As any sailor knows, conditions can change quickly at sea. Just a year ago, armadas of ships queued outside global ports waiting to transport containers at record rates, while owners collected stellar profits. Yet, as we enter 2023, port queues have mostly disappeared, rates have tumbled, and container liners are facing a crunch. S&P Global Ratings believes those challenges will peak over the next 12 months when container ship operators will struggle to limit the severe rate correction as supply growth outstrips demand.

Liners will have to react to protect currently robust creditworthiness. Their efforts to limit freight rate declines have largely failed so far due to weakening demand, the release of tonnage that was parked at congested ports, and accelerating deliveries of ultra-large containerships. Inflation, meanwhile, has swollen operating expenses.

Disciplined capacity management will be key, particularly given that supply-demand imbalances are likely to continue through 2023 and into 2024. Nonetheless, we believe that average freight rates could stabilize in 2023-2024 above pre-pandemic levels, which would allow container liners to (at least) cover operating cost increases since 2019. In our base case, we assume the industry can manage the excess supply using tested techniques including service cancellations (known as blank sailing), slow steaming, capacity reallocation, and perhaps deferral of new vessel deliveries.

A Different Outlook For Tankers

Not all shipping sectors are facing such obstacles. Tanker owners and operators are benefiting from tightening supply-demand conditions that should usher in a prolonged period of favorable rates (see chart 1). The oil-shipping sector's supply outlook is the best in at least two decades, buoyed by a record-low new tanker orderbook, while a structurally favorable shift to longer trade routes, the dislocation of refineries from importing countries, and stricter environmental rules provide further support.

Elsewhere, we see little scope for a rebound in average charter rates for dry-bulk ship operators over 2023, with the market likely to remain subdued by weak demand for commodities from China-- the largest global importer of iron ore and one of the largest importers of coal. Supply-side pressures are also likely to persist, with any benefit from an acceleration in the scrapping of older ships (due to sluggish demand and tightening environmental regulations) likely cancelled out by new vessel deliveries. Conditions could improve, though unlikely before late 2023, resulting in an uptick in rates that we incorporate into our base case.

Chart 1

Underlying the sector dynamics are macroeconomic and geopolitical uncertainties, which we expect will weigh on global shipping markets in 2023. Economic issues include cost inflation (headlined by the spike in energy prices), interest rate hikes, and dwindling disposable incomes. Geopolitical risks come from the ongoing conflict in Ukraine and uncertainty created by the surge in Chinese COVID-19 infections, which could lead to sluggish commodity imports and consumption.

The shipping industry will also have to deal with new environmental regulations' long-term costs, risks, and workload. That imposition accelerated at the start of 2023 when the International Maritime Organization (IMO) implemented regulatory measures aimed at improving ships' energy efficiency. In addition, a preliminary agreement has been reached to include maritime transport in the EU's Emission Trading System (ETS) from 2024. The new rules are structured so that much of their financial burden will be delayed, but it is further evidence that global shipping will not be allowed to shirk its climate responsibilities--not least because it accounts for about 3% of global greenhouse gas emissions, according to the IMO.

The Container Crunch

The container shipping sector limped into 2023 weighed down by the ongoing effects of the sharp downturn in consumer demand over the second half of 2022. Industry indicators, and container liners' recent financial reports, suggest that there will be little immediate respite, with a sharper-than-expected erosion in transported volumes likely to maintain pressure on freight rates. We expect global container shipping demand, as measured by boxes shipped, to increase only marginally, if at all, over 2023. That follows a 3%-4% decline in 2022, according to a January report by Clarksons Research, a provider of shipping data and intelligence. We expect that sluggish rebound (which lags our forecast for global GDP growth) will be anchored by macroeconomic challenges including inflation. Within that forecast, we see scope for market differentiation. That would reflect 2022, when Transpacific and Asia-Europe routes, which are dominated by consumer products shipments, experienced a sharper demand downturn than intra-regional and Transatlantic routes.

