BHP has booked 17 “Capesize” bulk ore carriers to carry its ore from the Pilbara to China next month. Normally, BHP books about 9 bulk carriers per month. But in April, BHP booked 13 and Rio Tinto 16. The armada of iron ore is relentless.

But BHP’s latest big booking may be exploiting a weakness in Rio Tinto’s flank, according to today’s Australian. Remember that last week reports circulated that the semi-official China Iron and Steel Association was calling for a boycott of Rio Tinto by Chinese steel makers. The Association pointed out that Rio was only fulfilling 82.2% of its contract obligations to Chinese mills.

That would matter for a simple reason. Last year’s contract price for ore is between US$60 and US$70. Meanwhile—because China imported a record 42 million tonnes of ore in April—ore in the spot market is going for closer to US$200. Rio said last year it would sell more ore in the spot market to take advantage of the big spread. The move was widely seen as a way of pressuring Chinese steelmakers to accept a much higher contract price for 2008 AND the so-called “freight premium.”

Hmm. If China is punishing Rio, is it rewarding BHP? Or is this a divide and conquer strategy? Either way, we have six weeks to go before a new contract must be signed. The strategies are clear: BHP and Rio want more for ore, China wants to pay less. But the tactics are sure getting interesting.

Either way, shipping rates are going through the roof. There was some anxiety about this in late January of this year, when the average daily rate for booking a Capesize freighter from Brazil to China fell to a paltry $84,000. In a Diggers and Drillers story at the time, we pointed out that this was no cause for alarm.

In our story, “A False Signal in the BDI and Boom Times Ahead for Coal and Iron Ore,” we pointed out that the slump in shipping rates, as expressed in the Baltic Dry Index (BDI), wasn’t an “abandon ship” signal for the resource bull. A harsh winter in China halted exports of coal. The power crisis in South Africa halted South African coal exports. And ships were queued up in Newcastle as infrastructure bottlenecks and flooding in Queensland dropped production volumes at Aussie coal mines.

Those three factors led to the dip in the BDI. But it’s back with a vengeance now. Daily rates are nearing $300k from Brazil, according to the Australian. In 2003, before this resource love affair between Australia and China began, rates were closer to $17k per day. Jeez, that’s barely 340 shares of BHP at today’s price.

“The dry bulk market is officially in riot mode,” says an analyst Norwegian-based Imarex. “Nearly 17 per cent of the 750-strong global fleet of Capesizes were delayed at ports over the weekend, according to the Global Port Congestion Index, which tracks ship delays,” again from today’s Australia. “Of the 129 bulk carriers at anchor, 52 are off Australia, with another 51 at ports in Brazil. Of the ships waiting off Australia, 38 are off Newcastle waiting for coal.”

Want coal, iron ore, or some other dry bulk commodity? Take a number.

Not everyone has their party hats on, though. A new report from Lehman Brothers says the commodity boom will become a commodity collapse at the turn of the year. “Once uncertainty about the physical state of the supply-demand balance clears, in terms of both inventories and spare production capacity, markets may face a sharp correction,” says Lehman analyst Edward Moore.

When predicting the demise of a bull market, it is important to distinguish between real demand and financial demand. If commodity prices were high merely because of financial speculation or foreign money bidding up Australian resource stocks, you bet we’d be concerned. And there is certainly a gathering momentum in the resource market that has just the whiff of a mania to it.

But it’s just a whiff right now. The term “perfect storm” is so overused that we refuse to use it any longer. So instead, you can think of the commodities bull as a positive feedback loop. That’s a situation where the causes of a given phenomenon accumulate and amplify the phenomenon. Boom begets boom.

Higher prices in commodities beget higher prices because they attract both investment demand (hot hedge fund and futures money) and eventually, hoarding. The great unknowns in the market are how much demand is real economic demand and how quickly supply can grow. Many oil skeptics, for example, believe there is plenty of oil in the world and that prices have taken on a fictitious life all their own.

But in the mania state of a bull market, prices become increasingly unstable and volatile as they go higher and higher, more and more removed from real supply and demand. We are clearly nowhere near that stage yet for bulk commodities or, we would argue, for oil. The boom is not yet a bubble.

If the boom goes bust, it will be because demand falls apart in China, or because the housing-related economic woes in America have a much worse second half than anyone is planning for. But right now, the new Silk Road isn’t a land route in Asia. It’s a line of Capesize haulers that stretch from Australia to China and back again.

We’ll have more specifics on oil Thursday and Friday. We’re taking a planned trip back to North America for two weeks and have decided to publish our analysis of the oil market in a two-part essay later this week. Until tomorrow…

Dan Denning
The Daily Reckoning Australia

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Source: Dry Bulk Market in Riot Mode

–That’s the percentage increase in the annual iron ore contract price Aussie producers charge major Chinese steel makers. It includes the much sought after “freight premium” which recognizes that its cheaper to ship ore from Australia to China than from Brazil to China.

–So what does it mean? Well, Chinese producer were hoping to NOT have pricing power in the ore industry lie with suppliers. But that hope seems to have faltered. Time for plan B. Plan B is to take equity stakes in a large number of smaller Aussie ore producers (see yesterday’s DR, and don’t discount the possibility of China Inc. taking a large stake in BHP a la Chinalco in Rio Tinto).

