Hedging your box bets
Container derivatives floated as tool to fight freight volatility.
By Chris Dupin
The Shanghai Shipping Exchange launched its Shanghai Containerized Freight Index on Oct. 16, 2009. The SCFI is based on the weighted average of the cost of moving freight from Shanghai along 15 different trade routes around the world.
To create the index, 15 shipping lines and 15 forwarders or shippers submit weekly to the exchange their estimate of the spot rates, quoting 'all-in rates' in dollars per 20-foot equivalent units, or in the case of the U.S. West Coast and East Coast trades, 40-foot equivalent units.
On Oct. 16, the SCFI pegged the cost of moving an FEU of freight from Shanghai to the U.S. West Coast at $1,369. The Transpacific Stabilization Agreement, which represents 15 leading container carriers in the Asia-to-U.S. trade, said that rates had fallen for many commodities by $1,000 per FEU.
That spurred the TSA to announce in October initiatives to restore rates, first with an $800-per-FEU general rate increase for West Coast cargo to take effect in May and June when contracts expired, and a peak season surcharge of $400 per FEU after Aug. 1. Then it announced in December that it would not wait that long, but on Jan. 15 seek to impose a separate 'emergency revenue charge' of $400 per FEU on shippers.
By Feb. 5, the SCFI's estimate of the freight rate on the Shanghai-to-West Coast route was 50 percent higher, $2,061.
That kind of price volatility may spur interest by both carriers and shippers in a new product ' container freight derivatives based on the SCFI or its components.
In January, London-based Clarkson Securities Ltd. announced it had arranged the first trade of a container freight swap agreement based on the SCFI.
The trade took place between the investment bank Morgan Stanley and Delphis, whose subsidiary Team Lines operates container feeder ships in Europe.
Financial derivatives for the container shipping industry have been long discussed ' even energy trading company Enron discussed the idea prior to going belly-up in 2001.
Freight derivatives are commonplace in the dry bulk and tanker markets where they have been in use since the 1990s, based on indexes created and updated daily by the Baltic Exchange.
'We have been working closely with the Shanghai Shipping Exchange to ensure the SCFI will be a suitable mechanism for container freight derivatives such as this and firmly believe this index heralds a new era for marine risk management,' said Alex Gray, chief executive officer of Clarkson Securities.
The forwards or swaps are 'principal to principal' derivative contracts that are traded over-the-counter, not on an exchange. They are agreements between two counterparties where one takes the view that freight rates will increase above some agreed level in the future, while the other believes they will decrease.
The contract is settled against the price of an index ' in this case the SCFI or one of its components ' with the difference between the agreed price and the index paid to the company that made the correct call by the other counterparty.
There is no 'physical delivery' of space on ships, as there might be with, say copper futures, where a contract might be settled by delivery of metal to a warehouse.
Benjamin Gibson, a freight derivatives broker at Clarkson, said the first contract was a small one, covering the movement of only five containers in each of two months.
As of early February, no additional trades had been made, but Clarkson was marketing the concept to container carriers and logistics companies and working with a clearinghouse for the trading of the derivatives.
He did not say which clearinghouse will handle the trades, but three groups ' the London Clearing House, NOS Clearing in Oslo, Norway, and SGX AsiaClear in Singapore ' do clearing work for bulk freight derivatives.
Companies trading container freight derivatives will have to pay clearing costs and a fee to a broker for arranging the trade. Gibson said Clarkson will charge $30 per container.
Clarkson believes there is big potential in the market, not only among shippers and carriers that may want to hedge their risk, but also by financial firms looking for a new product to trade.
Gibson noted there have been previous proposals to trade derivative products based on containerhip charter indexes such as the ConTex index published by the Hamburg Shipbrokers Association. But Clarkson believes there will be broader interest in a derivative based on the actual freight rates, he said.
'The freight market has so much more potential because of spot market volatility and also the wider customer base,' Gibson said.
To come up with a reliable estimate of dry bulk shipping rates, the Baltic Exchange averages freight rates estimates from a panel of brokers. The brokers who develop the Baltic Freight Index are seen as neutral since on one day they may be representing ship owners seeking cargo for their ships and the next day a cargo owner looking for the best rate to move its commodities.
The container industry doesn't have an equivalent to brokers, so to come up with a neutral estimate of container freight rates, the Shanghai Shipping Exchange is using a panel of companies with 15 carriers and 15 freight forwarders or shippers who buy transportation to get a neutral opinion.
Eleven of the 20 largest container carriers are supplying panelists to develop the index, while the shipper-forwarders are mostly Chinese firms.
Amir Alizadeh-Masoodian, a reader in shipping economics at the Cass Business School in London and co-author of the book Shipping Derivatives and Risk Management, notes the Baltic indexes are updated daily.
