Panama Canal Expansion: A Case of Bad Timing

“Panama exists for and because of the canal,” or so said former Panamanian President Belisario Porras (1856-1942) in describing the country’s main comparative advantage. When the Panama Canal opened in 1914 after a cost of $14 billion (in today’s dollars), the Atlantic and Pacific Oceans were finally linked through the Isthmus of Panama, saving shippers the circuitous and frequently treacherous trip around South America’s Cape Horn. Although the Panama Canal was quickly recognized as one of the great engineering marvels of the 20th century, even its builders would be impressed at how crucial the canal has become. Today, roughly 5 percent of all global seaborne trade passes through the canal, and the port is virtually at capacity with the number of ships traversing its passageway each year having increased from about 1,000 in 1914 to 14,000 in 2015. 

As Panama prepares for the opening of the third set of locks on the canal on June 26, the country today, with its booming service sector, is much more than the canal. What’s more, the planned canal expansion is likely to prove less of a watershed event for global seaborne trade in the short-term, as plummeting ocean freight rates may take the bubbles out of the celebratory champagne. Nevertheless, US East Coast and East Asian shippers could still reap long-term benefits as both trans-ocean shipping costs and the landed cost of agricultural exports fall. 

Bridging two oceans

Connecting the Atlantic and Pacific Oceans at the Isthmus of Panama tantalized Western societies for hundreds of years. In 1534, the Holy Roman Emperor Charles the V commissioned an exploration of Panama’s Chagres River to see if passage to the Pacific Ocean was possible. While Charles’s surveyors deemed it impossible, the idea of finding or creating a connection persisted. Western nations clearly understood the transformational impact that such a route would have on regional trade and, concomitantly, the geopolitical influence to be gained by those who controlled access to the isthmus. Nevertheless, the dream languished in engineers’ minds for centuries until personal ambition, political will, and technological advancement converged to make progress possible. 

Spurred on by his success with the construction of the Suez Canal, Ferdinand de Lesseps, backed by the French government, took up the seemingly impossible project of constructing a Panama canal in 1879. Fourteen years and $287 million (in 1893 dollars, or $6.8 billion in 2007 dollars) later, the French abandoned the project after realizing the impossibility of creating a sea level canal. In the wake of this national embarrassment, the French charged Ferdinand Lessep and Gustave Eiffel with fraud and turned the project over to the United States for $40 million. 

From the onset, the United States encountered monolithic challenges that began with the country’s support of the Panamanian movement to separate from Colombia. Without a successful separation, the United States could not secure the unrestricted rights to the canal zone needed for the project to begin. But political force alone could not build the canal. The project required raw manpower to cut through the jungle and Culebra Mountain Range, and more than 27,000 workers died during both the French and American construction periods. It also took engineering prowess to design the three stages of locks that would lift ships 85 feet above sea level as they crossed the 48-mile passage from the Atlantic Ocean to the man-made Gatun Lake on the Pacific side. By 1914, after 10 years of American construction, the canal was complete. 

Demand finally catches up to the canal’s inherent limitations

Though undoubtedly impressive, the lock system would eventually fall short of the logistical needs of a rapidly growing trading and military power. In the late 1930s, concerns were raised over the potential sabotage of the locks and the need to move larger warships through the canal. The US War Department decided that the building of a third lock system would aid in mitigating this threat and allow the new 58,000-ton Montana-class battleships to operate in either the Atlantic or the Pacific Ocean. Given Congressional approval in 1939, the project was later cancelled when the United States scrapped the Montana Class ships and began to focus its attention on mounting a land invasion in France. Any later additions were stymied when relations between Panama and the United States turned contentious after World War II. 

Interest in expanding the Panama Canal’s capacity did not pick up steam again until the later part of the 20th century when US trade with East Asia started to boom, resulting in transportation congestion through the canal. Spurring competition, US West Coast ports expanded their capacities to allow for mega-size container ships. After China was granted entry to the World Trade Organization (WTO), it didn’t take long for annual cargo volumes to close in on the canal’s maximum throughput capacity—first in 2007 and then in 2011. In the case of some products, shipping companies have increasingly decided to forego the bottleneck at the Panama Canal instead opting for other transit routes that better capture economies of scale or time efficiencies . In fact, it is estimated that the canal has lost 10 percent of its incremental global trade flow in the past years, owing in large part to its inability to handle larger ships. 

The Army Corps of Engineers has predicted that this trend will only continue, with close to two-thirds of the world’s containerships too big to use the current lock system by 2030. Panama, along with its canal, must change to stay relevant in global shipping. In 2006, the Panamanian government held a national referendum with 77.8 percent of Panamanians voting in favor of expanding the canal system. Although at this point the Panama Canal only directly contributes 10 percent to the country’s gross domestic product (GDP), the fact remains that Panama’s future economic success as a global financial and trading hub is inextricably linked to the continued relevance of the canal. 

