Dry Bulk Shipping - Bi-weekly: BDI correction, near-term rebound

The BDI declined for 10 consecutive days due to weaker iron ore trade as well as seasonality, and it has already stabilised. We expected near-term rebound. Reiterate UNDERWEIGHT.

BDI’s correction due to seasonality. The Baltic Dry Index (BDI) declined by 18% over the past two weeks, mainly due to seasonality. Weak coal demand, quiet grain trade, and fewer chartered-in activities from Australian iron ore miners caused BDI to fall for 10 consecutive days. Rates stabilised later in the week ended 14 August.

Capesize. Fewer chartered-in activities from iron ore miners hence eased ports congestions in China, Brazil and Australia dragged down the Capesize rate. Average earnings fell by 2.5% wow to US$42,972/day.

Panamax. Panamax rate recorded a bigger decline than Capesize due to quiet grain exports from Latin America, weaker global demand for coal, and China’s decrease iron ore import from India. Average earnings fell by 0.6% wow to US$15,390/day.

Handymax/Handysize. Dragged down by Capesize and Panamax rates as well as fewer enquiries, average earnings of Handymax fell by 11.9% wow to US$17,625/day.

We expected a rebound in BDI in the near term after an 18% decline in two weeks. We see strong production of small steel mills in China and a global recovery in grains and other minor bulk trades helping the rates to rebound in the next two weeks. In the longer term, we maintain our conservative view with a BDI forecast of 2,500 for 2009 based on our 2009 steel production forecast of 514mt, considering steel inventories are building up and steel prices are showing signs of weakness.

Rise in iron ore stockpiles stops. The continuous rise in Chinese ports’ iron ore inventory was over. On 14 August, the inventory decreased by 1% to 74.55mt, from 75.29mt, still at a high level. Small- to mid-sized steel mills were rapidly resuming production while fewer chartered-in activities from iron ore miners caused the first two weeks of decline in iron ore inventories since the beginning of the year.

In our shipping sector’s 1H09 results preview, we raised the fair price of COSCO (1919.HK/SELL) and China Shipping Development (1138.HK/SELL) to HK$8.50 and HK$10.40, respectively, but maintain SELL rating. We also raised the fair price of Pacific Basin (2343.HK/SELL) and STX Pan Ocean (STX.SP/SELL) to HK$5.80 and S$11.00 respectively in the 2Q09 results update, and maintain SELL rating. We suggest selling expensive dry bulk stocks. COSCO is our top SELL.

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Dry Bulk Shipping - A summer lull?

A combination of high commodity inventories, the ongoing investigations into iron ore irregularities, and the parity between domestic and imported prices of iron ore and coal may put pressure on dry bulk rates during the summer months. Despite the more bullish steel sector fundamentals for 2H09, we worry that domestic Chinese sources of iron ore and coal may supplant imports as prices increase. As a result, we maintain our UNDERWEIGHT stance on dry bulk shipping, with weaker iron ore and coal imports in 2H09 being the key potential downside catalyst. We retain our UNDERPERFORM recommendation on all the stocks in our universe, except for TTA which we upgrade from Underperform to NEUTRAL on the basis of its cheap asset valuation. Earnings and target prices have been revised higher for all stocks except for Maybulk, as we incorporate the higher BDI forecasts.

Dry Bulk Shipping - On the doorstep of a correction?

The substantial rise in the Baltic Dry Index over the past six months, despite global weakness in steel production and electricity demand, has been driven single-handedly by Chinese buying of iron ore and coal, as the freight-inclusive cost of iron ore and coal imports fell below domestic alternatives from the start of 2009. However, the tsunami of imports may be coming to an end. Adding the rise in the fob prices of commodities and the more expensive freight, the cfr prices of imports have now closed the gap with domestic Chinese prices. Furthermore, we expect sequential capacity growth of some 10.2% in 2H, against just 3.1% growth in 1H. These factors could cause the average BDI for 2H09 to be lower than in 1H09. Therefore, we remain UNDERWEIGHT on dry bulk shipping and continue to recommend UNDERPERFORMs throughout our universe. We also downgrade Pacific Basin from Neutral to Underperform.

Baltic Dry Index - expected correction in June / July

Background: The BDI surge is driven by very strong purchases of iron ore by small/medium Chinese steel mills and traders:

1. The small Chinese mills produce the bulk of long steel products, which may have seen a pick-up in demand in recent months from the Chinese stimulus programme. They also expect to see a further pick-up in long steel product demand in the quarters ahead.

