Dryships turns to the bond market

After repeated ATM share offerings with massive dilution, Dryships (DRYS) has now turned to the bond market for additional capital with a new US$ 400 mio offering (initially US$ 300 mio). The deal also includes a US$ 150 mio loan in notes to Deutsche Bank, the sole bookrunning manager of the deal. As a feature, the deal appears to offer investors a convertible arbitrage where they can take a short position against the company common share value so they can hedge their investment.

Dryships was badly hit by the financial crisis and precipitous drop in the dry bulk market last year. The company had been outperforming its peers with a more speculative policy of older vessels, shorter term employment, building up the fleet by riding the market up and selling older tonnage to finance and expand into new tonnage. Bank leverage rose accordingly.

George Economou's decision to use Dryships to support his foray into off-shore drilling purchasing OceanRig changed the nature of the company. He privately booked several additional oil rigs and in his usual practice shifted them to Dryships, where there was broader access to capital markets to support the transaction.

An oil rig is a substantially higher capital intensive investment than a ship. The oil rig assets on the company balance sheet quickly overshadowed the shipping operation. Capital needs increased geometrically.

Economou was constrained to posture his fleet with longer term employment to support the burden of ever increasing debt on the company balance sheet under the strain of this new scaling up in another sector. The longer employment profile for the bulk carriers proved a timely move in view of the subsequent financial meltdown in the fall of 2008.

The crash in freight rates and asset values put Dryships into default with its senior lenders that has taken months to renegotiate this year. At the same time, Economou had to restructure the aggressive company capital expenditure program that included both dry cargo vessels and oil rigs. The company was obliged to cancel a large number of new building orders and forfeit deposit money as well as to take substantial asset impairment charges.

To cover the financial hemorrhaging, Dryships embarked upon a series of ATM (at the market) share offerings to increase its capital by massive share dilution. As things have stabilized in the dry cargo market and the oil rigs on order are coming up for delivery, presumably Economou wants to avoid further share dilution by turning to the bond market, hoping to lock in good terms in the face of future increase in interest costs.

The short hedge feature is likely a sweetener for potential hedge fund investors, who are a mainstay investor market for the shipping sector. Most hedge funds have considerable experience in commodities . There is close relation between shipping freight markets and commodities markets. Spot rates are driven by inventory levels and the pricing structure between the derivatives and physical markets.

The higher than expected interest cost of the recent Genmar bond issue, however, would appear to create some clouds on the probable pricing for the Dryships bond issue. With Dryships there is always an ongoing debate on how much new capital is being used to refinance and manage existing debt as opposed to going into fresh investments.

DryShips's two semi-submersible units and four drillships on order for 2011 delivery have recently been valued by analysts at US$ 3.7 bio against the value of its bulker fleet and above-market charters, which is barely half that at US$ 1.9 bio. Most analysts are in agreement that Dryships will have no problems in securing contracts and employment for its oil rigs, but divergence on rate forecasts drives the stock recommendations for the company. Nordea tends to be cautious whilst Lazard is showing some optimism for DRYS.  Both are placing their emphasis on the offshore drilling market and assuming firmer oil prices in 2010.

A turnaround for Aries?

New CEO Michael Zolotas and CFO Allan Shaw recently gave a presentation of their plans to turn around Aries Maritime (RAMS) and use it as a platform for growth. They talked about recapitalization, fleet mix, in-house technical management, chartering strategy, steamlined GA costs and the new management team. Their new focus is on dry cargo and product trades. They have dropped in six additional units from GrandUnion and recapitalized with US$ 36 equity and US$ 182 mio additional debt. Let's evaluate.

The vessel transfer from GrandUnion consists of two 1990-vintage Capesize bulkers, two Panamax bulkers built 1990/ 2002 and two Dwt 37.000 product tankers built 2003/ 2004. The nominal purchase price is US$ 180 mio of which US$ 160 mio in debt liabilities and US$ 20 mio in shares (at a 125% premium to current price). The new management has booked the two remaining Aries container units for sale at US$ 11,4 mio .

In terms of hardware, Aries now has a fleet of 21 vessels: eleven product carriers and seven bulk carriers. Two Dwt 73.000 product tankers are on bareboat charter to Stena until 2H 2010. The two additional product carriers are time chartered until 2011. The remaining product tankers ranging from Dwt 38.000 t0 73.000 are on the spot market. All the bulk carriers are on time charters of various durations with fairly low rates mostly in the teens except the Cape unit Brazil, which has a good paying period charter with an initial rate of US$ 28.000 per day.

The large number of product carriers on the spot market presents a serious exposure problem since this sector was very hard hit this year and is suffering badly in the current market. The new management will have to determine a new employment strategy. This is a challenge but their new business director, Paul Wogan played an instrumental role in developing the Seachem pool for Livanos facilitating the Odfjell merger and is a capable person. They may have to invest to build up a chartering team. There appears to be no existing contract base from GrandUnion and they will have to create a viable customer base for Aries in the product sector.

Ironically their fleet mix is similar to Top Ships (TOPS), the other well-known Wall Street laggard of the Greek Shipping community, which seems to be doing a bit better lately. The Aries drybulk units are distinctly older than the TOPS units that were bought at the height of the market albeit with much better age profile. The Aries units are mainly Capesize units whereas TOPS focused on the Panamax size. The Capesize sector has been outperforming the market this year. Older units like the Aries vessels can be very profitable, but it is a very volatile market.  Presently they are tied up on time-charters with rate levels that are moderate compared to more modern units, excepting the Brazil charter. 

What is worrisome is the high level of debt on the six additional vessels (US$ 160 mio liabilities out of a purchase price of US$ 180 mio) and the large amount of additional debt in the recapitalization (US$ 182 mio against US$ 36 mio new equity). The 30.09.2009 pro-forma balance sheet looks ghastly with the shrunken asset values, high level of debt, free cash down to zero, US$ 124 mio loss of which a US$ 91 mio asset impairment charge and distinctly negative net worth.

It would have been helpful with all the additional changes and recapitalization that they had included in their presentation a restatement of their balance sheet after the additional changes in the fleet and capitalization. I find, however, difficult to see any major improvement in leverage in these subsequent events.  The largest share of new funds has been raised by additional debt. The new equity is small in comparison to the new debt and the drop-in units are highly leveraged. Aries still appears to be a company swimming in debt. Perhaps they preferred debt in the recapitalization to limit share dilution, assuming limited downside risk on further fall in vessel market values and looking to enhance returns. The positive hope is expectations of improved earnings from the expanded fleet and new management.

The new members of the management mark a considerable qualitative improvement from the previous management (the former CEO Jeff Parry was probably the sole credible person). It was a good move that they wrote down the assets and renegotiated the debt. Adding Newlead management was a very positive step. The previous technical management was disastrous and had a horrendous insurance record. It is now largely a matter of their commercial team and their opportunistic accreditive acquisitions to create value in their business.

They have secured additional funds for this, but they still appear to have a strained balanced sheet as a limiting factor. If there is a nice market upturn in 2010, it will provide them much necessary uplift in free cash flow and retained earnings to rebuild shareholder equity and deleverage. Rising asset prices will also help.  On the other hand, they will be at risk if market recovery is delayed and 2010 proves a poor year. In the negative scenario, they could end up with some of their new funds being cannibalized for debt service and require further financial restructuring.

Aries certainly shows significant progress, but it is still work in progress and a speculative play.

Is Chinese demand for dry cargo as sustainable as industry analysts claim?

Despite the global financial crisis, this year has seen some revival in dry cargo rates, especially for Panamax and Capesize vessels. This has led to some renewed investor interest in the sector, notably by Peter Georgiopoulos. The investment thesis rests on Chinese growth potential. Chinese analysts tend to be more reserved. They see significant barriers to expansion in the hinterland and have mounting concerns over misinvestment and asset bubbles, jeopardizing future financial stability.

Western frenzy over China and its prospects tends to resemble the dot.com enthusiasm of the late 1990's with glowing forecasts of everlasting, insatiable demand. It is true that China is a resource-scarce economy with increasing import needs but there are serious issues of longer-term sustainability.

Whilst China entered the crisis with the highest investment rate in history, there is also very high investment misallocation. The primary source of China's high savings rate is their state owned enterprises (SOE's) that are sustained by energy and land subsidies, cheap credit, low wage costs and lax environmental standards. Without subsidized and controlled interest rates, even ignoring the other subsidies, the most important of which maybe the currency undervaluation, Chinese SOE profits in the aggregate would be negative. There is no guarantee that the current environment of low interest rates and cheap money is indefinitely sustainable.

