The need for risk management – in freight as in other areas of business – has never been more important. Shipping markets may have seen millions of dollars of value washed away by the financial crisis and rampant over-ordering, but volatility is ever-present.
Most commodities – dry and tanker freight included – have long since embraced the move towards index-based pricing and the use of cash-settled swaps or futures contracts to hedge out price risk, but one shipping sector is holding out: containers.
In some ways it is easy to see why container swaps have not taken off until now. The carriers signalled their opposition early on and the recession in freight rates gives good reason not to divert attention from the core business. As volatility and risk increase, both these arguments become harder to defend.
The other major preventative factor is that unlike bulk, box rates are traditionally priced on private, long-term contracts, with little transparency on what one shipper is paying compared to another, even to the same line for the same volumes. The move to transparency, the lines believe, would remove their pricing power.
But this too is changing. The recent Container Freight Derivatives Association (CFDA) Global Container Freight Forum in New York City drew more than 100 delegates to the offices of Morgan Stanley, with many from the shipper and carrier communities alike.
The CFDA is a neutral voice for users of container swaps, with a mission to increase knowledge and education among all interested parties. As was obvious from the day’s proceedings, progress has been made in climbing the mountain. Morgan Stanley’s Michael Rainsford and Clarksons Securities’ Ben Gibson shared the results of a survey the association had conducted, with interesting and surprising results.
The majority of respondents agreed that the container market would gradually shift towards quarterly or spot pricing and the vast majority (90%) also believed that the industry would benefit from this change, even if they were for the most part, not using them at present.
Risk management is clearly an important topic but the results suggest there is a contradiction between those who think that the spot market provides this and those that think that long term contracts do the same.
The majority indicated that they engaged in no hedging activity, though as Ben and Michael pointed out, it could be argued that that is what a long term contract attempts to provide. Most said they did not have a good understanding of the use of swaps to hedge their positions but would probably use them if that understanding improved.
The issue of index-linked contracts (ILCs) is the first nut to be cracked if swaps are to take hold. And the first reality to be understood is that fixed-contract rates are frequently re-negotiated as rates move for and against the carriers.
For shippers, a long-term contract exposes them to the spot market too, because of the time at which it is negotiated. If rates move in their favour the joy may be short-lived if the lines bump their cargo for higher paying boxes.
An annual contract is in many ways a “sub-optimal hedge”, ineffective in volatile markets with pressure exerted to increase or decrease rates as the market moves. Recent high profile disputes between lines and shippers have also demonstrated that most contracts are more akin to ‘an idea’ of what freight should be paid and are far from legally binding. Using a long-term contract to manage price risk is asking too much of an agreement that isn’t designed to deliver this certainty.
Part of the reason for the slow adoption of ILCs could be that until now, the examples have been complicated rather than simple. In principle, however, a contract where the rate a shipper pays is adjusted monthly or quarterly to reflect the prevailing spot rates in the previous period is easy to understand.
The availability of forward curves, from the CFDA, which settles against the Shanghai Containerised Freight Index and latterly the World Container Index, mean that owners and shippers now have visibility of up to 12 months and more ahead.
A divergence of views in the market is what creates the conditions for swaps trading – carriers and shippers can cover physical requirements at a floating rate and lock in rates with swaps. In other words they can still do business with a firm contract, even if they disagree on the economics.
In fact, carriers are already using the indices, even if only internally, but few are prepared to go public for reasons of strategy and competitive position. Anecdotally, it seems, shippers have a new tool in the box in their negotiations – they want flexible contracts and can threaten to take business elsewhere if the carrier doesn’t play ball.
Even with this increased transparency, the leap to trading swaps is still a big one but the work behind the scenes is building support in the market for both ILCs and for swaps themselves. And as was pointed out, many lines are already hedging their fuel costs so much of the understanding here can effectively be re-used.
So why should container swaps happen now? Well, volatility is clearly evident, not just in the year to year swings between 2009 and 2011 but over this year as carriers try to force rates up and battle seasonal demand swings.
Both lines and shippers would prefer a stable, predictable rates environment and the recent container line alliances are a sign that commoditisation of container freight has become a fact of life. This means that all-in rates negotiated on an index can be a realistic option and shippers need not be exposed to the oil market through the imposition of bunker surcharges.
The process of matching curiosity to interest is continuing but what is clear from the CFDA event is that the increased interest in indexes is slowly changing the container market from the inside out. There is some evidence too that changing investor demands are driving the process forward. At a time of tight credit terms, lenders are asking their would-be clients what plans they have in place for price risk management before they agree to lend.
A final compelling argument for ILCs and hedging is that they allow lines and their customers to spend less time on negotiation and more time on improving quality of service. Neither can be done overnight, but time is the biggest commitment to developing an ILC. To begin hedging requires establishing brokerage and clearing accounts, though companies are emerging who will assume this intermediary role.
The argument against derivatives is often that using them is akin to playing a casino, but as more than one savvy industry player has commented before now, shipping containers without freight rate certainty really is gambling.
Source: BIMCO, Neville Smith
