Shipping Industry Risks

Introduction

Our objective Shipping is a business activity exposed to a wide variety of risks. In this presentation we are concerned with the measurement of particular form of

risk – namely freight market risk, or the risk of loss arising from unexpected changes in freight rates.

Our motivativation Shipping has proved rather slow in adopting modern risk management techniques

and best practices from other industries. Our motivation is to present a modern framework for measuring freight market risk.

Freight Rates

Freight rates generally tend to be volatile.

Freight rates and earnings of the shipping companies are primarily a function of demand and supply in the markets. Demand drivers are a function of trade growth and the supply drivers are a function of new ship building orders.

The global shipping industry can be broadly classified into wet bulk (like crude and petroleum products), dry bulk (like iron ore and coal) and liners.

There are various benchmarks that determine freight rates for

these segments. The prominent amongst them are Baltic Freight Index, Baltic Handymax Index (for dry bulk segment) and World Scale (for tankers).

High market volatility

Example of Freight Market Fluctuations (Baltic Freight Index, BCI Route 2, BPI Route 1)

Standardised scaling (base=100 @1/3/99)

0

50

100

150

200

250

300

1/4/1985 1/4/1987 1/4/1989 1/4/1991 1/4/1993 1/4/1995 1/4/1997 1/4/1999 1/4/2001 1/4/2003

BFI

BCIr2

BPIr1

Changes in the Baltic Freight Index can give investors insight into global supply and demand trends. This change is often considered a leading indicator of future economic growth (if the index is rising) or contraction (index is falling)

Incoterms or international commercial terms are a series of international sales terms, published by International Chamber of Commerce (ICC) and widely used in international commercial transactions. These are accepted by governments, legal authorities and practitioners worldwide for the interpretation of most commonly used terms in international trade.

Incoterms

Main carriage unpaid

FAS – Free Alongside Ship (named loading port)The seller must place the goods alongside the ship at the named port. The seller must clear the goods for export; this changed in the 2000 version of the Incoterms. Suitable for maritime transport only.

FOB – Free on board (named loading port)The seller must load the goods on board the ship nominated by the buyer, cost and risk being divided at ship's rail. The seller must clear the goods for export. Maritime transport only. It also includes Air transport when the seller is not able to export the goods on the schedule time mentioned in the letter of credit. In this case the seller allows a deduction of sum equivalent to the carriage by ship from the air carriage.

Main carriage paid

CFR or CNF – Cost and Freight (named destination port)Seller must pay the costs and freight to bring the goods to the port of destination. However, risk is transferred to the buyer once the goods have crossed the ship's rail. Maritime transport only and Insurance for the goods is NOT included. Insurance is at the Cost of the Buyer.

CIF – Cost, Insurance and Freight (named destination port)Exactly the same as CFR except that the seller must in addition procure and pay for insurance for the buyer. Maritime transport only.

Arrival

DES – Delivered Ex Ship (named port)Where goods are delivered ex ship, the passing of risk does not occur until the ship has arrived at the named port of destination and the goods made available for unloading to the buyer. The seller pays the same freight and insurance costs as he would under a CIF arrangement. Unlike CFR and CIF terms, the seller has agreed to bear not just cost, but also Risk and Title up to the arrival of the vessel at the named port. Costs for unloading the goods and any duties, taxes, etc… are for the Buyer. A commonly used term in shipping bulk commodities, such as coal, grain, dry chemicals - - - and where the seller either owns or has chartered, their own vessel.

DEQ – Delivered Ex Quay (named port)This is similar to DES, but the passing of risk does not occur until the goods have been unloaded at the port of destination.

For a given term, "Yes" indicates that the seller has the responsibility to provide the service included in the price. "No" indicates it is the buyer's responsibility. If insurance is not included in the term (for example, CFR) then insurance for transport is the responsibility of the buyer or the seller depending on who owns the cargo at time of transport. In the case of CFR terms, it would be the buyer while in the case of CIF or CIP terms, it would be the seller.

