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For the past few years I·ve co-hosted an interesting dinner, where I ask each guest to speak for less
than 2 minutes on a way they think the world will change in the next 5 years ² that is not obvious.

In December I hosted 70 leaders in a wide variety of disciplines ² from horticulture to economics.

The guest list included; 2 Governors, 7 CEO·s of companies of more than $2 billion in revenue,
Chief Investment Officers of more than $38 Billion, 11 venture capitalists, etc«.so you get the idea.

The 70 ideas were then voted on by each table, and below is a finalist ² on ways the world will change
that are not obvious. Please share your ideas on other non-obvious predictions and your thoughts
about this one.

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My idea has to do with inflation, which many people are expecting, but specifically the effect of
inflation on the U.S. supply chain, which will be very disruptive.

The U.S. supply chain is $1.8 trillion annually. For sake of comparison, the U.S. healthcare
industry, changes to which have led to much ink being spilled, is $2.4 trillion. So this is massive, 13% of
GDP. The trend over the last 20 years has been to embrace ´just in timeµ inventory management.
But JIT has an unexpressed premise: namely, deflation. In addition to its effects on cash flow,
there·s a collateral benefit to pushing production out to be as close to the point of sale, when the
costs of that later production are lower than today·s production because of deflation in labor and
materials.

So my question is: what happens to that whole model, premised on deflation, and to the supply chain
in general if we experience massive inflation?

The sharp spike in inflation many are predicting will erode that specific benefit of JIT. There are
multiple sources of inflation: raw materials costs, fuel expenses, regulatory compliance costs and
devaluation of currency through fiscal and monetary missteps. The greater number of these which hit,
the worse the picture will be. Raw materials and fuel have been in a 20-year deflationary cycle and
always rise significantly in periods of monetary inflation. The costs of operating trucks will go up
rapidly even if fuel prices are stable, because of environmental compliance reasons. History shows no
periods of rapid increases in money supply which are not followed by increases in inflation.

This will most likely play out in the area of transporting goods. Today, the cost to ship goods in
anywhere from 5x-7x the cost to store them. As reluctant as companies are to hold any inventory,
they will do so as an inexpensive hedge against a massively higher cost to transport. They will not
greatly expand inventory but decentralize it by operating multiple regional and smaller footprint
distribution centers in proximity to their major markets.

There are two sentinels of this change: One is Buffett·s purchase of Burlington Northern, which
validates the idea of greater use of the rails. The interesting thing about this purchase was that he is
known as a deep value investor, yet he paid a 30% premium to market. More interestingly, coal
represents 40% of rail freight business, but it seems likely that it is not a fuel of the future. So
stepping down coal revenues to Burlington over time only increases the size of Buffett·s premium.
The other sentinel is JB Hunt·s initiative to move from being a long haul carrier to extreme short
haul, or being the carrier of the final mile, which may mean they see operating costs of trucking spiking.

I predict that the drastic rise in shipping costs will lead to many smaller regional DCs with some uptick
in inventory levels, an increase in market share of the rails, a meaningful reduction in the long haul
trucking business, and that all of these can happen due to increased operating expenses and inflation
even without a rise in the materials costs.

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What will this mean for Open Innovation or Venture Capital? Watch for transportation related
technologies. Have a better way to track containers? Have a better way to increase transportation
uptime? Have a better routing optimization approach? This could be your time.


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The markets are bracing for an expected arrival of higher long-term inflation and a weaker dollar,
followed by the surprised rate cut of 75 basis points last Tuesday and again 50 basis points
yesterday by the FED. US congress has approved a U.S.D146 billion stimulus package.
Shipping is by and large a USD denominated business.

Today·s market comment considers the impact of these monetary and fiscal policies on the most
obvious aspect of the shipping industry, namely ship management and shipbuilding.

Ship management

Inflation and a weaker dollar have negative impact on costs for all shipping companies but some
companies will face special challengers - those adapted the business model of producing steady yields
for their investors by investing in assets against long-term time charter commitments.

