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CASE STUDY TANkER INDUSTRY

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CASE STUDY TANkER INDUSTRY

VERSION B
VERSION B

10175 Ana Filipa Seno Conduto
10289 Sera Ayouzy
625 Adrienn Molnár
747 Lorena Vukas

10175 Ana Filipa Seno Conduto
10289 Sera Ayouzy
625 Adrienn Molnár
747 Lorena Vukas

Question 1: “Identify the major differences between the spot and charter markets. Which do you think is more prone for price competition? Why?”

There are two types of market for oil tanker services – the spot market and the period charter market, which defer in the way trade is handled. In the spot market, a vessel was rented just for a single predefined transportation. In specific, ship-owner agreed to carry cargo only on one occasion between two specified ports in the near future, usually within two weeks of the date on which the agreement was made. On the other hand, in the period charter market the trade concerned actual ships as they were hired on a long-term basis with or without crews, maintenance and repair. They were hired for a particular period of time, a given number of voyages or the movement of a certain quantity of oil between specific points. In a nutshell, these markets were substantially different and used for different occasions so consequently prices were not determined in the same way. Nevertheless, prices in both markets were established through brokers whose task was to negotiate a price that would be acceptable both by an oil company and a ship-owner.

Prices in were based on the Worldscale index which comprised operating costs for different distances and routes for a theoretical tanker of 19,500 DWT and was updated every 6 months. As tankers are usually of higher capacity and costs variable bids were given in comparison to a Worldscale of 100. The index, as well as the price charged, decreases as the market is more concentrated if there is scope for profit and therefore price competition arises if oil companies are ready to bear the risk given. As there are more includable/excludable variable costs and scope for negotiation upon the period of the rent, the price competition is significantly stronger in the period charter market. Moreover, in period charted market tankers are rented for a longer period of time which logically lowers the price. These can be supported by examining exhibits 5 and 6 where Tanker Spot Rates and Tanker Period Market Rates are plotted. Simply by observing graphs it can be concluded that in general prices in the spot market are slightly higher, meaning that due to tougher price competition prices are pushed more down in the period charted market. Additionally, competition in both markets can be defined as Bertrand model competition since ship holders are competing in prices and by definition they set the lowest acceptable price through brokers in order to cover their costs and gain slight profit. Accordingly, we can also argue that this is a further reason for tougher price competition in period charter market as we can assume that products are more homogeneous in the spot market, making the pricing more similar. On the other hand, the period charter market can be defined as differentiated Bertrand model with horizontal differentiation since there are many variable costs that can be added or excluded to form the most adequate price.

Question 2: “What can you infer, in terms of efficiency, about the choice of the oil firms to vertically integrate into the tanker market? Does this choice still make sense even in a period of low spot prices?”

To begin with, vertical integration implies controlling a part of your supply chain, either backward (your suppliers) or forward (your distributers). In general, oil companies vertically integrate in both ways by controlling its whole supply change from locating crude oil deposits, drilling and extracting crude, transporting it around the world, refining it into petroleum products such as petrol/gasoline, to distributing the fuel to company-owned retail stations. The oil firms vertically integrating into the tanker market is an example of forward vertical integration since by doing so they control distribution of oil across the world; and most importantly its costs. In terms of efficiency, the oil firms benefited considerably from it by fully exploiting opportunity to decrease its operating cost to a significant extent. Most importantly, by owning its own fleet they could minimize the cost of transportation, which accounted for a major part of the cost and was, as mentioned in the text, referred as “a necessary evil”. By observing the Exhibit 4, we can conclude that transportation of oil was done on substantially long distances and therefore here was the widest scope for lowering costs and increasing profits. For this reason vertical integration into the tanker market was an obvious and dominating strategic decision, which can be backed up with observing Table 5 from which we can see that in January 1983 there were more than four times more ships owned than rented in the period charter market.

Secondly, oil companies could also control the skill of the crew and the maintenance of the ship and in this way improve its efficiency. What is more, they could invest even further in newly owned tankers and improve its capacity and utility; and also exploit the benefits of the possibility of financing tankers under shipyards’ subsided schemes.

In a nutshell, savings from being able to control its costs and benefits from improving its utility are substantial and crucial in order to stay competitive in the long run. That is the argumentation why this is in the long term the best choice for any oil company, even in a period of low spot prices since these periods last only for a short period of time and under the assumption the firm has an intention to stay in the business infinitely. By operating in a spot market in period of low prices an oil firm can definitively benefit from it in the short-term, but any firm should be concerned primary on its long-term profits if it wants to stay in the business and maintain competitiveness. Therefore, it is crucial to build up their strategy upon the computation of long term profits which should expectedly be higher than the current loss by investing in controlling their distribution channel.

Question 3: “Describe the broad strategic choices of the Hong-Kong Chinese independent ship owners (tip: bear in mind that strategic choices are conditioned by the specificities of the environment in which the owners operate).”

