Let's Discuss The Dry Bulk Shipping Rally

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Includes: DRYS, DSX, EGLE, GNK, GOGL, NM, NMM, SALT, SB, SBLK, SEA, SFL
by: James Catlin
Summary

The Baltic Dry Index recently hit new multi-year highs.

Capesize spot rates have led the way and Panamaxes have followed suit with fresh five-year highs.

But is this rally sustainable?

Note: This article was originally published July 12th on Value Investor's Edge, a Seeking Alpha subscription service.

Overview

2019 is turning into a roller coaster ride on the high seas for dry bulk shipping. It was just over four months ago when Splash247 reported:

Now, the Baltic Dry Index is setting fresh multi-year highs.

Source: stockcharts.com

Here, we take a look at the dry bulk shippers who specialize in transporting cargoes such as iron ore, coal, grain, and other materials around the world. The only ETF for the space is The Invesco Shipping ETF (SEA). Companies with exposure to dry bulk include Diana Shipping, Inc. (DSX), DryShips (DRYS), Eagle Bulk (EGLE), Genco Shipping (GNK), Golden Ocean Group Ltd. (GOGL), Navios Maritime Holdings, Inc. (NM), Navios Maritime Partners L.P. (NMM), Scorpio Bulkers (SALT), Safe Bulkers, Inc. (SB), Star Bulk Carriers Corp. (SBLK), and Ship Finance International Limited (SFL).

The BDI

The Baltic Dry Index is based on daily assessments of more than 20 benchmark routes large enough in volume to provide a material outlook for the overall market.

In 2018, the BDI was re-weighted to the following ratios: 40% Capesize, 30% Panamax, and 30% Supramax. It will no longer include the Handysize timecharter average despite widespread agreement that the smaller classes deserve a weighting in the index, perhaps in the neighborhood of 10%.

The old version of the BDI weighted all four classes of ships equally, each size representing 25%. Either way you slice it, we seem to be stuck with an imperfect index.

According to VesselsValue, over the past six months, Handysize vessels composed approximately 24% of the total number of vessels employed.

Source: VesselsValue

But due to their smaller size, they were only responsible for transporting 13.4% of the total cargo (measured in metric tons) underway over that period.

The exclusion of these workhorses has left the BDI skewed toward the larger classes. This not only makes historical comparisons with the BDI difficult but also creates greater volatility in the index since the supply of the largest ship classes is relatively inelastic.

Notice the Handysize class has not benefited in the same way as their larger counterparts as of late.

The Supramaxes have also been left out of this latest rally.

Therefore, we see the latest BDI rally being the work of the Capesize and Panamax classes, which represent 70% of the index.

Source: Above charts courtesy of VesselsValue.com

Therefore, we will be paying close attention to these classes, in particular, to find out what's behind the rally and if it is sustainable.

Causes

Speed

First, notice the drop in average speeds lately for the entire Capesize class, creating a supply side shift favoring higher prices (spot charter rates).

Source: VesselsValue

This drop in speeds could have been a cost savings response to the aforementioned BDI plunge at the beginning of the year, which put carriers in severe loss-making territory.

If that is indeed the case, history has shown that even after fortunes turn, the move towards slower speeds can be held collectively in the short run, but falls apart quickly thereafter.

However, on the horizon is the 2020 Sulfur Cap, which many have hypothesized would reduce speeds. Could this short-term shift in speeds serve as a bridge to a structurally supported move to a knot or two slower once 2020 hits?

Two more questions remain about vessel speed as we move through this report, highlighting the challenge of finding a single answer.

Scrubbers

Additionally, we are seeing vessels head to the shipyards for scrubber installations to prepare for 2020.

In June, 0.3% of the Capesize fleet was out of service for scrubber retrofits, based on data from Clarksons Research.

Source: Clarksons

It believes Capesizes would have earned $14,000 per day, but averaged $15,000 per day due to scrubber retrofits.

For the remainder of 2019, Clarksons sees an acceleration of retrofits with 1.2% of Capesize vessels out of service for scrubber installations. Scrubber installations are expected to continue throughout the first half of 2020. Clarksons sees 60 scrubbers Capesize installations as of June 25, 186 in January 2020, and 253 by mid-2020.

The ongoing removal of vessels will continue to provide support for some time to come.

Source: Clarksons

Regarding the issue of slow steaming - With vessels heading to the shipyards in greater numbers, could a small contribution to the recent slow steaming be attributed to shifting speeds reflecting what is economically optimal, or timely, for that specific journey?

Iron Ore

The January 25th Vale dam disaster sent Iron ore prices higher. Some forecasts called for massive supply disruptions lasting years, which had an immediate and profound impact on iron ore prices.

When the gap between current and expected prices is great enough, we often see a pulling forward of cargoes. This is common in any commodity trade and prominently figured into the container shipping strength on the China/US trade route in the back half of 2018, just before tariffs were implemented causing prices to dramatically rise.

Pulling forward distorts normal trade patterns. While it may be good for the short run, as volumes increase, it comes at the expense of future volumes, reducing required shipping demand further out.

