Is a Rally in Rates Almost Here to Relieve and Benefit DryShips Inc.?

DryShips has been calling for it for months. It may finally be there.

May 17, 2014 at 10:30AM

Nearly two months ago, George Economou, Chairman and CEO of DryShips (NASDAQ:DRYS), told the world that his company expects the freight market to be "hot" over the next three months. Instead, rates for the largest Capesize ships (to which he was referring) have been caught in a whirlpool. However, the downward course of those rates may be reversing. Better late than never.

To start, DryShips probably won't benefit much directly in the short term should a rally ensue. Most of its Capesize ships are locked into fixed rates, but it certainly wouldn't hurt indirectly in its capital-raising efforts and debt negotiations. This indirect benefit may be vital.

Look to iron ore
The key thing to keep an eye on lately has been the iron ore market. For those of you who don't know about recent developments in dry shipping, the short story is that the pivotal market price for iron ore is around $120; the further below that point the price falls, the higher the expected spike in shipping demand.

The logic is this: 70% of the world's iron ore shipping currently goes to China, but China actually consumes three times that amount due to its domestic supplies. However, its domestic supply has a very high burden of cost.

When iron ore prices fall below $120, many of those domestic mines have a cost basis higher than $120 and therefore cannot compete. As prices get lower and lower, more and more mines shut down and an increase in imports is required to compensate. This has the effect of raising demand and shipping prices. Economou does a nice job of explaining DryShips' stance on all this in this interview.

Iron ore is falling
The Baltic and International Maritime Council has stated that mining companies all over the world are ramping up production to the point of "flooding the market." Supply of this magnitude tends to mean cheaper iron ore prices; cheaper iron ore prices mean more shipping demand.

Iron ore prices were $130-$140 late last year, but they fell to $120 in April. Last week, they were around $105. Recently, according to a report from Bloomberg, Jeffrey Landsberg of Commodore Research & Consultancy stated:

Smaller Chinese iron ore miners are being priced out of the market and this is only going to continue. Such a development is phenomenal for the shipping market. There's going to be an even larger demand for iron ore imports. 

China's iron ore imports in April were the second-highest monthly figure on record, and followed the biggest monthly drop in iron ore prices in almost a year. At the time of this writing, the most recent price quote is $102.70 per ton, and that appears to be heading for $100. The treasury department of Australia is calling for $83 per ton within two years. If that were to happen, it would devastate China's domestic mining market while possibly making many dry shippers rich. -- even DryShips as its contracts expire.

Is the demand there?
The potential for such a drastic shift from expensive domestic iron ore to cheaper imported iron ore in China is so great that even if the overall demand for iron ore were to fall, import demand could still spike upward. Many have voiced concern that China is seeing the slowest growth percentage increase in its economy in 24 years. However, the two key words here are "growth" and "percentage."

First, it's still growing, which means that the total demand for goods and services, and presumably commodities, will be larger in quantity this year than last year. Much larger. Second, slower "percentage" is kind of misleading since it's part of a bigger pie. The sheer increase in quantity of economic output dwarfs by a humongous amount anything from 24 years ago, and in fact each year will still be expected to herald a new record. In short, there is nothing in China's growth expectations that suggests slower demand with anything that needs to be dry shipped. Quite the opposite.

Follow iron ore price and follow shipping rates. The dry bulk market could be experiencing something resembling a coiled spring on rates, which could also have a fast-changing, positive effect on stocks like DryShips. 

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Nickey Friedman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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