Ocean Carriers In January HEIDI, Mary Linn, Vice President of Finance for Ocean Carriers, a shipping company with ofces in New York and Hong Kong, was evaluating a proposed lease of a ship for a threeyear period, beginning in early 20133. The customer was eager to nalize the contract to meet his own commitments and offered very attractive terms. No ship in Ocean lCarrier's current eet met die customer's requirements. Linn, therefore, had to decide whether Ocean Carriers should immediately commission a new capesize carrier that would be completed two years hence and could be leased to the customer. Ship Operations Ocean lCarriers Inc. owned and operated capesize dry bulk carriers iat mainly carried iron ore worldwide. This type of vessel ranged in size from SDJJEH] deadweight tons to 21!],CHII' deadweight tons of cargo carrying capacity. Capesize carriers were too large to transit the Panama Canal and therefore had to sail around Cape Horn to travel between the Atlantic and Pacic Oceans. In January EDD], there were 553 capesizes in service in the world. Ocean Carriers\" vessels were mostly chartered on a "time charter" basis for a period such as one year, three years, or ve years, although the spot charter market was used on occasion. The company that chartered the ship was called the \"charterer." The charterer paid Ocean Carriers a daily hire rate for the entire length of the contract, determined what cargo the vessel carried, and controlled where the vessel loaded and unloaded. The company, in turn, supplied a seaworthy vessel that complied with international regulations and manned the vessel with a fully qualied and certified crew. Operations also included ensuring adequate supplies and stores were ontroard, supplying lubricating oils, scheduling repairs, conducting overall maintenance of the vessel, and placing all insurances for the vessel. For a new ship coming on line in early 2333, operating costs were expected to initially average MIDI] per day, and to increase annually at a rate of 1\": above inflation. Charterers were not charged a daily rate for the time the vessel spent in maintenance and repair, although operating costs were still incurred. Initially, 3 days a year were scheduled for such work. The me allotted to maintenance and repairs increased to 12 days per year after five years of operation, and to 16 days a year for ships older than ten years. The company had a policy of not operating vessels older than 15 years. Every five years, intemational regulations mandated that a special survey be undertaken to ensure seaworthiness as dened by international regulations. By the fteenth year, due maintenance required to comply with the special surveys was very costly. Exhibit 1 shows the capital expenditures anticipated in preparation for the special surveys. These outlays were considered capital expenditures, which would each be depreciated on a straight-line basis over a 5year period. To avoid the larger expenditures for older ships, the company planned to sell the vessel into the secondhand market, or "scrap"r the vessel just before the third special survey. 1|n-"ii'hen scrapped, the vessel was demolished and its steel was sold to demolition yards. The company estimated the scrap value to be $5M at the end of the fifteenth year. Exhibit 1 lCapital Expenditures Anticipated in Preparation for Special Surveys EDI}? 2B]! 201'? 2.1122 2B2? {5300.5313 $35GDGIG SEE-.000 $BED.DDGI $1.ESU.EHJG Source: Company estimates Suppl],r of Capesizes Daily hire rates were determined by supply and demand. The number of ships available equaled the nlunber of vessels in service the previous year plus any new ships delivered minus any scrappings and sinkings. When the market demand for shipping capacity was high, owners would keep a vessel in operation as long as possible. Conversely, when market demand was low, scrapping rose. Supply was also affected by the increases in size and efficiency the newer ships offered. As ships got bigger, faster, and more fuel efficient, fewer ships were needed to carry the same amount of cargo. Moreover. there had been very few scrappings in recent years, and most of the capacity of the worldwide fleet of capesizes was fairly young. Exhibit 2 shows the capesize eet by age category as of December 233\"]. Exhibit 3 shows the number of new capesize vesse by expected delivery date. Exhibit 1 Capesize fleet by age category as of December 2041] EE 3 Wholi 15b01'3 \"1101-! 'I'nar! 'I'nnrs Yams Eldribit 3 Current order book for dry bulk capesizes by delivery date Zt 1M2 2.003 200-1 Number of vessels BE. 33 21 9 Souroe: Comps my documents Estimates of future orders for vessels were not entirely reliable, especially projections spanning more than two or three years in the future. If sentiment was optimistic on market conditions, more vessels would be added to the order book. If the market outlook was poor, then vessels would be canoelled or converted to other types of vessels. A capesize took approximately 1D months to build, but oontracts were signed to secure a berth place approximately two years before delivery and over one year before steel cutting for the vessel. r'Elelivery\" referred to when the vessel was complete and delivered from the shipyard to the owner. Market