Most of the cargo demand for larger bulk carriers depends on the steel industry, where iron ore is a major factor. The iron ore market has been brutal for China, partly due to China's own inefficient system. China imports more ore than Europe and Japan combined. Skyrocketing prices have cost China dearly.

For four decades before 2003, fine iron ore prices fluctuated between US$ 20 and US$ 30 a ton. As ore was plentiful, prices were driven by production costs. After 2003, Chinese demand drove prices out of this range. Contract prices quadrupled to nearly US$ 100 per ton, and the spot price reached nearly US$ 200 a ton in 2008.  The gradual concentration of major iron ore mines by the world's three largest suppliers was a major reason for this price increase. The nature of Chinese demand was another major reason. China's steel production capacity has skyrocketed, even though capacity is fragmented.

China's local governments have been obsessed with promoting steel industry growth, which is the reason for fragmentation. Huge demand and numerous small players are a perfect setup for price increases by the Big Three miners, which often cite high spot prices as the reason for jagging up contract prices. But the spot market is relatively small, and mines can easily manipulate spot prices by reducing supply. On the other hand, numerous Chinese steel mills simultaneously want to buy ore to sustain production so their governments can report higher GDP rates, even if higher GDP is money-losing. China's steel industry is structured to hurt China's best interests.

The Chinese government is very much wedded to it’s 8% growth target and will do whatever it takes to come close to that target – including flooding the domestic banks with a wall of cheap money to lend as economic stimulus. However, preventing a downturn with easy money is a dangerous way to reflate the economy.

As profitability for the businesses that serve the real economy remain weak, there has been of shift of investment in the first half of 2009 disproportionately into property, stock and commodity markets rather than private sector capital formation. This shift in the medium term threatens to undermine China’s financial stability. Thus, China is experiencing a relatively weak real economy and red hot asset markets.

The Chinese imports that revived the bulk carrier market this year were mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

Even more foreboding is a looming real estate bubble. The real estate sector in China is especially critical to the bulk carrier market because approximately 50% of Chinese demand for steel is generated by the construction industry. Most Western shipping forecasts are based on unlimited future need in China for new construction. The reality is quite different. China’s urban living space is 28 square meters per person, quite high by international standard. China’s urbanization is about 50%. It could rise to 70-75%. Afterwards the rural population would decline on its own due to its high average age.

So China’s urban population may rise by another 300 million people. If we assume they all can afford property (a laughable notion at today’s price), Chinese cities may need an additional 8.4 billion square meters. China’s work-in-progress is over 2 billion square meters. There is enough land out there for another 2. The construction industry has production capacity of about 1.5 billion square meters per annum. Absolute oversupply, i.e., there are not enough people for all the buildings, could happen quite soon.

The most basic approach in studying bubbles is to look at valuation. For property the most important measures are price to income ratio and rental yield. China’s average price per square meter nationwide is quite close to the average in the US. Yet the US’s per capita income is seven times China’s urban per capita income. The nationwide average price is about three months of salary per square meter, probably the highest in the world! Consequently, a lot of properties cannot be rented out at all. Those that can bring in 3% yield, barely compensating for depreciation. The average rental yield, if one including those that can’t be rented out, is probably negligible. China’s property price does not make sense from affordability or yield perspective.

Some argue that China’s property is always like this: appreciation is the return. This is not true. The property market dropped dramatically from 1995-2001 during a strong dollar period.  Property prices could drop like Japan has experienced in the past two decades, which would destroy the banking system.

In summary, the market frenzy now will not last long. The correction may happen in the fourth quarter. There could be another wave of frenzy next year as China can still release more liquidity. The biggest risk is the global economy cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. With rising inflation expectations, the US Fed will be compelled to raise interest rates in an effort of soak up the excess liquidity created by its vastly expanded balance sheet. A stronger dollar and a weak US economy would almost surely send China’s asset markets and the economy into a hard landing like during the Asian Financial Crisis.

All this underlines the risks in overly optimist forecasts for China in the dry bulk sector and we have not even mentioned the huge order book overhang and new deliveries of tonnage in the coming years.

Rising risks of an asset bubble in China threatened by US stagflation

China and the US are dealing with their imbalances by exacerbating the very things that caused them in the first place. China entered the crisis with one of the highest rates of misallocation of investment in recent times. With its enormous liquidity released for stimulus, China with waning export markets has become a giant Ponzi scheme, with money pouring into asset speculation. US expansionary monetary policies are leading to a stagflationary environment that will pop this bubble.

Rising productivity from the build-up in infrastructure and manufacturing outsourcing, together with a policy of keeping its currency undervalued, led to massive export growth in China. The resulting dollar earnings pumped up China’s monetary system. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Chinese state-owned enterprises (SOE's) are the primary source of their high savings rate that is financing US deficits and public debt. China has been keeping its currency undervalued to boost SOE exports by purchasing US dollars and placing the surpluses in US treasuries in a symbiotic relationship.

The SOE's surpluses in China are simply part of the transfer from household income to the state sector. The state sector ramps up investment more for policy, not profit, concerns. In the past, they ploughed this money into construction and factory investment projects that may well be already non-viable, but now they are significantly making matters worse letting the stimulus money go into massive asset speculation.

While China is experiencing weak exports now, the weak dollar allows China to release the liquidity saved up during the boom in the past five year without worrying about currency depreciation. As profitability for the businesses that serve the real economy remain weak, there has been of shift of investment into property, stock and commodity markets rather than private sector capital formation. Thus, China is experiencing a relatively weak real economy and red hot asset markets. This shift in the medium term threatens to undermine China’s financial stability.

China's corporate sector increasingly looks like a shadow banking system. It raises funds from banks, through commercial bills or the corporate bond market, and then channels the funds into the land market. The resulting land inflation underwrites corporate profitability and improves their creditworthiness in the short term. As land sales and taxes from property sales account for a big portion of local government revenues, there are powerful incentives to pump up the property market. Land sales are often carefully managed to spike up expectation through SOE's. When SOE's borrow from state owned band and give the money to local governments at land auctions, why should the prices be meaningful? The money circulates within the big government pocket. Tomorrow’s non-performing loans, if land prices collapse, are just today’s fiscal revenues. If private developers follow the SOEs to chase the skyrocketing land market, they could be committing suicide.

China's imports this year have been mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

The US is trying to reflate by massive government bail outs and stimulus plans that are financed by high deficits and rising public debt levels. The FED has embarked on an aggressive expansionary monetary policy, keeping interest rates low by purchasing agency debt in order to reflate the economy and drive asset prices up. Whilst these policies are prima-facie inflationary and there will be a huge unwinding problem in the future, the low monetary velocity and slack economic conditions counter balance any immediate risk. There is, however, a growing carry trade borrowing in US dollars at ZIRP and leveraging this wall of liquidity into more risky assets such as stocks and commodities.

Monetary stimulus is considered an effective tool to soften the economic cycle. It works by inflating asset markets. By inflating risk asset valuation, it leads to more demand for debt that turns into demand growth. In other words, monetary policy works by creating asset bubbles.  In this crisis, household and business sectors in the US have not been increasing indebtedness; falling property and stock prices have diminished their equity capital for supporting debt. The public sector has rapidly ramped up debt to support failing financial institutions and increase government spending to cushion the economic downturn.

US households cannot continue leveraging up to absorb the excess production that Chinese companies  have invested in additional capacity to export. The recent rise in US personal consumption was accompanied by a 3.4% decline in household disposable income. If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption. So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending.

Regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before -- money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough.

The global economy is cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. This scenario is the best that the central banks can hope to achieve; it combines an acceptable combination of financial stability, growth and inflation. This equilibrium is balanced on a pinhead, requiring central banks constantly to manage expectations. The world could easily fall into hyperinflation or deflation if one major central bank makes a significant mistake.

With rising inflation expectations, should the US Fed be compelled to raise significantly interest rates in an effort of soak up the excess liquidity created by its vastly expanded balance sheet: this would be the worst possible situation: a strong dollar and a weak US economy. China’s asset markets and the economy would almost surely go into a hard landing. It would reverse the US - China symbiosis.

The Chinese would face a serious financial crisis where their overinvestment and misallocation of resources comes finally to roost with a rash of non-performing loans that would threaten their banking system with permanent loss of capital. The US would risk being caught in a conundrum with sky-rocketing interest expense on its high level of public debt resulting in ever larger fiscal deficits and there would be a drying up of Chinese surpluses to finance the deficits.

