Do derivatives have the potential to change the way the ocean freight market functions?
By Eric Johnson
Late June in San Francisco, and the scene was a bit strange, as if a hodgepodge of exporters from around the United States had accidentally stumbled into a time warp and ended up at a financial conference in central London.
Or perhaps it was the financial brokers who fell through some unseen crack in the universe and ended up talking to a bunch of fruit and nut and lumber growers a hemisphere away.
Either way, when Benjamin Gibson, Cherry Wang, and Michael Rainsford took the stage at the Agricultural Transportation Coalition’s annual meeting this summer, it signaled a potential change in the way container shipping markets might soon function.
All three are London-based derivatives brokers or freight traders, and they came to the AgTC meeting to describe how derivatives — or futures — work in the container shipping industry.
The session was well-timed, for it came weeks after the U.S. Federal Maritime Commission proposed to develop an index for export commodities, an index that could be used to develop long-term contracts but also to potentially help shippers and carriers hedge their rates in an ultra-volatile market.
The index would aggregate information from confidential service contracts filed with the FMC and disseminate them in the form of benchmarks based on specific commodities and trade lanes.
But the applicability of the derivatives market to U.S. exporters is the tip of the proverbial iceberg. Gibson, Wang, Rainsford, and others have been on a barnstorming tour the last couple of years. Their goal: to explain to shippers, carriers, and intermediaries that freight derivatives are not only appropriate for container shipping, but necessary. In essence, they want the industry to embrace the forward curve.
Of course, they often first need to explain the concept of futures — essentially the art of hedging — to people who have thought little of these financial instruments. That’s not to say that shippers and carriers have no knowledge or history of hedging.
“Carriers hedge on fuel,” Rainsford, a container freight trader at Morgan Stanley, told American Shipper in July. “Commodities traders, they’ve hedged something before. Retailers may have hedged something, whether it’s fuel, sugar, cotton, or even (foreign exchange).”
Outside the proposed FMC export index, there are a number of privately developed freight indexes, as well as government-backed ones in China, that have shone a light that never existed before on container freight rates. They include the Shanghai Containerized Freight Index and the Container Trade Statistics (CTS) Index, both developed in 2009, and the Transpacific Stabilization Agreement Index and the Drewry-Cleartrade World Container Index (WCI), both started in 2011.
The increased transparency these indexes provide is a natural development, according to the brokers tasked with selling not only the derivatives products, but also the concept that they belong in container shipping.
That’s despite the fact liner carriers have been slow to embrace the concept of derivatives, at least publicly.
“The container market has bigger potential to embrace derivatives than dry bulk,” Rainsford said. “The vessels are designed purely for specific trade routes. There’s a tangible way to hedge. If you have a fleet of 15,000-TEU vessels, there’s no getting around that you are long in that lane, and expect that trade to perform.”
Rainsford was speaking about the potential differences between applying derivatives to container shipping and bulk shipping, where futures play an established, major role. By noting that carriers are “long” in a trade in which they deploy a specific type of vessel, say 15,000-TEU ships on the Asia-Europe trade, Rainsford is suggesting that those carriers are inherently thinking long term about their business. Thus, they shouldn’t be thinking so short term about rates.
As if to prove a point, Maersk Group Chief Executive Officer Nils Andersen said in mid-August that the line doesn’t engage in contracts longer than one year, and 60 to 70 percent of its Asia-Europe volume is tied up in contracts shorter than one year or on the spot market. And Andersen said Maersk’s competitors are even less reliant on contracts than the Danish line is.
Could that realistically change? First, it helps to think about the ways indexes might affect the container shipping industry.
Flexible Tools. One way is that indexes can simply provide a shipper, carrier, or 3PL with a basic insight into freight rates, so they are better equipped during contract negotiations or spot-market decisions.
Second, an index can be used as a benchmark in an index-linked contract, typically one where a shipper and its carriers establish high and low parameters based on space, volume and rates over a period longer than one year.
A third way is for a shipper or carrier to use an index to make a pure play on the derivatives market. For instance, a shipper might fear that rates will trend up over the next six months and so would go to a derivatives broker and ask to buy forward rates over that period. If the rates rise as the shipper expects, he will have paid a lower rate than the spot market would have yielded. It’s the same theory behind fuel hedging.
A fourth way, and the one advanced by brokers, is to combine an index-linked contract with a hedge on the futures market.
