The Determinants of the Demand for Shipping Services

Chapter 1

God must have been a ship owner. He placed the raw materials far from where they were needed and covered two thirds of the earth with water – Erling Naess

1.0 Introduction – The importance of shipping in the world economy

Shipping can be defined as the physical movement of goods and passengers to the ports of demand from the ports of supply. It also involves all other related activities required to support and facilitate such movement. The movement of goods by sea is the economic lifeblood of many nations. This is because roughly three-fourth of the earth’s surface is covered with water, thus shipping plays an important role in world trade. Many of the commodities that are transported by sea are usually raw materials which are heavy, dense and have low economic value such as the likes of coal and iron ore. Transporting these goods over vast distances by ships is cheap and economical. Ocean transport costs are relatively cheaper in comparison to other means of transport and there are also no substitutes to shipping. On the other hand shippers of finished/manufactured goods also take advantage of the comparatively inexpensive rates charged for ocean transport. Ships also have a lot of cargo space and are therefore reasonably free of capacity constraints. Moreover ships have acceptable transit times. Because of all this 90% of all trade is done by sea, the operation of cargo ships brings an annual income of about USD 380 billion in freight. This amount is about 5% of the total world economy. The prospects for the industry’s continued growth looks to be strong on account of globalization and on account of the fact that seaborne transport is becoming more efficient. Moreover marine casualties have progressively decreased over the last many years and in comparison to land transportation it is also more environmentally friendly and less polluting. “In his book The Economic History of World Population, Carlo Cippola suggests that the transport industry has been one of the prime forces responsible for shifting the world from an essentially national system to the global economy that exists today” (Stopford, 2003). Shipping has made the world a smaller place and it has succeeded in connecting even isolated economies. On account of all of these above reasons, demand for sea transportation is increasing continuously at an exponential rate. Since 1950 the economic evolution of the shipping industry has been immense. Maritime transportation since 1990 has been experiencing new heights which lasted in the first years of the new millennium. However the economic crisis in 2008 brought a downturn in shipping sector resulting in a decrease in freight rates and a fall in demand for shipping services. In this paper Group 5C wants to point out and analyze the theory of the determinants on which the demand for shipping depends on.

C:UserskaDesktopWorld_trade_map[1].jpgThe boom in shipping trade (Source: The Scenario Thinking Website)

CHAPTER 2

Set your course by the stars, not by the lights of every passing ship – Omar N. Bradley

2.0 The nature of transport demand

Customers of Sea Transport have special requirements and these are met by shipping companies who provide a range of tailor made services and solutions. The following are some of the criteria which play an important role in the customer making a decision when it comes to choosing a mode of transport.

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2.1 Price

Shippers of cargo pay greater attention to the freight cost depending on the percentage that it makes up of the CIF cost. For example the cost of transporting a barrel of oil from the Persian Gulf to Europe cost about 49% of the CIF cost in the 1950s. Because of this the oil majors had their own tanker fleet so as to have greater control over the cost of ocean transport. But today the cost of seaborne transport is only about 2.5% of the CIF cost and therefore the oil majors prefer to charter in vessels. Also in the 1950s the cost of transporting a ton of coal from the Atlantic to the Pacific was about USD 10-15 per ton on a 20000 dwat vessels. Today the same coal is transported at similar rates on 150000 dwat vessel. This has been achieved by economies of scale.

2.2 Speed

Transit times are key for shippers of high value goods. Average speeds of deep sea going container vessels have increased from 17 knots in 1985 to 22 knots in 2007. In comparison to the cost of holding inventories in warehouses, it is cheaper to ship smaller quantities as and when required. Although the freight rates will be higher it is still smaller in comparison to the overall costs of stocking. In 2009 average transit speeds when down on account of many carriers slow steaming to beat the global downturn in order to reduce their costs. At this same period bunker prices also escalated so carriers further slowed down.

2.3 Transport reliability

Shippers are ready to pay premium freight for shipping services which provide just in time (JIT)/Kanban deliveries. Container ships are now days being used as floating warehouses. Speeds can be increased or decreased in order to deliver products exactly when needed.