conditions The demand for dry bulk capesizes was determined by the world economy, especially its basic industries. Over 35% of the cargo carried by capesizes was iron ore and ooal. Production and demand for these products increased in a strong economy. Changes in trade patterns also affected the demand for capesizes. For example, if a Il-"'I."estern European country decided to switch its supply of iron ore from the United States to Australia, the demand for capesizes would increase since the distanoe between Europe and Australia is greater than the distance between 1r'v'estern Europe and the United States. Spot charter rates tended to fluctuate more widely than time charter rates, i.e., the highs were higher and the lows were lower in the spot market. Therefore, when the market was high, ship owners sought time charters to lock in the high rates for as long a period as possible while the charterers preferred to trade in the spot market to avoid having to pay high daily rates any longer than necessary. Because Ocean Carriers\" vessels were relatively new and a bit larger than the industry average, they earned a premium to the market. For example. new ships generally earned a 15% premium in daily hire rates relative to the industry-wide average, while ships over 25 years old typically received a 35% discount from the industry average. Exhibit 4 shows average adjustments to daily hire rates for 3year time charters based on the age of the ship. Exhibit 4 Daily hire rate adjustment factor for dry bulk capesizes based on age of vessel Over 24 years 2D In 2.4 years 1.5 to 19 years It] to 1-1 years 5 to El years Under 5 years 0.65 1].?5 0.8+] 1.04] 1.135 1.15 The average prevailing spot market rate at the time was $22,000 per day.1 1r'v'ith Australian production in iron ore expected to be strong and Indian iron ore exports expected to take off in the next few years, Linn took an optimistic view of the long-tenn market demand for capesizes. However, she also considered that 63 new vessels were scheduled for delivery in 2001 and that imports of iron ore and coal would probably remain stagnant over the next two years. Linn therefore anticipated that spot rates would fall in 2001 and 2002. In 2003, however, Linn was aware that Australian and Indian ore exports would begin, and that these new supplies would significantly increase trading volumes. Demand for capesizes would likely increase with these higher trading volumes, possibly boosting prices. Exhibit 5 provides data on some demand drivers, fleet size, and average daily hire rates over time. ExhibitE Worldwide iron ore vessel shipments, fleet size and average dailyr hire rates for capesize charters, 19942001 1994 1995 1996 199? 1993 1999 21H!) 2001E Iron ore vessel shipments 3T5 39? 335 424 421] 4m 4110 436 Fleet size NA NA NA 54:} 23 23 552 612 Avg. spot rate $16,351 $20,149 $1 1.?30 $14,?9-1 $1 [1,105 59.42? 522.5?5 Avg. B-vrcharterrate $13,250 $18,544 $14,020 $16,063 $13,020 $12,620 $15,344: Souroe: Company documents Linn enlisted the services of a shippingindustry consulting firm to help her forecast daily hire rates for a new capesize. Worldwide iron ore vessel shipments and charter rates had been very strongly associated historically. The consulting group felt that this relation would continue to hold in the future, and based its forecast of charter rates off of longterm forecasts for worldwide iron ore vessel shipments. The longterm forecast for worldwide iron ore vessel shipments was for 2% annual growth during 2002 to 2005, and then dropping to 1.5% thereafter. Exhibit 6 shows the forecast of daily hire rates that was prepared for Linn. Newbuilding The charterer currently in negotiations with Ocean Caniers for a threeyear time charter starting in 2003 had offered a rate of $20,000 per day with an annual escalation of $20] per day. The expected rate of inflation was 3%. The vessels in Ooean Carriers' current fleet could not be committed to a time charter beginning in 2003- because the ships were either already leased during that period or were too small to meet the nastomer's needs. Moreover; there were no sufciently large capesizes available in the secondhand market. Ocean Carriers had to decide immediately if it should commission a new ISJDIII deadweight ton ship for delivery in early 213103. The ship would cost $39 million, with 10% of the purchase price payable immediately and 10% due in a year's time. The balance would be due on delivery. A new ship would be depreciated on a straight-line basis over 25 years. In addition, Linn expected to make a 35mm: initial investment in net working capital; which she anticipated would grow with infla tion. Linn was also confident that the charterer would honor his proposed contract with lOcean Carriers if the company agreed to the terms. While there is always a risk that the charterer would stop paying before the end of the contract or terminate the contract early, Linn considered 'lat the risk was small. l[Itcean Carriers had long established relationships with its charterers and only contracted with reputable charterers. The proposed ocrntract, though, 1was only for three yearsJ and it was Linn's responsibility to decide if future market conditions warranted the considerable irwestment in a new ship.