At the AgTC conference, Rainsford gave a specific example of how a hedge might impact a shipper whose cargo is in jeopardy of being bumped from a particular sailing due to tight capacity. If there’s one slot left on a ship, a shipper could use an index-linked contract to say to the carrier it will pay the higher end of an agreed upon range to ensure its cargo gets that last slot.
Then that shipper would use its hedged derivative contract as a backup, paying the shipper back the difference between the rate it thought it would get, and the rate it actually had to pay to get on the ship. The hedge allows the shipper to offer its carrier a more attractive rate without losing the money by doing so.
There are myriad ways a shipper or carrier could play with futures. Also consider that shippers could use the forward curve on an index to compel a carrier to provide it a contracted rate when it ordinarily would have had to chance the spot market to get that rate.
In that hypothetical situation, let’s assume the forward rate on a specific trade is $2,000 per FEU through December. A shipper may ask his carrier to offer him that rate for a specific number of boxes through December. If the carrier agrees, the shipper has locked in a rate at what he thinks is a favorable amount for that time period. If the carrier doesn’t agree, the shipper can buy a forward freight agreement at that price, and then contract with the carrier at a higher rate on a spot basis, with the forward agreement paying the shipper the difference.
The benefits of using index-linked contracts can extend beyond mere rates as well.
“Contracting is a lengthy process,” said Wang, a container derivatives broker for the GFI Group. “It takes a lot of time to renegotiate these contracts every month.”
Getting Onboard. Rainsford, meanwhile, said carriers are not dismissive of the concept and that the harder sell in a market with depressed rates are shippers.
“Shippers may be ready to do an index-linked contract, and then the carrier slaps down a below-market rate and the shipper says let’s do it next year,” he said. “Carriers are saying let’s have a market that’s based on indexes. But carriers are not ready to do it on a global scale. There is an appetite to use these for customers who ship 200 containers. They’re getting quite savvy at picking out customers who will be open to this. So it’s going from concept to working practice. The dialogue is changing all the time. From that perspective, the progress is huge.”
But Rainsford said in his dealings with carriers the biggest hurdle is not opposition to the idea of derivatives, but time and resources.
“They’ll say ‘internally, we’re not ready for this,’” he said. “Some of it is that they’re spending 90 percent of their time keeping their head above water. At the moment, this isn’t top of their list. The pushback we get is ‘this makes sense, but it will take us six months to get this signed off.’ It’s not ‘stop calling us,’ it’s ‘bear with us.’”
Wang said it makes sense the container derivatives market has yet to take flight since rate transparency only arrived a few years back after decades of mystery.
“It’s a nascent market,” Wang said. “Until 2009, there wasn’t much transparency into rates. People are still getting a grasp of this product. A lot of people are dipping their toes in the water. A lot of people are ready to trade. But a larger organization may take longer to integrate this into their strategy. You need to have systems to track this.”
Disagreements. As for the proposed FMC export index, brokers are undeniably in favor of it, but carriers have yet to be convinced.
“I firmly believe in indexing,” Ed Zaninelli, vice president of transpacific westbound trade for OOCL, said at a Containerization and Intermodal Institute seminar on expanding U.S. exports in June. “But once you establish a westbound index, how the hell do I index if I’m only covering 50 percent of my costs? Why would I tie myself to something that limits me to 3 percent up or 3 percent down? I can’t index until I get to the point where I’m at least recovering cost and that’s an extremely long way off.”
At the same event, Greg Tuthill, senior vice president of sales and marketing at NYK Line (North America), said an index is worth examining.
“I’m not suggesting we’re in favor of it,” he said. “But we just need to explore how to manage the risk, whether it’s transportation risk, budget risk, carrier profitability risk, or long-term planning risk. I think it might be worth looking at some of these new opportunities just to see if any are possible solutions.”
The Westbound Transpacific Stabilization Agreement, which represents nine of the top carriers on the U.S.-to-Asia trade, said it had a number of problems with the FMC index concept, most significantly whether confidential rate agreements would be compromised, and whether the FMC even had the jurisdiction to develop such an index.
It also argued that demand was not especially high for such an index, noting that only 61 of 45,000 contracts filed with the FMC referenced an index.
“Aside from the merits, WTSA is not aware of any Shipping Act or other authority for the commission to use its scarce resources to facilitate the development of investment vehicles,” the organization wrote in an Aug. 8 letter to the FMC. “If there is a demand for an index, the private sector is well-positioned to develop it, and there is no barrier to them doing so.”
