Many shippers have levied huge impairment costs du

Dry bulk shippers have struggled mightily in recent years. Dry bulk shipping rates bottomed in 2012-2013 with rates below operational costs. Multiple shippers, including Excel Maritime and STX Pan Ocean have filed for bankruptcy. In 1973 tankers hit bottom but shipping rates for tankers remained low until the mid 1990s Dry bulk shipping rates have risen in the last few weeks. Is this the beginning of a recovery for dry bulk shipping or is dry bulk shipping a value trap unlikely to return to profitability for years to come?

I think dry bulk shipping is interesting because it is highly cyclical. The advantage of cyclical effects is that there is a certain level of predictability. Cyclical effects are caused by the interaction of supply and demand. The cycle begins with rising demand that is followed by high profits and rising supply. A drop in demand leads to losses. Losses lead to a drop in supply until profits return which leads to rising supply until demand falls again.

The Boom: Rising Demand

What about dry bulk shipping? Dry bulk shippers prospered enormously after China joined the World Trade Organization in 1999. Demand from China for dry bulk goods rose steadily (primarily iron ore, coal and grain). Dry bulk shipping is economically a commodity. Barriers to entry are very low and the market is highly fragmented with many small competitors. Prices are set by the market. When the industry is profitable supply will increase both from existing shippers trying to increase market share and from new entrants. Rising demand after 1999 led to increases in shipping rates as measured by the Baltic Dry Index (BDI). The rise in shipping rates led to a rise in orders for newbuildings. The new shipping supply was not able to keep up with rising demand and the BDI rose enormously from about 1,000 in 2002 to a peak of 11,800 in May of 2008. The economic shock of 2008-2009 led to a decrease in demand and the BDI plunged as low as 660 in December of 2008.

The Crash: Supply Continues to Rise

When the economy crashed in 2008 the dry bulk orderbook was full at over 170 million dead-weight tons (dwt) of newbuildings. Dry bulk shipping has struggled because supply continued to expand despite weakness in demand. About 170 mn dwt of dry bulk shipping was ordered in 2007 and over 100 mn dwt in 2008. The dry bulk fleet increased by 9% in 2009, 17% in 2010, 15% in 2011 and 10% in 2012 (BofA/ML March, 2013).

Why did the supply of ships continue to increase after demand dropped? It takes 12-24 months to build a dry bulker. Some of the orders were cancelled and some delayed but most were built and shippers continued to place new orders for ships. In 2010 new orders were strong at 100 mn dwt. There are several reasons why supply continued to increase. The recession in the US bottomed in 2009 and there was hope that by the time the ships were delivered good times would be back. The price of new ships also dropped as there was now excess shipbuilding supply so shippers were enticed by low prices and easy terms. Also shipping rates bounced back in 2009-2010, the BDI went over 3000 and it seemed like dry bulk shipping was doing ok. However, dry bulk shipping was then hit by weak demand in Europe even as the fleet continued to expand. The BDI was below 2,000 for most of 2011 and below 1,000 for most of 2012 and into 2013. With the BDI under 1,000 dry bulk shippers were not only losing money but they could not even cover operating costs.

The Bottom: Scrapping

With shipping rates so low orders for newbuildings plummeted. Credit Suisse reported only 18 mn dwt of new dry bulk orders in 2012. Chinese shipbuilders are struggling and many are expected to close. Prices for newbuildings are down and fuel efficiency is up but few can afford to buy as most dry bulk shippers are losing money. Excel Maritime ran out of cash in 2013 and other dry bulkers like Genco, Eagle Bulk Shipping and Dryships are struggling with heavy debt loads. Dry bulk shippers are loath to lay up ships because it is costly to do so. However, they will sell their ships for the scrap value. The Chinese government is subsidizing scrapping to help out its struggling shipyards. Generally ship over 20 years old are candidates for scrapping. With shipping rates so low scrapping is up to 4-5% of the fleet per year. It is true that weakness in the Indian rupee is affecting scrapping but India primarily focuses on tanker scrapping, not dry bulk.

Recovery: Global Demand Rising

Dry bulk shipping has struggled since 2008 because supply has increased faster than demand. The increase in supply has now slowed significantly. What about demand? Demand dropped in 2009 but has been growing. Demand in the EU fell in 2012 but the EU seems to have bottomed in 2013 and although weak should be moving up. The US and Japan also seem to be growing modestly. The major dry bulk commodities are iron ore, coal and grain. Demand for coal is expected to drop in 2013-2014 in Europe but grow in China and India. Credit Suisse expects thermal coal trade to rise over 2%. The USDA projects world grain trade to rise 2% in 2013-2014 with Chinese imports up due to poor harvests.

The most important commodity is iron ore which accounts for over a quarter of dry bulk shipping. Iron ore is primarily used by the steel industry. Credit Suisse is forecasting world steel production to rise 3.6% in 2013 and a similar increase in 2014. Bank of America/Merrill Lynch has just raised its forecast for Chinese steel production for 2013 to 770 million tons, an increase of 7.5%. China is expected to invest in infrastructure projects to boost domestic demand. The most important piece of the puzzle is iron ore supply. Chinese growth led to a huge demand for iron and steel. Massive new iron mines are coming into production in Australia and Brazil to fill this demand. The iron ore is well in excess of Chinese demand for iron ore. This supply demand imbalance will lead to falling prices for iron ore and inexpensive iron from Australia and Brazil will take market share away from domestic iron ore in China. Credit Suisse projects iron ore to fall from $125 to 105 in q3 2013, to 100 in q4 2013 and to 95 in q2 2014 due to increasing iron ore supply. World iron ore imports are expected to grow 5% in 2013. In 2014 supply of iron ore could grow as much as 14% and demand is expected to grow over 7% with Chinese domestic iron ore production falling 11%.

The dry bulk shipping cycle seems to be poised to move into a new phase. We have passed the bottom and it looks like dry bulk shipping is on the way up. Supply and demand are moving closer into balance. New ship orders are down, scrapping of old ships is up. Demand is growing on economic recovery and increased supply of iron ore. In June 2013 the BDI rose from 800 to above 1100 on Chinese iron ore and grain purchases.

The goods news for dry bulk shipping is that it seems to have hit bottom and begun moving up. It is not clear how far up it will go. Shipping rates are rising but remain low. There is a danger that optimism will lead to new ship construction but that is a few years away. Global economic growth is fragile. Chinese growth is a concern but China's increased iron ore imports are dependent on price more than steel production. On balance I think dry bulk shipping seems likely to improve. Dry bulk shippers like Safe Bulkers ( SB ), Dry Ships ( DRYS ), Diana Shipping ( DSX ) should benefit.

Sources:

Bank of America/Merrill Lynch "Worst is behind; Upgrade Angang, Maanshan to Buy" July 16, 2013.

Bank of America/Merrill "Baltic Dry Index on a sustained recovery path" March 4, 2013.

Credit Suisse "Commodities' Forecast Update: The Return of Fundamentals," June 25, 2013.

Credit Suisse "Asia Dry Bulk Shipping Sector: Light at the end of the tunnel is a blow torch" February 21, 2013.