2.4 Security

Shippers are usually also ready to pay higher freight for transportation which can guarantee minimal damage to his cargoes. Safety is especially of prime concern in container shipping where the value of goods being transported can go into millions of dollars. After the events of 11 September, the ISPS Code came into existence. Although this code increased costs and time spent for both ship owners and port facilities, shipping has become a lot safer than before. Currently piracy is a big concern and is adversely affecting international trade as costs are going up and there are also delays in the delivery of goods. 2010 has seen as escalation in Somalian piracy and efforts are currently underway to curb this menace.

2.5 Substitutes to shipping

There are no real substitutes to shipping because of the following reasons.

2.5.1 Cost effectiveness

Shipping is the most cost effective mode of transport per TEU or per ton or per cubic meter of cargo carried. As an example seaborne transport is just about 10-15% of the costs for road transport

2.5.2 Space

Ships come in various sizes so there are no space constraints. The bigger the ship lower is the freight cost and vice versa. This is a very important criteria when it comes to shipping of raw materials which are usually shipped in large amounts

2.5.3 Carbon footprints

Shipping is one of the least polluting forms of transportation. This is especially of importance in the container shipping where green shippers like IKEA, Starbucks and Wal-Mart pay very close attention to the emissions of their preferred carrier. Regulations and advanced technology will further bring down emissions in seaborne transport which will increase the demand for shipping

2.5.4 Safety

Shipping also has a reasonable safety record in terms of accidents, spills and collisions. Regulations, fines and public opinion has resulted in shipping becoming a safer means of transport

2.5.5 Accessibility

3/4ths of the world is covered with water, shipping also permits access even to remotely located countries unless they are landlocked

the low cost of maritime transport

Typical Ocean Freight Costs (Source: www.marisec.org)

CHAPTER 3

My old saying: No loss should hit us, which can be avoided with constant care; this must be a watch word throughout the entire organization – A.P. Moller

3.0 The variables of the demand for sea transport

“Ship demand, measured in ton miles of cargo, is mercurial and quick to change, sometimes by as much as 10 – 20 per cent in a year” (Stopford, 2003).

The following are the variables on which the demand for shipping is dependent upon:

3.1 The world economy

The profile of world trade has changed a lot in the last 20 years or so. It has become more complex and it is dependent upon many elements such as technology, logistics, politics, finance and marketing. World trade has also become very highly competitive. “It is against this background that the role of shipping must be focused as the international trade cannot be effectively undertaken without the provision of the sophisticated global network of maritime services which exist today” (Branch, 1998). The demand for shipping is a derived demand and the world economy is the greatest influencer of the demand for shipping services. This happens through the import of raw materials and the export of finished commodities. Because of this there is a strong relationship between industrial production and growth in the maritime fleet. Therefore the shipping business is also highly cyclical as it is also affected by the fluctuations in the world economy. We will now briefly discuss the causes of business cycles.

3.1.1 The multiplier and accelerator effect

The most important cause of business cycles is the interaction between consumer demand and investment. As local investment in a country goes up it gives rise to consumerism. People working in growing industries have surplus cash which they spend. This is basically known as the investment multiplier. This extra circulation of cash in the economy causes growth and this is known as the income accelerator. This in turn causes even more demand for consumer goods. Finally when the economy heats up the reverse happens and the economy goes into a slump. This causes instability.

3.1.2 Time-Lags

Usually when ship-owners make a lot of money in a buoyant market they start placing orders for new buildings. These new buildings are usually delivered when the market is in a slump which further depresses the market. At this stage the owners don’t place any more orders with the yards and they too run out of business. So the delays in the time taken between placing new building orders and the arrival of new vessels also cause ups and downs in the cycle.

3.1.3 Stockbuilding

During an economic downturn manufacturers reduce their inventories and this further depresses the demand for shipping. However when the economy shows signs of recovery, there is a rapid increase in the demand for sea transport as manufactures increase stocks. This leads to a sudden and explosive boom period for the shipping industry. An example would be the crude oil tanker boom in 1979 caused by an increase in stocking of oil.