–Plan B also includes raising steel prices. Granted, as you can see from the chart below, courtesy of Macquarie Research, steel prices are already up 65% this year alone. But as you can also see, Chinese steel prices trade at about a US$400 discount to U.S. and world export steel prices. Whether this is how the Chinese subsidise domestic steel consumption or not, we can’t really say.

–But we can say that Chinese producers will increase exports this year and raise prices. Prices for domestic steel in China might differ from export prices. Who knows? But either way, you can be sure the Chinese steel producers aren’t simply going to absorb the huge increases in coking coal and iron ore. Chinese steel is going to get more expensive, whomever the buyer is.

–Normally, you’d expect to see higher commodity prices curtail demand. But for both steel and oil (see below) you haven’t seen any evidence yet that higher prices are slowing down demand. In fact, as this second chart from Macquarie shows, Chinese steel production is slated to grow by 10% this year. It even looks like the double bottom in steel production growth rates is in. Is it the beginning of a new steel boom?

–One company that hopes steel prices keep going up is Aquila Resources (ASX: AQA). The company told investors yesterday that it could produce about 25 million tonnes of iron ore per year from its ore bodies in the Pilbara…for the tidy sum of $4.1 billion.

–Welcome to the iron ore boom, Aquila (a company which also has coal and manganese assets). The company’s announcement was a little like a new doctor in a small town hanging out his shingle right across from the old doctor. The company isn’t producing anything yet. But like the other ore hopefuls in the Pilbara, it believes that with a little capital and a little deep water port facility at Cape Preston, its pre-feasibility study indicates it would have a nice little business.

–What is the difference between a shingle and a “for sale” sign?

–Meanwhile, the original third wheel in the Pilbara, Fortescue Metals (ASX:FMG), begins loading its ore for shipment to China this week. It’s been a long time coming. But FMG’s business has opened the door in the Pilbara and the Mid West for a long roster of other, smaller ore producers. The good old days of just BHP and Rio are long gone.

–What about oil? It just keeps going up. It reached nearly US$123 in New York trading over night. The Masters of the World at GoldmanSachs repeated their claim that a ’super spike’ in oil could drive it to US$200, on the back of red-hot demand in the developing world and the “non-recession” in the U.S. Supply bottlenecks won’t help.

The chart is below, click on it to see it full size.

Click on the image for a larger version

Queensland’s coal industry has never had it better. Yet one of the ironies of the recent rise in contract thermal and metallurgical coal prices is that coal producers may not be able to take advantage of them this year.

If you missed the news, thermal coal prices for 2008 more than doubled from $50 to $130. Meanwhile, the 2008 contract price for coking coal used by steel makers tripled, going from $80 to $300.

Unlike more widely traded commodities such as oil and copper, the prices for coal (both thermal and metallurgical) and iron ore are set in annual negotiations between major producers and consumers. The major producers are the large mining companies. Those include BHP Billiton, Rio Tinto, Xstrata (in coal), and Value (in iron ore).

The major consumers for thermal coal, used to heat boilers for steam-generated turbines and electric power, are Japanese Korean and electric companies. The relationship between these companies and Aussie firms go back all the way to the 1960s, when Japan and Korea began their post-war industrial growth spurts. For steel, the major consumers of Australian metallurgical coal and iron ore are Japanese, Korean, and, of course, Chinese steel makers. China is the world’s largest steel-producer (and consumer).

The price rises should be good news for Aussie producers. The trouble, at least in the coal business, is that bad weather and infrastructure bottlenecks are making it harder for Aussie firms to increase production volumes this year. You can’t sell what you can’t get to market.

So while export earnings for Aussie resource producers will be up this year because of the rising coal price, actual production volumes will not increase. As evidence, consider the first quarter production figures from Rio Tinto earlier this month. Rio’s coal operations are in the Bowen Basin of Queensland. That area was subject to heavy flooding in the first quarter. Coal production fell by 27%.

So who will benefit from the rising contract prices? The short answer is that coal mining service companies probably will. For the coal producers to expand production, they will to invest in mine expansion and infrastructure. In Queensland, where many of the mines are underground, that means work for the specialist firms that help build underground mines. Stocks to watch in the sector include:

1. Walter Diversified Services (ASX:WDS). According to the company, “Walter Diversified Services Limited (WDS) is principally engaged in the provision of specialist services to the underground coal mining industry, and to the infrastructure oil, gas and water pipeline construction and maintenance sectors in Australia.”
2. Whitehaven Coal Limited (ASX:WHC). Whitehaven actually operates several open-cut coal mines in New South Wales. But the company, which is really a group of companies, also mines and sells metallurgical and high grade thermal coals
3. Cockatoo Coal (ASX:COK) Cockatoo isn’t producing any coal yet. But it’s involved in four projects in Queensland, the Wonbindi project, the Dingo Coal Project, Guluguba and Mintovale. Cockatoo’s are in Queensland’s Surat coal basin, with slightly lower quality than the Bowen Basin coal. But as they are unmined, when production commences the company will be able to take full advantage of higher contract prices.

Another development to watch for? Coal-to-liquids (CTL) production of diesel fuel becomes economic with high crude oil prices, especially in areas where “stranded coal seams” are not large enough to mine economically as conventional coal. Those stranded seams now have to new routes to energy viability.

We covered one Aussie company engaged in the CTL business late last year in the Australian Small Cap Investigator. We suspect that there may more like it soon, if current events are any indicator.

Al Robinson
for The Daily Reckoning Australia