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Global Energy Weekly

Dry freight could recover next year

The Baltic Dry Index is lagging the economic cycle Traditionally, the Baltic Dry Index has been one of our favourite leading indicators of the business cycle. Now that the economy and commodity prices are finding support and cyclical commodities like iron ore, copper and crude oil are strengthening, the relative weakness of dry bulk shipping prices is somewhat surprising. Growth in global industrial production is rebounding at the strongest rate since 2000 but the freight market is lagging. This is because after decades of minimal new dry bulk carrier supply, fleet additions have picked up strongly and the total bulk carrier fleet is expanding rapidly.

We see some upside in the medium-term We believe that dry freight prices have troughed and should find some support going forward, benefitting from the global cyclical recovery. While the potential for the market to spike near-term is low, due to the overcapacity of ships, the outlook for demand is very positive. The global iron ore market is tight and seaborne demand is growing rapidly, particularly from China. Moreover, the global coal markets are starting to show signs of tightness with API4 coal prices rebounding to 18-month highs. We see some upside to dry freight in the medium-term, once the oversupply of ships is absorbed in 2011. A strengthening global economic cycle and unsaturated demand for raw materials in EMs is stimulating global seaborne iron ore and coal trade. In aggregate, total trade in dry bulks could increase by 7% this year. This will bring demand back to record highs, completely compensating for last year’s demand destruction.

Long forward freight positions benefit from backwardation We do not believe in a spiking market due to the abundant supply outlook which should keep freight prices on a gradual appreciation trend. However, we believe that the term structure of the freight market will remain in backwardation. Implied vols on dry freight contracts remain relatively high, particularly at the very front end of the vol term structure. Hence, overwriting options over a long freight position could generate a stream of income to complement exposure to flat prices.

Table 1: EIA Weekly Storage Update Latest Prev. Last Year Change Crude Stocks 355.9 354.0 370.6 1.9 Mogas Stocks 224.9 221.3 217.3 3.6 Mid Dist Stocks 148.9 146.8 142.3 2.1 Fuel Oil Stocks 44.4 42.6 36.3 1.8 Crude Imports 9,613 8,880 9,855 733 Mogas Imports 756 571 1,117 185 Mid Dist Imports 106 184 192 (78) Refinery Runs 14,678 14,813 14,516 (135) Refinery Ut (%) 85.9 85.6 83.4 0.3 Nat gas stocks 1,829 1,756 1,741 73 Source: US Department of Energy Note: Stocks in million bbl, Flows in 1000 b/d.

Commodities | Global 26 April 2010

Global Commodity Research MLPF&S (UK) Sabine Schels +1 646 855 3340 Commodity Strategist MLPF&S [email protected] Francisco Blanch +44 20 7996 4144 Commodity Strategist MLPF&S (UK) [email protected] Gustavo Soares +1 646 855 4835 Commodity Strategist MLPF&S [email protected] Tanapoom Damraks +44 20 7995 6574 Commodity Strategist MLPF&S (UK) [email protected] Shin Kim +1 646 855 5211 Commodity Strategist MLPF&S [email protected]

Chart 1: Seaborne demand for iron ore, coal or grains trade will unlikely absorb the supply of new ships this year

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Demand Supply

Growth in dry bulk demand and freight supply

Forecast

Source: Clarksons, BofAML Global Commodities Research

Table 2: BofAML Commodity Price Forecasts ($/bbl) 2Q10 3Q10 4Q10 WTI Crude Oil 83.00 90.00 94.00 Brent Crude Oil 83.00 90.00 94.00 USGC No. 2 HO 9.50 9.00 13.00 USGC RBOB Gasoline 11.00 10.00 5.00 USGC 1% Residual -10.00 -10.00 -8.30 NWE 0.2% Gasoil 9.00 8.50 14.00 NWE Prem. Gasoline 7.00 6.00 2.00 NWE 1% Residual -8.50 -9.00 -7.00 US Natural Gas 4.50 4.80 5.60 Source: BofA Merrill Lynch Global Commodity Research Estimates Note: products quoted in crack spreads, US nat gas in $/MMBtu

Globa l Energy Week ly 26 Apr i l 2010

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Dry freight could recover next year