3.1.4 Mass Psychology

Following the herd attitude can also give rise to sharp fluctuations in the economy. This is clearly notable in the stock markets and financial markets where investors can sell and buy stocks or enter and exit financial markets purely on account of pessimism and optimism. When this action happens in short periods and in large quantities it can give rise to large economic fluctuations.

3.1.5 Random shocks

These events stand alone and are not like cycles. They can be for example changes in weather and wars which can have a profound effect on the demand for shipping. The recent sub prime mortgage crisis in the USA which caused one of the worse recessions in container shipping in 2008-2009 is such an example.

3.2 The trade elasticity of the world economy

Trade elasticity = % growth of sea trade / % growth in industrial production

“For most of the last 30 years the trade elasticity has been positive, averaging 1.4. Sea trade grew 40% faster than world industry” (Stopford, 2003). Trade elasticity of different regions will change on account of following reasons. Firstly over a period of time the source of domestic raw materials begin to get exhausted and then countries have to start importing from other countries. Sometimes this happens also because domestically produced goods are inferior to those imported and moreover the cost of sea transport is also cheaper. Secondly as economies become very developed they begin to import less of raw materials as their activity tends to become less resource intensive and more service oriented. Last but not the least over time some countries loose their economic importance whereas others gain in economic importance. For example in the 1960s steel mills in Europe started importing iron ore from abroad.

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3.3 The nature of seaborne commodity trades

Firstly seasonality of trades causes short term volatility. Due to the seasonal nature of some of the agricultural commodities it is difficult for shippers to plan ahead their transport requirements and hence they prefer to work more the spot markets which tend to be more volatile and instable. Example is the grain trade (exports) from the US Gulf. Another example is the increase in demand for oil in Europe in winter time. Secondly trade patterns change with changes in the source of supply. When local sources are depleted then countries have to rely on imports and this affects the demand for sea transport. An example here is the import of iron ore by European steel mills from Australia and Brazil. Thirdly relocation of the processing of raw materials can also have a direct effect on vessel type/size and the quantities transported. As raw materials like Bauxite are refined, it produces Alumina which is lower in volume and therefore requires a smaller vessel. As Alumina is further processed it produces Aluminium which has an even less volume and therefore needs a smaller tonnage than Bauxite. Fourthly the demand for sea transport also relies heavily on the shipper’s transport policy. In the 1970s oil majors in the USA chartered in tonnage on long term basis or built ships in conjunction with ship owners against long term contracts. However after the 1973 oil crisis their policy changed and they distanced themselves from long term charters and used the spot market. Fifthly on account of bad harvest or drought or on account of adverse climate a country may be forced to import which in turn increases the demand for shipping services.

3.4 Average haul and ton miles

As distances over which cargoes are transported increases so does the demand for shipping. If export cargoes of crude oil from the Persian Gulf are transported to Europe via the Cape of Good Hope then the demand for shipping will be more than if the cargoes would be shipped via the Suez Canal. This distance effect is defined as average haul and is measured by ton miles which basically are the product of tons of cargo shipped and the average distance. During the Arab-Israeli conflict, Egypt closed the Suez Canal which led to ships being diverted via the Cape of Good Hope. The ton miles thus went up which increased the demand for shipping overnight. At the same time orders were placed at yards for supertankers. The Panama Canal is currently being widened to a width of 49 meters which means that it will be able to accommodate many vessels which earlier could not transit the Panama Canal on account of a beam greater than 32.9 meters can now transit via the Panama Canal. This is going to reduce the ton miles for these vessels and could result in an over supply of these vessels and a resulting fall in demand.

