Return to index-linked contracts an idea gaining traction with BCOs and forwarders
It’s time for the liner industry to ditch the flawed fixed tender process where “someone ...
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By Alex Lennane
The TAC air freight rate index, which is set to launch soon, has fought back against airline concerns that it could cheapen the air cargo product.
Carriers have expressed worries that an air freight rate index would push the focus of capacity buyers further towards the spot market.
“We would prefer long-term planning,” one major carrier told The Loadstar.
But Peyton Burnett, TAC managing director, argued that Freight Forward Agreements (FFAs), which would be possible using the index, allow hedges of up to seven years in advance, which could boost carriers’ financing prospects.
“An index is used to mirror the underlying physical market. In the case of the TAC Index, this means aggregating the previous week’s historical transactional data from a range of forwarders and, by statistical modelling techniques, produce the best average general cargo price on high revenue city pairings, for example, HKG-FRA,” he explained.
“In mature commodity markets there are two fundamental markets; physical and paper. In the former, the contracts have physical delivery; ie, air cargo capacity delivery. In a paper market, the contracts have cash delivery; ie, cash (US$) delivery. No paper market, also known as a synthetic market, currently exists for air cargo.”
In order to create a paper market, a new instrument (or contract) must be developed: an FFA. An FFA is a cash-for-difference (CFD) contract which settles in cash against an index.
“For illustrative purposes, let’s assume HKG-FRA is currently trading at HK$20/kg. But it is forecast to be HK$25/kg in six months’ time. Using an FFA contract, parties can hedge against any difference in this forecast by locking in a price six months’ forward; with two parties either side of the trade at HK$25/kg.
“Move forward six months and the index spot price is actually HK$27/kg; otherwise known as the settlement price. One party will have made HK$2/kg and the other would have lost the equivalent. The hedging party would then be able to use the HK$2/kg cash to buy on the spot physical market. A simple hedge.”
Mr Burnett argued that FFAs pushed the market forward – so much so that in bulk, a 20-year-old FFA market, contracts trade up to seven years in advance.
“This is a lot better than current air cargo physical contracts which might trade six months to one year in the future. Remember, these FFA contracts are actual trades, not just forecasts. Financial institutions would strongly favour aircraft purchases backed by FFAs over forecasts.”
Some forwarders have also expressed concerns. One said: “Where do they make this stuff up from? Margins on air freight are already at an all-time low.”
But Ricky Forman, container FFA broker at Freight Investor Services, said: “Different companies want different things. There will always be legitimate reasons to keep the original methods, but the Index and FFAs give the market another option, which could be a better fit for some companies.”
He added that the appetite among 3PLs had been highest so far in other markets.
“They have been the most successful. They have few assets, so they are not drawn into the obsession with slashing rates to pay off operating costs. 3PLs are much quicker to act, more flexible and more commercial.”
Mr Burnett added it could take some time for carriers to full understand the processes. “An airline treasury team will be able to quickly grasp the concept as they use similar products for fuel and currency hedging. But the commercial teams won’t, unless they have had previous exposure to this type of product.”
Other carrier concerns included the ability of the Index to monitor specialist products, which are becoming ever more important to the air cargo industry. But the Index only focuses on general cargo, said Mr Burnett.
The Loadstar would like to know what you think. And for more detail on this topic, please see www.airlinecargomanagement.com
Comment on this article
Andy Robins
September 10, 2014 at 2:25 amI think this sentence says it all “One party will have made HK$2/kg and the other would have lost the equivalent”. As of now I do not see either side losing as the rates ebb and flow and are passed down to the Agents who in turn pass to the Shipper or Consignee on that basis.
There is enough competition between airlines and also between agents to keep rates decent.
Derek Jones
September 12, 2014 at 11:42 amIt seems the vultures are once again circling over airfreight, waiting for an opportunity to tear off a little more flesh.