Dry bulk freight prices have been depressed this year This week, the IMF upgraded its forecasts for global economic growth. The fund now expects growth of 4.2% in 2010, the fastest pace since 2007, from 3.9% prior (Chart 2). Our economists have for months forewarned of a sharper-than-expected cyclical recovery, now calling for 4.6% growth in 2010 and 2011, led by emerging markets and manufacturing. Despite the continuous rebound in industrial production around the world, dry bulk shipping prices—a major gauge of the cost of hauling iron ore, coal, cement or grains around the world—have failed to gain any strength this year. In fact, the Baltic Dry Index is barely trading at the same level that it closed at in 2009. Freight rates in the capesize market, referring to the extra large ships transporting iron ore, coal and grains, are down over 22% YTD. Although Baltic Dry freight rates quadrupled over the course of last year when demand for dry bulk shipping rebounded, the market failed to find any direction this year (Chart 3).

The Baltic Dry Index is lagging the economic cycle Traditionally, the Baltic Dry Index has been one of our favourite leading indicators of the business cycle. Now that the economy and commodity prices are finding support and cyclical commodities like iron ore, copper and crude oil are strengthening, the relative weakness of dry bulk shipping prices is somewhat surprising (Chart 4). Growth in global industrial production is rebounding at the strongest rate since 2000, partially driven by base effects, but the physical freight market is lagging (Chart 5).

Chart 2: The IMF just sharply upgraded its global economic growth forecasts, closing the gap to our own forecasts

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1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Global economic growth (PPP weights)YoY F'caststrend growth: 1980-2008

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Source: IMF WEO, BofAML Global Commodities Research

Chart 3: Freight prices for Baltic dry carriers shot up sharply last year but have remained fairly erratic over the past months

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Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Baltic Dry Index Capesize Panamax

Baltic Dry Index value and values by ship

Source: Bloomberg, BofAML Global Commodities Research


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We see some upside in the medium-term We believe that dry freight prices have troughed and should find some support going forward, benefitting from the global cyclical recovery. While the potential for the market to spike near-term is low—due to the overcapacity of ships—the outlook for demand is very positive. A strengthening global economic cycle and unsaturated demand for raw materials in EMs is stimulating global seaborne iron ore and coal trade. The global iron ore market is tight and seaborne demand is growing rapidly, particularly from China. Moreover, the global coal markets are starting to show signs of tightness with API4 coal prices rebounding to 18-month highs. We see some upside in the medium-term, once the oversupply of ships is absorbed in 2011. Interestingly, volatility in the sector is still realizing way above the long-term average. In our view, realized volatility is likely to remain high near-term given the uncertainty about China’s iron ore demand and the oversupply of ships (Chart 6).

Near-term, strong supply growth is weighing on the market Prior to the ‘Great Recession’ of 2008/2009, severe supply bottlenecks coupled with a remarkably inelastic demand side boosted dry freight prices and volatility (Chart 7). Prices spiked due to a lack of spare capacity in the shipping market, resulting from over two decades of underinvestment. Of course, solving a supply

Chart 4: Traditionally, dry freight signalled the strength of the global economic cycle but dry freight is now lagging

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Jul-09 Sep-09 Nov-09 Jan-10 Mar-10

Baltic Dry Index Crude Oil Copper Iron ore

Price movement of cyclical commodities

Rebased to July 2009

Source: Bloomberg, Reuters, BofAML Global Commodities Research

Chart 5: Prior to the ‘Great Recession’, severe supply bottlenecks coupled with an inelastic demand side boosted dry freight prices

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BDIY World IP (rhs)

World IP growth and Baltic Dry Index

index YoY

Source: Bloomberg, Ecowin,, BofAML Global Commodities Research

Chart 6: Realized vol could remain high given the uncertainty about China’s iron ore demand and the oversupply of ships

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3-month realized volatility on the Baltic Dry freight index

Source: Reuters, BofAML Global Commodities Research

Chart 7: After decades of minimal new dry bulk carrier supply, fleet additions picked up strongly over the past years

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Dry bulk carrier development (lhs) Dry bulk freight index (rhs)

mn dwt indexDry bulk freight market

Source: Clarksons, Reuters, BofAML Global Commodities Research


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bottleneck in dry bulk shipping is relatively simple as construction lead-times are very short. Hence it is no surprise that the order books of ship builders around the world filled up rapidly following the price increases of 2007 and 2008. After decades of minimal new dry bulk carrier supply, fleet additions picked up strongly over the past years and the total bulk carrier fleet expanded rapidly.

