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The FFA Article (Forward Freight Agreements)

Over the past two years, as the tanker and drybulk shipping segments have moved to historicallystrong levels and remained firm, the long inchoatepaper markets are beginning to blossom. Now,as traditional hedgers and speculators from thebusiness have grown the markets, professionalsfrom both the hedge fund and structuredcommodity financiers are taking a fresh look at amarket that has been around since the mid 1990s.The dramatic growth is due to both a marketstrengthening, but, equally importantly, to anemerging availability of credit support, in theform of OTC clearing, that did not exist three

years ago.

The present forward markets owe their genesis to regulated futures markets in freight, with margining andclearing, at Londons Baltic Exchange, and later LIFFE. The legacy of these markets is the methodologyfor compiling daily broker quotes for per tonne movements, or for per day ship values, on individual freightroutes, quoted mainly by the Baltic Exchange, but also on Platts for certain tanker trades.

The forward markets were developed beginning in the mid 1990s, partly in response to difficulties inhedging and speculating using the baskets of sometimes uncorrelated individual routes. Market users whohad been bedeviled by basis risk in replicating the financial performance of physical ships began to focuson route-specific quotes from the Baltic contained within its half dozen daily freight indices.

Shipping brokers in London began the Forward Freight Market (FFA), building on developments in theenergy markets, most notably commodity swaps tied to an ISDA contract. The first swap deals were pureover the counter (OTC) transactions, between shipping principals. In 2002, an exchange of differencescontract was introduced by the FFA Brokers Association- the FFABA form.

Basis risk might have been reduced, but counterparty risk, well known to owners and charterers in period

time charters (a forward physical market hedging mechanism), was alive and well. However, the FFAarena was stung by defaults by a number of Scandinavian and Far Eastern freight operators, and one highprofile player- Enron.

The next phase in the evolution of shipping derivatives is the clearing of trades by a financial guarantor, inthe form of the Norwegian Futures and Options Clearinghouse (NOS), closely tied to Oslo basedInternational Maritime Exchange (Imarex), which started life five years ago as a screen based venue forfreight trading. The authorized share capital of NOS, partly owned by Imarex, is NOK 150 Million(approximately US $24 Million), with another NOK 250 Million maintained through bank guarantees.Imarex is said to be planning in IPO in the coming months.

Its list of 75 clearing members reads like a Whos Who of shipping, including listed companies such asMaersk, Teekay, Pacific Carriers and OMI Corporation, and oil companies including Hess and Sempra,

Shell, Statoil and Conoco Phillips. The member roster also includes marquee financial intermediaries J.Aron (the commodity arm of Goldman Sachs) and Morgan Stanley and UK money centre bank Barclays.Reportedly, energy powerhouse NYMEX in New York, and a Greek consortium, are said to be looking atclearing of freight swaps, attracted by an overall freight derivative market with US $20 Billion of aturnover (tanker and drybulk trades), according to Imarexestimates. Press reports have also indicated thatLondon Clearing House Clearnet (LCH- Clearnet), which cleared freight futures trades for LIFFEthrough the mid 1990s, was also looking at the freight market.

The realm of structured finance in the energy commodities has also provided financiers with ways tounlock value from shipping company balance sheets. Market sources at Imarex and active intermediaries

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such as London based Clarksons point to two important uses of FFAs in shipping finance- the use of FFAs as part of a lenders security package, and as an instrument for financial institutions to protect theirown portfolios. One major shipping lender, Royal Bank of Scotland, had reportedly been acting as a marketmaker for its borrowers, accessing the market as a principal and then selling positions to its clients.

According to FFA market sources, at least one large Continent shipping bank recently accepted an FFAcontract whereby an owner purchasing a second hand vessel was able to lock in two years worth of revenue. Much like the time honored practice where a shipowner would assign a period timecharter to abank, the owner executed an FFA commitment to receive two years worth of cash inflows, settled monthlyat levels tied to one of four timecharter routes quoted daily by brokers who produce the Baltic PanamaxIndex. Usually, monthly settlements are derived by averaging daily broker quotes over the last five businessdays in a month. Cla rkson Securities Pierre Aury, pointed out that in this type of deal, the owners stillhave the flexibility to take advantage of peaks in spot rates. This deal was described as a belt andsuspenders situation, using ISDA type documents. Mr. Jaap Kalverkamp, who oversees worldwide shipfinance at Netherlands based Fortis Bank, acknowledges that his institution has allowed owners to useFFAs instead of timecharters, as part of a security package tied to financing the purchase of vessels in thepresent high market. He cautioned that the FFA market, where many deals are done directly betweenparties, still presents counterparty (credit) risk, and that the tenors typically only extend beyond a year orso.

The market is not without its growing pains, as users have still not arrived at one standard contractualinstrument. Of the several thousand swap deals done annually in the marketplace, most are tied to theFFABA contract, or to a master Imarex contract that is tied to a daily position recap. Documentation forsome transactions is based on contracts incorporating many ISDA type features. The FFABA and Imarexcontracts are also used for options transactions. Mr. Morten Erik Pettersen, an ex commodity banker fromthe Nordea organization, who now handles Business Development at Imarex, describes the FFA contractsas very suitable for use in connection with structured finance, although Mr. Pierre Aury, of ClarksonsSecurities in London, said that the ISDA based on contract is probably fit better in a structured deal.

