Is bigger really better?

Is bigger really better?

The old statement that U.S. military leaders "spend most of their time and money preparing to fight the last war," can also be said of business managers whose decision-making reflects an outmoded understanding of the economic drivers of their industry. Given the speed of change and the complexity of today's business environment, even senior managers often base decisions on what used to be true - and not on what is true today or what might be true in the future.

Increasingly, firms are learning that Will Rogers was right when he said, "It's not what we don't know that gives us trouble. It's what we know that ain't so."

In the container shipping business, one of the most well-accepted "truisms" is that large economies of scale exist in many areas of the business, including vessel construction, vessel operations, fleet management, terminal operations, information systems, and other back-office activities. This article briefly explores some generally accepted industry beliefs about "bigness"- bigger ships, bigger carriers, and bigger ports - and whether these beliefs still hold true.

Truth 1: "Container ships will keep getting bigger"

A few years ago, APL's former CEO Tim Rhein stated that, "This is a cost business. The line with the lowest cost is the one that is going to be standing at the end of the day." The container shipping industry's drive to reduce costs and the attractive economics of larger vessels have pushed liner operators to continually invest in larger, more cost-efficient vessels; and it is a generally accepted truism that larger ships are more cost-competitive.

Twenty or 25 years ago, the largest container ships in service were about 2,500 TEUs and Sea-Land Service Inc. had just taken delivery of an order of 10 D9 vessels with capacities of 1,600 TEUs. Such vessels now would be considered feeder ships or, at best, vessels to be placed in secondary service. It is widely believed that this trend toward larger container ships will continue, with rumors of orders for 10,000 TEU vessels and expectations that some carrier will soon order a 15,000 or 18,000 TEU Malacca max container ship. While such events might happen, making such major leaps is risky without a better understanding of the scale economies of large-vessel operations.

At-sea vessel operating costs per unit have dropped dramatically over the last 20 years due to a number of factors other than increases in ship size. These include the shift to lower-cost crews, significantly smaller crews, lower vessel-acquisition costs caused by shipyard competition, and improved vessel deployments by ocean carriers.

In the past, vessel scale economics were heavily driven by ownership costs, which can constitute about half of the vessel's operating costs. It is true that up to a point, larger new vessels do cost significantly less per slot to acquire. However, based on delivery costs over the last year, beyond about 4,000 to 5,000 TEUs, new vessel acquisition costs per slot do not seem to decrease significantly and have stabilized at about $11,000 per TEU. Thus the cost of a 4,000-TEU ship should be about $44 million and an 8,000 TEU ship about $88 million.

Another factor that contributed to past scale economies were crew costs. With high-cost American, European, or Japanese crews, it certainly made sense to spread crew costs over increasingly more boxes on the ship. However, as operators have generally moved toward lower-cost crews and smaller crews, the effect of crew costs on larger-ship economics has diminished.

Fuel consumption is another factor affecting the operating cost of a vessel. Available data indicates that there are very limited scale economies in fuel consumption, and that beyond 4,000 TEUs the unit cost impact is slight. Other costs such as insurance and equipment tend to increase on a linear basis with the size of the vessel, and thus do not contribute to any scale economy.

Although total vessel operating costs depend on specific deployment factors such as percent of time at sea and vessel speed, it is possible to estimate the relative costs of larger vessels for a specific itinerary. Figure 1 shows that the vessel at sea cost per TEU-mile basically levels out beyond about 6,000 TEUs. Increasing a vessel size from 2,500 to 3,500 TEUs reduces operating costs per unit by about 16 percent. However, increasing vessel size from 6,500 to 7,500 TEUs will result in only a 1 to 2 percent savings per TEU-mile.

The costs shown in Figure 1 are based on 100 percent slot utilization, which starts to highlight some of the economic disadvantages that can be associated with larger vessels. The economic benefits of larger vessels, however slight, are only gained if the incremental capacity is used effectively. The 2 percent unit cost savings associated with increasing from 6,500 TEUs to 7,500 TEUs is not going to be realized if the extra 1,000 TEUs of capacity are only used 20 percent of the time. In fact, the cost per TEU actually moved will increase.

Beyond the slot utilization issue, a number of other factors can produce negative diseconomies of scale for larger vessels. These include increased reliance on feeders or additional port calls to fill the slots, as well as the need for larger terminals, more and larger cranes, and deeper channel and berth depths. The terminal infrastructure investments associated with 8,000 TEU vessels have largely been made or committed to by many ports and carriers. However, it is not clear how many ports are willing to make the next round of size expansion investments when the costs are balanced against the relatively small economic benefits of the larger ships.

For these reasons, I am not convinced that the recent growth in new container ship size will continue, at least in the near term. Rather, I think that we are likely to see a period where 6,500- to 8,500-TEU vessels will be ordered to handle traffic growth and to replace older, smaller vessels.