3.5 Political disturbances and the Geopolitical scene

Political events such as wars, revolutions, coups, hostilities, political nationalization of foreign assets and strikes can all have an indirect effect on the demand for shipping. Their effect on shipping is sudden and unexpected and moreover is usually not directly felt but has an indirect effect. For example the closure of the Suez Canal in July 1956 caused crude oil tankers to sail to Europe via the Cape of Good Hope. This in turn increased the ton miles which again increased the demand for shipping. “In general, political stability is a condition for economic stability and prosperity, as well as for investment attractiveness and meaningful economic value creation” (Lorange, 2010). Although historically it can be seen that very often freight rates increase when there is political instability, in the long term growth of shipping is a function of political stability. A change in government may cause a change in foreign policies which may alter her foreign trade. After 11 September, 2001 terrorism and piracy have also negatively affected shipping on account of the growing concern for the cost of security.

3.6 Transport costs

Seaborne transport costs have progressively decreased in the last 50 years. Ships having become bigger in size; greater efficiency at ports and more efficient organization of shipping operations have all contributed to lowering of transport costs on account of the economies of scale and better and higher quality of service. This has led to an increase in the demand for sea transport.

3.7 Globalization:

On account of globalization markets around the globe have increased in size and have progressively become bigger. Many homogenous trading blocs like the European Union (EU), North American Free Trade Agreement (NAFTA) and the Association of Southeast Asian Nations (ASEAN) have been established. These have facilitated increased cross border trade and barriers to the free movement of goods have been systematically reduced. This has also promoted the demand for shipping.

3.8 Dispersed manufacturing:

In the past Japan was the biggest manufacture of durable consumer goods. Later on with economic prosperity the costs of manufacturing went up so other centers like Taiwan and South Korea were established. Today China is the biggest manufacture of consumer goods and one third of the world’s container traffic goes to and from China. A future manufacturing hub is Vietnam. Since these low cost manufacturing centers are developing further and further away from the major consuming areas the demand for shipping is going up as the ton miles go up.

3.9 Increased global demand for commodities and consumer goods:

With increased economic prosperity, the low cost manufacturing centers of the world are investing heavily in their own domestic infrastructure. This leads to an increase in global demand of raw materials such as iron ore and coal. This newfound wealth of developing countries is also playing an important role in increasing the demand for shipping. It is predicted that the purchasing power of certain Asian countries will soon surpass that of the USA and Western Europe.

3.10 Demographic shifts:

Today the world’s population is concentrated in Asian countries. India and China are the two most populous countries in the world. Other South Asian countries are also catching up. On the other hand the industrialized countries of Europe and North America are having aging populations. Although Asian countries are still producers of commodities in the not too distant future these areas may become more consumers based. So the demand for shipping in the future will definitely be focused on Asia.

3.11 Technology:

Technological advancements in navigational equipment, less friction hulls, less polluting and more efficient engines and better propulsion systems have all contributed to making shipping safe and more environmentally friendly. This has in turn increased the demand for shipping services.

3.12 New legislations to increase safety and to reduce environmental pollution:

With high profile maritime accidents like the Exxon Valdez, Prestige and Erica incidents the governments of the USA and Europe have passed mandatory legislations to phase out single hull tankers for double hulls. This has increased safety but on the other hand has resulted in the scrapping of single hull tankers which in turn reduces supply and therefore increases demand for shipping.

3.13 Congestions and delays:

Port congestions in bulk cargo loading ports like that of Australia and Brazil and discharging ports like that in China also help in increasing the demand for shipping in the short run. This is because on account of severe congestions vessels have to wait on roads for 2 to 3 weeks before they can berth. This decreases the supply in the market of free tonnage and therefore increases demand of ships in the short run.

3.14 Predictions, projections, forecasts and expectations of shipping gurus and pundits and the effect of speculation

Future predictions in the shipping industry can sometimes increase and decrease demand of seaborne transport (the case of irrational exuberance). As an example in 1970 there was a prediction that Japanese steel production would double in 5 years. This motivated Japanese steel mill charterers to charter in bulker in large quantities. This frenzy led to about 40% of the world’s bulk fleet (19000 ships or 40 million dwt) being chartered in simultaneously. This led to a sharp increase in the demand for bulkers and freight rates also went up. Then in the winter of 1970-71 the same charterers withdrew from the voyage market and suddenly there was surplus of unemployed tonnage in the market. This sent demand spiraling and with it the freight rates.

