The shipping industry is in rough waters lately. In many categories, global capacity exceeds demand, and shipping rates and ship values have sunk to near-abyssal lows. Take the VLCC (“very large capacity carrier”) tanker business, for example.
Back in 2005 and 2006, shipping companies had every reason to be optimistic about potential demand. Asian economies were booming, and their need for oil was surging. So they ordered scores of large, new vessels.
Between 2007 and 2011, the world’s VLCC fleet grew by 10%, but demand for oil grew by only 3%. With capacity that far ahead of demand, shipping rates plunged to near-record depths. Reduced income from ships meant reduced values for ships, and vessel prices fell by 55% over the same period.
The industry got caught in a perfect storm of business cycle and industry cycle risk. The business cycle drove down demand for shipping when the United States and Europe went into recession in 2008 and 2009 and emerging economies slowed down. But even after the global economy recovered in 2010 and 2011, shipping remained trapped in a classic industry cycle.
Industry cycles occur when capacity exceeds normal, recovery-stage levels of demand. Prices plummet, and revenues fall with them. Industry cycles are different from business cycles. In business cycles revenues are demand-driven; in industry cycles they are price-driven.
There is more at work in industry cycles than the simple microeconomics of supply and demand. They have a complex set of drivers. They are most common in industries with these characteristics: commodity products or services; large economies of scale; high fixed costs; intense competition.
Commodity industries are especially likely to get caught in industry cycles. It is hard for competitors with commodity products to differentiate themselves and compete on distinctive product features, so they compete on price instead. When supply steams ahead of demand and customers begin to exploit their new bargaining power, the only course commodity producers have is to cut prices.
Many industries benefit from economies of scale in production, purchasing, distribution, and the like. Because competitors invest heavily for scale, they have a big burden of fixed costs. In periods of weak pricing, they make things even worse, cutting prices aggressively to keep sales volume above break-even levels.
A tendency for competitors to add capacity all at once makes things even worse. The companies with the newest capacity have the biggest economies of scale and the latest, most efficient technology. Afraid of being at a cost disadvantage, the other competitors add capacity too, and then total capacity sails ahead of demand and a price war ensues.
Shipping is not alone in this. There is a whole fleet of industries prone to industry cycles. Chemicals, pulp and paper, memory chips, airlines, commercial real estate, and many others share a tendency for capacity to overshoot demand and prices to fall as a result.
The risk lesson in all this is clear. Even in good times for the economy as a whole, when demand is at least recovering and at best strong, be careful. Be sure the company you are following isn’t headed for the shoals of an industry cycle.