We are also wary of lingering macroeconomic and geopolitical risks to global trade. The potential for escalation and fallout from the conflict in Ukraine remains a significant concern. But it is the roiling of business as usual in China, where COVID-19 infections have spiked with the abrupt scrapping of the "zero-COVID" policy, that is most likely to dominate near term forecasting. A surge in infections risks stifling activity, and thus demand for shipping from the world's second-largest economy, the world's leading exporter, and the second largest importer. That could hurt capacity utilization and undermine freight rates. At the same time, a full and rapid reopening could prove an economic mixed blessing given that increased Chinese production and the loosening of manufacturing bottlenecks should be disinflationary, while increased Chinese demand for goods and services, as well as energy and raw materials, could support higher prices. Our expectation is that momentum from China's reopening, will fade, leaving its growth at about 4.4% in 2022-2030, and 3.1% in 2031-2040. That is well short of the 6% recorded in 2017-2021.

An End To Boom And Bust

It took a dip in consumer durables demand, the decongestion of maritime ports, and just a few weeks in September and October 2022 for container shipping rates to crash back to earth after a year-and-a-half of unprecedented highs. The Shanghai Containerized Freight Index (SCFI) tumbled to 1,006 on Feb. 3, 2023, down just over 70% from its average of 3,410 in 2022 and 3,750 in 2020, but still above its pre-pandemic average of 810 in 2019, according to Clarksons Research. The weekly weighted freight rate per 40-foot-container plunged to $2,030 at the beginning of February, near its pre-pandemic levels, from a high of $10,400 in September 2021, according to the World Container Index (as assessed by Drewry Supply Chain Advisors).

The falls have not been homogenous. Container prices tumbled on Asia-Europe and Transpacific main lanes, while Transatlantic and Europe-South America routes remained buoyant (see chart 2). Period tonnage markets dipped too, with time charter rates falling fast and far across all vessel classes in late 2022 (see chart 3).

Chart 2

Chart 3

The rapid shift in market dynamics has also raised the menace of oversupply, and with that lower-for-longer prices. New vessel orderbooks currently equate to about 29% of the total global fleet, up from an all-time low of 8% in October 2020, according to Clarksons Research, whose data suggests containership capacity will grow 6%-7% in 2023 and 2024, all else being equal.

Delivery schedules indicate that capacity growth will be lumpy. This is notably due to additions of ultra-large containerships ordered years ago by ship owners looking for economies of scale and better environmental performance. The addition of these large vessels will weigh on hopes of a rate rebound--particularly on the Asia-Europe and Asia-U.S. lanes where mega-containerships tend to find a home. The current delivery schedule indicates that the number of neo-Panamax ships (which can carry 12,000-16,999 twenty-foot equivalent unit (TEU) containers) and post-Panamax ships (17,000 TEU and above) could double over the next three years.

Operators need not despair. With disciplined and timely adjustments, the industry could curb overcapacity and its adverse effect on rates. We expect that container liners have learned the lessons of the past and will be more rational in managing excess supply. They also have a range of tools, many of which have been tested in recent years, to manage over supply. They include cancelling routes (known as loop withdrawals), skipping or cancelling stops (blank sailing), slow steaming, re-routing, swift capacity reallocation, and deferral of new vessel deliveries. There are already signs of this new rationality in the capacity reductions by major liners, which have happened in the past few months. However, more stringent and sustainable measures must follow if the industry is to avoid lower rates and stabilize supply-demand ahead of a multi-year fleet expansion.

We credit consolidation for the container shipping industry's improved discipline. Mergers and acquisitions, which have happened in spurts over several years, have increased the market share of the top five players to about 65%, from about 30% in 2000, according to Alphaliner, a provider of container shipping market data and analysis. During that time, about half of the top-20 players were either absorbed through deals (for example, Hapag-Lloyd's merger with Compañía Sud Americana de Vapores and United Arab Shipping Company; CMA CGM's acquisition of Neptune Orient Lines Ltd.; and A.P. Moller-Maersk's acquisition of Hamburg Süd) or defaulted (Hanjin Shipping). That has widened the total carrying capacity gap between larger and smaller players, with that greater market concentration laying the foundation for a more rational and efficient industry.

