Published: July 26, 2010

There are dozens of very large ships plying the global waters that do nothing but ferry dry goods. Think of coal, grain, steel and other such bulk goods. When major nations actively trade these goods, bulk ships are in hot demand and the cost to lease them can surge. But when trading activity cools, their lease rates can plunge very sharply.

Investors love to track this activity, using a handy indicator known as the Baltic Dry Index (BDI). Just a few years ago, investors were treating shipping stocks like they were internet companies from the dot-com era. The index surged from just over 2,000 in late 2005 to above 11,000 in 2008. As demand for these ships surged, lease rates soared thanks in large part to rising economic activity in China. Shares of DryShips (Nasdaq: DRYS), a leading bulk carrier, rose from under $10 in early 2006 to around $110 in May, 2008.

Two years on, the BDI has made a return trip all the way down to below 2,000 as new ships came on line just as demand was cooling. A headline on July 14 in the Wall Street Journal wryly noted: "Baltic Dry Index: Yes, It's Still Collapsing." The article opened on a sobering note: "Tuesday's close lower on the Baltic Dry Index marked the thirty-third consecutive decline of the index." And DryShips recently saw its shares fall below $3.50.

Those tough times appear to be coming to an end. The BDI has risen in each of the last five sessions, giving some long-awaited relief to sector shares. DryShips, for example, has risen more than +30% since July 2 to a recent $4.60.

Make no mistake, shares in the dry-shipping sector -- which also includes Eagle Bulk (Nasdaq: EGLE), Excel Maritime (NYSE: EXM) and Genco Shipping (NYSE: GNK) -- could really take off if rates rise a bit further and then can be sustained at those levels. That's because these shippers have huge fixed costs and the difference between low rates and decent rates can mean the difference between big losses and big profits.

So is this just a head fake, or the beginning of the next bull run for the BDI? That depends on a pair of questions. First, is global trade activity headed higher over the next few years? And second, how many ships are plying the waters in relation to potential demand?

On the first question, it seems increasingly likely that the global economy will not slip back into recession. Both Europe and the U.S. have likely dodged a bullet, which is why the International Monetary Fund predicted +3.5% growth for global GDP.
 

Yet China remains wildcard thanks to its voracious demand for raw materials. And there's good news on that front. China had been stockpiling key materials such as iron ore but more recently had been working to whittle down those stockpiles. Hence, their need for ships has cooled. That largely explains why the BDI had been falling sharply through mid-July.

But recent data imply that China is back in the market for more iron ore and other materials, and it is booking ships for use later this year at higher rates. The day rate for a 900 foot-long bulk carrier, known as Capesize, now stands at $12,755 a day, but they will go for $30,000 a day by the fourth quarter, according to a Bloomberg survey.

If those forecasts are correct, the BDI will trend well higher from here, and these high-beta stocks could double from current levels.

But back to that second question: how many dry bulk ships are available? Too many for the industry's liking. The shipping boom of 2008, when some of these ships garnered more than $200,000 a day in lease rates, led to a flurry of new construction. And that led to a glut of new ships that were only recently put into service. Future price wars for these mega-ships are unlikely to ensue, so the BDI and sector share prices are unlikely to reach 2008 highs in the foreseeable future.

Temper your expectations. A stock like DryShips won't surge towards the $100 mark like it did a few years ago. Instead, shares look poised to run towards the $7 or $8 mark if BDI rates can rise higher, as economists increasingly suspect. That's at least a +50% gain from current levels.

You also need to get a sense of each carrier's contracted backlog. In some instance, previous high-priced contracts will expire and be replaced by lower-priced leases. Genco Shipping for example, is expected to garner less for its fleet as peak-of-the-market contracts roll off. That's why analysts think per-share profits will fall more than -30% next year to around $2.80. Looking beyond next year, a modest rise in the BDI could push EPS back north of the $3 mark, and perhaps closer to the $4 mark. Shares trade for around $17, giving the company a very modest P/E.

In a similar vein, Excel maritime also trade for less than 10 times projected 2010 and 2011 profits. And those profits could spike far higher in subsequent years.

Action to Take --> DryShips, which trades for just 4.5 times next year's projected profits, reports quarterly results this Wednesday. A positive report could be great news for this entire sector, which only recently was plunging into the abyss.

-- David Sterman
Staff Writer
StreetAuthority