Wednesday, July 13, 2011

Baltic Dry Index - A Leading Economic Indicator?

In recent years, the Baltic Dry Index (“BDI”) has gained a lot of notoriety outside its narrow audience of ship-owners, freight traders, or even investors in publicly traded shipping companies. Many economists and analysts now view the BDI as a leading indicator of world economic activity in general, and industrial growth among emerging economies in particular. What does the Baltic Dry Index really measure, and should analysts & investors use it as a leading economic indicator?

The Baltic Dry Index (“BDI”) is a spot assessment of the ocean transportation cost for dry bulk commodities. The BDI is published every business day by the Baltic Exchange, a 250 year-old London-based maritime association. Dry bulk commodities consist of the three major bulk commodities (iron ore, coal & grain products), and the minor bulk commodities (fertilizers, steel products, scrap iron, bauxite & alumina, cement, petroleum coke, etc).

By definition, the Baltic Dry Index represents the current balance between the supply of ocean going vessels and the transportation demand for raw materials. Now, it is true that transportation demand for dry bulk commodities is driven to a large degree by industrial growth in emerging economies such as China, India, etc. Thus higher industrial growth should lead to higher demand for ocean transportation and an increase in the BDI.

It is also true that at any given point in time the supply of ocean going vessels, i.e. the size of the dry bulk carrier fleet, is fixed. Any short-term changes in the BDI should then mostly reflect changes in industrial activity. Case is closed: We just proved that BDI is a leading economic indicator, or did we?

First we have not said anything about the supply of ocean going vessels. The size of the dry bulk carrier fleet is not constant over time. Its size changes with the delivery of new-building vessels, and the scrapping of older tonnage. Also the overall fleet size may or may not be correlated to current industrial activity. It is the sum of investment decisions made over several years, since the lead-time to build a new vessel is approximately two years, and the average economic life of a bulk carrier is 25 years.

Once a vessel is built it stays in the fleet during good times and bad. When the market becomes oversupplied, like we are witnessing this year, the BDI tends to be depressed irrespective of overall industrial activity! As a matter of fact, the BDI is currently being assessed at below historical average levels, not-withstanding a very robust demand for raw materials. Which means that at times of tonnage over-supply or under-supply, the absolute BDI level becomes uncorrelated to industrial activity.

Also short-term changes in the BDI can be caused by several factors other than underlying industrial activity. Changes in trading patterns, seasonality, inventory management, port delays, weather and/or political disruptions, can add more to short-term volatility than mere changes in industrial activity.

For publicly traded shipping companies that have exposure to the spot freight market, the BDI is a perfect proxy for their short-term earnings capacity. But as a leading economic indicator, the BDI does a rather poor job. (Originally Published April 25th, 2011)