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Weekly dry bulk digest: Fundamentals show bullish light (Part 6)

Continued from Part 5

What are forward contracts?

If there are shipping rates for today, then there’s also the expectation of tomorrow’s rates. 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 consider 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.

Capesize Time Charter Forward Agreements 2013-07-30Enlarge Graph

Higher forward contract prices

Time charter rates for Capesize vessels (ships that mainly haul iron ore and coal) fell slightly from $12,300 per day on July 19 to $12,925 per day. However, forward one- and two-year contracts rose from $12,755 to $13,600 per day and from $14,500 to $15,175 per day, respectively. Rates have all drifted lower over the past few years because shipbuilders delivered more than a necessary amount of newbuilds (new ships), driven by shipping 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. This is a positive sign for dry bulk companies, as it suggests importers expect China’s real estate activity to continue to improve, unlike 2008’s crash. Whether iron ore import will remain strong this year is open to debate. The series Must-know: Commodity prices and dry bulk shipping stocks suggests this is possible, although there are risks.

Spread between contracts narrow

More importantly, contracts that are farther 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).

In earlier articles, we mentioned that investors should keep a close eye on the spreads between the three contracts. Since May, that spread has been narrowing, and it looks like the one- and two-year forward contract rates want to rise higher. This is possibly a reflection that traders are locking themselves into forward contracts, seeing that shipping rates will likely rise, which is a bullish sign since the opposite happened in 2010 when the Baltic Dry Index also collapsed (see Part 5).

Learn more about the key performance indicators of the dry bulk shipping industry

Continue to last week’s article, Ship prices or vessel values, or go back to Part 1 to see the list of key shipping indicators. For curious investors, to read how commodity prices may benefit dry bulk shipping stocks, continue to Must-know: Commodity prices and dry bulk shipping.