Asset Management

Not For The Faint-Hearted, The Shipping Derivatives Market

Vanja Sljiva, 28 January 2008

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The rise in the cost to charter ships and the rally in shipping derivatives was so spectacular in 2007 that it conjured up images of shipping hey day of Aristotle Onassis.

The rise in the cost to charter ships and the rally in shipping derivatives – also known as forward freight agreements – was so spectacular in 2007 that it conjured up images of shipping hey day of Aristotle Onassis. Hire rates and derivatives rose exponentially throughout the year and the only correlation they showed with other markets was that the worse the falls in the main stock markets, the more investors turned to this niche investment.

The Baltic Exchange Dry Index, an assessment of the cost of moving raw materials by sea, hit its highest-ever level in mid-November at 11,039 - that’s from around 4,421 at the beginning of 2007 and from around 2,000 in the 1990s.

But in mid-January the mood turned completely and over a space of days the BDI fell to 6,513.

This could be good news for investors because it provides an entry point to this $70 billion market that is forecast to rise by between 6 per cent and 7 per cent this year.

Two thirds of the world’s goods are shipped by sea but the two biggest users of the large dry bulk vessels which transport iron ore, coal, bauxite and grain are China and India.

China is still undergoing an economic boom and domestic demand shows no sign of abating. China imports iron ore from the two main producing regions – Brazil and Australia, while India is currently on a massive drive to increase electricity production through coal plants and for this purpose imports coal from Australia.

The dynamic between China on one side and Brazil and Australia on the other led to the cost of hire for capesize ships – the largest in the market and capable of transporting over 100,000 deadweight tons – rising to $149,000 a day in late 2007.

In January, however, capesize hire slipped to around $111,000 a day as Brazilian producer Companhia Vale do Rio Doce started withholding iron ore to gain leverage during annual price negotiations with Chinese buyers. One port outside Rio de Janeiro closed for repairs causing a sudden glut of available ships.

The move down was exaggerated by the fact that prices rose so much in 2007, and by rising expectations that the US will slide into recession this year potentially hurting Chinese exports. As a consequence the market dropped over 30 per cent in the second and third week in January.

While the drop was fairly spectacular, the annual negotiations between Companhia Vale do Rio Doce, Australia’s Rio Tinto and BHP Billiton and Chinese buyers will come to a conclusion at some point and loading of ships will continue. Once that happens the shortage of large cargo ships will be felt once more and prices will move up.

China’s appetite for raw materials does not show signs of easing off and analysts believe that even if the US goes into recession it will not affect the shipping market because Chinese domestic demand for raw materials remains strong. Lehman Brothers is forecasting that Chinese iron ore demand will rise in 2008 by 15.4 per cent followed by an increase of 12.5 per cent in 2009.

For investors keen to enter the market there is a small number of hedge funds currently involved in the arena plus a number of investment banks such as Goldman Sachs, Merrill Lynch, Deutsche Bank and Morgan Stanley. Citigroup is the latest big player to enter the market, having launched a trading desk in December 2007.

London-based M2M Management is running Global Maritime Investment, a hedge fund which is involved in a mixture of physical and paper trading – that is, chartering ships and shipping derivatives.

Steve Rodley, joint managing director for the fund, explained that being involved on the physical side and having ships at sea provides invaluable information which is otherwise not readily available. “This allows us to make profit from price differences in the system,” Mr Rodley said. M2M is planning on launching two more shipping funds in the second quarter, one dedicated to chartering and one to derivatives.

The derivatives are mostly traded over the counter and are cleared through the London Clearing House, NOS in Oslo and SGH in Singapore. A spokesman for the Baltic Exchange said that the volume of trade in derivatives went up by 34 per cent in 2007, adding that the increase was mainly in reaction to the volatility of the market. On the one hand, ship owners were keen to lock in rates to protect themselves from future swings, while financial players thrived on the price moves.

One such player is London-based hedge fund Castalia Springs which trades exclusively shipping derivatives. Castalia’s managing director Philip van den Abeele said he believes everything is in place for a good market for the next two years. “But the world is getting smaller and smaller and everything in the news is affecting the market,” he added. Two of the largest and most established hedge funds are Tufton Oceanic and Clarkson that trade a mixture of derivatives, shipping stocks and commodities.

Looking forward, despite the January decline in FFAs and the Baltic Index, fundamentals are expected to keep the market strong until the middle of 2009, when a number of ships currently being built will come onto the market, said James Leek, analyst for broker ICAP-Hyde.

M2M’s Steve Rodley argues that the situation will not be straightforward even then, because a lot of the delays in loading currently happening is being caused by the fact that main port facilities around the world are old and struggle to keep up with demand for loading. Most have not been updated for over 20 years and although work is in the pipeline, it will take a while before the situation is rectified.

In the near term, however, imminent grain sales in the US will help demand, said James Leek. In addition, analysts believe that China has only another two to three weeks of iron ore reserves left. Unless negotiations are resolved by then, it will have to start buying in the spot market, and given the high prices there, Chinese steel mills will very likely want to avoid that.

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