Understanding The Risks Of Index-Linked Contracts In Ocean Freight

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Index-linked contracts are gaining traction in ocean freight container shipping for their ability to adapt to market volatility. However, a critical flaw in some contracts could lead to significant overpayments for shippers. This issue arises when contracts benchmark against 20ft equivalent container indexes (TEU) while shippers use 40ft equivalent containers (FEU).

Why Index-Linked Contracts are Needed

The ocean freight industry has faced significant disruptions over the past five years, including the Covid-19 pandemic and the Red Sea conflict. These events have caused extreme market volatility, leading to accusations of opportunistic behavior by carriers. Index-linked contracts offer a solution by allowing rates to track market changes, reducing the need for constant renegotiations and fostering better relationships between shippers and carriers.

The Potential Flaw

The flaw in some index-linked contracts is the use of TEU indexes for pricing, despite the dominance of FEU in global trade. FEU rates are not simply double the TEU rates, often resulting in higher costs. This discrepancy can lead to substantial overpayments when contracts do not align with the correct container size used by shippers.

Financial Implications

The financial impact of using TEU indexes for FEU shipments can be significant. For example, shipping 1,000 FEUs from China to South America could cost over $4 million more if based on TEU rates. This discrepancy is evident across various trade lanes, where FEU rates are consistently higher but less than double the TEU rates.

Protecting Against Overpayments

Shippers can avoid overpayments by ensuring contracts are benchmarked against the appropriate index for the container size they use. Using FEU data for FEU shipments and TEU data for TEU shipments is essential. Even with discounts, shippers must consider the volatility in the price differential between TEU and FEU to avoid financial pitfalls.

Index-linked contracts offer many benefits, including financial visibility and stronger shipper-carrier relationships. However, they must be correctly benchmarked to prevent significant overpayments and ensure mutual benefit. Properly structured contracts can protect shippers from market volatility while ensuring fair pricing and supply chain stability.

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Source: XENETA