The Baltic Dry Index reflects global shipping prices for dry bulk commodities such as iron ore, coal, cement, and grain. Rates are affected by a combination of demand for these commodities, ship supply, seasonality, and fuel prices. Together these factors can cause dramatic swings in the fortunes of dry shipping companies.
Over the course of 2013, rates have been climbing and many companies and analysts are calling for this trend to continue well into the future. If they are correct, this will greatly improve the fundamentals of many dry shipping companies. If they are wrong, and rates reverse, investors run the risk of realizing large losses on their investments, and possibly total loss if the companies they invest in go bankrupt.
Invest in dry shippers that are diversified
One solution for investors is to invest in companies that have diversified their operations into other areas. This strategy allows investors to still be exposed to potential increases in positive rate changes while being less exposed to possible devastating financial loss or wipeout.
One example is DryShips (NASDAQ:DRYS) which represents a unique situation. As of last quarter, it had $336 million in revenues, but $263 million of those revenues came from its majority-owned subsidiary Ocean Rig UDW (NASDAQ:ORIG). The other $73 million in revenue was split between $10 million in tanker revenue and $63 million in dry bulk shipping revenue. Ocean Rig is an international contractor of offshore deepwater drilling services. It has a current backlog of around $6 billion, or over 22 quarters worth at the last quarter's rate. By investing in DryShips, the risk of fuel prices rising and hurting its dry bulk shipping operations is at least partially hedged by its drilling service segment which would be positively affected by rising oil or fuel prices.
Another example is Ship Finance International (NYSE:SFL). It has a fleet of around 70 vessels and rigs, with 12 of them being dry bulk carriers. It also owns and operates tankers, container ships, chemical ships, offshore supply vessels, and even car carriers. It is well diversified against any negative disruption in any one seagoing area. It does not report its dry bulk financial information separately, but in its conference call the company stated, "[More] than 50% of our charter revenues came from offshore segment, less than 30% from tankers and the remaining 20% split between our dry bulk and container assets." If you assume an even split between dry bulk and container, then Ship Finance International had 10% of its revenues attributed to dry bulk shipping. That comes to around $15.4 million in revenues.
Why small dry bulk segments could lead to big gains
As rates for dry bulk shipping increase, much (if not all) of those rate increases tend to fall directly to the bottom line. The Baltic Dry Index has more than doubled since the average of the second quarter. If DryShip's average rates had been double what was reported in the second quarter, the revenue would have been around $63 million higher, reversing its GAAP-reported net loss of $18.2 million to a GAAP net income of $44.8 million -- quite a reversal of fortune due to a segment that was originally less than 20% of its revenues.
Ship Finance International reported $32 million in net income last quarter. At double its second-quarter dry shipping rates, the $15.4 million in extra revenue would have increased its net income by nearly 50%. This is despite the dry bulk shipping business being around only 10% of its sales last quarter.
Investors can participate in dry bulk shipping in ways that can lead to tremendous upward gain while taking on limited fundamental risk. Even companies with only 10%-20% of their businesses in the dry bulk shipping segment can see huge improvements in the bottom line. Drops in rates could also affect the bottom lines in a negative way, but with so little percentage exposure the risk is not as devastating. Companies that have others areas of business to sustain them during drops in dry shipping rates offer investors a unique opportunity of reduced risk yet high potential reward.
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.