Container lines are expressing growing optimism that they will be able to fully recoup the higher operating costs caused by a global low-sulfur fuel mandate in annual trans-Pacific service contracts.
That’s a positive sign not just for carriers, but also for shippers, who could see increased blank sailings and even canceled service strings if the container shipping industry is forced to slash capacity because it can’t shoulder the billions in extra annual costs to meet the International Maritime Organization’s (IMO’s) mandate.
Container carriers and beneficial cargo owners (BCOs) tell JOC.com they are separating fuel and freight costs in annual service contracts, despite a historical preference for “all-in” contract rates. Even more importantly, carriers and shippers are developing bunker fuel adjustment factors, either proposed by the carrier or the shipper, leaving the actual cost of low-sulfur fuel as the only variable to be plugged in later this year.
Beginning Jan. 1, 2020, carriers globally must reduce emissions from vessels through the use of bunker fuel with a sulfur content of 0.5 percent, compared with 3.5 percent sulfur in the current high-sulfur fuel. The IMO mandate stipulates that carriers can achieve compliance by installing sulfur scrubbers on their vessels, which would allow them to continue using lower-cost high-sulfur fuel. However, only about 5 percent of the liner fleet is expected to be retrofitted with scrubbers, with the remainder relying on either low-sulfur fuel oil (LSFO) or alternative fuels such as liquefied natural gas (LNG).
Slowly but surely
Executives from three separate carriers told JOC.com they’re seeing a greater recognition from shippers that although it is a separate item, the fuel component has to be nearly finalized before an agreement can be reached on freight rates. Shippers that have ended negotiations over carrier insistence that all additional operating costs related to the mandate be recouped have found other carriers have similar stances, bringing them back to the table and more willing to accept higher fuel costs, the executives said.
“It’s been slow, but [BCOs] are getting it,” said one container line executive, who said his team has resisted any shipper-proposed bunker adjustment factors (BAFs) that don’t fully compensate the carrier.
The stakes for the container shipping industry are enormous. The IMO 2020 mandate is estimated to cost carriers an additional $10 billion to $15 billion annually. Despite rising global volume and higher revenues, already higher fuel costs have dragged carrier profitability in the last three quarters. The industry ended 2018 with roughly $1.5 billion in total profit, according to Drewry Shipping Consultants. Drewry, Maersk Line, and others have warned over the last six months that the rule could spur widespread capacity cuts and even another round of carrier consolidation via mergers, acquisitions, and bankruptcies.
“Fuel is an operational cost and I don’t know any business that doesn’t recover its operational costs,” Uffe Ostergaard, president of Hapag-Lloyd North America, said at the TPM 2019 Conference in Long Beach. “This is a game changer; $10 billion to $15 billion will hit the industry next year and that is a difficult number to have in your P&L [profits and losses]. If any carrier tries to give that away, it is going to be a very short venture and they will close shop very soon.”
While each carrier is expected to handle pricing in its own way, Hapag-Lloyd will quote a “floating” BAF that changes every three months. The fifth-largest container line argues clarity and transparency will be ensured because the underlying data used to formulate BAF are publicly available.
Lars Jensen, co-founder and CEO of SeaIntelligence Maritime Consulting agrees that inclusion of a floating low-sulfur BAF into service contracts later this year is inevitable. “This is not a give and take,” he said. “The bill will be paid by the BCO. There is no one else to pay it.”
Carriers, however, have a poor record of passing on incurred costs — whether for fuel or other factors in the logistics chain — to customers, Neil Glynn, head of European transport equity research and global transport research coordinator at Credit Suisse, told the TPM 2019 Conference. In order for them to do so, market conditions this autumn must be favorable, and carriers will have to be disciplined in managing capacity to bring supply and demand into balance, he said. “If some carriers do break ranks, that will be particularly difficult for the sector,” Glynn said.
Carriers and BCOs want to avoid a situation such as that which occurred in 2018, when carriers slashed capacity in the trans-Pacific to reduce their financial loses, only to have the market turn, resulting in soaring spot rates. “If the carriers fail in getting the BAF through [which is a distinct risk], the shippers will be in a situation where contracts without BAF[s] are exceedingly unlikely to be of value if the carriers suddenly face a [$10 billion] loss — and consequently the concept of having a contract rate will cease to have meaning and instead it will be a de facto spot market,” Jensen said in a February blog post.
A BAFfling formula
The outcome of negotiations over trans-Pacific service contracts, which generally run from May 1 to April 30, 2020, will provide a clear signal as to how carriers will fare in recouping higher operating costs globally. While BCOs would prefer to have clarity as to the formula carriers intend to use to determine how much the additional cost per container will be, both carriers and their customers agree more information is needed around the availability of LSFO and the difference in cost compared with today’s high-sulfur fuel. Carriers will incur additional costs of as much as $265 per FEU to the West Coast and $700 to the East Coast compared with traditional bunker fuel, according to one study.
As a result, negotiations are likely to contain a clause stating that both sides agree to finalize the formula for a floating BAF in the fourth quarter, when carriers are slated to begin the transition to LSFO.
“Absolutely, that’s what we are doing,” said Lawrence Burns, senior vice president of trades and sales at Hyundai America Shipping Agency. Burns said shippers pushed back on earlier formulas proposed by Euopean lines, so the task at hand for both carriers and their customers is to “find an index we can all agree upon.”
