Since May this year, the Baltic Dry Indexhas collapsed (falling by 93%) – a movement that may be of concern for a smalltrading nation like New Zealand.
The Baltic Dry Index (BDI) is effectively anindex of shipping costs for 26 of the main "dry commodity" shipping routes. Asa result, movements in the index give us some idea about how the cost ofinternational shipping is changing.
However, over recent years the index hasalso been used as an indicator of the outlook for commodity prices. This interpretationof the index is something we discussed in detail back in March .
The reason behind this use of the index isas follows: as demand for commodities increases (which in turn increasescommodity prices) it puts upward pressure on the limited number of shippingvessels – increasing the rates that shipping companies can charge. As aresult, the recent decline in the index appears to indicate that demand forcommodities has fallen sharply – and as a result current and future commodityprices may be a lot lower. Given New Zealand’s role as a commodity exportingnation, this implication is concerning.
Even so, it is important to take intoconsideration why the Baltic Dry Index has fallen before moving to anArmageddon type conclusion about the outlook for New Zealand commodity prices. The decline in the index is solely the result of the "capacity constraint" onshipping loosening – implying that we need to know why this has happened beforewe can make any conclusion about commodity prices.
BDI and shipping volumes – prior to thebig run up and following
In order to get some perspective onmovements in the Baltic Dry Index, it is important to look at the primarydrivers of the index prior to the recent five-year "run-up" in value. Over theperiod from 1992 to 2002 the index was remarkably stable – even though tradevolumes were just as variable as in recent history.
The two primary drivers of shipping costsare petrol prices and movements in international trade. Analysing the dataindicates that the impact of these factors on shipping costs was relatively mildover this period.
Fundamentally, over this periodinternational trade was not "capacity constrained" – there were plenty ofshipping vessels that were all very similar. These vessels competed stronglyfor clients – implying that any change in international trade volumes did notlead to a marked change in shipping costs.
However, recent history is very different,as Graph 2 shows.
The run up in the BDI over the past fiveyears is strongly the result of rising world trade volumes. Over this time theavailability of trading vessels hit a wall, and exporters that wanted to shipproducts were forced to bid up the price of shipping in order to get hold of a carrier.
In other words, as the price of commoditiesincreased the shipping vessel owners gained part of this windfall through thelift in the price of shipping.
What does this tell us about now?
The collapse in the BDI solely tells us thatthe capacity constraint has loosened – and at current trade volumes may not evenbe an issue anymore.
Given that we know this decline is theresult of a loosening in this capacity constraint we have to ask, how has itloosened?
There are two possibilities:
- Demand for commodities has fallen markedly enough,
- The supply of shipping vessels has increased,
- Credit issues.
Now, it is likely that each of thesefactors have been significant in the current environment. Slowing globaldemand has seen demand for commodities fall – a factor that would have reduceddemand for shipping vessels.
However, it is also the case that, inrecent years, shipping companies have been investing in new shipping vessels totake advantage of high fees. These vessels take a while to be built, howevermany were forecast to hit completion by early 2009. As a result, an increasein the number of shipping vessels may partly be behind the recent decline inthe BDI.
Furthermore, shipping is a high "fixedcost" industry that relies strongly on being able to run up debt to maintaincash-flow when demand is low. Recent credit market events have made itincreasingly difficult for shipping companies to borrow – forcing them toaccept lower payments for shipping in order to receive the payment in cash.
It is not clear which of these factors hasdominated, but it is important to note that if the BDI has declined because ofan increase in the supply of vessels, then the decline does not indicate thatcommodity prices will fall as markedly. As a result, we have to be carefulwhen using the decline in shipping costs as evidence of falling internationaldemand for New Zealand products.
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