Shipping Woes: More Than Just Pirates

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As global trade hums along, the index gains, because the number of ships in the world is pretty steady at about 22,000, so increasing demand increases shipping costs.

But when the index drops, eyebrows go up, since lower demand for commodities today means lower economic activity a few months down the line. "These rates represent the cost of shipping goods that are maybe two to three weeks from being put on a boat, and about a month or so from being delivered," says Phillip Rogers, a researcher at Galbraith's, a London shipbroker. "A falling index means fewer of these goods are actually getting shipped."

Most of the index's fluctuations are tied to the cost of shipping steel around the world. China, which makes up almost 60% of the index and is among the world's biggest steel consumers, has seen its annualized rate of steel production drop from 570 million tons in June to less than 475 million tons in September, according to data provided by the Chinese government. The International Monetary Fund predicts the global economy will slow the most since 1982, primarily on the back of reduced trade that's exacerbated by the credit crisis. "We really are at the point where there is no real trade," says Jon Windham, an analyst with Macquarie Securities. "The recent correction in dry bulk freight rates is very troubling for industrial production numbers over the next few months."

"Reversal of Sentiment"

But the falling demand for commodities—and their falling prices—is also a wait-and-watch game for manufacturers, who are delaying shipments as far out as possible to let commodities correct from the peak reached during the last bull run in commodities. Steel prices, for instance, are dropping almost every day and are down almost 20% globally from their July prices, mostly due to reduced demand. "The dry index has fallen for several factors, but the clearest factor is the reversal of sentiment," says Jeremy Penn, chief executive of the Baltic Exchange, which compiles the index. "But there are short-term factors, including [the drop in] the letters of credit."

Letters of credit are the second part of the equation. Before shippers can put commodities on a boat, they like to get letters of credit from the eventual purchaser—a bank guarantee that their client is capable of paying when the cargo arrives. But since the credit crisis has tightened, manufacturers are having more and more trouble getting letters of credit. "With the credit crisis causing banks to shy away from lending to one another for much longer than overnight, there have been reports of banks refusing to honor letters of credit from other banks," said Matt Robinson, an Australia-based analyst for Moody's (MCO), in a report issued on Oct. 23.

Nearly 90% of the world's shipments rely on letters of credit, according to the World Trade Organization. While the drop in the availability of letters of credit is still largely anecdotal—there is no centralized data available—reports of shipments being stranded are doing the rounds of transportation companies. Galbraith's, the London shipbroker, said in a news release in late October that "stories [are] coming from all parts of the globe referring to early redeliveries, withdrawal by buyers from ship purchase agreements, bankruptcy of numerous steel traders, credit facilities being closed without notice to companies with previously unblemished records."

And then there's the falling price of steel. Steel prices peaked earlier this year, leveling off demand, leading to a drop in the Baltic dry index. But now, even as steel prices have dropped significantly and shipping rates are ridiculously cheap compared to a year ago, nobody is ordering more steel or iron ore. So the movement of commodities across the globe has slowed to its lowest rate in six years. The credit crisis is making it tougher for the manufacturers to import, even at a time of falling commodity prices, and steel consumption is refusing to increase, even as both purchase and shipping rates drop.

Srivastava reports for BusinessWeek from New Delhi.