The Cost of Doing Nothing: Interest Rates and Eco-Investing in Shipping
What difference, if any, will rising interest rates do to investment in renewables for shipping?
Written by Mark Williams, Managing Director, Shipping Strategy
Jerome Powell, governor of the US Federal Reserve, has the capacity to stoke or choke global economic growth by making borrowing easier or harder, using the simple tool of setting US dollar denominated interest rates.
The general expectation is that interest rates will rise several times in 2022. This is because inflation is rising. High inflation is seen as a sign that an economy is growing too fast and creating supply shortages. By raising the cost of debt, Mr Powell can slow growth, limit the supply shortages and in time bring about lower prices. This is classical monetarist theory, a form of economics favoured in the 1970s and 1980s and therefore about as up to date as a telephone table. But governments of all flavours, whether democracies, autocracies or dictatorships, nominally left or right wing, all follow standard monetarist behaviour these days.
So when Mr Powell rouses himself from his spreadsheets to make pronouncements, investors around the world sit up to listen. On Wednesday, January 26 Mr Powell did make a public appearance, and gave no surprises (markets don’t like surprises) when he said that interest rates would rise in March. He also indicated that more interest rate rises will follow, and that this was in part a response to pressure from US politicians:
“I would say – and this view is widely held…that both sides of the mandate are calling for us to move steadily away from the very highly accommodative policies we put in place during the … pandemic.”
Mr Powell was concerned to add caveats and disclaimers to this, to ensure that we know he will be pragmatic and not dogmatic: “It is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate. So at this time, we haven’t made any decisions about the path of policy, and I stress again that we’ll be humble and nimble. We’re going to have to navigate cross-currents and actually two-sided risks now.
What I’ll say is that we’re going to be led by the incoming data and the evolving outlook.”
The consensus view seems to be settling around four 25 basis point interest rate rises this year, one per quarter, with interest rates rising by one per cent in total. Hardly earth shattering but indicative that the era of ultra-low interest rates which has persisted since the Global Financial Crisis is coming to an end.
This lengthy preamble leads us to a question: what difference, if any, will rising interest rates do to investment in renewables for shipping?
The answer lies in part in the reason why interest rates might rise – because prices are rising. In our industry, newbuilding prices have soared upwards by around 20 per cent overall during the coronavirus period. A VLCC might have cost USD 82 Mn at the start of 2020 but an owner seeking a dual fuel LNG capable VLCC today might have to find USD 105 million, some 28% more.
When Tor Olav Troim ordered his LNG fuelled Newcastlemaxes a year or so ago, the first four cost USD 67.9 million while a second group of four cost USD 69.1 million and the last group of four cost USD 69.6 million. This month, Japan’s NYK announced that it will order four new LNG-fuelled Capesize bulkers of its own design. They will cost USD 82 – 83 million according to brokers, though NYK has not reported the price, that’s about 17 % more than the Himalaya ships cost.
Newbuilding prices have risen in part because input costs at the shipyards – steel, power, labour – have increased. They have risen in part because there is about 60% less shipbuilding capacity today worldwide than at the peak of the newbuilding boom in 2008. Newbuilding prices have not gone up because the price of debt has increased. As one investor put it to me last year, the cost of money is not the deciding factor in a shipping investment; the key factor is whether the investment itself makes sense. Keynes called this confidence or animal spirits. In shipping we frequently refer to gut feel. Neurologists will tell you that your gut has as many nerve connections as your brain does, hence the idea of gut feel is valid.
On a case-by-case basis, this approach makes perfect sense. But in the economy overall, the quantity of investment tends to fall as interest rates rise – otherwise, using interest rates to try to manage economic activity would be pointless. Higher interest rates require a higher rate on return of capital invested to justify making an investment in a capital good, like a ship, a wind farm or a solar farm.
But for some months now the world has been living with negative real interest rates. With inflation at about 5% and interest rates at 0.25%, the real interest rate is -4.75%. This means that people are encouraged to take on debt because it will in time be inflated away. (Incidentally this classical monetarism is why governments, especially those who espouse monetarism, could and should be borrowing rather than increasing taxes to pay for increased social costs during the pandemic).
So as real interest rates rise to match inflation, there should be a disincentive to borrow to invest in capital goods, all other things such as animal spirits being equal. Therefore, it is quite possible that as interest rates and inflation normalise over the balance of 2022, assuming the pandemic receded and normality (whatever that is) returns, the amount of investment in new capital goods will fall.
This means that investment in fossil fuels may not increase as rapidly as some observers of high oil and gas prices fear. But it also means that investment in next generation technology and fuels may not happen at the required replacement rate.
The required replacement rate is a numinous and as yet unknown number I just thought of, but it is a very important number. Its value may be unknown but it has a definition. It is the level of investment in new, low carbon technology required to ensure that fossil fuel technology can be switched off safely by a predetermined date (like 2050 in shipping’s case) without preventing the system from working.
