The beauty of shipping investments is their cyclical nature embedded in the industry and although there are always explanations and reasons for each leg of the cycle, usually ex post, the plain reality is that shipping rates go up and down because this is just the natural behavior of the shipping market balance: Sometimes demand exceeds supply and sometimes the opposite is true. Such a balancing act happens all the time in short-term cycles but the market is also always subject to a broader industry-wide cycle, one that is mainly driven by the balance between global economic growth, and thus demand for commodity transportation, and the number of available ships to perform such a service.
We believe we are currently in such a long-term upswing which will last several years and is driven by major economic forces on both the demand and the supply side of the equation, but that does not mean prices won’t fluctuate, sometimes violently, during that period. Looking at the current state of the market, it seems we have now peaked near-term and we are in the midst of a correction, albeit a mild one in our view.
Once again, predicting peaks and troughs is a risky game, but for investors and market participants alike, the exact turning points should be less relevant as long as they are able to identify the majority of the moves on each direction.
History might be a useful first step in measuring the magnitude of the drawdowns. Looking at the freight rates during the past several years, there have been quite volatile periods so identifying the absolute top/bottom in each instance requires some qualitative judgment on top of quantifying the size of each rate decline. Moving averages of the respective indices might also be useful, while freight futures (given the embedded averaging in prices) is also a time series to consider in such exercise.
For the core Capesize sector, volatility has been much higher that the rest of the dry bulk sub-sectors. The spot nature of Capesize chartering combined with the much higher leverage that the economies of scale due to size provide, are the main reasons for such volatile performance. As a result, both rallies and drawdowns have been materially larger than the rest of the sector (i.e. Panamax and Supramax rates).
Below are some of the most important drawdowns in terms of % change as well as point drops on the Capesize Index over the past 20 years:
Percentage drop and point drop from most recent significant highs, Baltic Capesize Index
Note: shaded area excluded from the average calculation as absolute rates were much higher during that period
For comparison purposes, a 67% drawdown from he recent high means an index in the mid-teens while a ~18,000 drop places the index in the md/high 20,000 level. Currently the spot Capesize index stands at about 33,000 (although might soon drop below 30k, in our opinion).
However, it is very important to remember that the current dry bulk rally is NOT Capesize driven. Over the past decade, it was Capesizes that would lead the way and have the most important influence on the rest of the dry bulk sub-sectors. The current dry bulk rally is mainly driven by smaller, sub-cape vessels. In fact, Capesize fundamentals have not changed materially from last year in terms of cargo flow and vessel supply.
Such a setup makes it particularly tricky when it comes to the magnitude of the drawdown if indeed we are in the middle of a correction. For example, if Capesize rates drop significantly, charterers that might otherwise choose to use a Panamax vessel for a certain cargo might opt out for a Capesize one that has double the capacity and thus save on freight costs. Such a “substitution” factor makes it difficult to see Capesize rates below Panamax rates for a sustainable period of time. Although Panamax rates are also currently retreading, the relationship between different sizes of dry bulk vessels will play a very important role this time around in terms of the magnitude of the drawdown.
Baltic Dry Index
Our suspicion is that the drawdown will be shallower versus history, as the past decade had been particularly harsh in terms of the smaller size ships, and thus the “substitution” support has always been so much lower leading to deeper drawdowns for Capesize ships.
We believe we are close to halfway through the recent correction. Once again, it is impossible to identify bottoms or tops in such a volatile industry like shipping. History is a guide, but rarely it is an accurate predictor of the future. Freight futures also having a hard time identifying the bottom, and thus will continue to trade at the direction of spot, with the necessary risk premium or discount embedded. For now, the Capesize curve is in slight backwardation, but this is to be expected, given the fact that the index is still dropping.
Furthermore, looking deeper into seasonality, we expect another peak up in demand in late June. Although this year might play out quite different versus what the market is used to in terms of seasonal strength (see how strong the “seasonally weak” first half of the year already has been) it is interesting to us how market views have changed over time relating to seasonality. A few years back market participants would look forward to the second half of each year when dry bulk freight rates were expected to perform the best. Demand was high as China would restock commodities ahead of the winter while supply especially for iron ore out of Brazil would peak in the fourth quarter, thus aiding freight rates.
Currently we sense the opposite. Market participants see increasing risk of lower demand as the year progresses, reflecting China’s policy changes aiming at reducing pollution and controlling carbon emissions, combined with potential softening in economic activity as the stimulus boost gradually fizzles out.
All of the above are very valid concerns. Record-high commodity prices are taking a toll on China’s growth, inflation is becoming a mainstream subject while geopolitical conflicts (see Australia-China) are only intensifying. It is extremely difficult to handicap such major issues that would directly affect dry bulk rates.
Yet, here we are in May with Capesizes in the low-30,000s level, Panamaxes above 20,000 and smaller size vessels at their best in a decade. Vessel supply growth is slowing down, owners confidence is high, and the industry has already been through a decade of consolidating returns and sub-normal levels and is currently recovering.
More importantly, it is not only dry bulk that is pushing higher. Most major commodities, especially the ones that are linked to infrastructure (steel, iron ore, copper, lumber, cement and glass to name a few) are close to or above record highs. This is not a dry bulk rally. This is a infrastructure demand rally that is also affecting dry bulk.
Longer term, the significant focus on reducing carbon emissions in global shipping is also a bullish change, in our view, although that should play out over several years into the future. Major disruptions in technology and operations can only mean stronger pricing, at least in the early stages of such core changes. Slower steaming, limited new ordering and increased scrapping of older highly polluting vessels are all positive factors for the supply side of the shipping balance. Demand might fluctuate, but at least shipping has the supply side under control this time around (at least for now).
The current fundamentally-driven upcycle remains intact, in our view, and it is only the natural volatility of the industry that is scary sometimes but provides such attractive trading opportunities especially for the investors that choose to ignore the day to day fluctuations but focus more in the medium term turning points. We will find the bottom once again soon, and rates will turn up and another upcycle will develop, hopefully leading to a higher highs for the year.