_747-400#747-400ERF. The 747-8F is next in the 747 evolution and closer to 140 tonnes loading (nominal pricing about USD300m). http://en.wikipedia.org/wiki/Boeing_747-8 ….The A380F lifts 150 tonnes.

http://www.marad.dot.gov/documents/Glossary_final.pdf

http://en.wikipedia.org/wiki/Waterline

http://www.worldslargestship.com/

http://en.wikipedia.org/wiki/Boeing_747-400#747-400ERF

http://en.wikipedia.org/wiki/Boeing_747-8

OSK Research



APPENDIX III Selected Additional Charts ‗Tis the Season for Chinese New Year … BDI WoW % Changes (BDI CNY seasonal bias upside)

Sources: Transport Trackers; Baltic Exchange

WoW % BDI Changes All Series, 1986 – 2010 (2010 emphasized in purple bold)

Sources: Transport Trackers; Baltic Exchange

OSK Research



BDI Standard Deviation Ranges Based on Entire Period (to make a point…) Apr ‘86 to early Sept ‗11

Source: Baltic Exchange; Transport Trackers

NOTE: Rebound to 2,000 level in recent days/weeks, partly shortage of good credit ships and China demand based on price oppty

Tanker Lay-ups as % of Fleet, 1970 – 1998 (note: this falls into our discussion with scrapping)

Source: Clarksons

OSK Research



Container % Imbalances in Transpacific Trade (boxes to Asia as % boxes to US… more recovery needed)

Sources: JOC Note: This is a simple calculation main issue; core tradelane data may vary

Transpac TEU Volume Annual Patterns, 1997 – 2011E (expecting zero growth in Transpac East)

Source: JOC; Transport Trackers

OSK Research



Container YoY % Port Comps: Singapore vs S. China (HK + Shenzhen), Jan ‘00 – 2011YTD

Source: Ports; Transport Trackers

S. China (HK & Shenzhen) Ports & China Less Shenzhen+Shanghai Y-o-Y % Change, 2005 – 2011 YTD

Source: Ports; Transport Trackers

OSK Research



Divergent Container $Rev/TEU and Bunker $/TEU in 2011E

Sources: Transport Trackers

Average Bad Case for Global Container Volume and Rates 2011E – 12E (Also depends on Govt Deficits)

Sources: CI; Carriers; Drewry; Transport Trackers

OSK Research



China Containerized Freight Index (CCFI) Y-o-Y %, 1999 – 2011YTD

Source: CCFI; chineseshipping.com.cn; Transport Trackers (NOTE: TT Intra-Asia = avg of Japan, HK, Korea, SE Asia, OZ/NZ)

TEU Standing Fleet in ‗000 TEU, 1994 – 2012E (above trendline…)

Source: Clarksons; Transport Trackers

OSK Research



This is the first report on the transport sector from the collaborative effort between the OSK‟s regional research team and Transport Trackers. Transport Trackers (“TT”) was founded in 2008 by Charles de Trenck. TT aims to provide unbiased, comprehensive market coverage of the shipping, ports and other related sectors ranging from logistics to shipbuilding. Based in Hong Kong for 20 years, the founder has spent most of his time as a rated Transport analyst. Contributors to TT included industry veteran Niels Kim Balling, an occasional contributor based in Malaysia in recent years who recently passed away at the age of 60. Please refer to www.transport-trackers.com for a profile.

http://www.transport-trackers.com/

OSK Research



All research is based on material compiled from data considered to be reliable at the time of writing. However, information and opinions expressed will be subject to change at short notice, and no part of this report is to be construed as an offer or solicitation of an offer to transact any securities or financial instruments whether referred to herein or otherwise. We do not accept any liability directly or indirectly that may arise from investment decision-making based on this report. The company, its directors, officers, employees and/or connected persons may periodically hold an interest and/or underwriting commitments in the securities mentioned.

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Documents

30. OSK-DMG ShippingPrimerDrivers-TheBasicMechanics Sep 22 2011