Shipping overcapacity is the new norm During 2004-2008, the average annual growth rate for the dry bulk fleet hovered around 7%, significantly above the previous decades. More recently, there has been a major step change in fleet additions (Chart 8). In 2009, the total dry bulk fleet expanded by 10% YoY or 42 million dwt, the strongest growth in the fleet’s history, ending the year with 460 million dwt of capacity. On top of that, the fleet is expected to grow another 12% this year, adding 55 million dwt, after accounting for cancellations, delays and fleet scrappage. On our estimates, that will bring the total fleet to 515 million dwt by the end of 2010. The growth is already happening as we speak. As of March this year, 170 vessels have already been added to the fleet.

The capesize fleet continues to grow dramatically Capesize vessels are largely driving the phenomenal growth (Chart 9). Last year, the fleet increased by a record 19%, or 132 incremental vessels. The capesize fleet just surpassed the 1000 mark (179 million dwt), from about 820 by the end of 2008. We estimate capesize supply will increase by another 18% and expect 125 vessels to be delivered. Outside the capesize fleet, it is also worth highlighting the growth of the smaller Handymax and Panamax vessels, which we expect will show 12% and 9% growth this year, respectively.

Still, the industry is responding Supply additions, however, appear to be peaking in 2010 and 2011, and will level off sharply thereafter (Chart 10). Moreover, there are some tentative signs of the industry responding to the overcapacity. According to Clarksons, 40% of the fleet orderbook was cancelled or delayed in 2009 and shipyards are continuing such practices given concerns of ongoing oversupply. Our estimates discount a similar non-delivery rate. Since the end of the 2008, the fleet orderbook has been coming down steadily, particularly in the last few months (Chart 11).

Table 3: Bulk carrier market, as of March 2010


Chart 8: The dry bulk freight fleet is seeing staggering growth this year and next...

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1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010Handysize Handymax Panamax Capesize

Dry bulk freight supplymn dwt


Chart 9: ...driven particularly by the extra large capesize vessels

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Handysize Handymax Panamax Capesize

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Dry bulk freight supply growth



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We do not see further downside to freight rates near-term In our view, it is highly unlikely for the seaborne demand for iron ore, coal or grains to entirely absorb the supply of new ships this year and in 2011 (Chart 12). The market will likely remain oversupplied for the remainder of this year and for most of 2011, likely restricting dry bulk freight prices from rallying sharply. Still, while the expansion of the global fleet of dry bulk carriers will help temper the market for the remainder of this year, prices will unlikely go lower. Quite crucially, the wave of new ships is hardly a surprise to anyone in the shipping industry. A significantly flatter-than-normal capesize forward curve indicates that the market is already discounting the rising supply of new ships (Chart 13).

Demand for iron ore, steel and coal is growing strongly Equally, we see support for dry bulk freight prices at current levels. In aggregate, total trade in dry bulks could increase by 7% this year to 3.2 million tons. This will bring demand back to record highs, completely compensating for last year’s demand destruction (Chart 14). Within the major bulk commodities, iron ore is undoubtedly the single biggest driver of dry bulk trade at the moment. The global

Chart 10: Supply additions will level off after 2011

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2005 2006 2007 2008 2009 2010 2011 2012

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Annual dry bulk freight supply additions

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Chart 11: The order book has been coming down steadily as the industry is responding to the oversupply

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Chart 12: It will be hard for the seaborne demand for iron ore, coal or grains trade to entirely absorb the supply of new ships this year

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Demand Supply

Growth in dry bulk demand and freight supply

Forecast


Chart 13: A significantly flatter-than-normal capesize forward curve signals that the market is already discounting the new supply of ships

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Capesize average front month timespreads

$/day

Source: Bloomberg, BofAML Global Commodities Research


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iron ore market is probably one of the tightest commodity markets and we expect it to remain in deficit until 2012 (“Metals & mining industry primer”, 22 April 2010). Reflecting strong demand, spot iron ore prices just spiked to a record $185/tonne.