For that rationality to hold, larger players will have to resist the temptation aggressively manage capacity and fight for market share, which has been the historical norm. We also note that many container liners have signed contracts, running up to several years in length, that commit to elevated time charter rates for leased-in tonnage. That is likely to encourage them to keep these chartered ships operating, which could exacerbate the already strained supply situation.

Lower Rates Can Still Match Inflated Costs

Supply discipline might prevent the worst price excesses over the longer term, but it won't avert pressure on freight rates during 2023 when expectations of sluggish demand and accelerating new containership deliveries will weigh. That outlook, combined with the collapse of rates in late 2022, has shifted the balance of power toward shippers, setting the stage for a difficult round of annual negotiations for container liners. Our base case scenario includes an average freight rate for 2023 of about half the record-level set in 2022. The decline in the contract rates should be prove initially shallow, cushioned by longer-term fixed-rate agreements that expire with a time lag, while the speed and magnitude of the decline in spot rates will be more immediate. Accordingly, we expect the pace of decline in revenues (volume times freight rates) for most container liners' to be slower than the deterioration in market spot rates, with the lag dependent on the liners' exposure to fixed-rate contracts agreed at previously elevated rates.

We forecast average freight rates will decline further in 2024, before stabilizing at still profitable levels (and above their 2019 base), which will enable container liners to (at least) cover operating costs increases since 2019. That is not an insignificant increase. Many container liners reported average operating cost increases of up to 30% (excluding fuel) over 2022. Given prevailing inflation, we expect operating costs will remain inflated in 2023, with increases likely to counter expected efficiency improvements and leave the industry's cost base (excluding fuel) largely unchanged. Bunker prices could ease from their mid-2022 highs, though any change (which is typically closely linked to crude oil prices) will likely to be passed through or returned to customers through freight rate adjustments, with a time lag of a few months. Our base case assumption is that the industry will adhere to the tight capacity discipline it demonstrated shortly after the pandemic's outbreak in 2020, when blank sailing and other measures counterbalanced the significant and abrupt decline in trade volumes. Furthermore, we think new environmental regulations incentivize slow steaming (which ties up effective ship capacity) and demolition of older tonnage, which should support freight rates, although the impact is unlikely to be apparent before 2024.

Intra-Asia Shows Resilience

Asia's relatively balanced supply and demand outlook could support more resilient intra-Asia freight rates over the next two years, at least compared to other long-haul routes. We expect economic growth in the Asia-Pacific region will slightly accelerate in 2023, driven by China's abandonment of its "zero-COVID" policy and property market stabilization. Our forecast for Asia-Pacific region GDP growth is higher than that of the U.S. or Europe, while intra-Asia container trade will grow 1.2% in 2023 and 3.9% in 2024, according to Clarksons Research's January projection. That compares to the shipping research provider's forecast for global container trade of a 1.6% decrease in 2023, and 3.3% in 2024. Furthermore, a global push by major international brands to lower geopolitical risk by diversifying supply chains, away from China to southeast Asia and India, is likely to accelerate, to the material benefit of intra-Asia trade volumes.

On the supply side, incremental total capacity growth in smaller-size vessels (under 3,000 TEUs), which are typically deployed on intra-regional routes, will be 3.8% in 2023, before likely contracting in 2024, according to data from Clarksons Research. That should support stable freight rates for intra-Asia routes. Smaller-size vessels suit the intra-Asia market, where infrastructure limitations mean some ports can't accommodate larger-size vessels. Smaller-size vessels modest capacity growth and then decline is in stark contrast to the expected 10%-20% capacity growth of megaships over 2023 and 2024.

While the risk of overcapacity in the intra-Asia region is relatively low, at least compared to other main-lane routes, it is not zero. Freight rates and lifting volumes will not be immune should the region experience sharply weaker export volumes. Our forecast is for a decline in volumes over the coming few quarters before a rebound gradually emerges.

