Here are two numbers to consider: 25% and -60%. These numbers should be moving in tandem, so there’s a really good chance the positive number will be sucked back down by the negative number.

I’m talking about the stunning rally for dry-bulk shipping stocks and the sharp plunge in daily lease rates for these ships. The shipping rates have been plunging on concerns that too many newly-built dry-bulk ships are about to enter service. And with the supply of ships already overwhelming demand, the addition of new supply has put a lot of pressure on lease pricing, as you can see in the chart below.
 


The slumping Baltic Dry Index (BDI), which reflects daily bulk ship lease rates, should be crushing the sector’s stocks. Instead, a number of them are posting sharp gains. Credit goes to the rising stock market, which is leading short sellers to cover their positions. Several of these stocks have short positions that are equivalent to more than five days’ wor9.9th of trading volume…

In effect, these stocks are up for the wrong reasons. And in coming months, their shares are likely to slide to fresh lows, since the prospects of a rebounding BDI are quite dim and company-specific debt burdens are coming home to roost.

Watch the balance sheets
Many companies in this niche are undergoing pretty severe financial distress. They decided to ramp up spending by ordering new ships a few years ago, when industry conditions were stronger. Now, they’re taking delivery of those ships, though they would prefer not to.

Let’s take a look at Genco Shipping (NYSE: GNK) as an example. Roughly 20% of its stock was held by short sellers as of the end of 2011. Look at what’s happened to this stock as short sellers have grown nervous about a rising-tide-lifts-all-boats rally.

 
The fact that the BDI has been plunging in recent weeks actually bolsters the case that short sellers were making. Low lease rates imperil Genco because they limit the cash flow generation that would be used to pay upcoming loans.

In December 2011, Genco was able to convince its lenders to hold off foreclosing on loans, even though the company had begun to breach debt covenants. The deal caused Genco to pay another $28 million ($0.78 a share) in annual interest, which has just created more headaches.

#-ad_banner-#”We believe Genco is less likely to be able to service its debt amortization of $131 million in 2012 and $215 million in 2013. As such, we view the current amendment as only the next step in the path toward an ultimate restructuring, which is unlikely to be accretive to GNK holders,” note analysts at Citigroup. This is a fancy way of saying that either a lot of dilution, or outright bankruptcy likely looms.

With a fully-tapped out $1.2 billion credit line — which will need to be repaid or rolled over by July 2014 — Eagle Bulk Shipping (Nasdaq: EGLE) can’t afford to see cash flow drop, either. Yet the plunge in the BDI in recent weeks means the company may garner less revenue and income in 2012 than it had previously anticipated.

Just a month ago, analysts said Eagle Bulk would lose $0.17 a share this year. That loss forecast has now doubled, and unless industry conditions quickly improve, it’s increasingly difficult to see how the dry-bulk carrier will avoid the clutches of bankruptcy court.

The silver lining
There is one clear beneficiary from the industry’s distress: Diana Shipping (NYSE: DSX). While other shippers were on a spending spree a few years ago, Diana decided to hoard its cash. That was a wise move: As of the end of last year’s third quarter, Diana had nearly $400 million in gross cash. Management has expressed an interest in acquiring other firms’ ships if those other firms need to unload assets at fire-sale prices. Diana Shipping reports 2011 fourth-quarter results on Feb. 28, 2012, and it will be curious to see how management is seeking to press the company’s advantage while rivals are on the ropes.

Risks to Consider: This industry is quite fluid at the moment, seeing that share prices surge even as the BDI slumps. Any target for short-selling needs to be guarded against balance-sheet restructurings that preserve the equity.

Action to Take –>  Diana Shipping is the proverbial “best house in a bad neighborhood.” The entire dry-bulk shipping group will need to ration its fleet, probably with several players going into bankruptcy, which could create a much more robust long-term backdrop for Diana Shipping.

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