London-based Drewry argued, in its own letter to the FMC, that the commission would be in an advantageous position to collect specific data points that private sector entities are not able to, but also that derivatives markets need a certain amount of volume to work.
“New commodity-specific, route-specific container freight rate indices will basically assist index-linked service contracts,” wrote Drewry director Philip Damas. “However, for derivative trading, the key is liquidity and volume. Thus, for this, it is likely that only a couple of export routes will eventually be successful. It is therefore important that there is sufficient data/analysis done to determine the co-relationship between commodity export routes and the ‘main’ derivative index routes, so that exporters/markets can use these main index routes for hedging.”
Later in the letter Damas said Drewry, which released a white paper in June explaining the concept of index-linked contracts, expects trading in freight derivatives to grow, but slowly, over the next five to 10 years, with the volume of the derivatives market likely to be “much lower” than the volume of the physical market.
Ag shippers are torn, the AgTC said in its comments to the FMC, with some of its members favoring an index and others against it for fear their confidential rates would somehow become known.
But the AgTC said an index would help even the playing field for shippers.
“There is a fundamental imbalance when it comes to the matter of transparency of ocean freight rates,” the coalition wrote. “Almost by definition, the ocean carriers have far better insight into the freight rates than do the shippers. There are literally thousands of shippers, but approximately two dozen ocean carriers in the primary international trade routes serving the U.S. and Canada.
“If an ocean carrier handles, say, 30 percent of the cargo moving from the U.S. to a destination in Australia, New Zealand, South America, Central America, Africa, that carrier knows, with absolute certainty, how much the shippers on their vessels are paying. Thus, while a single carrier knows what 30 percent of the shippers are paying, each shipper knows only the rate that it is paying.”
Transparency Unleashed. Indexes on U.S. and European inbound trades are well-established. American Shipper receives daily updates from brokers on forward rates. The transparency cat is largely out of the bag.
But there is a reticence from carriers to admit that derivatives are an inexorable part of the industry’s future. Gibson, a freight derivatives broker for Clarkson Securities, admitted as much at the AgTC meeting: “One of our biggest challenges is to get more carriers involved.”
But Rainsford argued the industry as carriers once knew it no longer exists.
“When carriers actually employ mechanisms to rationalize capacity, rates still go down, and that indicates carriers have little control of the market,” he said. “Carriers are so aware of it right now. Now more than ever, everybody’s questioning the business model.”
The public argument against derivatives has centered around the idea that futures markets essentially commoditize the liner shipping industry, boiling it down to a simple rate on a forward curve, like a stock price.
But Rainsford argues the opposite. He said there has been significant interest in derivative instruments from the freight forwarding community.
“If carriers are worried about commoditization, the best thing they could do is to index,” he said. “The players who make it less commoditized are the freight forwarders. Carriers don’t have a clue how to pull their customers in different categories. If it was all based on an index, they would have the ability to differentiate service.”
Rainsford also argued that informed hedging activity could benefit carriers in terms of attracting financing for future vessel orders, as financiers would be able to get a picture that their investment is sound.
The Tipping Point? But whether derivatives truly catch on — and whether container shipping eventually resembles the dry bulk market — depends on whether volatility persists. Remember that even though container rates tend to rise and fall dramatically, the current peaks and valleys are small relative to more volatile markets.
“Volatility feeds volatility,” Wang said. “These things take time. It’s very much an industry and cultural thing as well.”
Rainsford said the tipping point may very well come when a major shipper or carrier publicly announces it has hedged a significant contract or portion of its volume on the derivatives market.
“There’s quite a bit of trading going on in the background, but the reason these remain confidential is that carriers and forwarders see this as a strategic benefit. We’re hopeful the level of transparency increases — it has to be from the players themselves.”
He also said the potential for the container derivatives market far exceeds that of the dry bulk market because there are far more shippers and individual transactions on the container side, whereas dry bulk contracts tend to be signed on a long-term basis with one commodity owner.
“Every carrier has to be looking at indexed contracts or they will lose business,” Rainsford said. “Every carrier needs to hedge or they will expose themselves. The whole idea of not hedging in such a volatile market is crazy. Carriers have for so long chased the spot market. They can’t just essentially be bullish all the time.”
— Eric Kulisch and Chris Dupin contributed to this story.
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