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A long overdue futures market could decrease rate volatility in trucking

If a product is going somewhere in the U.S., 7 out of 10 times it is getting there on a truck. Further, according to the American Trucking Associations, over 80% of the nation’s nearly $900-billion freight bill became revenue for the trucking industry. That means the trucking industry has a market size of $726B, making it one of the larger industries in the US.

In fact, by revenue, the trucking industry is about 70% larger than the agriculture, forestry, and fisheries markets, and it is larger than the iron and steel; basic metals; and basic chemicals and fertilizers as a group.

The US trucking industry is even 35% bigger than the U.S. petroleum and coal production industries- combined.

To say that it is massive would be an understatement. It employs over 8.7 million people overall in the United States alone and is the number one job classification in 29 states.

The correlation of physical commodities to futures markets

This begs the question: if each of these industries has correlated futures markets, why doesn’t trucking? Futures are exchange-traded agreements to buy or sell a product at a point in the future, and they are essential in price discovery, transparency, and risk management. Some futures have been around since the 1800s, yet trucking, an integral part of nearly every industry, has been largely neglected.

Introducing new financial instruments is not an unheard-of concept. Crude oil futures, contracts that are more actively traded than gold futures, NASDAQ futures, even some treasury note futures, were not introduced until the aftermath of the energy crisis in the 1970s. These futures were introduced as an effort to reduce pricing volatility in the energy markets – and it worked. A study from Fleming and Ostdiek in 1998 found that as more people traded in the crude oil futures market, the spot market volatility actually dropped.

It’s hard for people to get their head around a futures contract that isn’t a physical good such as corn or oil, but contracts have been traded on non-physical goods for years. Interest rate futures are commonly traded between banks and corporations. Electricity is actively traded, as is maritime freight.

Electricity is exchange traded and has been since the mid-90s, after the market went through deregulation and floating prices. Electricity futures contracts were built to provide price transparency and so market participants could hedge their exposure to market swings.

Electricity has a lot of similarity to trucking freight. It is capacity constrained, can’t be stored, and travels a grid. Truckload freight meets all those standards, but it is over twice the size of the electricity market.

The case for a trucking futures market

There is a precedent for freight being exchange traded as futures. The Baltic Exchange has been listing dry-bulk futures contracts for over 30 years. The Baltic Dry Index has been a barometer of global economic activity and sentiment ever since. Dry-bulk maritime freight is much smaller than the U.S. truckload market. Singapore Exchange (SGX) purchased the Baltic Exchange in 2016.

There have been a lot of questions about why the truckload market has not had a futures market built around it. The answer might lie in the fact that until recently there was no agreed upon spot-market index that accurately tracks the market. This changed in the last decade. DAT developed a spot-market index that is incredibly reliable and tracks the broader spot market. Aggregating over $33B of annual truckload spot freight from over 600 different providers gives DAT a statistically relevant index to track the market.

DAT takes in pricing data from across the trucking physical spot market and publishes a daily index. This is extremely useful, but without a futures market, it leaves off with where the market used to be and not where it is headed. That is why DAT and FreightWaves have chosen to collaborate, along with Nodal Exchange, LLC, a leading futures exchange for electricity, in developing a futures contract for trucking freight.

Additionally, the common view by market participants is that truckload freight is hard to standardize because of all the nuances of the market. The service requirements can vary widely, commodity types are very differential, and the market is hardly uniform in terms of origin and destination.

Spot trucking rates can move as much as 40% within a week in given lanes, and today the pricing information is slow to get to the active participants in the market. A number of the rate indexes track monthly activity, but by the time they are published – it’s too late. This leads to decisions being made with either old, and often nearly irrelevant, information or gut feelings. If the introduction of a futures market can improve the quality of the crude oil market, a market in which global news can move prices wildly, why not trucking?

How trucking could benefit from futures contracts

Not only should a futures market for trucking decrease the pricing volatility in the spot market, it should also allow participants in the market to protect themselves from that remaining volatility by hedging, a strategy the larger groups in the industry already employ for fuel price fluctuations. Even those who are not familiar with hedging should feel the impact of a trucking futures market.

With the implementation of a futures market, participants will gain a huge advantage in knowing where the market is headed. Shippers, carriers, and brokers will be able to negotiate rates with a perspective on what the future holds and where the market is headed. Less guessing, more activity. This provides a huge advantage over using historical pricing information that is a week or more old.

Additionally, by having a futures market, participants can hedge their positions in the market to protect against rapid swings in price. This provides protection in instances where the physical market moves against them.

The introduction of a futures market in trucking will provide opportunity for brokers, shippers and carriers, but most of all, it will provide everyone involved in moving goods more transparency into the cost of moving those goods.

A futures market is coming to trucking

Nodal Exchange, part of the EEX Group, and FreightWaves are planning to collaborate to list Nodal Exchange futures contracts that finally settles to trucking spot price indexes. The companies have partnered with DAT and the futures contracts will finally settle against the DAT spot-rate index. DAT was chosen because it is widely accepted as the benchmark index for the industry and is designed using Price Reporting Agencies (PRA) standards that are recognized by the U.S. Commodity Futures Trading Commission (CFTC) to be a methodology that ensures transparency and avoids manipulation.

