The cruise industry expects to carry 30 million travelers in 2018. In many ways, that has caused a sort of arms race between the biggest cruise operators, wherein they need to keep building bigger and more impressive boats. So far, that has worked, but it's possible that eventually the industry will create too much capacity, which could hurt pricing power for Carnival (NYSE:CCL) and Royal Caribbean (NYSE:RCL), the two biggest players in the space.

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This video was recorded on July 23, 2019.

Shannon Jones: I know you and I have been talking about the cruise line industry for a long time now. We've been talking about doing a show. Dan, you're an avid cruiser. I'm a cruise convert thanks to the Disney Cruise Line. But we've been talking so much about it. We really wanted to come talk about the big cruise operators, talk about what's going on in the industry, how they make money. And so finally we are here, Dan. You came back from a cruise. I could probably say that to you about any week and it would be true.

Dan Kline: [laughs] I had never done a cruise until about a year ago, December, I begrudgingly went on a family cruise. And it was fun. It was on a lower-end ship. But I sort of liked the experience. So my son and I did it again. And then I tried a different cruise line and realized, there's some more -- and when I say adult, I don't mean adult in the R-rated sense. I mean, more music, more grown up related things. And now, I've found that not only is it something I enjoy doing, but when you live in South Florida and you gamble, it's also something you can do at a lower cost than people who don't live here. So it's sort of like my relationship with theme parks. Maybe I wouldn't spend all the money to do them, but because I live here and it's accessible and inexpensive, I've taken like six or seven cruises in the last six months.

Jones: That is amazing! One day, I can get to your level, Dan. But while we wait, just to give our listeners some perspective, I came across a few stats to frame the scope and the size of the global cruise industry. The cruise industry is indeed the fastest-growing category in the leisure travel market, estimated at about $45.6 billion in 2018. That's huge. Also in 2018, the cruise line industry welcomed over 26 million travelers. That's mind boggling to me, Dan, and that's up 3% from 2017. This year, that number is actually expected to hit 30 million. The industry itself is pouring goo-gobs of money into these ships, building out new fleets, building out new terminals. Estimated about $65 billion will be invested into building all of that out between now and 2029.

On the one hand, Dan, I look at stats like this, and I think this is an industry, fastest growing within the travel segment itself. But yet, there's still some questions and challenges and even some opportunities that the major cruise operators still need to figure out. What are those key questions?

Kline: There's major questions. When we talk the cruise industry, for shorthand, we're largely talking about Carnival and the associated brands it owns, and Royal Caribbean. Those are the two big players globally. There are many others. They own a lot of sub-brands. But that's the shorthand for the biggest part of the industry.

What's scary about it is capacity. If you look at a market like Las Vegas, during a big trade show, say the Consumer Electronics Show, hotel rooms go for $400 a night, it's hard to book, you have to plan six months in advance. But a lot of the year, there's an awful lot of capacity. But there are fixed events, you have to go during those times. The cruise industry sort of works the same way. There are fixed events like school vacations where prices go up. But in general, its prices are set by demand and capacity. So when you're adding five or six major ships to the two big cruise lines each year, you run the risk of, what if you build too many? That's not a huge problem when you enter a new market. If they go to China, and, say, Royal Caribbean or Carnival has a joint venture in China, and it doesn't work, well, they can mothball that very expensive ship or move it someplace else. But if you're adding capacity out of Miami, Fort Lauderdale, Galveston, Texas, some of them major cruise markets, and all of a sudden there isn't enough demand, then you're going to lower prices across the entire industry. It's a very tricky pricing game.

What happens with a cruise ship is, they are trying to fill it to capacity. Capacity doesn't mean every room is filled. It doesn't mean every berth is taken. It means that based on the amount of rooms they have, there's two people in each one. You might have an inside room that has a family of four that's full, and then you might have a balcony that never sells that's empty, but that ship could still be at capacity. When you start seeing openings, that's where things get a little tricky. That's why I've been cruising so much -- because they canceled Cuba, the U.S. government made it illegal to stop in Cuba, a lot of people got the right to cancel their cruise or get half price or book another one. So, what the cruise line does, the first thing when they have capacity that they know they're not going to be able to fill quickly, is they go to loyal customers. They go to gamblers, they go to people who live within the market, and they say, "Hey, would you like to go at a reduced price?" And when not enough people take them up on that, they say, "Would you like to go free?" And so far, that has not only kept all the ships at capacity, it's also kept revenues growing, because yes, if I get a free cruise, I am not paying for the ticket, which is 50% to 75% of overall revenue. But what I am paying for is, maybe I eat at a specialty restaurant, maybe I gamble and lose some money, maybe I buy a T-shirt or a watch, or who knows what. I've never bought a T-shirt or watch.

So, it's a very complicated picture that's kind of a house of cards in some ways.

Jones: So, capacity and demand, that is certainly something to watch over the long term. You mentioned Cuba. All the major cruise lines had some exposure to Cuba. I think all in all, because of the U.S. sanctions that were tightened in reference to communist Cuba, about 800,000 bookings were affected as a result of that ban that came in June. For something like this, I feel like this is more of a short-term headwind, because a lot of these cruise operators have either been able to cancel or reroute the ships to other places. Norwegian probably had the biggest exposure, about 3% of their annual capacity was set for Cuba. But I feel like something like Cuba, in reference to capacity and demand, that seems more short-term in nature.

Kline: It is short-term, but if you figure that most people are planning on a cruise about a year out, it has a ripple effect. What happened was, once it became no longer legal to go to Cuba, Royal Carnival and Norwegian had boats that they had specifically either purchased or retrofitted, and in some cases purchased back, to go to Cuba, which is a smaller port. So, instead of the 5,000-passenger mega ships, think maybe like 1,800 or 2,000 passengers -- smaller ships. So, they send you an email that says, "Hey, we can't go to Cuba. By the way, all of the places you might like to go are booked up and planned out. We can't go to our private islands. So now, we're stopping in Key West and Nassau," because Nassau has an endless capacity for cruise ships, it seems. There's always six or seven docked.

So, passengers in most cases were either able to take a discount, usually half off, or book any other cruise they wanted with a credit for what they paid. And a lot of those -- in the short term, six months to nine months -- they weren't able to rebook interesting itineraries. I don't mean to dis Nassau, but it's kind of the most pedestrian of cruise line stops. Even the private islands only have so much capacity. Royal Caribbean just redid theirs, so while they could land two ships there, they generally haven't been doing that. So, it did create some heartache in passengers. And I was on a ship that was supposed to go to Cuba. And people were fairly humdrum about it, because they were on a ship that maybe didn't have all the top amenities, and it wasn't going to the place that they wanted to go. But, yes, a year from now, they're going to have figured that out.

It is a negative. You're a millennial, or at least closer to a millennial than I am. Cuba was a travel exotic travel destination, whereas a lot of the cruise stops in the Caribbean and Mexico are more just cruise ports. So it was kind of a hook to bring a new generation in. And I do wonder if that's going to have a long-term effect of maybe 2% that would have tried cruising and liked it, maybe they won't, and that's going to create some marketing issues for the cruise lines.

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