Are long-term freight contracts reset periodically to reflect variations in spot rate indices the answer to rate volatility? A small, but gradually growing number of carriers and shippers are dipping their toes in the unfamiliar waters of these relatively new instruments to see if they can achieve more predictable rates and cargo volumes.
“The idea is to cut those sharp peaks and valleys out a little bit and flatten these curves and gain some experience,” said an executive with one large global non-vessel-operating common carrier. The NVO negotiated a single contract with one carrier with indexed rates “to test the waters and see how it works out for everybody and understand the mechanics,” he said.
The NVO’s year-and-a-half-long contract, which covers only a small percentage of its business, kicked off in March, when spot rates in the Asia-Europe trade were in the middle of a six-month surge during which they soared 250 percent, from $499 per 20-foot container in December to $1,742 per TEU in May. Under the contract, the rate the NVO pays for the space it has booked resets every three months to an average of spot rates over the last quarter.
The contract won’t stop the volatility of rates, but it will smooth it out. “At the end of the day, the index will still go up and down, so you are still going through the same swing. The idea is to cap the top and cap the bottom so you get a flatter curve, but it will not change the way the market behaves,” he said.
Several liner companies also are experimenting with a few longer-than-annual contracts using spot rate indices to periodically reset the rates at three- to six-month intervals. APL, China Shipping, CMA CGM, Hyundai Merchant Marine, OOCL and Maersk Line are among a growing number of carriers testing longer-term contracts, but shippers have been slow to accept the concept, largely because of their unfamiliarity. The Federal Maritime Commission has only 62 index-linked contracts on file, up from 50 last year.
Drewry Shipping Consultants, which tracks spot rates in a number of trade lanes (the Drewry Container Benchmark for the Hong Kong-Los Angeles trade appears weekly in the JOC’s By the Numbers section), estimates that approximately 50 index-linked contracts have been signed this year in the Asia-Europe trade, where rates have been more volatile than in trades touching the U.S.
“A lot of shippers I talk to shrug when I talk about indexed contracts,” said Joe Alagna, vice president of sales for China Shipping Container Lines in the U.S. “What I see in discussions with beneficial cargo owners who are willing to talk about indexed contracts is that other people in those companies need to get an understanding of them.”
Alagna’s comment reflected the view of many participants at a forum of the Container Freight Derivatives Association at Morgan Stanley’s offices in New York on June 18. Shippers who have long been used to negotiating annual contracts at fixed rates on various trade lanes are slow to accept index-linked contracts because they don’t understand them and they want to nail down rates at annual rates they can put in their budgets for the shipping season.
“There are a lot of unknowns at this point,” said David Brady, vice president of the trans-Pacific eastbound trade at Hyundai Merchant Marine. “We need to know more and how it affects pricing because we can’t sustain the current model.”
Some shippers are bringing indexed contracts to Hyundai, which negotiated its first long-term indexed contract in 2011 and a second this year. “We like the multiterm aspect of them,” Brady said.
To help shippers better understand the concept, Drewry and the World Container Index published a white paper that explains how index-linked contracts work, providing the first definitive guide since widespread adoption commenced two years ago. “It lifts the veil on a much misunderstood subject that has the potential to transform the way in which container shipping is contracted,” said Martin Dixon, Drewry’s freight rate research manager.
The days of fixed-rate annual contracts may be numbered, according to a survey by Clarkson Securities. Although the survey of 1,000 carriers and shippers drew only 69 responses, mostly from shippers and NVOs, the respondents said they are concerned their fixed rates could be renegotiated later in 2012, said Benjamin Gibson, a freight derivatives broker at Clarkson’s. “They said fixed-rate contracts are on their way out,” but that won’t happen any time soon, because “the majority of indexed contracts are very complex and convoluted, and the industry appears reluctant to be exposed to spot markets,” Gibson said.
Many shippers and carriers are looking for a better way of setting freight rates, because the volatility makes it difficult to budget for freight pricing and allocate space for expected volumes. It also makes it increasingly difficult to negotiate annual contracts at fixed rates.
“I have five people who do nothing else for four months out of every year than squeeze ocean carriers on rates. How unproductive is that?” said Bjorn Vang Jensen, vice president of global logistics for Swedish appliance manufacturer Electrolux.
He said indices could 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.
Shippers and carriers can trade derivative instruments based on indexed contracts, akin to pork belly futures contracts, as hedges against extreme rate fluctuations, but neither the number of indexed contracts nor the volume of derivative trades has grown large enough to provide the liquidity needed to establish a viable trading market on the exchanges where they can be traded.
The NVO that started testing indexed contracts this spring is cautious about trading derivatives. “We are going through a learning curve,” the NVO executive said. “I don’t think our thoughts would focus on trading derivatives, but let’s first gain some experience with an index-linked tool and then move forward from there.”
Futures markets have been firmly established for rate derivatives based on contracts with dry and liquid bulk shipping lines in sectors where rate volatility has been even greater recently than in the container trades.
Related: Container Indices Galore.
“Hedging has become a necessity in the dry and liquid bulk trades, but progress in the container trades has been slow, in part because derivatives are a dirty word,” said Michael Rainsford, a freight trader with Morgan Stanley in London. Moving from support for indexes to derivatives will take time, but the direction is positive.”
One of the factors delaying widespread acceptance of indexed contracts in the container trades is that that no single large organization or group has stepped forward as a sponsor, the way BHP and other large Australian mining companies did when China defaulted on its fixed-rate dry bulk shipping contracts for iron ore imports in 2008, after spot rates fell to $50 per ton from the $180-per-ton contract rate.
Without a large single sponsor or group of sponsors for container rate derivatives, the impetus for trading them may come from shareholders or banks that finance container ship orders. “Equity markets, shareholders and ship finance banks will drive the growth of the markets,” Rainsford said, “because investors won’t invest in carriers, and banks won’t lend to carriers unless they are smoothing out cycles by hedging their freight rate risks.”