Incoterms

Transport to exporter's port

Unload from truck at the origin's port

Landing charges at origin's port

Transport to importer's port

Landing charges at importer's port

Unload onto trucks from the importers' port

Transport to destination

Insurance

FAS Yes Yes No No No No No No

FOB Yes Yes Yes No No No No No

CFR Yes Yes Yes Yes Yes No No No

CIF Yes Yes Yes Yes No No No Yes

DAF Yes Yes Yes Yes No No No No

DES Yes Yes Yes Yes No No No No

Industry inefficiencies Capital needs vs. sources of funds:

Shipping is a capital intensive industry with significant funding needs for fleet expansion and replacement purposes. Yet, it has very limited opportunities to diversify its sources of funding, as most of its financing comes in the form of bank debt.

Asset – Liability (mis)matching

Asset economic life >> term of debt financing Variable (uncertain) revenues to meet fixed debt claims

Pro-cyclical lending practices Many banks tend to be influenced by the general sentiment of the market

and ignore the cyclical nature of the business. Thus, they appear more willing to lend when the market (and vessel prices) is high, despite the fact that the market will eventually revert back to lower levels. In contrast, they appear rather hesitant to extend credit at a period of low freight rates, although they are likely to rise to more sustainable levels.

Definition of Risk We define risk as the prospect of financial loss due to unforeseen changes in

underlying “risk factors”. These risk factors are the key drivers affecting portfolio value and financial results. Such risk factors are equity prices, interest rates, exchange rates, commodity prices, freight rates, etc.

Types of Risks Business: The risk of loss due to unforeseen changes in demand,

technology, competition, etc., affecting the fundamentals of a business activity. Market: The risk of loss arising from unexpected changes in market prices

or market rates. Credit: The risk of loss arising from the failure of a counterparty to make a

promised payment. Operational: The risk of loss arising from the failures of internal systems or the

people who operate in them. Other types: Legal, Liquidity, etc.

Measuring Market Risk Shipping Banks

Determining credit terms: maximum advance ratio, liquidity covenant, loan spread Risk assessment: repayment risk, probability of covenant breach Estimating default probabilities, verifying internal risk ratings Promoting cross-selling, derivatives sales, hedge proposals

Ship-owners Investment decisions, e.g. dry bulk vs. tanker segments Chartering decisions, e.g. time charter vs. spot employment Financing decisions, e.g. high-yield bond vs. bank debt Hedging decisions, e.g. derivatives vs. long-term charter

Freight Traders Risk assessment and monitoring Risk-adjusted performance evaluation

Forward Freight Agreements (FFAs):

-An agreement between two counterparties to settle a freight rate for a specified quantity of cargo or type of vessel, for a certain route, and at a certain date in the future. -The underlying asset of the FFA contracts can be any of the routes that constitute the indices produced by the Baltic Exchange.-FFAs are settled in cash on the difference between the contract price and an appropriate settlement price at expiration.-To establish an FFA, we need to specify: route, price, duration/quantity, settlement

What cause physical damage ?AccidentoFire oExplosionoCollisionoSystem failure

Direct causeoUnsafe actoUnsafe condition

Indirect causeoJod factoroPersonal factor

Root causeoLack of control

Ship inspection

Inspections based on an industry standard VESSEL INSPECTION QUESTIONNAIRE Tankers typically inspected twice per yearInspectors are trained, audited & accreditedApprox 11,000 reports per year into the OCIMF Ship Inspection Report (SIRE) databaseReports contain only factual observations, not judgments Interpretation of the data is the responsibility of the user

Port & Terminal Safety

Ports & Terminals are encouraged to self-assess their operations, and to have independent audits, based on OCIMF standard references:

International Safety Guide for Oil Tankers & Terminals (ISGOTT)

Marine Terminal Baseline Criteria and Assessment Questionnaire, which is to supersede the Marine Terminal Survey Guidelines in early 2004

Thank you