But some BCOs don’t trust carriers’ existing BAFs for high-sulfur fuel, saying the data cited by carriers in some formulas does not necessarily support the price that carriers quote. “The real challenge is understanding the underlying data. We have customer BAFs because of a lack of clarity of the old formulas,” Matt Muenster, senior manager, applied knowledge, at Breakthrough Fuel, told the TPM 2019 Conference.
Globe Express, a non-vessel-operating common carrier (NVO), is telling its customers to build into their logistics programs for the fourth quarter an as-yet-to-be-determined surcharge. “This is one of the most important discussions we are having with our customers,” said president, Americas, David Bennett.
A half-dozen BCOs told JOC.com in their negotiations with carriers for the 2019-2020 service contracts, currently under way, they are trying to divorce the BAF from the freight rate. They prefer to keep the existing floating BAF for high-sulfur fuel in effect for six months. They will then agree upon a floating low-sulfur BAF to take effect by the end of the year based on the cost of fuel at the time. Carriers emphasize that the individual, customized BAFs they have negotiated with individual BCOs, normally larger shippers, must give way to a single BAF formula that the lines intend to impose on all customers, large or small. A single BAF is easier to administer, and it prevents larger BCOs from negotiating their own BAFs that could lead to deterioration in fuel surcharges.
Carriers and BCOs realize it is risky to wait until the fourth quarter, traditionally the apex of the peak shipping season, to finalize the details of the new low-sulfur BAF. The base ocean freight rate will already have been in effect for five months, and BCOs will have declared the minimum quantity commitment on container volume to be shipped through the end of the contract.
However, formulas floated earlier in the year by lines such as Maersk, Mediterranean Shipping Co., CMA CGM, Hapag-Lloyd, OOCL, and Ocean Network Express were met with resistance from customers. BCOs said the lack of an agreed upon index on which to base the surcharges, uncertainties around low-sulfur fuel availability, the formulas for the fuels that will be blended to reach the IMO’s requirement for 0.5 percent sulfur content, and the prevailing market conditions during peak season 2019 necessitated a delay in determining the BAF.
In the meantime, every carrier has been independently determining how many vessels in its fleet will burn LSFO and how many ships will be retrofitted with scrubbers so they can use the less costly 3.5 percent sulfur fuel, and calculating what their additional costs will be, Ernie Kuo, senior vice president of Pacific International Line Agency Services, told JOC.com.
Delinking freight rates
Developing a mutually-agreeable, low-sulfur bunker fuel formula will be a multi-step process that will extend through much of the year, said George Goldman, president of Zim American Integrated Shipping Services. At present, bunker fuel charges are often imbedded in the base service contract rate, meaning carriers and their customers must first agree that a formula for calculating the low-sulfur BAF will be removed from the base rate and stand alone as a floating surcharge. The parties must then agree upon a new formula. And by the end of 2019, the actual price of low-sulfur fuel at the time will be plugged into the formula, he said.
A boilerplate example for calculating the low-sulfur BAF on an FEU basis is the number of days the vessel is at sea, multiplied by the fuel utilization per sea day and the fuel cost per metric ton, divided by the total loaded containers carried on a round-trip voyage. Individual carriers and industry analysts have posted examples of boilerplate formulas.
Given the imbalance in cargo volume — and values — of imports and exports in the east-west trade lanes, carriers are struggling to determine what portion of the fuel cost the headhaul voyage should absorb. US imports from Asia, for example, are predominantly higher-value consumer merchandise goods, while exports are mostly low-cost grains, scrap paper and metals, and plastics. With spot rates on imports from Shanghai to Los Angeles at $1,329 per FEU last week and spot pricing for US exports to Shanghai at only $497 per FEU, according to the JOC Shipping and Logistics Pricing Hub, adding a $500 fuel surcharge to the base rate would double the all-in cost of an ocean voyage, potentially killing some low-margin exports.
On the other hand, neither carriers nor BCOs are looking to make the BAF a separate line item to be negotiated based on minimum volume commitments. In the headhaul eastbound trans-Pacific, the accepted practice is for the largest retailers to negotiate base rates that set the benchmark, with other BCOs and NVOs paying higher rates depending upon volume. “At the end of the day, our objective is to delink bunker fuel discussion from the freight discussion. The worst thing we can see is all-in rates,” said Goldman.
Kuo said carriers do not want larger BCOs to receive reduced BAFs. “We hope that doesn’t happen,” he said, adding that if carriers begin to erode the BAF based on the size of the customer, it will be a very slippery slope that could lead to a downward spiral. Bennett agreed, saying the eastbound BAF should be the same for all importers.
The length of the voyage, however, will necessarily be a factor in the new BAF formulas. Importers that ship through the East and Gulf coasts will pay higher low-sulfur BAFs than those that ship through the West Coast, given that more fuel is consumed during the longer voyages. According to one study, if low-sulfur fuel at the time is priced at $450 per metric ton, a 13,000-TEU ship on an all-water service to the East Coast might command a low-sulfur BAF of $475 per FEU, while a 13,000-TEU ship to the West Coast might have a BAF of $265 per FEU.
Carrier executives who addressed the annual TPM conference on March 4-6 were blunt in stating that shipping lines intend to pass the entire added cost per container on to customers. Maersk CEO Soren Skou told attendees low-sulfur fuel could add $270 per container to the carrier’s costs, and that would equate to 10-15 percent of the entire freight bill. Similarly, NVOs are telling their customers to prepare for a straight pass-through BAF charge later this year. “This is a charge that can’t be avoided. This is a legitimate cost,” Bennett said.