In 2020, carriers are making decisions in a challenging environment of persistent overcapacity and significant trade lane uncertainty.
The greatest challenge facing ocean carriers today is overcapacity. Since 2011, the annual growth rate of global ship capacity expansion has outpaced the growth rate of global container trade in all but two years. In 2020, capacity is expected to grow 3.1% while trade is forecasted to grow by only 2.6%. This will mark the third consecutive year in which capacity growth has exceeded demand growth. Consequently, the ocean carrier market will continue to be oversupplied with container ships.
In 2020, 45 new containerships with capacities between 10,000 twenty-foot equivalent units (TEU) and 23,000 TEU are scheduled to be delivered to five carriers—Hyundai Merchant Marine, CMA CGM, Evergreen, MSC and Yang Ming. These carriers will need to gain market share in order to support capacity expansions.
In addition to overcapacity, carriers also face another big challenge: significant uncertainty surrounding the U.S.-China trade war. Over the last year, there was a large-scale reorientation of imports away from China and Northeast Asia more generally. Southeast Asia was the main beneficiary, however, roughly half of China’s share loss was absorbed by countries not in Asia, and this has had a disproportionately negative impact on Pacific Coast ports.
If the trade war persists or escalates, this trend will continue. If, on the other hand, the trade war is resolved, we should see some volumes return to Northeast Asia, much to the benefit of Pacific Coast ports and terminal operators.
It’s within this environment of uncertainty regarding both overall shipping demand and demand on specific trade lanes, that carriers are developing deployment strategies. Their decisions regarding where to deploy newbuilds and redeploy the vessels that the newbuilds displace will ultimately affect spot prices, contract rates, service levels, and, importantly, the likelihood and propensity for sailings to be blanked/voided/cancelled in the coming year.
Carriers have employed slow steaming and route diversion strategies to absorb excess capacity over the last 10 years, but neither should be expected to absorb the current capacity overhang. Without dropping port calls, carriers cannot slow vessels on the headhaul leg, and the benefits to slowing further on the backhaul are minimal.
Route diversion offers another, albeit limited, strategy for capacity management. This strategy is mainly used in the Asia-U.S. Midwest trade. A container of Asian imports to the U.S. Midwest may arrive via one of three routes: over Pacific Coast ports (the “land bridge” route), or over Atlantic/Gulf Coast ports either via the Panama Canal (the “all water” route) or via the Suez Canal.
Maintaining a weekly land bridge vessel service requires only five or six vessels, whereas maintaining a weekly all water service requires at least nine vessels. Suez services require eleven or more vessels.
Prior to the global financial crisis of 2008-2009, ocean carrier capacity had been growing more slowly than global container trade, and carriers focused expansion efforts on the Pacific Coast route, even though in doing so, they must share a much higher portion of revenues with the railroads that link the Pacific Coast to the Midwest. After China entered the World Trade Organization in 2001, the share of imports from Asia grew rapidly, and the Pacific Coast ports gained market share.
After the global recession, carriers managed capacity by shifting their respective expansion efforts to the all water option. Prior to the expansion of the Panama Canal in 2016, the maximum vessel size was only 5,000 TEUs, but today 14,000 TEU vessels can be deployed on this route.
Between 2011 and 2018, the share of Asian imports moving over the Pacific Coast declined steadily. U.S. Pacific Coast ports will continue to lose share of Asian imports to competitors on the Atlantic and Gulf coasts so long as overcapacity in the ocean carrier market persists.
Route diversion is limited as a strategy for absorbing global ocean carrier capacity, however, because there are no other major inland global markets that can be competitively served by ocean routes of such great distance disparity.
Persistent overcapacity has suppressed ocean freight rates over the last 10 years despite carriers’ attempts to manage capacity through slow steaming and route diversion. In turn, carriers have attempted to maintain profits (or avoid losses) through cost management and economies of scale.
Fuel accounts for around half of a container carrier’s total operational costs, and vessel upsizing can reduce fuel consumption by as much as 30% per container. But savings depend on capacity utilization levels. Operating larger vessels at suboptimal utilization levels negates the scale advantage.
In this way, rational decisions made by each independent carrier can lead to an oversupplied market, and in a circular manner, overcapacity erodes both contract and spot rates, which puts further pressure on carriers to control costs and often leads to a decline in the service level delivered by the ocean carriers.
Rate erosion has also caused industry consolidation through mergers and acquisitions. More than that, ocean carriers must increasingly rely on each other to fill ever-larger ships, and this, in turn, has caused alliances to grow larger in size and fewer in number. In turn, there are fewer options for importers and exporters, and it becomes more difficult to differentiate service quality between carriers within each of the three major global carrier alliances.
