GOGL - Golden Ocean Group: Supply Constraints And War May Offset Recessionary Demand Decline

Summary

• Dry bulk shipping companies face significant volatility as demand and supply trends become increasingly unstable.
• Time charter rates have fallen significantly recently as the global economy faces a recessionary dynamic.
• Increased commodity demand from the Americas due to the Russia-Ukraine war and a reopening of China's economy may improve shipping rates.
• The upcoming IMO 2023 regulatory burdens and the aging global dry bulk fleet will lower vessel supply levels over the coming years.
• Golden Ocean Group faces headwinds today, but it is among my favorite long-term investments at its current price.

The global shipping industry has faced immense turbulence over the past three years. Intermittent and chronic lockdown policies have led to declines in the demand and supply of goods, creating large fluctuations in shipping rates. Further, the war in Ukraine, geopolitical and trade conflicts, and elevated fuel costs have exacerbated volatility and have altered the global shipping landscape. Fundamentally, I believe the shipping industry entered a new era in 2020, where higher shipping rates are expected due to the rise in numerous volatility factors.

More recently, with the end of lockdowns in China, there is the potential for some normalization, but in today's market, market stability seems short-lived. The re-opening of much of the Chinese economy may result in greater demand and supply of global goods, but that does not necessarily fix the country's fundamental economic issues. Falling demand has significantly lowered worldwide dry bulk shipping costs, but that factor may be offset by immense fleet aging that is increasingly limiting available commercial vessels. Further, while the US and Europe are no longer battling severe supply-chain problems , they are seeing quickening economic declines that will likely result in a recession this year.

As shipping companies sail through challenging waters, I expect those with the greatest resiliency and investors with "stronger stomachs" to fare best. Key shipping stocks, such as my long-time favorite, Golden Ocean Group ( GOGL ), have skyrocketed and declined in value over the past three years. While GOGL has reduced by nearly 50% since last June, it trades at an incredibly low TTM "P/E" of 2.67X with a staggering 30% TTM dividend yield. Although its future cash flows will likely be much lower due to the decline in shipping rates, the company is trading at an extremely low valuation. Short-term economic fundamentals certainly increase the company's risk exposure. Still, as things stand, I believe the stock is highly attractive for long-term investors willing to hold steady through this volatile period.

Golden Ocean's Fundamental Outlook

The past two years were solid for Golden Ocean Group and most of its peers. The company's stock rose by nearly 4X in value from its 2020 lows to its 2022 peak as the Baltic Dry Index, or "BDI," soared. The BDI measures the average cost of shipping dry bulk goods (commodities like coal, grain, metals, etc.) across various global shipping lanes. This measure of shipping costs rose significantly from 2020 to 2022 as the 2020 recession proved extremely short-lived, while the associated decline in global production (and general business capacity utilization) led to massive supply-demand imbalances (spurring global inflation).

In 2020, businesses reduced production while global governments pursued stimulus that artificially increased demand. This led to widespread energy shortages, immense port congestion, and general supply chain issues. Many shipping companies also reduced contracting in 2020, expecting a prolonged recession, creating further imbalances in the global shipping market. These factors are generally winding down, and shipping costs are returning to normal, leading to lower BDI and GOGL prices. See below:

Today, Dry bulk shipping prices are about where they were before 2020. Golden Ocean has some contracted sales set at higher prices from last year that will keep its income slightly elevated this year. However, with shipping prices where they are today, I expect Golden Ocean's operating cash flow to decline toward the ~$150M TTM level unless there is an improvement in the fundamental environment. See associated margins and income over the past five years:

Golden Ocean has not made considerable changes to its balance sheet over the past three years, opting to pay most of its high profits to dividends. That said, the company's tangible book value rose by around $400M to $1.92B last quarter, which means it is trading at a lower "price-to-book of ~0.83X. Historically, that figure is roughly average for the company. See below:

At a relatively normal price-to-book ratio and an expected forward price-to-cashflow of ~10X (based on pre-2020 cash flows), I believe GOGL is trading around its fair value, assuming there is no change in dry bulk shipping prices. The stock is at its lowest point since its rapid 2020-2021 ramp-up. Despite its high TTM yield, investors are seemingly backing off from the stock due to recession concerns and lower anticipated earnings. In my view, that is an entirely understandable position from a short-term standpoint; however, GOGL may be particularly attractive today due to the longer-term fundamentals that may support an additional wave higher for dry bulk shipping rates.

