Baltic Dry Index: Turning The Corner

| About: DryShips Inc. (DRYS)
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Following its dramatic rise into 2008 and subsequent collapse, the Baltic Dry Index more or less pressured downwards, before flattening out in 2012 and breaking out to the upside in the summer of 2013. After pulling back roughly half its gains to the 1,500 area, the BDI then continued its rise at the end of Q4 2013 to new highs not last seen since the end of 2010.

For an investor, the question then is not only whether the higher BDI is sustainable, but whether it's the start of a new trend upwards. If so, it has a number of significant implications for national economies and financial asset classes.

The conclusion for this article is that the BDI has indeed turned the corner, and is in the early stages of a longer-term trend up. This conclusion is based primarily on two factors-one, expected increased demand for raw materials, and two, the cessation of the supply glut that plagued the shipping industry since 2009. A third, minor factor is the easy-money policies pursued by the central banks of the US, Europe, and China. These policies, which are likely to go unchanged, encourage demand for raw materials by one, lowering borrowing costs with which to buy said materials, and two, by promoting the allocation of financial capital from depreciating assets like currencies into real assets like commodities, thereby causing inflation-induced demand.

Factor 1: Expected Increased Demand for Raw Materials

Demand for raw materials is arguably the most important factor in determining the future direction of the BDI. With greater demand, more ships will be needed to transport raw goods from port to port. This greater demand pressures shipping rates upwards.

To determine expected demand, I centered my analysis on China's relationship with raw materials. While the US has entrenched itself as a service-sector economy, China has established itself as the manufacturing base of the world, just by sheer volume. It accounts for the lion's share of global trade for nearly every commodity important to the dry cargo shipping industry, which means as China's demand goes, the seaborne shipping industry goes. China accounts for 70% of all iron ore maritime shipping, 47% of coal's, 44% of lead's, 42% of copper's, 41% of zinc's, and 36% of nickel's. These commodities comprise a bulk of all dry cargo shipping. Iron ore is the largest form of dry cargo shipped, accounting for 25% of all maritime shipping alone, followed by coal.

These statistics should underscore the importance of China for the shipping industry, as well as highlight iron ore as a useful benchmark with which to gauge overall demand for raw materials in general. Chinese demand for iron ore alone is large enough to substantially affect the BDI, and it's unlikely a substantial rise or fall in demand for iron ore will occur without correlated moves in the other major raw material commodities (for example, coal is often used as an energy source in the process of turning iron ore into steel; therefore, increased iron ore demand should increase pressure on coal demand. To illustrate, we can see on the right that coal imports have risen relatively unabated since 2006, in tandem with iron ore imports, the latter shown further below. Again, these two commodities are the two most common freights by volume for dry maritime shipping, and therefore the two most important).

On the left-side chart below, we can get a ten year view of China's iron ore consumption patterns by looking at China's crude steel production, since the majority of iron ore is used to make crude steel. The key takeaway is the yellow line-it's continued up more or less unabated, and thus far, there's no reason as yet to believe that should change. Even the 2008-2009 financial crisis did little more than create a minor blip.


With the right-side chart above, we can see the correlation between crude steel production and China's iron ore imports, the main driver for dry cargo shipping volume, and thus the shipping rates charged, measured by the BDI. Just as Chinese crude steel production has been little more than a steady uptrend, so have iron ore imports.

Now, is the long-term uptrend in iron ore demand sustainable? It seems yes. This deduction is based on three data points: low iron ore inventories, low steel prices, and weak Chinese manufacturing PMI data. Together, these three determinants point to the probability of increased iron ore demand.

First, Chinese iron ore inventories are low enough that given past history, we can reasonably expect imports to continue at a steady, if not increasing, pace. Looking at the chart to the right, we can see that China's inventories are below the trend since the lows of the financial crisis. Given that China's rate of steel production has increased nearly 50% since then, while its iron ore inventories are only around 33% higher, it's reasonable to conclude that China will need to import more iron ore to keep up with steel production, resulting in greater demand for dry cargo shipping vessels and thus higher shipping rates.

The second data point that supports rising Chinese iron ore demand is the low price of steel, shown on the right. This price, based on the Chinese domestic hot rolled steel price, is hovering just above the 3,400 RNB/metric ton level, an area that's marked the lows in price throughout the past decade except very briefly at the end of 2005/beginning of 2006 and on a spike below during the financial crisis. If inflation is accounted for, it could be argued the current price is right at the lows from the past decade. Given that steel prices recovered every time, it's not unreasonable to think they'll do so again, indicating demand will come in to move price to higher levels. This impending demand for steel means an expected increase in demand for iron ore. While some of the potential rise in steel prices may be attributable to impending inflation, current relatively low iron ore inventories indicate at least some will come from demand alone, which will pressure shipping rates higher.

