• The shipping industry is central to the world’s economy, carrying 80% of global trade

• Nevertheless, it is sometimes considered a ‘hard to own’ sector by long-only investors

• Applying a supply-focused lens to the dual trends of deglobalisation and the energy transition suggests hidden upside for the sector

Robert D. Arnott

Back in 2017, we wrote a Hosking Post which highlighted our growing exposure to the shipping industry (“What shall we do with the drunken sailor?”). Seven years later – over which period the portfolio’s shipping holdings have outperformed our ACWI benchmark by a considerable margin – we return to the high seas once again to discuss this fascinating but often overlooked area of the equity market.

We have written in previous Active Ownership Reports about how the energy transition is unlikely to unfold in quite the way many expect (“The maze to net zero”, “A diverse world”). We have also written about how oversimplified approaches to ESG may be leading to capital misallocation (“Embracing complexity”), and how these two issues are connected (“Only dead fish swim with the stream”). The shipping industry provides a neat case study that brings this to life, and demonstrates how our capital cycle approach allows us to see the world from a differentiated perspective, unlocking opportunities others find difficult to access.

In this piece we will explore three reasons why shipping appears ‘difficult to own’ for long-only investors, and how Hosking Partners’ capital cycle lens and holistic approach to ESG finds opportunity where others see challenge. In overview, we will cover: (1) the role shipping plays in a fragmented global economy; (2) its environmental profile and the role it plays in the energy transition; and (3) the inherently cyclical nature of the industry. We will conclude by discussing Hosking Partners’ exposures, and their performance in recent years.

Is deglobalisation a threat or an opportunity?

The history of commercial shipping traces back almost 9,000 years. The oldest known sea route appears to have run across the Aegean Sea, transporting obsidian from the volcanic island of Milos towards the southern Balkans where it was refined into blades. Over time, advances in shipbuilding, navigation, and trade expanded global shipping networks. The advent of coal-fired steamships in the 19th century and then containerisation in the 20th revolutionised the industry, facilitating faster and more efficient transportation of goods between continents. Today, shipping remains a cornerstone of the global economy, with circa 80,000 commercial vessels (counting all non-passenger classes over 100 gross tonnage) carrying 80% of international trade by volume. (1) Without shipping, the modern world as we know it would grind to a halt.

Unsurprisingly therefore, geopolitical factors weigh on the industry. Tit-for-tat US-China frictions and sanctions on Russian energy that have incentivised a ‘shadow fleet’ of uninsured vessels are symptoms of the broader trend towards deglobalisation. This has been accelerated by the Covid supply shock and geopolitical insecurity arising from the Russia-Ukraine war, but data suggests it has been over a decade in the making. Global trade as a percentage of GDP grew steadily through the 19th century, before stagnating and then shrinking in the interwar period. Post-1945, it reaccelerated sharply until around 2010, growing from 5% to 25% of global GDP. That moment, coming out of the WTO consensus and rise of China, marks the high watermark of globalised trade. Since 2010, it has stopped growing and been range-bound between 20-25% (see figure 1).

It remains to be seen whether growing geopolitical instability leads to a prolonged retrenchment in trade. Some experts have drawn concerning parallels between the pre-WWI years and today. (2) If we are indeed entering such a period, then there will inevitably be impacts on the world’s shipping industry as the primary carrier of that trade. But as we will see, a supply-focused lens shows that it is not necessarily a wholly negative picture for investors. Furthermore, this deglobalisation trend must be considered alongside the energy transition. These are – in many ways – two sides of the same coin (as we discuss in “A diverse world”). Fuel cargoes constitute 36% of shipborne trade alone, but this excludes broader category ‘energy-derived’ products such as food, chemicals, plastics and so on. The flow of all of these will be affected by changes to the world’s energy mix and distribution patterns. Meanwhile, the world is moving towards more volatile energy sources. The output of wind and solar assets varies by ±3.5% each year due to their intermittent nature. As these energy sources ramp from 5% to 30% of the useful energy mix, the standard error in global energy balances may double. In turn, that means ±2% swings in energy balances due to abnormal weather events could become 250x more likely in 2050 than today. (2) This volatility will be even more extreme at the local level, as weather events affect regions differently. So it seems likely that the energy transition – whatever its final shape – will increase energy price volatility as long-established patterns are upturned, the global energy ecosystem reorders, and intermittent energy sources are built out.

