How to Invest in Shipping and Whether You Should

By Julian Murdoch

The last time we looked at shipping was all the way back in April. At the time, we commented on the new entrants into the index market for dry bulk shipping - UBS and their Blue Sea Index. Six months later, we have another new entrant; this time in the form of an actual, investible exchange-traded fund.

A quick refresher: Shipping rates are tracked primarily by the Baltic Dry Index, a blending of the rates to ship dry goods (largely ores) on three different-sized boats on the four main shipping routes. Back then, we safely commented that nobody was actually doing much in the way of derivatives on the BDI beyond freight forward agreements. In other words, for most investors, it was functionally untradable.

It turns out not having some kind of derivatives=based Baltic Dry ETF was a blessing in disguise. Since a heady peak in early summer, the BDI has lost an astonishing 50% of its value.

 

 

 

Looked at in the long term, the recent decimation in shipping rates has essentially obviated the entire commodities boom, resetting the shipping market back to 2006 levels.

 

 

 

So what the heck happened? China. Going into the Olympic games, China stopped buying pretty much anything. So far, China doesn't look like it's started buying again, but it's just a matter of time. But the restart won't be instant; Lloyd's List is reporting that there are 70m tones of iron ore just sitting in Chinese ports still waiting to be unloaded. It will take some time - my guess is a quarter or two - for the shipping market to stabilize back into any kind of run-rate demand.

All this volatility has understandably increased interest in locking in prices through derivatives, and indeed, freight forward agreements - the main way shippers lock in prices - have been steadily increasing in volume. In May, ICAP - a British derivatives firm, bought JE Hyde, a ship broker, and in June launched full electronic trading of OTC shipping. Also in June, IMAREX launched a full-on BDI futures contract. While not as accessible as one of the established U.S. exchanges, it's a real and booming market, with BDI futures trading a nominal $1 billion in August, a 50% increase in size over July. This month's issue of The Baltic - 100% required reading for commodities investors - predicts that overall derivatives activity in shipping will increase 25% in 2008.

For most investors, the only way to play the shipping game has been through the shipping companies - the equivalent of a pick-and-shovel miner approach in gold: companies like DryShips (DRYS) and Diana Shipping (DSX). As you'd expect, these stocks have been slammed alongside the revenues predicted by the BDI. After all, they're the sellers of the commodity represented by the BDI - the use of ships.

 

 

 

I will admit, there's a part of me that looks at a chart like this and screams "buy buy buy" with Jim Cramer-like enthusiasm, minus the mania and forehead sweat. After all, the fundamentals should stay strong, if emerging markets and China still plan on pressing forward into the 21^st century.

But what about supply? It's all too easy to look at demand in shipping, but supply, in the form of shiny new ships, gets short shrift in the press. The challenge is that getting new capacity into the market takes years - and the investment is a lot less granular than simply putting more hours into a mine or planting a few more acres. So while shippers rush to get new ships into production when rates are high, they can delay or cancel those orders when prices plummet. This creates lead/lag issues that make prognosticating crop plantings look positively speedy and transparent. Morgan Stanley is estimating that over $22 billion in ship orders could be cancelled in the next few years.

Throughout this plummet, shipping companies have continued to order new ships - although there's some evidence that a lot of those orders are on hold. Still, the combination of the continued building and the maturation of China's steel market (iron ore is the big dry bulk import for China) has some analysts calling for near-Armageddon collapse in the shipping market by 2015, calling for the key Capesize rate to get cut in half again between now and 2011.

China, emerging markets, new derivatives markets, and a stepwise and unsure supply. Add to this uncertainty the continuing credit crunch, and the only certainty is continued volatility. Shippers like DRYS have been tremendously volatile, with a historical volatility of .82. Compare this with the S&P 500's volatility of .22, or even agricultural suppliers like Potash (POT, .52) and miners like Barrick Gold (ABX, .53).

The good news is that highly volatile stocks with long declines often rebound aggressively - if you call the bottom. And if you're feeling like this is it, there's finally an ETF you can use to make that call. In August, Claymore launched the Claymore/Delta Global Shipping Index ETF (SEA). No, this doesn't invest in the fancy new BDI futures. It's a dirt-standard, 65-basis-point pick-and-shovel approach to the sector, taking positions in all the giant shipping companies (like the aforementioned DRYS, DSX and even bigger giant, Seaspan [SSW]).

As an ETF, you can theoretically short it, so whether you think shipping's going to pick up (because China gets busy again), or headed for a deeper fall (because all that oversupply comes on line), SEA could be a great way to get your feet wet.

Pardon the pun.

Comments

[User 215177:]

Thank you for the useful article with excellent references including the Baltic. The BDI simply tracks spot demand for dry bulk ships and should therefore be interpreted with care.

The decline since its all time high in May 2008 is partly due to seasonal factors, exacerbated by the drop-off in Chinese iron ore imports (Olympics ), declining steel prices and possibly secular factors including the physical activity (versus fear of ) slowing global growth. This latter point is difficult to determine

My view is that the BDI will pick up once the Para Olympics finish and the Chinese run down historically high port iron ore stocks (due to stocking prior to Olympics and a contributor the all-time high in the BDI in May ) . The start up of Northern hemisphere grain shipments will also boost Panamex rates- analysts suggest this won't happen until October.

Ship supply remains tight for 2008 but will pick up significantly in the the second half of 2009 (irrespective of cancellations and delays). The Morgan Stanley supply comments have been largely discredited by industry experts.

Other key indicators include the FFA curve , which is in contango through 2009 and period time charter rates ( 1-10 years) . Although period charter activity has been predictably muted through August and September, contracts that were signed prior to the slowdown , and those deals that have been done over the summer are still at highly profitable levels for owners.

Unfortunately , drybulk stock prices are closely correlated with spot rates (BDI). Investors have ignored the fundamentals including time charter coverage (many owners fully covered in 08, up to 80% covered in 2009, and already with up to 50% in 2010; relative yields ; historical dividend performance , capacity to increase and sustain dividends ; growth profile; and ,quality of management. Exacerbated by the credit crisis and fears of global recession , the market has punished all stocks whether higher yielding plays (e.g. DSX, EGLE, GNK ) or lower yield with more exposure to the spot market (DRYS, TBS, EXM )

However, regardless of a softening in global economic growth, China and India will continue to invest in infrastructure ( only 15% Chinese GDP is export related). Seasonal factors (grain) and restocking (iron ore ahead of 2009 rate negotiations with iron ore producers as well as tight supply for the next 6-9 months suggest , all else being equal, an excellent buying opportunity in the near term

2008 Sep 17 10:12 AM

[smurphny:]

Greek shipper DSX has experienced an "ebbing tide lowers all ships" price decline during the recent market and commodities turmoil. It looks as if some factors would lead one to look at this as a buying opportunity. First, the plummeting BDI futures are not really a good indicator of a shipper's value because companies like DSX are in long-term contracts with predictable profits for all their ships. Second, China will have to start resume importing commodities very soon. Third, traditionally this is an up season for shipping demand. Fourth, technically the stock is due for a big rally. Fifth, "this too shall pass" regarding the recent panic. Most investors, as usual, will wait until it is too late to buy stocks with great fundamentals like this at these prices. We're probably closer to the bottom than the top.

2008 Sep 18 03:14 PM