Will Dry Bulk Return To Shortage Dynamics?

The Dry Bulk shipping market was stuck in a persistent glut throughout most of the 2010s due to immense fleet growth toward the end of the 2000s. Supply growth outpaced demand growth until ~2013-2014, creating a glut dynamic that persisted until ~2020. Demand growth was essentially zero last year due to the economic pressures in China and Europe, but supply growth has been low for longer. See below:

Virtually all sectors today are plagued by the "low demand, low supply" problem. Massive government stimulus in 2020 artificially increased aggregate economic demand without improving general supply; as stimulus turned into tightening, developed economies faced falling demand but still no production growth. The shipping market is a more extreme example since vessels are extremely high-cost items that take years to build, so shipping companies have avoided creating new vessels for nearly a decade due to low profits. Even when profits were high last year, few new vessels were produced due to supply-chain constraints and remaining business uncertainty.

Commercial shipping vessels worldwide, including dry bulk ships, are much older on average today than they were ten years ago due to low vessel production. To exacerbate this issue, the shipping industry faces the UN's "IMO 2023" maritime decarbonization regulation barriers this year. This policy is expected to lead to the detention of older vessels, speed reductions for many vessels, higher transit times for specific routes, and the adoption of energy-efficiency technologies.

The goal of the policy structure is to reduce maritime carbon emissions by 40% by 2030, with the most significant changes being phased in this year. As Golden Ocean's management team mentioned, this change's impacts are challenging to quantify. Still, they will almost certainly lead to a relatively rapid decrease in global dry bulk shipping supply. They estimate around 70-75% of the worldwide fleet is not IMO 2023 compliant or does not have the necessary ship upgrades to improve efficiency, meaning they will be required to travel at a slower pace.

One immediate impact I expect this year is a material decline in vessels as more companies "dry dock" ships to complete upgrades. Golden Ocean has recently increased the number of dry-docked vessels to install various energy-saving devices to keep up with regulations. Ideally, that change will mean Golden Ocean's ships can run at full speed while many competitors will not, or they have more vessels offline for upgrades. This regulatory change generally benefits larger public shippers like Golden Ocean and harms smaller private firms with less available capital - many of which have older vessels and poor ability to pursue necessary upgrades.

In my view, this policy, combined with the old fleet, will significantly decrease global dry bulk vessel supply that will likely last several years. With most economies falling into a recessionary dynamic, demand for dry bulk shipping may decline this year, as it is seemingly priced into GOGL today. However, with the Russia-Ukraine war resulting in lower aggregate Eurasian commodity production, dry bulk shipping demand from the Americas (Panamax) may rise faster. China also recently eased COVID restrictions, potentially improving demand, although another rise in its virus levels may soon offset this factor. In my view, China's economy, policy, and social information have become increasingly opaque in recent years, so I generally have a poor outlook on the country's economic situation. That said, I believe the dry bulk market may still surprise the upside as supply falls faster than demand.

The Bottom Line

Overall, I am bullish on Golden Ocean Group from a long-term perspective. The stock faces many challenges in 2023, as 2022 ended with firm indications of a global recession this year that will likely lower demand for international shipping. Still, there are many non-economic factors, such as the war, that are offsetting economic-led declines in demand. More importantly, years of poor fleet growth and a significant increase in regulatory burdens this year appear likely to spur a supply decline that should offset recessionary factors.

I believe GOGL is now at a low enough valuation that investors may want to consider buying the stock at a discounted price and potentially increasing its positioning if it falls further. Notably, most bullish catalysts facing the firm may not improve shipping rates for some time, so I would not be surprised to see GOGL meander around its current price or even fall further for most of 2023. That said, it is among my favorite stocks from a long-term standpoint due to its attractive core valuation, strong market positioning, and secular factors facing the shipping industry.

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