Berlian Laju taking its distance from Eitzen Chemical in the CECO Merger

Berlian Laju (BLT) plans to leave Eitzen Chemical as a separate entity and retain the previous management to run it. They will transfer Eitzen Chemical debt from the CECO holding company back to the subsidiary. As a deal prerequisite, CECO lenders must agree to waive all principal payments and loan covenants for a three-year period. Of the US$ 200 mio cash that BLT is required to inject in CECO, only US$ 50 mio will go to Eitzen Chemical. BLT will invest US$ 130 mio of these funds in Indonesian projects.

It is clear that BLT does not have the management resources to run Eitzen Chemical and prefers to rely on its existing management to deal with its problems rather than to be involved directly themselves. They make it a condition that the senior lenders grant forebearance for three years as a condition to their participation in the merger deal.

BLT is sheltering itself from Eitzen by removing all the Eitzen Chemical debt liabilities from Camillo Eitzen and Company (CECO) and putting them back on Eitzen Chemical. BLT's share in Eitzen Chemical through CECO will be just under 50% and their role will be as shareholders with any transactions with the company taking place on a third-party basis.

There are no plans to fold CECO or its operations into BLT. There appear no major changes in the way CECO does its business. Of the US$ 200 mio cash that BLT is raising by a bond issue for this transaction, only US$ 70 mio will go to CECO and of these funds, US$ 50 mio will go to Eitzen Chemical.

Needless to say previous reference to cost savings and synergy in the merger deal was mostly window dressing for retail investors, since BLT has confirmed that will be no integration or rationalization. On the chemical side, BLT is three different companies operating independently:

• BLT's Indonesian operation trading cabotage in Indonesia and internationally in southeast Asia, which is their home market and core business.
• Chembulk operating from Connecticut with stainless vessels mainly Dwt 20.000-30.000 with fairly large tanks in long haul trades.
• Eitzen Chemical (subject the merger), which also has a Connecticut office that they acquired from the Songa merger in 2007. Their fleet is mainly smaller vessels of which the largest concentration is their City class units: stainless Dwt 12.000-13.000. They also have some coated units.

Compared to larger, traditional chemical parcel operators like Stolt or Odfjell, this new BLT/ Eitzen Group has little resemblance. Stolt and Odfjell are fully integrated operations. Their vessels have many small tanks suitable for higher-paying specialty chemicals carried in smaller lots. They have a worldwide presence in both regional and long haul markets together with a complimentary tank storage business in key areas like Houston, Rotterdam and Singapore. They are heavily contracted with end-users up to 70%. Both companies have positioned themselves in the Middle East with local partners for the commodity chemical business envisaged from the new refinery projects. Financially, they have been outperforming BLT and Eitzen in bottom line results.

BLT/ Eitzen by contrast have vessels on the smaller end of the scale. The larger Chembulk units have fewer and larger cargo tanks than the Stolt or Odfjell vessels and more suitable for product-oriented and commodity chemical trades. BLT/ Eitzen have no tank terminal business. Their contract base is much thinner. Eitzen is only 30% and BLT is 50%.

To a large degree, Eitzen Chemical will have to stand on its own. BLT is using US$ 130 mio of the new money raised for this merger deal in its own operations in Indonesia. Their cash risk in the CECO merger is US$ 80 mio of which US$ 50 mio is in ailing Eitzen Chemical, but their leveraging the merger deal to put new capital in their own domestic operations.

The fact that BLT is looking to put most of the new capital (US$ 130 mio) in their domestic activities is not a good sign of support for Eitzen Chemical. It shows where they view their priorities. It is also a graphic example of the value they are bringing to the table for CECO/ Eitzen Chemical in this transaction. BLT is doing what they know best: Indonesian cabotage business and taking its distances from Eitzen Chemical. They get the benefit of the profitable CECO dry cargo operation and the offshore business. It is an attractive share exchange deal where they put minimal cash in CECO and get additional cash for their own business.

Frankly, I would have expected the Eitzen senior creditors to be a lot more demanding to grant CECO a three-year moratorium on principal payments and loan covenants and especially to dilute their security by accepting the risks in transferring the Eitzen Chemical debt from the CECO holding company. In effect, all they are getting from BLT in comfort is an additional US$ 30 mio in CECO and US$ 50 mio in Eitzen Chemical. There is no new management, no revised business plan or attractive commercial synergies, except in promises for the future. There is also no extended financial involvement, but rather an attempt to limit their future liabilities.

Georgiopoulos gives thumbs up to dry bulk in an opportunistic play

Peter Georgiopoulos is aiming for an opportunistic asset acquisition play thorough Genco's (GNK) new Baltic Trading, which could seek US$ 230 mio in its initial public offering (IPO) with a plan to purchase five to seven vessels by the end of 2010. He is betting on recovery in this sector, carefully sheltering his existing dry cargo company Genco and he is demanding top dollar for his participation and management in the new venture.

Georgiopoulos's concept is to set up a new company "Baltic Trading" with a symbol BDI as a speculative play in the dry cargo sector using equity capital to purchase vessels, avoiding senior debt and operating the vessels in the spot market at least initially. His NYSE-listed Genco (GNK, an owner of 34 bulkers, plans to contribute US$ 75 mio to the company in exchange for Class B stock, giving the parent 50% of the voting power.

It will be a full-payout company, paying dividends that amount to all net income minus cash expenses. The fleet will likely be made up of Capesize, Panamax and Supramax bulkers through timely and selective acquisitions. Baltic pledges to grow through follow-on equity issues that require little debt financing but says it may use a revolving credit line for bridge loans.

This will be the first initial public offering (IPO) in New York since the ill-fated Britannia Bulk in June 2008. Morgan Stanley and Dahlman Rose, who both have strong connections with hedge funds, will be the underwriters.

Genco chairman and founder Peter Georgiopoulos will also serve as chairman of Baltic Trading. Genco finance chief John Wobensmith will play the same role at the new outfit. Genco board member Basil Mavroleon will also hold a Baltic seat, but there will also be a significant number of independent directors.

Genco also is to receive management fees of up to 1.25% of gross charter revenues for commercial services, US$ 750 per vessel per day for technical management and up to 1% of gross purchase price in sale-and-purchase (S&P) transactions. Genco farms out technical management to Wallem and Anglo Eastern. Charter-oriented Genco is to have first rights to charter opportunities, while spot-focused Baltic gets first look at voyage deals.

Georgiopoulos is making heavy use of investor equity capital in this venture, yet he retains considerable control over the operation though Class B voting power. Further Genco will benefit in fees and commissions both on vessel sale and purchase and chartering. Peter Georgiopoulos has a strong track record with investors and he is demanding his price for involvement and participation.  He is taking a conservative position in sheltering his existing dry cargo business and limiting his risks.

Innovative use of capital markets for Navios Maritime

Angeliki Frangou has been outperforming her Greek peers in innovative finance for her opportunistic expansion and aggressively picking up distressed assets in the dry cargo market. Her use of "mandatory convertible preferred shares" in the recent purchases of Capesize newbuildings lessens the leverage risks for Navios and avoids dilution. She succeeded in raising US$ 374 mio new equity for NMM at a minimum discount. Her US$ 375 bond issue to cover new buildings and debt is smart finance.

Frangou's strategy to buy a mature dry bulk company with a cargo system was quite different from her Greek peers, who started up with block vessel purchases on a vessel-provider model and scaled up on the same basis, using bank debt and raising new equity at discount. Scaling up at the top of the market prices led to sizeable losses for many listed companies with asset impairment charges and protracted negotiations with senior debt lenders for asset coverage covenant violations. Several companies were compelled to raise additional capital by massive 'at the market share issues' (ATM) that were highly dilutive. Jumping the gun in scaling up, many are now quite limited to expand their fleets at today's lower asset prices.

Initially there were issues about what direction the new Greek management under Frangou would lead Navios; but this year Frangou has been outperforming all her Greek peers in share price recovery. Whilst Navios (NM) peaked in early June, Navios Partners (NMM) surged in August when her Capesize deals attracted a lot of attention and NMM has continued to outperform NM, albeit NM has also been holding its own.

The use of convertible shares allowed Navios effectively to do the Capesize acquisitions at a discount to the nominal value. Navios funded US$ 47.9 mio of the purchase price in convertible shares. Two-thirds of the convertibles went to the previous owner and one-third to the shipyard.

Navios shares were trading at US$ 4.45 per unit at the time the deal was announced. When it comes time for the paper to be converted into Navios common shares, they will do so at no less than US$ 10 each. And they could fetch as much as US$ 14 under better circumstances. In either case, Navios gets more buying power than it would have at its current share price. Putting it another way, instead of paying about US$ 71 mio each for the Capesizes, Navios would pay only US$ 57.8 mio each if the shares convert at US$ 10. If Navios's common share does better in the meantime, however, and conversion comes at $14 each, Navios would pay only US$ 54.6 mio for each ship.

