Hiding out in the high seas

NEW YORK (Fortune) -- The global economy may still be adrift, but if you want to ride it out, consider hiding out in the high seas. Seaborne shipping companies are positioned to pick up the traffic from the eventual economic recovery, and they're a bargain these days - but predicting anything in the near term is much tougher.

Like some other sectors at the moment, shipping is coming off a terrible 2008, in which global shipping trade came to a slow down amid credit-freezing and frightened buyers of commodities. Now, China's half-trillion dollar stimulus package is spurring it to restock its raw materials inventories and seaborne shipping stands to benefit.

As China adds to its stores of coal, iron ore and gravel, so-called dry bulk shipping companies have been enjoying a relatively strong couple of months. The Baltic Dry Index, which is a measure of the average price of hiring such a ship, has been rallying in 2009, recovering about 15% of its drop from its May 2008 high. The index is also expected to get a boost when global iron-ore prices, negotiated every year between China and extractors like Rio Tinto and CVRD, are set on April 1.

"What we saw five or six weeks ago was a lot of buying after the Chinese New Year," says Omar Nokta, an analyst with shipping-focused boutique investment bank Dahlman Rose. "That led to a big run on dry bulk. Dry bulk is so attuned to China, which imports about half of the world's iron ore that's traded seaborne." Other economic stimulus efforts, like those in the U.S., are having a much smaller but also positive effect on rates as demand for dry goods picks up.

As a business, shipping seems easy enough: you have the boat, I have the stuff, I pay you to move it. But the art of it lies in knowing when to make ships available for short-term charters (known as the spot market) or when to go for a long-term contract.

In the spot market, an extractor like an oil or mining company needs something moved from point A to point B on a given day, and they pay the shipper a market rate. In a long-term contract, the shipper and the extractor agree to ship on a schedule and at an agreed-upon rate.

Shippers with the best management teams know how to use the spot market when prices are rising and switch to contracting when prices are falling, says Douglas Mavrinac, chief shipping equity analyst at Jefferies, an independent investment bank that does a lot of business raising capital for shipping firms.

But using spot to turn things around completely may not happen this year. Respected industry forecasting firm Drewery Shipping Consultants, based in London, wrote last week that it expects dry-bulk shipping rates to fall later in the year. "The current rally of freight rates is seen as a short-term recovery," analyst Jaya Banik wrote in a report. "Although the worst might be over, the market is expected to remain depressed over the coming months."

Analyst Nokta of Dahlman Rose, also bearish on the Baltic Dry Index, says the only real picks in shipping are those with the strongest balance sheets that can ride out a choppy year. In an industry with such capital-intensive activities like buying and repairing ships, leverage is always an issue. Royal Bank of Scotland, a big lender to shipping firms, said in December that it expected about half of all public shipping firms to default on their loans this year.

He also cautions that even if prices fall, contracts aren't necessarily a good guide to who might do well. While one shipper, DryShips (DRYS), switched quite a bit to contract at the peak of the market, he says, the question is whether those contracts will hold up as counterparties go bankrupt. "There's not a lot of trust these days," says Nokta. "We have seen charters unilaterally walk away and put these under a lot more pressure."

Another question mark is the supply of new boats hitting the seas. The boom in commodity prices of the early 2000s, which led to a boom in shipping, also produced a long backlog of boat orders that will continue to hit the market this year. In February, U.K. ship broker Galbraith's reported that the dry bulk fleet's capacity will increase by 17% this year, causing what it calls a "headache on the supply side" leading to a price drop in charter rates.

Mavrinac is bullish on dry-bulk shipping, but he cautions that his enthusiasm doesn't extend to wet bulk like crude oil because of a tanker glut. He believes delivery of new ships will be a far bigger problem in the tanker market. Plus, while falling oil prices aren't strictly bad for shipping, the price of oil futures is now falling faster than spot prices. So fewer investors will want to pay shippers to hold oil for them.

"As oil inventories reach very high levels, people aren't concerned about future access," Mavrinac says. "Also as OPEC has cut production, it's creating spare capacity." Stay away from companies like Frontline (FRO) and Overseas Shipholding Group (OSG), he advises, which each have most of their ships exposed to the spot market rather than on contract.

Nokta, on the other hand, says Nordic American Tanker Shipping (NAT), with very little debt, fits the strong balance sheet mold for buy-and-hold stocks. He also thinks that with many oil tankers set to be scrapped, due to new regulations by the U.N.'s International Maritime Organization requiring tankers to have stronger hulls, the supply glut won't be quite as bad as it could be.

There are funds, like the Claymore/Delta Global Shipping ETF (SEA), that hold a mix of dry-and-wet bulk shipping shares. At the moment it's more heavily weighted toward dry bulk, thanks to their better valuations and higher market caps. But it is also heavy in containership stocks, a sub-sector that shipping analysts are universally bearish on, since containerships -- which move durable goods like TVs or T-shirts mostly from China to the developed world -- are closely tied to the world's struggling consumers. Any uptick in wet or dry bulk could be overwhelmed by their poor performance.

"The macro factors are so unsure," says Nokta. "It's hard to make the case that any longs will work out this year."