Index-linked contracts catching on?
Adoption of index-linked contracts for container freight is growing, says Martin Dixon, research manager for freight rate benchmarking at London-based Drewry Supply Chain Advisors.
He believes “it is quite conceivable that by 2020 most container shipping contracts will be index-linked.”
That’s a bold prediction. Last May, the U.S. Federal Maritime Commission found just 61 service contracts that were linked to indexes and Dixon estimates 100 such contracts have been signed in the Asia-Europe trade.
Until now, shipper-carrier relations have been based largely on fixed-rate contracts, but Dixon said interest in index-linked contracts is growing rapidly because of freight rate volatility.
Cherry Wang, a container derivatives broker at ACM/GFI Group in London, said it used to take the container industry seven years to go through a market cycle, but the Asia-Europe trade has gone through one and a half cycles in the past three years.
Dixon explained the volatility is caused by global economic and political changes, but also developments within shipping, including the addition of great numbers of large, energy-efficient ships and what he calls “collective carrier behavior.”
Volatility in freight rates results in disparity between spot and contact rates, he said, and that can lead to defaults where carriers and shippers are not “living within the spirit of their agreements or break them all together.”
When spot rates are high, shippers may find they must pay higher rates than they had contractually agreed to pay to secure vessel space; when spot rates fall, shippers may shift cargo from contract carriers to other shipping companies.
The situation is unsustainable, Dixon argues, and the solution may lie in the wider use of index-linked contracts that reduce the disparity between contract and spot rates and “provide the space and freight rate security both parties seek.”
There are several different indexes in use and they can be linked to contracts in two main ways: contract prices can be adjusted continually in “real time” or adjusted with a time lag, looking at, for example, what has happened in the spot market over the past quarter or month and adjusting the contract rate accordingly.
By adjusting the contract rate so it more closely resembles what is happening in the spot market, the temptation by the shipper or carrier to break the contract is reduced.
The shipper and carrier can, however, limit their exposure to big swings in their contracts by having the adjustments dampened (for example, limited to 50 percent of the change that happened in the prior quarter or month) or limiting the amount of change with a “floor” or “ceiling.”
The shipper and carrier may also agree to ignore relatively minor changes in spot rates and only trigger a change in the contract rate if the disparity between the contract and spot rate reaches a predefined level.
Drewry has its own index-linked contract model, called the Stable Market-Adjusted Rate Term or SMART, which uses a number of different tools, including a “collar” to limit changes in contract rates to a maximum or minimum, and a trigger so contract rates remain constant if spot rates only move a small amount.
The FMC found last spring five different indexes were being used — the Drewry Container Freight Rate Insight, China Container Freight Index (CCFI), Transpacific Stabilization Agreement index, Shanghai Container Freight Index (SCFI), and U.S. Bureau of Labor Statistics Consumer Price Index (CPI).
The agency has also looked at developing a contract for agricultural exports based not on spot, but contract rates, but FMC Chairman Richard Lidinksy said the initiative has been, at least for the moment, shelved after getting a mixed reception by the industry. But he also believes index-linked agreements may become more popular as shippers and carriers become more familiar with them.
“We anticipate a big acceleration in that uptake over the next few months,” said Dixon, who noted index-linked contracts have also been used in the South American trades.
Retailers and shippers of fast-moving consumer goods and shippers of commodities on backhauls have been users of index-linked contracts, he said.
The FMC found the most widely used index was the Drewry Container Freight Rate Insight, which offers rate estimates on 600 trade lanes, updated monthly.
Drewry, in a joint venture with the Singapore-based clearinghouse ClearTrade Exchange, also publishes the World Container Index, a collection of freight rates on 11 major East-West trade lanes that are updated on a weekly basis. The rates are determined by averaging freight-all-kind (FAK) rates from forwarders and non-vessel-operating common carriers.
Unlike the SCFI, which only includes headhaul rates out of China, the Drewry Container Freight Rate Insight and World Container Index cover backhaul rates as well.
Dixon said most shippers, carriers and forwarders have used the index experimentally on key traffic lanes with partners with whom they have strong relationships and mutual trust, “rather than rolling the concept out across all their cargo requirements.”
Trust is essential for the contracting to work, Dixon said, given the long-term nature of the arrangements. He said the main barrier to using these contracts is the lack of organizational knowledge and expertise among stake holders. “It takes time for such concepts to take hold,” he said.
“Real time index-linked contracts combined with hedging have the optimal potential to provide the space and freight rate security that both parties seek from an index-linked contract,” he said.
Wang noted trading of container derivatives based on the SCFI started in 2010 and is still a fledgling market.
Four SCFI routes are traded on indexes from Shanghai to North Europe, the Mediterranean, and the U.S. West and East coasts. About 90 percent of that trading is focused in the Asia-Europe trade and about 200 to 250 TEUs are processed through clearinghouses, and perhaps three times as many on a bilateral basis.