The structure also lessens the level of dilution that would occur if Navios just sold shares today to pay for the purchase. Under most circumstances, the preferred shares do not become common units for at least three years and that is in the more favorable US$ 14 scenario. Under the base-case US$ 10 conversion, they become common units five years (30%) and then 10 years from now (70%).

Navios AA rating and good track record allow them to tap the high yield market in a period of tight bank finance conditions and low interest rates. Whilst the equity buyers for recent ATM issues by weaker peer companies have been largely individual or "retail" investors, high-yield investors tend to be large institutions more fussy about where they place their money.  The offering will provide extra funds to pay for the purchase of two new vessels set for delivery in late 2009 and early 2010. It will also help cover debt on existing loans.

Navios is concentrating heavily on Capesize tonnage and expanding very aggressively. This carries risks if dry bulk recovery in the coming years is less robust than expected, but Frangou has been very prudent in fixing the new acquisitions with good charter cover and posturing her fleet with secured income. The use of use of convertible notes and bond finance is good financial posturing.

Is Dryships really an offshore play?

Lazard Capital markets analyst Urs Dur raised his rating on the George Economou-led company to “buy” suggesting coming offshore UDW drilling contracts for new rigs will provide a lift over the next couple of quarters. The deals will mark DryShips’ shift from a dry-bulk company with offshore interests to a deepwater rig company with exposure to the dry-bulk term market.

Considering the weight of the UDW drilling operation on the DRYS balance sheet, I would certainly agree with Lazard. The assets and liabilities of the drilling operation overshadow the bulk carrier operation. DryShips has become a deepwater rig company with exposure to the dry bulk term charter market rather than a spot focused dry-cargo owner with drillship investments.

DryShips still has a US$ 1 billion gap in its debt financing for two drillships, which is staggering compared to its dry cargo liabilities and recent attempts to raise additional capital by share dilution. Contracts attained over the next few quarters will be crucial for the company to finance this gap. At least two of DryShips’ four drillships must have contracts in place by the end of this year. The vessels are set for delivery in 2011.

According to the analyst, the charters should be worth around US$ 500.000 daily, reducing the risk hanging over the company and speeding up a long-awaited offshore spin-off, which would again change the company dynamics if it happens.

The dry-bulk market still faces oversupply issues but most of DRYS's dry-bulk ships are chartered out for much of 2010. Banking on rising oil price in the next year, as is expected by consensus, investors might chose to play DRYS more as a UDW driller in an attractive UDW drilling market.

BLT-Eitzen Merger: too big to fail or too unmanageable to succeed?

The ailing Camillo Eitzen Group recently astounded the market with a merger announcement with the Indonesian-based Berlian Laju Group (BLT) by share exchange to comprise the world’s largest and most modern chemical tanker fleet. Yet neither company is financially strong and both companies suffer from over leverage and aggressive expansion at top of the market prices during the boom times. Fitch promptly revised the rating of the acquiring company BLT as "B" with rating watch negative (RNW) while its US$ 400 million bond issue is "CCC", also with RWN.

Will this merger make a stronger company with a better balance sheet and a good synergy with a shared vision and complimentary product lines that leverage existing infrastructure or vertical integration?

Certainly the joint announcement presents a rosy picture for investors. Total revenues of the combined company for the past 12 months (presumably 30.6.2008 - 30.6.2009) amount to approximately US$ 2.3 billion with an EBITDA of US$ 499 million. Including newbuildings the group will own and/or operate 157 chemical tankers, 14 oil tankers, 42 gas tankers, 50‐60 bulk carriers and 1 FPSO, in addition to services offered through Eitzen Maritime Services (“EMS”). Given that BLT and Eitzen have market shares of 5,3% and 8,2% respectively; the new company would have a 13,5% share roughly the size of Stolt Nielsen!

BLT says that it plans to submit a voluntary exchange offer for all outstanding shares in CECO (Camillo Eitzen Group). CECO shareholders will be offered mandatory exchangeable bonds (MEB) equivalent to NOK 25 per CECO share which will be converted into shares. BLT said the offer represents a premium of 270% on the CECO share price of NOK 6.75 ($1.17) at the close of business on Friday. The deal is subject to a number of conditions including the successful private placement in BLT of a minimum of US$ 200 million in new equity. The offer is expected to be completed by the end of November.

Eitzen has a strained balance sheet. The group has grown rapidly in the chemical tanker sector during the boom years by both vessel acquisitions and mergers. There have been been some integration problems. Their 30-35% contract cover for their fleet is much lower than established chemical operator like Stolt and Odfjell (approx 60-70%) and their dependence on the product markets is relatively high. They were poorly positioned to face the market downturn from the financial crisis. The drop in cargo volume and exposure on the spot market led to a significant drop in their free cash flow whilst they were over leveraged from their aggressive expansion.

Last week CECO and Eitzen Chemical reached agreements with banks to restructure loans of over US$ 800 million. Further they are on the verge of a US$ 100 million equity issue. The merger announcement saw its market value rise 22.17% to NOK 2.81 per share, or NOK 479.86 mio. Eitzen share value had fallen fallen 65.88% from a high of NOK 48.90 each this year following its high-profile financial difficulties.

BLT has also been expanding rapidly in the chemical tanker sector. The group started in the Indonesian cabotage trades first in oil tankers and later products and chemicals with Pertamina employment.. In 2007 it began its global expansion with a US$ 850 million acquisition of US-based chemical-tanker specialist Chembulk. This gave the company access to the US markets, although in 2008 a full 75% of its revenues still came from the Middle East and Asian markets.

American Marine Managers had bought Chembulk earlier in the year as MTM from its founder and main shareholder Doug MacShane and then marked it up and sold it for a premium to BLT at the peak of the market. To finance the $850 million deal, BLT turned mainly to bank debt. The company still has US$ 400 million senior unsecured notes due in 2014 and a US$ 125 million five-year convertible bond due in 2012, issued by BLT Finance BV, a wholly owned subsidiary of BLT. This sent the company's gearing into orbit and it had to resort to drastic measures including sale-and-leaseback deals to bring down its debt load.

BLT appears to have a better contract book than Eitzen, but it is reportedly only 50% so they have considerable spot market exposure and it has been hitting their bottom line. BLT's most recent audited accounts for the first six month period 2009 indicate a fall in gross profits of 32%. BLT closed 30th June 2009 with a US$ 5,98 million net loss as opposed to a net profit of US$ 109 million for the first six months in 2008.

Given the above, it is surprising that BLT has the financial capacity to undertake this merger. The recent Fitch cautionary note on high risks is not unexpected. Of course, the operation is a share exchange and dependent on BTL raising US$ 200 million in new equity with a CCC bond rating subject to downgrade. BLT is merging with a troubled company that needs to be turned around and has severe financial problems. Camillo Eitzen booked a US$ 215 million loss last year as revenue declined 14 percent to US$ 1.32 billion. No one knows whether this deal is a bargain or simply a Trojan Horse. There is a serious risk that this merger - if it goes badly - could cause BLT, which is already in a weak financial position, severe problems.

Statistics indicate that only approximately 50% of all mergers succeed. Both these companies are already pieces of other companies due their recent expansion. Integration and the timing of the market upturn will make or break this deal. Eitzen clearly was not a total success in its merger and expansion deals or it would not be facing its present woes. Putting Eitzen in order is a tall order for anybody.

BLT's main move was its Chembulk acquisition but we do not really know how successful they have been in integrating the Westport-based operation. Off-hand, Indonesians running a US-based outfit with American managers seems a challenge where formible foreign firms like Daimler have met their match and failed in the US. The value of the Chembulk contract book with end-users depends on end-user client satisfaction, which could be potentially eroded by the new ownership or sudden defections by the American management.  It seems that BLT may have let Chembulk run independently and its home office works more like an Asian operation than to try to integrate it.

Axel C. Eitzen will remain actively involved in the further development of the combined group, and will be its second largest shareholder. How will these two groups be integrated successfully to add value to shareholders? How will Eitzen get along with the Indonesians?

* Will the new executive team speak with one voice?
* Will employees of either the buyer or the seller bad-mouth the deal?
* Will the reputation of either company alienate customers?

The merger announcement boilerplate reads:

"The combined entity will create a truly global network capable of serving an international customer base across key markets. In addition to the complementary businesses of the companies, both share a set of common values, and a belief in the value of strong corporate cultures..."

How much of this is really true remains to be seen since there is nothing about this that is prima-facie obvious. It also remains to be seen when chemical market will start to improve. This year 2009 has been miserable.  Both companies are making losses and face challenges with senior lenders.