As capital cycle investors, we see the world through a lens that observes supply rather than tries to forecast demand. We can observe the impact this collective uncertainty is having on supply, where shipping orderbooks have reached multi-decade lows and average vessel age is rising (see figure 2). The dual trends of deglobalisation and the energy transition are likely to constrain future supply as uncertainty across several fronts suppresses new vessel orders into the 2030s. Deglobalisation – or perhaps more accurately – ‘re-localisation’ may lead to less efficient shipping routes, lower fleet utilisation, and thus lower supply. Meanwhile, commodity price volatility – driven by both trends discussed above – favours shipping as the industry enables cross-border arbitrage by transporting energy and other goods from areas of surplus to areas of deficit.

Do simplistic ESG approaches conceal an energy transition winner?

The shipping industry accounts for about 3% of global CO2 emissions. This is about a sixth of the 20% or so attributable to transport as a whole, three quarters of which is road transport. Stripping out light passenger vehicles to focus on freight, in gross terms shipping sits second to trucks (5%), but ahead of aviation (2.5%) and rail (0.5%). (4) This physical reality makes shipping the target of environmentalists – and by extension – ESG-focused investors. In brief, it is a ‘hard-to-abate’ sector. Ships are large, heavy objects and require energy-dense fuels to operate. Accordingly, oil-based fuels meet over 99% of their energy demand. (5) For the sector to decarbonise meaningfully, these fuels must either be replaced with a lower carbon alternative – biofuels, LNG, methanol, etc – or the emissions must be captured and stored (or some mixture of the two). Unfortunately both options – replacement and capture – remain either technologically immature, prohibitively expensive, or both. Because of shipping’s fundamental role in a growing global economy, gross emissions from shipping emissions are growing rather than falling. Meanwhile, uncertainty over which technology will win out means shipowners are delaying allocating capital to newbuilds. After all, who wants to commit $250 million on a hard asset with a lifespan of 20+ years if it is unclear whether it will be able to operate in a few years’ time? (6)

The industry is also poorly served by some of the simplistic metrics used in ESG portfolio construction. Shipping benefits from economies of scale, meaning that larger vessels are generally more efficient per tonne of cargo carried. Thanks to this efficiency, revenue per tonne-km (number of tonnes transported multiplied by distance travelled) is lower than in other transport industries. As a result, portfolio carbon metrics like Weighted Average Carbon Intensity (which divides emissions by revenue) structurally disfavour shipping companies. Demonstrably, in the unconstrained Hosking Partners portfolio, shipping accounts for just 6% of portfolio assets but contributes over 25% of the total WACI (see figure 3, above). No other sector comes close to this level of imbalance, which makes the sector literally ‘hard to own’ if carbon intensity is an exclusionary consideration in portfolio construction. The more concentrated the portfolio, the more extreme the effect.

These issues make investing in the shipping industry a challenge for some ESG-focused investors. But the analysis is misleading. While shipping’s gross emissions represent an opportunity for decarbonisation, we should not lose sight of the sheer efficiency of carrying freight by sea. When measured by emissions per tonne-km, shipping compares highly favourably to other forms of transport because of the scale advantages of carrying more mass over longer distances. By this measure – which is favoured by the Transition Pathways Initiative – a very large container vessel is about 26x more carbon efficient than a truck, and 145x than a plane (see figure 4). Furthermore, while absolute sector emissions are rising thanks to the growing global population and economy raising demand for shipping, emissions per tonne-km are falling steadily. This is due both to gradual progress in alternative fuels and carbon capture, but mainly to a proactive regulatory approach by the International Maritime Organisation and other industry bodies. These rules are targeting the accelerated phasing out of older, dirtier ships alongside speed restrictions designed to increase round-trip fuel efficiency.

