In shipping business, output can be measured either by:
- Tonnes of cargo carried by ship per day, per trip or per year
- Tonne-miles produced by ship per day, per trip or per year
Nature of the cargo carried is unimportant to shipping cost analysis. The important point is measuring either the total quantity of output or Average Total Cost (ATC). Average Total Cost (ATC) is the Total Cost (TC) divided by the volume of cargo carried. Average Cost per tonne is calculated on the quantity of cargo being carried on any voyage. On the other hand, Unit Cost is calculated on the maximum quantity of cargo the ship is designed to carry. Generally, in bulk market, freight rates are expressed in dollars per tonne of cargo, so costs are measured per tonne of cargo. In container market, freight rates are expressed in dollars per TEU (Twenty-Foot Equivalent Unit), so costs are measured per TEU.
In short-run period, there are two (2) types of costs:
- Fixed Costs: (Indirect Costs)
- Variable Costs (Direct Costs, Avoidable Costs)
Fixed Costs (FC) are all expenses which must be met when producing the output of goods or services. Fixed Costs (FC) do not vary with the level of production of output. Fixed Costs (FC) are necessarily incurred costs. Fixed Costs (FC) are unaffected even if production fell to zero. Variable Costs (VC) are all expenses which do vary with the production of output. The distinction of Fixed Costs (FC) and Variable Costs (VC) distinction is only valid in the short run period. In the long run period, all costs become Variable Costs (VC) and Fixed Costs (FC) does not exist. Capital cost (mortgage repayment) is a Fixed Cost (FC) because capital cost does not vary with the output of the ship. Ship’s daily capital cost has to be recovered either the ship sits at lay-up (no output) or the ship is actively trading. Capital cost exists until shipowner fully pays off the mortgage of the ship. Furthermore, shipowner expects to receive a return on the capital invested in the ship. Opportunity cost is a Fixed Cost (FC). Ship bunkering expenses are directly related to producing output (laden tonne-miles or tonnes of cargo moved). Therefore, bunkers are Variable Costs (VC). In the short-run period, Fixed Costs (FC) are unaffected by the change in the level of production. Hence, Fixed Costs (FC) can be treated as a constant. For example, daily overhead costs attributed to 200,000 DWT capsize bulk carrier have been calculated by shipowners as being $15,000 a day. Bulk carrier will trade from Rotterdam to New York and back, a round-voyage distance around 6,000 nautical miles. Output produced by this journey can vary between zero and 600 million tonne-miles, assuming bulk carrier is laden one way. Round trip from Rotterdam to New York takes 20 days. Total fixed cost attributed to the trip is $300,000. Variable Costs (VC) will be voyage-related costs such as bunker consumption, both at sea and in port, must be accounted for. There will be port dues and stores and provisions for the crew. If loading and discharging costs are on shipowners account, there would be cargo handling costs to consider. Bunker consumption will rise as the laden weight of the ship rises, but port and cargo handling charges will increase with the volume of cargo being moved. Assuming that cargo handling and bunker costs increase at a constant rate per tonne. Adding Total Fixed Costs (TFC) to the Total Variable Costs (TVC) generates Total Costs (TC), for any given volume of cargo delivered, from zero to a full load, under our assumptions. In shipping business, examining Total Costs (TC) may be useful, but market prices are expressed per tonne of cargo delivered. Therefore, calculating Average Costs (AC) would be more useful. In the example above, Average Total Cost (ATC) per tonne of cargo delivered can be found by dividing the Total Costs (TC) of delivering the cargo by the quantity of cargo delivered.
Average Fixed Costs (AFC) and Average Variable Costs (AVC).