The only savings grace has been a rise in chemical feedstock imports to China due the cheap prices but this only filled vessels in one direction.  Whilst operators like Stolt with a large contract book benefitted, this offered little comfort to those with spot exposure faced a difficult return voyage with very low rates. Even Stolt and Odfjell have been redelivering chartered vessels, reducing capacity and cutting costs.  Chemicals are tied to consumer economies and the market is not likely to pick up until a return of positive growth in the US and EU. Many commentators, including DnB-NOR bank, are projecting a slow, sluggish recovery for 2010.

If this prevails, it may prove a very trying time for this merger together with the immense challenge of integration and value creation for shareholders.

Odfjell is well positioned in the current shipping crisis

Odfjell is one of the big four traditional parcel chemical tanker operators together with Stolt Nielsen, JO Tankers and Tokyo Marine. Odfjell controls 17.8% of the global core chemical market. They have an integrated logistical system with tank storage, large chemical tanker fleet and sizeable contract book with end users. They are expanding their tank storage business to complement their ME partnership with NCC for Middle East refinery exports to the Far East.

Odfjell is a mature chemical parcel operator with the largest share of the world market of any peer operator. They are well positioned to weather the financial meltdown and current shipping market slowdown. In recent boom years, they expanded moderately their fleet without taking on excessive leverage.  They relied on time-chartered tonnage to fill excess demand. Their large contract book protects them on the downside.

The drop in cargo volume and nominations has caused bottom line damage. EBITDA first half 2009 for their parcel chemical tankers was US$ 49 million, compared to US$ 101 million in the same period 2008. Operating result (EBIT) was a loss of US$ 9 million first half 2009, compared to a gain of US$ 47 million in 2008. Compared to their peers in dry cargo, tankers and container; they are sharing the pain of the downturn, but their situation is comparatively more manageable.

Odfjell is focussing on building up their partnership with their Saudi-Arabian partner National Chemical Carriers (NCC) in the Middle East. In the first quarter the entered into an agreement with NCC to bare-boat charter three 37 000 stainless steel parcel tankers for ten years with purchase options. The three ships are NCC Jubail (1996), NCC Mekka (1995) and NCC Riyad (1995). Furthermore, Odfjell entered into three to six year time charters for three ships that earlier were owned by NCC. These ships are Bow Baha (24 728 dwt/1988), Bow Asir (23 001 dwt/1982) and Bow Arar (23 002 dwt/1982).

In June 2009 Odfjell SE signed a new 50/50 joint venture agreement with NCC to establish a company in Dubai, to be named NCC-Odfjell, to commercially operate our respective fleets of coated (IMO 2/3) chemical tankers of 40 000 dwt and above, in a joint pool for trading in the chemicals, vegetable oils and clean petroleum products markets on a world-wide basis, with emphasis on the growing production and export of the Middle East region. The new company will start operations early next year with 15 vessels and a total dwt capacity of nearly 660.000 tons, which is planned to grow to 31 vessels and total dwt of nearly 1.4 millions tons over the next three years.

Stolt is competing with Odfjell in their partnership with Gulf Navigation where they have ordered a series of Dwt 44.000 coated chemical tankers from Korea, but Gulf is a much weaker partner in providing local commercial business than NCC.  Stolt has recently refused to take delivery of one of these units due late performance.

The Odfjell expansion in its Singapore tank terminals is to facilitate the Far East export business that they expect to develop from the Middle East refinery projects coming on on line. In this context, it is not surprising that senior debt financing for the tank terminal project was easily forthcoming.

Things seem to be looking up for Navios Maritime Partners

The New York-listed company (NMM) announced recently that it would sell 2.8m units to help fund its fleet expansion. The sale of 2.8m units would bring in $34.18m at the offer price. The company has attracted a lot of attention for its opportunistic Capesize purchases of four units in June and two additional units with long term charters in August. Whilst the parent Navios Maritime Holdings reported recently a 56% decline in earnings, Navios Maritime Partners had a 34% increase in revenues.

Navios Maritime Partners (NMM) is a spin-off from Navios Maritime Holdings (NM) after it was acquired by a SPAC set up by Angeliki Frangou and sponsored by Sunrise Securities. It is part of a complicated corporate structure where a general partner company Navios GP L.L.C. owned 100% by Navios Maritime Holdings (NM) has holds a 2% interest in Navios Maritime Partners (NMM). Navios Maritime Holdings (NM) has a 44,7% limited partnership stake in the spinoff company, Navios Maritime Partners (NMM). The remaining share 53,3% limited partnership interest in this spin off company is held by 'common Unitholders', which are publicly traded common units of which 2% is held in a company controlled by Angeliki Frangou. Judging the participation of John Stratakis in the BoD, perhaps Poles, Tublin advised on this structure and played a role in the rationale.

There have recently been some intercompany transactions for vessels, where the spin off company struck a deal to escape a Capesize purchase from parent Navios Maritime Holdings and bought "all rights" to a Panamax with share exchanges. The new Capesize deals with reduced asset value have been channeled to the spin-off company. Already the parent balance sheet lacks transparency and the relations with this new spin-off company further complicate matters. Yet for the time-being in share performance, Angeliki Frangou seems to be managing better than most of her Greek peers in the dry cargo sector.

Whilst Navios Maritime Holding (NM) has made a good recovery from March lows and is outperforming most peer companies, Navios Maritime Partners (NMM) has been out performing its parent company. The parent company is an old established firm with a solid contract customer base providing far more intrinsic value than most publicly traded, Greek controlled dry cargo companies, which are nearly all vessel provider business models dependent on third-party charterers for vessel employment. Further Navios is a mature company, whereas its Greek peers are recent startups, which expanded their fleets rapidly in the boom years with large block acquisitions.

Navios Maritime Partners is more along the lines of its Greek peers. It is a new start up operation, but unlike its peers it is now expanding its fleet in present market conditions with marked down asset prices. It is concentrating on Capesize vessels, which have had the biggest revival this year in the dry bulk sector. The vessels have been conservatively chartered on long term contracts with profit sharing. The company holds options for further vessel acquisitions in 2010, 2012 and 2013 and additional growth through Navios Holding-controlled vessels.

Lately the Capesize market has been waning to lower levels. The tonnage supply on order in this category is substantial but the real question is the sustainability of the Chinese demand for iron ore and coal and the inventory restocking. The domestic stimulus plans have been centered on the construction industry and thus steel intensive, but China has a substantial overcapacity problem in both construction and industry. Export demand continues to be weak.

It is a reasonable play that Navios Maritime Partners (NMM) benefits from lower asset prices with the marked-down Capesize vessel acquisition transactions and better break even levels than most peer companies. The ultimate success of the venture depends on the fate of the dry bulk sector in the coming years and the major driver is Chinese supply chain needs for steel and iron ore.

Grand Union-Aries merger: where is the value?

This reverse merger is one of the strangest shipping deals ever done. Aries (RAMS) is an ailing NASDAQ-listed company with nine product tankers, two container ships and big financial problems. The original IPO had a rough start with a lot of question marks and thereafter there were operating setbacks. Things improved somewhat when Jeff Parry, formerly of Poten, took the helm at CEO. The deal is a barter where Aries (RAMS) acquires three middle-age Capesize bulk carriers in return for a complicated share exchange agreement as well as management and debt restructuring. Whilst the deal may be attractive to major shareholders, it not so clear whether investors are getting much of deal.

Grand Union is Greek shipowning venture launched by Newfront Shipping boss Nick Fistes and Stamford Navigation’s Michael Zolotas. It also by coincidence the name of a well-known US supermarket chain. This is a privately owned, family-controlled shipping company with a fleet of 46 bulkers, tankers and newbuildings. The companies have been around for a number of years, but this is a fairly new venture that has had a very aggressive expansion plan. As a private firm, it difficult to assess its financial condition and how it has been impacted by the financial crisis and bear shipping market environment. Aries (RAMS) is a penny stock and it has had a balance sheet qualification about its future as a going concern.

The vessels that Aries is acquiring are the 135,364-dwt Yiosonas (built 1992), the 151,738-dwt Grand Nike (built 1995) and the 172,972-dwt Grand Mirsinidi (built 1993) in return for transfer a complicated share exchange and debt restructuring. 2,67 million Aries shares are being transferred to Rocket Marine (controlled by Mons Bolin and Gabriel Petrides), giving Rocket 36.8% of the total shares and Grand Union (controlled by Michael Zolotas and Nick Fistes) control of 34.2%. But the voting agreement gives Grand Union control of 71% of Aries. As part of the overall transaction, Investment Bank of Greece is buying $145m in 7% senior unsecured convertible notes, due in 2014, which Aries plans to use for vessel acquisitions and paying down debt, among other potential uses.

