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I've written several articles about DryShips Inc (DRYS) and why I feel like they have bottomed out. In order to fully understand the dry bulk shipping industry, I feel it's important to understand the supply and demand factors that pull on the daily rates. While I focus specifically on DRYS, I feel bullish on Navios Maritime Holdings (NM) and Genco Shipping and Trading (GNK), as well as the sector as a whole.

The Baltic Dry Index is a composite benchmark for daily shipping rates based on the Capesize, Panamax, and Supramax indexes. In the past week it has surged, but mainly because of the higher rates of Capesize ships, and not the entire fleet. In choosing where to invest in the dry bulk industry, it's important to understand the composition of the fleet of each company and what they would likely ship.

Supply

The current dry bulk fleet is estimated at around 700 million Dry Weight Tons. Since these are massive projects, that take years to build and deliver, it's difficult to have any effect on the size of the fleet in the short term, other than laying up or mothballing ships for short term. A typical ship will have a life span of anywhere between 20 to 30 years, however for most commercial companies, after about 15 years they will look sell the ships off in favor of newer ships. Currently around 10.6% of the fleet is older than 20 years. When comparing day rates and the break even points for these ships, the newer the ship, the more fuel efficient, the lower the maintenance costs, and the lower the breakeven point, meaning when the Baltic Dry Index dips, they have a higher probability of remaining profitable compared to older ships.

The shipping companies will place new ships on order when they either feel the market is swinging up, and by the time the ship is delivered (about 2 years), they will be able to place it on contract, or when the ship building rates become so low, they can afford to scrap older ships in favor of more efficient newer ships while maintaining the same capacity. I believe both of these factors are in play right now. Over the past two years, ship building rates have been at all time lows, triggering companies to place new orders, and they would figure it out latter.

Many of those same companies are having problems financing their spending sprees, and are forced to either sell the contracts off at a loss or take delivery and sell older ships that may not be at the end of their useful life.

At the same time, demolition prices have also been falling, and many companies are reluctant to sell off a ship at a depressed price. While they may take it out of circulation, it still has the perception for the market that the fleet is oversized. There is current speculation that China may offer a tax incentive to Chinese companies to lay up their older ships in order to encourage companies to reduce the supply.

So with all the talk of order books and scrapping, what is the bottom line of the current size and project size? I'm estimating the total size of the fleet at around 700 million DWT. The project scrapping for 2013 is around 24.1 million DWT, with an expected order book deliver of around 70 million DWT, or 10%, projecting the 2014 fleet to have a capacity of around 745 million DWT.

Demand

The main cargos for the dry bulk carriers are iron ore, coal, and grain.

China has been by far the largest driver of the demand, and the sole cause of the increase in the Baltic Dry Index. The two largest exporters of iron ore are Australia and Brazil, with China consuming about two-thirds of the ore. China's stockpiles have remained relatively low with 72.7 million tons of iron ore (24% lower than a year ago), and stand around 26 days of supply. It can be expected that while the Chinese continue to process ore, they will attempt to get their stockpiles back up to at least their average inventory, keeping this rally going.

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Brazil has also been a huge exporter of iron ore. During the recent NM 2Q13 earnings release and conference call, the company highlighted the following slide, detailing the correlation between the seasonality of Brazilian iron ore exports and the Baltic Cape Time Charter (implying that the recent uptick in the Baltic Dry Index will only last through 4th Qtr 2013):

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During the same conference call, the company outlined how global iron ore production is going to more than quadruple into 2016 due to increased production from Australia, Brazil, and Africa.

(click to enlarge)

Coal is another driver for the dry bulk index. In June, Queensland shipped 15.6 million tons (roughly 90 capesize ships worth, or 3 a day if the average capsize is 175,000 dwt), the second highest amount on record for the port. It is projected that exports will continue into 2013 with an increase of 6% and 2014 with an increase of 8%. According to Genco Shipping and Trading , Chinese coking coal imports will increase by 40% in 2013 due to a drop in spot coking coal prices, and India thermal coal imports will rise 16% in 2013 to 142 million tons (over 800 capesize ships or about 3 per day).

Conclusion

As of 10 September 2013, the Baltic Dry Index was as follows:

(click to enlarge)

The free market theory states that where supply and demand meet is where the price will settle. Up until now, it looks like the supply outstripped the demand, and the daily rate for dry bulk shippers was below the breakeven point. Now that demand has surged, Clarkson Securities Ltd predicts that fourth quarter daily rates will average $28,000. This will carry the price higher and return the sector to profitability.

Source: Understanding The Supply And Demand Of Dry Bulk Carriers