The idea of an index, and selling airfreight futures, is wrong and unworkable on every level:
– it commoditises airfreight and introduces an unhealthy focus on price, when rates are already way too low, and the industry’s concentration should be on selling it as a premium service and pricing it accordingly
– Nobody will hedge unless they see a price advantage in doing so; that means even lower rates and margins
– How can anyone assess the “correct” market price on which to base the CFD, in an environment where so many variables are at play, every minute of every day? Yesterday’s average rates mean nothing, never mind last week’s
– When did anyone last predict rate rises in airfreight, upon which CFDs are predicated? The trend has been static or downwards for a long time, so why would anyone forward buy today and risk paying too much?
– You can buy, sell or store aviation fuel, so the worst that can happen with a CFD is that you buy and settle above the market. The underlying commodity still has value. But you cannot store airfreight capacity; it has a finite life span after which it disappears and becomes valueless. This will adversely affect the market price at any time near to flight, so the likelihood of making any profit, unless severe under-supply drives up last-minute rates, is nil. Why would anyone buy airfreight capacity and risk being stuck with it in an oversupplied market at settlement time, either paying too much or, worse, unable to sell it? Thus, the comparisons used here between a service and a commodity are meaningless.
– The very nature of airfreight is ad hoc, highly volatile and low volume, with wild variations in supply and demand. It is nothing like ocean freight, which tends to be about massive volumes and consistent demand. Even if a viable futures market exists in a small part of the ocean freight sector, that is no indication it will work with air.
– Why would any forwarder or manufacturer forward buy airfreight even a month ahead, when many seem incapable of even filling their existing PBs? In fact, how many BSAs are actually in force today? They aren’t needed any more on most routes.
– Futures markets are gambling, and in all gambling there is a winner and a loser. It looks like losses will either go to shippers who buy too high, or airlines who sell too cheap, while the exchange will be the only ones to rake off a consistent profit on every trade. There is no room in airfreight for anyone to take profit unless they add real value.
– We already have a futures market for airfreight; it’s called spot-rating. And it doesn’t require the “help” of any costly intermediary.
In conclusion, it seems to me that TAC knows little or nothing about airfreight and how it works. I would hope the airfreight industry would have the good sense to walk away from this crazy idea, which – if it ever gets off the ground – is designed only to put money in the pockets of the exchange and its brokers, to the cost of the industry and its customers.
Alex Lennane
September 12, 2014 at 1:07 pmA passionate plea, Derek!
The index, and FFAs, are supported by many top air freight executives who do know the market well – but most agree that right now is not necessarily the best time for FFAs. But it could serve the industry in the future, and an index, at the very least, gives transparency. It will take many years for FFAs to come into play.
But I think probably the key point in the article is Ricky Forman’s – “Different companies want different things. There will always be legitimate reasons to keep the original methods, but the Index and FFAs give the market another option,
which could be a better fit for some companies.”
Some airlines and 3PLs are more active in the financial markets than others, and they may see an advantage. It is of no loss to others, that choose not to play this particular game.
Richard Ward
September 16, 2014 at 7:56 amUnfortunately it is a common misconception that the futures markets are used for gambling. Take for example a treasury teams decision to purchase a new asset, whether this be a power plant, airliner, cargo ship etc. Without hedging tools the purchaser and financier are taking a huge gamble that the market will remain favorable and hence lead to the repayment of the loan, if this does not happen (as we have seen most recently in the container market) then huge losses for both parties can occur. Alternatively the purchaser of the asset can take a macro view and hedge a proportion of future income of the asset prior to financing/delivery. This will hedge (not gamble) against any possible future downturn in the market, protecting both purchaser and financier from huge potential right downs and losses. This of course is also seen favorably from the financier as well as investors who require a level of stability and certainty.
Nick Coverale
September 17, 2014 at 8:03 pmAgreed Derek, there will be winners and losers ,but not the brokers (the bookie) they get their money irrelevant
of what the outcome is.
Richard, With all due respect the scenario you mention does not relate to speculating on what an air freight might be which is exactly what this is – gambling.