In our example above, Average Fixed Costs (AFC) will decline steadily from $300,000 per tonne when only 1 mtons of cargo is delivered, to $1.5 per tonne when 200,000 mtons of cargo is delivered. Average Fixed Cost (AFC) value declines steadily and Average Fixed Cost (AFC) is minimized when the maximum output is produced. When we assume fixed journey length, fixed ship speed and fixed cargo handling charge per tonne of cargo delivered, Average Variable Cost (AVC) will be constant. Average Variable Costs (AVC) are the same whether 1 mtons or 200,000 mtons is carried and discharged. Total Variable Cost (TVC) increases but Average Variable Cost (AVC) is constant. Adding the constant Average Variable Cost (AVC) with Average Variable Cost (AVC) yields Average Total Cost (ATC). In this case, Average Total Cost (ATC) reaches minimum at the maximum cargo volume which can be carried. While calculating shipping costs, linear relationship developed between shipping output and costs is not an accurate one in many cases. It is possible to find a more complex interrelationship between shipping output and costs. Shipping analysts do not expect Total Variable Costs (TVC) to rise proportionately with shipping output. Because, variable quantity of bunker is combined with a fixed quantity of another input. Law of variable proportions states that there is an optimal combination of these inputs. Law of variable proportions implies that if the mix of inputs is not optimal, efficiency is reduced and Average Variable Costs (AVC) are higher than can be achieved at a different level of output. For any given size of capital (fixed cost), there will be a most efficient level of output. Efficiency here is being measured in terms of the lowest Average Total Cost (ATC).
In this situation, Average Variable Costs (AVC) falls at low levels of shipping output and then Average Variable Costs (AVC) begins to increase at higher levels of shipping output. Fully-laden ship going faster will increase shipping output but at a higher bunker cost. Average Total Cost (ATC) is the sum Average Fixed Costs (AFC) and Average Variable Costs (AVC), this generates a U-shaped Average Total Cost (ATC) curve. At low levels of shipping output, fixed costs are a very large share of total costs. Fixed costs fall sharply in share when shipping output increases. When combined with a falling Average Variable Cost (AVC) curve, Average Total Cost (ATC) must fall. When shipping output continues to increase:
- Relative importance of the fixed costs declines
- Average Variable Costs (AVC) start to rise rapidly which makes the Average Total Costs (ATC) rise
Marginal (Incremental) Cost
Marginal Cost (MC) is the change in Total Costs (TC) generated by the production of an extra unit of output. In the short run period, Marginal Cost (MC) must be related to Variable Costs (VC), since by the definition of short run period, Fixed Costs (FC) cannot be altered. Only changes in Total Costs (TC) are generated through the change in Total Variable Costs (TVC) associated with the change in shipping output. When Average Variable Costs (AVC) rise, Marginal Costs (MC) will be rising even faster. When Average Variable Costs (AVC) fall, Marginal Costs (MC) will be decreasing even faster. Measurement of Marginal Costs (MC) can vary depending on conditions. For example, Marginal Cost (MC) of carrying extra one metric ton of cargo on a ship which is not already fully laden would be extremely small number. On the other hand, if the ship is fully loaded, Marginal Cost (MC) would be extremely high, since the costs incurred will constitute those associated with providing an extra ship.
In long-run period, ship capacity utilization is close to 100%, the latter type of Marginal Cost (MC) is a measure of the long-run total cost of meeting that extra demand. If capacity is idle, the same Marginal Cost (MC) can be measured as a very small number relative to the total costs involved. If extra costs accrued for shipping extra tonnage generates additional revenues which exceed the extra costs incurred, the shipowner or operator will be better off by accepting the business. Long-run period is defined as the period of time in which it is possible to vary all the input quantities used in producing a given level of shipping output. In long-run period, Fixed Costs (FC) such as capital, land, bunker and crew required to produce a given level of shipping output becomes Variable Costs (AVC). In other words, in the long-run period Fixed Costs (FC) do not exist. Assuming that the unit prices of inputs remain unchanged.
In shipping business, one of the key determinants of shipping output produced by a ship trading on a particular route at a given speed is its size. Larger the size of a ship, larger the cargo volume is carried per time period when other things being equal.