In some systems, like electricity generation, the required replacement rate of investment is relatively easy to work out. Electricity demand in a country grows predictably according to its state of development, population, urbanisation and industrialisation rate, and so on. It is possible to forecast electricity demand in 2050, add on a multiplier to account for increasing rates of electrification, then work out how much renewable capacity would be required to generate the electricity, work out what that capacity would cost to build at a standard falling cost due to economy of scale, then go out and raise the money (or dip into governments’ pockets) to build the capacity. You wouldn’t get the number right first time, but you could avoid underinvesting and therefore reduce the risk of the lights going out in operating theatres and underground stations some time around, say, Christmas 2043.
The Least Worse Case Scenario
In the case of shipping, things are a bit harder because calculating the required replacement rate of investment means calculating the capacity of shipping required to meet demand in 2050. But how do we define demand? Tonnes loaded onto ships? Tonne miles? Tonne mile days, approximating for ship speed? How do we account for systemic changes in demand, for instance, when global economy passes peak coal, oil and natural gas consumption? Because coal, oil and natural gas make up about 40 per cent of shipping demand today. How can we work out how much ammonia, methanol, liquefied hydrogen, or lithium ores will need to be shipped?
Most shipping analysts and executives struggle to predict total oil shipping demand in the next 12 months, let alone over the next 30 years. For a recent example of this principle in action, look no further than comments Kim Ullman made in his final market report for Concordia Maritime, the company he led since its launch, before his retirement at the end of last year. Ullman said, “We expected both oil production and freight rates to rise when stock levels were at or below the five-year average. However, this has not been the case…The map was right … but the reality wrong.”
Ullman is a wise and capable man for whom I have great respect. I am not singling him out, just noting his own wry comments about how hard it is to make predictions, especially about the future.
I have been forecasting shipping markets since 1996 and I have learned over 25 years that there is no such thing as a good forecast, only the least worst forecast. The value in forecasting lies not in the number you get at the end of the process, but in identifying the input variables you can manage and those you cannot. Management energy should focus on the first group. For the second group, prayer and less cost-effective insurance products are available as risk management tools.
We can tell that the shipping industry is poor at forecasting because the industry cycles are so volatile and dramatic. A cycle starts from its base, when earnings are low, asset prices have slumped and ship owners are haemorrhaging cash. They sell old ships for demolition to raise money and the rate of fleet growth slows. Demand growth eventually rises faster than supply growth and day rates rise. Eventually ship owners start to make profits again and finally they have money burning a hole in their pocket so they invest it in new ships, which deliver one to two years later and the cycle peaks then collapses. Shipping cycles tend to go up on the escalator and down in the elevator. Whenever there is a strong quarter of VLCC earnings growth, VLCC orders go up – you can test the historical data if you like (or read about it in my online course on shipping markets analysis).
On the basis of shipping’s rather poor track record of forecasting even over short time periods, working out the required replacement rate of investment to decarbonise the shipping industry would appear to be a fool’s errand. Where does that leave us?
It leaves us in the realm of qualitative forecasting as opposed to quantitative forecasting. In other words, it leaves us guessing. My guess is that we start from the premise that the ships we build this decade may not last 25 to 30 years as they have in the past. We should build ships to last until, say, 2040 and then invest the heck in the zero carbon technology for the next generation.
When we plan those ships, we have to think about the world in which they will operate, and in 30 years we will live in a very different world from today.
It will be warmer, wetter and more frequently damaged by extreme weather.
It will be less globalised, more regional as globalisation retreats into bilateral and club trade deals, spheres of political influence and a nuclear-armed version of the Great Game of the nineteenth century.
The population will be older and less inclined to spend on items with short lifespans, because the biggest consumers are young people in the years before and after they settle down and have families, but fewer are doing so and they are doing so later and having fewer children.
After 2050, our grandchildren will travel less far, less frequently, and more slowly than today, to manage their personal carbon budgets and to maintain their social credits. They will lease, not own, capital goods like cars. They will interact virtually in the metaverse rather than fly.
Shipping will react to this by operating smaller, slower ships focused on optimising supply chains and minimising emissions rather than simply on economies of scale.
To work backwards from that to calculate today’s required replacement rate requires more than calculation. It requires either a leap of faith or a policy decision from government. But as shipping is beholden to no single government, being a payer of tax to none by preference and only some by necessity, there is no single policy we can currently get behind. It makes things even harder when able and hard working government shipping ministers lose their jobs because of their religion, as is alleged to have happened in the UK.
Bringing this piece back to Mr Powell and interest rates, it doesn’t really matter if interest rates are 0.5% or 5.5% or even 25%. Shipping cycles have been consistently inconsistent in all three interest rate contexts in my own lifetime. So if people ask you what the cost of debt will do to investment in green shipping, simply tell them: nothing, compared to the cost of doing nothing.