The future of freight

The Baltic Exchange has recently shelved plans to offer freight derivatives,yet rising freight rates should aid the development of the embryonic forwardfreight agreement market. By Paul Lyon

The world’s shipping industry is approaching 2004 with optimism, analysts agree, thanksto rising freight rates across the tanker, container and dry bulk markets. Asa result, the freight derivatives market looks set to explode as shipping companiesand oil producers in particular are tipped to increase their freight hedgingactivities to mitigate against soaring freight costs.

According to research by professional services firm Deloitte & Touche, 39%of senior executives interviewed from 43 of the world’s largest shippingcompanies say they plan to use freight derivatives, known as forward freightagreements (FFAs,) in the next twelve months. While freight brokers would liketo see this figure increase, brokers agree that the numbers are already impressive.After all, some feared that shipping companies would have been put off from usingthese financial instruments in the wake of Enron’s demise. Enron dabbledin freight derivatives, and following the company’s bankruptcy, it wasexpected that corporates would be wary of being overly innovative in their derivativesusage.

But this has not proven to be the case. Indeed, some estimates by London-basedshipbrokers such as Simpson, Spence & Young (SSY) suggest that the numberof traded FFAs have increased by between 25% to 30% since this time last year.And Tom Even Mortensen, managing director of Oslo-based freight derivatives exchangeImarex, predicts that the combined dry and wet tanker market could almost doublein size from its existing level of $2 billion a year. To put freight rates inperspective, Mark Richardson, SSY’s head of futures, points out that currentrates for the Panamax route stand at three times the 10-year average.

The rapid expansion of Chinese manufacturing is cited as a significant driverof freight rate increases – particularly in the dry freight market. Inthe ‘wet’ tanker market, Chinese oil imports are predicted to grow,and other factors point toward tanker rates increases, including rising oil exportsfrom Nigeria, Venezuela and Russia.

And the rise in demand for shipping, whether it is for coal, oil or gold, iscausing gridlock at various ports that lack the necessary infrastructure, Richardsonsays. In turn, this causes ships to be delayed before docking, thereby increasingthe costs of freight rates even further.

It is surprising, then, that the London-based Baltic Exchange has mothballedplans for an online FFA trading facility. The Baltic’s electronic platform,balticexchange.com, was launched in August 2001, providing users with electronicaccess to the exchange’s freight market information, which is publisheddaily and remains the benchmark for all FFA trades. But due to the lack of demandfor online trading, the Baltic has shelved its FFA trading facility until furthernotice. One market participant, who asked not be named, said that this was dueto brokers’ hesitancy to cooperate on the same screen. “The Baltic’smodel was misjudged. After all, if a broker gets a good price he wants to dothe trade himself, not cooperate with rivals.”

What’s more, the Baltic’s model had one fatal flaw, says SSY’sRichardson. Whereas SSY built an online trading platform with the help of companiesdirectly involved in the physical shipping of commodities, the Baltic Exchangewas solely relying on the broker segment of the industry. In April 2003, SSYlaunched a freight derivatives trading service on globalCOAL’s tradingplatform. London-based globalCOAL currently has 36 members, who use the serviceto trade coal, freight and related products. They include energy companies suchas EDF, Enel and Powergen.

That isn’t to say that the Baltic hasn’t been involved with aidingthe development of the FFA market. Indeed, as the exchange’s chief executive,Jim Buckley, points out, the exchange has launched a new derivative-related product — theBaltic Ship Valuation Assessment (BaSVA). The BaSVA is described by the Balticas “a brand new concept for the industry, providing independent assessmentson the market value of four [second-hand] ship types – the very large crudecarrier, aframax, capesize and panamax (dry)”. Buckley says that all thevaluations are made on five-year-old vessels and based on professional assessmentsmade by a panel of 10 reporting companies. BaSVA will be published twice a monthon balticexchange.com. One derivative trade, based on the BaSVA, is close tocompletion, Buckley says, although he declined to provide further details.

Meanwhile, the exchange has also launched Baltic Forward to provide the freightderivatives industry with weekly mark-to-market information on three individualroutes – P2, P2A, C4 as well as the average of the four panamax time charterroutes. And Buckley told Energy Risk that the exchange is also working on otherinitiatives, involving FFA clearing.

Evidence that the FFA market looks healthy can be seen in ship broker earningreports. London-based shipping services firm Clarksons, for example, reportedprofits before tax of £5.3 million for the six months ending 30 June 2003,compared with £4.5 billion for the full year 2002, and this was in no smallpart thanks to record levels of new business recorded in the brokers’ futurestrading.

The influx of hedge funds looking to trade FFAs speculatively, and the arrivalof banks such as Deutsche to the freight market, is another positive development,according to Imarex’s Mortensen.

But, as SSY’s Richardson says, “financial brokers looking to enterthe freight industry may find it something of an uphill struggle. For end-usersusing FFAs, added value is all-important, and that is what dedicated ship brokerscan provide.” Maybe so, but the market still misses Enron’s marketmaking presence, according to Buckley. Some estimates suggest that Enron tradedup to 30% of FFAs in its heyday. But then again, as Buckley adds, since risingfreight rates have driven business to new highs , the freight derivatives markethas not really had a moment to notice Enron’s disappearance.