Few markets illustrate the dramatic turn of events in the world economy more vividly than shipping. The Baltic Exchange Dry Index (BDI), which measures the cost of shipping dry commodities (iron ore, coal and grain) across the globe, plunged 94% from May to December last year, leaving a number of bankrupt shipping companies in its wake.
Associated freight derivatives also took a pounding. The average weekly volume of dry bulk forward freight agreements (FFAs) - the standard derivatives contract for dry commodities - fell by 38% in the final quarter of 2008 compared with the first three quarters of last year, from 46,053 trades to 28,349. But while the sinking value of the BDI may prove to be a short-term market dislocation, the insolvencies of shipping companies such as Armada Singapore, Atlas Shipping, Britannia Bulk and Industrial Carriers could have more lasting effects on the freight derivatives business.
"It is obviously not good news for the market. Some of those participants that are no longer around had been quite active traders, so it is a pity to lose the liquidity they provided," says Jeremy Penn, chief executive of the Baltic Exchange in London.
"I would estimate liquidity has dropped between 30% and 40%, if not more," adds Philippe van den Abeele, London-based managing director at Castalia Fund Management UK, a hedge fund specialising in freight derivatives.
The recent collapse of the market is all the more surprising given the way 2008 began. The BDI climbed steadily throughout the year, reaching a high of 11,793 on May 20. To lease a capesize vessel - 100,000 dead weight tons and over in size - on the Brazil to China route would cost approximately $300,000 a day. Buoyed by expectations of a continuing bull run in commodities, conversations centred on how to attract a wider range of investors to the rapidly developing freight derivatives market, which had begun to thrive on the back of the booming shipping business (Risk July 2008, pages 61-63). Some weeks had seen dry FFA volumes reach as high as 85,000 trades.
However, this bullish sentiment was quick to evaporate. China's seemingly insatiable appetite for raw materials - one of the principal drivers of world trade - has diminished. Chinese mills cut monthly steel production from highs of 47 million tonnes in June to an estimated 35 million tonnes in December, according to Oslo-based shipbrokers Lorentzen and Stemoco (L&S). Data from the Chinese General Administrator of Customs shows Chinese imports of iron ore and concentrate falling 29%, from 42.85 million tonnes on April 30 to 30.62 million tonnes on October 31.
The intensification of the financial crisis exerted further pressure on the shipping industry. Letters of credit - guarantees fundamental to world trade - became increasingly hard to secure as lack of confidence in financial institutions spilled over into the wider economy. "The credit crunch has added a great deal of credit difficulties to the market," says Duncan Dunn, a senior director of business development at shipbrokers Simpson, Spencer and Young Futures (SSYF) in London.
In November, L&S estimated as many as 197 of the 808 capesize vessels in the global market were lying idle. Meanwhile, there were a growing number of lawsuits levelled at steel and iron ore giants for non-performance. In one such case, Zodiac Maritime Agencies, a London-based shipping company, sued ArcelorMittal, an Indian steel producer, for $101.4 million for a failure to charter vessels.
The threat of economic slowdown hit the BDI hard, with the index bottoming at 663 on December 5, before limping up to 872 as of January 20, 2009 - still 92.6% lower than its peak last May. FFAs on capesize vessels from Brazil to China reflect this, plummeting from $108.13 a tonne on May 20 to $6.82 a tonne on December 1.
With the index falling quickly, volatility in FFA trading volumes has been rife (see figure 1). September and October, in particular, saw a series of spikes followed by dramatic falls, with trading volumes rocketing from 26,369 contracts in the week of September 1 to 85,963 in the week of September 29, only to plunge back to 22,111 in the week of October 27.
The effects on companies using freight derivatives have been telling. China Cosco Holdings, the second-largest shipping company in the world, reported losses of 3.95 billion renminbi ($577 million) on dry bulk FFAs as of December 12. The losses were sustained after using FFAs to lock in the cost of chartered vessels before the BDI tanked, the company says.
Elsewhere, there have even been suggestions of malpractice. Britannia Bulk, a UK shipping company placed into administration on October 31, is being sued for allegedly buying FFAs in order to speculate rather than hedge. The plaintiff, acting on behalf of shareholders in the firm, believes the company left itself more exposed "than it would have been if its historic practice of using FFAs as economic hedges had been followed", according to court filings.
The issue of counterparty credit risk has also assumed critical importance in recent months, with the bankruptcy of Singapore-based shipping company Armada proving particularly devastating. When it filed for bankruptcy in December, the company owed $1.08 billion to 64 counterparties. "The high-profile bankruptcies we've had have brought into sharp relief the risks of not clearing trades," says James Leake, London-based managing director of research at shipbrokers Icap Shipping.