The Securities Purchase Agreement is subject to a number of conditions, including but not limited to (1) the entry into definitive agreements for the issuance of the Convertible Notes and the closing of that transaction; (2) the entry into definitive agreements with the Company's existing syndicate of lenders for the refinancing of the Company's existing credit facility; and (3) the absence of any event reasonably likely to have a material adverse effect on the Company or the three Capesize drybulk carriers.

The deal will see Fistes become chairman of Aries, while Zolotas will become executive director and president, as the board swells to seven members. It is difficult to evaluate the financial impact of this complex transaction on Aries. The management and BoD changes are significant.

Financially no party appears to be putting cash in the deal. The 'equity' appears to be in the vessel transfer. Further there appears to be some additional debt and refinancing from a bond issue with the Investment Bank of Greece, not a run of the mill shipping finance entity. It is not clear whether this increases Aries leverage. Some cash in the deal would have provided more transparency and plain vanilla comfort for investors.

The weakest point is the lack of commercial synergy. The biggest value in Aries is its nine product carriers (their container business is a dead letter, but the product sector is also in deep recession), but Grand Union brings no expertise or contract base to service these units. A merger with a group like Scorpio (of Monte Carlo) would have offered a better synergy, adding more value here. Aries (RAMS) is clearly betting all their strained resources on the Capesize unit additions in the dry bulk sector. This follows the Top Ships example of opportunistic fleet diversification to get out of their hole at the time, but at much lower asset price entry levels and ready financial structuring that purports to improve the balance sheet.

It would be helpful if Aries (RAMS) prepared an investor presentation to make sense of this complicated transaction. Perhaps something will be soon available so we can make further comments.

Eagle/ Kelso partnership: constraints and options

Eagle is presently limited at best in its ability to acquire new vessels, even at distressed levels with constraints to pay half of any future equity raises to reduce debt. By the Kelso partnership, Eagle CEO Zoullas will work with Kelso to pursue vessel purchases on a private basis but will pay commercial and technical management fees to the public company for any bulk carriers acquired. Eagle will have right of first refusal on any bulker the private venture wants to buy.

Eagle has fared relatively well in the crisis so far but not without some setbacks. The block expansion deal with Alba Shipping at the top of the market prices put them into this crisis with the pain of overvalued vessels, some charterer defaults, some order cancellations and over-leverage putting them in violation of their senior debt covenants.

Management did its housekeeping to put things in order. It raised last month US$ 100 mio cash by share sales, which represents a modest share dilution compared to some other peers. It amended its credit facility with lender Royal Bank of Scotland (RBS). The non-amortizing facility has been reduced to US$ 1.2 bn from US$ 1.35 bn, with Eagle also shouldering a higher margin of 250 basis points over Libor, plus the above-mentioned obligation to pay half of any future equity raises to reduce debt.

The Kelso agreement appears fairly structured in terms of interest conflicts. Eagle has right of first refusal on any bulker the private venture - called Delphin Shipping - wants to buy. It also gets a "first look" at any bulkers Delphin acquires and decides to place on charter. Whilst probably a good thing for Kelso and Zoullas, it is neutral for Eagle.

The China Conundrum

A great debate rages over whether China's economic model is sustainable. Western economists often express fawning admiration of the success of this state capitalist model, some of the most virulent critics are Chinese. There are issues of asset bubbles in real estate, massive export production overcapacity, missallocation of resources and a banking system riddled with non-performing loans.

The Western conventional wisdom is that Chinese stimulus has been more effective because it is state-directed and financed by trade surpluses rather than debt. There is a general confidence that rising domestic consumer demand will save the day in the end.

Back in 1994, Paul Krugman wrote an article: "The Myth of Asia's Miracle", where he compared rosy Western projections of Asian growth with cold war projections of Soviet growth rates. Krugman maintained that the rapid growth in output could be fully explained by rapid growth in inputs: expansion of employment, increases in education levels, and, above all, massive investment in physical capital. He pointed to two basic implications:

• The willingness to save, to sacrifice current consumption for the sake of future production.
• Future limits to their industrial expansion - in other words, economic growth based on expansion of inputs, rather than on growth in output per unit of input, is inevitably subject to diminishing returns.

We know that the Soviet system fooled most Western intellectuals and eventually imploded. Are today's China watchers any smarter?

Sceptics like Andy Xie and Martin Hutchinson argue that most statistics out of China are misleading and false. China remains a repressive, closed society with little transparency and lots of corruption. The state corporate sector is still gigantic and supported by state-owned banks. Savers are not permitted to take money out of China, and their huge savings prop up an overvalued stock market and a bond market that is comparable in size to the freely flowing international bond market. Private sector companies are either youthful fly-by-night operations or dubiously privatized state behemoths. Prices are still largely administered, and investment flows mostly to the politically connected rather than the economically attractive. Education is relatively poor outside the main population centers, and land ownership is still restricted.

Even though China has had three decades of high growth, few companies are globally competitive. While China is experiencing weak exports now, the weak dollar allows China to release the liquidity saved up during the boom worrying about currency depreciation.

Xie stresses that there is tremendous over capacity in the construction industry. The pricing structure is highly distorted. State-owned enterprises borrow from state owned banks and give the money to local governments at land auctions, so everything turns around the big Government pocket. Further the rapid urbanization and one-child birth policy will have a very adverse effect on demographics that will create a train-wreck situation. "China’s wealth inequality is already very high. A sizable or even the majority of China’s population may not have meaningful wealth even after China’s urbanization is complete."

Xie argues that the party in China will be over when the US dollar starts to appreciate again. The risks are that prevailing FED easy money and massive increase in US sovereign debt will lead to higher inflation, obliging the FED to raise interests rates as they did in the 1970's.

Of course, there are two divergent aspects in this argument. Easy money and massive FED liquidity are already putting some renewed pressure on the US dollar. Higher interest rates, however, are only foreseeable when and if inflation rises in the US. Right now that is unlikely with only the slope of GDP decline improving, but the massive overleveraging and debt overhang in the US opens the temptations to debt monetization down the line. Already treasury yields are starting to harden. Should the FED be obliged to raise interest rates as they did under Paul Volcker, then Asia could be in deep trouble.

In any case, with the US consumer shopped out, overleveraged and coming prospects of higher tax load, it is certainly not evident that there will be a quick revival of consumer export markets. The EU is also likely to recover slowly. This is likely to lead to a permanent structural rebalancing of Chinese export surpluses. It is not obvious that Chinese domestic demand could absorb the production overcapacity, especially considering what was said above. The stimulus is not workable for an indefinite time period.

Shipping markets are highly dependent on China as the main demand driver against a massive order book built up in recent boom times. The construction industry accounts for approximately 50% of Chinese steel demand so it is closely related to coal and iron ore imports in the dry bulk sector. Massive container ordering was predicated on unlimited export market potential to the West. There have been substantial refinery projects in the ME for export to the Far East as well as huge refineries built in China for the tanker business.

The China story still excites Wall Street investors and already this year, China has again brought a revival in the dry cargo market. Should reality further down the line not meet these expectations, then truly hard times could fall on this industry.

Will there be any distress deals in shipping?

Since the fall 2008, public policy response to the financial crisis has to reinflate asset prices by flooding the markets with massive central bank liquidity. Banks have not been aggressive in covenant breaches. Some major shipping players feel that asset prices are artificially high. ATM share offerings have enabled public companies to bail themselves out. All eyes are presently on the quality of the future recovery in 2010 and beyond.

Last fall shipping markets plunged with the outbreak of the financial crisis. Shipping had enjoyed unprecedented boom times, riding globalization, outsourcing and the rise of China as an economic superpower, following the footsteps of Japan in the 1950's and 60's.

This year's notable recovery of the BDI - mainly in the Capesize sector - is due to a new surge in Chinese inventory building in coal and iron ore after several months of market penury with rates below breakeven levels. Chinse importers were renegotiating supply contracts down to the lowest possible prices and drawing down stock. There is a great deal of debate whether this is the beginning of a new bull market for dry cargo or it is simply temporary inventory hoarding for speculative purposes and concerns of more US dollar weakness ahead.

After a period of relative out performance, the tanker markets took a nose dive. Early in 2009 there was big demand for storage due the extreme premiums in forward oil futures over prevailing spot prices. The rise in oil prices changed this situation. Clean petroleum markets have been hit the hardest. Chemicals are somewhat better off with a surge in Chinese feedstock imports, but most other routes are slack with significant drop in cargo volume. Containers continue very weak, often below operating costs, except some feeder trades.