We know that management cost is generally assumed to be growing at 4% to 5% per annum but under
the current very inflationary environment one really needs to scrutinize the traditional assumptions for
each and every cost item making up the budget of a typical ship manager to see if they are realistic:

- Crewing costs ² this is the biggest item in the ship management costs. A leading ship managers
confirmed to us that this cost has been increasing for over 10% for the past 3 years and it is expected
to get worse when large number of new buildings are going to be delivered (we hear of former Master
for LPG vessels getting lured out of retirement with a $20,000 per month salary); - P+I premium for
2008/2009 is set to increase by about 16%; - Repair/dry docking ² just by way of example - typical
provisions are 5/7 days a year or half a million for the 1st dry dock for a medium size container vessel.
But availability of dry dock is a function of cost ² in order to keep the cost budget managers
probably have to divert the ships further afield as repair/dry dock capacity gets tighter and tighter
for the next 3/4 years as repair yards are increasingly being converted to shipbuilding yards and the
remaining repair yards choose conversion over repair. So either the cost will likely to exceed budget
or off hire time will exceed their traditional allowance; - Luboil ² it is leveling off a bit but ² even
though we generally avoid being the ´amateur economistµ offering views on macroeconomic issues but
we just can·t see how oil price will realistically fall. Inflation is simply a matter of the printing press -
when there is more paper money for any given amount of commodities, Market Comment

Prices tend to go up.

The monetary and fiscal measures taken or will be taken so far are no doubt inflationary. Oil is a
´special commodityµ which faces real supply side constraints (this is touched upon in our previous
market comment ´One-Eyed Analysisµ dated 18th December 2007) ² so in our view luboil will
constitute a bigger and bigger item.

The combined effect of these will be that all ship owners in general will face higher technical
management costs, but some of the ´shipping solution providersµ who have locked in long-term t/c
employment for their asset will be especially hard hit. Some public companies even have made cost
commitments to the investing public ² but we can·t see how they can realistically keep them, by quite a
long way. Those who are offering bareboat charters are of course not exposed this way.

Shipbuilding

Cost inflation is obviously negative in general but in our view it is especially negative for shipbuilders
in China. Cost for steel/marine equipment/wages are increasing all across the board, which of
course eats into margins but Chinese yards will be hit harder than most. By comparison, the Yen is a
currency of a mature economy whilst there is a higher scope of strengthening for the Korea won;
Korea is still much higher up the economic ladder than China. As we have pointed out elsewhere, if
the trajectory of the Japanese Yen against US Dollar is any guide, the Chinese Reminbi is just at
the starting stage of long-term appreciation. Japanese builders anyway have little dollar exposure as
many of their contracts are denominated in Yen. The US dollar is widely expected to rebound
against the Euro in the medium term, but we don·t think it helps much. The Chinese Reminbi has
actually lost ground against

Euro (it was gaining against US Dollar but not as far as the greenback is losing against Euro). If
US dollar rebounds against Euro, the Reminbi will actually start to appreciate against the Euro
too, which is bad for many yards in China (Chinese yards typically import much more from Europe
than their Korean/Japanese counterparts).

There is another little-noticed side of the shipbuilding cost story. According to many estimates, labor
cost as a percentage of total cost is in fact higher for Chinese builders than for their
Korean/Japanese counterpart, even though Japanese/Korean workers command 10/8 times
higher pay respectively, on a per capita basis.
The reasons are that Japanese/Korean builders started much earlier and have fought the battle
against their currency appreciation for 15/20 years and they emerged victorious - most are super
efficient. On the contrary, barring some pockets of excellence, Worldyards thinks that overall labour
productivity for Chinese builders has actually gone backwards because there are so many start-ups
there without a solid strategy.

Productivity stems from optimal shipbuilding processes and procedures that take years to develop,
and it is fostered by focused marketing strategies based on longseries of repeats of proven designs
which are not practiced by most of the Chinese builders. Both private as well as the state-owned
start-ups have no focus, they are instead chasing immediate good margin opportunities. Many are
engaged in repair, conversion, offshore and different kinds of merchant ships all at the same time. The
established nationally-owned yards in China are productive but they are also affected Market as
they have lost lots of middle/senior management staff to the private sector.

Some months ago when the stock market was singing praise for the ´shipbuilding super cycleµ many
financial analyst thought (and some still do) that Chinese builders have higher profit margin than
Korean/Japanese yards ² we already pointed out then this is complete myth when one considers
that man-hour in a typical Japan yard for a VLCC is 500,000 whilst Chinese yards need 3,000,000
man-hours for the same ship.

Chinese yards will have to fight currency appreciation for many years to come at the same time as
they make efforts to increase their labor productivity; during this maturing process some truly world-
class yards will no doubt emerge. ***

In sum, we think that the recent monetary and fiscal policies in the US will result in more pronounced
inflationary tendencies (which were already there before these policies) and they are and will impact
negatively on ship management costs and shipbuilding, Chinese yards especially. Let us hope that
the income/demand side will do so well as to cancel out these developments. The positive thing is that
higher inflation/cost generate provides higher support levels for asset prices going

forward«