Contracts in volatile markets – Ocean freight procurement in 2013

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Since the start of the recession the ocean freight market has become increasingly volatile. Slowing demand from shippers and increasing supply in space due to new vessels in the market have led to very low rates. Counteractive measures by carriers have included reducing space as well as pushing for General Rate Increases (GRI’s) to limit their losses. Another round of GRI’s has just been announced by all major carriers for the Main Ports China – North Europe route but it remains to be seen how long the carriers will be able to maintain the rate level which is about 150% higher than a year before.

This volatility poses a new challenge to the procurement specialist focussing on container freight. The initial default position of negotiating once a year for a one-year contract now seems out-dated and includes a certain element of risk. A one-year contract should give much desired budget security as well as space security. The reality is that throughout the contract length a changing rate can put pressure on the contract – the shipper might want to re-negotiate the contract or may threaten to leave the carrier if market rates fall well below contract rates.  Conversely, carriers may tighten the available space for containers under contract in order to provide space for containers on higher rates.

A few ideas are in the market to address these issues and have been implemented to varying degrees. Operating on spot rates requires more resources and gives no certainty in terms of budget – downsides that often over-shadow the upside of purchasing at true market rates. Quarterly or half-year negotiations or rate adjustments with carriers are a middle way – but in a highly volatile market pressure on the rates and contracts is still to be expected. In summary it can be said that the longer the fixed- rate period, especially with low market rates at time of negotiations, the higher the risk premium on the rates the carrier is asking for.

A different approach is to link the contract rates to indices, such as the Shanghai Container Index. The shipper and carrier link the contract rates to the chosen index and once the index leaves certain boundaries the contract rates are adjusted. Clear advantages of such a contract are increased security in space as well as rates close to the market for the shipper, while the carrier enjoys increased security in volumes and a market- related yield.

However the index-linked contract lacks the budget security fixed- rate contracts provide especially long-term contracts. For some years now index-linked contracts, in combination with hedging tools, have been available for the container market and, in theory, the combination appears as the ideal solution. So why are so few shippers using hedging in ocean freight procurement? It appears that the financial capabilities required are not yet available within the ocean freight procurement field and that there is certain scepticism towards introducing such financing tools.  Many shippers shy away from such a construct, wary of introducing third parties with purely financial aims and no vested interests in products or services.

An alternative way forward could be a long-term contract, for example over three years. Given that parties, shipper as well as carrier, are looking for a more stable market – which offers security in space/volume while allowing the carrier to perform on a modest return – such a construct could work.

Looking at one of the main routes from China Main Ports to Rotterdam the market rates and discussions with carriers suggests that the break-even rate should be between USD 2000 and USD 2200 per 40’GP, depending on carrier and their vessel sizes. In such an environment a fixed-rate contract over three years of USD 2300 could well work. The additional advantages for the shipper of lengthened planning stability and reduced costs in negotiations and administration of such contracts could be high. The key element of such contracts is trust between the parties involved that the fixed- rate is a true reflection of the underlying costs and that both parties will fully honour the contract.

In summary, the ocean freight contract design and length as well as financial tools are expected to change and develop in upcoming years. The perfect generic contract type cannot yet be envisaged, it appears that it very much depends on what your company- specific requirements are and what capabilities you possess in your procurement department, as well as your relationship with your contract partner.

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