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Summary

  • The demand and supply situation in the iron ore market will have a profound impact on the drybulk carriers over the next few years.
  • China will continue to play a big role in the international iron ore market as it is the biggest consumer of iron ore in the world.
  • Drybulk carriers will benefit as Australia and Brazil continue to increase the supply of iron ore over the next few years.

The current year has not been a good one for Dryships (NASDAQ:DRYS) - the stock is down over 26% year-to-date due to the concerns about the drybulk business. Despite bullish views presented by the drybulk carrier companies, Baltic dry index continues to disappoint. In our previous articles, we have discussed the company's financial position as well as the economic situation of the drybulk industry. In this article, we will focus on the major factors which drive the Baltic dry index and how it will affect Dryships in the coming months.

Factors affecting Baltic Dry Index

Although the Baltic Dry Index depends on many factors, the basic driving force is the demand and supply of the commodities it carries. Among these commodities, Iron ore has proven to have the greatest impact on drybulk prices. Increased demand in the iron ore supply will result in increased supply by the miners. Subsequently, this increases the demand of drybulk carriers leading to an increase in price. However, in the case of iron ore, things are not that simple. The following factors need to be taken into account while looking at the iron ore demand.

Iron Ore and Chinese demand

China is the largest iron ore consumer in the world. While being a huge producer of iron ore, it is also the biggest importer of the commodity. Due to its ability to produce, China desperately tries to cut back on imports of Iron ore to encourage the local miners. China's local production to import ratio was roughly 2:1. However, it recently increased its imports last month by 12.75% to meet the rising steel demand in the country. This did increase the Capesize prices for a short period of time, but prices have now come to the original position. Moreover, in order for the drybulk carrier companies to prosper, the increase has to be in the longer term as most of their shipments are based on long-term fixed rate basis. Interestingly, there could be a silver lining to this situation not long from now.

Australia and Brazil Aggressive Export

Australia is the largest exporter of iron ore while Brazil is the second largest. Both the countries have been aggressive in the export of the commodity and continue to be so. In our previous article, we have also discussed how the two countries were increasing their iron ore output capacity when the prices were low. This is increasingly leading the iron ore market to an oversupply situation. Therefore, the prices are falling. These countries might continue to increase iron ore supply as it accounts for an important part of their overall exports and even if they face lower prices, they would want to find economies of scale in order to achieve acceptable profit margins. Interestingly, Australian and Brazilian miners have huge margins left even at the current price levels that will be discussed later in this article. Both the countries are still ramping up their exports, even at low prices. This year, Australia and Brazil plan to increase their iron ore export volume by 22.1% and 9.1%, respectively.

Falling Prices Might Put Local Chinese Miners out of Business

Firstly, there is a huge difference in the quality of Chinese iron ore and Australian iron ore. Iron content in Chinese raw ore is roughly 26% as compared to the global benchmark of 62% on average. This alone makes Chinese ore very expensive for the manufacturers to process. On the other hand, miners in Australia face costs per ton of $45 to $55. Freight charges are roughly $25 dollars. The current price of $100.56 is an extremely alarming situation for the local miners of China.

According to Wood Mackensie, the price of iron ore would be around $101 for the rest of 2014 and will drop to $98 in 2015. Morgan Stanley has also lowered its previous prediction and now expects iron ore prices to stay around $105 for 2014 and around $90 for 2015. This oversupply situation is expected to continue till 2020 and 40% to 50% of Chinese miners might go out of business while facing strong price competition. Wood Mackenzie further expects that Australia's iron ore would account for 60% of Chinese iron ore imports by 2020.

Conclusion

On the basis of the situation and its possible consequences discussed above, we strongly believe that drybulk carriers would have a good second half of this year and things should get much better over the next 5 years. Iron ore will impact the Capesize vessel prices and would have a strong positive impact on the company's profit margin.We believe DryShips will do well over the next 3-5 years and it is a good choice in the drybulk carrier segment.

Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investing in stock markets involves a number of risks and readers/investors are encouraged to do their own due diligence and familiarize themselves with the risks involved.

Source: What Now For DryShips?