Long-run Average Costs (LRAC) can be related to output in three (3) different ways:
- Long-run Average Costs (LRAC) may fall, as shipping output levels rise. Economies of scale are said to exist. Larger the volume of shipping output, lower the average cost of production.
- Long-run Average Costs (LRAC) may remain unchanged as output levels rise. Constant returns to scale are said to exist. Average Costs (AC) are the same, irrespective of the level of production.
- Long-run Average Costs (LRAC) may rise as output levels rise. Diseconomies of scale are said to exist.
In the short-run period, ships’ costs are classified into three (3) distinct categories:
- Capital Related Costs (Fixed Costs)
- Direct Operating Costs (Fixed Costs)
- Voyage Related Costs (Variable Costs)
1- Capital Related Costs (Fixed Costs) are be attributed to the ownership of the ship itself.
- Loan Principal if a mortgage or other financial instrument has been used to acquire the ship
- Loan Interests on the outstanding balance of any loan or mortgage
- Opportunity Costs for shipowner’s capital tied up in the ship (shipping consultants include a notional 8%), shipowner would have such a return on capital investment
2- Direct Operating Costs (Fixed Costs) incurred in the running of the ship. Direct Operating Costs do not vary with the ship’s use. Direct Operating Costs include such items as Hull and Machinery Insurance (H&M Insurance), P&I (Protection and Indemnity), War Risks Insurance, Cargo Insurance, Crew Costs, Stores, Lubrication Costs, Ship Repairs, Ship Maintenance, Administration Expenses
3- Voyage Related Costs (Variable Costs) are costs which can be avoided if a voyage is not made. Like Bunker Costs, Port Dues, Canal Dues, Pilotage, Towage, Cargo Loading/Discharging Costs (if it is on owners account), Crew Provisions
Specific Factors Affecting Relationship Between Costs and Shipping Output:
- Load Factor (LF)
- Ship Speed
- Voyage Distance
- Cargo Handling Rates
- Ballast Distance
- Port Time
- Ship Size
Specific factors interact with each other. For example, if ship speed is increased, bunker consumption rises. On the other hand, when ship speed is increased, time spent at sea will fall, so the amount of overhead allocated to a specific cargo trip will fall. One way of analyzing relationship of these factors is to allow only one specific factor to change at a time and keeping all the other possible specific factors as constant as in below analysis.
1- Load Factor (LF)
Average Load Factor (ALF) will affect the Average Cost (AC) per tonne of cargo delivered. If Average Load Factor (ALF) increases, Average Cost per tonne of cargo delivered decreases and vice-versa. Container shipping has high fixed costs and low variable costs, in the short-run period, high Average Load Factor (ALF) decreases Average Costs (AC), because the overhead costs are spread over greater output volumes. In container shipping market, short-run average cost is minimized at 100% ship utilization rate. Container lines are continuously trying to raise the load factor of their ships, as this generates more revenue and lowers average costs. In tramp shipping market, ship’s Load Factor (LF) is not really an issue. Tramp shipowners seek cargoes that match ship’s capacity and usually tramp ships sail with full cargoes. In tanker market, oil cargoes are one-way cargoes (unbalanced cargoes), generally one leg of the tanker trip is carried out in ballast.
