At times, it seems the only thing shippers, forwarders and carriers share is a common mantra: They say they want to talk about service quality but complain their counterparty is only interested in price, price, price. This age-old failure of communication carries a high cost in terms of supply chain efficiency and the resources spent constantly haggling over freight rates in a volatile market.
“We all want to focus on something other than rates,” said David Goldberg, senior vice president and head of ocean freight in the Asia-Pacific for DHL Global Forwarding. “Every time rates go up or down we have to have hard conversations with thousands of customers.”
How then to break the container shipping impasse and turn confrontation into partnership? Some believe index-linked contracts could be the key to changing the terms on which business is conducted.
On a basic level, index-linked contracts simply mean that price fluctuations during the course of the contract will reflect the change in the reference price index, plus any other pre-agreed criteria. By removing the need for ceaseless negotiation, advocates say such rate adjustment systems free up man-hours, cut administrative costs and allow shippers and carriers to focus on service quality.
They can also reduce the likelihood of one party failing to honor its commitments because of lurches in spot rates, not an uncommon occurrence in the last three years, particularly on the trans-Pacific, where annual fixed-rate contracts are common.
In essence, they can take the very volatility that has roiled shipping markets the past three years and provide a sense of stability shippers and carriers crave. “Index-linked contracts do not mean that carriers, forwarders and shippers can do away with negotiations,” said Philip Damas, director of Drewry’s Supply Chain Advisors division. “But the scope of the price negotiation is narrower and their frequency lower. They only need to negotiate the initial base price, the discount off the reference index — if any — and the duration of the contract as well as the usual service deliverables and capacity-volume commitments.
“After that, there is no need for negotiations on price during the entire life of the contract, even if the market rises or falls, because the price will be adjusted based on the reference index,” said Damas, whose company publishes a weekly Container Rate Benchmark in a variety of ocean trades, including a Hong Kong-Los Angeles index published weekly in The Journal of Commerce.
Adoption of index-based pricing has been slow, not least because indexes have only existed since the pioneering Shanghai Containerized Freight Index debuted in October 2009, but interest is clearly rising. “The Chinese like financial instruments, so it’s a matter of a few years and then this will get popular, but for now it’s still in the development stage, said Paul Tsui, chairman of the Hong Kong Association of Freight Forwarding and Logistics.
Approximately 50 service contracts referencing freight indexes in U.S. trades were filed last year, mostly based on annual price adjustments, though some were adjusted on a half-yearly or even quarterly basis, according to the Federal Maritime Commission.
“My sense is that most of the lines each have a relatively small number of longer-term indexed contracts, primarily with large accounts,” said Niels Erich, a spokesman for the Transpacific Stabilization Agreement, the discussion group of 15 carriers in the Asia-to-U.S. trade. “Interest in, and acceptance of, index-based contracts appears to be growing, but slowly. The attraction, particularly for more complex contracts, is relative rate stability and predictability over time and avoidance of lengthy, often difficult, negotiations every year.”
There are multiple options available for utilizing index-linked contracts in the trans-Pacific, where long-term contracts are more widely used than in other trades, as well as any container lane where there is an index and a suitable amount of historical data.
Drewry, for example, offers a number of options. Its Stable Market Adjusted Rate Terms model incorporates a ceiling rate and a floor rate to mitigate the risk of extreme price volatility. The London-based research analyst and consultant also offers rates on 550 port pairs that can be used for benchmarking or as reference points for index-linked contracts.
Container Trade Statistics and the Shanghai Containerized Freight Index also provide data, and a number of suppliers have developed products enabling these indexes to be incorporated into off-the-shelf contracts, including ICAP Shipping (Story, page 32).
Another option is the TSA Revenue Index, which tracks average revenue per 40-foot container among the TSA’s liner membership. Its application is mainly aimed at longer-term service contracts that begin with a specified set of rates and charges that then have built-in escalator provisions, or are allowed to fluctuate within a band, over the life of the contract to avoid further negotiations.
But carriers and shippers alike have reservations about the use of index-related contracts. Those concerns often relate to the failings of the indexes themselves — the use of only a small sampling of carriers for data, for example, or of spot rates between high-volume ports as a guide to an overall trade, or the small amount of information available for historical comparisons.
Related: Swapping Data
In addition, neither shipper nor carrier wants to be on the wrong end of a rates-cost shift. Philadelphia-based forwarder and logistics provider BDP International said its monitoring of index-based mechanisms found that most yielded higher rates than it was able to secure through long-term relationships and volume procurement.
A concern for lines is ensuring the contract provides insurance against increases in operating costs. On the flipside, shippers don’t want to agree to a long-term freight rate only to have surcharges added and then hiked.
