By far the largest, most mature and most liquid freight futures market in the world is for Capesize dry bulkers, vessels with a capacity of around 180,000 deadweight tons. There is over $2.6 billion in open interest in Capesize forward freight agreements (FFAs) and options as of today.
When it comes to generating daily rate assessments to underpin these futures contracts, London’s storied Baltic Exchange has been the only game in town for as long as this derivatives market has existed. But that may be about to change.
S&P Global Platts, a giant in the index and price-assessment arenas, has just launched a Capesize index at a time when the Baltic Exchange still faces lingering reputational backlash after a controversial decision on its index definition announced in March. This confluence of events could eventually open the door to new Capesize futures products based on Platts assessments.
Platts said it launched its new index in response to “feedback from market participants who said they are exposed to basis risk and cannot hedge effectively without a new reference” – a polite way of claiming it was told that the Baltic Exchange’s paper assessments diverge too far from physical reality. “The shipping industry deserves better,” maintained Peter Norfolk, global head of shipping for S&P Global Platts.
The new index that debuted Oct. 1, the Platts CapeT4 Index, is a weighted average of assessments of four Capesize round-trip voyages: China-Australia (weighted 46%); China-Atlantic (i.e. Brazil, weighted 45%), China-South Africa (6%) and trans-Atlantic (3%).
During an in-depth interview with FreightWaves, Norfolk explained how the new product came about, how Platts’ process diverges from the Baltic Exchange’s, and how the product could evolve in the future.
“S&P Global Platts has had a presence assessing freight in the tanker markets, which made sense given our background in oil markets – and we now have four tanker assessments that are listed on CME and ICE as a basis for derivatives that are actively traded,” he explained.
“But we also assess [dry] commodities – metals, coal, agriculture – and as part of that we have been assessing dry freight routes,” he added, noting that Platts now assesses over 120 bulker routes.
It initially gauged this pricing on a “spot voyage” basis, calculated in dollars per ton of cargo, excluding fuel and other voyage charges. It then developed what are known as “time-charter equivalent” or TCE assessments for the same routes; the spot dollars-per-ton rate is converted into a dollars-per-day rate by adding in fuel and other costs and making various assumptions on voyage length and vessel speed. The new Platts CapeT4 index is derived from the weighted average TCEs in the top four lanes.
Platts vs. Baltic Exchange methodology
“Our methodology is obviously very different [than the Baltic’s],” said Norfolk. “It’s a methodology that has underpinned some very successful derivatives contracts – like dated Brent [crude oil futures]. It’s a methodology the trading community is very comfortable with.”
Following are the main differences between Platts’ and the Baltic Exchange’s Capesize methodology:
Weightings that comprise the index – The comparable Baltic Exchange index is the Capesize 5TC Index, which has one extra voyage versus the new Platts index as well as totally different weightings: China-Australia round-trip (weighted 25%); China-Brazil round-trip (25%), trans-Atlantic roundtrip (25%), Europe-to-Canada (empty) then Canada-to-China (full) one-way (12.5%) and China-to-Europe one-way (12.5%).
Norfolk said that the Platts weightings are derived from using the company’s cFlow vessel-tracking software, which he said provides an accurate reflection of the ton-mile demand (cargo volume multiplied by distance) in each lane. In other words, the index weightings are designed to mirror the actual physical commodity flows at sea.
Asked whether Platts would dynamically reweight the percentages of its lanes if the cargo flows changed, he replied, “We thought about revising the weightings every year, but based on feedback, we decided that for people who are going to trade this as a forward contract, that might be problematic, because they don’t like the basis of their contracts changing every year.
“So, what we’ve said is that we’ll review the weightings in the event of a substantial change in the observed trade flows. If those weightings start to look out of whack – if all of a sudden Australia stops exporting iron ore to China or something – then obviously we’d look at them again. But we want to make sure people don’t get unsettled by it shifting all of the time.”
Voyage versus time charters – In a time charter, the charterer pays for fuel and voyage expenses. That’s why those expenses are added into the equation when a voyage rate in dollars per ton is converted to the equivalent of a time charter, i.e., the TCE rate. When Baltic Exchange assessors are calculating pricing to determine the time-charter indices that comprise its Capesize 5TC Index, they first assess actual time-charter contracts in the market; only when they cannot find those do panelists assess spot voyage charters and convert to TCE.
Platts is coming at it from the opposite direction. It is always starting with the spot voyage rate and then converting to the TCE. Norfolk explained, “If you’re an iron-ore miner or a steel mill, you know how much you’re spending in dollars per ton and you want the same number equivalent for your freight commitment. If you can provide both the dollars per ton and time-charter-equivalent dollars per day alongside each other and people can see both, that gives greater transparency.”
Canvassing for rates – The Baltic Exchange gets its daily assessments via designated “panelists,” who are largely ship brokers.
Platts canvasses a different population. “We have teams of editors in both Singapore and London that spend all day talking to market participants,” explained Norfolk. “They talk to brokers, charterers, ship owners, ship operators – anybody who’s involved with those trades. It’s a survey of the market according to MOC [market on close] principles.”
Addressing the scrubber controversy
The new Platts Capesize index arrives just two months before the IMO 2020 regulatory deadline. On Jan. 1, all vessels not equipped with exhaust-gas scrubbers will be required to burn more expensive fuel with 0.5% sulfur content or less. Ships with scrubbers will continue to burn cheaper 3.5% sulfur fuel.
