Baltic baloney

PORTFOLIO POINT: The Baltic Dry Index has lost its relevance as an indicator of commodity prices with the arrival of the giant Valemax ships.

The theory is simple. Customers placing orders to buy seaborne dry goods, such as iron ore, coal and grains, have to book an ocean-going bulk carrier well in advance. Demand for ships thus leads apparent demand for commodities, and given freight rates are set on a “spot” basis determined by demand/supply of ships, rising freight rates should indicate rising commodity prices to follow, and vice versa.

At least they did up until 2010, and traders worshipped the Baltic Dry Index as a commodity price crystal ball. In 2010, the relationship broke down.

One problem has been commodity price volatility post-GFC. But the real problem has been the supply side – of ships that is – not the demand side. These hulks take years to build and thus there is a big risk of under/oversupply across any cycle. Commodity prices were still booming into 2008 when a lot of new ship orders were placed.

Your standard Panamax and Capesize bulk carriers are enormous. And by 2010 the number of new ships hitting the seas was accelerating. Then along came Brazilian iron ore giant Vale, which decided to build its own ships to send ore to China. Originally called the Chinamax but now dubbed the Valemax, the first of these new vessels is now in the water, with many more to follow. And they make Panamaxes and Capesizes look like tinnies. You could put the Titanic in the hull of Valemax, notes ANZ, and still have a football field left over.

If the Baltic Dry Index had not already gone awry as a forward indicator as a fleet of new regular carriers set sail, the Valemax about seals its fate. Aside from its size, they are producer-owned, suggesting there is no longer an “open” freight market. This actually works in the favour of Australian iron ore producers because all up, seaborne freight rates will adjust lower. You can't commercially pull a brand new Panamax or Capesize out of service. (Presumably, however, you could hand over to an Italian captain and go for the insurance.)

Indeed the BDI has been trending lower since around mid-last year. But as the following chart from ANZ shows, BDI-commodity price correlation began to fall apart in 2009. Here ANZ uses the Australian dollar as a reasonable commodity price proxy.

Commentators yet to cotton on to the demise of the BDI's predictive powers have been warning lately that the current downward BDI trend is heralding lower commodity prices ahead. Ignore them. That is not to say commodity prices can't go lower, it just means they could also go higher as the BDI slides.

This article was first published in FN Arena and is reproduced with permission.