Overlook of the Freight Hedging
Physical commodities traders cannot only take into account their gross margin on transactions (the difference between the selling price and the purchase price of commodities). They must also take into account the cost of supplying, processing and
transporting the commodity to meet the buyer’s specifications. Where the commodity is to be shipped overseas, the cost of chartering a suitable vessel is a key indicator of the profitability of the transaction. The lower the gross margin, the more important this indicator is. Charterers pay freight rates corresponding to the supply and demand conditions at the time of charter. Depending on the commodity to be transported, the quantity, time and location, freight prices can vary significantly. Traders will generally set freight costs in advance to protect against the risk of increased transport costs. This is usually done through Freight Forward Agreements (FFA). Forward Freight Agreements (FFAs) are commodity derivatives that originate from the underlying physical shipping markets. In a volatile market, FFAs give companies the opportunity to manage their freight risk. They also provide a mechanism for companies to assume price risk through exposure to global trade and are an important element of shipping markets. Freight derivative products were first traded by dry bulk shipping companies in the mid-1980s. Today, they are widely used in the dry bulk and tanker sectors. New contracts have recently been introduced for the maritime transport of LNG and LPG. Let’s illustrate the FFA product by an example: a commodity trader wants to charter an oil tanker in 15 days to carry his cargo of crude oil for 30 days to a given destination and is concerned that freight prices will rise, he buys an FFA to lock in the current freight price at $19,000 per day. If the trader is right and the average price during the following month is $23,000 per day: this will be what he will have to pay to the shipowner. However, the FFA comes to his rescue. In this example, the FFA contract closes above the agreed price and the FFA buyer will receive the price difference multiplied by the duration of the contract. The FFA buyer receives :
23,000 – $19,000 = $4,000 x 30 days = $120,000.
For the charterer, the FFA compensated for the increase in the freight price he had to pay. For the counterparty to the contract, probably a shipowner, the exact opposite happened – a gain in the physical freight price resulted in a loss on the FFA. But neither party is better or worse off than the other. The derivative stabilizes the cash flow of both parties.
Written on 25/11/2020