The Capesize Index: Damn If You Do, Damn If You Don't

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In a world with tens of thousands of financial indices, the dry bulk market stands out when it comes to benchmarking, with the Baltic Exchange remaining the dominant provider of price information and index constitution. As the largest vessel category in dry bulk, the Capesize 5TC Average Index has become the go-to index for market participants and industry watchers alike when one needs to take the sector pulse as a whole. Yet, for the ones who closely follow the market it is important to not only understand how such a index works but also the different calculations behind it, something that we have found is not really the case even when it comes to seasoned shipping professionals.

More importantly, for investors, it is equally critical to understand the index and the mechanics behind it as it usually acts as the benchmark for many of the industry’s calculations and forecasts. While running the risk of confusion and complicated math behind the calculations, we will attempt to debunk the index and the physical trading mechanics behind it to the best of our ability as observers.

The Capesize 5TC Average Index is basically the weighted average of 5 different routes around the world. The weightings are not equal, but are predefined as follows (definitions adjusted for simplicity):



25% represents the daily roundtrip earnings for ships in the Australia to China route

25% represents the daily roundtrip earnings for ships in the Americas to Europe route

25% represents the daily roundtrip earnings for ships in the Brazil to China route

12.5% represents the daily one-way earnings for ships in the Atlantic to Pacific route

12.5% represents the daily one-way earnings for ships in the Pacific to Atlantic route



As one can see, the “basket” is quite diverse and not precisely defined. For example, the “Atlantic to Pacific” route can be very long or very short in duration depending on loading and destination ports and the same goes for the reverse route. The Americas to Europe roundtrip route can be as short as 10 days and as long as 60 days, again depending on ports. More importantly, the above weightings look nice and round, but they don’t really match the actual physical cargo flows in the Capesize sector. After all, Brazil and Australia dominate the market when it comes to Capesize loadings while China is by far the most popular destination for Capesize vessels.

Europe accounts for ~7% of global iron ore imports and about 10% of global coal imports, with a lot of cargoes being transported by smaller vessels, yet it gets a 25% representation in the Capesize index (even more if you assume the “backhaul” weighting).

On the other hand, Australia, that accounts for 60% of all global iron ore seaborne exports and some 30% of all global coal trading gets a mere 25% representation in the Capesize index.

Now, the above is not to criticize the construction of the index. After all, it is a very useful tool that has worked quite well for decades and has also evolved overtime and in a gradual manner to capture the changing dynamics of the dry bulk market. It is an index and the purpose is not to constantly change based on different patterns and economic differences but to show the evolution of the market over time and make comparisons meaningful. A vastly different index that constantly adapts would defy the purpose of being able to measure and compare similar values over time.

However, market participants and investors better understand how the index is calculated, as there are a lot of instances of either profitable missed opportunities or potential hedging mistakes if one just assume the state of the Capesize market is a reflection of the 5TC Index.

A great example is what is currently happening in the Capesize market. The current 5TC Average stands at ~21,000, a relatively high level for this time of the year. However, the most popular trading routes, namely Brazil and Australia to China, are some 30% lower, to around 14,000. To assume that currently owners earn 21,000 per day, on average, would be a mistake, as the actual weighting of trade is vastly tilted towards Australia and Brazil and thus the actual market weighted average is closer to the 14,000 level. Currently, there is a positional tightness in the North Atlantic that is keeping the rates at very high levels, closer to 30,000, and with a 25% weighting on the index, the 5TC Average comes to a higher level. Yet, there are a few and apart ships that are employed in the North Atlantic at any given time and few business is concluded daily (at least compared to the Brazil/Australia markets). Few owners choose to position their ships so far up north, as there are few cargoes and the waiting times for a new cargo might offset the benefits of the higher rate.

Atlantic Roundtrip rates minus the 5TC Average

Furthermore, all the above are based on calculations and assumptions made by shipbrokers and as a result, might not represent reality. After all, like most shipping indices, it is an assessed index. However, for freight traders (especially the ones engaged in freight futures or index-linked trading) such mathematics are extremely relevant. For instance, why would an owner trade a ship commercially when it can charter her out on an 5TC index-linked basis (a vessel that basically earns whatever the index is) and “beat” the actual earnings for the two main commercial routes, namely Brazil/Australia to China, with little effort? Additionally, traders can charter-in index linked ships and employee them in the Transatlantic market and could be making a nice spread (note: a lot of them actually do).

How do the above apply to the average shipping observer or investor? Lets take the example of shipping companies that have significant Capesize exposure. To assume that their ships are currently earning 20,000+ per day would be wrong. As a result, at the end of the quarter, when shipping analysts will try to calculate the earnings for the first quarter and they go back and look at the Capesize average, most likely they will overestimate the actual earnings of the company due to such misalignment.

Furthermore, for shipping professionals who are looking to hedge their forward exposure or trade on a speculative basis, the fact that some routes are so much lower than the index makes it risky as the basis risk is significant. After all, freight futures settle against the index, so imagine if a hedger is looking to lock in the Australia-China daily earnings, but ends up with a payout that reflects only 25% of such route with the rest being a totally unrelated market. Obviously this is known in advance, but such sharp divergencies between markets makes hedging even more challenging.

Now, over time, the correlations between routes remains extremely high. After all, if there is the opportunity to earn more money in a different route, ships will sail around the world to maximize their profits. However, once again it is not as clear as it sounds. Using the recent divergence in rates as an example we believe the waiting time for vessels that would like to do the North Atlantic routes is high enough to make such a decision not so attractive. Yet, the calculations assume no waiting time, which, once again, might represent an overstated index.

All of the above definitely are subject to debate in a market that relies on assessments and not actual fixtures to construct an index that aims at reflecting the state of a physical market as unique as shipping. The problem is not the index or the mechanics behind it which we believe serves its purpose. Understanding the index and taking the right decisions based on such understanding becomes the challenge, in our view.

As the Capesize market is currently facing a significant backwardation in the futures curve, the potential for profit grows as the future of the index does not rely only on the future strength of the overall market, but also on the potential strength of a sub-segment that historically is more volatile and could develop in an uncorrelated way during short periods of time. On the other hand, the volume of trade in the main routes might eventually impact this small market as well or take a life by itself and converge higher.

The consensus believes that Capesize rates across the board are about to collapse to the very low teens once again as is always the case early in each calendar year. As in every market, views are abundant but sometimes the right information and interpretation of such information is equally important with everyone’s views and doing some homework sometimes can pay well.