2. The price of long products has risen in line with demand, and the small/medium mills are able to capitalise on the higher product price, against the very low spot price of iron ore, to capture a 200 yuan/tonne profit on the production of long products.

3. The traders are buying iron ore because they are betting on a rise in the iron ore price in the quarters ahead. In fact, they made a good call, since iron ore spot prices reached as low as 40% discount from last year's benchmark price early 2009, but are now trading at about 33% discount from last year's benchmark.

4. There is also a rush in April and May for more imports from India, as India will enter its monsoon season from June to September, which typically restricts the loading of vessels on its west coast Goa port.

5. About half of the Chinese iron ore mines have closed down over the past few months, because their cost of production is around US$67-73/tonne and they sell for US$87/tonne, whereas Indian iron ore can be imported at a cfr cost of US$67-68/tonne including freight. Indian ore is higher quality than domestic Chinese ore. Same goes for Australian ore. As a result, Chinese mills' reliance on domestic iron ore has reduced from 35-40% in Jan 09, to just 25% in Apr 09.

Reasons #1-4 are cyclical, where reason #5 is more structural.

Is this sustainable? There are a couple of reasons why BDI is ripe for a pullback.

1. Steel market experts have recently warned that there is a big surplus of long product inventory in China right now. Not to mention a huge surplus of iron ore inventory. Many steel mills in South Korea, Japan, Russia and Ukraine are exporting HRC and CRC into China, to take advantage of the higher domestic Chinese price against low international price. This could exacerbate the oversupply situation, which could lead to lower finished steel prices. If this happens, and iron ore prices continue to appreciate, the 200 yuan/tonne profit margin could narrow or disappear. This could cause the swing producers (small/medium mills) to cut output, leading to lower imports of iron ore.

2. The coming Indian monsoon season.

Will the pullback take BDI below breakeven? We don't think so, because of the Chinese stimulus spending.

An explaination the movements in the Baltic Dry Index (BDI)

This is a great and informative article....

The rise in the BDI has taken everyone by complete surprise. But in reality the reason for the rise is rather simple. China binge buying Iron Ore against all expectations with imports rising at 27+ pct higher in 2009 than for 2008, based on the annualized results of the first 4 months of this year, shows you where the big move from the Demand side has come from.

This rise in Iron Ore imports is despite the fact that Steel production in China in the first four months of 2009 has been roughly at the same levels as we had seen in 2008. An explanation for this increased Iron Ore imports could be from the fact that domestically produced Iron Ore in China is of arather poor quality and quite expensive when compared to spot imported prices. Another explanation could be that of speculators getting into the import market to try and get hold of 'cheap' Iron Ore that would possibly be required under the Chinese Governments USD 586 Billion stimulus plan. And a third could be the impending conclusion of the Iron Ore Contract Price negotiations.

Obviously, when you binge buy and compress imports of a single commodity, carried mainly by Cape size ships, into a very short space in time, you tend to create two issues at the same time. Firstly, you tend to push up freight rates due to the time-compressed/explosive demand growth for that ship-sector. And more significantly, you create queues at loading and discharging ports which tend to reduce availability of spot ships driving prices even higher. Combine this with delayed delivery schedules of dry bulk ships during Q4 08 and Q1 09 and you have the ingredients of a perfect storm especially when you take the number of Cape size ships that have been sent to the scrap-yard during the last 6/9 months.

The change in the average Time Charter (t/c) rate or earnings per day per ship in the different size categories is instructive.

The BDI hit its recent peak on the 3rd June 2009 closing at 4,291 points with the average t/c rate per day per ship for the Capes at USD 93,197, Panamaxes at 28,110, Supramaxes at 19,470, and Handies at 12,668. Compare these numbers with what was prevailing on the 5th December 2008 when the BDI hit a two and half decade low of 663 points, then Capes were earning a paltry t/c rate of USD 2,763 per day per ship, the Panamaxes were at 4,058, Supramaxes at 5,726, and the Handies at 4,352.

Clearly the BDI is more reflective of the Capes and the Panamaxes, as the Panamaxes are a shadow of the Capes, than of the market as a whole.

Besides this sudden, sharp and unexpected rise in the market will have two very bad consequences. Firstly, scrapping will come to a grinding halt. This will stop the squeeze on the supply side which was originating from the permanent removal of ships via the scrap-yards. Secondly, with the new 'confidence' in the market, all the delayed deliveries of new ships from the builders might make a startling reversal and lots of new ships could suddenly start appearing on the market.