The problem grows more complex on U.S. trades, where carriers can use the cost of the inbound leg to subsidize ocean carriage, because index-based contracts essentially are based on port-to-port services.
“Each index has different elements and updates different fundamentals,” Goldberg said. “But using neutral bodies can be a good thing if that mechanism allows us to smooth out rate fluctuations, especially if service can be thrown into the equation and we can all focus on quality.”
As time passes, and as products are improved and contracts balanced out to potentially include agreement on issues such as fluctuating fuel costs, many of these concerns are expected to become obsolete. Carriers certainly are increasingly receptive to the concept of pre-agreed pricing mechanisms. “We believe that in the future more and more of these contracts will be signed as customers need visibility on their costs and carriers need sustainability in revenue to continue to invest in the supply chain,” CMA CGM said in a statement.
The French carrier is pushing the use of long-term indexed contracts using market adjustment factors whereby the contract freight rates move according to an index. “The interest for the shipper and the carrier is that the rate is capped and floored,” CMA CGM said. “That way, both carrier and shipper are protected from the extreme volatility of the market.”
Israel-based Zim Integrated Shipping Services said it is examining different contract options with customers. “We want the contracts to reflect the expected increased freight rates, and to reflect changes in bunker rates throughout the length of the contract, in order to ensure a viable and reasonable freight rate level,” a spokesman said.
Stephen Ng, director of corporate planning at OOCL, said the Hong Kong-based carrier was receptive to discussion about new contracts that protected both parties from changes in market conditions and fluctuations in cost, but few contracts of the kind had been signed.
“It seems the majority of shippers are focused on fixed-rate contracts,” he said. “It is difficult to judge whether ocean contracts linked to freight rate indices will become an industry trend in the future. Many factors come into play for both the shipper and the carrier. We try to emphasize our unique service features during contract discussions to build longer-lasting relationships with our customers.”
The other heralded potential use of index-linked contracts is in opening up container shipping to the application of sophisticated hedging strategies using swaps to enable the forward proofing of shipping costs.
Although this application is in its infancy, Drewry already publishes container freight rate indexes on 11 east-west routes in collaboration with Cleartrade through its World Container Index joint venture. This is designed specifically as a pricing mechanism for the settlement of derivative trades and hedging, although it also can be deployed as a reference point for index-linked contracts.
Using hedging strategies allows different parties to fix future prices at a level the shipper, carrier or both deem acceptable. “Under hedging, any reduction in price in the index-linked contract is offset by a profit from the hedging transaction relative to this acceptable future price,” Damas said. “The end-result is that both shippers and carriers can fix future freight rates. Speculators can also use hedging to bet on the market and lose or make money, but this is their prerogative, and it does not change the position of industry players.”
He said carriers and shippers could use existing products to hedge freight rates on major routes up to two years ahead, although not many companies have utilized the option. “Adoption of freight rate derivatives — Forward Freight Agreements — in the bulk shipping sector has taken several years to become standard widespread practice, and I would expect that the same timeline is likely in container shipping,” Damas said.
Electrolux is testing index-linked contracts with a trusted carrier partner using a proportion of its volumes shipped on the Asia-Europe trades. The intention is to work out the pitfalls for both parties to see how far the arrangement can be rolled out globally to reduce pricing volatility. “It’s a new concept which I think will eventually be driven by the 3PLs who are often the meat in the sandwich when rates change,” said Bjorn Vang Jensen, vice president of global logistics for the Swedish appliance manufacturer.
He believes indexes can more reliably be used for creating a “corridor of neutrality” around rates to flatten the curve. The next step is aligning pricing controls with a global hedging strategy across all container trades. “Lots of brokers are offering swaps, but very few shippers are buying, because nobody wants to go first,” Jensen said.
“With hedging, if you do not have 100 percent correlation between your real life and the index, then you’re not actually hedging, you’re gambling. With swaps, you need to tick a lot of boxes if your aim is to achieve a true hedge, which is a zero-sum game,” he said. “There are a lot of swaps out there for SCFI, for example, and that has a lot going for it, but it’s only for cargo from Shanghai. You can’t truly hedge cargo from Hong Kong with it unless you can prove there’s a 100 percent correlation.”
With so much at stake in ocean freight contract negotiations, and with so many factors to consider for all parties, most of those interviewed for this article said it was difficult to judge how big a part of the industry freight rate indexes will become. All agreed, however, that as the sophistication of indexes improves and familiarization grows, index-linked contracts could be a game-changer in relations between shippers, forwarders and carriers, and also how shipping finances and costs are managed.
“What is exciting is that the possibility of all this now exists,” Jensen said. “Four years ago, there wasn’t an index, so it’s fantastic. It’s cool that we’re all just talking. We need to change.”
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