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 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)

Example of Freight Market Fluctuations BFI

(Baltic Freight Index, BCI Route 2, BPI Route 1) BCIr2
Standardised scaling (base=100 @1/3/99) BPIr1
300

250

200

150

100

50

0
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
Incoterms
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.
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.

Landing Unload onto

Incoterm Transport to Unload from Landing Transport to charges at trucks from Transport to
exporter's truck at the charges at importer's Insurance
s port origin's port origin's port port importer's the importers' destination
port port

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 ?
Accident
oFire
oExplosion
oCollision
oSystem failure

Direct cause
oUnsafe act
oUnsafe condition

Indirect cause
oJod factor
oPersonal factor

Root cause
oLack of control
 Ship inspection
Inspections based on an industry standard VESSEL
INSPECTION QUESTIONNAIRE
Tankers typically inspected twice per year
Inspectors are trained, audited & accredited
Approx 11,000 reports per year into the OCIMF Ship Inspection
Report (SIRE) database
Reports 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