Frogs concern about the Baltic Dry Index

Over at Frog Blog, Frog discusses the current economic crisis and the magnificent fall in the Baltic Dry index. The sentence that summarised this feeling for me was:

Another part of me says that any indicator that drops 93% in less than six months is reflecting a serious ailment in the global economy

Now Frog is right to be concerned – he is right that this movement indicates a slowdown in global trade, and that any slowdown in global trade will impact on New Zealand by knocking down commodity prices. However, I would like to put the movement in perspective – as a figure such as a “93% drop” may give people the impression that we are in a more dire situation than we actually are.

The Baltic Dry Index is a measure that captures the “average daily cost for shipping raw materials” (*).

Now the reason that people have had so much interest in the BDI recently is because they believe rising shipping costs have been the result of rising demand for commodities – therefore an increase in the BDI indicates that there has been an increase in commodity prices. This makes sense as long as we have an “upward sloping supply curve” – an issue that will be important in this discussion.

However, the BDI has not always been seen as important in this way, going back to 1992 the index appears as follows:

bdi

Now between 1992 and 2002 the index mainly moved with actual cost pressures – namely the price of oil. The demand for commodities and international trade varied wildly over this period, but didn’t have a big impact on the BDI.

Fundamentally the 1992-2002 period and the 2003-now period for the Baltic Dry Index have one major difference which completely changed the behaviour of the index value – the capacity of shipping vessels.

What?

Shipping vessels are what is called a homogeneous good – effectively as long as people with raw materials can a dry goods ship to hire they can ship their goods, they don’t value different companies vessels differently.

Over 1992-2002 there were plenty of vessels, and there was good information about the price of different vessels, as a result we had a situation that was akin to perfect competition with a flat market supply curve. As a result shocks to demand for vessels did not change the price in the market (the vessel hiring fee), but shocks to the cost of providing the vessel (such as the price of oil) did have an impact.

However, moving through 2003 global shipping began to run into some “capacity constraints”. Now people that wanted to sell products had to compete to get a hold of some of the limited shipping capacity. People involved in the forestry industry in New Zealand will know all about this.

In the short run it is very difficult and costly to get new shipping vessels out and about – and as a result the supply curve becomes virtually vertical. In this case any increase in demand will directly translate into an increase in shipping costs and the BDI will give us a good indication of where commodity prices are going – namely because a major chunk of this increase is stemming from rising shipping costs!

Now there are two possible reasons why the BDI has collapsed:

  1. Piles of new shipping vessels have come online to take advantage of “super-normal profits”,
  2. Demand has collapsed sufficiently enough to see the capacity constraint fall by the wayside.

The second reason is the more likely reason (although we can’t exclude the first as playing some role – some vessels were due to come online around this time).

But this is still an intensely bad thing right?

If the run up in the BDI was solely the result of capacity constraints, then the loosening of these constraints isn’t necessarily bad for a country that doesn’t own any of the shipping firms. After all, the increase in shipping costs stemmed from the shipping firms ability to extract “surplus” from the supply chain – as a result the cost to producers and manufacturers will fall as a result of this.

However, the main point I want to get across is that if the plummet in the BDI is the result of a loosening in the capacity constraint then the index will no longer provide a good indicator of the movement of commodity prices. Yes the fall tells us that commodity prices will fall, but it doesn’t tell us if the net profit of exporters in our country will ease (as costs will also fall) and any movements of the index in its current range merely tell us what is happening to the costs faced by shipping companies – not general commodity prices.

So we are home clear!

Not necessarily. For one, the initial increase in the Baltic Dry index did come with an increase in the profitability of commodity sellers – and the fall is likely to see profitability fall.

Furthermore, we aren’t a “dry commodity” nation, we are a soft commodity nation – meat and milk. The collapse in the Baltic Dry Index does not actually tell us anything about the costs that our producers will face to ship goods – as the vessels are completely different.

Frog is right to have some concern over the fall in this index – but I think its role as a brilliant “leading indicator” will fall by the wayside as capacity constraints in the shipping industry ease.

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  • John

    I’m not sure how the economies of scale argument works in NZ’s case Matt .
    If we start out with a small population and economy based on farming fishing and forestry (and now tourism), while more people mean a healthy market for local producers and scales of production for local industries, is it assumed that exports grow as well?

  • Hi John,

    Good question, but is the comment meant to be on the productivity post?

    http://tvhe.wordpress.com/2008/11/18/do-we-want-productivity-growth/#more-1932

    Note in the comment on that post I was not saying that we do have increasing returns to scale – just that it is a possibility.

    Increasing returns to scale is an interesting issue. It stems from a situation where individual inputs increase the productivity of other inputs sufficiently so that a doubling of inputs leads to a more than doubling of outputs.

    http://en.wikipedia.org/wiki/Increasing_returns_to_scale

    Whether this is the case in the industries you have described I do not know – but I’ll have a look into it if you like, as it is interesting.

  • PaulL

    So all we can really say from this index (and the graph you provided) is that we are no longer capacity constrained in shipping. This tells us nothing about the profits of commodity sellers, but presumably as you say means either demand dropped somewhat (enough to get us below the capacity constraint – which might be 5% or might be 50%), or more capacity came online.

    Or, that future expectations of capacity are such that prices have dropped in anticipation (presuming that shipping is procured on some sort of forward contract, rather than cash on the day of loading).

    Any visibility of what sort of contracts these are on, and whether it perhaps represents shipping companies locking in contracts quickly in case the bottom really drops out of the market (and they have to operate below cost)?

  • Exactly PaulL 🙂

  • Does anyone know the actual (26?) routes to compile the BDI?

    I have always been sceptical of the appropriateness of the BDI as an indicator for lil’ ol’ NZ – and you have nicely articulated reasons why it is appropriate to be so.

    We do not need to look at the BDI to know that demand in developed countries is likely to to fall because of the credit crisis. And as you say, if it’s a result of improving capacity (yes – shipbuilding has been picking up in recent years and these are typically the result of orders placed several years in advance) then to the extent that the same overcapacity is present in shippers that service our neck of the woods, we should see lower costs for imports and possibly higher demand for our exports.

    BTW the dry term refers to the fact that these ships are not liquid – e.g. oil, chemicals. A ship that carries logs would be a dry bulk carrier. However, I believe that refrigeration generally means refrigerated containers and this type of shipping would not be covered by the BDI.

  • “Does anyone know the actual (26?) routes to compile the BDI?”

    No idea – however none of them will be routes down these ways methinks.

    “then to the extent that the same overcapacity is present in shippers that service our neck of the woods, we should see lower costs for imports and possibly higher demand for our exports”

    I think the important thing to remember is that a large part of shipping services is internationally flexible – so if demand for carriers falls overseas the ships can come here if the price is right. In the past, many ships haven’t bothered to come here because the price was so good overseas – and we have struggled to ship our forestry products, even when a buyer existed.

    With this constraint loosening it could help these guys out.

    “However, I believe that refrigeration generally means refrigerated containers and this type of shipping would not be covered by the BDI.”

    Indeed, our primary exports are not even covered by the BDI, and the ships are sufficiently different that the BDI gives very little indication of what is going on for the shipping costs we face.

    Looking at the index was always more of interest for people in the forestry industry rather than milk or meat exporters – and rightly so.