Bill Lines

The freight market is huge and complex with shipowners, operators and charterers at the mercy of fluctuating freight rates. Thousands of events can have an impact on the cost of transporting goods by sea and anyone moving commodities by sea operates in an extremely volatile environment.

Seaborne trade is a vital component to the health of the global economy and the world relies on its global fleet of ships with a cargocarrying capacity of 743.8 million deadweight tonnes to carry every conceivable type of product. From grain to crude oil, iron ore to chemicals, the latest United Nations figures show that more than 5.8 billion tonnes of trade was transported by sea in 2002.

While the freight market is subject to a wide range of external variables, it is fundamentally driven by six factors; fleet supply, commodity demand, seasonal pressures, bunker prices, choke points and market sentiment.

Since 1985, the Baltic Exchange, whose international members are estimated to be responsible for a third of all dry cargo fixtures and half of all tanker fixtures, has produced a set of indices and route-rate assessments for both the shipping markets. These paint an accurate picture of the cost of transporting industrial goods around the world by sea.

The Baltic Dry Index is the composite average of three other shipping indices: the Baltic Capesize Index, Baltic Panamax Index and Baltic Handymax Index. They are based on the cost of shipping the major dry bulk commodities on key trading routes. On the wet side are the Baltic Clean and Dirty Tanker indices.

The broad nature of the BDI means that it is used by some economists to help forecast the performance of a number of other economic indicators including the Hang Seng, the price of crude oil and US, European and Asian industrial production figures.

The freight markets are extremely volatile and notoriously difficult to predict. For example, between January 2003 and July 2003 on the West Africa to US Gulf very large crude carrier route rates fluctuated between W49 and W160. This essentially meant a differential of about $3.8 million in freight costs between the low and high points over a sevenmonth period. On the dry side, the cost of transporting coal from Richards Bay to Rotterdam in a capesize vessel fluctuated between $8.783 per tonne to $12.828 over the same period — a price differential of $606,750 on a 150,000 tonne lifting.

Energy companies and banks have an increasing exposure to shipping. Power generators have seen their seaborne coal trade grow faster than electricity production, while market deregulation has increased their exposure to risk. Banks are exposed to shipping through their involvement in the commodities trade, as well as through their ship lending portfolio. Increasingly, banks are expecting their shipowning clients to be able to demonstrate an ability to lock in future revenues before funding the purchase of additional ships.

Traditionally shipowners have used period timecharters — chartering their vessels to a company for a certain length of a time for a fixed rate — as a method of reducing their exposure to the fluctuating spot market. However, although still in its infancy and dwarfed by other paper markets, there has been an increasing use of freight derivatives in both the wet and dry markets on various major ship sizes. This trade has an estimated annual value of $4 billion in implied freight rates.

Shipowners, charterers and traders alike are increasingly turning to Forward Freight Agreements (FFA) to hedge and speculate on future charter rates. An FFA is an over-the-counter agreement between two principals which sets a freight rate for a specified volume of cargo on a specific Baltic route at a date in the future and usually negotiated through a broker. FFAs can be used for any tonnage over any period between five and 15 days and two years forward on any of the 41 shipping route assessments made daily by the Baltic Exchange. While it is the shipowner who bears the brunt of freight market risk through the speculative ownership of a ship worth millions of dollars, it is the energy companies and finance houses which are proving to have stronger stomachs for speculative freight derivative trading. In recent months there have been a number of newcomers into the shipping derivatives market. There is, however, still plenty of room for growth with the physical chartering market worth at least $150 billion annually.

However, the freight derivatives market is unlike any other derivative market as it relies on indices based on professional assessments of how the freight market will perform in the near future. Stock and commodity market indicators on the other hand are historical and based on what trades were actually transacted. The reason for this difference in approach is that there is simply not the same level of liquidity in the shipping markets as the stock markets. On any given day the world’s commodity, stock and security exchanges will be processing millions of trades — in the shipping market there can at best be hundreds of daily fixtures.

As a neutral body with no vested interest in reporting market rates to be any higher or lower than they actually are, the Baltic Exchange is uniquely placed to coordinate cooperation between shipping market participants who compete in other spheres of activity.

A panel of international shipbroking houses makes assessments of the performance of different ship types on 41 routes. This information is then collated, averaged and then published on a daily basis at 13.00 hrs (dry) and 16.00 hrs (wet) London time. To ensure that these assessments remain fair and accurate, only broking companies of the highest calibre are contracted to report and principals excluded. The Baltic panellists report under a very tight set of conditions, ensuring the accuracy of their returns.

Each route reported on is transparent with a reasonable level of fixtures taking place on a daily basis, and, where possible, trades dominated by a limited number of charterers are avoided. Each panellist is provided with a manual containing rules governing construction and publication of the indices, guidance in making assessments and a set of criteria including vessel descriptions and route definitions to calculate their assessments. The Exchange audits its panellists on a regular basis to ensure that reporting standards remain of the highest quality.

The Baltic’s freight market department itself is active in the shipping markets compiling various daily market reports including a fixture list and is, therefore, able to challenge unrealistic assessments made by panellists.

The routes that make up the Baltic indices as well as the vessel descriptions are constantly evaluated and adjusted to keep pace with the ever-changing shipping markets. The Baltic Exchange does its utmost to ensure that its market information is what the market wants. Through the Exchange various committees and groups meet on a regular basis to ensure that the voice and needs of its freight market information users are heard and met.

At present the use of freight derivatives is still relatively limited, given the vast size of the physical chartering market. However, with the existence of an accurate and reliable set of market indicators; an extremely volatile freight market; an increasing familiarity with hedging and trading techniques throughout the shipping community together with a growing recognition of the importance of the shipping market by energy companies and financial institutions alike, the freight derivatives industry looks set to take off.

Bill Lines is the Baltic Exchange communications Manager. Contact him on Blines@balticexchange.com or +44 (0) 20 7623 5501.

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