Dry Bulk: Now What?

As spot rate volatility seems to be cooling off and futures have now gradually returned to a state of increased caution (see backwardation except Supramaxes), the natural question for shipping investors and traders is what’s next for dry bulk rates. The recent rally, which in fact one can trace its roots in early December of last year, has left rates elevated versus historical ranges. What comes next will either further solidify the opinion of a new longer-term upcycle for dry bulk or, once again, the last few weeks will be viewed and dismissed as an unexpected positional tightness in the context of a continuation of the “low and slow” freight rate environment of the last decade.

Interestingly, for believers of a new upcycle in shipping, the more of a dismissal of such a potential state for the market the better, as all relevant investments (futures, assets, stocks) will continue to reflect low expectations thus providing an opportunity for further bullish positioning into the cycle as the year progresses.

Baltic Dry Index, 10-Year Seasonality and Current Implied Futures

We expect rates to marginally retract in the next month or so, especially for the sub-Capesize segments. The underlying demand for the commodities that such vessels transport remains robust and this comes on top of the lengthening of the average mile traveled given the significant dislocation of trading patterns, thus multiplying the demand factor. Port congestion, force majeures and inclement weather given the particularly harsh winter in the North hemisphere, further add fuel to the fire. As a result, although spot rates should ease a bit, they won’t return back to range until the above factors normalize, something we don’t anticipate in the near future.

However, this is in fact the consensus view as well. Freight futures are trading below spot for both Capesize and Panamax, but not by much. Yet, the futures curve is above the historical range, as the chart above demonstrates. After all, Supramax Q2 futures were at 17,000 just a few days ago, a level that, if realized, would be at par to the levels this segment was earning during periods in the 2000’s shipping supercycle.

Consequently, our attention turns to Capesizes, which, despite the recent significant volatility in futures as well as spot prices for the sub-cape segments, have not really reacted in an extraordinary way. For that segment, near term fundamentals don’t look promising at the moment. Demand for iron ore remains subdued, something that was anticipated due to seasonal factors.

Although the high iron ore prices (overnight, Chinese iron ore futures reached a new all time high) are overall pushing more iron ore in the water, while relatively strong demand for bauxite out West Africa and coal cargoes to Asia are adding to tonne-miles, the market needs even more iron ore exports out of Brazil to see a substantial increase in Capesize demand. On top of the lackluster current iron ore cargo flow, a large number of Capesize vessels are now steaming towards the Atlantic basin to take advantage of the relatively stronger rates there, which should limit any near term potential. As a result, for now, a major rally in Capesize rates should be on hold, despite the fact that Panamax rates would be pointing to almost 30,000 spot Capesize rates all else equal, based on the historical relationship between the two (Note: this is also by far the consensus view, and although we tend to agree with consensus, any indication of strengthening in rates will lead to a significant squeeze in the futures market given the current traders positioning, in our view)

Brazilian Capesize demand remains below trend

Not all is bad though for Capesize rates. As it is always the case, once the supply/demand balance tightens, the strength of the market will more than compensate for the current weakness. Such a rebalancing is not as far as one might think. Indeed, the current state of the Capesize market tilts towards marginal weakness, but one has to remember that so far this year spot rates have averaged well above recent years. As we enter the spring months when Chinese steel demand tends to recover, Capesize rates will start any potential upturn from a higher base, which combined with a broader optimism coming from the smaller, sub-cape segments, should indeed push Capesize spot rates higher and at an accelerating pace.

We have again and again made predictions about the direction and level of rates which sometimes were wrong but more times were right. With less than two months into 2021, our thesis of the strongest year for dry bulk in a decade has so far been proven correct. It is early, but all signs continue to point to a material change in both sentiment towards commodities, and thus shipping, but also a fundamental shift in the industry’s supply/demand balance that should only further tighten in the next several years. Volatility will remain elevated for dry bulk rates, and we anticipate that the Capesize spot index will, at some point this year, print north of 50,000, something that has not been seen since late 2010. Although such level might sound quite high, one has to remember that as a percentage of the current delivered iron ore price of some $175/t, such a prediction translates to a freight cost just above the historical average.

Brazil to China Freight Cost as a % of Spot Iron Ore Price

Finally, shipping is an integral part of the commodities market. It would be odd to see freight rates thriving in a weak commodity environment, while the opposite is also true. As commodity prices move higher, production levels increase, arbitrage opportunities reappear and profitability is refocused on volume. Shipping is a direct beneficial of all the above. This time around, however, the supply side, as reflected by the current orderbook, is also constrained due to uncertainties regarding the future development of vessel engines and environmental-friendly propulsion, creating for the first time a unique and unpredictable cycle for the highly cyclical and supply-inelastic industry that is dry bulk shipping.