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Special Coverage: Ocean freight industry enters a pivotal 2017

What has been accepted as standard practice for decades – large shippers cementing big volume annual contracts with carriers and smaller shippers, forwarders and NVOs picking up the scraps on the spot market – is now being heavily scrutinized.

Bob Dylan

   Bob Dylan wasn’t talking about ocean freight procurement when he penned his landmark song “The Times They Are a-Changin,’” but how appropriate those words are as the industry enters a pivotal 2017.
   What has been accepted as standard practice for decades – large shippers cementing big volume annual contracts with carriers and smaller shippers, forwarders and non-vessel-operating common carriers (NVOs) picking up the scraps on the spot market – is now being heavily scrutinized.
   That model has created incredibly favorable ocean freight rates for shippers, especially in the last five years, but it’s also created an unhealthy environment that carriers have struggled to manage. And so in 2016, the industry saw an unprecedented amount of upheaval – carrier mergers, acquisitions, alliance consolidation, and even a major bankruptcy.
   At the heart of this unhealthy patient lies a simple symptom. Contracts are not honored by either side, a vicious cycle that induces shippers to book multiple slots for a single container to ensure capacity, and carriers to overbook sailings to avoid losing a perishable commodity – the capacity on board a fixed sailing.
   Even as shippers and carriers are confronted with a host of potential new means to procure capacity – marketplaces and digital freight forwarders, among others – yet another option has emerged in recent months. A guaranteed forward contract, an instrument that locks in capacity for shippers and containers for carriers, protected by a neutral clearinghouse that would assess significant penalties to either side for failure to uphold their end of the contract.
   It’s not a new idea. Carriers have tried to individually enforce penalties against container no-shows. But the new contract, developed by a group called the New York Shipping Exchange (NYSHEX), is taking a more comprehensive and neutral approach.
   The exchange facilitates a new kind of contract that binds shippers and carriers to adhere to the terms of the deal. Under the terms of the contract, NYSHEX assesses penalties against shippers that fail to provide containers on a stipulated sailing, and carriers that roll cargo despite agreeing to provide capacity on a particular sailing.
   In other words, a contract agreed via the exchange would compel shippers and carriers to conduct their business relationships as businesses do in virtually all other industries.
   “This is the first solution that brings a value proposition that speaks to both shippers and carriers,” said Jesper Præstensgaard, chairman of ocean carrier Unifeeder, and a non-executive board member of NYSHEX. “All prior attempts to do automation or exchange of freight spaces, it’s always been ‘either/or.’ It’s always been a situation of who can strong arm who.”
   The issue of unhealthy contracting behavior, as Præstensgaard sees it, is itself a symptom of the underlying problems with the industry.
   “There is a structural overcapacity, and [capacity] is a perishable commodity,” he said. “If you don’t sell it on Monday, it’s gone forever. These industry fundamentals create a textbook case for an industry that will resort to discounting.”
   According to Præstensgaard, NYSHEX contracts will help carriers to avoid what he calls the “Friday afternoon fire sale” to which they are currently exposed. “Everybody knows when carriers approach the last port of call in Asia, marginal cost will drop (as carriers try to fill unused capacity),” he said. “NYSHEX provides everybody a predictable process that allows people to do their planning on the delivery and production side. That should avoid the Friday afternoon fire sale.”
   Carriers have tried to unilaterally implement contract provisions that penalize both sides (industry leader Maersk Line last unveiled such a plan in mid-2011), but those singular efforts went nowhere because shippers could simply turn to other carriers on the same trade lane that had no such provisions. Due to the overcapacity on most trades, finding slots generally is not an issue, especially for larger shippers that wield considerable leverage in negotiating favorable annual contracts.
   But there are huge swathes of shippers that don’t have such leverage. Those shippers are often left dealing with regular amendments to contracts and rates, and the chance their cargo could be rolled in certain weeks when outbound capacity is tight in key ports. Or they can play the spot market.
   All are risk factors that have the potential to drive up costs.

