George Economou, CEO of DryShips (NASDAQ:DRYS), has been predicting through various mediums low global iron prices would cause Chinese mines to close, which would in turn lead to further importation and shipping demand. Sometimes, theories look great on paper but don't play out in reality. Based on that, I had my doubts, but the latest developments suggest that this vision is being played out now. .
The DryShips forecast
The logic from Economou, which was shared by many other executives, was that Brazil and Australia are ramping up production of iron ore and this would lead to excess world supply. This excess supply would lead to a steady but big drop in global market prices of iron ore.
The resulting depressed prices make various mines in China, which have very high costs, unprofitable; this leads to closures. Since China received around two-thirds of its massive iron ore needs last year from its own domestic mines, the closures would naturally lead to a much higher demand for imports. This would naturally increase the demand for dry shipping from companies such as DryShips.
April to May
Iron ore prices have indeed been in a tailspin lately, down 30% this year alone. . Iron ore has been flowing from Australia like water. The only reason (according to DryShips and others) shipping rates haven't quite responded yet is delays in Brazilian iron ore shipments and China's domestic mine closures. Quite frankly, these delays were starting to make the theories from DryShips look bad.
Brazil is twice as far from China as Australia is, and it therefore eats up twice the shipping supply. According to the Brazilian Ministry of Development, Industry, and Foreign Trade, shipments of the ore in the month of May spiked up 24.25% compared to April. This was possibly the beginning of a long trend upward.
Meanwhile, according to Ivan Szpakowski of Citigroup, we are now witnessing on average another mine closure in China every day. He stated, "Imported ore is much cheaper than domestic ore, so the shift in buying has moved to imported ore." That's exactly as DryShips expected.
The double-edged sword
There is one thing that DryShips failed to point out that hints things may not go as smoothly as the company expects. As these mines close and supply is taken offline, it may bring stability, or even increases, in iron ore prices. Since it is low iron ore prices that is bringing on the mine closures, any price recovery could slow down future closures.
Analysts from Morgan Stanley disagree however. They wrote, "We believe cost support provided by higher-cost Chinese operations will cease to exist as Chinese mines see widespread closures leading to a decline in prices." This implies the higher-cost iron ore will no longer be around and will no longer be passed on to customers. After the Chinese mine closures, the average per-ton supply of iron ore on the world market will have cheaper costs built into their prices and resulting in possibly less resistance for prices to fall.
Regardless of who is right, the whole situation should still be a net positive for DryShips and the dry shipping industry in general.
I was skeptical the mines would actually close and their owners would not hold out hope for possibly some sort of support such as a bailout from the Chinese government. It appears that DryShips' theory is turning into reality, and the next domino to fall will be increased shipping demand translating into increased freight rates. DryShips mentioned in its last conference call there was marginal oversupply in the shipping industry, and once that goes away then rates will shoot up. It will be interesting to see if it bears out as forecasted over the coming weeks and months.
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.