Container Liners Are Exposed To Volatility

A ship operator's ability to protect itself against volatility and weaker rates is dictated, to a large extent, by the contracts and norms of the sector in which it operates. That is likely to be particularly apparent over 2023, when we expect container liners will face greater uncertainty due to their sectors' typically low revenue visibility. That opacity is the result of a relatively low number of fixed contracts and a tendency toward short-term agreements, which means the bulk of trading is conducted at spot rates agreed at the time of shipment. The appetite for longer-term arrangements increased during the pandemic, driven by customers seeking to add resilience and predictability to their supply chains. But currently low rates are likely to encourage shippers to turn to spot markets rather than agree longer-term and more expensive contracts.

Elsewhere, tanker, gas carrier, containership (tonnage providers), and dry-bulk segments should find some protection from volatility in their more conservative time charter profiles and subsequent use of medium- and long-term fixed-rate contracts. Some of the dry-bulk, containership, and tanker tonnage providers we rate have charter profiles with durations extending from two to four years and at rates above cash flow breakeven--including Danaos Corp., Global Ship Lease Inc., Navios Maritime Partners L.P., and Seaspan Corp. Liquified natural gas (LNG) shipping company Nakilat Inc. stands out because of its 25 carriers transporting LNG produced by Qatargas and RasGas (joint ventures majority owned by Qatar's QatarEnergy) under 25-year fixed-rate agreements with 11 years remaining.

Longer-term contracts cannot, however, fully insulate tonnage providers from weak markets and can ultimately serve to extend the effect of a downturn on earnings. This happens because ship owners regularly need to renew a portion of their charter portfolio, and when markets are subdued for significant periods, can find themselves forced to fix rates at prevailing lower levels and below those of their current charters.

Financial Leeway Supports Ratings But Uncertainties Loom

Container liners and containership tonnage providers find themselves in largely unchartered territory as they enter 2023. The spectacular freight/charter rates of recent years delivered exceptional free cash flows and strongly improved credit metrics, leading to multiple upgrades and positive outlook revisions over 2021 and 2022 (see table 3). Some companies used that windfall for M&A (mostly aiming to diversify away from traditional container shipping) or to fund shareholder returns, while many significantly reduced debt, bolstered financial headroom, and find themselves entering 2023 with unprecedented net cash positions (cash exceeding S&P Global Ratings-adjusted debt) or credit metrics well above their pre-pandemic levels.

Those buffers should help container shipping companies to cope with lower rates, meet rising fleet investment needs (partly dictated by more stringent/evolving environmental regulations), and fund prudent shareholder remuneration, all of which underpins our stable outlooks on most rated liners and tonnage providers (see table 2). Yet the unfamiliarity of the current situation is also cause for caution and constrains expectations of further improvement in ratings. Container shipping companies, in most cases, lack a track record of operating with significantly reduced leverage, while a majority haven't committed to maintain their current financial risk profiles. It is also evident that the extraordinarily high EBITDA posted in 2021-2022 is not sustainable, and that uncertainty over future normalized freight-rates reduces the predictability of credit ratio projections and increases the risk that adjusted leverage could overshoot what can be reasonably built into our current base case.

At a more strategic level, liners' systematic diversification, via mergers and acquisitions with logistics services and maritime ports, has spread revenues along the container shipping supply chain. That should reduce the impact of volatile freight rates on revenues and could therefore be a benefit to credit quality.

Emergent market trends could also have a significant influence on credit worthiness over 2023. We see danger, for example, of an increase in counterparty risk for tonnage providers due to the widening gap between fixed charter rates in longer-term contracts and spot prices. Longer-term time charter contracts typically serve to protect ship lessors (tonnage providers) from volatility and lower rates, but only so long as customers (typically container liners) deliver on their commitments. We assume that will happen as part of our base case but recognize that should a low charter rate environment prevail, and container liners' credit quality markedly weaken, then they may seek contract amendments, payment deferrals, or nonpayment under charter agreements. This is far from a theoretical risk. Some rated tonnage providers were forced to amend charter terms, or face defaults under charters, during past cyclical downturns. Meanwhile, the gap between fixed time charter rates and current industry rates has widened (since the later collapsed in late 2022), which may prompt charter amendments, although we consider that unlikely in 2023.

