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Friday, September 20, 2013 - 13:00

The Best-Looking Commodities Chart You'll See All Year

Friday, September 20, 2013 - 1:00pm

It's pretty safe to say that there is just one global index that has managed to double in the past three months. The fact that it is involved in the still-weak commodities sector makes the spike all the more stunning.

I'm talking about the Baltic Dry Index (BDI), which is "an assessment of the price of moving the major raw materials by sea," according to the Baltic Exchange. These daily rates involve major ships (known as dry bulk carriers) that carry a variety of commodities, including coal, iron ore and grain.

What the heck is happening to make this index spike so quickly? Credit goes to China, which had been working off bloated inventories of iron ore and coal, and is now in the process of restocking those raw materials. (The amount of iron ore on hand in China sank to 28 days' worth of demand in late August, according to Morgan Stanley, three days below the 12-month average.)

To be sure, there is an economic explanation for the demand spike in ore and coal as well: Chinese industrial production rose 10.7% in August from a year ago. Will stockpile growth (in excess of end-user demand) be sustained, now that iron ore prices have moved up 20% from their 2013 lows to recent $131.70 per ton? Time will tell. To be sure, prices are still below the $160 peak seen in January.

Don't discount the impact of coal on the BDI. China tends to build stockpiles of coal ahead of rising winter demand, so this trend is unlikely to hold once stockpiles have been built to suitable levels.

The fact that the Chinese economy is also firming, means that the BDI will likely find some sort of equilibrium in the 1,500 to 1,750 range, even if inventory stocking peters out. As a point of reference, since the start of 2011, this index moved up above 2,000 only once and stayed there only briefly.

Still, even if this index stays in the 1,500 range, then the whole set of operating dynamics in this industry is about to change. Many dry bulk shippers are saddled with high levels of debt and have generated poor cash flow. A deep slump in the Baltic Dry Index would have led some of them to bankruptcy, as I discussed last November.

Those concerns are now starting to recede (though not for one firm, as I'll note in a moment).

For investors, the question becomes: Do you look for value among the most beaten-down firms that might make a solid turnaround trade? Or do you stick with the industry's quality operators, just in case this index plunges right back below 1,000?

In this instance, it pays to focus on the strongest financial players, as the supply part of the industry equation remains concerning. For example, the fleet of ultra-large Panamax ships is expected to grow by nearly 25% over the next two years as newly-built ships enter service.

Slightly smaller ships, known as CapeSize, are also being built at a fast pace: Morgan Stanley anticipates that 240 new CapeSize ships will have entered service between the start of 2013 and the end of 2015. Unless demand grows at an equally robust pace, then the daily lease rates for these ships are bound to fall.

At first glance, some of the industry's weakest players are seeing the greatest share price gains. Genco Shipping (NYSE: GNK), for example, has rallied sharply, in part due to massive short squeezes. That leaves this stock quite vulnerable once the short squeeze has passed and the BDI starts to consolidate at lower levels.

With less than $100 million in cash on hand and more than $1.5 billion in debt, Genco may run out of money by the first half of 2014, according to DNB Markets.

Indeed, whenever you see a stock that has been sharply boosted by a short squeeze, the opportunity emerges to apply a new short position as the current price likely now reflects an artificial overvaluation. Unless Genco addresses its balance sheet problems, shares could quickly move back towards the $1.50 mark once again, where they traded this past spring.

As I mentioned earlier, it's wise to assume sort of pullback in the BDI to levels that should still be supportive of industry profits. But it's best to avoid stocks that would tumble badly if the BDI in fact returned back to the lows seen in early 2013. The industry's healthiest operators: Diana Shipping (NYSE: DSX) and Navios Maritime (NYSE: NM).

When I looked at this industry back in early 2012, I noted that Diana Shipping was the industry's strongest player, in terms of balance sheet and cash flow metrics. Cash is a nice luxury to have when the profit picture is murky. The company is expected to generate roughly $55 million in cash flow this year, according to Morgan Stanley, and another $50 million in 2014, compared with projected cash flow deficits at many rivals.

The company's financial strength brings another perk: "DSX is currently focused on expanding its fleet adding vessels at a pace of around one vessel every month, taking advantage of the historical low asset prices and positioning itself for a future recovery," noted analysts at Morgan Stanley.

Navios Maritime also appears to have solid support in the form of various interests in subsidiaries. For example, the company owns:

  • 52% of Navios Maritime Acquisition (NYSE: NNA)
  • 23% of Navios Maritime Partners (NYSE: NNM)
  • 64% of Navios South American Logisitics

These assets are worth roughly $8 to $9 a share, according to Clarkson Securities, modestly above the current share price -- and perhaps significantly more if global trade flows perk up in 2104.

Risks to Consider: As China has such a huge influence on global shipping rates, you need to track that economy for signs of further strength or weakness.

Action To Take--> The stunning rally in the BDI has created opportunities on the short and long side. You may want to apply a paired trade strategy, going long Diana and/or Navios (in the event that BDI rates remain at current levels or move higher) while shorting Genco Shipping, which remains in very weak financial shape and is vulnerable to a fresh pullback in the BDI.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.