Both these consequences will result in long term damage to our market and eventual balance between demand and supply will be pushed further away on the time horizon.

In our opinion, based on the congestion at Chinese discharge ports and the present increased level of Iron Ore imports the index could actually cross 5,000 points. We think that congestion should clear up once this binge buying of Iron Ore abates or more new Capes are delivered from the ship-yards than the demand can absorb. Once one or both of these events take place, congestion will vanish very quickly with the BDI crashing down as quickly as it has advanced.

The fundamentals still overwhelmingly point to a world economic recession with tremendous job losses and we suspect that will put a real dampener on the current burning hot BDI.

BDI's first decline after a long sharp rally since end-April. Short-term investors should lock in gains

The Baltic Dry Index (BDI), the barometer of spot dry bulk shipping freight rates, saw its first correction after a long sharp rally since 29 April. The BDI fell 5% last night to close at 4,093. Share prices of dry bulk shipping stocks synchronise closely with the BDI. Most dry bulk shipping stocks have doubled in the recent rally. I recommend short-term investors to lock in gains. The risk of vessel oversupply with the influx of newbuilds from 2H09 remains. Our fundamental view on the dry bulk shipping sector remains UNDERWEIGHT.

BDI will likely reverse on lower iron ore imports and easing port congestion

China's iron ore imports have been rising sharply in the last 3 months (Apr 09: +33% yoy to 57mt) despite its sluggish crude steel production growth (Apr 09: -2.8% to 43mt). This was mainly because traders were stockpiling iron ore in anticipation that prices would rise, according to the China Iron and Steel Association (CISA). This has led to a near record high iron inventory of 70mt, resulting in many ore carriers congested at the Chinese ports. Figure 3 shows rising Capesize tonnage waiting at Chinese ports.

The Baltic Dry Index (BDI) has risen 250% ytd to 2,707 from a extremely depressed level due to 3 reasons a) some easing in trade financing, b) high iron ore cargo shipments in the past 3 months, and c) the port congestion in turn soaks up more vessel capacity, boosting spot freight rates.We expect China's iron ore imports to ease, which in turn will ease port congestion. This will have a double-whammy impact on spot freight rates.

The BDI breakeven level for most dry bulk shipping companies is about 2500. At the current BDI level of 2,707, the profit level remains low for most companies. They will likely make losses in spot trades when the BDI reverses. The China's Ministry of Industry and Information Technology has issued a circular to authorities to control the number of steel traders and to crackdown on stockpiling.

We believe the current rally in BDI is not sustainable and will likely come off. We recommend selling dry bulk shipping stocks into strength. They have had a good run in the current stock market and BDI rallies. We remain UNDERWEIGHT on the dry bulk shipping sector in view of alarge influx of newbuilds into the market from 2H09 onwards.

BDI might test 200-day EMA

Based on current trajectory, good chance the Baltic Dry Index might test its 200-day EMA soon. This development could lead to positive sentiment spilling over to STX PO, Courage Marine and Mercator Line.

Dry bulk shipping stocks are not good proxies to China's rising commodity demand

It's true that investors' first reaction is to treat dry bulk shipping stocks as commodity plays. While share prices have risen, freight rates are still in doldrums. We have just experienced the first market rally from a recession trough. In such a rally, investors don't dwell deep into fundamentals. They just buy stocks that are sold down a lot, in anticipation of rising demand and completely ignore the supply problem.

I expect over the next 2 quarters, investors will start to differentiate the real recovery stocks from those that will be in doldrums for a while. The shipping stocks belong to the latter category. As quarterly results continue to pose losses, investors will wake up to the fact that there's no quick fix to the oversupply problem. I expect rising vessel deliveries in the next few quarters. Current Capesize orderbook stands at 105% of global Capesize fleet. Total dry bulk orderbook is 71% of global overall fleet. Vessel cancellations/delays can't fix 2009's problem, but might fix 2010's problem. That said, I think the dry bulk shipping market would likely face oversupply for 2 years in view of weak global economic growth (i.e. a U-shaped recovery).

This time round, the problem in the shipping market is supply, not demand. The current situation should not be equated to the inflexion points of the dry bulk shipping market over the last 5 years. Despite rising number of Capesize vessel fixtures (i.e. rising vessel demand in anticipation of rising iron ore cargoes) since Nov 08, freight rates (proxied by the BDI) are still in doldrums (see below chart). This time round, it is not just about the return of demand. The litmus test of a shipping recovery is about overcoming oversupply.