The same desire to reduce costs has resulted in a continuing trend toward consolidation within the container shipping industry. In 1987, the top five container carriers controlled about 13 percent of the total world's fleet capacity. Now Maersk Sealand alone controls that percentage. It is generally accepted that further consolidation within the industry is inevitable as the individual companies struggle to cut costs. Almost every month the industry hears new or recycled rumors about an imminent merger or acquisition.

Frank Caradonna, formerly with Orient Overseas Container Line, observed several years ago that "whether they realize it or not, it is going to be very difficult for some lines to effectively compete with the giant new lines. You don't necessarily have to be as big or bigger, but you have to be in the same league." This was certainly the industry belief in 1998 and 1999 when carrier acquisition activity hit all-time highs and several high-profile acquisitions occurred (see Figure 2).

Given the advantage of time, it might be useful to review the results and test the still generally accepted truism that for container carriers, "bigger is better," and that we can expect further consolidations. At the time, it was generally felt that to prosper you had to become a mega-carrier with actual top-5 carrier share in nearly all trade lanes. Aside from Maersk Sealand, that has not happened. Looking at the 2002 Asia-to-U.S. trade versus worldwide market shares, as shown in Figure 3, it is clear that carriers can and do focus on specific trade lanes and that even worldwide carriers are not equally strong in all markets. Also, if the primary driver of mergers is to gain better market coverage, it is possible that an alliance structure may be a safer mechanism. A recent Booz Allen review of merger results in a variety of industries indicated that about 35 percent of mergers actually reduced the value of the combined company.

In at least two of the mega-mergers, P&O Nedlloyd and APL-NOL, the major driver was not to gain better market coverage but rather to improve the cost structure and financial results. These mergers anticipated that about 60 percent of the merger-related cost savings would be in back-office functions such as IT, with relatively small benefits in actual vessel operations. In both mergers it was felt that being a larger company was necessary for them to reduce back-office-type costs.

Publicly available information on financial results for 2002 (Figure 4) does not indicate any strong financial advantage to being a larger carrier. Obviously, the financial results from a single year where the industry was operating under severe rate pressures is not definitive proof that there are limited scale advantages to being a large carrier, but it is an indication. Another indication that carrier size is not necessary to succeed in this market is the relative growth rates of the carriers from 1990 to 1999. During this period, the growth rates of what in 1990 were small carriers such as Mediterranean Shipping Co, CMA CGM, Hyundai Merchant Marine, and Zim Israel Navigation Co. were much greater, often several times greater, than the growth rates of their larger, more established competitors such as APL-NOL, NYK Line, Hapag-Lloyd, OOCL, MOL and "K" Line. The differential in growth rates is not a strong argument that only mega-carriers can survive in this industry. It also highlights the fact that strong carrier growth in the industry is not always best done through mergers, since most of these carriers' growth was organic.

Truth 3: "Container ports will have to consolidate into fewer, but bigger ports"

During the 1990s, there was clearly a push toward the "hub port", which loaded and unloaded large ships with traffic brought in by feeder vessels or an extensive inland distribution system. In a recent article in a national magazine it was even theorized that the Asia to U.S. trade could be totally served through one Southern California port. However, several factors are now are working against the further growth of the hub port concept.

The key driver is the phenomenal growth of international trade that facilitates direct call service at ports that previously did not have the volume. Thus we see a shift away from the need to use feeder vessels to move North China traffic over a relay hub port such as Pusan. Instead, vessels are increasingly picking up this traffic through direct calls at Chinese ports. Another factor supporting the trend to more direct service is the service scale provided by the alliance structure. By working with other lines, an individual carrier can have the scale to increase frequency or to establish a direct service.

Another deterrent to the hub port concept is the simple fact that many of the major container ports are simply running out of room. Our analyses indicate that the Southern California ports of Los Angeles and Long Beach will reach capacity in less than four years, and several of their individual terminals are already operating near capacity. On the Gulf Coast, Houston is already pushing the limits of its existing terminal and its plans to expand are being severely challenged on environmental grounds.

Finally, both the carriers and shippers have realized that the hub port concept can eventually run into significant economic and service problems. While the carriers' vessel unit costs have been driven down, their terminal and inland distribution costs have gone up and have become the major share of a container's total delivery cost. Therefore the hub port's past advantage of providing traffic scale to support larger ships may be overcome by efforts to reduce terminal and inland handling costs.

The intent of this article was not to prove definitively that these generally accepted industry trends toward larger vessels, carriers, and ports will change in the next year or even in the next three years. Instead it was intended to challenge the accepted industry "certainty" that these trends will continue indefinitely. The economic and service drivers of the industry are continually changing in response to the market and yesterday's answers are not necessarily tomorrows' answers.

Steven Petracek, is a senior associate associate at Booz Allen Hamilton. He can be reached at (703) 917-2289 or by e-mail at petracek_steven@bah.com