Various factors precipitated Armada's bankruptcy. The company may lose as much as $375 million on FFAs linked to all sizes of shipping vessels. It was also hit by non-performance on cargo contracts with Fortescue, a Perth-based iron ore producer, and Ashapura, a Mumbai-based miner, which owed $81 million and $58 million, respectively. Exposure to bankrupt counterparties took its toll too: Atlas, a Copenhagen-based shipping company, owed $10 million and Britannia Bulk owed $6 million. Pioneer Freight Futures, a subsidiary of Hong Kong-based Pioneer Metals, also defaulted on FFAs worth $45 million.
"Once you start to see failures and a selective lack of willingness to pay, some segments of the over-the-counter market can grind to a halt. Once counterparties begin to default, it has the potential to cause a chain reaction," says Richard Bowler, London-based head of freight origination at Citi.
Of Armada's 64 creditors, Hong Kong shipping company Transfield Resources had an exposure of $113 million, while two London-based freight derivatives hedge funds - Global Maritime Investments and Castalia Fund Management UK - took hits of $30.2 million and $8.2 million, respectively.
"We were one of the lucky 64," jokes Castalia's van den Abeele, who confirmed their losses were all on dry FFAs. "Our return over the past 12 months was 5.31%. Without the Armada default, it would have been in excess of 10%."
By October, traders were becoming increasingly aware of the damage OTC freight trades could inflict, and sought ways to lay off the risk. Sensing the concern surrounding counterparty risk, NOS Clearing, a Norwegian freight derivatives clearing house, launched a netting pool. "We offered counterparties in the OTC market the opportunity to send in their trades, which we would then settle," says Hanne Baevre Johanson, vice-president of freight clearing and settlement at NOS.
The first monthly pool was run in October. It costs $2,000 to enter the pool and $100 per trade. In October, there were 38 participants settling 318 contracts, reducing the notional amount of trades from $300 million to a net $41 million. The netting results for November and December reduced notional from $623 million to $96 million and $600 million to $88 million, respectively.
"It was an emergency measure, which provided a lot of comfort for a lot of people, but the way ahead is clearing," says SSYF's Dunn. Market trends support Dunn's assertion. Historically, cleared and OTC trades have sustained similar volume levels. In fact, before the BDI plummeted, there were often instances of traders substantially favouring the OTC market. The week of April 28, 2008 saw 58,250 OTC trades - almost double the 24,753 cleared trades.
As the year went on, a migration towards clearing became more pronounced. In the week of September 29, there were 64,874 cleared trades, compared with 21,089 OTC trades. Indeed, the ratio of cleared to OTC trades in the last quarter of 2008 was 4.3 to 1.
"People are prepared to pay the premium for clearing - it provides cheap insurance relative to the exposure you get," says Bjorn Stromsnes, global head of dry freight derivatives at the International Maritime Exchange (Imarex), an Oslo-based intermediary and clearer of freight derivatives.
Bankers and brokers agree OTC trades are unlikely to regain their former prominence - van den Abeele says Castalia hasn't executed a single OTC trade since September. However, it seems there will always be an OTC element in the market. "There are still market participants that are willing to give and take each others' credit risk because they are doing it in the physical market as well," explains the Baltic Exchange's Penn.
Meanwhile, reports on the physical market make for grim reading. Lambros Varnavides, head of credit to the shipping industry at Royal Bank of Scotland, predicts up to half of commodity shippers may default on loans by April. Shipbuilding also looks set to take a hammering: L&S estimates 40% of orders on vessels due to be built by 2010 and 2011 will be cancelled. Shares in South Korea's Samsung Heavy Industries, one of the world's largest shipbuilders, have sunk from 44,300 won ($31.80) on June 3 to 27,200 won as of January 28 - at one point dropping to a low of 11,850 won on October 27.
"You will have companies not being able to pay for their orders and some will be cancelled. Some of the yards may even tilt over in this process," says Stromsnes at Imarex.
Despite the current turmoil in the physical market, brokers insist there are still viable investment opportunities for freight derivatives. "While the volatility continues and sea-borne trade continues, we're going to see an interest in FFAs," maintains Dunn at SSYF.
Others remain unconvinced, suggesting lower FFA weekly volumes - which averaged 16,911 contracts in the first four weeks of January - highlight a major tailing off in interest among hedgers and investors.
"Ship-owners aren't interested in locking in their income streams at this level. For commodity houses, buying at this level doesn't make a huge amount of sense because forward rates are still a lot higher than the spot rates," says Citi's Bowler.
"The market has shrunk by 20-30%. The pool of money has shrunk and therefore people are going to be very careful about what they invest in," says Castalia's van den Abeele.
Analysts and brokers alike are reluctant to volunteer predictions as to when exactly the market will recover, but most believe the resuscitation of the underlying shipping sector holds the key.