2- Ship Speed
In the short-run period, in tramp and bulk shipping market, altering the ship speed is effectively the only way of varying shipping output. Ships are designed to be operated at a particular speed. Ship speed is determined by:
- ship’s size
- ship’s technical characteristics
- ship’s engine power
Generally, ships are designed and optimized for a particular trade at the shipyard. Once ships are built and commissioned, flexibility is reduced but there is still some room to vary ship’s speed. When ships steam faster, bunker consumption increases. 1% increase in ship speed will lead to 3% increase in bunker consumption. In other words, ship’s bunker consumption will rise, even when trip time has been reduced. Decrease in trip time means a reduction in the allocation of overheads to this trip. Average cost per tonne of cargo delivered falls and then rises, around the ship’s design speed. A ship that is designed for 14-knots may have an effective speed range of 10 (-30%) to 16 (+12%) knots. Ship may loss of ship maneuverability and steerability below lower end of design speed and after top end speed may discomfort the crew. That is why range of ship speeds is limited. Bunker consumption and ship speed relationship is derived for a given price of bunkers. An increase in the bunker price will shift the entire relationship up and to the left, least cost speed. A decrease in bunker prices will do the reverse. When shipping market is good and freight rates are high, profit rate increases, and it becomes worthwhile to increase ship speed. In bulk shipping market, there is a strong correlation between freight rates, bunker prices and ship speed in the bulk trades. In container shipping market and liner trades, shipowners and operators have to meet deadlines in order to satisfy their contractual obligations to their customers. Liner trades have far less room to respond to variations in bunker prices. Container and liner ship operators insert a clause in charter-parties that permits them to pass on the effects of unexpected movements in bunker prices to the customer (Bunker Adjustment Factor – BAF). This response is needed because of the different nature of the service offered in these trades. In container shipping market and liner trades, slow steaming is possible as long as the savings outweigh the cost of adding an additional ship to the loop.
3- Voyage Distance
Assuming all other factors are constant, altering the voyage distance increases the Total Costs (TC) incurred by a ship of a given size. When ship speed held constant, longer voyage distance mean larger bunker costs. Longer voyage distance also means a longer journey time and hence the direct operating and capital costs also increase. Larger ships have larger daily direct costs and capital costs. Bunker costs of larger ships required to steam further will be lower than small ships, because bunker consumption at a given ship speed rises less than proportionately with ship size. On long voyage distance, large ship becomes more efficient than smaller ship as the voyage distance increases. As the voyage distance increases and the time spent at sea increases relative to the time spent in port, the preferred or optimal size of the ship increases.
4- Cargo Handling Rates
Rise in the rate of cargo loading/discharging will reduce the amount of time the ship spends in port. Other factors being equal, this will reduce the constant terms. Reduction in the constant terms will alter the critical distances at which one ship size becomes more efficient than another. Higher cargo handling rates will reduce port time. Hence, larger ships become more economic than smaller ships.
5- Ballast Distance
Reducing the proportion of ship voyage that is spent in ballast will lower the average cost per tonne of cargo delivered. Reducing the ballast distance means ship is carrying more cargo, producing more output, with more or less no change in total voyage costs. Bunker consumption will increase slightly, but not significantly. Reducing ballast distance effect is exactly the same as raising the ship’s load factor.
6- Port Time
Relative proportions of time spent in port and at sea by a ship directly related to costs. Furthermore, port time costs will be affected by a ship’s size because:
- Larger ships will incur greater port charges
- Larger the ship, greater the cost of capital and opportunity cost of idle port time
On the other hand, large ships are often able to discharge their cargoes more rapidly than smaller ones. Because, larger ships are equipped with higher capacity cranes. Larger ships need to spend in port does not need to be longer than that expected for a smaller ship. Because, larger ships lose more revenue than smaller ships when are idle at port. Other things being equal, larger the proportion of time a ship spends in port per year, the smaller its preferred size such as coaster ships and feeder ships.
7- Ship Size
In the long-run period, there are two (2) ways to alter ship size:
- Altering the dimensions of an existing ship. Ships are jumboized at the shipyard by the insertion of an extra section of the hull
- Ordering a new ship. Design stage at the shipyard before commissioning the construction
For long voyage distances, the preferred size of the ship increases. Furthermore, full examination of the relationship between average costs and ship size leads into an analysis of long-run costs.
Long-Run Ship Costs and Economies of Scale
In the long-run period, relationship between average cost and ship size, which is taken to measure output, is constructed with a number of underlying assumptions such as input prices are assumed to be constant. In other words, price of capital (interest rates), labor (crew), bunkers are assumed to take the same values when comparing average costs at different sizes of ships. Furthermore, voyage characteristics, load factors, and so on would also need to be kept constant. Three different relationships between Long-Run Average Costs (LRAC) and output were identified:
- Economies of Scale
- Constant Returns to Scale
- Diseconomies of Scale.
