Iron Ore And Coal Will Help Boost Demand For The Baltic Dry Index

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 |  Includes: BDD, BDG, BOM, BOS, DBB, HEVY, JJM, RGRI, RJZ, SEA, UBM, USMI
by: MTF Investing

Summary

Investors should understand the supply and demand of the dry bulk industry, in order to predict market improvements.

Iron and coal are the primary market drivers for the demand side of the market.

An improvement in the global economy, primarily driven by China and India, will help improve the Baltic Dry Index rates.

Since the collapse of the Baltic Dry Index in 2009, investors in dry bulk shippers have seen their investments wither away. The global demand for the movement of raw materials soon fizzled out as the global economy slowed down.

(Source: Dryships.com)

Almost five years on, the market has failed to recover, however, there are many in the industry that are pointing to the recovery to begin the second half of 2014 and extend into 2015. In order to truly understand the problem, an investor has to understand the supply and demands of the Dry Bulk Index.

On the supply side are the dry bulk ships. Mainly Capesize, Panamax, and Supramax (or Handymax).

As shipping rates began to shoot up, companies overextended their reach with taking on debt and put ships on the order books, believing the rates would stay at astronomical rates. Once the rates fell, the companies were already on the hook for the ships. This has led to a surplus of ships... and excess of supply. An excellent article by Mad Hedge Fund Trader explained this in detail, and instead of restating it, investors should refer to it for additional understanding.

On the demand side is the global economy. Countries, especially China, were experiencing a boom in growth during the late 2000s, which required loads of raw materials in order to build the infrastructure and goods required for housing and manufacturing. Mainly coal and iron ore. The demand for these goods is what helped to drive the price of the BDI up.

Once the global economy slowed down, the dry bulk shippers faced a double whammy they are still recovering from. The first was from the excess of supply that came on-line during some of the lowest points of the BDI rates in the form of newer and more fuel-efficient ships. The second was the reduction in demand.

Click to enlarge

(Source: Navios Maritime)

A pickup in demand

With that understanding in mind, there are some indicators that demand for raw materials, primarily coal and iron ore, are going to be picking up. That increase in demand will help to move the BDI in favor of investors.

The first is the falling price of iron ore. Australia is the largest supplier of iron ore to China. While China does have some deposits, they are of lower quality with a higher excavation cost. The falling price of iron ore means that it will be cheaper for China to import the ore rather than mine it themselves.

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(Source: Navios Maritime)

Australia is already predicting that the increase in production, and-cost cutting measures will not be enough to offset the fall in ore prices. Australian production for 2013 was 609.2 million tons, and is predicted to rise by 14% to 692 million tons by 2015. It is predicted to rise another 17% by 2020 to 812 million tons.

Brazil has also increased production, with Vale (NYSE:VALE) reporting a record 79 million tons. The company expects production to increase 40% over the next four years, with the current projects completed and additional projects coming on-line over the next two years.

Click to enlarge

(Source: Company website)

In addition to the increase in iron ore production, there is also an increase in demand for coal. Both India and China are increasing their energy production and relying on cheaper thermal coal to fuel their economy.

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(Source: Navios Maritime)

Australia has approved a controversial thermal coal mine with exports destined for India. The Carmichael coal mine is expected to produce 60 million tons of thermal coal for export a year.

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(Source: Adani website)

The "So What" Factor...

Shipping companies can choose to either operate their ships on a contractual basis or on the spot market. The contractual basis offers more predictability for the companies, but fails to capture increases in demand. The spot market captures the swings in demand for shippers, but is more volatile, and companies may end up operating at a loss from time to time.

Dry Ships (DRYS) has tried to balance these strategies with a phase-out of its contracts as its predictions for an improvement in the market arrives. The upside is day rates that are many times higher than what the company could get from a contract. The downside is the company may let contracts expire without the expected rise in day rates, and cause additional losses for the company.

During the 2013 year-end report, DRYS CFO, Ziad Nakhleh stated the following for the 2014 outlook for the company:

Going forward, there are numbers of factors that can really set the markets on fire, amongst of which are the commodity trade growth as a result of improving fundamentals in global economic outlook; steel production demand as well as steel margins, which are expected to further improve during 2014

When looking at the dry bulk shippers, investors need to understand the demand factors and how they apply to the company they choose to invest in. While contracts may be safe and predictable, they will fail to capture the improvements in the market as they come.

Disclosure: The author is long DRYS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.