3.15 Effect of new regulations and legislations

New Regulations and legislations often tend to increase the demand for shipping services. For example after the grounding and spilling of oil by the Exxon Valdez in Alaska, the US legislators implemented the Oil Pollution Act of 1990 (OPA ’90). This law did not allow single hull tankers to trade to US ports so this led to scrapping of single hull tankers and a rise in demand for double hull tankers.

CHAPTER 4

Without goals, and plans to reach them, you are like a ship that has set sail with no destination – Fitzhugh Dodson

4.0 Relationship between demand, supply and freight rates in shipping

Supply and demand are the forces that make market economies work. The interplay of supply and demand in shipping determines finally the freight rate. “Shipowners and shippers negotiate to establish a freight rate which reflects the balance of ships and cargoes available in the market” (Stopford, 2003). As supply of tonnage in the market goes up demand falls and so does the freight rates. On the other hand as supply of tonnage in the market fall demand increases and so do the freight rates. This induces shipowners to provide more transport. “Demand, however, rarely exceeds supply for long; rather, there tend to be relatively short peaks of prosperity in the freight markets, followed by longer slumps” (Lorange, 2010). The supply of shipping services changes very slowly to a response to changes in demand. On the other hand demand for shipping services changes very rapidly. Ships take several years to build and moreover have a lifespan of between 15 to 30 years. So when demand falls the fall in supply will take a very long time to catch up. As an example in the mid 1970s tanker demand fell drastically by 60%. It took more than 10 years for supply to adjust to this fall in demand. Although there was no demand for tankers in this period supply continued to increase as new buildings ordered during the good times were delivered. So demand fell further and freight rates hit the bottom. This forced owners to start scrapping the vessels. This is very briefly the relationship between demand, supply and freight rates.

CHAPTER 5

Admire a small ship, but put your freight in a large one; for the larger the load, the greater will be the profit upon profit – Hesiod

5.0 Elasticity of demand

Fluctuations in freight rates have an effect in worlds demand for goods, commodities and raw materials. The volume of that effect varies from one good to another and depends on the elasticity of its demand. Elasticity measures the reaction of gross revenue and production caused by a swift in shipping freight rates.

As we have already mentioned, demand for shipping services is a derived demand depending on the need of the transferred bulk cargoes or finished goods. Through shipping transportation goods are moved to the areas where they are needed, in order to enter other stages of production or to fulfill demand for finished goods in the importing country.

When freight rates rise or fall, determinants of the elasticity drive demand in a positive or negative way. There are three main factors driving that change:

5.1 Consumer demand for the products made by using imported raw materials or imported final goods.

Through shipping transportation raw materials, commodities and final goods reach the source of their demand. If we assume that freight rates rise, which will lead to a rise in the price of the final goods, the equilibrium in the market of those goods will change. Higher prices will drag down the quantities demanded, which will slowly reduce the quantities produced. Cutting down production, results in shrinking the imports. The amount of that reduction depends on the elasticity of demand of the final goods imported or the goods produced with the use of the imported raw materials.

More elastic demand for final goods, commodities or raw materials will lead to an elastic transportation service which will be affected from the rise in freights. On the other hand, if the elasticity of the final goods is inelastic, as in the case of using raw materials for production of commodities, the demand for sea transportation services will remain the same, not taking into account the rise of freight prices.

5.2 The cost of sea transportation as a percentage to the market price of goods carried or produced with the carried materials.

The final price of a product is a proportion of different costs which are added during the production procedure. The cost of sea transportation is one part of the total cost which sometimes is formed, even before the procedure of production begins. A relatively small proportion on the final price, will lead to an inelastic transportation demand. On the other hand, if the cost of transportation plays a big role in the finals’ product price, then the demand for transport will be relatively elastic.

An increase on freight rates will affect the final price of a product more, if the cost of transportation is a big percentage of its total cost. As a result, by increasing freights, the price of the good will increase, resulting in a decrease in markets’ demand. As we have already mentioned a domino effect will take place, and production of goods will decrease driving down raw materials’ or commodities’ demand. In contrast, if the transportation cost is relatively low, increasing the freight rates will have no influence on the demand for transportation.