The global iron ore market is dependent on China The global market is highly dependent on China, the world’s top producer and consumer of iron ore. China is also the largest blast furnace steel producer given its voracious appetite for steel. With production in China likely to expand at a rate of 11% this year, iron ore will continue to be in very high demand. Similar to thermal coal, China has ramped up its imports of iron ore rapidly over the past 5 years as domestic production growth could not keep up. Since most of China’s iron ore reserve base is of very low quality and costs of new mines are high, its reliance on foreign-sourced ore will remain high going forward. While we expect a lower growth rate than last year, iron ore imports so far this year are still expanding at a strong rate, particularly from Australia (Chart 15). Outside China, demand for steel is already growing faster and recovering earlier-than-expected, helping to support global seaborne iron ore demand.

The seaborne coal market is picking up steam Developments in the coal and grain markets also point to rising demand going forward. South African coal prices have just rebounded to $100/mt, the highest since November 2008, on signs of tightness, and European coal prices have rebounded even more strongly. Asian demand for seaborne coal continues to be strong, pushing coal prices in the Newcastle above the $100/mt FOB mark for the first time in four months (Chart 16). China’s interest in seaborne coal has picked up marked steam since our last update on coal, partially driven by stronger economic growth and partially by a higher coal-burn due to low hydro levels in the South West. Underscoring the strong demand momentum for coal in the Asian region, India just bought its first capesize cargo from Colombia (Chart 17). In our view, the relative weakness of API2 coal relative to API4 coal could now start to dissipate on the forward curve.

Chart 14: Unsaturated demand for raw materials in EMs are stimulating seaborne iron ore and coal trade

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Total dry bulk demandF'cast


Chart 15: The global iron ore market is highly dependent on China, where imports are highly volatile but still growing positively

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02 03 04 05 06 07 08 09 10-10%-5%0%5%10%15%20%25%30%35%40%45%50%55%60%65%

Iron ore imports % YoY (rhs)

mn tons China iron ore imports

Source: CEIC, BofAML Global Commodities Research

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Long forward freight positions benefit from backwardation We believe the dry freight market has upside in the medium-term, benefitting from the global cyclical recovery, so a long position makes sense. At the same time, we do not believe in a spiking market due to the abundant supply outlook which should keep freight prices on a gradual appreciation trend. In our view, the term structure of the freight market will remain in backwardation. Moreover, implied vols on dry freight contracts remain at relatively high levels (Chart 18). Implied vols are particularly high on the very front end of the vol term structure (Chart 19). Hence, overwriting options over a long freight position could generate a stream of income to complement exposure to flat prices.

Chart 16: Chinese coal imports have ramped up sharply in March on a MoM basis

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Chart 17: Global coal prices are picking up lately, indicative of the positive demand momentum

Global coal prices

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$/t


Chart 18: Implied vols in dry freight contracts remain at relatively high levels

Freight options implied vols and Baltic indices realized vols

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Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10Capesize implied vol on the front quarter Panamax implied vol on the front quarterBaltic Capesize index past 90 realized vol Baltic Panamax index past 90 realized vol

Source: IMAREX, Bloomberg, BofA Merrill Lynch Global Commodity Research

Chart 19: The implied vol term structure in Capesize and Panamax options is quite backwardated

Freight options implied vol term structure

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Capesize Panamax Source: IMAREX, Bloomberg, BofA Merrill Lynch Global Commodity Research


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Petroleum – US Chart 20: US crude oil stocks

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Source: US Department of Energy

Chart 21: WTI crude oil price

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Source: NYMEX, Bloomberg

Chart 22: US gasoline stocks

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Chart 23: US RBOB cracks

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Source: NYMEX, Reuters

Chart 24: US distillate oil stocks

90100110120130140150160170180


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Chart 25: US distillate oil cracks

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Petroleum – US & Europe Chart 26: WTI implied volatility

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Chart 27: WTI Term Structure

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Chart 28: European crude oil stocks