Economies of scale exist in two (2) principal areas of shipping:
- Port facilities, terminals
Economies of scale are essentially of two (2) broad types:
- Internal economies of scale: enjoyed by a single company through that company’s individual policy
- External economies of scale: enjoyed by number of companies within the industry or expansion in scale of the whole industry
Types of Internal economies of scale are:
- Commercial economies of scale
- Managerial economies of scale
- Financial economies of scale
- Risk-bearing economies of scale
- Technical economies of scale
1- Commercial economies of scale
Commercial economies of scale are referred to as marketing economies. In buying, large companies are able to buy bulk at a discount. In selling, large companies marketing costs per unit of output and advertising is cheaper in larger volumes. Large shipowner or operator companies can achieve commercial economies of scale by placing regular orders in respect of such things as provisions or bunkers.
2- Managerial economies of scale
Managerial economies of scale are concerned with the control of the organization which is also known as the division of labor. As Adam Smith mentioned in the 18th century, individuals increase their productivity by specializing in a specific task. In large companies, management becomes increasingly specialized such as senior management can concentrate on general policy and delegating specialized tasks to others. Large companies have a divisional structure. For example, a small shipping company with only a few ships may find it cheaper and more efficient to have their ships managed by a specialist ship management company. Hence, small shipping company with only a few ships will benefit from the managerial economies of scale which has already achieved by a large ship management company. Furthermore, large shipping companies are able to have their own specialist legal and insurance departments. Major liner shipping companies have offices all over the world and transfer employees to other office locations in order to create an all-round management structure.
3- Financial economies of scale
Large shipping companies have advantages in raising finance for expansion either through banks or by going to the public through the sale of shares at the stock exchange. On the other hand, it might be difficult for a small shipping company to convince banks for their financial stability.
4- Risk-bearing economies of scale
There are three (3) types of risks:
- Insurable risk: large shipping companies can insure at low premiums
- Risk-bearing: large businesses might bear their own risks such as by introducing a new commodity
- Uncertainties: risks which cannot easily be insured against. Uncertainties can cause the bankruptcy of small companies. Large companies like large multinational companies can diversify their products or compensate for the difficulties in one area by the buoyancy in another. For example, large shipping companies are diversifying their interests and investing in related services in order to spread risk, like through-transport and logistics services. Furthermore, large shipping companies can switch ships from one trade to another trade.
5- Technical economies of scale
There is a decrease in average construction costs with increases in ship size. Newbuilding ship prices are market-driven as well as cost-related, so newbuilding ship prices will reflect demand conditions as well as the costs of production. In average construction costs, there is significant technical economies of scale when purchasing larger ships. For example, largest benefit to shipowners appeared to be available in the crude oil sector.