Now, we are seeing talk of iron ore prices peaking, with a potential for declines as Brazilian output recovers more quickly than initially expected.

Source: CME Group

Expected price declines have the effect of causing buyers to postpone purchases as long as possible to secure the lowest price.

Therefore, we might be seeing the end of pulling iron ore cargoes forward and shifting toward a trend of pushing back when possible.

Fleet Balance

The number of available vessels has a significant impact on rates.

Often we see a healthy ebb and flow of laden (loaded) and ballast (unloaded) vessels, even though speeds do vary, with laden voyages typically a bit slower.

However, sometimes with severe shocks, we can see that balance distorted. The Vale collapse was one of those incidents, and, I believe, impacted the balance of vessels which contributed significantly to the aforementioned BDI collapse, and now supports the multi-year highs.

With a supply side shock of this magnitude, the logistics supporting these iron ore volumes were inevitably impacted.

Which brings us to our last question about vessel speed - Could the slow steaming lately reflect ballast vessels slowing as they awaited new orders following this massive shock?

Source: VesselsValue

In the Capesize class, following the Vale tragedy, the ballast portion of the journey saw speeds slowing while laden voyages remained consistent, which suggests that could be the case.

Turning back to the fleet balance, we have seen some highs and lows in a certain metric that suggest fleet balance was significantly distorted following the incident.

On January 23rd, the Capesize class had 48.7% of the fleet laden and underway. 43.8% of the fleet was underway in ballast. 7.5% was not underway, representing port calls, dry docks, inactivity, etc.

Then came the Vale disaster and Capesize flows suffered a serious setback. As the availability of vessels grew quickly, measured by those in ballast (which implies current or near term availability), rates plunged to extraordinary levels swiftly.

But by April 5th, the percentage of Capesize underway in ballast swelled to 51.3%, a figure not seen in VesselsValue's data until this point. Furthermore, April experienced the biggest ton mile demand drop so far in 2019, down 8.6% compared to the previous year.

That also represented the approximate time when the Capesize, and BDI, fortunes began to shift as tonnage grew tighter from early April onwards.

Source: stockcharts.com

Of course, the implication here is that things will not settle perfectly back into balance following a shock of this magnitude. Ripple effects will continue throughout the market.

Currently, it looks like we are now trending toward a lower than average number of vessels in ballast indicating a tight market, playing to this current rate strength. Those will eventually discharge their cargoes, likely in a less collective manner this time around, bringing around a new cycle. Each cycle brings us closer to a re-balancing.

As many know, the market typically ebbs and flows back to a balance following a shock, creating highs and lows that are beyond what would be expected. Could this be the case here with the sudden drop and rise of the BDI and especially Capesize fortunes? After all, the Capesize class was the most impacted by this Vale shock as their fortunes are tied more heavily toward iron ore than any other.

It's also noteworthy that much of the strength lately in Capesize rates can be attributed to the Brazil-China rate hitting decade highs, possibly prompted by pulling too much tonnage out of the region too quickly, as estimates of an iron ore supply crisis in the region are appearing a tad overblown. This has left vessel availability very tight in the Atlantic.

Panamaxes

Readers may have noticed that the short-term shocks above revolved around discussion of the Capesize class, with no mention of the Panamax. But the Panamax class has been gaining ground, so what's behind the move then?

As noted above, owners may have pulled too many Capesizes out of the region too quickly. If that were the case, Panamaxes would benefit not only because of Capesize availability issues but also as Capesize rates increased relative to Panamaxes.

From July 23, 2018, through January 23, 2019, just before the Vale disaster, looking at just the Capesize and Panamax classes, Panamaxes represented 55% of the total vessels employed between those dates out of Brazil.

But following the disaster, starting on January 26, Panamaxes represent 60% of the total.

"Fronthaul and transatlantic trades for capesize vessels remain the brightest spots, where shortage of available early units have forced major Brazilian exporters to split capesize stems destined for China into panamax lots at high cost to secure tonnage," ship broker Fearnleys said in a report.

Additionally, it looks as though a bumper crop of Brazilian winter corn is adding to the agricultural haul, as 72.35m tons is expected, a 34.2% jump YoY.

Furthermore, Panamaxes are experiencing strength from coal demand, which continues to show resilience and likely will provide ongoing support.

Beyond these short-term factors is a market that will ultimately be dictated by structural fundamentals in the long run.

China Steel/Iron Ore

It's no secret that China deserves to be a focal point of dry bulk research, being an epicenter of demand for so many key commodities.

Chinese steel production over the first six months has risen approximately 10% YoY, heightening demand for iron ore.

This robust steel production was prompted by attractive margins.

Overseas supply constraints and high prices have forced China to tap stockpiles, bringing them down to 2-1/2-year lows of 115.25 mt at the end of June.

Source: WSJ

These high iron ore prices have also led to Chinese steel companies' profits falling by 18% in the first five months of the year because of rising costs.

At the same time, steel stockpiles are growing, up approximately 17.3% YoY.