Despite substantial fall in asset prices and high senior debt leverage levels of many publicly listed companies from the popular fleet block vessel acquisition/ merger deals at the top of the market, few companies have gone into serious default, leading to liquidation. In the relatively few cases of foreclosures, banks have tried to transfer assets to new entities, hoping to position themselves for recovery.

The financially weaker companies have been aggressively issuing new shares, mostly sold slowly in small lots over the market. George Economou has pioneered in this technique raising nearly US1 billion for DRYS. Initially there was brisk investor enthusiasm until the market started to perceive the massive increase in share count. Lately even some of the worst performers like TOPS with a bad record in share value and continuing restructuring negotiations with senior lenders have found ready new money from a standby facility that Yorkville - a New Jersey-based financial firm - offered them with open arms.

For these reasons, Peter Georgiopoulos argues that "While that's [sic governments have supported the banks and banks essentially have returned the favor by supporting clients] good in some ways, it has kept the market artificially high".

So far, this downturn in the shipping markets has been different from some of the historic collapses. Meanwhile the war of attrition continues and the issue ahead will be the quality of the recovery as well as the sustainability of the Far East growth model (see my accompanying article: "The China Conundrum").

Is Wall Street optimism over reaching rational expectations?

PIMCO's Bill Gross argues that median GDP and capital stock returns have been based on 5% PA whereas the government policy efforts to re-inflate the economy have hidden costs and restraints that will reduce median GDP and capital stock returns to 3% PA. This means a new period of sluggish growth and high unemployment where people will have less disposable income.

I have argued in the past that we risk a period of prolonged sluggish growth with high levels of public debt that become a permanent drag on the US economy. The major ideological battle of the new Obama administration is over ultimate control of the US economy between government and the private sector. President Obama is committed to government control as the superior solution. I believe that these policies will result in a poorer country than Americans have been accustomed in the past with lower competitiveness in global markets.

The stimulus plan is based largely on government programs. Efforts to promote 'Cap and Trade' policies and universal Health Care represent the transfer of an increasing share of the US economy to the US government. Already a large share of the banking industry and the US auto industry has been transferred to the government. The FED has a vastly expanded balance sheet.

All these programs are rife with hidden costs and restraints. Further the expansion of US sovereign debt has been substantial. There are rising risks in currency devaluation and higher interest rate exposure. Little has been done to address the problems of over-leveraging . There is no additional resources to assist the underlying goods and services economy.

As Mr. Gross puts it:

"Investment conclusions? A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

A corollary of this is that the US financial sector is far larger than warranted and needs considerable downsizing.

Financial instruments turn a first half loss into a large profit for Exmar

Exmar is battling drooping revenues from waning freight rates to post the healthy result in poor market conditions. Earnings have fallen the most in the VLGC sector and less sharply in midsize gas carrier.

Exmar has three 150,900-cbm LNG newbuildings under construction at Daewoo shipbuilding & Marine Engineering (DSME) for which financing is yet completed.

LPG export volumes from the Middle East have declined sharply and the lack of long-haul trading opportunities resulted into a substantial fleet surplus. Overtonnaging in the VLGC sector has been evident for a number of years.

The midsize gas carrier fleet is also hurting with substantially reduced ammonia movements gradually increasing pressure on this segment during the first half of the year.

Exmar hopes to secure financing the first two vessels on order fairly shortly and will begin working on the financing of the third vessel in the course of the fourth quarter 2009 with an objective of securing commitment by the first quarter 2010.

It is not clear when market improvement in the gas sector is likely to come in the current economic environment.

Energy player inks 10 bulkers/ Exporters and steel mills seek long charters

With the fall in dry bulk vessel asset prices, Chinese players have been avid buyers, looking to take a larger share in Chinese-related transport trades. In this case, coal player Lanyue Energy Development signed up for 10 supramax bulk carriers at Xiamen Shipbuilding. This trend is likely to put Western competitor companies at a disadvantage.

Lanyue is one of the top coal transporters in Guangdong province. As aChinese company it benefits from advantageous domestic financing as well as preferential connections for employment contracts. Major London brokerage firms have been saying for sometime now that they feel the Chinese will be moving closer to the Japanese system of covering their transport needs by long-term contracts of affreightment with their own domestic shipping companies.

Notably, Vale's recent deal with NYK comes amid a rush of fixtures by iron-ore exporters and steel mills looking to secure tonnage long term (http://www.tradewinds.no/weekly/w2009-07-17/article540938.ece). Will the Chinese start to follow suit?

NY-listed dry cargo operators will find this tough competition in the future. Many of these companies expanded in large block deals at top of the market prices and leveraged senior bank debt. They have both higher capital and operating costs in comparison to their Chinese competitors.

The issue in the future is the quality of the recovery in shipping for which the dry bulk sector - especially the larger Capesize units - seems to be taking the lead so far.

Is the Handymax sector as good as conventional wisdom claims?

From the outset of the crisis in shipping markets, conventional wisdom has praised companies in the Handymax/ Supramax sector and castigated the Capesize sector. Analysts based their arguments on the record order book for larger bulk carriers and the high age profile of the smaller sizes suggesting need for fleet replacement. Yet the smaller sizes have not been immune to decline in asset value. On the other hand, the recovery in cargo demand this year has favored the Capesize sector.

Secondhand Handymax-bulker values have fallen between 70% and 85%, according to a review of the market by DVB Bank. Shipowners who invested in Capesize bulkers got the best value for money last year, according to research from a top shipbroker, Lorentzen & Stemoco (http://www.tradewinds.no/weekly/w2009-07-17/article540873.ece) and are likely to keep the lead this year.

Whilst most shipping analysts remain focused on supply and demand, they tend to overlook matters like operating margins and leverage as well as investment returns. The larger-size units benefit from lower unit costs. For example, crew cost for a Capesize unit is far less analogous to a Supramax or Handymax on a per Dwt basis, but the freight market for the larger sizes is a lot more volatile with significant profit potential.

Of course, the order book situation for the larger sizes is troubling, but the higher age profile of the smaller sizes is due to the traditionally lower investment returns for the smaller sizes whereas the money for new tonnage follows the higher investment returns.

So far Far East demand has once again smiled on the larger bulk carriers despite order book concerns. The question is whether this is sustainable over the long run? The debate between the smaller and larger bulk carriers is a bit like the Tortoise and the Hare.

Will the analysts backing the smaller sizes laugh last and best?

Diana Shipping is upgraded

I have long been a fan of Diana Shipping because of its restrained expansion policy in boom times, strong balance sheet with low leverage and good liquidity and its conservative chartering policy. This was very unfashionable in boom times and some felt that CEO Simos Palios was a poor steward for his shareholders. They found the block deals at record prices and substantial debt leveraging of its peers more exciting. They discounted asset impairment charges and loan restructuring as of no consequence to shareholder value. In these times of crisis, however, Diana is well placed to survive and profit.

Natasha Boyden lifted her rating on the NYSE-listed bulker owner from "hold" to "buy." "We believe [Diana's] healthy balance sheet, high charter coverage and strong free cash flow generation puts the company in a position of strength to potentially expand its fleet by buying vessels at what we view as potentially distressed asset values," she wrote in a note to clients. She said Diana's share price offers an "attractive entry point" for investors.

I do not always agree with Natasha, but I think that she taking a reasonable position here. Others have complained about the company's brokerage commissions levels and practice to put their vessels on charter to operators. The company's relative openness and transparency gave them some room to make such comments because many peer dry bulk companies keep private their chartering details. There is little evidence that Diana is out of line with peer performance in these matters and openness on these matters with investors is to management's credit.

These are challenging times and Diana is one of the few listed shipping companies with a genuinely strong balance sheet to create substantive shareholder value.

Is TOPS still a going concern?

After recently publishing a piece on Top Ships (TOPS) signing a deal with Yorkville Advisors to sell up to US$ 200 mio in new shares as part of a US$ 500 mio shelf registration, Tradewinds is now reporting that the company auditors - Deloitte, Hadjipavlou, Sofianos and Cambanis - have raised "substantial doubts" about the ability of Top Ships to continue. They point to the company's negative working capital position, minimum asset cover ratios and other loan covenants on more than $342 mio in debt, nearly US$ 290 mio of which has been declared current because of the covenant breaches because the breaches impact other loans with so-called cross-default provisions.

TOPS has been one of the weakest Greek listed shipping issues and the worst performer in the tanker sector. Last year, QVT - the leading institutional shareholder in the group - filed an activist petition, calling for the nomination of two independent BoD members. TOPS management strongly objected and prevailed over them.

