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Ships and oil

Created:

3 July 2009

Written by:

Chris Dillow

Never mind the oil price. It's the rise in shipping costs that has been really spectacular this year. So far this year the Baltic dry index has risen 480 per cent, dwarfing Brent crude's 57 per cent gain.

With hindsight, though, this rise in freight rates seems reasonable. My chart shows why. It shows the ratio of the Baltic dry index to Brent crude. You can see that this tends to mean-revert; a high ratio of shipping costs to oil prices leads to a fall in the former relative to the latter, and vice versa.

There's a simple reason for this. Both oil and shipping are barometers of the global economy; strong growth should raise both. So when the Baltic dry index is low relative to oil, it signifies either that the shipping market is unduly pessimistic, in which case freight rates will rise, or that oil markets are too optimistic, in which case oil prices will fall. Or, that high oil prices will themselves choke off economic activity, thus validating the Baltic's pessimism. Whatever the mechanism, the ratio mean-reverts. Since 1990, the correlation between the level of the ratio and changes in it in the following 12 months has been minus 0.58.

Late last year, the Baltic dry was at a record low relative to oil. In this sense, its rise relative to oil is quite normal.

So too is its rise in absolute terms. Post-1990 relations suggest that the Baltic-Brent ratio mean reverts more because of moves in shipping costs than oil prices. Since 1990 the correlation between the ratio and subsequent annual changes in the Baltic dry index has been minus 0.42, whilst that between the ratio and changes in oil prices has been 0.26.

Despite its recent rise, though, this ratio is still below its long-term average, which implies that shipping costs have further to rise. If post-1990 relations continue to hold, they'd rise 40 per cent by next July - although because these are very volatile, there's considerable uncertainty around this. By contrast, the ratio predicts little change in oil prices.

But why should we care about the price of boats? Isn't this only interesting to men in beards. No - for one thing, the Baltic dry index is correlated with global economic activity - for example, its collapse in the autumn was a warning that economies were in meltdown - and a good lead indicator of inflation. If this rises, therefore, it would be a sign that the economy is strengthening and the risk of severe deflation is receding - though of course really big rises would themselves eventually restrain economic activity.

Secondly, the Baltic-Brent ratio can be a lead indicator of equity returns. The All-share index tends to do well after the Baltic dry has been high relative to oil prices - for example in the mid-90s and in 2003-05 - and badly after it's been low, for example in 2001-02.

Right now, the ratio is sufficiently low to point to lacklustre returns. However, if the ratio continues to rise, the outlook for shares should improve.