Determining Optimal Ship Size
When the ship size increase, the cost per tonne declines, but large ships need extra time to load and discharge cargo, assuming that cargo-loading and handling rates are constant. This boils down to the gains from larger ship sizes when the ship is at sea being offset by the extra port time implicitly required to load and discharge cargo. When a ship is traded on short-distance route, ship spend more of its time in port in a year, compared to if a ship is traded on a long-distance route. In other words, there may be a point at which the potential cost savings from using a larger ship when at sea are more than offset by the higher costs involved with the same ship sitting idle in port. Formally expressed in a model of ship costs has three (3) elements:
- Daily capital costs
- Daily operating costs
- Voyage related costs
Here above model ignores cargo loading and discharge costs when it is on shipowners account. When ship is in port, daily capital and operating costs must be covered. Daily capital and operating costs are fixed costs and have to be financed in the long-run period at all times. Ship also incurs voyage related costs when a business is accepted and ship is at sea. Relative importance of cost components clearly depends on the number of days spent at sea and the number of days spent in port. Short sea ferry spends a large proportion of its working year in port, compared to very large crude carrier (VLCC) trading from Arabian Gulf to Far East. Short voyage distance raises the number of port days relative to sea days, and affect cost structures. When ship size increases, average costs decrease. On the other hand, when ship size increases, capital costs increase. Relationship between ship size, speed and bunker consumption is complex which affects voyage related costs. 10% increase in ship size raise the newbuilding price of by 7%, direct operating costs rise by 5%, implying larger savings than from capital. Ship’s direct operating costs do not increase relative to size. For example, compare crew costs of 20,000 DWT and 100,000 DWT bulk carrier, ship five times larger does not require a five times larger crew. Voyage related costs at sea are affected by ship-operating speeds and bunker consumption of main engines. Assume a constant voyage speed for both ballast and laden voyage. 10% increase in ship size, increase daily bunker consumption by 7.5%. Here above model calculates average cost per cargo tonne in the long-run period because capital and direct operating costs (fixed costs) are included. Assume there (3) different size bulk carriers handysize 20,000 DWT, panamax 80,000 DWT and capesize 150,000 DWT.
- For a very short distance voyage, smaller size ships (handysize) have lower unit cargo costs per tonne than larger ships (panamax and capesize).
- As the route length increases, larger ships (panamax and capesize) have lower unit cargo costs than the smallest ship size (handysize), but the very largest ships (capesize) may have marginally higher unit cargo costs per tonne. In other words, there is a range of ship sizes that generate lower unit costs. In the mid-range distance, both smaller (handysize) and larger ship sizes (capesize) will have higher unit costs. There is an optimum range ship size for these route lengths.
- As the voyage distance gets longer, optimum ship size gets larger (capesize) and the range of sizes shifts to the right.
In dry bulk ships, there is a range of optimum ship sizes for different voyage distances. Altering basic elements of the model like ship prices, bunker prices and assumed values of the elasticities, affect optimal ship sizes. As the proportion of sea time rises, fuller exploitation of the economies of scale are to be gained from using larger ships, costs including longer time in port with longer loading/discharging times, are offset by the longer-distance voyages. In similar manner, this model explains the use of hub and spoke networks on the liner trades and container market. Liner shipping company will have a main terminal (hub), to and from which the containers are distributed to the other ports (spokes). Here above model assumed that ship is fully laden in one direction. When demand levels do not generate cargo lot sizes that are the same as the ship size, then the average costs rise. Hence, the model assumed ship’s size and average lot size are the same.
Ship Costs at Different Fiscal Regimes
In the long-run period, the way that national governments set the tax regime on ship investment plays a critical role in influencing average costs of operating ships under the national flag. The way that ship’s depreciation expenses can be written off and taxation can have a highly significant effect on the overall profitability of a shipping company. Shipping fiscal treatment is governed by the Community Guidelines on State Aid to Maritime Transport 2004 in the European Union. EU members cannot give unrestricted aid to their national shipping. European Commission supports EU-registered shipping and seafarers. In principle, European Commission is anti-protectionist. Community Guidelines on State Aid to Maritime Transport 2004 are therefore a balance between support for EU shipping and maintaining open shipping markets. Objectives of Community Guidelines on State Aid to Maritime Transport 2004 are:
- Promote the competitiveness of EU shipping
- Reduce fiscal and other burdens on EU shipping to world norms
- Encourage flagging/re-flagging of EU-owned or managed ships to EU ship registers
- Contribute to the shore ‘maritime cluster’ of industries
Community Guidelines on State Aid to Maritime Transport 2004 cover four (4) areas:
- Fiscal incentives for shipowners and ship managers
- Investment aid for ships
- Labor-related costs, crew relief and training
- Short-sea shipping
As for fiscal incentives for shipowners and ship managers, EU members may allow accelerated depreciation on ship investments. Depreciation is the reduction in the value of an asset (ships). Depreciation reduces annual taxation by offsetting against profits. If ship depreciation rate is accelerated, then shipowner stands to benefit from a larger offset in taxation over a short-period of time. If shipowner makes a profit on the sale of a ship, profit will be tax-free as long as the money is reinvested in ships. EU members are allowed to replace corporation tax by a tonnage tax. In most EU member states, shipowners decide which tax method to choose. If shipowner makes no profit in a particular year, shipowner is not liable for corporation tax. On the other hand, if shipowner elected for tonnage tax, tonnage tax which is based on ship’s net tonnage, must be paid regardless whether shipowner makes a profit. Different ship registries have different tax regimes and tax burdens for shipowners. If we compare and list Panama, Liberia, Greece, Netherlands and UK flags from lowest to highest tax burdens for a bulk carrier, Panama and Liberia rank first and second respectively. Magnitude of tax payments are relatively small when considering the overall capital and operating costs of a ship. Ship flag is not always selected for tax reasons.