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Source: Euroil

Chart 29: Brent - WTI crude spread

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Source: IPE, Bloomberg

Chart 30: European distillate stocks

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Source: Euroil

Chart 31: ICE gasoil cracks

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Source: Reuters


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Petroleum – Asia Chart 32: Japanese crude oil stocks

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Source: International Energy Agency

Chart 33: South Korean crude oil stocks

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Source: International Energy Agency

Chart 34: China crude oil imports

1.52.02.53.03.54.04.55.05.5


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Source: Reuters

Chart 35: Brent - Dubai crude oil spread (1-month contract)

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Chart 36: Singapore light & mid distillate stocks

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Chart 37: Singapore residual stocks

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Gas & Power – US Chart 38: US natural gas stocks

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Chart 39: US natural gas price

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Chart 40: US natural gas implied volatility

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Chart 41: US natural gas term structure

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Chart 42: US NYMEX forward coal prices

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Front quarter contractFront y ear contract

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Chart 43: US spot PJM power prices

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Gas & Power – Europe

Chart 44: UK Interconnector gas flows

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Source: UK Interconnector Flows

Chart 45: UK gross gas production

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Chart 46: UK National Balancing Point (NBP ) day ahead

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Chart 47: Germany and France CAL09 Baseload

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Chart 48: TFS API2 coal in Rotterdam

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Chart 49: European CO2 Emissions Price

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Table 4: Global Commodity Research Publications - Past Topics* Date Publication Title 22-Apr-10 Commodity Derivatives Insights The oil vol (non-identical) twins

19-Apr-10 Global Metals Weekly Platinum and palladium for autocatalysts

19-Apr-10 Global Energy Weekly Oil prices struggling near term

11-Apr-10 Global Metals Weekly The copper pain and gain matrix

09-Apr-10 Global Energy Weekly Drowning in liquid gas….or not?

01-Apr-10 Commodity Portfolio Monthly Call overwriting: from broad to selective exposure

31-Mar-10 Global Energy Weekly Light-heavy oil spreads to continue to widen modestly

30-Mar-10 Metals Strategist Opportunities in metals: update to price forecasts

25-Mar-10 Commodity Derivatives Insights The fearless nat gas market

22-Mar-10 Global Energy Weekly Gasoline and gasoil are back!

19-Mar-10 Global Metals Weekly Key co-ordinates of Chin's gold market

15-Mar-10 Global Energy Weekly Lowering nat gas forecast on shale output

12-Mar-10 Global Metals Weekly Nickel: window of opportunity

08-Mar-10 Global Energy Weekly Crude oil curve to flatten further

07-Mar-10 Global Metals Weekly Does the shape of the yield curve matter?

01-Mar-10 Commodity Portfolio Monthly Momentum strategies in commodities

01-Mar-10 Global Energy Weekly Not much upside to API2 coal near-term

26-Feb-10 Global Metals Weekly Lead market surplus to be small

24-Feb-10 Commodity Derivatives Insights Despite recovery, macro concerns linger

22-Feb-10 Global Commodity Paper #11 Commodity alpha, beta and the super-cycle

21-Feb-10 Global Metals Weekly Why aluminium is a dog

19-Feb-10 Global Energy Weekly Non-OPEC oil supply could peak in 2011

16-Feb-10 Global Energy Paper Medium-term oil outlook: a balancing act

14-Feb-10 Global Metals Weekly Positioning on the LME

07-Feb-10 Global Metals Weekly Zinc mine supply is the swing factor

05-Feb-10 Global Energy Weekly A cocktail for backwardation

01-Feb-10 Commodity Portfolio Monthly 2010 starts with a sell off

01-Feb-10 Global Metals Weekly Chinese metals demand to slow down

29-Jan-10 Global Energy Weekly Petchem strength to lead recovery in oil

27-Jan-09 Commodity Derivatives Insights Launching the MLCX Vol indices

24-Jan-10 Global Energy Weekly CO2 prices: Mission Impossible

22-Jan-10 Global Metals Weekly Nickel project delays possible

17-Jan-10 Global Metals Weekly Raising PGM price forecasts

15-Jan-10 Global Energy Weekly Tighter money in china is a positive for oil

08-Jan-10 Global Metals Weekly Restocking will support metals demand

08-Jan-10 Global Energy Weekly Upside to oil capped near-term

05-Jan-10 Commodity Portfolio Monthly Commodity returns in review

18-Dec-09 Global Metals Weekly Precious metals as FX reserve diversifiers

18-Dec-09 Global Energy Weekly Cold weather temporarily revives nat gas

15-Dec-09 Commodity Derivatives Insights Commodity correlations not low, just lower