A Third Option. NYSHEX proponents note that the forward contract isn’t intended as a replacement for existing ocean freight procurement mechanisms. It’s meant to be a third option in addition to traditional contracts and the spot market.
   “Despite the advanced stage of companies playing in this space, the counterparty risk is huge,” said NYSHEX CEO Gordon Downes, whose past roles include stints with Maersk and its freight forwarding subsidiary Damco. “NYSHEX’s one job is to reduce counterparty risk. That’s the job of marketplaces around the world.”
   With a NYSHEX contract, shippers and forwarders use the online exchange to find a carrier providing capacity on a sailing on which they want to book a container. The two parties agree to a binding contract, the so-called “forward contract,” which is secured through a cash deposit, a bank guarantee or bond, collateral, or bank financing.
   This act of securing the contract is pivotal to the idea of the exchange. It’s the skin in the game that compels both sides to honor the specific terms of the deal, eschewing the inefficient behaviors that have become endemic in traditional contracting and spot market transactions.
   “This product is not being forced on anyone,” Downes said. “It’s a different product. These are the rules. The shipper needs to decide how much is this worth to me. In virtually every other industry, you put down some sort of deposit. Managing counterparty risk is just new to this industry.”
   The question of how much the forward contract is worth to a shipper is critical. There might be an initial assumption that such an instrument would be more expensive than a traditional contract rate, but forward rates are subject to market dynamics, just as other contracts and rates are. The difference lies in those dynamics.
   For instance, a carrier that knows it has difficulty filling a sailing out of a certain port might be willing to accept a forward contract for a container at a rate lower than that shipper might have been able to negotiate in a broader agreement. It’s still about what rate the market will bear – the only difference is that the contract is binding.
   Shippers might expect to pay a premium to lock in capacity on an in-demand lane during peak season, but carriers might similarly be eager to lock in volumes during that same season, rather than risk sailing with an empty slot during a period in which every slot is a lucrative, but still perishable asset.

Not A Derivative. In speaking with shippers and forwarders about the concept, it seems clear that, at least initially, the NYSHEX contract will be a tool in the toolbox for shippers and forwarders, not necessarily something that will transform how they do things immediately.
   David Briggs, a senior manager in the NVO business of grain trading firm the Scoular Co., had previously worked on container derivatives as his company sought a way to better balance its risk. NYSHEX, incidentally, emphasized to American Shipper that forward contracts are not “future” contracts, also known as freight derivatives.
   “It’s a way for us to get forward pricing,” Briggs said. “It’s exactly what we’ve been looking for. Physically executable, whereas the derivative was a financially settled deal, not guaranteed physical freight on either side of deal. This is not that.
   “For our business, there are huge advantages,” he added. “It seems a little ridiculous that the airline industry has figured it out. You buy a ticket in April, you pay for it today, and you know a seat will be available. They have the money already. Then you think about how much bigger ocean freight transactions are.”
   But Briggs said the forward contract offered by NYSHEX won’t completely wipe away the traditional methods by which carriers and their customers do business.
   “This is not going to replace everything, because it’s not going to fit for every person,” he said. “It’s going to be another option.”
   Arnold Kamler, CEO of Kent International, a bicycle manufacturer with 7,000 TEUs of annual volume that supplies to Walmart, Target, and Toys R Us, as well as a host of regional retailers, said his company will use the NYSHEX contracts, if only on a limited basis.
   “I’m not sure how much, but certainly for a medium-sized shipper, this has got to be a gift from heaven,” he said. “No pleading and begging, with dramatic penalties on both sides.
   “I’m not thinking it will be 30 percent of my business. I can see using it if XYZ [carrier] is insisting on a $1,000 increase. I may end up paying them that through NYSHEX anonymously, but it becomes a strong bargaining tool.”
   Kamler, who has been negotiating ocean contracts for more than four decades, said there’s been a decided shift in the tenor of those negotiations in recent years.
“The last five years have been a war,” he said. “Steamship companies can’t wait to punish their customers. They rationalize it [by saying] that market demands are this, in complete disregard to contracts.”
   From Kamler’s point of view, the burden of contract amendments has shifted his procurement strategy. The picture changed in 1998, when some cargo was rejected “because the price was too low.”
   “It’s consistently been an issue since that time,” he said. “When business is booming, carriers consistently disregarded their contracts. When business is weaker, it’s ‘we’re so sorry for what happened, and it’ll never happen again.’”
   Kamler booked 100 percent of his cargo direct with carriers until a few years ago, but now has a 50-50 balance between carriers and NVOs, a number that’s risen steadily the past three to four years, he said.
   “I used to handle negotiations myself, and it wouldn’t take so long,” he said. “We had maybe five contracts. But now there are so many amendments. I had to hire a couple people to handle the craziness that ensued.”

