Deciphering the Rising Baltic Dry Index

The past two months has seen a rise in most of the asset classes. One index that has outperformed all other indices is the Baltic Dry Index, the index that is considered to be a barometer of the world's shipping freight charges. Over the past two months the index has nearly doubled from about 2163 to about 4668. This has led to renewed optimism that the global economy is on the path to a recovery. This is because, shipping (along with other transportation indices) were some of the few advance indicators that signalled the present recession.

The Baltic Dry Index is an index that is computed from the average of twenty two bulk cargoes on a futures basis including iron ore, coal, cement, steel and food grains. It is quoted every working day at 1300 GMT. The index does not include wet goods such as crude oil. The index is a daily average of shipping freight rates. The important feature of the index (and its relevance) may be due to the fact that it is not a tradable contract and is exclusively the preserve of actual users of shipping services. It does not directly include short-term speculative inflows (or ‘hot money’) directly. There are however, derivative products (futures) introduced by other exchanges (the International Maritime Exchange, MAREX) that trade on Baltic Dry Index. There are a number of other ways to trade shipping freight including exchange traded funds like Claymore/Delta Shipping Index exchange traded fund. This exchange traded fund (ETF) trades under the symbol SEA. The ETF does not replicate the BDI and instead invests in shipping companies.

Bubbleomania’s Note of Caution: Be more circumspect on the BDI

The fact that the index was one of the earliest indicators that warned of an impending crisis, has led the investing public to become enamoured with the movement of the index over the past couple of months. While in the past it rare to come across a price quote of the index, it has now become common for the financial media to give this index great prominence, probably a contrarian indicator that should warn investors that it is time to move on to another indicator. Investors as well as observers may be well advised to be more watchful that giving primacy to the index. Circumspection may be in order because it is imperative for investors to keep in mind the fundamental of economics – Demand and Supply – before overemphasising the importance to any one indicator. The global economy is far too complex, sophisticated and dynamic for investors to depend solely on only one indicator. To place the BDI in perspective, it rose from about 5600 in early 2008 to a record of 11,793 in mid-2008 and in the aftermath of the Lehman Brothers’ bankruptcy it collapsed to a low of 666 in December 2008-in about six months.

Baltic Dry Index

                   

If we were to over emphasise the indicator with all the irrationality of a financial herd, then we would have to believe that the world trade would double (as the index more than doubled in 2008) and then expect the world trade to collapse by 98 percent by the end of 2008. WTO indicated that world trade would decline by about ten percent. In May 2009, the New York Times quoted a report that indicated that nearly 735 ships were anchored in ports, due to lack uneconomical freight charges. This seems to have turned around as the present rates would make freight profitable on all routes for the companies. This is not to claim that the BDI as an indicator is redundant.

Questions Galore, Answers limited:

Among the many questions that investors and observers would now have to grapple would be:

-What is the likely consequence of the near doubling of the BDI?

-Does it merely reflect the bubbles that are likely to be being built in the other asset classes of the nearly 150% increase in the monetary base in the US economy?

-Is it the harbinger of a new era of economic prosperity that all of us so desperately yearn for after more than a year of financial turmoil that has not been witnessed since the end of the Second World War?

-Does it indicate that the commodity bull market has just been renewed with great vigour?

-What would be the impact of the rising cost of shipping on the weak recovery?

The simplest answer would: Nobody knows accurately. But nevertheless we hope to provide some valuable insights, which hopefully should enable investors to come to their own informed opinion.

Why is the BDI rising?

The simple answer would be that there is a large, rising demand for commodities in the emerging markets, especially China. Undoubtedly, there is some truth in that assertion, though it would be difficult to quantify the exact quantum of that impact on movement of the index on the movement of the index. There are a number of important factors that have to be kept in mind. The crisis of 2008 has dramatically altered the landscape of the shipping industry (as with most of the other industries).

It should be kept in mind that the recent boom led to an exponential large increase in world trade, due to globalisation, which necessitated the need for more number of ships. This shipbuilding activity increased with the boom, and ship orders increased, especially in 2007. Considering the fact that it takes nearly two years for ordered ships to be delivered, these will increase in 2009 and 2010. It has been pointed out that capacity addition to the present fleet will be to the tune of about 60 percent of existing fleet capacity.

