(Chad Prevost contributed to this story)
Using futures to hedge your exposure to price movements isn’t gambling. Doing nothing…that’s taking a different kind of risk.
That was the underlying message that J. Scott Susich, director of analytics and advisory services at DTN, gave to the audience at the first-ever public training program for the freight futures contract to be launched by FreightWaves on the Nodal Exchange March 29. The starting date for the contract, the first of its kind in the trucking industry, was announced a day earlier at the Marketwaves18 conference near Dallas.
Susich said in his years of training futures, he runs into the same sort of resistance that goes something like this: my uncle bought futures. He lost his shirt.
As Susich said, if that actually occurred, “you weren’t hedging. You were gambling.”
The definition of a true hedging program needs to have two sides to it. The hedger needs to have some sort of financial exposure to the market, and that exposure is hedged through the futures market. With that balance, the fate that befell the bankrupted uncle can’t happen. The losses in the future market will be offsetting improvements in some other part of the hedger’s business, such as what they’re paying to move freight.
Susich gave his hedging 101 lesson by envisioning a freight market that is coming to grips with growing concerns over a trade war. Carriers are concerned that trucking rates will fall; buyers have the opposite concern (or hope). But both have budgeted their operations for a $2 per mile rate on an imaginary lane.
The carrier is exposed to prices dropping. So a current rate of $2 in the spot market might translate to a $2.12/mile rate six months down the road on the freight future contract’s forward curve. In the scenario laid out by Susich, the carrier sells the $2.12 contract for several months down the road.
When the trade war hits and commerce is slowed, rates plunge. The carrier’s operations are now out of whack with the budgeted $2 rate. But the futures position that was sold at $2.12 can now be closed out at a lower price. So in the example below from Susich’s slide presentation, the physical market is standing the carrier at a 25 cts deficit to the budgeted number. But by selling high and buying low through the futures exchange--in that order—the carrier has been able to minimize that shortfall. (The amount protected would also be a function of what percentage of that exposure was hedged, a decision that needs to be undertaken at the highest levels of a company).
The shipper does the opposite. It too has a $2 rate budgeted for that lane. Its actual physical rates decline, but they can’t fully take advantage of that drop because it bought a futures position at the higher level. It closes out that position with a sale of that position at a lower number; unlike the carrier, it bought high and sold low. Its gains in the physical market have been offset by the losses in the futures arena. As Susich noted, they might not be too happy about that.
But as Susich pointed out, the goal all along was not to make money in the futures market. It was to protect that $2/mile budgeted figure.
It also raises the question, as Susich put it, “Who is going to be dumb enough to buy those futures?” And the answer is: “Somebody who has the exact opposite position you have.”
Several other features of the freight futures contract were discussed during the three-hour training session:
--It is a cash-settled contract. No truck capacity will be delivered; the seller of a contract will not need to be dispatched to close a contract. But cash-settled contracts need some sort of index to close out positions on the final day of trading for a given contract month. (In a physically-delivered contract, like the CME WTI crude oil contract, actual oil can be delivered to settle up an obligation, though only a small percentage of contracts get to that point). DAT is the provider of that index. It will publish daily indices based on a methodology for the lanes that will be traded on the contract: Los Angeles-Seattle, Los Angeles-Dallas, the combination lanes between Chicago, Atlanta and Philadelphia and a national average. That index will be averaged on a straight basis to produce that final-day settlement. Although the reality is that most contracts are closed out prior to that final day at the prevailing market price when the position is exited, a settlement mechanism like that provided by DAT is necessary for any cash-settled contract.
--The number of lanes that can be traded on the futures exchange is a micro-fraction of the number of lanes actually out there. Why not more? Because, as Susich explained, you need a small number of standardized commodity contracts to achieve liquidity. It creates more general interest, and if liquidity is high, it’s far easier to go into a market knowing you’ll always be able to get out. Susich noted that there will therefore be a basis risk between the rates in a less-traveled Waco to Wisconsin lane and futures contracts rates for an Atlanta-Chicago lane, But if the gap between the rates in those lanes gets particularly wide, capacity can move from one to another relatively easily, helping to keep them moving—financially—in the same direction.
--The DAT number is not the only daily index. Nodal will set an end-of-day settlement for the contract. All traders with positions on the exchange will need to mark those positions to market. Danny Gomez, a director with Nodal, said the settlement will be based on actual transactions and bid/offer spreads where no transactions have occurred. This is a similar practice for all exchanges, including Nodal’s other contracts such as electricity. But the role of the exchange is not just to serve as a home base for the contract. As Susich said, when you enter into a futures contract, “you’re not just matched up with you and the counterparty. You’re effectively matched up with others.” Through its role as a clearinghouse, the exchange takes on the role of credit guarantor. If company A has traded with company B on the exchange, and company B goes bankrupt with an open position with company A, it is the exchange through its clearinghouse that guarantees the trade gets completed.
-- The financial commitment in a futures position is not just the difference between what a contract is bought and sold for. Margining—both initial and ongoing—is required. Susich explained that as a contract is marked to market every day, losses on paper will require the counterparty to put up additional capital; those requirements ease as the contract goes more into the black. “Cash management is a very, very important aspect of trading futures,” Susich said. And he used the opportunity to note what he said several other times: undertaking futures position is an activity that needs to be decided upon by the very top layers of any company that joins in.
--A company that chooses to participate in the freight futures exchange will need to establish a relationship with a futures commission merchant. Representatives from FCMs Macquarie and Archer Financial Services, an affiliate of ADM, were in attendance at the session. Setting up an account with an FCM takes about 4-6 weeks, Susich said, with representatives from the FCM representatives in attendance in agreement (though it could be shorter).
And when that company decides to take that step, Susich reiterated, it isn’t gambling. “By executing a futures position, you are not doing it to gamble,” he said. “You are managing that risk and trying to control it.”