Forecasters navigate treacherous waters in Panama 

Understanding the Panama Canal’s long-term geopolitical and trade significance has always been an easier task than pegging the long-term outlook for shipping volumes through the isthmus. The US Army Corps of Engineers, for example, would likely have never expected in 1934 that total shipping tonnage through the canal in 2009 would exceed its forecast for maximum shipping volumes by almost a factor of four. When the Panama Canal Authority (ACP) officially opens the third set of locks for business, the canal’s handling capacity will double to 600 Panama Canal Universal Measurement System (PCUMS) tons per year, assuming that post-panamax vessels are predominantly utilized. Nevertheless, it’s as true in 2016 as it was in 1934 that those who are attempting to forecast the success of the Panama Canal are navigating murky waters. 

However, that hasn’t stopped some analysts from estimating that 20 to 25 percent of West Coast imports could end up being captured by East Coast ports via the canal in coming years. What’s more, the ACP estimated in 2006 that the expanded canal could offer a 23 percent cost savings over the Suez Canal for products moving from East Asia to East Coast ports. 

These forecasts aren’t wrong, per se, but the landscape is so unpredictable that it’s hard to hold any stock in a medium-term outlook. On the one hand, it is possible that the canal could lower unit shipping costs by accommodating post-panamax ships to East Coast ports. These larger ships have the economic advantage of double the carrying capacity. Additionally, ocean freight trade bypasses labor and port congestion expenses that are incurred by products that are shipped by intermodal rail from the West Coast. But on the other hand, any number of these variables—post-panamax ship utilization, West Coast port conditions, East Coast port preparedness for larger ships—could change and skew the entire forecast. And indeed, this is largely what has happened. 

One twist that the ACP and industry forecasters weren’t expecting when the canal expansion was approved in 2006 was a precipitous drop in shipping rates. The China Containerized Freight Index, a measure of shipping prices based on spot and long-term freight rates of Chinese exports, has hit record lows, dropping from about 1100 in January 2014 to about 350 today—a 70 percent decrease. Overinvestment by shipping companies and China’s economic slowdown is mostly responsible for this nose dive. Basically, with ocean freight rates so low, cutting shipping costs from East Asia to the East Coast by using the shorter Panama Canal route is of less value than initially expected.

Other considerations—such as inland freight costs, canal tolls, transloading-drayage fees, and port congestion levels—will become the more significant limiting factors that determine how products are ultimately moved globally.

Gro Intelligence spoke with Kevin Kaufman, Managing Director of TTMS, a consultancy specializing in trade and transportation, and former group vice president of Agricultural Products at BNSF, who framed it this way: “Today, I do not think that the opening of the Panama Canal expansion is a game changer simply because there is so much surplus ocean freight and other surplus infrastructure capacity making ocean freight rates historically cheap.” Kaufman added that some East Coast ports have lagged in upgrading infrastructure to take advantage of additional canal capacity. 

But the long-term trend, according to Kaufman, still favors the Panama Canal. “[O]ver time, I am confident that the Panama Canal expansion will change the landscape as East Coast shippers benefit from the increased optionality in shipping options,” he said.

Low ocean freight costs will likely not last forever, and so the canal’s logistical importance should not be cast overboard too quickly. If costs rise and become a primary concern, the economies of scale promised from the expansion could enable the Panama Canal to capture a larger portion of the tonnage being shipped over longer routes, such as those through the Suez Canal. 

The canal’s expansion will solidify its time saving advantage by eliminating congestion that at times has made the longer trip through the Suez Canal faster. However, when it comes to particularly time-sensitive shipments, the Panama Canal isn’t likely to capture a meaningful share from East Asia. Instead shippers will continue to use faster routes through West Coast ports.

Unlocking bottlenecks for grain and oilseed exports from the Americas

It’s important to keep in mind the expansion’s effects on cargo going the other direction, too, particularly US agricultural products. With the United States exporting more than $10 billion worth of soybeans to China a year, more than half of which goes through the Panama Canal (about 16 million out of 25 million tonnes), US exporters could benefit from the canal’s expansion in the long term given the potential for improved landed costs, especially during times of peak demand. In fact, the United Soybean Board projected, albeit in 2014, prior to the last leg down in ocean shipping rates, that after taking into account charter fees, ports fees, fuel, and canal fees, $650,000 ($7.59 per tonne, or over 10 percent ) could be saved on each shipment of soybeans when using post-panamax vessels. The implications are similar for cereals, such as corn, wheat, and barley; more than 7 million tonnes of cereals are exported from the United States to China each year.

The canal could also make Brazilian grain and oilseed exports more competitive, though it is still unclear whether Brazil will have an edge over the United States. Currency fluctuations, changes in port and canal fees, and ongoing logistical improvements in Brazil will all affect export competition between the two countries. In 2015, according to Forbs Export Services, it cost $0.80 to transport a bushel of soybeans from Iowa to a southern port, while in Brazil it cost $2.40 to transport from Mato Grosso to a port. Nevertheless, land prices in Brazil are often lower than in the US Midwest, which can decrease production costs and offset Brazil’s higher inland shipping costs. Furthermore, the US’s inland cost advantage may not last forever. Brazil is steadily improving its road and inland port systems, including adding new transloading capacity and blue ocean ports in Northern Brazil in anticipation of the Panama Canal expansion. 

