Expansion into Overcapacity: Is it a winning strategy or value destructor?

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Nattanun (Jerry) Intharayaem's picture

In recent years, there is an interesting phenomenon in the container shipping industry. Since the financial crisis, container capacity has been growing rapidly even there is a slow growth of freight volumes. A myriad of factors have contributed to this rather than one specific thing. The question worth asking is whether the expansion into overcapacity creates a winning strategy or destroys the value of firms and the industry. The trend of buying bigger ships from large players in the container shipping industry for the last decade results from the overwhelming cost savings. Costs in the shipping industry can be divided into capital costs, which are associated with the construction of the new vessels, operating costs and how much the fuel consumption or so-called voyaging costs. 

Construction costs increase slowly compared to the ship size. The Organization for Economic Cooperation and Development or OECD stated that by increasing the container ship from 16,000 TEU to 19,000 TEU, companies can cut the annual capital cost per TEU slot by $69; TEU is the Container ship capacity, which is measured in twenty-foot equivalent units. In addition, for the operational side, larger ships can be operated more efficiently compared to smaller ships approximately $50 per slot. More importantly, bigger ships or so-called Megaships consume fuel more efficiently. They consume less fuel than 16,000 TEU ships for the same distance. By considering these tempting cost benefits, it not difficult for companies to make a decision whether they should increase the size of future vessels. However, these cost advantages are not absolutely true.

Fuel consumption is directly related to the cube of speed. To be specific, the cube rule economically implies that the faster a ship travels, the more fuel will be consumed. Thus, when the fuel prices are high, companies optimize a voyage by slowing vessels down to cut fuel costs. Companies may operate more ships in order to transport the same amount of cargo with this slower speed. When the fuel prices are low, it is understandable that companies increase the speed of carriers and use fewer ones. However, since the oil prices plunged in 2014, it is difficult to use the faster vessel scenario because the slow steaming function has been designed and embedded into the new generation of megaships. 


In addition, according to the OECD, when upgrading the ship size from 15,000 TEU to 19,000 TEU, between 55 to 63 percent of the savings per TEU are actually attributable to the lower speed vessels. Therefore, cost reductions associated with the current megaships come from the slow steaming rather than from the upsizing vessels. It is true that when ships become bigger, the cost savings are greater. Still, the cost savings for ships, which are upsized beyond 5,000 TEU, are much smaller. 

In coming months, the gap between shipping supply and demand will grow as bigger as new fleets. Drewry Shipping Consultants, one of the leading international providers of research and consulting services to the maritime and shipping industry, believed that the overcapacity problem will lead to several years of financial losses in the container shipping industry. New data from Drewry showed that while the fleet capacity is expected to grow 7.7%, the shipping industry will not reach 2.2% as expected. Drewry also reported that several services will be combined for the new generation of vessels, making new ships to be approximately 40% larger than ten years ago. Besides, several carriers have removed routes. Between Asia and North Europe, two large weekly routes are suspended. Furthermore, five carriers have canceled megaship service between Asia and East of South America. 

Megacarriers need to load cargo close to maximum capacity in order to benefit from the economies of scale. By this requirement, the industry needs to consolidate into an alliance network. Shipping lines also employ hub-and-spoke system from airline to assure that the large container megaships sail nearly full. The consolidation of container volumes into fewer and larger magaships creates challenges for firms in the freight business. Unintended costs associated with insurers, shippers, freight forwarders, port operators and logistic firms will be inevitably imposed. Insurers are concerned about huge losses if those upsizing vessels have some big accidents. In the case of a collision between two megaships, the losses can be between $1 billion to $2 billion, according to the Allianz Insurance. Shippers and freight forwarders are not satisfied with the consolidated schedule because they prefer higher sailings; the higher sailings, the less concentrated risk involved. Containers for different destinations must be transshipped by a smaller container vessel or road, rail and barge. Port channels have to be dredged deep enough for supporting the megacarriers. When a bigger ship is tied up, quaysides must be raised up and strengthened to bear the increased forces. Port operators need to invest more heavily in order to attract and manage more megaships. Likewise, ports need more skillful staff for operating more quickly and efficiently. They need more cranes, more space, and ability to handle more trucks, railcars, barges, so containers can be moved inland. The most crucial concern is the average turnaround time for a container ship. Ports need to unload a megacarrier into the sea as fast as possible, so they can decrease the peak-time pressure. The OECD also estimated that these new bigger ships will increase landside costs from extra equipment, dredging and port infrastructure and hinterland costs by $400 million per year. 

While there are several concerns related to upsizing vessels, during the OECD’s International Transport Forum, there was a discussion about the trend that the size of container ships has been growing faster than any other ship type. Since companies are ordering and deploying new ultra-larger vessels, in this current market condition, those cost-related concerns are not a big issue for large players in the industry. Major carriers such as Maersk Line and CMA CGM have great competitive advantages. They can operate with lower fuel, capital and employer costs per container carried. From Mearsk’s relative wealth chart, the CFROI level has been consistently below the cost of capital since 2011. This means that the company has been generating shareholder value inefficiently. As a shareholder in Maersk, I would like to follow the scale strategy for dominating the market. As mentioned, megaships are more cost-effient if companies can achieve a full capacity usage. In order to succeed that, the company needs to consider offering lower rates for a period of time to boost sales and defend or win market share. By doing so, the company can secure enough volume to achieve the full-capacity goal for the new megaships. Besides, Maersk has to use as few ports as possible to be able to attain high utilization and gain an efficient turnaround time.

Optimizing a megaship’s composition and designing the best network should be done at the same time. In other words, network design is very important for improving the performance of Maersk. Mainly, this stems from the fact that clients like to do a business with a carrier, which is flexible and efficient. The completed network design must evaluate all aspects including profitability, competition and rate development in order to have a high degree of network flexibility and have a potential to optimize port stays. Besides, a transparent and well-designed information technology system will help the company to deliver data precisely and on time.

In conclusion, cost effectiveness and the current market condition are main reasons for carriers in the container shipping industry to consider whether they should buy upsizing vessels or not. For smaller carriers, they should not buy bigger ships. Rather, they need to succeed lower costs on a point-to-point basis by contacting directly at ports served by megacarriers. Thus, small firms can eliminate extra handling of containers. On the contrary, for larger players, it is easier for them to decide buying new megaships. In order to grow organically in industry, the scale dominating strategy and the optimized network design are great tools for them to utilize. For Maersk, even in the downturn, the company can use megaships to win the market share from the economies of scale. By decreasing the rates, Maersk can beat other small firms easily. An alternative option for Maersk is the acquisitions or strategic alliances. I would recommend Maersk the strategic alliances rather than the acquisitions. Specifically, Maersk may have less power to control and do not have much flexibility but this approach serves a scale advantage and have less competitive cost. The strategic alliances between Maersk and CMA CGM related to megaships should be formed because they have very similar business functions. By doing so, both companies can consider options for concentrating on volume, utilizing the vessel capacity, offering more competitive prices and secure financing for new vessels. In a nutshell, only upsizing for Maersk is not enough, the company needs to have strategies for the long run including fleet composition, new network design and strategic alliances. The successful company in the container shipping industry must be efficient, flexible, and have easiest processes for current and future clients. 


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