What Is the Baltic Dry Index?

Dry bulk freighter. Source: Flickr user Roy Luck.

The Baltic Dry Index is an economic indicator. It takes an assessment of nearly two dozen major shipping routes to gauge the rate of ships carrying dry commodity goods like coal, iron ore, and grain. When shipping rates are down due to slowing demand for commodities, it pulls the index lower. As such, the index is said to forecast economic storms that are brewing out at sea. However, like most weather forecasts, it's not always accurate as a range of factors can cause the index to forecast sunny economic times when a storm is actually about to make landfall.

Its history and inner workingsThe Baltic Dry Index traces its roots back a couple hundred years to when merchants gathered in London establishments to regulate trade and formalize the exchange of securities. However, the current index dates back to 1985, when the first daily freight index was published by the Baltic Exchange in London. Its name is derived from that exchange as it's not limited to Baltic trade routes.

Today, the Index is based on a daily panel of shipbrokers that submit their view of the current freight cost for various routes to the Baltic Exchange. The routes are representative, cover four different sizes of dry bulk ships, and are weighted together. The result is an assessment measuring the demand for shipping capacity against the supply of ships. Because it measures shipping capacity demand, it is considered a leading economic indicator because demand for capacity increases as the global economy expands and contracts along with a recession.

That said, it's not a perfect measurement because that demand is weighted against the supply of available ships, which can grow faster than demand due to poor planning. For example, when times are good, shippers are flush with cash that is, more often than not, spent on new ships. However, it takes a couple of years before these ships are built, leading to the potential for a number of ships to hit the market at the same time in the future, pulling the Baltic Dry Index lower as a result of oversupply of ships as opposed to signaling weakness in demand for capacity.

Weak signalBecause of these outside factors, the Baltic Dry Index can sometimes send the wrong signals to economists. The most obvious example of where it failed to be a leading economic indicator was in May 2008. At that time, the Baltic Dry Index was surging and reached an all-time record high of 11,793 points, suggesting robust global growth and smooth sailing ahead. However, the cracks in the global economy were already beginning to form elsewhere that simply weren't indicated by looking at the index. In this case, it almost became a lagging indicator as within six months the index had dropped by 94% to just 663 points.

Furthermore, it's worth noting that the plunge at the end of 2008 wasn't the index's all-time low. That occurred even more recently as the index touched a historic low of 509 this February. It's a low that wasn't fueled entirely by weak economic activity, although slowing growth in China certainly didn't help matters. Instead, the low was caused by shippers overbuilding ships in 2013 based on the assumption that robust Chinese demand for coal would continue, only to see coal demand weaken just when a number of new vessels were coming to the market in 2015.

Why we should care about the Baltic Dry IndexDespite its shortcomings, the Baltic Dry Index is still a useful measure. For example, while it was slow to signal troubling times in 2008, its rise in 2009 did suggest that demand for commodities was increasing, thus hinting that the worst was over for the financial crisis. As such, the index can be a useful tool for investors -- it can provide an early sign that the global economy is improving after being battered during a global recession. This is because the index should increase as demand for shipping capacity rises, which should happen as an economy begins to heal from a downturn. While it shouldn't be the only sign investors look for, it can be combined with other indicators to signal that the worst is finally over.

The article What Is the Baltic Dry Index? originally appeared on Fool.com.

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