The ‘dragon’s burp’ spells trouble for commodity investors

Commodity prices – like shares – have enjoyed an impressive bounce in 2009. However, as Capital Economics flags in a recent note, one indicator – the Baltic Dry Index – points to trouble ahead.

The BDI captures the cost of hiring a bulk cargo ship to transport commodities such as coal, iron ore, grains and other raw materials.  As such, notes Capec, it’s “an indicator of the health of the global economy”. If so, having shown recent signs of life, the patient now isn’t looking too well – the BDI has halved since June. Why?

First off – and the least worrying explanation unless you happen to be a shipowner – there are more ships around that are not needed. Many were ordered during the boom years – but they can take two years to deliver, so they became available just as demand dropped. Extra competition for cargo is therefore putting downward pressure on lease rates.

But only up to a point. As Capec notes “the supply of new ships began to rise in January, well before the recent correction in shipping costs”.

So, commodity investors need to beware of a more sinister force – “the dragon’s burp”. When commodity prices suddenly fell as the recession hit, China took advantage by hoovering up and stockpiling what it could on the cheap. But that looks to be fizzling out. For example, having shown a healthy appetite recently for cheap iron ore and coal, it seems the Chinese are content with their stash – the Baltic Capesize sub-index that captures demand for the biggest ships that carry this type of commodity “has plummeted 65%”.

In short given “commodity markets have already priced in a strong economic recovery” investors should watch out – prices may be set for a sharp fall before the end of the year.