Executive Briefings

The Pros and Cons of Hedging Ocean Freight Rates

Over the last five years, the word "hedge" has become something of a dirty word. Think hedge funds - those massive, unregulated accumulations of capital that played a key role in bringing about the Great Recession. The idea of protecting oneself against adverse economic conditions seemed sound, but it quickly mutated into a bewildering flurry of transactions that ended up creating more risk than they were designed to mitigate. What's more, the original concept behind hedge funds became watered down to the point that many today aren't really "hedging" against anything. They're simply a means for investors to park their money with a trusted fund manager who might or might not repay that trust in the form of steady returns - all with minimal regulatory oversight.

Which brings us to the notion of hedging in the world of ocean freight transportation. It's hardly a new idea, but has yet to be widely embraced by shippers and carriers alike. Once again, on paper, it appears to make eminent sense. After all, the notion of a service contract in the oceangoing container trades has become something of a joke. Carriers routinely raise rates or refuse cargo moving under contracts, and shippers often fail to meet their volume commitments. Throw in the natural volatility of ocean freight rates, a seemingly unending series of surcharges and the ups and downs of the economy at large, and you have a pretty good argument for taking steps to protect yourself against the unexpected.

A sound hedging strategy can begin with the use of an ocean freight index as the benchmark for establishing rate levels. Examples include the Shanghai Containerized Freight Index, World Container Index of Drewry Shipping Consultants Ltd. and Baltic Dry Index. Instead of locking into an arbitrary level that might not mirror actual conditions in the trade, contracting parties allow the rate to be adjusted periodically in line with the applicable index. Such arrangements typically will be tailored for specific geographies and trade lanes, and include minimum and maximum rates that can be charged over the life of the contract.

The use of a freight index for ratemaking results in greater transparency of transportation costs, fewer rate fluctuations and shorter negotiating periods, according to Cherry Wang, a container freight broker with GFI Group. As a result, "neither party will walk away when market conditions change," she said at the annual conference of the Agriculture Transportation Coalition (AgTC) in San Francisco.

Until now, most rate indices have focused on the Asia-Europe or North American import trades, offering little guidance for products moving in the opposite direction. U.S. agricultural exporters, who are subject to huge variances in worldwide commodity prices, are now seeking an index of their own. They're heartened by the recent action of the Federal Maritime Commission, which has launched an inquiry into the creation of indices specifically for agricultural exports, based on confidential service contracts filed with the agency.

Of course, freight indices don't eliminate the possibility of rates going up or down. That's where the idea of hedging comes in. As with any type of investment, it's essentially a means of betting against yourself - of covering your losses in the event your initial assumption proves wrong. Carriers will take the long position on a contract to protect against falling prices, while shippers will short the rate to offset the impact of any price hikes.

The mechanism for doing that in the ocean freight sector is the container freight swap agreement, a futures contract in which two parties take opposite positions on container rate levels for a particular trade over a set period of time. The loser pays out the difference between the contracted and actual price at the end of the term.

In the process, shippers and carriers can stabilize their future costs and get a better handle on margins. "A fixed contract with no hedge is ineffective in a volatile market," said Michael Rainsford, a freight trader at Morgan Stanley Commodities. "Indexation and hedging delivers guaranteed rates, efficiency gains and tailored contracts. Service is king."

Of course, one's ability to enter into a swap assumes that another party is always willing to take the opposite position. There are other challenges as well. As Rainsford noted at the AgTC meeting, "indexation is a new concept for the [container] market to understand. You need curiosity, education and patience." Still to be answered are such questions as the optimum duration of an indexed contract, and the best index to use in each trade.

"Industry has a tendency to over-complicate," said Rainsford. "That's evident in early indexed contracts."

That's putting it mildly. Look at what happened to hedging strategies in the mortgage market, in the runup to the recession. We saw the emergence of arcane instruments such as credit default swaps, which seemed deliberately designed to conceal their true natures.

Moreover, the existence of a swaps or derivatives market always attracts that parasitic animal who has no stake in the underlying event. These speculators, often hailing from investment banks, buy and sell swaps at will, driving up values far in excess of the original transaction. (The market for dry-freight derivatives was already estimated to be in the $200bn range back in 2007.) In the process, they create huge amounts of uncollateralized debt, destabilizing the industry in question. Look at the pain that followed from the massive - and sometimes secretive - shorting of the housing market.

I'm not suggesting that an identical outcome will befall the ocean container business; the two industries are too different in size and nature for that to occur. Still, there's plenty of opportunity for hijinks, confusion and obfuscation. Indexation and hedging make a lot of sense for both shippers and carriers, but participants need to take care that the techniques don't get out of hand. As Rainsford put it, "the step from understanding the concept to putting it into practice is huge."

