Companies sometimes engage in forward contracts to lock in the availability of resources in the future. The dry bulk shipping industry, which transports key dry bulk materials, such as iron ore, coal and grain, is no exception. When shipping companies negotiate the rates of shipping raw materials, they will take into consideration future expected supply and demand. If the rate of renting a ship and service in a forward contract is higher than the current rate, it is often a positive indication that shipping rates will rise in the future. Higher shipping rates will mean higher revenues, earnings and free cash flows.
Future forward contracts priced above current rates
On March 29th, cape size ships’ time charter rates for the current quarter stood at $7,000 per day while the one year forward contract was priced at $10,000 per day and the two years forward contracted at $13,500. The three contracts have all drifted lower in 2012 as more than a necessary amount of newbuilds (new ships) commenced service. As a result, shipping rates (time charter in this case) continued to fall in 2012.
Unlike pre-2010, however, contracts that are farther out into the future are now priced above current rates. This is an indication that demand is expected to increase more than supply will over the next few years. Similar to an auction, when more people demand a limited amount of goods, the price of the good will rise.
Implications for dry bulk shipping companies and the shipping industry
This will be positive for shipping companies, such as DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Safe Bulkers Inc. (SB) and Eagle Bulk Shipping Inc. (EGLE) because higher shipping rates will translate to higher revenues. As costs are predominantly fixed, these firms will be able to capitalize on operating leverage: any marginal revenue due to price appreciation will flow towards higher earnings and free cash flows. It will also be positive for the Guggenheim Shipping ETF (SEA), which invests in large shipping companies worldwide.
On a final note, investors should also keep a close eye on the spreads between the three contracts. When the rate for current contracts edge up against contracts that are further out into the future, it is an early sign that demand is growing faster than expected. Higher demand growth is almost always positive for any industry.
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