The fact the SCFI is determined on a weekly basis and that container freight is generally purchased over a long period of time ' sometimes for months or on an annual basis ' could make them more difficult to trade.
He also noted that when dry bulk trading started up, trading was based on the Baltic Dry Index, an index based on the cost of moving several different commodities on several different routes with several different size ships.
That proved not to be popular, he said, and today most trading is based on different components of the Baltic Dry Index which focus on a particular trade.
Derivatives based on the SCFI may be attractive to speculators, but Alizadeh suspects that 'for a company like Wal-Mart or Target in the U.S. that wants to use the index to secure their transportation costs or even shipping companies operating between Shanghai and the U.S., they are not going to want to use an index where the trades they are interested in may represent only about 20 to 30 percent of the index weight.'
Clarkson's Gibson agreed, and noted it will be possible for companies to trade either the comprehensive index or individual components. For example, the Morgan Stanley-Delphis contract was based on the Shanghai to North Europe component of the SCFI.
Gibson said Clarkson is focusing most of its attention on marketing derivatives based on the four largest export trades out of China which are also the most heavily weighted components of the SCFI:
' Shanghai to North Europe.
' Shanghai to the Mediterranean.
' Shanghai to the U.S. West Coast.
' Shanghai to the U.S. East Coast.
'Overall, I think it's a positive move, because about 25 percent of the world trade is containerized shipping, so to have a liquid market in container shipping to be able to hedge exposure and manage risk is quite important,' Alizadeh said.
While shippers and carriers can hedge risk by entering into long-term contracts, he said financial instruments give greater flexibility.
'If you enter into a physical contract for a certain volume of cargo, then it is more difficult to get out of the contract if the market moves against you,' he said.
It also gives traders or speculators a chance to bet on downturns in the market, he said.
'A third advantage is that you can break your hedge into different periods ' you can have short-term risk management, long-term risk management, and the physical contract. In the physical market you can have long-term and short-term contracts, but by using paper instruments you can rebalance these short-term/long-term exposures as you go along.
'Also in the physical market you have exposure to one counterparty who either performs or delivers against a contract or not. But if you have financial contracts and they are cleared, then you can eliminate counterparty risk,' he said.
Of course, companies must have the expertise to use derivatives and he noted there are also costs and accounting issues for which companies using freight derivatives have to be aware.
'From my discussions in the past, there is some interest among shipping lines for financial products of this type to hedge some of their market risks, but there is no interest from shippers,' said Philip Damas, division director of Drewry Supply Chain Advisors. 'It is very different from the bulk shipping sector, because shippers in container shipping are exposed to relatively low risks of freight cost volatility,' defined as freight cost spending in dollars as a percentage of product landed costs in dollars.
'For this reason, I do not think that container derivatives will catch in container shipping, due to lack of demand from shippers,' he said.
The SCFI is based only on freight routes out of China. Shippers of low-value exports from the United States and Europe ' things like waste paper, scrap metal, hay cubes and grain ' would like to hedge their container shipping costs like shippers of bulk products, Damas said, and in fact may use both bulk ships and containers to move their commodities.
But he also noted it is 'not these low U.S.-outbound or Europe-outbound freight rates that container shipping lines would like to hedge. They have such a marginal importance in the overall business of carriers, both in volumes and in revenue generation terms, that they hardly register. So the two sides have no common ground in this respect.'
Gibson agrees with Damas' point about the importance of freight as a component of total landed cost, but said his firm has gotten interest in the concept of derivatives from shippers moving a wide range of goods, from commodities such as coffee and forest products, to more expensive products such as white goods.
Derivatives have also been a success in the tanker market where freight is much less as a total component of landed cost than in the dry bulk market, he said.
Interestingly, Delphis, which made the first trade is not a participant in trade out of Shanghai, but operates feeder ships in Europe.
But Gibson said a carrier like Delphis might find that its business is strongly influenced by what's happening in the Shanghai-to-Europe trade. If business is booming from Shanghai to Europe and rates are strong, for example, demand for its feeder services may be strong and vice versa.
Gibson also noted that container freight derivatives can also be used for speculation as well as hedging.
'We have a lot of interest in this product by the financial industry, mainly banks, but also hedge funds, who come from outside of the container shipping industry, but see a lot of potential in using their experience in other markets to predict where freight rates are going in six to 12 months and want to use this product to speculate,' he said.
Traders will be able to trade futures as far forward as they feel comfortable. Initially, Gibson said he thinks it will be possible to arrange trades for rates three or six months forward, but said he would like to see trade going 12 months forward.
In the dry cargo futures market there are trades on freight up to three years out, he said.