Brazil’s location is also advantageous for utilizing the route around Cape Horn. The country’s ports therefore have the ability to capture greater economies of scale by transporting goods on large capesize vessels, which offer double the carrying capacity of panamax ships. The International Grains Program Institute at Kansas State University found that ocean freight rates for grain cargoes from South America to Asia are often less expensive than from the US Gulf Coast because of a larger variety of dry-bulk vessel route patterns, lower port charges, and higher Panama Canal tolls. Additionally, a 2014 study by O’Neil Commodity Consulting found that ocean freight spreads favored Brazilian soybeans by roughly 30 cents per bushel. All of this means Brazil can likely maintain its own unique trade advantages while also leveraging the canal’s expansion to its benefit when trade through the canal proves most economical.

While other nations are addressing their internal transportation problems to prepare for the expansion, Colombia could solve its internal deficiencies via the canal. Colombia has coastal access to both the Pacific and Atlantic Oceans, but the Andes isolate the Pacific coast. With the expansion, not only will Colombian exports of coffee have better access to East Asia, Chile, and California, Colombia’s isolated Pacific coast will be able to trade more with the Atlantic coast and mountain cities, which are more developed. 

Last, the Panama Canal expansion may not only offer China and other Northeast Asian countries a lower landed cost for agriculture commodities, but it could also provide a defense against growing manufacturing centers in Southeast Asia that are benefiting from the Suez Canal’s cost advantage. 

Increased refrigerated shipping capacity

The expansion of the canal could also act as a pivotal moment for the refrigerated cargo (reefer) industry, as it spells the gradual but inevitable end for traditional hull refrigerated ships in preference for the versatility of shipping perishables via refrigerated containers on larger container ships. In 2014, the conventional reefer ships transported 26 percent of perishable items, down from 60 percent in 2000. However, that value is expected to drop further to 20 percent by 2018. With the canal’s expansion, the use of refrigerated containers will only become cheaper as more containers can be transported in fewer trips. 

This change in shipment mode will undoubtedly have implications for perishable products exported from the Americas. With the majority of reefer products going to Northern Europe, Ecuador, which exports 51 percent of reefer products on the West coast of South America, is one of the South American countries that stands to benefit greatly from the expansion. However, this positive impact will only kick in three years from now when Ecuador completes its first deep water port capable of accommodating post-panamax ships. 

Lower-cost transportation could also potentially whittle away at Mexico’s advantage (Mexico has coastal access to both the Atlantic and the Pacific) in exporting agricultural products over emerging Pacific fruit and vegetable producers like Peru. Last, increased throughput of refrigerated container capacity should only compound the advantages of one of the world’s largest exporters of pork, the United States, allowing American exporters to sell their product to high-demand countries in East Asia at more competitive levels during periods of high ocean freight rates. 

A slow start doesn’t necessarily portend a poor finish 

After the the Panama Canal was completed in 1914, canal traffic expanded by an average of 15 percent a year between 1915 and 1930. Although it is difficult to predict where ocean freight rates will be in a few years, it seems unlikely that the canal will experience similar blistering growth after the third set of locks open. For now, the Panama Canal Authority has initially estimated that the volume of cargo transiting the canal will grow by an average of 3 percent per year, almost doubling 2005 tonnage levels by 2025. 

Still, one should never be too certain. The specter of China’s inland New Silk Road; the ongoing shift in manufacturing from East to South Asia; improved intermodal service from Port Rupert, British Columbia, to Chicago; and a rumored Nicaraguan canal could undermine the Panama Canal’s commercial potential in the distant future.

In the near-term, the Suez Canal will continue to compete for East Coast port volumes, and West Coast ports will still be positioned to benefit from even greater economies of scale by handling mega containerships with carrying capacity 30 to 40 percent greater than that of post-panamax vessels. Finally, US rail operators BNSF and Union Pacific are unlikely to give up their current intermodal rail share of Asian imports without a fair fight. In fact, Piers-IHS trade data in March showed that the West Coast’s share of US imports has recovered to its recent historical range of 51 to 53 percent after plunging to as low as 46 percent in the same period last year following a prolonged labor dispute. 

Last, not all East Coast ports will be able to handle post-panamax ships this summer. Miami, Norfolk, and Baltimore are the only East Coast ports that can handle the larger ships. Others including New York/New Jersey, Savannah, Charleston and Jacksonville would have to dredge to accommodate post-panamax vessels. 

Nevertheless, ocean freight rates will not stay in the cellar forever, and East Coast ports will eventually get dredged for larger ships. The benefits of the Panama Canal expansion will likely be realized more gradually in comparison to the initial hype. But the inherent value of increased throughput and optionality that the expansion offers to farmers in the Americas, East Coast shippers, and North East Asian manufacturers will be felt for years to come.