Taming Flighty Rates
By Nicola Hughes
The air cargo freight market is undergoing a transformation that is more than just digital. True, new entrants are challenging established business models and promising new levels of transparency using tools that threaten long-standing relationships.
But in addition to technology threats, high levels of price volatility are causing cash management problems for buyers and sellers of air freight. With new capacity additions expected to remain low in the next few years, further volatility is likely for shippers, carriers, forwarders and end users alike.
The majority of air cargo pricing is negotiated on a 60:40 basis spot vs forward, with little guarantee on performance or delivery, locking forwarders and carriers into inflexible bilateral contracts. The process of estimating annual volumes and fixing the majority of prices without being able to factor in short-term effects has resulted in some painful results for shippers and carriers alike.
This is a market that is growing rapidly, with volume expected to more than double in the next 20 years, potentially increasing the level of price volatility. So bad is the problem that end users are beginning to directly approach carriers and cargo handlers to cover air freight requirements to work around the pricing opacity.
The size of the air cargo market – 35 percent of global trade by value, but only 1 percent of trade by volume – puts huge amounts of value at risk every day. This market is equivalent to 52 million tonnes of cargo annually with a value of US$6 trillion and US$70 billion in freight costs.
How to Manage Volatility
FIS believes the inherent volatility of the air cargo market presents an ideal opportunity for participants to hedge their exposure, and for traders to take positions against physical market movements, so protecting profitability.
The air freight market is beginning to recognize the value of price risk management, with the increased use of index-linked block space agreements for physical cargo shipments. The next step is to adopt purpose-designed financial risk management tools. Moving in that direction, FIS recently published an air cargo forward price curve, showing rates on an Asia-Europe basket route to August 2019. The curve illustrated the challenges that shippers and carriers face: rates are forecast to rise over the normally soft summer period to higher levels in the first quarter of 2018.
FIS spent a year working with impartial index provider TAC Index to develop a robust methodology for the air freight market. Using the forward curve for price discovery and the TAC Index for settlement, participants can use air cargo Forward Freight Agreements, or FFAs, for trading and to hedge the cost of their shipments. FFAs are a financial product which take their value from underlying freight rates and are cash-settled, with no physical delivery.
FIS is not setting out to create disruption for its own sake, but this is a market ripe for change. We believe that air cargo FFAs are an opportunity to move the industry to a position of increased freight rate transparency, bringing more actionable price points to freight users and providers.
All the components for a liquid, successful futures market exist in air freight: a huge, unhedged physical market; opaque, volatile pricing; and significant untapped value. FFAs could offer a solution to these problems.
Nicola Hughes is air cargo business development manager at FIS, a company focused on cargo-related derivatives.
Photo credit: Shutterstock
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