The deals done with the intermediation of a clearing house are subject to margining rules of the clearinghouse- presently NOS, but soon to include NYMEX and possibly the LCH- whose rosters of membersinclude the cargo side of the tanker trades. According to Mr. Pettersen, the margining at NOS follows a risk based approach originally developed at the Chicago Board of Trade- the SPAN model. Using highly

sophisticated algorithms, margining levels include a base amount and then a variation amount based on thevolatility and price levels of positions in the market place. But, indicative of the immature nature of themarket, the NOS itself has seen the difficulties of volatility in the freight market, with at least one clearingmember defaulting on margin calls during the volatile Spring of 2004. NOS has been attempting to increaseits capital base, dwarfed in comparison to behemoths such as NYMEXs Clearport system or LCHClearnet. In 2004, Clearport handled an estimated 14 Million swap and other energy derivatives, in crudeoil, refined products, natural gas and electricity. Fortis Banks Mr. Kalverkamp says that Clearing willbecome helpful as a new credit tool. If the market is going to get broader, clearing will be a requirement.

The advent of the OTC clearing business since 2002, a post Enron development, could have a profoundimpact in shipping finance, where counterparty risk has always loomed on the horizon. After the Enrondebacle, large banks expected to fill the OTC credit void, however it was the futures industry clearinginstitutions that gained the lead. Fast forwarding to a world where energy clearing house becomes the

credit intermediaries behind FFAs, tied to well recognizes broker quotes, a wealth of potential new toolsfor shipping bankers is unfolding. FFAs offer more granularity and can be better managed thantimecharters, in providing requisite coverage for a vessels forward earnings.

Even though the all parts of the drybulk market have seen both unprecedented levels and volatility, thetanker market, and coal trades, are likely to be the real growth areas, due to a twenty year legacy of energyfutures and derivative markets, and the burgeoning OTC trades in coal that support FFA shipping activities.Both Mr. Pettersen and Mr. Aury (who logged time at Enron before its collapse) described freightderivatives as supporting a missing link between disparate markets in the underlying commodities,creating both hedging and arbitrage opportunities . For example, the differential between the Brent and WTI

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oil markets are tied together by several Europe and North Sea/ US East Coast tanker trades quoted daily byBaltic Exchange broker panelists. Likewise, Atlantic and Pacific coal markets, where cargoes move inCapesize lots, are tied together by vessels chartered on routes quoted each day by a set of dry cargopanelists.

With increased transparency for listed shipping companies, market volatility has caused eyebrows to beraised as listed companies have reported gains and losses from freight derivative trading- particular if FFAactivities loom large in relation to overall turnover. In 2004, Hong Kong based Jinhui Shipping (with totalrevenues of US $216 Million) startled analysts with a loss of $62 Million on FFAs , while Italian traderCoe Clerici booked a gain of nearly $100 Million (2003 shipping revenue of $263 Million). Frontline(which owns approximately 30 % of Imarex) recorded a $17 Million loss on marking positions to market in3Q 2004, in contrast to modest gains of less than $1 Million in the other quarters, all very tiny in relationto $1.8 Billion annual revenues.

In spite of seemingly big numbers, some principals view the market as still immature. Mr. Peter Evensen,an ex JP Morgan Chase banker and now CFO of Teekay Shipping (an Imarex clearing member), whichclaims to move more than 10 percent of the worlds oil, in the 4Q 2004 Conference Call to investors, inresponse to questions about the firms likely tanker FFA activities and a $13.8 Million hedging loss(contrasted with $2.2 Billion annual revenues), said, It is not a hugely liquid market in the freight futuresmarket for tankers.

The margining system inherent in the clearing schemes, has provided a catalyst for marking freightpositions to the market. The mark to market discipline, borne out by emerging accounting standards, willprove useful in assessing risks of lending to shipowners, and analyzing their published results . Citinganother paradigm shift brought on by FFAs, Fortis Banks Kalverkamp pointed out that, now when weanalyze shipping company credits, we must also look at FFA positions, in addition to ship charters anddebt, when we do our risk assessments. We must be very careful. Freight derivative trades are subject tothe mark to market accounting implicit in International Accounting Standard (IAS) 39, applying tocountries in the EU, and to SFAS 133 in the United States.

An unfolding development is the announcement by blank check company International ShippingEnterprises, wh ich raised $182 Million net, effectively as a blind pool, that it had entered into anarrangement to purchase dry bulk stalwart Navios Corporation from its private owners for $607 Million.

Navios re-invented itself in the 1990s as a merchant in freight, where physical ships, contracts, andderivative instruments such as FFAs were viewed as interchangeable. The huge price tag on Navios speaksto the role of freight derivatives in creating value for shipping companies, and is a harbinger of the growingimportance of the market in paper freight.