Executive Briefings

Can Index-Linked Contracts Bring Sanity to the Liner Trades?

On October 13, 2011, the Federal Maritime Commission launched a rulemaking that proposed to allow rate levels within oceangoing service contracts to be linked to industry freight indices. Some carriers and shippers had pushed for the change in hopes of achieving greater rate stability in the notoriously uncertain liner trades.

Can Index-Linked Contracts Bring Sanity to the Liner Trades?

FMC's action became a final rule in March of 2012, but there wasn't exactly a stampede to adopt the technique. Two months later, just 61 industry-linked contracts (ILCs) had been filed, according to Ed Sands, global practice leader for logistics with Procurian. Drewry Shipping Consultants Ltd. has estimated that there are currently about 50 in place on the Asia-Europe route. "It's a start," said Sands.

The idea isn't that complicated. A freight index is essentially a database which provides a snapshot of conditions in the trade. There are a number of well-established ocean-based indices out there - the Shanghai Containerized Freight Index, Drewry's World Container Index and the Baltic Dry Index, to name a few. Similar services exist for other modes of transportation, as well as for fuel and bunker prices.

An ILC permits periodic rate changes, within a specified range, for various trade lanes and regions. The practice acknowledges the need for price adjustments during the life of the contract, based on such factors as capacity availability, fuel cost and port congestion.

Fair enough. So why have relatively few shippers sought more predictable rates through reliance on a freight index? Could it be that they prefer chaos?

Speaking on a panel at this year's Trans-Pacific Maritime Conference, sponsored by the Journal of Commerce, Sands laid out the situation. Carriers continue to negotiate service contracts, mostly running one year, with a deadline of May 1. Minimum quantity commitments (MQCs) and shortfall penalties are frequently ignored. Carriers tend to favor volume over profit margin, while shippers demand excessive free time and equipment.

"If they can't make that work, we're going to talk about indexed contracts and derivatives?" asked Sands. "We're probably reaching too far."

Both sides are culpable. "Carriers claim they are not a commodity, and then they price like one," Sands said. "Shippers claim they want service, then negotiate prices as if they are a commodity."

Both sides can further reduce risk through hedging, whereby each takes a financial position that pays off if rates fall outside expected parameters - too high for shippers, too low for carriers. For ocean freight, the practice works best in the most unstable trades, such as Asia-Europe.

But hedging is far more common in financial markets than in transportation, and many shippers and carriers fail even to take the first step of indexing rates to narrow the degree of risk. (Contracts, of course, are themselves a form of hedging, but only if the negotiating parties adhere to their provisions.)

One shipper that hasn't been indexing, but is seriously considering the practice, is Dick's Sporting Goods. Brian Bernarding is director of international transportation and customs compliance. He has reached out to a number of other cargo owners to learn of their experience with ILCs.

The company's goal, Bernarding said at the TPM conference, is to achieve the greatest possible return on investment from its rate negotiations. Yet he worries about the proliferation of general rate increases (GRI) coming from carriers, who fail to hold the line on rates, then scramble to make up for their lack of discipline. "What are these GRI announcements doing to the index?" he asked. "Do we want to tie our business to that?"

Some cargo owners with ILCs report success in holding rate instability in check for up to three years. But Dick's needs to be certain that the practice will match or improve the results it can achieve through an annual business cycle.

Questions abound. "How should we do it?" asked Bernarding. "What index should we use? What are the adjustment triggers? Are you conservative or aggressive? Are you OK with keeping your rates at the same level, even if the market has gone up and down slightly? What thresholds should be in place? Where's the turnoff switch?"

Timing is yet another issue. Should Dick's go for an ILC now, in a dynamic market with large amounts of new vessel capacity coming on line? What about the impact from the expansion of the Panama Canal in two years? Wouldn't it make sense to lock in at the market's lowest point - whenever that might be?

While some cargo owners endorse ILCs, others are reluctant to give them a try. "They don't understand the purpose," said Bernarding. "Carriers haven't done much of a job selling it to them." So the potential of ILCs has yet to be fully tapped.

Non-vessel operating common carriers (NVOs), who tend to operate on thin margins, appear to be especially good candidates for ILCs. TSC Container Freight is the NVO arm of The Scoular Co., a grain trader and transporter. It relies on the Shanghai Containerized Freight Index.

"There's no real need to be scared of indices," said Dave Briggs, senior manager of container freight derivatives with TSC. "It's just a way to define the market in regard to prices.... Linking to an index is essentially linking to the market and agreeing to pay what the market will pay."

ILCs could prove to be a compelling means of reducing risk in certain trades, provided carriers can break free of their historical seesawing rate policies. Considering the giant new containerships that are entering into service over the next several years, I wouldn't put money on that happening.

Still, some experts see it differently. Sands believes ILCs could give shippers a better handle on their landed cost, while keeping risk within more manageable boundaries. "There are big benefits on the merchandising side," he said. "It's a huge deal."