Of course, larger vessels require ports to dredge deeper berths, and they require terminal operators to invest in larger cranes, additional yard equipment and truck gate expansions. Moreover, higher capacity vessels require more time to load and unload, and they create more significant surges in both on-terminal and off-terminal congestion. In short, while economies of scale lower operational costs on the ocean leg, the deployment of larger vessels causes BCOs to incur other direct and indirect costs while receiving lower service levels.
When capacity cannot be absorbed through slow steaming and route diversions, carriers can choose to blank sailings. As Chinese imports plummeted last year, the number of blanked sailings jumped, especially in the fourth quarter.
Blanking a sailing on a six-vessel Transpacific string results in a capacity reduction of 17% (over a six-week period). In turn, elevated capacity utilization rates can have a meaningful impact on spot rates, which are used in annual shipping contract negotiations.
Carriers also face uncertainty regarding how the implementation
of IMO 2020 regulations will affect fuel costs and how effectively
these costs can be passed on to BCOs.
Carriers also face uncertainty regarding how the implementation of IMO 2020 regulations will affect fuel costs and how effectively these costs can be passed on to BCOs. We have already begun to see that the revamped fuel surcharge formulas have resulted in a wide range of fees being levied across carriers operating in the same trade lane, and the differences are not clearly tied to vessel size. This—along with a lack of transparency—has left many BCOs with the impression that carriers are doing more than simply passing on the fuel costs.
Toward the end of 2018, my firm, Mercator International, began advising BCOs to not simply accept new fuel surcharge formulas because, in actuality, they are negotiable, and they are not designed in a manner that incentivizes competition and improved carrier performance.
The carriers’ various low sulfur fuel fee formulas are all similar, and each one purports to simply pass fuel expenditures on to ocean freight users. On its face, this seems fair, but the devil is in the details. Let’s look at a couple of examples.
Hapag-Lloyd’s Marine Fuel Recovery (MRF) fee is calculated by first multiplying the average low sulfur bunker price by the volume of fuel consumed, and then dividing this figure by the number of loaded TEUs carried. MSC’s Bunker Recovery Charge (BRC) is calculated the same way, except the surcharge is then multiplied by a trade factor such that shippers loading containers in the headhaul direction pay a higher percentage, thereby further subsidizing backhaul shipments.
In the trans-Pacific, Hapag-Lloyd operates a handful of services including the six-vessel 6,500 TEU PS4 service. Similarly, MSC operates numerous services including the 16-vessel 13,100 TEU Pearl service (a pendulum service connecting Asia, North America and Europe). If we assume optimal capacity utilization, the larger vessel string will consume around 25% less fuel than the smaller string, and even after accounting for the headhaul factor, an importer using MSC should pay a lower bunker fee. The differential, of course, depends on how well each respective carrier fills its vessel slots, and herein lies the rub.
A carrier’s incentive to fill all vessel slots by being rate competitive diminishes when the single greatest cost can be passed in full to the customer. In highly imbalanced trade lanes, like the trans-Pacific, this can be a real issue. After accounting for all of the overhead involved in attracting and managing backhaul loads, carriers make minimal profit from these moves, and losses are not unusual.
A carrier will not be penalized for curtailing efforts to fill empty backhaul containers if the reduction of overhead costs exceeds lost revenue. If the full cost of fuel is covered, this situation becomes all the more likely. But because the fuel costs are spread across all loads, an importer in this circumstance would have to pay a higher fee.
In short, carriers are making decisions today in an environment of persistent overcapacity and significant trade lane uncertainty. Carriers that are expanding capacity will need to compete for market share, and should they fail, they may be the most likely to blank sailings.
If the trade war persists, and no current services are cancelled, we should expect to see elevated blanked sailings—especially on the Pacific coast routes—as carriers struggle with overcapacity. If the trade war is resolved, we should anticipate a return of some portion of China’s share loss, but it is unclear how large that portion would be, and from where the returning share would come.
We should see a wide range of fuel surcharges despite the overall similarity across each carrier’s fuel fee formulas not only because a wide range of vessel sizes are deployed within the major trade lanes, but because capacity utilization rates will vary across carriers, especially on the backhaul leg.
Finally, carriers also face uncertainty around how the implementation of IMO 2020 regulations will affect fuel costs.
The two best pieces of advice we can provide to BCOs:
Be sure to use this knowledge during contract negotiations.