The Tanker Segment Remains A Bright Spot

We believe that prolonged tight vessel supply and a structural shift in oil exports (toward longer distances) have paved the way for strong utilization rates and sustained tanker market strength. Those factors likely underpinned the remarkable spike in rates for crude oil tankers and oil product tankers (gasoline, jet fuel, naphtha) in the fourth quarter of 2022, when one-year time charter rates for very large crude carriers soared to an average of about $43,000 per day (/day), up from about $26,000/day in 2022, and $21,000/day in 2021. Meanwhile, rates for large range (LR) product tankers climbed to $39,500/day, up from an average of about $25,000/day in 2022, and about $13,500/day in 2021, according to Clarksons Research's data.

We see little reason for tanker charter rates to weaken in 2023, when growth in the number of both crude tankers and oil-product tankers is likely to be minimal. The current orderbook for new vessels equates to just 4% of an already ageing global fleet, according to data from Clarksons Research, which like us, expects low single-digit fleet growth in 2023 and a potential fleet contraction in 2024 and 2025. Incentive to order new ships appears limited by uncertainty over future fuel technologies and by elevated new ship prices. What's more, shipyard capacity is constrained. We understand that the current lead time is at least two years, from order placement to fulfillment.

The impact of fleet constraints has been compounded by changes to international oil trade patterns that have boosted ton mile demand (volume multiplied by distance) and tied up ship capacity. That includes a structural shift in refineries' placement, which has extended the distances between oil/oil-products producers and consumers. That is likely to prove a lasting change given refinery closures across net importing regions (Europe, the U.S., Canada, and Australia) and new capacity opening in the Middle East and Asia.

Yet it is the conflict in Ukraine, and Europe's substitution of Russian crude oil (following the EU and U.K. bans on seaborne imports from Russia on Dec. 5, 2022), that has had the biggest immediate effect on the distances that tankers are steaming. European imports that used to come from Russia are now sourced from the more distant Middle East, U.S. Gulf region, West Africa, and Latin America. Meanwhile, Russian crude has found buyers in the farther flung markets of China and India. That situation will be exacerbated by an EU ban on all Russian oil products, which came into force in February 2023. Danish tanker operator TORM expects a realignment of trade routes due to that ban will add a net 7% to product tanker ton-mile demand (see chart 4).

Chart 4

For tanker operators, greater ton-mile demand coupled with tighter capacity should more than offset expected sluggishness in global oil demand due to macroeconomic headwinds in 2023--both the U.S. Energy Information Administration (EIA) and the International Energy Agency (IEA) are predicting demand in 2023 will be largely in-line with pre-pandemic levels. We also expect oil imports to China (the world's No. 2 oil consumer after the U.S.) could accelerate once the impact from the current wave of COVID-19 infections eases.

Dry Bulk Should Soon See Better Days

Charter rates for the dry-bulk shipping sector have been constrained, principally by weak demand prospects, but that could be about to change. A gradual recovery in rates is unlikely before late 2023, but should continue in 2024, driven by a considerable decline in the rate of global fleet growth. That would signal the end of softening that began in the second half of 2022 and which left average bulker earnings down 24% over 2022, at an average of about $20,500/day (see table 1). The rate at the end of December was about $14,000/day, or about half the level of a year earlier, according to Clarksons Research.

Table 1

The decline was mainly due to the generally weaker macroeconomic environment, but it was also ushered in by weak Chinese commodity imports due to stringent COVID-19 restrictions, sluggish construction sector activity, lower Ukrainian grain exports, and easing congestion at maritime ports that released tonnage into the network.

The current new vessel orderbook represents about 7% of the global dry bulk fleet, which is the lowest level for about 30 years, according to Clarksons Research. And the supply of new dry-bulk vessels could decline further given evidence that ship building yards' capacity over the next few years will largely be filled meeting containership and gas carrier orders. With supply constrained even a modest uptick in demand may be felt through rates. And global imports of dry bulk commodities could post low single-digit growth in 2023 and 2024 (following a fall in 2022, according to Clarksons Research) on the back of gradually strengthening macroeconomic conditions and China's reopening. The effect of that mild growth on rates could be further exacerbated by additional ton mile demand, due to global trade patterns shifts that lead to longer trade routes--such as the sanctions on Russia, which have resulted in longer seaborne-coal routes.