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Keywords: supply chain, global logistics, ocean freight derivatives, container freight index, freight rate index and hedging, index linked contracts, logistics & supply chain, supply chain risk management

FMC's action became a final rule in March of 2012, but there wasn't exactly a stampede to adopt the technique. Two months later, just 61 industry-linked contracts (ILCs) had been filed, according to Ed Sands, global practice leader for logistics with Procurian. Drewry Shipping Consultants Ltd. has estimated that there are currently about 50 in place on the Asia-Europe route. "It's a start," said Sands.

The idea isn't that complicated. A freight index is essentially a database which provides a snapshot of conditions in the trade. There are a number of well-established ocean-based indices out there - the Shanghai Containerized Freight Index, Drewry's World Container Index and the Baltic Dry Index, to name a few. Similar services exist for other modes of transportation, as well as for fuel and bunker prices.

An ILC permits periodic rate changes, within a specified range, for various trade lanes and regions. The practice acknowledges the need for price adjustments during the life of the contract, based on such factors as capacity availability, fuel cost and port congestion.

Fair enough. So why have relatively few shippers sought more predictable rates through reliance on a freight index? Could it be that they prefer chaos?

Speaking on a panel at this year's Trans-Pacific Maritime Conference, sponsored by the Journal of Commerce, Sands laid out the situation. Carriers continue to negotiate service contracts, mostly running one year, with a deadline of May 1. Minimum quantity commitments (MQCs) and shortfall penalties are frequently ignored. Carriers tend to favor volume over profit margin, while shippers demand excessive free time and equipment.

"If they can't make that work, we're going to talk about indexed contracts and derivatives?" asked Sands. "We're probably reaching too far."

Both sides are culpable. "Carriers claim they are not a commodity, and then they price like one," Sands said. "Shippers claim they want service, then negotiate prices as if they are a commodity."

Both sides can further reduce risk through hedging, whereby each takes a financial position that pays off if rates fall outside expected parameters - too high for shippers, too low for carriers. For ocean freight, the practice works best in the most unstable trades, such as Asia-Europe.

But hedging is far more common in financial markets than in transportation, and many shippers and carriers fail even to take the first step of indexing rates to narrow the degree of risk. (Contracts, of course, are themselves a form of hedging, but only if the negotiating parties adhere to their provisions.)

One shipper that hasn't been indexing, but is seriously considering the practice, is Dick's Sporting Goods. Brian Bernarding is director of international transportation and customs compliance. He has reached out to a number of other cargo owners to learn of their experience with ILCs.

The company's goal, Bernarding said at the TPM conference, is to achieve the greatest possible return on investment from its rate negotiations. Yet he worries about the proliferation of general rate increases (GRI) coming from carriers, who fail to hold the line on rates, then scramble to make up for their lack of discipline. "What are these GRI announcements doing to the index?" he asked. "Do we want to tie our business to that?"

Some cargo owners with ILCs report success in holding rate instability in check for up to three years. But Dick's needs to be certain that the practice will match or improve the results it can achieve through an annual business cycle.

Questions abound. "How should we do it?" asked Bernarding. "What index should we use? What are the adjustment triggers? Are you conservative or aggressive? Are you OK with keeping your rates at the same level, even if the market has gone up and down slightly? What thresholds should be in place? Where's the turnoff switch?"

Timing is yet another issue. Should Dick's go for an ILC now, in a dynamic market with large amounts of new vessel capacity coming on line? What about the impact from the expansion of the Panama Canal in two years? Wouldn't it make sense to lock in at the market's lowest point - whenever that might be?

While some cargo owners endorse ILCs, others are reluctant to give them a try. "They don't understand the purpose," said Bernarding. "Carriers haven't done much of a job selling it to them." So the potential of ILCs has yet to be fully tapped.

Non-vessel operating common carriers (NVOs), who tend to operate on thin margins, appear to be especially good candidates for ILCs. TSC Container Freight is the NVO arm of The Scoular Co., a grain trader and transporter. It relies on the Shanghai Containerized Freight Index.

"There's no real need to be scared of indices," said Dave Briggs, senior manager of container freight derivatives with TSC. "It's just a way to define the market in regard to prices.... Linking to an index is essentially linking to the market and agreeing to pay what the market will pay."

ILCs could prove to be a compelling means of reducing risk in certain trades, provided carriers can break free of their historical seesawing rate policies. Considering the giant new containerships that are entering into service over the next several years, I wouldn't put money on that happening.

Still, some experts see it differently. Sands believes ILCs could give shippers a better handle on their landed cost, while keeping risk within more manageable boundaries. "There are big benefits on the merchandising side," he said. "It's a huge deal."

Comment on This Article


Keywords: supply chain, global logistics, ocean freight derivatives, container freight index, freight rate index and hedging, index linked contracts, logistics & supply chain, supply chain risk management

Can Index-Linked Contracts Bring Sanity to the Liner Trades?