The Baltic Dry Index is a lousy predictor of commodity prices

Despite being touted every so often as an early indicator of an emerging economic trend or sign that commodity prices are about to dramatically strengthen or weaken, the Baltic Dry Index (BDI) has typically performed very badly. Indeed its important to remember what exactly the BDI is. See this excellent explanation from former Citi analyst Vincent Fernando (emphasis mine).

Why do shipping rates seem to jump all over the place? Due to near-term supply of ships versus demand for commodities. Its just a matter of bottleneck problems. If rates go up it can come from either of two things: not enough ships at the time or too much commodities demand at the time. In a situation where ship owners match demand, which over the long run they will, then rates won’t skyrocket and will just track their costs plus some margin for their effort.

But essentially one problem with using the BDI for economic forecasting is that the BDI could feasibly go up in an environment where commodities demand was shrinking, if the supply of ships was shrinking even faster. These would be negative economic factors. This is because the BDI’s value is not solely driven from the demand side. To me, it makes far more sense to just look at nominal demand for commodities rather than the BDI since the BDI has the complicating factor of vessel supply growth one needs to consider. The other thing is that the BDI is a measure of spot rates for dry bulk commodities consumers who, generally, are in the near term forced to pay whatever it takes to get their raw materials shipped (A steel plant needs to keep operating despite some higher ore transportation cost). On the flipside, vessel owners are in a similar boat (no pun intended), and in the near term are generally forced to take whatever rate they can get to fill their ships. (A ship sitting around is just a cost, ie. fixed costs are high, thus using a ship at a loss is usually better than not using it at all). Because of these inelastic characteristics of supply and demand, and since the BDI is a measure of spot rates, the BDI is thus absurdly volatile.

Fernando then offers up this very obvious example to explain the volatility …

Imagine you have 10 loads of iron ore and 9 ships, and that every load of iron ore must be sent no matter what while every ship must be filled no matter what. Imagine the bidding war between those 10 iron ore consumers fighting over just 9 ships. Shipping costs would skyrocket since they all need to ship regardless of cost. Now imagine if a week later two more ships enter the market. Now imagine the bidding process. Suddenly the tables have completely changed. You have 11 ships, that all need to be filled no matter what, and only 10 loads of ore. Shipping rates would plunge, despite a period of just a week passing by. This is, in a simplified nutshell why the BDI is so volatile.

And to conclude…

Now, add to this the fact that predicting ship supply and commodities demand has a pretty high margin of error, at the same time remembering how sensitive the BDI is to small mismatches due to the inelastic nature of its underlying supply and demand, and you quickly realize that predicting the BDI is a fool’s game and also that it is not a reliable forward indicator given that it is a spot rate index in a market where both sides are basically forced to close a deal due to high fixed costs. The BDI is a measure of supply/demand mismatch at the moment, and can change drastically on a dime. It’s little else beyond this. It hit its peak not when the global economy was in its healthiest state, but in early 2008 when things were already starting to come apart, but Chinese commodities demand growth still had some steam and just kept outstripping stagnant vessel supply growth. For a moment. And then it all collapsed.

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