This regulation created a pressing question for Capesize FFAs linked to Baltic Exchange indices that were sold prior to IMO 2020 implementation and will settle in calendar years 2020 and beyond. Would the “reference ship” for the index that informed the eventual settlement price be scrubber-fitted and thus burning the same fuel as was being consumed when the original FFA contract was sold, or would it be non-scrubber-fitted and burning pricier 0.5% sulfur fuel?
The debate, which continued throughout 2018 and into the first quarter of 2019, was highly acrimonious at times. A contingent of FFA traders that were “long” FFAs settling after Jan. 1 argued in favor of using a scrubber-fitted reference ship.
They insisted that the fuel type was highly material to the time-charter rate and thus the index level (given the expected wide spread between compliant and non-compliant fuel), and that effectively changing the fuel type to 0.5% sulfur fuel in the reference ship would decrease FFA values, all else being equal, by hundreds of millions of dollars on a market-wide basis.
They believed the Baltic Exchange should create parallel indices – one for scrubbers ships, one for non-scrubber ships – and FFAs settling post-Jan. 1 should be settled on the scrubber index, in which the fuel type was unchanged.
After extensive consultations, the Baltic Index Council decided on March 27 against dual indices, and affirmed that indices would continue to be based on non-scrubber-fitted ships. The Baltic Exchange had previously stated that it would separately consider the possibility of creating a new index for larger scrubber-fitted bulkers in the future.
Platts has addressed the scrubber issue head on. Starting Nov. 1, it will begin publishing dual indices for scrubber and non-scrubber ships for its dry freight routes. “There will be two CapeT4 indices,” confirmed Norfolk.
“In fact, when one of our team was at the ASBA [Association of Ship Brokers and Agents] conference in Miami last week and mentioned that we’re doing dual indices, there were audible cheers in the room.”
Getting listed for FFA trading
The CapeT4 can immediately be used as a basis for index-linked charters in the physical market (as Platts individual voyage assessments already are), but there is a sizeable hill to climb before CapeT4 is a viable basis for paper trades.
The challenge for Platts is that there is a very firmly ensconced incumbent dominating the Capesize FFA landscape and providing reference data underlying paper trades that boast very high liquidity. This creates a “chicken and the egg” issue for Platts in terms of attracting FFA market participants, who require the liquidity they can already find via Baltic Exchange-linked contracts.
At one point earlier this year, it seemed at least possible that Platts could get a jump-start on its entry. Dry FFAs are “cleared” by three clearinghouses: SGX in Singapore, which owns the Baltic Exchange and which handles about 50% of the dry derivatives volume; NASDAQ in the U.S., which handles 43%; and EEX in Germany, handling 7%.
If one of those clearinghouses did not believe the Baltic Exchange decision on IMO 2020 was fair to its customers, it could have decided to settle those FFAs against another index, i.e., Platts’.
In a Feb. 22 letter to the Baltic Exchange obtained by FreightWaves, EEX said that it had the power to “use alternative benchmarks if appropriate and possible.” It said that it did not currently view the Baltic Exchange’s decision as “creating a significant change in the benchmarks” but as of that date, it had not reached a conclusion of whether the index change would “have an economic impact on the open interest.”
On March 28, EEX hosted a meeting in Singapore for FFA market participants regarding the Baltic Exchange IMO 2020 decision and how it would affect contract settlements. According to the agenda of that meeting obtained by FreightWaves, Platts not only attended the event but gave a presentation on its own “Time Charter Indices for IMO 2020.”
In the end, neither EEX nor the other clearinghouses opted to resettle post Jan. 1-maturing FFAs on an alternate basis. Consequently, if Platts is to become a player in the Capesize futures market, it will be starting fresh. It cannot initiate this process – it is up to one of the existing dry freight clearinghouses, or another that might enter the field, such as CME or ICE, to do so.
“We’d welcome that if it were to happen,” said Norfolk. “Obviously, Platts has relationships with the clearers so these things evolve. If you take as an example the tanker FFAs, we launched a couple of U.S. Gulf-loading tanker assessments last year after we observed U.S. crude exports ramping up, and quite quickly, two clearinghouses saw that we did that.
“We exchanged information around that and they listed those as new FFA contracts. And since then they’ve become active and successful FFAs. The same with a VLCC [very large crude carrier] Arabian Gulf-to-China assessment we launched last year; that’s also become a successful FFA. It’s all about market demand. If brokers and market participants want to trade an FFA, they’ll talk to the clearinghouses and the clearinghouses will look to react to that.”
FreightWaves asked Norfolk about the confluence of timing between the new Platts CapeT4 dual indices, the nearing IMO 2020 deadline, and the lingering acrimony within certain circles of the speculative FFA trading community about the Baltic Exchange decision in March. Financial speculators (who do not own or charter ships) are particularly important to the long-dated Capesize FFA market, providing most of the liquidity on the “sell” side, with charterers and other speculators taking the “buy” side.
Norfolk confirmed that Platts views the recent controversy as an opportunity. “Certainly, the disruption around IMO 2020 presented people with an appetite to look at fresh alternatives,” he said. “We’re hoping that this will provide them with that fresh alternative.” More FreightWaves/American Shipper articles by Greg Miller
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