In 1983 Japan was one of the biggest countries in oil tanker shipping business. Japanese had developed major improvements in shipbuilding techniques and created the world’s largest and most competitive shipbuilding industry. They had huge transportation requirements and had built up the largest fleet but it was not enough to meet the demand. Since they could only cover half of the requirements they decided to enter a business with Hong Kong Chinese. As we can see in Exhibit 4 Japan and China were very disconnected from the rest of the world. Therefore, they were close competitors but it was also in their best interest to collaborate with each other and be mutual partners.

At the time, Japan had many legally imposed restrictions and the Chinese were conditioned by those limitations when doing business with them. The Japanese were very protective and had rules to defend what is national (“nationality principle”), on which they insisted and therefore had interest only and exclusively in buying Chinese ships to meet their requirements. Hence, they established a transaction called shikumisen, by which Hong Kong Chinese owner signed a long-term charter to a Japanese oil company and at the same time, financed by the Japanese Export-Import Bank, ordered a tanker from a Japanese shipyard. With this transaction, the Japanese were able to have enough ships to meet the demand but were still protecting their country, since the Chinese had to make the ships in Japan and were financed from Japanese banks. What is more, a strong barrier for entering this business trade was that Japanese ship-owners could not register their ships under foreign flags and couldn’t employ foreign crews. However, with shikumisen transaction they had the opportunity to lower the transportation costs in the other way and remain competitive. In specific, using the ships that were owned by Chinese, the Japanese could operate with Chinese or Indonesian crews that were less expensive.

When observing the reasons of the Hong-Kong Chinese for entering this directly beneficial trade agreement for the Japanese, it is crucial to understand their indirect motivation since logically they could have refused it as they were, as aforementioned, close competitors. It is apparent that they directly received profits from renting their ships, but they based their core strategy on the indirect benefits from Japanese situation. Precisely, making a ship in Japan had many advantages for them since the Japanese had developed shipbuilding techniques and hence the Chinese could build up significantly better ships than the ones constructed in China. Therefore, their strategy was well determined in advance and both countries were able to benefit from this trade- the Japanese in the short term by covering their demand and the Hong-Kong Chinese in the long term by improving their own fleet.

Question 4

a) How do you explain the preference of the Scandinavian owners for technological sophistication?

Scandinavians were present in every type of shipping. They had run general cargo operations, specialized shipping businesses, they had LNG shipping and offshore drilling rigs and oil tankers. Therefore, Scandinavians enjoyed much respect in the industry and they were said to possess the most sophisticated technology among individual ship owners. Their ships were constantly exceptionally maintained and crews were highly skilled.

Their ships had high operating and investment costs. They had to pay high costs to crews due to the fact that their ships had to operate under the Norwegian flag. In addition, Norwegian owners ordered mainly of their ships from Scandinavian shipyards that charged the highest amount of construction costs. Moreover, Scandinavian shipowners were subject to a remarkably high taxation, however, they could benefit from liberal depreciation and reinvestment allowances. Reinvestment opportunities allowed owners to stress on employees’ working skills and techniques by providing trainings. Their willingnes to put in more costs into proving human capital expresses that they were in favour of technological sophistication because they aimed to gain the best quality in terms of skills.

The Scandivanian nation was one of the major dominant in shipbuilding, so countries such as Sweden and Norway were considered economically significant. There was quite a strong relationship between this nation’s shipyards and the individual shipowners. Since the majority of the orders were delivered to the local shipyards, it can be safely assumed that the owners were engaged in implementing advanced technology and gaining maximal benefits by that. Since construction costs were related to the surface area of a vessel rather than to its volume, cost could be reduced to 1/3 by constructing a vessel with increasing twofold its surface, which represents the Cube – Square rule. Having taken account the fact that building ships was highly labor intensive, this information also characterizes the effects of learning economies besides the advantage of reinvestment allowances. Basically, shipyards had been able to reduce production costs through excessive experience, so employees/crews had learned and experienced over time so that they could implement better and better techniques for the production process.

b) Comment on the validity of the following quote: „The Scandinavians were considered the gamblers of the shipping industry”.

Firstly, Scandinavians seemed to act such as gamblers because they preferred to trade with VLCCs and ULCCs. Which, accounted for the largest types of tanker and these had been developed in order to bring crude oil from the Middle East to Europe and Japan. However, in 1967 the Suez Canal had been closed having affected the demand of enormous oil carriers. Since the distance had grown significantly its demand had started to increase in the early 1970’s. As a result, the average cost of tanker transportation can be seen to decrease from 2,25 dollars/barrel to 0,95 dollars/barrel by 1970. Moreover, according to the tanker spot rates it can be concluded that from the appearance of high demand for VLCCs and ULCCs had driven to diminishing average freight rates in the spot market which almost perfectly corresponds to the rates in the tanker period charter market. In both markets large tankers had lower freight rates than that of Medium and Large 2 types.