A critical element in the future of shipping would be the state of the economy as a natural corollary, the demand for goods. This unfortunately is likely to be the Achilles heel for the shipping industry. Recent statements by some of the shipping companies is instructive of what we can expect from the sector. A.P Moeller-Maersk, the owner of the largest container shipping line has announced that volumes are likely to grow by 3 percent to 8 percent in 2010. That would indicate that the world economy is unlikely to grow at a pace that the optimists think as it essentially means that the growth is likely to come after a 10 percent drop in container traffic in 2009. The third largest container shipping company CMA is reported to have stated that the while the Europe-Asia route has seen some recovery, the US-Asia route is yet to see demand pick up. Some analysts have pointed out that the proportion of the container fleet that was idel was likely to rise to 15 percent or een 20 percent over the next year.

What is causing the BDI to rise?

The quick answer would be imports by China of Iron Ore, Coal and oil. The Chinese continue to increase their import of most of the commodities, including copper, lead, iron ore, coal as well as oil. This demand is likely to increase as China has announced that it would like to establish a coal reserve that would store at least about 10 percent of the annual consumption in the reserve. The recent rising food prices has only increased the demand.

It is pertinent to note that companies tend to start building stocks for the forthcoming Christmas shopping season, we are likely to see this happening. The fact that business inventories are at their lowest levels in recent years only seems to be aiding the movement of goods.

Two important developments seem to be causing the BDI to rise. The first is the consequence of the financial crisis, where shipping companies were forced to close due to the non-availability of credit. This is to be seen in the context of the fact that shipping a capital intensive business. It has been pointed out that the collapse in the credit markets led to an estimated US$350 billion of orders for new ships unfinanced. To this may be added the cost consequnces of partly funded orders/loans which were cancelled as the banks continue to pull back. This is not likely to improve over the next year.

A second important factor that is positive for the shipping sector and a predominant factor that is supportive of the shipping prices are ironically the activities of speculators in the oil market.

Another important cause for the rise in the Baltic Dry Index seem to be the rise in short positions in the futures segment of the BDI futures. The October 2009 futures indicate that there seem indicte that the rally may have more to do with futures market issue (again a consequence of financialisation) rather than those based on demand and supply of actual goods.

Source: IMAREX

The following chart provides a snapshot of the rising trading in the futures and derivatives segments of the BDI futures.

Source: IMAREX

The charts below provide an overview of the problem of rising inventories in China. This should be a cause for concern as the recent boom in the commodity sector as well as rise in the Baltic Dry Index was largely to import of commodities by China. The Chart below indicate the problem of rising inventories in Shanghai (Copper Inventories)

Source: Bloomberg

Zinc inventories in China too are at their highest level since 2007.

                            

Source: Bloomberg.

A counter weight to the above problem would be that the BDI may find support from the import of Coal and food grains. The world will continue to remain short of food grains and since countries like Philippines and India have announced large import of food grains, this likely to remain supportive of prices in mid 2010, if not a bullish factor.

Interestingly, the number of ships that are waiting for coal load has not increased as one may have expected, considering the Euphoria that we have seen. It has remained more or less constant within the range that we had seen in between 2008-09 as can be discerned from the chart of New Castle Mining port authorities:

Source: Bloomberg

Reasons to be Cautious:
-Shipping freight derivatives for 2010 and beyond imply lower freight rates.
-New ship deliveries are estimated to approach 34 million DWT of capacity in 2009, there is a possibility of another 26 million DWT being added to the capacity, though shipping companies can delay the deliveries.
-What is more worrisome is the fact that we have been witnessing a continuous rise in inventories of various base metals, including copper and lead, among others. If demand were not to return in 2010 due to a faltering global economy, it is likely to lead to yet another round of collapse in the shipping sector as the sector is likely to be hit by increasing capacity which will be aggravated to high commodity inventories.
-According to Paris-based AXS-Alphaliner, 10.7 per cent of the world’s container ship capacity is now laid up out of use, with most of the idle ships belonging to independent owners

Hence, investors may be well advised not to over-emphasise the importance of the Baltic Dry index, while at the same time, we should not be hasty to dismiss the index as redundant.