Individual Global Inve...'s  Instablog

September 29, 2009 by Bryan Banish – Individual Global Investor

 

Last Friday, the Baltic Dry Index ended the week on an up note at 2,183, finally. It was the first up day in 10 sessions. In fact, the 7.3% decline for the week was the ninth weekly drop in ten weeks. In the last three months while global equity markets have rallied on increasing expectations of global recovery, the Baltic Dry Index (BDI) has quietly, steadily declined. Since its peak this year on June 3, 2009 at 4,291 it has declined 49%. The S&P 500 Index in the United States, for example, has increased 13% in the same time frame.

 

This is important because unlike asset markets, this Baltic Dry Index measures economic activity that is supposed to be at the heart of the economic recovery. The index reflects the demand for, among other things, transporting iron ore and coal from Australia to China that is a direct input to Chinese industrial production topics I have discussed in past articles. Much of justification for a recovery, particularly in commodities prices, is linked to Asia-related trade and consumption. Yet if this trade and consumption was so robust the BDI should be headed up (or at least holding flat) rather than in retreat.

           
                                 

                                                            

Baltic Dry Index has been in a steady slide since Chinese stockpiling peaked. As is common knowledge now, the government of China launched a massive fiscal stimulus program early this year that included stockpiling of raw materials and metals. This program was a gift to miners such as BHP Billiton (BHP) and Rio Tinto (RTP) by putting a floor under and even driving up prices on key commodities such as iron ore, coal, aluminum, and copper. 

 

Much of the positive effect of this program has come and gone now. Chinese authorities have expressed concern about over-production of steel and cement. Setting aside last week’s drop in crude prices, commodities markets have been acting as though demand for raw materials remains robust.   Through the period of Chinese stockpiling iron ore spot prices recovered from a low of $60/ton to almost $100/ton. Today they have dropped back to the mid 80s. This is in line with the iPath DJ AIG Industrial Metals ETN (symbol: JJN), up 51% year to date.

 

                               

Commodities are trading as much as an asset class as material to be consumed. It is quite unclear what the future holds for the demand for materials like iron ore, aluminum or copper. There are bullish arguments to be made based on the industrial production that is recovering worldwide (albeit still at low levels) and mining production that has been shut in. There are also bearish arguments to make such as slack demand and robust production gains made during 2005 through 2008. 

 

The chart above looks at the iPath ETN for industrial metals (JJN) in green against the backdrop of a key global equity market, the S&P500 (SPY) and the Baltic Dry Index over the last year. While one would expect prices of industrial materials would reflect industrial demand. Industrial production in the United States hit its bottom in June 2009 while Japan and Germany bottomed a few months prior to that. The steady march up in price of industrial metals from February to August appears more in line with an asset market than demand reflected in the BDI. However, the Baltic Dry Index, while imperfect, may today be a better reflection of commodities demand than prices themselves. To understand this it is best to explain what the index is and what it measures.

                                                                                        

The Baltic Dry Index is calculated each day in London at the Baltic Exchange that specializes in ocean shipping of bulk materials. The exchange is privately held by its members and is over 250 years old. The exchange derives its name from the Virginia and Baltick coffee house where it originally met in the 18^th century. The Baltic Exchange specializes in bulk shipping of items such as metals, coal, iron ore, grains and steel. Excluded from this focus are container ships, car carriers and shippers of crude oil so it is important not to focus too exclusively on what the Baltic Dry Index can cover. Recently the Baltic Exchange has developed two indices (Baltic Dirty Tanker & Baltic Clean Tanker) to track prices of tankers of crude oil and another for the shipment of Liquefied Natural Gas.   The Dry Index is Baltic’s specialty, though.

 

To calculate the BDI, the Baltic Exchange summarizes the average price of the contracts cleared on given day for four different categories: Capesize, Panamax, Supramax, and Handysize. These four categories represent the four categories (sizes) of dry bulk ships in use today. 

 

Handysize and Supramax are the smallest, often used to transport grain and other foods to ports where facilities for larger ships are not available. Ships from each of these categories are also used to transport industrial materials such as scrap iron, concrete, and steel. 

 

The Panamax category of ship derives its name from the fact that it is the largest class able to navigate the locks at the Panama Canal. It can carry grains and industrial materials similar to the smaller ships but also is pressed into service for coal and iron ore shipments. 

 

The Capesize is too large for the Panama Canal and must circumnavigate the globe via the Cape of Good Hope (Africa) and Cape Horn (South America). While less versatile than the small ships it has become the workhorse for the iron ore and coal shipments, particularly those between Australia and China. 

 

 

This year’s volatility in the Baltic Dry index has been driven by iron ore and coal shipments. The Baltic Index also publishes the four sub-indices from which its main index is derived. Since the beginning of the year, it has been the Baltic Capesize Index that has been the driving force behind the movement in the broader Dry Index. Earlier in the year anecdotes abounded of Capesize ships stacking up at Chinese ports waiting to offload shipments from Brazil and Australia. Such port congestion can lengthen the transport time and drive up daily spot rates for the vessels. 

 

The Capesize Index spiked above 8,000 the day of June 3^rd, providing the high water mark for the year for this index and its parent, the BDI. The Capesize Index approached but did not reach 8,000 later that month. Since June, this sub-index has fallen by two-thirds, closing last week at 2,677, double from where it stood at the end of 2008. 

 

The other three sub-indices have had a more muted effect on the Baltic Dry Index with the Panamax Index also benefiting from the China iron ore stockpiling effect. As the Supramax and Handysize indices are largely insulated from that stockpiling effect, they have marched steadily higher, likely based on the gradual return of global growth. 

 

With the Baltic Dry Index hitting 5 month lows, the question is “Will the slide in the Baltic Dry Index continue?” I have no data with which to suggest a forecast but I do believe the BDI provides a better view of underlying global demand for raw materials than the prices of many commodities. My best guess is that the index will flatten out as it nears or drops below 2,000 (the BDI is at 2,183 as of Sept. 25, 2009) and move sideways for the rest of the year. 

 

Today’s anecdotes are not of port congestion but of a “ghost fleet” of tankers floating empty off the coast of Singapore. Many shipping companies are still expecting delivery of new ships this year and next adding to capacity. A look at the most recent analyst presentation from bulk shippers Eagle Bulk Shipping (EGLE), Dryships (DRYS), Genco Shipping (GNK) and Navios Maritime (NM) is not reassuring. They point to the scrapping of older vessels (which is common in a downturn) as evidence capacity is coming in line. At the same time, they cite bullish stories of Chinese iron ore imports and steel production. 

 

It is true that this phenomenon lifted shippers’ business in the first half of 2009 as it did in for miners BHP, Rio, and Brazil’s Vale (VALE). But given that we know this is a story of the past, we might just say, “that ship has sailed.” At least BHP and Rio have highlighted to their investors that the end of the stockpiling story, describing instead a murky near term outlook. For dry bulk shippers in the coming month there is more downside risk than upside potential.

 

Disclosure: No Positions