Ship Costs and Flag of Registry
After 1945, Open Registers (Flags of Convenience) and the practice of flagging out ships from traditional maritime countries to Open Registers (Flags of Convenience) increased rapidly. In 1950, only 4% of world shipping was flagged in Open Registers (Flags of Convenience). In 1995, it had reached 50% and in 2013, 75% of world shipping was registered to Open Registers (Flags of Convenience). At the beginning, shipowners were flagging out for tax reasons. For example, Liberian flag levied no tax on profits but subscription tax based on the registered tonnage of the ships. Flagging out gave shipowners the opportunity to reduce operating costs in 1980s’ shipping recession by employing cheaper crews. In 1980s, many traditional European flags required shipowners to employ more expensive national crews. Under Open Registers (Flags of Convenience), similar size and type of ships may well be operated at significantly lower costs (approximately 10%) than under national flags.
Major Open Registers (Flags of Convenience) countries:
- Panama (21% of world fleet)
- Liberia (12% of world fleet)
- Marshall Islands (9% of world fleet)
Some traditional maritime nations have responded to rise of Open Registers (Flags of Convenience) by introducing Second Register. For example, in 1990, Norway introduced Norwegian International Shipping Register (NIS) which permits Norwegian shipowners to avoid national crewing regulations. Norwegian International Shipping Register (NIS) has attracted a large volume of tonnage owned by Norwegian shipowners back from other open registries. Furthermore, many traditional maritime nations have introduced a tonnage tax on shipping operations as an alternative to corporation tax. Fall in the share of traditional maritime registers does not necessarily imply a fall in the share of ship ownership. Because, beneficial owners of Open Registry ships are not resident in these countries. Foreign shipowners account for almost 100% of the tonnage in Liberia, Bahamas, Panama, Marshall Islands, Malta, Antigua and Barbuda and Bermuda. Most ships fly a flag that is different from that of shipowner’s nationality. Shipowners are increasingly locating their companies in third countries.
Ship Costs and Quality
Shipping industry stakeholders and regulatory authorities became increasingly concerned over the decline in ship standards in the 1980s and 1990s. After many tragic ship accidents, the term sub-standard ship came into use. Many charterers are solely concerned with price which may lead shipowners to reduce repair and maintenance expenditures to below that standard for the long-term quality of the ship. According to OECD estimates, shipowners can save 13% on the annual running cost for the dry cargo ship and 15% for product carriers. In order to reduce the incentives to cheat and raise the overall standard of ship management, IMO (International Maritime Organization) introduced International Safety Management Code (ISM Code) in 1998. International Safety Management Code (ISM Code) have improved the shipping industry’s performance overall and implementation of the regulations appears to have led to a significant reduction in accidents and an increase in ship quality. Maritime nation’s port state authorities carried out more frequent ship inspections that increased the ship quality. Equasis database permits maritime administrations to swap information on ship detentions which improve the targeting of ships calling at European ports. Paris Memorandum of Understanding (Paris MOU) is very effective at targeting, detaining and banning ships that pose a safety and environmental risk. Beside poor standard ship, ship’s flag state, classification society and shipowner are also identified.