DAT is a known entity in trucking and logistics, but Nodal Exchange is likely a new name to many of our readers. Nodal Exchange started in 2009 as a startup exchange to trade power futures contracts on more granular basis reflecting the many pricing nodes across the United States for electric power.  Somewhat similar to trucking freight routes, electricity futures are often traded as spread contracts between two pricing nodes. Power futures contracts help the power industry to manage future price risk as well as the credit risk (through clearing) and liquidity risk (through standardized cleared contracts) associated with transactions based on a forward price contract.

Power markets are similar to trucking

Nodal Exchange also clears all of its contracts through its wholly owned subsidiary, Nodal Clear, that acts as the central counterparty clearing house as the buyer to all sellers and the seller to all buyers through a process called novation.  Nodal Clear provides credit protection through 1) calling variation margin based on at least daily price marks, 2) holding initial margin to handle a certain number of day’s price movement to a high degree of probability, and 3) a default waterfall that includes a guarantee fund contributed by its clearing members which include such entities as Goldman Sachs, Citigroup Global Markets, Morgan Stanley and Merrill Lynch.

The power market is around $260B a year in annual revenue and forward price contracts started to trade actively after the mid 1990’s when states deregulated their power markets. While consumers benefited from competition and lower prices, the volatile nature of power production costs and usage created a need to manage the unpredictability in the price of electricity.

The development of futures markets in electricity enabled the power generation companies to have predictability in their cash flows, while giving the power load serving entities and retailers the ability to offer more consistent pricing to consumers. Electricity price is volatile. Demand is fraught with periods of peak demand, including in the summer and winters, as people look to heat and cool their homes.

And like trucking freight, electricity is capacity constrained, and perishable- meaning any of the supply that is not used at the moment of generation, is gone forever. Electricity also travels a grid, similar to how freight travels the highways and roads.

The tri-party partnership

FreightWaves, which has been working on the concept since April 2016, decided a partnership with a global financial exchange was far superior to developing its own exchange. Craig Fuller, CEO of FreightWaves, stated, “I have been around the trucking industry my whole life and have had to learn about cold-starting a futures market over the past year. What we learned is that building a futures market that does not involve physical delivery requires a benchmark index and access to global financial players that have interest in the underlying commodity. Going at it alone would likely end in failure because no one would be there to trade the contracts. But by partnering with the de-facto benchmark index provider (DAT) and an exchange that is a leader in listing a capacity constrained futures contract (Nodal), helps to ensure our success.”

FreightWaves has been working with Nodal for over a year on designing the contracts and to gain insights in how futures markets are built. Nodal is a powerhouse (pun intended) in the electricity market. Nodal Exchange has about 30% of the open interest of the entire power contracts in the US. Nodal was started in 2009 by firms connected to the power markets to allow companies to gain more geographical granularity. Today Nodal offers over 1,000 power contracts, far more than any other exchange.

Earlier this year, Nodal was purchased by one of the largest exchanges in the world. The European Energy Exchange (EEX) which is majority owned by Deutsche Börse, purchased Nodal and made it a wholly-owned subsidiary. This was the first acquisition of EEX in North America and will likely serve as a beachhead for future expansion in other futures markets.

The deal was initially a surprise and concern by Fuller who said, “As the deal was first consummated, things slowed down as bit as Nodal’s executive team focused on closing the acquisition. This set us back a few months, but it was a blessing in disguise. We were able to focus on developing a more complete go-to-market strategy and ensure we had the proper pieces in place to create a liquid market. This includes the team, the user experience, product, and customer commitments.”

On Friday, October 27, 2017, FreightWaves, DAT, and Nodal Exchange announced they were going to launch the futures contracts in partnership. 

FreightWaves brought in executives that have worked in capital markets and have built futures markets before. This includes Glenn Goldberg, former President of S&P Platts; Eric Frank, former President of Thomson Reuters; David Sheppard, former head of global dry-bulk commodities trading at Morgan Stanley. The company also expanded its transportation markets team that now has three of the top Wall Street sell side analysts in John Larkin, Thom Albrecht, and Donald Broughton. Fuller likes to call them the “tri-fecta” of Wall Street power players. “If these three guys don’t know about it, it didn’t happen.” Fuller stated.

One the things that FreightWaves discovered in the process of knowing more about the EEX Group is the fact that it is one of the largest exchanges involved in the maritime freight futures market. In 2016, EEX acquired Cleartrade Exchange, also a cold-start exchange that became one of the largest exchanges in maritime freight futures contracts in less than six years.

Trucking Freight Futures contracts are set to launch in late 2018 or early 2019. Stay tuned to FreightWaves as we provide on-going coverage of the development of this innovation that could bring stability to our industry.

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