An analysis by The Economist suggests that the shipping container market has had a greater impact on globalization than all trade agreements over the past 50 years combined. Approximately 90% of global goods are transported by sea, with about 60% of that cargo carried in steel containers.
Traditionally, shipping companies have used long-term fixed price contracts to trade container freight. Shipping liners provide rates to freight forwarders or, in some cases, directly to large cargo owners, with pricing determined by the volume of goods transported. Freight costs can represent up to 20% of the cargo's value. Due to increasing volatility across major trade routes, managing price risk in container freight has become critically important.
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Before December 2021, liners, freight forwarders, cargo owners, and major financial institutions had limited tools to effectively manage price risk. The introduction of CME Group futures contracts, based on index prices from FBX and overseen by the Baltic Exchange, has helped address this issue.
Surge in Demand Strains Supply Chains
The pandemic lockdowns caused major disruptions to global supply chains, leaving many containers stranded in the wrong locations. This, coupled with strong demand for goods, forced companies to contend with significantly higher freight costs. In addition, Brexit-related stockpiling ahead of the UK's formal exit from the European Union in January 2021 further drove up freight prices, particularly on the key European trade route from North Asia to Northern Europe. Export markets from the U.S. and Europe experienced similar price hikes, reflecting the worldwide container displacement.
These challenges have put considerable cost pressure on companies, with some having to pass on increased freight costs to their customers. As a result, many businesses are now seeking ways to cap rising container freight expenses, with risk mitigation tools like futures contracts offering a solution.
Leveraging Freight Futures for Hedging
Consider this scenario: A cargo owner needs to purchase 300 forty-foot equivalent unit (FEU) containers each month for the next six months, which amounts to 300 futures lots (one lot equals one FEU). To keep their supply chain running smoothly and ensure the flow of goods remains stable, they aim to cap the cost at $10,000 per FEU.
Since the cargo owner has a short position in the physical market, they would buy 300 futures lots to take a long position, creating a matched hedge for their physical exposure. This could involve buying 300 lots each month or instructing a broker to purchase a six-month strip of futures, totaling 1,800 lots.
With the futures market pricing at $10,000 per FEU for the next six months, any price increase beyond this level could result in additional costs along the supply chain. However, by securing an average hedged price of $10,000 per FEU over the six-month futures strip, the cargo owner can maintain stable prices for their buyers without significant price hikes, ensuring they meet their supply and volume commitments.
In this scenario, the cargo owner faces two potential hedging outcomes:
- The container freight price increases from $12,000 to $15,000 per FEU over the six-month period.
- The container freight prices decrease to $9,500 per FEU during the same timeframe.
By implementing a hedge, the cargo owner can secure a “net purchase price” of $12,000 per FEU in both scenarios. Without a hedge, if the price rises to $15,000 per FEU, the cargo owner would incur significantly higher freight costs. Conversely, if prices drop to $9,500 per FEU, they could potentially benefit from a lower rate. Ultimately, hedging helps eliminate the uncertainty regarding future price fluctuations.
When trading futures on an exchange, a company must provide a futures margin, known as the initial margin, to a futures broker. This margin is not a down payment, and the market participant does not gain ownership of the underlying commodity. Typically, the futures margin is a percentage of the notional value of a container freight contract.
Additionally, the variation margin is the daily or intraday payment made by a clearing member based on the price fluctuations of the customer’s positions.
For instance, if the cost to ship a container from North Asia to the U.S. West Coast is $15,000 per FEU, then the notional value of one contract would also be $15,000. Any change in the container price will be reflected in the notional value of the contract.
Managing Container Price Risk Through Hedging
Despite the supply chain challenges faced over the past few years, the demand for shipping containers is projected to increase, with estimates indicating it could reach a $12 billion industry by 2027. Global uncertainties and abrupt spikes in demand have underscored the importance of effectively managing container price risk.
Hedging secures a future purchase price, enabling liners, cargo owners, and other stakeholders to achieve their target prices, irrespective of fluctuations in spot market prices. These hedging transactions utilize cash-settled container freight futures linked to one of six FBX container indices. By opting for cash-settled instruments, participants can sidestep delivery risks associated with their hedging strategies.
This approach can be essential for managing container price risk, potentially reducing the burden of rising costs on the supply chain.
The Bottom Line
In conclusion, hedging freight futures presents both risks and benefits for market participants navigating the complexities of the shipping industry. On one hand, using futures contracts allows companies to lock in prices, effectively mitigating the uncertainty associated with fluctuating freight costs. This stability enables cargo owners and shipping liners to maintain competitive pricing and protect profit margins, even amid volatile market conditions.
However, participants must also be mindful of the inherent risks, including the potential for margin calls and the impact of market movements on their positions.
Utilizing Freight Forward Futures from SGX offers a tailored solution for managing freight price risk, allowing market players to capitalize on a transparent, efficient trading platform. By employing these financial instruments, stakeholders can better navigate the shipping landscape, ensuring that their supply chains remain resilient and their financial performance stable, despite the unpredictable nature of global trade.
Keen to read on? You may also wish to learn more about Shanghai Containerized Freight Index Futures
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