- Robert J. Bowman, SupplyChainBrain

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Over the last five years, the word "hedge" has become something of a dirty word. Think hedge funds - those massive, unregulated accumulations of capital that played a key role in bringing about the Great Recession. The idea of protecting oneself against adverse economic conditions seemed sound, but it quickly mutated into a bewildering flurry of transactions that ended up creating more risk than they were designed to mitigate. What's more, the original concept behind hedge funds became watered down to the point that many today aren't really "hedging" against anything. They're simply a means for investors to park their money with a trusted fund manager who might or might not repay that trust in the form of steady returns - all with minimal regulatory oversight.

Which brings us to the notion of hedging in the world of ocean freight transportation. It's hardly a new idea, but has yet to be widely embraced by shippers and carriers alike. Once again, on paper, it appears to make eminent sense. After all, the notion of a service contract in the oceangoing container trades has become something of a joke. Carriers routinely raise rates or refuse cargo moving under contracts, and shippers often fail to meet their volume commitments. Throw in the natural volatility of ocean freight rates, a seemingly unending series of surcharges and the ups and downs of the economy at large, and you have a pretty good argument for taking steps to protect yourself against the unexpected.

A sound hedging strategy can begin with the use of an ocean freight index as the benchmark for establishing rate levels. Examples include the Shanghai Containerized Freight Index, World Container Index of Drewry Shipping Consultants Ltd. and Baltic Dry Index. Instead of locking into an arbitrary level that might not mirror actual conditions in the trade, contracting parties allow the rate to be adjusted periodically in line with the applicable index. Such arrangements typically will be tailored for specific geographies and trade lanes, and include minimum and maximum rates that can be charged over the life of the contract.

The use of a freight index for ratemaking results in greater transparency of transportation costs, fewer rate fluctuations and shorter negotiating periods, according to Cherry Wang, a container freight broker with GFI Group. As a result, "neither party will walk away when market conditions change," she said at the annual conference of the Agriculture Transportation Coalition (AgTC) in San Francisco.

Until now, most rate indices have focused on the Asia-Europe or North American import trades, offering little guidance for products moving in the opposite direction. U.S. agricultural exporters, who are subject to huge variances in worldwide commodity prices, are now seeking an index of their own. They're heartened by the recent action of the Federal Maritime Commission, which has launched an inquiry into the creation of indices specifically for agricultural exports, based on confidential service contracts filed with the agency.

Of course, freight indices don't eliminate the possibility of rates going up or down. That's where the idea of hedging comes in. As with any type of investment, it's essentially a means of betting against yourself - of covering your losses in the event your initial assumption proves wrong. Carriers will take the long position on a contract to protect against falling prices, while shippers will short the rate to offset the impact of any price hikes.

The mechanism for doing that in the ocean freight sector is the container freight swap agreement, a futures contract in which two parties take opposite positions on container rate levels for a particular trade over a set period of time. The loser pays out the difference between the contracted and actual price at the end of the term.

In the process, shippers and carriers can stabilize their future costs and get a better handle on margins. "A fixed contract with no hedge is ineffective in a volatile market," said Michael Rainsford, a freight trader at Morgan Stanley Commodities. "Indexation and hedging delivers guaranteed rates, efficiency gains and tailored contracts. Service is king."

Of course, one's ability to enter into a swap assumes that another party is always willing to take the opposite position. There are other challenges as well. As Rainsford noted at the AgTC meeting, "indexation is a new concept for the [container] market to understand. You need curiosity, education and patience." Still to be answered are such questions as the optimum duration of an indexed contract, and the best index to use in each trade.

"Industry has a tendency to over-complicate," said Rainsford. "That's evident in early indexed contracts."

That's putting it mildly. Look at what happened to hedging strategies in the mortgage market, in the runup to the recession. We saw the emergence of arcane instruments such as credit default swaps, which seemed deliberately designed to conceal their true natures.

Moreover, the existence of a swaps or derivatives market always attracts that parasitic animal who has no stake in the underlying event. These speculators, often hailing from investment banks, buy and sell swaps at will, driving up values far in excess of the original transaction. (The market for dry-freight derivatives was already estimated to be in the $200bn range back in 2007.) In the process, they create huge amounts of uncollateralized debt, destabilizing the industry in question. Look at the pain that followed from the massive - and sometimes secretive - shorting of the housing market.

I'm not suggesting that an identical outcome will befall the ocean container business; the two industries are too different in size and nature for that to occur. Still, there's plenty of opportunity for hijinks, confusion and obfuscation. Indexation and hedging make a lot of sense for both shippers and carriers, but participants need to take care that the techniques don't get out of hand. As Rainsford put it, "the step from understanding the concept to putting it into practice is huge."

- Robert J. Bowman, SupplyChainBrain

Comment on This Article