BDI rose 49 points after falling 3 consecutive days

Good trading opportunity if BDI continues to head north.

Baltic Dry Index (BDI) rose 49 points or 2.7% to 1,895 after falling for three consecutive days.

We might see some upside in share prices of dry bulk shipping stocks if the BDI continue to rally.
Our top trading stocks are STX Pan Ocean (STX SP), China COSCO (1919 HK) and Pacific Basin (2343 HK).

Bulk declines ahead

We held a conference call with Peter Kerr-Dineen, chairman of leading ship broker, Howe Robinson, and former chairman of the Baltic Exchange. KerrDineen’s outlook for the dry-bulk market reinforced our view that the sector retains substantial oversupply risk and that freight rates will remain under pressure in both short and medium term. As such, the industry continues to face a deflationary asset-valuation prospect and we maintain our Underweight recommendation on the sector.

Demand remains benign. On demand, Kerr-Dineen is above consensus, forecasting flat to a 20m tonnes decline for iron ore, and small falls for both coal and grain, while China coastal shipping should grow at 5%. We broadly agree with these estimates, with the exception of China coastal shipping, which we expect to contract as coal shipped from northern ports to southern power plants suffers with weak power generation. The risk to our view remains that there is little import substitution if iron-ore prices remain high, permitting Chinese mines higher on the cost curve to remain viable.

Oversupply still a key concern. The Baltic Dry Index (BDI) traded in a normal range of 1,000-2,000 band from 1985 until 2003, when the supercycle took off. At the bottom of the range, vessels cover cash operating costs as utilisation rates fall to 80-82%, and then fully cover buildup costs (including depreciation and interest) as utilisation hits 95%. Kerr-Dineen flagged that the massive supply/demand disjoint will take a long time to balance, resulting in the market reverting to the long-term trading range of 1,000-2,000 in 2009 (we forecast 1,650), but without major cancellations/delays in deliveries and scrapping the market is likely to head down to below 1,000 in 2010 (we expect an 1,120 average for 2010).
Short-term squeeze to end. The short-term BDI bounce is driven by Chinese ore traders restocking and with idle vessels hitting 130 at year end it created a shortage of available tonnage in February. However, we believe the actual underlying demand in China remains subdued given the gloomy outlook for property projects, which account for 40% of steel usage. KerrDineen expects capacity to become available in March easing supply constraints allowing freight rates to decline again.

We could head back to 1986 asset-price levels. Asset price deflation for ship values will be dramatic if the market is going to head back down to below 1,000, with vessels then being valued at scrap. At the other extreme, a premium to new-build value and in a normal cycle, values should reflect the mean cost of building a new vessel less straight-line depreciation of 4% per annum. So, we could be potentially heading back to 1986 levels if 2010 results in a sub-1,000 level again and cash costs struggle to be covered.

Japan shippers remain a conviction SELL because earnings will collapse from FY3/09 onwards, as 45-60% of their recurring profits came from the dry-bulk spot market in FY3/08 during the super commodity cycle in 2003-08. The commodity super cycle is petering out as supply increases to meet past demand expectations of high perpetual growth. Meanwhile, performance of Japan’s container-shipping businesses (second-largest segment in sales terms) will remain weak with no recovery until 2010, given slowing global demand and excessive capacity in the market. We have a SELL rating on Mitsui OSK (9104 JP - ¥577 - SELL) (30% downside, 0.8x FY3/10CL PB), and Underperforms on Nippon Yusen (9101 JP - ¥457 - U-PF) (23% downside, 0.7x FY3/10CL PB) and Kawasaki Kisen (9107 JP - ¥362 - U-PF) (12% downside, 0.5x FY3/10CL PB).

Regional - SELL China Cosco and U-Ming. Regional shippers’ share prices will also come under pressure as spot freight rates decline and with the realisation that asset prices will continue to plummet. With 80% exposure to the spot market, 43% of capacity in capesize vessels, high charter costs and an expensive new build programme, China Cosco (1919 HK - HK$5.11 - SELL) sees 35% downside potential to our target price of HK$3.34. Elsewhere in Taiwan, we remain bearish on U-Ming Marine (2606 TT - NT$44.0 - SELL), which carries 40-50% spot-market exposure and sees 34% downside to our price target.

The Baltic Dry Index (BDI) continues to rally.

BALTIC DRY Index +14.6% at 1,316 Wednesday, or up 51.6% over past 12 sessions. Use the following link to track the BDI. http://www.dryships.com/pages/report.asp