What are forward contracts?
Companies use forward contracts to lock in the availability of resources in the future at a set price. The dry bulk shipping industry, which transports key dry bulk materials such as iron ore, coal, and grain, is no exception to this practice. When shipping companies negotiate the rates of shipping raw materials, they 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’s often a positive indication that shipping rates will rise. Higher shipping rates mean higher revenues, earnings, and free cash flows—and vice versa.
Higher forward contract prices
The current quarter’s time charter rate for Capesize vessels (ships that mainly haul iron ore and coal) rose from $10,950 per day on June 5 to $12,225 per day on June 12, while forward one- and two-year contracts rose from $12,500 to $12,550 and $14,300 to $14,350 per day, respectively. Rates have all drifted lower over the past few years because more than a necessary amount of newbuilds (new ships) were delivered, driven by companies’ over-optimism toward future trade growth. But since last year, shipping rates have begun to base, as several companies began to report negative earnings, and capacity growth improved because of lower new ship deliveries and the continued scrapping of older vessels.
Shipping rates recently improved due to China’s iron ore restocking activity. Iron ore inventory has fallen ~27 million tons (28%) since mid 2012, and prices for imported iron ore have fallen ~$40 per metric tonne (~29%) since the government moved to cool property prices earlier this year. As a result of restocking activity, iron ore prices and import volumes also rose. This is a positive sign for dry bulk companies, as it suggests importers expect China’s real estate activity to continue to improve over the long term. Whether iron ore import will remain strong this year is open to debate. The series Must-know: Commodity prices and dry bulk shipping stocks (Part 1: Inflation and steel) suggests this is possible, although there are many uncertainties.
Forward contracts priced higher than current contracts
More importantly, however, contracts that are farther out into the future are now priced above current rates, unlike pre-2010. This is happening because supply growth is expected to fall even further in 2014 and 2015, as companies plan to allow the current excess capacity condition to alleviate and profitability to improve, which is a long-term positive for dry bulk shipping companies such as DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Safe Bulkers Inc. (SB), Navios Maritime Partners Inc. (NMM), and Eagle Bulk Shipping Inc. (EGLE). Investors should keep a close eye on the spreads between the three contracts. Current contract rates edging up against contracts that are farther out into the future is an early sign that supply and demand balance is tightening faster than initially estimated.
Learn more about the seven key shipping indicators
Continue back to Part 1 to see the list of other key shipping indicators.
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