The BDI And Shippers

The Baltic Dry Index, possibly "the best economic indicator you've never heard of," has begun showing signs of life after losing about 95% from its historic high in 2008. The BDI is a daily indicator released by the Baltic Exchange that tracks the average dry bulk shipping costs across 26 sea routes.

From a basic economic perspective, the BDI is set by the supply of available cargo ships against the demand for raw material shipments. External factors come into play, of course, including energy prices, port fees and regional issues. Nevertheless, given the BDI's position in tracking global commodity demand coupled with "real-time" data, it is an effective yet oft-ignored leading indicator for global industrial production -- factoring out potential inventory reserves, manufacturers that anticipate a sustained rise in orders need to source raw material inputs before they can meet customer demands.

BDI has been a highly effective tool for tracking global economic activity over the past decade. But given the current economic climate and a potential supply shock, interpreting the BDI right now is not as straightforward as it might seem.

After reaching all-time highs in mid-2008 thanks to China's insatiable demand for natural resources, the BDI experienced an unprecedented drop of nearly 95% by year's end. To help put this into perspective, an article published by The Independent noted that at its peak, the cost of a coal shipment from Brazil to China would have been $15 million, compared to just $1.5 million by the end of 2008. But since the beginning of 2009, the BDI has begun showing signs of recovery, reaching a seven-month high this past week.

A casual observer might take this as the beginning of an upward trend in global economic activity. It is unlikely, however, that the BDI's current rally can be sustained -- it has resulted primarily from a Chinese government stimulus package that stoked the country's imports of iron ore, coal, and copper, combined with companies looking to take advantage of historically low commodity prices to boost reserves.

Without a global uptick in demand for Chinese goods, these levels cannot likely be sustained; portions of these imports are just adding to growing reserves. Further downward pressure will come in the form of a supply shock on the horizon. Shipping companies looking to take advantage of historically high margins contracted a record number of new vessels from 2005-08, most of which are scheduled for completion over the next two years. According to Lloyd's List, a leading journal for the maritime industry, 492 vessels -- or 9.6% of the bulk tonnage on order -- have been canceled since the crisis began.

Roy Thomson, a regional manager in Asia for Lloyd's Register, indicated at a recent conference that he expects that number to rise further and that current cuts will not circumvent a supply glut. In all, this confluence of factors should place downward pressure on dry bulk carriers and ship builders.

As for the BDI, I expect it will remain rangebound between 1,500 and 3,500 through 2010, mostly dependent on the magnitude of any economic recovery and supply management of new vessels.

Unsustainable demand coupled with a capacity glut will place significant strains on dry bulk margins through 2010. Furthermore, highly leveraged shipping companies, with extensive ongoing new vessel orders, will face even greater pressure over the coming months.