We believe growth in demand for dry-bulk shipping could closely match capacity growth in 2023, before the sector tips into a demand surplus in 2024 (see chart 1). Consequently, we expect average time charter (T/C) rate for Capesize vessels of $16,000/day-$17,000/day in 2023, down from $21,400/day in 2022, and $26,500/day in 2021. Our forecast for average Panamax ship rates is $15,000/day-$16,000/day in 2023, down from $20,200/day in 2022, and $22,000/day in 2021. We believe that industry conditions might ease next year, but also expect that any significant rebound in charter rates will depend on greater certainty of demand, particularly from China.

Climate Costs And Challenges

At the start of 2023, the International Maritime Organization (IMO) imposed two new regulatory measures aimed at improving ships' energy efficiency. They are the Efficiency Existing Ship Index (EEXI), which relates to vessel design and specifications, and the Carbon Intensity Indicator (CII), which relates to CO2 emissions (based on cargo-carrying capacity and distance travelled and evaluated on an annual basis with increasingly demanding emission limits).

Meanwhile, the EU's legislative bodies have struck a preliminary agreement to incorporate maritime transport in the EU ETS. Under that deal, 100% of emission from intra-EU voyages, and 50% of emissions on voyages between EU and non-EU ports, will be included. To ease the transition, the percentage of verified emissions covered will start at 40% in 2024, rising to 100% in 2026, according to the published terms, which remain subject to approval by EU member states.

The environmental measures should encourage ship owners to adopt greener technologies and scrap older tonnage, while also incentivizing ships to operate at lower speeds--all of which could partially offset the effect of new vessel deliveries on supply. The impact is likely to be limited in 2023, because the measures are structured to become more pronounced over time, though their impact on capacity could be significant from 2024-2025 and beyond.

Shipping companies will have to get used to the imposition of tighter emissions standards. The IMO's goal is to reduce the shipping industry's greenhouse gas emissions by at least 50% by 2050 (from a 2008 base), and to reduce carbon dioxide emissions intensity (per transport work) by at least 40% by 2030, and 70% by 2050 (also from a 2008 base). The 2030 carbon intensity goal appears to be attainable with some adjustments to current operations. Not so the longer-term target, which will require alternative and greener technologies and fuels, involve higher running costs, and necessitate lumpy investments in new vessels. The targeted decarbonization will require about $3.4 trillion worth of newbuild orders from 2020-2050, according to Clarksons Research.

Shipping companies are getting on board. Some are exploring the use of carbon-neutral fuels (green ammonia and green methanol) or liquified natural gas (LNG) technology--which we view as a transitional solution. Larger players have also initiated green fleet renewal programs, for example by stipulating that newbuilds will be methanol-enabled and dual-fuel capable. There is room for improvement. About 5% of the current global fleet can use alternative fuels, up from 4% in 2022 and 2.3% in 2017, Clarksons Research noted in its January 2023 report. That should increase rapidly. About 47% of orders (in global fleet tonnage terms) will be capable of using alternative fuels or propulsion, including LNG (about 40% of the orderbook), methanol (about 3.5%), liquefied petroleum gas (about 2%), and other alternative fuels (2%-3%), according to Clarksons Research.

Disciplined Change Is The Key To 2023 And Beyond

The shipping industry has already shown that it can accommodate environmental changes. The IMO's demand, in 2020, to reduce the sulfur content in fuel to 0.5%, from 3.5%, saw shipping companies quickly adopt lower-sulfur bunker oil, install exhaust gas cleaning systems (known as scrubbers), and switch to cleaner alternative fuels such as LNG. That transition also provided a model for how environmental changes might be funded, with higher fuel costs typically passed through to customers, while scrubbers were frequently co-funded by charterers.

The industry will have to prove equally adept at managing changing market dynamics if it is to post consistent profits. Ship owners and operators (and container liners in particular) need to demonstrate in 2023 that they have the discipline to manage large cash reserves and reign in supply excesses. Rising to that challenge will not only be credit quality positive but will help provide the financial platform needed to meet the coming environmental challenges.

Table 2

Table 3

Writer: Paul Whitfield