Obviously, the new reality of high iron ore prices, increasing steel inventories, shrinking margins, and dwindling port stocks is unsustainable with regard to 1H 2019 output - if the correlation between profitability and production holds.

Therefore, we will likely see steel output adjust accordingly unless we can see steel prices rise allowing producers to maintain healthy margins.

However, as iron ore prices retreat (either through demand destruction and/or output gains), a rebuilding of port stocks may provide a reprieve for dry bulk demand.

Obviously, this situation presents a bit of a wild card with iron ore prices and steel margins playing a key role in determining both steel production and iron ore restocking at ports.

Nevertheless, the demand side trend for iron ore imported into China appears clear. 2018 saw a 1% decline, and 2019 is already seeing a 5.3% YoY reduction.

A Note on Supply

Before we go, here is a quick update on supply.

The Capesize class has benefited lately from very favorable net fleet growth, allowing the demand side turmoil to play out amid a stall in fleet additions.

Low rates paved the way for a large number of demolitions in the Capesize class over the past 18 months, while newbuilds hitting the water slowed.

Source: ShipBrief

But gross fleet growth will be resuming in a big way over the next 18 months, coming in at almost 10% over that time, meaning it will be challenging for retirements to keep net fleet growth subdued.

The saving grace here may be upcoming 2020 Sulfur Cap. As indicated by the level of scrubber installation activity, the Capesize class has a strong incentive for cost control and efficiency.

Suggestions of a two-tiered market abound, with drastically different on the water costs projected for vessels with and without scrubbers. But other tiers should be included, like Eco vessels, which represent highly efficient vessel and engine designs bringing about significant fuel savings. Additionally, Eco vessels with scrubbers represent potentially the ultimate in cost savings.

Left in the dust will be non-eco vessels without scrubbers.

Source: Data courtesy of VesselsValue - Chart by Value Investor's Edge

There are 253 Capsize vessels on the water that have undergone or are scheduled for scrubber installation through June 2020. While only a handful of active Capesize Eco vessels have scrubbers, there are 54 scheduled for delivery, representing a new level of efficiency older vessels without scrubbers must compete with.

Currently, there are 179 Capesize vessels without Eco engines, that are not scrubber equipped and are older than 15 years of age. They will find these new costs and competition difficult to shoulder even at current spot rates. 99 of those vessels are 18 years or older, while 68 are 20 years old and beyond. Typically, vessels in this age group are not economically viable candidates for scrubber installations.

Charterers have been opting for Eco and scrubber equipped tonnage making any sort of long-term time charter difficult to obtain for these inefficient vessels.

A high level of scrapping activity can be expected if we see MGO rates significantly higher than spot rates can support. Significantly is a keyword there, as owners expect the HFO/MGO spread to narrow as time moves on and minor losses at first may not inspire heavy scrapping if conditions are expected to improve.

Conclusion

The recent dry bulk rally has been a welcome relief from a first quarter that looked to be spelling disaster for 2019.

However, we must keep things in perspective. In their July 9 report, Breakwave notes that the BDI average is still down 24.6% YoY, while average Capesize spot rates are down 25.3%, and average Panamax rates are down 23.6%.

Short-term factors look to have been responsible for quite a bit of the downward pressure experienced early in the year as well as the ensuing recovery.

But not everything beneficial lately is a short-term shock. Increasing dry docking for scrubber installations, which looks to be a noticeable tailwind over the next couple of years has been playing a stronger role.

Additionally, strong coal volumes and harvests look to be supporting the mid-size classes.

The notion of slow steaming gaining traction on a sustainable level remains a bit questionable this early on as several factors could have played into this speed reduction as of late.

On the downside, potentially, iron ore pricing could become an issue if futures present a compelling reason for delaying purchases. The pace of recovery of iron ore supply will be reflected in futures pricing and the magnitude of the shift will likely be apparent in short-run iron ore cargoes.

A fast recovery in supply may actually work against iron ore cargoes in the short run as prices fall and buyers delay purchases when possible to capture better future pricing.

Future vessel supply in the Capesize class appears a bit challenging, however, ample demolition candidates are present. The level of demolition activity moving forward will be dictated by a combination of spot rates and MGO pricing.

The latest downturn at the beginning of the year coincided with typical seasonal weakness, and the ensuing recovery also joined historically relevant dates for a seasonal dry bulk recovery. This strong seasonality has sometimes abated at the beginning of August. The historical rise in April and decline in August has been observed lately in 2015 and 2018 with regard to Capesize spot rates, which again has been leading this charge.

I expect the short-term shocks to give way to the long-term structural outlook outlined in previous reports. Think of it like a rock being thrown in the water, the first ripples are quite large, but each subsequent wave is smaller until a balance returns.

We have been hit with a very big rock. But fundamentally, the long-term outlook for dry bulk remains one where even subdued fleet growth will be challenged by lackluster demand side growth.

Thank You

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Disclosure: I/we 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.

Additional disclosure: Four days after this article was originally published on VIE, I sold my SBLK position.