Understanding World Indexes: Baltic Dry Index

The Baltic Dry Index/Dry Bulk Index (BDI) is an index covering dry bulk shipping rates and managed by the Baltic Exchange in London. The index provides an assessment of the price of moving the major raw materials by sea. It is a daily average of prices to ship raw materials. It represents the cost paid by an end user to have a shipping  company transport  raw  materials  across  sea  on  the  Baltic Exchange.  The  Baltic  Dry  Index  is a composite of three sub-indexes that measure different sizes of merchant ships - Capesize, Supramax and Panamax carrying a range of commodities including coal, iron ore and grain.

The Baltic exchange maintains prices on several routes for different cargoes and then publishes its own index, the BDI, as a summary of the entire dry bulk shipping market. Changes in the BDI can give investors insight into global supply and demand trends. To be more precise, the index measures the demand for shipping capacity versus the supply of dry bulk carriers. However, since the demand for shipping varies with the amount of cargo that is being traded in the market and the supply of ships, the index indirectly measures  global supply and demand for the commodities.

As the dry bulk primarily consists of materials that function as raw material inputs to the production of finished goods, such as concrete, electricity, steel, and food, the index is also seen as a good economic indicator of future economic growth and production.

Investing in the Index

When an investor buys a shipping stock which has presence in dry bulk, they are effectively buying into the Baltic  Dry  Index.  But  the  quantum  of  exposure  depends  on  how  the  company  enters  into  shipping contracts. For  instance  if  the  company has  its ships  contracted on  a spot  basis  then  it  implies  that  the contracts are  directly corelated  to the daily  price  of the  BDI.  This means  that their revenues are  directly dependant on the movement of the index. For example if the BDI price shows an increase it would entail a profit for the shipper. Another way of contracting is the time charter contract which means the shipper has entered into a contract which is usually 2-5 years in duration. This contract follows a fixed daily rate which protects the shipping companies profits in case of a fall in the BDI price. This gives the company an opportunity to hedge their risk against the falling BDI rates.

What makes the BDI rates / freight rates fluctuate?

The freight  market is subject  to a wide  range  of external variables, but it is  fundamentally driven  by the following factors:

•      Commodity demand – This can be understood from the levels of industrial production and the demand for different commodities such as steel , coal , iron ore, other metals , crude oil across the globe. Also, the performance of the specific industry gives us an indication of the level of demand. If the commodity demand is  strong,  BDI  rates  will  increase  regardless  of  the  spot  price  of  those  commodities.  For example – China being a major producer of commodities, if coal is demanded by them, then the BDI rates would see an increase.

•      Supply of Fleet – This depends on the different types of vessels available and the number of vessels being delivered/scrapped.The average age of ships is 25 years. If the average age of a ship is closer to that number, supply would decrease in the short term. But on the other hand supply is also determined by the delivery of new vessels.

 •    Seasonal pressures -The weather has a big impact on the shipping demand. For instance cold weather may increase the demand for coal and other energy creating raw materials which would push up the freight rates.

 •      Bunker  prices -With bunker fuel  accounting  for  between  one  quarter  and  one  third of  the  cost  of running a vessel, oil price movements directly affect shipowner margins.

 •      Market sentiment – Market opinion can greatly affect the freight exchange. The recent fall in the BDI can   be   attributed   to   many   companies   forecasting   lower   global   growth   and   cutting   their production/demand targets.

 

Index Interpretation for an Investor       

 
 

The index is the purest leading indicators of economic activity, devoid of speculative players. It measures the demand to move raw materials to the point of production. It helps an investor understand the demand for raw material as per the growth in the infrastructure sector and economy as a whole.

The BDI is totally devoid of speculative players as the trading is limited only to the member companies. The parties, which are relevant to secure a contract, are those who have actual cargo to move and have the ships to move it. The  BDI  will  show  how  much a company  or country  is  willing  to pay  to import raw  materials immediately.

For example, if a Chinese company has contracted out coal prices for the next year from Rio Tinto (RTP), then the  spot  price  of coal  increasing  after a mine accident will not impact that  established  contract. However, when this company is willing to pay more (per ton) to ship the coal then an investor can see that the price growth would accelerate.

When the BDI rates shown an increase, the cost of raw materials also goes up as the producers and refiners pass the cost of procuring the raw material along the value chain. At the end, the consumer would pay a higher price for the goods they derive from the raw materials, which get shipped across with a higher dry bulk rate.

For example when the rates of BDI went up in 2007 the cost of importing coal also saw a jump. A country, which meets its energy requirements through importing coal witnesses the situation that the overhead costs for factories goes up with the increase in the price of coal. As the overhead cost increases, the end product price also goes up in order to maintain the margin.

So in a nutshell we can say that when BDI increases, it has a positive impact on the margins and revenues of shipping companies. On the other hand when BDI decreases, the producers in the value chain stand to gain as their procurement cost comes down.

The index has gone through a flat move in the recent period and has seen a gain of ~10% and ~41% since the beginning of January 2010 and December 2009 resp. Note: The index has shown a strong recovery as it had not seen gains when the BDI was performing. Therefore 41% is basically on a low base. Additionally, increased OPEC spot fixtures in December 2009 and expectation of increased petroleum trading activity has led to the spurt in the index.