At the time, TOPS was overextended in a diversification into bulk carriers that they booked in 2007 at top of the market prices. They had hoped to finance this operation by raising additional capital and took out bridge debt financing that was to be repaid by the new equity money. As the subprime crisis broke out, the capital markets turned against them, so their attempts in December 2007 and spring 2008 did not lead to anticipated results. This resulted in share dilution and they made some asset sales to complete the operation.

QVT was unhappy with company performance and rebuffed by TOPS management, but it has held on to its holdings, taking even deeper losses. During the winter this year, TOPS shares were briefly at penny levels, but since then they have improved and are trading at US$ 1.90 - US$ 2 range.

To the credit of TOPS management, they subsequently did some timely and substantive restructuring in 2008, unwinding onerous ship leases and de-leveraging by selling most of their aging Suezmax fleet to Frontline (FRO) shortly before all hell broke loose in the fall financial crisis. Earlier in the summer, they covered their newbuilding commitments for a series of Dwt 51.000 product carriers by leasing them out on bareboat charter to the D'Amico group for seven years. TOPS carries the counterparty default risk on this operation, but they have covered their operating risk.

The issue is whether TOPS has sufficient investor credibility to pull off their plans to raise fresh capital in current market conditions. They seem wary of an ATM issue - perhaps in part because of their experience with activist shareholders - and the climate has hardened recently on ATM operations. So perhaps they are hoping for a private placement. The pricing is open question as TOPS investors were badly burned in a discounted PIPE placement in the spring last year at US$ 7 per share.

I would not rule out success at this point. TOPS has proved resourceful in the past and management has managed to turn around recent company performance to a profit position from previous losses. The auditors' comments apply to many shipping companies these days, but other companies like DRYS have raised capital whilst in senior lender negotiations on technical default.

TOPS remains a speculative play and possible future takeover target.

End of ATM private bail-outs for troubled shipping companies?

Rewarding failure and value destruction has lately been the fashion on Wall Street. A number of troubled shipping companies with massive losses have been raising new capital at market prices to investors in order to restructure their senior debt and recapitalize from massive losses. Hedge funds and institutional investors have shown remarkable tolerance to loss-making companies in the shipping sector, where they have taken big hits themselves in their holdings. American business culture seems to take losses with relish as if they are only imaginary and cannot not have forward impact. This week Dahlman Rose's Omar Nokta made a tepid protest at this share-issuing practice, saying the boutique New York investment bank has found investors reluctant to buy shares in any owner with a pending ATM programme because of dilution concerns.

The dean of this technique is without doubt George Economou of Dryships (DRYS). Largely through the use of ATMs, DryShips has gone from a shares count of 40 million last autumn to 258 million today, raising over US$ 1 billion in fresh capital whilst in restructuring discussions with his senior lenders and posting massive losses

Investors gobbled up the DRYS shares with enthusiasm. It almost became a self-fulfilling pyramid with shares rising daily at double digit figures, reaching over US$ 10 per share until reality finally set in about expanded share count. Certainly Economou cannot be blamed for the 'get-rich quick' mentality and blissfulness of US investors.

Other companies like OceanFreight have followed suit with this technique. It is been an important source of fee income for Wall Street brokerage houses since the meltdown last fall.

The results will depend on the future of shipping markets, especially in 2010 and further out. If there is a robust recovery, everyone will win. If it is a poor market where many of these companies may be obliged to undergo a second round of debt restructuring with their senior lenders, things may start to get dicey.

Distressed asset opportunities for listed shipping companies

The recent Navios acquisition of three Capesize units seized by Commerzbank may set a precedent for similar deals to come. Current economic conditions are stressing shipping companies. As time goes on, senior lenders will be increasingly pressed to cleanse non-performing loans from their balance sheets. An obvious means to reduce losses is to shift assets to stronger owners.

Private companies have a financing advantage over private companies. They can raise capital in public markets. They have many options like issuing more shares, doing a preferred issue or going to the corporate bond market.

Navios, of course, has its own share of problems with charter party defaults and downside earnings announcements and it is not the most transparent company, but recently Neuberger Berman increased their share in the group. Generally analysts like Omar Nokta of Dahlman Rose have become bullish again on the dry bulk sector.

The Capesize sector has performed well in this year's improvement on the BDI. The rate volatility attracts owners to this size. There are only a few major cargoes for the larger bulkers. When market orders rise, rates surge. When they wane, rates collapse. The effects are multiplied by port congestion and longer voyages in boom times. The profitability has been very good the last few years before the crash. These vessels in the Navios deal come with attractive charter commitments.

Dry bulk is very dependent on continued China growth. The issue is whether the recent increase in demand is sustainable. I believe that the surge in dry bulk rates this year is due to Chinese inventory stockpiling. The Chinese renegotiated supplier rates with substantial discounts. They have been more successful than the US in their stimulus program. Government easy money policies lead the way to commodities speculation regardless of demand in the underlying economy.

On the other hand, I do not see a lot of evidence yet that Chinese export markets are coming back. After all, Europe is really in the doldrums and the US consumer markets have not turned around. China has a lot of excess capacity. They will have to restructure. They cannot go on indefinitely by stimulus money. If there is a sluggish recovery in 2010, China may have a growing problem of non-performing loans. Meantime, the dry order book is still big despite cancellations.

All in all there is a high probability for future distressed asset deals. Publicly listed companies will be favored players for many senior lenders.

George Economou vs Jim Kramer

Both George and Jim are iconoclastic personalities. They both have had a mixed performance record with personal ups and downs. Until 2008, DRYS had an exceptionally successful strategy of building up its fleet by retained earning from profitable operations and vessel sale transactions. The company seems often a one-man show with lack of transparency with the Principal appearing to use his private company for business development and passing the transactions to the public company for financing. Stockholders have benefited by this process in results in the past but lately they have been taking some hard hits. The turning point for DRYS was Economou's decision to diversify into the offshore drilling business acquiring OceanRig and ordering additional deep water oil rigs. The financial crisis hit DRYS very hard. Since then, DRYS has been increasing capital with major share dilution. George Economou is not as bad as Kramer says but he has been struggling lately.

The offshore transaction was large for the existing DRYS balance sheet. It absorbed the companies reserves and required a substantial increase in leverage. The company postured itself by reducing spot market exposure on its fleet and moving to longer term employment. The timing was good.

Last fall Economou added some new building contracts generated from his private company that later DRYS was forced to cancel and take losses. This caused some negative comments.

This year, DRYS has been raising capital by issuing new shares and dribbling them out at the market prices. This increase of capital was initially needed in the Groups arduous loan restructuring negotiations for its loan/ asset coverage clauses. In subsequent share issues, DRYS announced a strategy to acquire additional vessels, but there has been some market skepticism about company capacity for additional finance to leverage this new capital.

The China story has enthralled investors in the dry cargo sector for many years now. In the boom years, Far East demand consistently soaked up new tonnage in the market and drove rates to ever higher levels. China now has a great deal of over capacity that it has built largely to service its export markets in the US and EU. These markets have now collapsed.

The US seems to be improving since March this year if one takes Wall Street as a guide but mainly in the financial sector due public monetary policies to bail out lame duck companies and reflate asset prices. The EU has been worsening. It is still an open question how robust the recovery will be so the revival of Chinese export markets is still in question.

China has ample reserves for stimulus and they have probably outperformed the US in putting this money quickly to work. They have renegotiated their commodities contracts and moved to inventory replenishment that has brought a revival in the BDI for dry cargo sector. The Capesize tonnage has had the most benefit with a recent mini-boom. It is not clear whether this is sustainable.

China will most likely need to restructure their export model and this could have a negative impact on future demand projections for dry bulk commodities cargoes in coming years. Meanwhile the dry cargo orderbook is large and China has a significant share of the newbuilding contracts.

DRYS has taken large asset impairment charges for its foray into the offshore sector. It has new rigs on order that need to be financed. It also has had plans to spin off this business to a separate entity.

DRYS is facing large challenges in the present environment. Whatever the outcome, shareholders have gone through significant share dilution this year that will affect future share value. There is the issue of dry market recovery. This year things so far have gone pretty well for the sector. DRYS is completing its first round of debt restructuring. Prolonged market weakness in 2010 could lead to a much more difficult period with its senior lenders but markets may also improve and beat expectations. The main issue in the offshore side of the business is the future of the spinoff plans and its impact on DRYS shareholders. If it goes well, it could boost share value but the company is right now carrying the debt liabilities for this.

Kramer has the ease of being a pundit who can say whatever he likes without much responsibility. George Economou has a lot more weight on his shoulders. I have been critical of George for his excesses in the boom years but I appreciate his struggle in present market conditions. I think that Kramer should show a bit more generosity here. I have outlined the risks for shareholders.