These regulations will help curb gross emissions, but they also have operational impacts. Engine power limiters result in a one-time permanent reduction in speeds, which will limit the global fleet’s ability to speed up to meet short-term increases in demand. The overall effect of slower speeds is to reduce existing shipping capacity, in terms of new capacity. In other words, some of the increase in the industry’s fleet size is to compensate the lost efficiency caused by slow steaming. This creates an illusion of growth in capacity when, in reality, it is merely an adjustment to maintain baseline service levels. Concurrently – because of the uncertainty over both regulations and which future fuel technology will triumph – many operators (e.g. portfolio holding Pacific Basin Shipping Ltd) have committed not to order new ships until zero or near-zero carbon models are both available and affordable. This constrains ‘real’ new capacity coming online. This all adds up to a ‘tighter for longer’ supply picture.

Do low barriers to entry mean low returns?

The shipping sector is also affected by a range of other issues which can spook investors. As we discussed back in 2017, the sector is highly fragmented, so ship owners have limited pricing power. Meanwhile, barriers to entry are extremely low. After all, anyone can cobble together some equity, get a loan from a bank, and order a ship with very little down payment at the shipyard. These factors have in the past incentivised poor discipline among owners. This time, however, uncertainty over future fuels and the engines to consume them, combined with more expensive capital due to ESG metrics which penalise the sector, mean that the typical supply response to higher time charter rates is delayed. Nevertheless, carefully evaluating the quality of management teams, their level of ownership, and how they are incentivised remains key to avoiding those pirate-operators looking to place ‘heads I win, tails you lose’ bets with shareholders’ funds.

Taking this supply-focused, behavioural approach allows us to see opportunity where others see challenge. It is in this context that examining trends like deglobalisation, the energy transition, and even ESG fund flows lends one valuable additional perspective. Many of the factors discussed in this report – technological uncertainty, low capital investment, oversimplified ESG approaches, imperfect emissions regulations, and a tarnished reputation for capital allocators – have combined to place a natural constraint on near-term marginal supply. Over the last seven years, this has led to higher returns on capital and higher share prices across a basket of shipping stocks in the Hosking Partners portfolio.

This is not a one-size-fits-all approach. Also required is an understanding of the cycles in each separate class of shipping, and how they interact. We noted earlier how LNG tanker orderbooks have recently swelled, particularly in China. In response, over the last year, we have trimmed our exposure to LNG carriers and recycled it into dry bulk, where in contrast to 2017 the supply picture now looks more attractive (see figure 5). Similarly, there are early signs that product tanker supply is picking up, leading us to moderate our position in Hafnia, which has returned 349% in USD terms since we first added in 2019.

Conclusion

Since we wrote “What has become of the drunken sailor?” in 2017, Hosking Partners’ shipping basket has outperformed the index by about 25%. This has been driven by particularly strong performance in the past four years, over which period it generated cumulative returns of 274% (see figure 6) in USD. As of the date of publication, shipping companies make up about 6% of the Hosking Partners portfolio. This is a significant active bet – the weight in the benchmark is just 0.1%.

To invest in an industry like shipping, Hosking Partners benefits from being able to take a long-term approach and from our unconstrained remit. Bottom-up analysis must be paired with a broader appreciation of global trends, where a focus on supply helps distinguish the signal from the noise. Assessing and understanding management behaviour helps us avoid principle-agent conflicts. As we concluded in 2017, investing in this industry is never likely to be plain sailing. But our approach thus far has caught favourable winds, and with due caution and an eye on the horizon, we sense some life remains in this old sea dog yet.