11-Dec-09 Global Energy Weekly Weather turning colder; economy warming up

11-Dec-09 Global Metals Weekly Copper pressure indicator supports prices

08-Dec-09 Commodity Strategist 2010 Commodity Outlook

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Table 4: Global Commodity Research Publications - Past Topics* Date Publication Title 06-Dec-09 Global Energy Weekly Strong headwinds for UK nat gas in 2010

04-Dec-09 Global Metals Weekly Platinum market is rebalancing

01-Dec-09 Commodity Portfolio Monthly Index rebalancing: what's in & out in 2010

27-Nov-09 Global Metals Weekly A primer on the iron ore spot market

20-Nov-09 Global Metals Weekly Gold prices move towards $1500/oz

20-Nov-09 Energy Strategist 2010 Energy Market Outlook

20-Nov-09 Commodity Derivatives Insights Gold and FX volatility at odds

12-Nov-09 Global Metals Weekly Update to price forecasts

12-Nov-09 Global Energy Weekly Revising up our crude oil price forecasts

06-Nov-09 Global Metals Weekly Aluminium to stay weak

06-Nov-09 Global Energy Weekly Gold leads oil: competitive depreciation?

02-Nov-09 Commodity Portfolio Monthly Commodities rally in October

01-Nov-09 Global Metals Weekly The union of China, USD and metals

30-Oct-09 Global Energy Weekly Gasoline to weaken against HO this winter

28-Oct-09 Commodity Derivatives Insights Gold bugs hold on to their calls

23-Oct-09 Global Metals Weekly Silver: the golden child

23-Oct-09 Global Energy Weekly Oil still lags other asset values

16-Oct-09 Global Metals Weekly LME week in a nutshell

16-Oct-09 Global Energy Weekly Week USD driving coal now, EM demand next

09-Oct-09 Global Metals Weekly Zinc demand set to increase

09-Oct-09 Global Energy Weekly Residual fuel cracks to weaken slightly

02-Oct-09 Metals Strategist Lower Chinese metal imports as entry point

02-Oct-09 Global Energy Weekly China back in a box oil vs. FX

01-Oct-09 Commodity Portfolio Monthly September puts gold in focus

25-Sep-09 Global Metals Weekly Unbalanced global growth affects nickel

24-Sep-09 Global Energy Weekly Value opening up in US nat gas in 2H2010

23-Sep-09 Commodity Derivatives Insights WTI oil impl vol high compared to realized

18-Sep-09 Global Metals Weekly Are time-spreads fairly valued?

18-Sep-09 Global Energy Weekly Distillate cracks on a recovery path

17-Sep-09 Global Commodity Paper #10 Investing in agriculture

11-Sep-09 Global Metals Weekly Gold is breaking out

10-Sep-09 Global Energy Weekly OPEC: Brothers in arms…or not?

01-Sep-09 Commodity Portfolio Monthly Metals perform again in August

28-Aug-09 Global Metals Weekly Housing as a foundation to metal demand

26-Aug-09 Global Energy Weekly Crude oil volatility trending lower

21-Aug-09 Global Metals Weekly Tight scrap supply to support metals

19-Aug-09 Global Energy Weekly Rebound in distillate cracks months away

17-Aug-09 Commodity Derivatives Insights Determining the risk premium in WTI crude oil futures

14-Aug-09 Global Metals Weekly Governments save the day for metals Source: BofAML Global Commodity Research *Please contact us if you would like to receive copies of any of the above


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Link to Definitions Macro Click here for definitions of commonly used terms.

http://research1.ml.com/C?q=wpAvVk4sJJM_


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dry freight could recover next year · global energy weekly dry freight could recover next year the...

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