The Commodity Investor: Tracking the Global Economy – The Baltic Dry Index

Columnist Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the bestsellingCommodities For Dummies, published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities. 

The Baltic Dry Index (BDI) is an important gauge of the world’s economic activity. The BDI measures shipping rates for dry commodities such as iron, coal and grains across the globe. The index covers 26 of the major shipping routes used around the world, and is therefore a good indicator of global economic activity.

In theory, when BDI rates are high that usually signals strong shipping activity which  usually means a strong economic situation. When rates are elevated, that means demand for ships to transport important commodities around the world is high. Up until the 2008-2009 period, the BDI did a wonderful job of measuring economic strength in the world’s economies. As economies grew the BDI accurately reflected this economic growth through increased maritime rates.

However, right after the 2008 economic crisis the BDI became a less reliable indicator of economic conditions globally. To be sure, the BDI dropped precipitously during the crisis reflecting the crippling economic conditions the world economy was facing. However, as the economy started recovering and global import and export activity picked up (especially in maritime trade), the BDI did not reflect this economic recovery.

The BDI closed at a level of 700 in February, down from 4600 levels in end of 2009. This drop of over 80 percent represents a dramatic move in a relatively short period of time. What’s even more puzzling is that this precipitous drop in the BDI does not correspond with economic realities, which actually saw a recovery with increased trade following the 2008 crisis. So, is the BDI an accurate measure of global economic growth and, more importantly, how can you use it to make sound investment decisions?

History of an index

The Baltic Dry Index traces its roots to 18^th century London, where grain traders began recording shipping rates and aggregate them into a single database to make pricing of transporting goods across the seas easier to track. Today, the BDI measures a weighted average price of the four main types of dry bulk cargo vessels (Capesize, Panamax, Supramax and Handysize) in key shipping routes. As such the BDI is a good measure of the costs it takes to transport key commodities such as iron ore, coal and coffee beans.

In January 2012, the BDI started making headlines because prices collapsed, dropping about 60 percent for the month. This has driven many market commentators to question the reliability and relevance of the index. In order to understand this sudden price drop, it’s critical to examine the historical patterns of the index which will allow us to better appreciate its uses, and help us use it as an additional tool in our investment toolkit.

The price mechanism of the index is influenced by two key factors: the first is the demand volume for shipping vessels, and the second is the supply of shipping vessels in the marketplace. Traditionally, the demand for shipping vessels has been the main driver of price shifts in the index since the number of available ships remained pretty constant from 2000 to about 2007. During this period, the index was driven by demand for ships: so the greater demand for ships to transport iron and coffee was immediately reflected in the index. In such an environment it’s easy to extrapolate that higher index prices meant stronger economic activity as measured by import/export activity.

Beginning in 2007, however, we started seeing an important shift in the marketplace. As a result of increased trade in commodities, many companies went on a shipbuilding spree to accommodate for all this growth. 2007 was indeed the year that saw shipbuilding orders reach a historical high. Since it takes about 3-5 years to fulfill such an order, shipyards around the world went on overdrive building new ships, and this wave of ships began hitting the market in 2010 and 2011, exactly 3 years after the large orders were placed.

Take the following figures for example: in 2007 the number of new ships entering the market was 45; in 2008 it was 50; in 2009 it more than doubled to 115; in 2010 it was 214; and in 2011 the number of new ships in the marketplace jumped to an astounding 260. This dramatic shipbuilding activity has resulted in a severe oversupply in the marketplace, and for the first time the supply side of the index began dictating prices, as opposed to the demand side.

What’s an investor to do?

The Baltic Dry Index is a useful key indicator in the commodities markets. It remains an important measure of economic activity even though its indicative characteristics have been skewed by excess supply of ships. If you’re an investor in commodities, the BDI is a helpful gauge of the trading of certain key commodities, such as iron ore, coal and coffee.

If you’re interested in trading the BDI, you can look at The Guggenheim Shipping ETF (ARCA:SEA), which is an ETF that aims to track the movements of companies that base their pricing mechanisms on the BDI.

Additionally, you can also invest directly into dry cargo shipping companies. One such company is DryShips Inc. (NASDAQ:DRYS), which owns and operates a fleet of dry bulk vessels in key shipping routes. With a $1.5 billion market cap, it’s one of the bigger names in the industry and is also one of its more profitable ones, boasting net profit margins of 11.5 percent (2011 figures).

My advice is to monitor the index regularly, at least on a weekly basis, because it can be fairly volatile. My outlook for the shipping industry in general, and dry bulk cargo specifically, is still fairly bearish. There were so many orders placed in the 2007-2009 period that I still expect to see even more ships hitting the market between now and 2014. Make sure to keep that in mind as you enter this market.

Securities Disclosure: I, Amine Bouchentouf, hold no direct interest in the companies mentioned in this article.