Demand and Inventory on Optimal Ship Size
Optimal ship size is affected by:
- Volume and characteristics of demand
- Level of inventory costs
Inventory cost is the cost of time incurred by the cargo being transported instead of being sold and the revenue then being invested. Other things being equal, the larger the average lot size of cargo, the larger the optimal size of ship. The more frequent the required cargo delivery, the smaller the optimal size of ship.
- If demand volumes and average lot sizes rise, then large ships to be used, provided that unit costs continue to fall
- If demand levels are not sufficient to allow very large ships to be used at the appropriate service frequency, demand acts as a constraint on the ability to exploit larger ship size
After China joined the WTO (World Trade Organization) in 2001, rapid growth in world trade triggered a boom in demand for liner shipping services. China’s principal trading partners have been the Europe and North America, which are long-distance routes. As cargo volumes grew, larger container ships were introduced for Far East to Europe and North America routes. When large ships were introduced, previous ships were used in short-distance routes where demand volumes grow. In the dry cargo sector, China’s demand for coal, iron ore and steel to record levels, push the dry bulk carrier size as large as 400,000 DWT. In tanker sector, when oil demand had peaked in 1981 after rapid growth, gigantic tankers were built. Demand volumes dictate both the largest economic ship size and by implication, average ship size, in the different trades. In some cases, ship operators also own the cargo. Hence, inventory costs also affect the optimal ship size. Cost of holding the cargo on the ship increases directly with the size of that ship. Assuming a fixed interest rate and a fixed average value for the cargo. Higher the inventory cost, the smaller the optimum ship size. High cargo unit prices tend to reduce the optimal size, low cargo unit prices tend to increase the optimal size. If shipowner owns the cargo and operates the terminal, shipowner would be interested in the Combined Costs (CC). For example, large multinational oil company which owns the cargo and terminal. Increased ship size means increased draught, beam and length. Many ports and canals have draught restriction. Furthermore, many ports do not have the facilities necessary to handle the large ships. Therefore, the trading flexibility of very large ship is more limited than the small ship.
There has been a general increase in the average size of all ship types (except general cargo ships) over the past 35 years due to increase in trade volumes. Some ship types have been able to exploit the potential economies of scale to a greater extent than others. Increase in tanker sizes in the 1970s can be explained by:
- Growth in volume demand
- Growth in average parcel sizes
- Shift toward longer hauls
Average tanker voyage distances increased rapidly with the closure of the Suez Canal in 1967. Larger and larger ships were built, but increase in average ship size was reversed in the early 1980s due to recession in western economies. Crude oil prices had risen to their highest ever value, thus raising inventory costs significantly. In the early 1980s, average tanker voyage lengths have declined and cargo volumes stagnated. These pressures led to a decline in the average size of tankers in the years 1981 to 1987. Afterwards, the trend has again reversed. In the 1990s, the price of crude oil had fallen to its lowest level in real terms since 1973. Since 2002, demand for crude oil has grown and is close to projected maximum refinery capacity, creating a volatile market price which is now much higher, trading well above $100 a barrel. This situation raises inventory values of crude oil again and tanker average sizes have fallen slightly in 2015. Tanker market trends is consistent with the model outlined above. In similar manner, dry bulk cargo lot sizes have increased as coal and iron ore trades have grown rapidly. Dry cargo bulk ships have also grown in size which reflects the longer route structures and greater volumes traded. Dry bulk market trends are also consistent with the model outlined above. In container shipping sector, cargo volumes have boomed in last decade. Container ships are now 21,000 TEU for Far East to North America and Europe route. Size of container ships has grown rapidly since 1995 due to greater trade volumes and globalization. In last 35 years, general cargo ships show the least increase in ship size, because of low growth in demand for general cargo ships and very slow loading/discharging rates.