This week Hanjin, the world’s 7th-largest ocean carrier, failed to reach terms with its creditors, and started down the path to bankruptcy. The company’s primary creditor, who refused to renegotiate terms with the carrier, was the Korean Development Bank (KDB), a government agency in a country with a long history of intervening in the economy to support an export-led growth strategy.

Why would KDB suddenly allow a company that supports the activities of virtually all Korean exporters to fail in dramatic fashion? There must be more to this than meets the eye. Let’s investigate.

Background

While the news of Hanjin’s failure came as a shock to some in the business press, most industry observers saw it coming for months. Indeed, data from ImportGenius.com shows that some of the most savvy freight forwarders including Kuehne and Nagel, Expeditors, and Flexport ceased virtually all bookings with Hanjin several months ago*. But thanks to the interconnected system of global alliances between carriers, even forwarders who saw this coming have exposure.

As container shipping rates have bottomed out at historic lows, Hanjin lacked both the economies of scale and the balance sheet to compete with bigger, better-funded competitors.

With just 3% of global capacity, and charter prices locked in back at 2010 highs, the company’s cost structure didn’t allow it to price competitively against bigger rivals.

The logic of economies of scale dictates that the player(s) with the most capacity will be able to share fixed costs across more container moves, and thus have the lowest average overhead cost. Over the last 5 years the largest carriers—Maersk, MSC, and CMA CGA; as well as those with the deepest pockets, like COSCO and UASC—invested heavily in new megaships to drive another cost efficiency: operating costs per container. This has led to an arms race to achieve supremacy in global containerized shipping capacity.

Though that arms race is now fairly advanced, we still see no clear end in sight, as more and more megaships continue to be added to the fleets every quarter. The results of this arms race have borne out in the market, as for the last two years we’ve seen the companies with the largest vessels, and therefore the lowest average cost, start to drive rates down to levels their smaller competitors simply could not match sustainably.

Globally ocean carriers stand to lose as much as $10B from operations this year, and that doesn’t even count the steep declines in the book value of their ships. The intense pressure has led not just to the collapse of Hanjin, but to CMA’s firesale acquisition of Neptune Orient Lines (NOL), China Shipping’s merger into COSCO, UASC’s merger with Hapag-Lloyd, and a realignment from four global ocean carrier alliances to just three. Industry experts at BCG predicted this wave of consolidation and we suspect the mergers, acquisitions, and outright failures are not all behind us yet.

At the same time, Hanjin’s financial position was unsustainably weak: The company carried a debt to equity ratio of 850%, where many other carriers of its size remain completely debt free. And unlike rivals like China Ocean Shipping Company and United Arab Shipping Company, Hanjin is not owned outright by a deep-pocketed nation state willing to fund losses in perpetuity for economic and national security reasons. Rather, it is a private company with massive loans from KDB.

Which brings us back to the question, why would the Bank allow Hanjin to go under? Is there some larger strategy at play here for the Korean government to continue supporting its export-led strategy even as it lets Hanjin go?

Analysis

To understand this, one must look to Hanjin’s competitive position within Korea, where it competes neck and neck with arch-rival Hyundai Merchant Marine (HMM). HMM is financed by none other than the KDB. Surely a less painful solution would have been to force a merger between the two ailing companies. Instead, tens of thousands of employees and customers are left hanging out to dry.

What led KDB to prefer unwinding Hanjin in the chaotic distress of bankruptcy over an orderly merger between rivals? Actually, it’s pretty simple: an orderly merger would have been extremely costly for HMM, and the company would have struggled to enact the price increases required to restore itself to profitability. With the sudden collapse of Hanjin, rates on freight coming out of Korea have spiked more than 50% on the first day, and given HMM’s dominant market position, are likely to remain higher for the next 45 days.

If you multiply those new higher prices by the peak season volumes on all the freight coming out of Korea, where HMM now owns a dominant position, the increased revenue may just be enough to restore HMM to profitability. By mopping up all of Hanjin’s demand over the next 45-days and rolling out the 13 additional box ships announced this week, HMM should be able to increase its capacity to about 1 million TEUs almost immediately.

Given how competitive the ocean freight markets are, we suspect these higher prices won’t stick beyond the next 45 days, the amount of time it takes a container to make a transpacific voyage and back. But with prices surging as much as $400 per TEU during that time, HMM stands to generate about $400M in additional profits from the collapse of its rival just in the next 45 days. For perspective, Hanjin and HMM lost a combined $500M in the first half of 2016, so this is starting to look like a very savvy move indeed. In addition, HMM gets to acquire only the best assets from Hanjin, leaving aside any outdated infrastructure and inefficient ships they would’ve had to take on in an outright merger.

After some messiness with customers not getting cargo delivered on time over the coming weeks, the Korean government gets a rather acceptable outcome: Instead of supporting two ailing carriers with constant bailouts as they compete all the profits out of Korean trade lanes, they get a single national champion that they can support as it competes on a global basis with best of breed carriers around the world.

