A New and Better Way to Manage Freight Trucking Risk?

I was recently informed of the new start-up company named TransVix that is developing a US trucking futures exchange market. Admittedly, my logistics research is focused more on warehousing than on transportation. However, I do have a solid understanding of both logistics and financial markets, and of financial derivatives such as forward contracts and futures. So I thought I would take this opportunity to discuss the concept of trucking futures and provide my perspective, and hopefully some insights, into this interesting topic.

Trucking Rates, Volatility, and Uncertainty
Trucking rates and the costs borne by carriers are an ongoing operating concern for trucking carriers, freight brokers, and shippers due to pricing. A number of variable operating costs (fuel, labor) and market factors (supply and demand) affect shipping rates. Market participants often look to mitigate the uncertainty surrounding these costs to better manage their operations and ultimately their profit margins. Carriers can currently manage the uncertainty of fuel costs by purchasing futures contracts on fuel. Airlines are especially well-known to hedge their fuel costs, often to their own detriment. The fact that airlines often lose money on their fuel hedges begs the question, why do it then? Well, some companies choose to do it and some do not. Futures contracts on an underlying product or service like truckload rates can result in a financial gain or loss when compared to doing nothing. But their attraction is in the ability to lock in a service price ahead of time, kind of like entering into a fixed price contract for a service that would otherwise have variable pricing. And this added certainty can have secondary financial benefits to an operating firm like a truckload carrier. Namely, it can reduce the company’s operating risk and may allow it to obtain bank loans or other forms of financing at a lower interest rate due to the better predictability of the company’s cash flows, leading to decreased risk to the lender.

Trucking Futures –  Form and Function
The TransVix website states that the company plans to use index-based spot trucking rates as the mechanism for settling its freight futures contracts. However, I didn’t see any mention of the specific indexes, pricing mechanisms, or lanes that will be utilized.  I plan to reach out to TransVix management to obtain details about the structure these contacts will take. For now, the Baltic Exchange of maritime futures is the most well-established transportation futures market and is a likely model for the US freight futures. So it is worth looking at how the Baltic Exchange structures its offerings.  Baltic Exchange forward freight agreements (FFA) are available for different sub-categories based on vessel size (Panamax, Supramax) and dry vs. wet cargo routes. TransVix will likely offer futures on major US lanes and other defining characteristics. Baltic Exchange settles its futures prices (marks to market) based on Baltic Exchange Forward Assessments submitted by participating brokers. It remains unclear what indexes or pricing sources TransVix will use to measure daily pricing for the purposes of marking its contracts to the current market price. However, there are numerous sources of lane benchmark data currently available, as my colleague Steve Banker noted in a prior post about The Science Behind the Benchmarking of Lane Rates. Baltic FFAs have predetermined settlement dates, and settlement prices are produced on the last working day of the month. Settlement dates and prices are core features of futures contracts as “price”, “value”, and “marketing to market” are often confusing to those unfamiliar with the concept.

Quick and Dirty on Futures Contracts
A futures contract, in our example, is a contract to buy/sell truckload freight capacity on a given date for a given cargo type, on a given route.  The price of a futures contract is simply the agreed upon price between the two parties. For example, for $110 I will buy load size A delivered from Boston to Los Angeles on February 15, 2018. The price of a contract, generally speaking, is calculated as the current price (spot price) multiplied times 1+the interest rate, plus carrying costs (the equivalent of storage costs for a commodity like oil). For example, the price on that given shipment on that route, today February 15, 2017 is $100, and the interest rate is 10%, leading to $110 in one year as the futures price. The seller and I agree on the futures contract price today and the value of this contract is therefore $0 to both parties because we didn’t gain or lose anything. If tomorrow, the price for this shipment on this route goes down by $20, I will essentially owe the seller $20 at which time the value to the seller will be $20 and the value to me will be -$20.  That $20 will be taken out of my bank account and placed in the seller’s account. Once this occurs, the value of the futures contract is back to $0 for both of us. If the spot price goes up by $10 the next day, the seller will place $10 in my account, and so on. This daily settling process removes the risk that the person of the other side of the trade will not follow through with their commitment. [This risk, known as counterparty risk is much of what was behind the 2008 global financial crisis as many of the major banks engaged in similar contracts with each other without settling (marking to market) on a regular basis.] So by entering into this contract, I have committed to spending $110 on this shipment in one year, regardless of whether the price at that time is higher or lower.

Now, the pricing of futures isn’t exactly the same as the expected spot rate at the given settlement date because of issues such as assumed risk and other adjustments. But it does allow market participants to trade away much of the price fluctuations that they face.  It’s worth noting that the TransVix market will be a cash settlement market. This means that the actual purchase and sale of shipping capacity will not occur. The settlement of changes in price will simply serve as a financial mechanism to deal with price volatility and risk. Transactions for trucking freight will occur separately.

As a final note, derivatives such as futures have received a bad rap in the media in the recent past due to the role some of them (that did not mark to market or have guarantees against default) played in the financial crisis. Also, a lot of the criticism is toward speculators. In reality, most of the market is occupied by operating companies that are looking to hedge against price volatility embedded in their given industry.

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