Mitigating freight rate volatility.
By Eric Johnson
Up, down, up, down.
That’s been the theme on the transpacific in recent years, and those swings don’t just apply to annual periods, but rather quarters, or even months.
In response to the swings that have frankly been a feature of liner shipping through the decades, the idea of longer-term service contracts has been offered as a solution.
But is the concept actually gaining traction?
“Certainly the use of longer-term contracts is much more common on the transpacific than say for the bigger Asia-Europe trades for the carriers,” said Paul Bingham, economics practice leader at the consultant CDM Smith. “The U.S. shippers may like this from a certainty perspective but it hasn’t really reduced spot rate transpacific rate volatility, nor locked in healthy rates for carriers or shippers. Contracts are only as good as both parties are in enforcing terms and we’ve seen volume commitments and rates not hold over the last three years on either the shipper or carrier side at times.
“So while they are contracts, their enforcement is less than what you’d see in many other business contexts. With the recent advance in trade-specific liner rate indexes, with the potential for more shipper rate-hedging through a trade specific futures market developing, contract use could be at risk as shippers now can have more often an alternative method besides the use of carrier contracts and self-insurance to manage shipping rate risk.”
One of the biggest proponents of using long-term contracts has been London-based Drewry, with its Drewry Supply Chain Consultants arm recommending this approach for years. The company has also more recently partnered to develop a rate index upon which long-term contracts can be linked.
“Longer-term contracts incorporating index-linked pricing mechanisms are certainly becoming more prevalent, in our experience,” said Martin Dixon, research manager for Drewry’s Container Freight Rate Insight. “Also, the Federal Maritime Commission confirmed that most index-linked contracts filed with its organization in the 2011-12 contracting season have been based on annual price adjustments, implying multi-year contracts.”
Dixon said such contracts provide assurances not just on rates, but also on capacity.
“We are certainly seeing a significant increase in the use of index-linked contracts, and we expect this trend to continue as both carriers and BCOs (beneficial cargo owners) look for ways to mitigate the impact of increasing freight rate volatility,” he said, noting that half of all index-linked contacts filed to the FMC referenced Drewry’s freight rate indexes. “Index-linked contracts reduce the risk that either party will withdraw from an agreement, enabling surety of supply for the shipper and market-related revenue recovery for the carriers. A by-product of this trend will inevitably be longer-term contractual agreements.”
John Isbell, vice president of the supply chain consultant Starboard Alliance, said for long-term contracts to practically work, both sides need to feel the other won’t abandon the deal at the first chance.
“From my experience, a successful longer-term contract has to be built on trust between the shipper and carrier,” said Isbell, a former logistics executive at Nike. “The keys to a successful longer-term contract are based on the starting rate and the formula or process used to negotiate rate adjustments in subsequent years. If the contract allows each party to easily opt out at the end of the contract year because the parties cannot agree on what the rate increase or decrease should be, then a longer-term contract will not be successful.”
Among liner carriers, the French line CMA CGM has been one of the more outspoken proponents of long-term deals. Jean-Philippe Thenoz, senior vice president of North America lines at CMA CGM, said the U.S. trade might be the best place to test the true viability of deals that stretch two years or longer.
“First of all, the U.S. trade already has the experience of long-term deals through service contracts which last generally one year,” he said. “Now to go beyond one year is certainly a positive evolution for both customers and line operators as it gives to the two parties a good visibility on shipping terms and service commitments.”
CMA CGM’s push for index-linked, long-term deals is based on the idea that year-to-year volatility is bad for both parties. It’s particularly hard on carriers, who have to make expensive choices on long-term physical assets.
“Our industry which is capital intensive needs to have a better view on investment return considering the cost of buying a ship and the fact it will be operated for over 20 years,” Thenoz said. “At the same time customers want to have a cost budget for their logistics chain which goes beyond a few months. If we find a way to give to our clients a mid-term contract which provides them logistics cost visibility up to three to four years, we will avoid the erratic rate phenomena we have been living with for decades.
“This is valid for any trade in the world, but we believe the U.S., due to its volumes and the importance of its customers, is a mature market to test these long-term arrangements for the benefit of all parties, including the consumers at the very end of the chain.”
In a Supply-Demand Outlook webinar hosted by American Shipper in early March, Mathijs Slangen, maritime advisor for the consultant Seabury, said he hasn’t seen widespread evidence that long-term contracts were pervasive.
Though as Hayes Howard, chief executive officer of American Shipper and its liner research affiliate ComPair Data, noted during the webinar: “Shippers who locked in long-term rates last year should be pretty happy.”
Long-term contracts