Or to put this more simply, rather than the Korean government and Hyundai’s owners having to finance a costly merger with Hanjin, this disorderly bankruptcy process means that shippers like you and I end up paying for the merger through higher freight prices.

It’s ugly out there, and beyond the immediacy of Hanjin’s announcement this week, we should not be surprised to see other weak ocean carriers failing or being absorbed into larger rivals in the months and years to come. Let’s hope for the sake of shippers and consumers everywhere that any forthcoming consolidation happens in a much more orderly fashion.

What does this mean for companies with products to ship?

The Hanjin failure is unprecedented. Previous bankruptcies, like that of the then second largest ocean carrier US Lines, took place when containerized shipping was a far smaller industry. US Lines had a capacity of just 90,000 twenty-foot equivalents (TEUs) compared with Hanjin’s 600,000.

And US Lines went under before the rise of the global ocean alliances, its fallout was contained only to freight moving on its own vessels. Because Hanjin was a member of the CKYHE Alliance, a vessel-sharing agreement that also includes Cosco, K Line, Evergreen, and Yang Ming, it will be far more complicated for those companies and their creditors to figure out exactly which cargo should be held, and who owes whom for what.

Untangling this complex web will not be simple. Creditors will scramble to put liens on everything they can get their hands on, and will hold up ships and other assets–including cargo–pending court rulings. Hanjin customers may be surprised to find their cargo held by creditors until they make payment for services they never ordered in the first place.

The timing for companies with products to ship could not be worse. Hanjin’s collapse will create a short-term capacity crunch and an excuse for other ocean carriers to increase rates to crisis levels just as peak shipping season gets underway in Q4. Smelling blood in the water, the carriers lost no time at all in hiking prices by as much as 50%, and many have already announced new “emergency” peak season surcharges to increase shipping prices and recoup the losses of the first half year.

And yet forwarders and large shippers would be wise to push back hard on the ocean carriers’ price increases. First, the carriers are already sitting on 1 million TEUs of idle capacity, or about 5% of global capacity. Hanjin’s 600,000 TEUs of new (but temporary) idle capacity represents a temporary 2.9% increase, but there are plenty of ships out there, and most major carriers have huge new ships being delivered over the next 12 months and beyond. Those orders were placed years ago, and will deliver whether or not the carriers want them. In addition, roughly 55% of Hanjin’s capacity was chartered, not owned, so those ships should be back on the market relatively soon.

And while Hanjin’s capacity represented about 7% of transpacific freight, most of the company’s ships operated only out of Korea and Northern China, not regions further south. For shipments originating in Southern China and other Asian countries, Hanjin mostly purchased space on the ships of other members of the CKYHE alliance. That means that shippers moving cargo out of Korea and Northern China will be heavily affected, but the capacity on other trade lanes should remain largely unaffected. With the bulk of the impact constrained to a single country’s trade, especially one whose government has never been afraid of strategic interventions in its economy, the fallout should be relatively easy to contain.

Already Hyundai Merchant Marine, Hanjin’s South Korean rival, plans to deploy idled ships to gather up Hanjin cargo. And Business Korea, an online news publication, reported that the South Korean government plans to add HMM ships on four shipping routes to the United States and nine routes to Europe. The Korean government also intends to ask CKYHE Alliance members to rearrange their ships to aid customers with exposure to Hanjin.

In the United States, at least, ocean freight is a very heavily regulated market, and we can be sure the Federal Maritime Commission (FMC) will be watching the current situation carefully to ensure no foul play by carriers. If the FMC rules that carriers are colluding to raise price artificially in the wake of the crisis, we can expect regulatory action to restore market pricing.

Yet despite all the painful reorganization, clean-ups, and possible government interventions, there is a more fundamental reason why the fallout from Hanjin’s bankruptcy should be relatively short-lived: No amount of financial restructuring will make its container ships disappear.

Summary

Hanjin’s ships will emerge from bankruptcy proceedings with new owners, and shortly thereafter they will continue to ply the seas in search of cargo. And global overcapacity is expected to increase further in the next 5 years as carriers take deliveries of new megaships already on order.

In short, regardless of what happens with individual firms, until global demand for cargo catches up with ocean shipping overcapacity, we can expect market pressures to keep ocean prices near historic lows. In the meantime, freight forwarders would be wise to sharpen their pencils and warm up their haggling skills in their negotiations with ocean carriers, especially on the South China trade where the Hanjin fallout hardly impacts capacity.

It’s going to be a rocky peak season for everyone in the industry. Stay tuned for updates as we monitor this fast-moving situation.

*Unfortunately Flexport did have a handful of customers with cargo on Hanjin ships this week. We’re working overtime to ensure we do right by them, and get their cargo released and delivered.