Although most of the times the sea transportation cost and associated expenses are a negligible percentage on the final cost of a product, there are times where these costs may reach 8 and even 15%. As a result its demand is greatly affecting transportation demand.

5.3 Substitution in transportation.

Transportation of goods may be performed by using different means of transport. However, shipping transportation provides services with law cost and in high volume. Nevertheless, when freight rates become more expensive, the convenience in which sea transportation services can be substituted by other means of transport, makes the demand more or less elastic.

Higher freight rates, will lead importers in a search for substitution. In the short run, as we can see in Figure 1, the rise of freight rates won’t have a big effect on the demand on shipping services. As a result, gross revenue will be increased for transportation companies, as the transported volume remains the same but the freights have increased. However, that situation will not last for long.

On the long run, the importers will be able to react in a raise on freight prices by substituting sea transportation by other means of transport. As a result elasticity of demand for the final goods, becomes more elastic (Figure 2) and so does the demand for sea transportation services.

Graph showing the elasticities of the demand for shipping (Source: Metaxas, 1981)

CHAPTER 6

He who loves practice without theory is like the sailor who boards ship without a rudder and compass and never knows where he may cast – Leonardo da Vinci

6.0 Introduction

In this chapter we will discuss about the determinants of the demand for shipping in the three basic shipping categories which are container shipping, dry cargo markets and the wet trade. In all these three sectors the role of China as a force driving the demand for these commodities cannot be replaced.

6.1 Determinants of the demand for liner shipping

“Liner services operate between fixed ports on a strict timetable. Liner services can be operated by one company, or by a group of companies in what is known as an alliance or consortium. Costs and revenues are shared in accordance with each company’s contribution. Liner shipping companies primarily operate container ships, which carry containerized cargo” (UNCTAD, 2010). From an economic perspective, international division of labor and decentralization of production processes have provided an important impetus for the demand of liner shipping. The USA and some traditional industrial countries of Europe have increasingly turned to low-wage countries of Asia instead of some nearby regions with cheap labour force, such as Eastern Europe and Mexico. More and more products suitable for container transport are being produced, like refrigerators, air-conditioners and other consumer electric products with relative high value, which are required to be transport over longer distances. Outsourcing and global maritime transport has to some extent stemmed from the liberalization of global trade during recent years. Lower custom’s duties and the abolition of non-tariff trade barriers have also acted as a catalyst for international trade, which has further affected the demand of shipping. Containerization has definitely had a big impact on the business of shipping. Without containerization China would not have emerged as a large scale shipper of consumer goods. China has played an irreplaceable part in this respect. China has attracted more and more foreign investments in its industry sector, which has established it as a factory for the world production activities. Furthermore, the rising proportion of freights shipped that are highly suitable for container transport like final goods and intermediate goods, as well as some traditional general cargoes, is another positive factor for increasing the demand of liner shipping. Increasing exports and technological developments have led to an increase in the growth of this sector. Size of the container ships and average speed has also progressively increased. Maersk Line has recently ordered a series of 18000 TEU vessels (Malacca Max) to achieve more economies of scale. A major slowdown in the world’s leading economies would have a negative effect on international trade and hence on container shipping. Terrorism risk might also lead to a slowdown of international trade and this is very much relevant for import containers to the USA where there is a serious concern that a “dirty” bomb might be placed in one of the containers. This has led to the USA implementing the 100% scan for all import containers to the USA. The cost and time lost on account of these extra security procedures is costing the industry a lot of money and has increased the cost of shipping containers to the USA. These increased costs might cause a downward adjustment of consumer’s purchasing trends and might cause a slowdown of imports into the USA. The growth in the demand for this sector has been about 10% per annum over the last few years but recently it has fallen down to around 5%. In 2007 the Far East – Europe trade grew by 20% but in 2008 – 2009 these numbers have fallen. “G