Contract Paradox. Both Kamler and Briggs said one of the most intriguing aspects of the NYSHEX contract is that shippers, more often than not, have iron-clad agreements with customers they must meet to deliver a certain amount of product to a certain place by a certain date. And having a contract for ocean carriage that is not as iron-clad can create serious problems.
   “I can’t handle when the rate is $2,000 one week and $3,000 the next week,” Kamler said. “We make agreements with our customers.”
   “In the spot market, it’s hard to get rates past 30 days without the risk of a GRI,” Briggs said. “Our margins are slim – maybe $4 a ton, with 25 tons in a container. A $100 increase, that’s your whole margin. When you talk about thousands of tons of [dried distillers grains], that’s a huge risk.
   “When you’ve sold delivered contracts, and get hit with a GRI, you’re doing deals for gross break even. And that’s not counting the risk, the cost to execute the deals. Forward contracts are standard in other industries. If someone sells nails to Menards, they get a price for the year. Container contracts are legally binding, it’s just the industry chooses not to follow them.”
   Kamler pointed to another traditional bugaboo in ocean freight contracting: the fact that minimum quantity commitments presume that annual volume is spread evenly throughout the year.
   “When you sign a contract at $2,000 for 40 containers a week, it’d be nice if it was like that, but we have peaks and valleys, and [the carriers] say, ‘sorry, we can’t do that.’”
   Kamler and others said this assumption that volumes are spread evenly lies at the heart of the corrosive behavior that leads to overbooking and cargo rolls. They also said forward contracts could go some way to providing a market-based solution to overcome that ingrained behavior.
   “If I have the sense NVO space is getting tighter, then I can book contracts with NYSHEX,” Kamler said. “Anybody in this import/export business is a gambler by nature, but I see NYSHEX as an insurance policy. It could be 10 to 20 percent of our volume. It gives me that leverage also.”
   “Maybe I don’t agree on a price,” added Briggs, “but I can see where the rates are trending, and carriers know I have skin in the game.”
   The equilibrium that NYSHEX is trying to bring to contracting will likely be a crucial factor in the success of the exchange.
   “Attempts in the past to change the way we procure freight have left out carriers,” Briggs said. “We’re all in this together. We need them because we don’t have ships and they need us because they need our cargo. The exchange is doing a good thing in trying to include carriers. They’re saying, ‘we want to work with you,’ not ‘here’s the model and we know your business better than you.’”

Zero-Sum Game. Lars Jensen, CEO of maritime analyst SeaIntelligence and a Maersk veteran, said NYSHEX “seemed an earnest way to address an issue we’ve heard at every conference the last 15 years,” namely that neither carriers nor shippers honor their contracts as written.
   “Both parties are saying we should collaborate better, but instead it gets worse. Why has that been? There’s been sustained overcapacity in an environment that’s a zero-sum game. If I’m a carrier and lose the cargo, I can’t replace it with another container,” he said.
   “NYSHEX looked like a different approach, rather than a ‘how can we, as carriers, enforce a contract’ because one carrier will always break ranks. Let’s not touch existing contracts. Let’s start a third option. If you want the enforceable part, you can go with us, he added.”
   Jensen, who serves on NYSHEX’s board of directors, said he sees adoption of the forward contract and online ocean freight marketplaces as a gradual evolution, not a disruption.
   “For some this appeals better than others,” he said. “It depends on the market situation. When there’s a capacity crunch, you’ll want to lock it in. But even in an overcapacity market, you can still be in a situation where there’s tight capacity. Say a bunch of carriers blank their sailings the same week from Ningbo.”
   The uncertainty of a vastly changed market in 2017 – one with fewer carriers, new alliances, and potentially lackluster demand – could compel shippers to better value certainty.
   “For a commodities shipper, freight is something where they want to eliminate the risk,” Jensen said. “Both the potential to be rolled, but also the rate. Contracting within the existing framework doesn’t actually work.
   “If you are a large importer who thinks you can beat the market, you probably won’t see them use this. It’s a perennial discussion: if I can truly lock in the freight rate, what if the rate drops? Well, when you lock it in, you should make sure it’s still a good rate. This is not a tool to beat the market. It’s a tool for managing risk in a market that’s anything but stable.”
   Jensen also spoke about how burdensome the act of procurement has become. More than just an annual event, it’s become an incessant process of managing amendments, finding alternative sources of capacity, or scouring the spot market. And it’s no less burdensome on the carrier side.
   “It’s an onerous process, but one they’ve chosen,” Jensen said. “If they like stability, with the forward contract, the market changes and amendments come out.”
Jensen also noted that the forward contract is determined by market characteristics and the two parties doing the contracting.
   “How should a NYSHEX contract be priced?” he asked. “It could lower the cost because a carrier is certain of the volume it is getting, and that incrementally reduces the costs of no-shows. In markets where space is at a premium, the rate would be higher.”

