The Simplified Investor

One of the lesser-known fundamentals underpinning the global economy is the Baltic Dry Index, a benchmark that measures dry-bulk shipping rates. Dry bulk goods include the most commonly used raw materials, like grains, coal, and metals. When global economies are booming, demand for these inputs (and the ships to transport them) fuels high day rates for companies like DryShips (NDAQ:DRYS) to transport these goods across the world’s oceans.

The Baltic Dry Index (BDI) tracks rates in the 22 main shipping routes for these key inputs. The BDI has plummeted in the past several months, as the U.S. financial crisis has snowballed into a global economic downturn and the consumption of raw materials has ground to a halt. For example, China is the world’s biggest consumer of steel, but it has cut its consumption as infrastructure projects have slowed in response to slumping economic growth. The same situation has played out with a host of other raw goods - and as demand for materials slows, so too does the earnings growth of a dry bulk shipper.

And there’s more to the story than a simple supply-demand curve. Companies that ship goods overseas often use “letters of credit,” or contracts in which a bank will guarantee a company’s ability to pay back loans. This way, a company can take delivery of orders immediately, but pay for them weeks or even months later. When they pay, they’ve already turned the raw goods in the order into revenues by manufacturing products and selling to consumers. These letters of credit are an essential part of the shipping system - but they create risk for banks, which are on the hook for the balance owed by the company that shipped the goods in the event of a default. In today’s lame economic climate, when banks are wary of all risk, it is increasingly harder for struggling companies to pay back loans - and it has also become quite difficult for companies to get letters of credit. This means that companies can’t pay to have their goods shipped overseas - and their shipments simply sit at port, waiting for the voyage to be financed. As the cargo languishes, so too do the companies that depend on shipping orders for revenue growth.

But the credit crunch is just one reason why DryShips and its peers have seen their stock prices get hammered in recent weeks. There’s another force at play as well - shipping companies are being squeezed from both sides because while revenues dry up, the value of their assets (shipping vessels) are also declining. Forbes reports that net asset values for dry bulk ships have fallen roughly 50% in the last four months, but outstanding loans for ships and contracts have remained static - creating a situation that has quite a few parallels to what happened to homeowners and property values during the subprime lending crisis.

Shipping companies now owe more on the loans taken to build or buy a ship than the ship is currently worth. Furthermore, a company’s existing fleet is often used as the collateral to secure loans for new building projects - and as the value of these underlying assets declines, the company must post more collateral to secure a loan. This could possibly lead to foreclosures by major shipping lenders like the Royal Bank of Scotland and HSBC and will certainly lead to a slow-down in the construction of new ships, as owners become wary of taking on these costs while struggling to make good on existing loans.

So what does this mean for the dry bulk shipping business? Two things - ships sitting at anchor, with no cargo to transport (but no fuel or crew costs for a company to pay either); or, more ships hitting the scrap heap as companies downsize to stay efficient. It’s unlikely that the turnaround for shippers will be quick, as revenue growth will depend on a revitalized global economy creating demand for raw materials. It seems unlikely that stock prices (down 75% in this industry in the past six months) can fall any lower - but if 2008 has taught investors anything, its that you never know just how low we might go.

Tags: Baltic Dry, Baltic Dry Index, BDI, dry bulk goods, Dry bulk shipping, DRYS, DryShips, Economics, Investing, Shipping, Stocks, Transportation

This entry was posted on Thursday, October 30th, 2008 at 7:22 pm and is filed under Shipping, Stocks. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.