Container Freight Indices, Index Linked Contracts and Risk Management

Richard Heath – Heartland Shippers Conference – April 2013

• The World Container Index

• Freight Rate Volatility – Trends observed by the WCI

– Freight Rate Risk

• Freight Rate Risk Management – Risk Management Options

– Derivatives - The Basics

• Index Linked Container Contracts – Types & Uses

– Industry Adoption

• Indices, Index Linked Contracts and Risk Management – Implications & Conclusions

Agenda

Heartland Shippers Conference – April 2013

Heartland Shippers Conference – April 2013

The World Container Index (WCI)

The World Container Index is a joint venture between:

Drewry Maritime Advisors and Cleartrade Exchange

• Weekly freight rate levels on 11 major port to port routes – Trans-Pacific, Asia-Europe & Trans-Atlantic

• Weighted average Composite Index

• Highly granular data providing an average, lowest and highest rates

• Sourced from an international panel of NVO / NVOCC’s providing over 300 prices each week

The index is designed for: • Benchmarking freight rates and trends

• Index Linked Contracting

• Settlement of freight derivatives

Heartland Shippers Conference – April 2013

Trends Observed by the WCI

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3100

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3700

3900

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4300

1200

1400

1600

1800

2000

2200

2400

2600

2800

3000

Jan

-10

Mar

-10

May

-10

Jul-

10

Sep

-10

No

v-1

0

Jan

-11

Mar

-11

May

-11

Jul-

11

Sep

-11

No

v-1

1

Jan

-12

Mar

-12

May

-12

Jul-

12

Sep

-12

No

v-1

2

Jan

-13

Mar

-13

USEC

USD

/FEU

USW

C U

SD

/FEU

Trans-Pac Head Haul

China - USWC China - USEC

Container freight rate volatility has increased for three primary reasons:

– Macroeconomic & geopolitical uncertainty

– Step change in vessel size

– Carrier market behaviour

Freight rate volatility is not a short term phenomenon:

– Defining feature of the decade

– Industry adaption critical

– Impact on shipper-carrier relations

750

800

850

900

950

1000

1050

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

May

-12

Jun

-12

Jul-

12

Au

g-1

2

Sep

-12

Oct

-12

No

v-1

2

Dec

-12

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3

USD

/FEU

Trans-Pac Back Haul

USWC - China

Heartland Shippers Conference – April 2013

Freight Rate Risk

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

May

-12

Jun

-12

Jul-

12

Au

g-1

2

Sep

-12

Oct

-12

No

v-1

2

Dec

-12

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3

USD

/Tonne

Trans-Pac Back Haul Quarterly

Volatility

Decrease Increase

Unpredictability of freight rates constitutes real risk:

– Rate volatility and short

validity contracts make forward pricing impossible

– Offering derived forward prices exposes the exporter to large risks

– Although backhaul rates look to be more stable margins are smaller

Heartland Shippers Conference – April 2013

Freight Rate Risk Management

Risk Management Options

1. Removal of Risk / No Risk Management – Buy Spot

2. Pass Risk Downstream – Pass to client

3. Fixed Rate Long Term Contract – Suited to BCO/Intra-Firm trade

4. Flexible Index Linked Contract

5. Freight Derivatives

Heartland Shippers Conference – April 2013

Freight Derivatives – The Basics

The “Physical” and “Paper” Markets

• Physical Market – Agreement to move XX TEU at XX USD/TEU between POL and POD

– Between, carrier and shipper, carrier and NVO, NVO and shipper etc.

– Physically settled, e.g. boxes shipped

• Paper Market – Agreement for XX TEU at XX USD/TEU on route XX in XX month/quarter/year

– Between, party A and party B

– Cash settled, e.g. party A pays party B or v.v.

Heartland Shippers Conference – April 2013

Freight Derivatives – How do they Work?

• Freight derivatives are used to manage risk by securing a fixed rate

• A fixed rate is achieved by creating a position in the paper market which is equal and opposite to a position in the physical market

Shipper Example

• Physical Market Position = pay more if freight rates go up (Short Position)

• Paper Market Position = get paid if freight rates go up (Long Position)

• Physical Position + Paper Position = Fixed Freight Rate

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

May

-12

Jun

-12

Jul-

12

Au

g-1

2

Sep

-12

Oct

-12

No

v-1

2

Dec

-12

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3

Fre

ight R

ate

USD

/Tonne

Paper P&L

Loss Profit

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

Jun

-11

Jul-

11

Au

g-1

1

Sep

-11

Oct

-11

No

v-1

1

Dec

-11

Jan

-12

Feb

-12

Mar

-12

Ap

r-1

2

May

-12

Jun

-12

Jul-

12

Au

g-1

2

Sep

-12

Oct

-12

No

v-1

2

Dec

-12

Jan

-13

Feb

-13

Mar

-13

Ap

r-1

3

Fre

ight R

ate

USD

/Tonne

Physical P&L

Profit Loss

Heartland Shippers Conference – April 2013

Index Linked Container Contracts (ILCC’s)

ILCC’s are used to create flexible long term agreements which move with the market reducing the drivers for contract default

• Ensure contract rates move relative to the market

• Removes drivers for contract default

• Eases shipper – carrier tensions

• A “BAF” clause for your freight

Heartland Shippers Conference – April 2013

ILCC Types – Time Lag vs. Real Time

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USD

/FEU

Time Lag ILCC

Spot Contract

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Apr

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USD

/FEU

Real Time ILCC

Spot Contract

• Time lag contracts measure a change in the market over time

• This change is then applied to the agreed contract rate

• The example uses the average change in the index over 1 quarter

• Time lag contracts decrease disparity between market and contract rates

• Real time contracts are synchronised with the market

• The difference between the contract and the index is a fixed differential

• Differential is either numeric or ad valorem

• E.g. Index – 200 USD/FEU or Index x 0.7

Heartland Shippers Conference – April 2013

Industry Adoption of Index Linked Contracts

Early Adoption

• To date mostly used on Asia export trades to North America and North Europe

• Trans-Pacific was first to see ILCC’s after 2009-10 contracting season

Number of ILCC’s in 2012-13

• North America Trades – 61 (FMC)

• North Europe/Other Trades – 100 + (Drewry estimate)

Early adopters

• BCO’s (Retail/FMCG)

• European Lines

• NVO/NOVCC’s/Freight Forwarders

Approach & Tactics

• Experiments focused on small number of key lanes

• Agreed within existing strong relationships

• Mutual trust essential

Common Contract Methodologies

• Time lag

• In frequent changes (replace tender)

• 1 – 3 year duration

Barriers to Uptake

• Knowledge and expertise

• Step change in contracting behaviour

Heartland Shippers Conference – April 2013

Implications and Conclusions

• Freight indices create tools with lots of potential

• Derivatives and ILCC’s can have the advantage of moving pricing out of the

shipper-carrier relationship

• To date uptake of these tools has been relatively slow

• More transparency, more experience and adopters are required

• Derivatives and ILCC’s will bring evolution not revolution to the container market

• The WCI will continue to work with the market to help develop new index based

tools

• In the future these could form part of every organisation’s freight tool box to be

used as and when they deliver best advantage

World Container Index 15-17 Christopher Street London EC2A 2BS United Kingdom + 44 20 7759 2146 info@worldcontainerindex.com www.worldcontainerindex.com