Procurement Innovations. One can also view the instrument that NYSHEX is offering through a broader prism: that ocean freight shippers and carriers will have many more options in how to transact with one another than they have in the past, even beyond the forward contract.
   While the founders of NYSHEX pointed out emphatically that theirs is not a “technology solution” or “platform,” but rather a way to enable a different form of contracting, the reality is that the ocean freight industry is being broadsided by a mix of smart minds and new waves of technological innovation.
   Most of these technologies and ideas are trained, at least in part, on procurement. Some offer shippers, forwarders, and carriers a neutral marketplace in which to buy and sell capacity. Others aim to empower shippers or forwarders with new tools to better understand their leverage in negotiations. And some aim to help forwarders or carriers to attain new business, better optimize their networks, and diminish the cost of sales.
   What’s emerging is an environment where there are different procurement options for shippers of different sizes and goods beyond just long-term contracts and spot rates. Carriers, too, will have different options for selling capacity beyond those two traditional methods.
   Many of these new forms of procurement depend on dynamic pricing. And this is where Downes said NYSHEX has particular relevance.
   “You cannot do dynamic pricing unless you have enforceable contracts,” he said. NYSHEX told American Shipper that as of early January, five of the top 10 carriers, 20 shippers and five NVOs were using the exchange as part of two pilot tests – one on the U.S. import side and another on the export side. The exchange is also finalizing registration and onboarding with six more NVOs, two additional carriers and another crop of shippers.
   In terms of how a forward contract on NYSHEX might impact the actual booking process, the exchange said “the booking process is at the discretion of how the shipper or NVO/forwarder prefers to execute it. In other words, whatever the preferred method or policy/process that the booking party has is the one they can use.
   “There is zero barrier to entry as we have already developed the process/technology to receive the booking information through multiple channels whether that be carrier direct, third-party platform or right through the exchange. As part of our onboarding and integration with the ocean carriers, we work with them to establish channels to ensure that booking data is filtered back to us to track contract compliance.”

Transferrable Contracts. Another facet of the forward contract to note: NYSHEX officials say contracts consummated on the exchange can be sold or transferred. So while a shipper is bound by a contract, if the need for a particular contracted slot goes away, that shipper can sell the slot on the exchange.
   That “sublet” slot, so-to-speak, might sell for less than the price the initial shipper paid, but it’s a way to recover some of the cost and avoid the no-show penalty. Alternatively, if the shipper no longer requires that slot in a premium period where capacity is tight, it actually might profit from the secondary sale.
   Præstensgaard said the exchange could also be a tool for carriers to better price the scarcity of their slots in a fairer way. He suggested carriers could, for instance, reserve 5 percent of their slots during peak periods and sell them on the exchange at a premium.
   “And that would provide an orderly market for shippers to get premium slots,” he said. “Right now, the alternative is airfreight. That’s not 20 percent higher, that’s 10 times the cost of ocean freight.”
   Præstensgaard said the biggest hurdle for NYSHEX and the concept of forward contracts to overcome is the industry’s inherent nature.
   “Liner shipping is incredibly conservative,” he said. “So is ocean freight procurement. Shippers still complain about liner alliances [despite rates being so low]. But there’s never been a neutral clearinghouse. There have been attempts in the past. People have tried to build models to allow people to hedge their exposure. Carriers were afraid of that because they felt they’d be exposed, and that trading volumes exceeding the physical movement of goods would increase volatility.
   “The risk now is that carriers and shippers have to realize this is a different way of doing things.”

Eric Johnson  Eric Johnson is Research Director and IT Editor of American Shipper. He can be reached by email at [email protected].