Third, historically weak Chinese manufacturing PMI data give further reason to believe a rise in demand for raw commodities, including iron ore, is sustainable. Looking at the PMI data to the left, we can see that the PMI is fairly low relative to the past decade, and the most recent data is no better-the November 2013 PMI came in at 51.4, while the December 2013 PMI came in at 51.0. The key point is that there is much room to grow. The only lengthy period the PMI came in below the 50 level was during the the financial crisis, and even then it recovered relatively quickly. Given this, it's more likely the PMI is hovering around a low point with room for further expansion. Unless there's another financial panic, the risk for the PMI is now to the upside, meaning demand for raw materials is more likely to grow than not, and very unlikely to fall from current levels. Because a more-likely-to-uptrend-than-not PMI supports demand, it also supports the probability of a rising BDI. The connection between the PMI and BDI is made clearer by their correlation on the chart above.

Factor 2: Tightening Supply of Ships

A major dampener on the BDI has been the glut of ships that have continued to deluge the shipping industry since 2008. In the run-up to the crisis, shipping companies ramped up their orders for new ships to expand capacity, only to have the market collapse. Because they were unable to renege on their orders, these ships continued to be built, a process that takes on average two years. This created expanding shipping capacity at a time when demand for shipping was in decline; put plainly, supply was rising while demand was falling.

If the BDI is to continue its recent rise comfortably, this supply glut needs to have ended, and indeed it has. On the chart to the right, we can see that shipping capacity growth waned throughout 2013, just prior to and as the BDI began its ascent. The growth rate seems to be stabilizing now in the lower percentage numbers, such that it should no longer pose the same threat it did before to a higher BDI.

Factor 3: Continued Easy Monetary Policy

Should major central banks, and in particular the Chinese central bank, tighten monetary policy significantly, demand for raw materials and inflation should fall, thereby causing the BDI to fall. But with an inflation-biased Yellen at the helm of the Fed, Draghi supposedly willing to "do whatever it takes" to prevent deflation, and Chinese inflation at relatively low levels, it's unlikely that any major form of tightening will occur.

In particular, we can see on the left that official inflation in China, as measured by the CPI and PPI, is relatively contained, and are in the lower end of their ranges from the better part of the last decade. This gives little incentive for the Chinese central bank to tighten monetary policy.

Investment Recommendation: DryShips, Inc. (DRYS)

Because the number of shipping companies is small, selection comes down to three main parameters: one, the degree of correlation with the BDI, two, the strength of the balance sheet, and three peer-to-peer valuation.

Based on this, I think DryShips provides the best single opportunity to play the BDI, though it may be prudent to consider taking a small basket of leading shipping stocks to diversify away company-specific risk.

Parameter 1: Correlation with the BDI

Regarding the first parameter, DryShips is well-positioned to track the BDI. Of its dry bulk fleet, 24 of its 28 Panamax vessels and both its Supramax vessels operate on spot-market prices, though only 1 of its 12 Capesize ships do. However, the latter are the smallest of its ships in dry cargo shipping, which still affords the company fairly good exposure. We can see DryShips' correlation with the BDI on the chart to the right.

We can also see that DryShips has tracked the BDI fairly closely relative to its peers. The left-side chart shows that Dryships has produced a middle-of-the-pack performance in 2013, compared to the biggest leader, Eagle Bulk (NASDAQ:EGLE), and the biggest laggard, Genco Shipping and Trading (NYSE:GNK). Much of Eagle's gains came on company-specific news prior to the rise in the BDI, and Genco was weighed down by its considerable debt overhang throughout the year. DryShips gave one of the purest performances in the sector.

Parameter 2: Balance Sheet Strength

Regarding the second parameter, DryShips does not have a traditionally sound balance sheet, but neither has the rest of the sector since 2008. However, it's been good enough not to have faced bankruptcy issues, unlike many of its peers. DryShips has survived by diluting its shares repeatedly, the most recent of which occurred near the share-price highs on 1/1/14. While this is normally a reason for caution, given the sector climate for the past five years, it's understandable, and if the BDI continues to trend up, share dilution becomes less likely, as earnings are highly sensitive to minor changes in the BDI. The company also has a majority stake in Ocean Rigs UDW (NASDAQ:ORIG), which is set to pay a quarterly dividend beginning Q2 2014, which will provide DryShips an annualized payment of $59.4 million, with which to cushion its balance sheet.

While it would be ideal to find a company that has both strong spot-rate exposure and a strong balance sheet, none really exist. Diana Shipping (NYSE:DSX), for example, has arguably the strongest balance sheet, but only because all its vessels operate on fixed-rate contracts, which will give it negligible BDI upside exposure. Genco Shipping and Trading Ltd. has the highest amount of spot-market exposure, but it has so much debt that the company may continue to flirt with bankruptcy unless the BDI continues to rise relatively quickly. Its debt has been so problematic that its shares finished 2013 in the negative, despite all its spot-rate exposure (as seen in the recent chart above-left).

Parameter 3: Peer-to-Peer Valuation

Regarding the third parameter, DryShips is trading undervalued to its peers. As of the end of 2013, its price/book ratio was .43, while the industry average was 1.4. The difference seems to stem largely from market disgust with its share dilution practices, but as stated before, this practice seems unlikely to continue, given one, significant expected dividend payments from its subsidiary Ocean Rigs , and two, the probability of an uptrending BDI.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.