The Pivotal Point for DryShips Inc., Diana Shipping, and Others

It's now almost May. Where is that 2014 drybulk recovery that DryShips (NASDAQ: DRYS  ) , Diana Shipping (NYSE: DSX  ) , and so many other executives were calling for? On a year-over-year basis, the Panamax ship rates are firmly in the red, and the Capesize rates aren't doing much better. Here's a key thing that may need to change and what to look for.


Source:  Diana Shipping

Good for now
To start, let me just point out that the no. 1 thing that is negatively affecting shipping rates is the import demand for iron ore to China. Both DryShips and Diana Shipping aren't affected much by the short-term swings in the daily spot rates since their ships are almost entirely locked in fixed-rate long-term contracts. The way their stocks trade are affected by the emotion of the market, however.

In an interview a little over a month ago, DryShips CEO George Economou stated, "No one has a crystal ball, but we have every reason to believe that the fundamentals for the dry bulk market are quite clear and point to a stronger market ahead."

Economou went on to say that DryShips expects a "hot" market over the next three months before it temporarily slows down for the summer. So far, it has done nothing but crash instead. For the sake of the dry shipping industry, let's hope that DryShips is as wrong about the summer as it has been about the spring.

Psychology is temporary
Shipping broker George Iliopoulos points out that despite the weakness in shipping rates over the last several weeks, the asset values of ships being sold in the secondhand market continue to be strong. The secondhand market is considered more sophisticated and much less prone to emotional swings.

Illipoulos notes that "psychology, as always, is still playing a very important role for both buyers and sellers" and doesn't have much longer-term meaning. Sometimes, weakness in prices will cause freight buyers to temporarily hold off in reaction to the price volatility itself, further causing a somewhat downward artificial hit. Illipoulos added, "There are a lot of people who firmly believe that the market will make a come-back in 2014 and freight rates will bounce back up."

It's all about the iron
According to the Baltic and International Maritime Council, or BIMCO, "The fleet development in the dry bulk segments has been fully along the forecast lines, both for inflow of new ships as well as demolition." This means the shipping supply side is unfolding as forecasted. Now watch demand.

BIMCO notes that "2014 will be a year with full focus on the big mining companies, who are ramping up the production of iron ore." More production means more shipping demand and higher rates. BIMCO describes the iron ore situation as a "flooding of the market," which has already begun since iron ore prices were between $130 and $140 per ton and are now at $120. It crashed all the way down to $105 in March with a rebound since.

As DryShips has pointed out in the past, China imported only 1 ton of iron ore for every 2 tons it mines and uses domestically last year. This means that it's not just demand for iron ore by itself that affects shipping rates but the "market share" of imports compared to domestics.

The key is that at certain price levels, many domestic mines simply can't compete with the imported shipments. China will have little choice but to increase shipping orders. Not surprisingly, when prices hit $105 per ton in March, iron ore import shipments exploded to a 13-month high.

The pivotal point

Source: DryShips

Global market price of $120 per ton for iron ore happens to be a key pivotal. According to Frik Els, editor and writer of MINING.com, the $120 mark has "long been considered a price floor for iron ore as many of China's hundreds of small scale miners quickly become unprofitable at these levels."

Below that will cause a material uptick in import demand since much of the imported supply comes from Australian, Brazilian, and South African miners where costs for them are only between $45 and $55 a ton. With delivery, it's around just $60 to $65 a ton. It's hard for Chinese mines to compete.

If iron ore prices happen to fall below $100, then the market could "explode" as DryShips expects. Pan Guocheng, chief executive of privately owned miner China Hanking, believes that with iron ore prices below $100 per ton, between 40% of 50% of Chinese miners could end up being forced to close their mines and cut off 150 million tons of annual supply. All other things being equal, DryShips would easily be right and rates would indeed explode.

Foolish final thoughts
Long term DryShips and Diana Shipping are affected by changing Capesize rates even though short term neither sees much fundamental effect. With new iron ore supply from mines flooding the market, however, we could see a long-term depression in iron ore prices. That could spell higher rates for new contracts for DryShips and Diana Shipping. For now, watch that $120 per ton mark as it seems to be the pivotal decider of where the market is going.

This is important for dry shipping too
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