Secondly, during 1970’s Scandinavians had placed more early orders for VLCCs and ULCCs than other nationalities, and had run their fleet mainly on the spot market. Trading on the spot market was based on the Worldscale index. It concerns highly volatile market characteristics as high net profits attracted wealthy shipowners with low risk aversion. Thus, competition with many participants had taken place which had led the Worldscale index to decrease. Scandinavians had invested a lot, they had mainly owned fleets than chartered ones and sometimes they were not able to pay for new ships due to their high operating expenses. Yet, their government assured owners to repay their debts. For instance, Reksten company had employed 52% of its fleet on the spot market, 19% on the period market and 29% was laid up. Unfortunately, intervention had not occured in time to save the company, so it went to bankruptcy. Even though they had high investment costs they had been willing to take the risk. Therefore, these factors had contributed to the „gambler” identification of Scandinavian owners.

Question 5

„Do you agree with the usage of different types of thankers the Greek owners did for the spot and charter markets? Justify while acknowledging the differences in relative efficiency of each type of vessel.”

Greek owners purchased secondhand ships which were smaller and older than Scandinavian ships. They were considered as frequent buyers and sellers of used ships. One of the main factor of their relative efficiency was that Greeks traded with Norwegians,thus they could operate their fleet with less expensive labor costs. With the reaction of the increasing demand for large tankers in the early 1970’s, Greek shipowners had also ordered some large ships. They had been tempted to trade with more modern and larger vessels on the charter market. On the contrary, they had placed old and small vessels on the spot market. Another benefit was represented by that secondhand ships were significantly cheaper to obtain than purchasing them form shipyards. In addition, their average price reflects to be decreasing over time. They had also less operation costs and fewer people were required having resulted in low labor costs.

Furthermore, the reason why we consider it as a sensible approach is the behaviour of the markets in terms of volatility. The Worldscale index in the period charter market had shown less amount of fluctuation than in the spot market. Thus, owners could not have lost much capital if the Worldscale had shrunk due to low investment and low expenses. From the given tanker spot rates, we can see that owners of small tankers had to face highly likely with larger freight rates than they did so in the charter market trading with large vessels. For instance, the Greek Onassis group employed only 29% of its fleet on the spot market and 71% on the period charter market. This describes appropriately the Greek owners’ attitude. To conclude, with their strategy they obtained relative efficiency in lower acquisition costs, lower operational costs, lower labor costs and frequent trading in both markets.

Question 6: “A Japanese shipowner is pondering between the acquisition of a combined carrier or an oil tanker carrier. Both vessels would be brand new and have the same cargo capacity and maintenance costs. In light of what your knowledge of entry and exit barriers, carefully compare the potential entry deterring effects of each type of vessel.”

Since both vessels have the same cargo capacity and equal maintenance costs (assumption made in the exercise), there is neither capacity nor cost advantages. However, advantages lie in economies of scale. In fact, economies of scale are present in oil tanker carriers, mainly in their construction, crew costs and fuel. In the construction process the cube-square rule is present: “Construction costs were related to the surface area of a vessel rather than to the volume enclosed, which of course determined cargo capacity. (…) Thus the size of the engine did not grow in direct proportion to ship cargo capacity, resulting in more efficient use of fuel and power in larger vessels.”

Furthermore, economies of scale represent structural entry barriers. So if the Japanese ship-owner decides to acquire an oil tanker carrier, he will advantage from the fact that an oil tanker carrier generates significant economies of scale, and, consequently, this asymmetry will constitute a barrier to enter the industry. On the other hand, even if both vessels have the same cargo capacity, oil tanker carriers represent a higher portion of the world's shipping fleet (see Table 1). By acquiring an oil tanker carrier, the Japanese ship-owner will increase its market share (and consequent profits). Assuming that the Japanese owns a large firm, this new acquisition will consolidate his image of “big and tough firm” and this might dissuade entry of firms in the industry. Even if he is not though, he can appear tough and the effects will be the same.

Regarding combined carriers, we can see in Table 1 that they represent a lower portion of the world's shipping fleet (still taking into account the assumption that they have the same cargo capacity). They are the most flexible vessels and are15% more expensive to build. Nevertheless, combined carriers are sometime used as oil tankers so, in this case, their higher price won't be justified. Due to their flexibility, combined carriers allow shipowner to expand their capacity and even excess it. Thus, holding excess capacity is a strategy of deterring entry because it creates asymmetry between the firm how is producing in excess and the entrant. For this strategy to be successful, we assume that the Japanese ownership has sustainable cost advantages on the entrant, the market demand grows slowly, the investment in excess capacity in a sunk cost and the entrant does not have a reputation for toughness. On the other hand, if the Japanese ownership, by acquiring the combined carrier, meets more demand and is closer to Japan's total marine transportation requirements this will reinforce his brand identity, his reputation for being a “large and strong firm that can sustain and survive to a price war” and so keep the entrant out of the market.