BDI reached 498p, the lowest ever, on November 20th, and has since remained around 500-599p. Thanks to the continuing low freight rates due to an oversupply over an extended period, shippers are reaping benefits from lowered transport cost, whereas carriers have no choice but to operate their ships at the risk of sustaining a big loss due to a freight rate that fails to cover variable operation costs.

With low freight rates being protracted, the transport-related decision-makers with shippers even question the need for a long-term transport contract, which incurs a relatively burdensome cost. In turn, concerned about landing a low-rate long-term transport contract when their negotiation power over freight rates is compromised by an oversupply, some of the carriers negatively view the option.

All along, a long-term transport contract has been perceived as a standard method for averting volatility risk (such as change in freight rate). Moreover, since long-term transport contracts have greatly benefited carriers’ business as a basis for their stable income, shippers have been urged to sign a long-term transport contract with national carriers for the purpose of overriding the on-going depression.

Long-term transport contracts that appeal to shippers’ patriotism only may not be so sustainable to shippers who set great store by profitability. This means that a long-term transport contract can become valid only when it is recognized as a transport strategy that is economically reasonable from the perspective of actual experience in the shipping market.

Cost and volatility reduction with long-term transport contracts

The economic rationality of a long-term transport contract can be tested in various ways, and its validity can be demonstrated from the perspective of what it costs a shipper to get a vessel. For this purpose, we consider six-month charter a short-term contract and 3-year charter a long-term contract and have analyzed the data for time charter cost for a 150,000 DWT capesize vessel.

From 1992 through this year, the average cost for getting a ship lined up shows lower for a long-term contract than for a short-term contract. While the average cost for getting a ship through a three-year charter contract costs 23.24 million dollars for each of the three years, a six-month charter contract costs 29 million dollars.

The standard deviation in time charter cost shows 66% lower for a long-term contract than for a short-term contract. This shows that the volatility risk is smaller for a long-term contract than for a short-term contract.

(source: Clarkson, KMI)

A long-term contract exerts greater effect during a boom

Meanwhile, for long-term and short-term contracts, the vessel acquisition cost varies with business cycle. As you see in the figure below, in the low-BDI period (in a depression), the vessel acquisition cost on a short-term contract (the vessel acquisition cost for a six-month charter) is relatively low, whereas in the high-BDI period (in a boom), the vessel acquisition cost on a short-term contract is relatively high.

In a nutshell, we can see that we find no big difference for the vessel acquisition cost in a depression between a long-term and a short-term contract, whereas we find that the vessel acquisition cost is significantly greater for a short-term contract that for a long-term contract.

The analysis shows that the vessel acquisition cost is lower for a long-term contract than for a short-term contract, which means that long-term contracts benefit shippers. Moreover, as it shows less volatility, a long-term contract is accompanied with less market volatility.

Meanwhile, it is true that bad times financially motivate shippers to reduce the vessel acquisition cost through a short-term contract. However, if supply is reduced through vessel overhauling and reduced orders caused by depression and a boom is thereby created, the vessel acquisition cost for a short-term contract may increase again.

In other words, from a broader perspective that encompasses both good times and bad times, the vessel acquisition cost can be reduced through a long-term contract, which will deliver benefits to shippers.

Achieving carrier profitability needs a measure for making up for cost of revenue

By the way, we should note that the above findings haven’t come out of a simple theoretical analysis or test but is grounded in the experience of the dry bulk carrier market. In other words, history and experience tell us that a long-term transport contract is an economically reasonable solution that provides shippers with the benefits of cost reduction and diminished volatility.

Meanwhile, while a carrier benefits from reduced market volatility caused by a long-term transport contract, the catch is that a contract concluded in bad times brings in a low freight rate, thus failing to achieve profitability. Carriers’ fear of a low-rate long-term transport contract is something that can be addressed by implementing a measure for making up for cost of revenue.

Thus, we may conclude that a long-term transport contract which includes an appropriate measure for recouping cost of revenue makes a win-win strategy for ship-owner and shipper.

Author: Jeon Hyeong-jin, Shipping Market Analysis Center Director
Source: KMI Shipping Market Trend Focus, No. 281