Differences And Correlation Between Spot Rates And Contract Rates in Shipping12/05/2023
Ever since the start of Covid, there has been a lot of focus in the shipping industry and amongst exporters on the relative developments in spot rates and contract rates.
What has given rise to these discussions is the steep increase in spot rates in the months succeeding the spread of the Covid infection, which was thereafter followed by slightly more measured increases in contract rates.
Throughout this period, the overall rate scenario was characterised by extreme volatility, which impacted freight procurement spending for shippers and rendered supply chain, transport, and inventory planning even more difficult than it usually is.
With the prevailing global uncertainty and geo-political tensions, exporters, trade associations, carriers, competition watchdogs, and governments alike closely watch developments in freight rates.
In this article, we will understand the differences between spot and contract rates, the correlation between the two, the circumstances in which these rates prevail, and how both Carriers and Shippers attempt to balance cargo carried on spot and contract rates to their maximum advantage.
What are Spot rates and Contract rates?
When a shipper or exporter, or cargo owner needs to ship cargo overseas, he approaches a few container carriers with an inquiry, providing all the necessary information (such as origin, destination, load port, discharge port, consignee details, commodity, weight, value, packaging, special instructions, pre-carriage and on-carriage details, and other relevant details). Based on this information, the carriers will quote accordingly.
Given that the shipper will need some time after rates are quoted by the Carrier (in order to negotiate and finalise the rate, make a booking, get the cargo ready for shipment, and then arrange transport to the load port or pick-up point), Carriers generally specify a certain validity for each rate quoted. The expectation is that the shipper will complete all the steps mentioned above within the validity period, and the cargo/ stuffed container will be handed over to the carrier within the validity period specified.
In the case of bigger exporters/ manufacturers, however, the requirements and circumstances will be different. Big corporations such as Ikea or Walmart have massive volumes shipped globally and throughout the year. Since manufacturing and sourcing are concentrated in a few locations, deliveries are destined for countries where there exists a market for their products.
They have an established presence, and the number of origins and destinations is known in advance. Also, by utilising demand forecasting techniques and supply chain planning tools, the company has a fairly accurate idea of the regularity and volume of cargo flows.
Besides, by virtue of the huge volumes that they control, such companies have the scale and size to negotiate better rates with carriers.
Thus, bigger shippers or cargo owners with large quantities of goods to export/ import and with relatively steady cargo flows – in terms of an even split across months, seasonality, and origin-destination combinations – generally value supply chain reliability and stability in terms of transport planning, wherefore what they require is rates that are valid for a longer period and accompanied by minimum guaranteed space commitments.
Under these circumstances, the shipper will require rates that are valid for a longer period (the most common period being 1 year, but it could be shorter at 6 months or longer at 2 or 3 years), covering their important trading corridors, with a certain amount of guaranteed space every week/ month.
In this case, the shipper will sign a long-term contract with the carrier, where the shipper commits a certain quantity of volume that they will give the carrier (known as the Minimum Quantity Commitment or MQC), in return for which the carrier extends to the shipper the benefits of better rates (which are lower than the prevailing market rates), guaranteed space and equipment, the relative stability of rates (which facilitates long term planning and stability of cost base, which in turn helps annual transport budgeting and product pricing).
For contractual customers, carriers often also lower the quantum of surcharges and accessorials or keep the surcharges at a fixed level (subject only to the caveat that the quantum will be re-evaluated and revised should the carrier’s actual costs for that activity exceed a certain pre-decided level).
These rates are known as contractual rates, recorded in the contract signed between the shipper and carrier. The nature of these rates is such that they are long-term and relatively stable.
Spot rates, on the other hand, are the rates that are currently available in the market. These rates are determined by the interplay between supply and demand and constantly keep changing.
When shippers do not have regular and/or sizeable cargo volumes that will flow steadily over a year or so, they will be constrained to approach carriers on an ad hoc basis as and when they have cargo to export to international markets.
For such ad hoc shipments, other than the typical pricing drivers, carriers will price primarily depending on how much capacity is available on the corridor in question (with secondary considerations being the need to have the container sent to the destination – for repositioning purposes or to fill with export cargo from the destination, availability of cargo on backhaul trades, etc.).
Thus, these are, in essence, the prevailing market rates that are dynamic, constantly varying in response to fluctuations in the shipping market, impacted by both the demand for shipping services and the supply thereof.
Spot rates are typically quoted for each booking or consignment of cargo. They are short-term rates that are valid only for a certain period, depending on the volatility of the transport markets.
The validity of these rates will generally vary between a week to a month, depending on the average time taken for shippers to get the cargo ready for shipment (in exceptionally volatile times or during a bull run when freight rates are moving upwards at a rapid pace – as happened during the Covid induced disruptions in 2020 and 2021 – rates offered by carriers will be valid for an even shorter period of perhaps just a few days.
This is not to imply that the shipper has just a few days to get the cargo ready and hand it over to the carrier; rather, it means that the shipper has only a very short time frame within which to confirm acceptance of the freight rates offered and place their bookings. Once the bookings are made, the standard terms and conditions and timelines will apply.
Summary of Differences between Spot Rates and Contractual Rates
The difference between spot rates and contract rates can be summed up as under:
1. Validity period: spot rates have a very short validity (generally not more than a month) and essentially involve playing the spot market. In comparison, contractual rates have a far longer validity (typically 1 year).
2. Tactical or strategic: Spot rates can be considered a very tactical approach and essentially involves not committing to any carrier in the long term, instead relying on the spot market to get the best rates in the current scenario, while contractual rates are negotiated and entered into with a more strategic mindset, keeping holistic, long-term supply chain requirements in mind.
3. Ad hoc shipments vs regular cargo flows: Spot rates are obtained in the case of ad hoc cargo, whereas contractual rates are opted by shippers who have regular cargo flows spread evenly across the duration of the contract, with relatively fewer fluctuations.
4. Degree of volatility: Contractual rates offer a greater degree of stability in terms of freight and transport costs since they are fixed for the duration of the contract (with clauses to review and revise rates should the market change drastically or the carriers’ cost base change considerably; however this contingency is generally remote and the extent of the increase, if at all, will be more measured than increases in spot rates). Spot rates are inherently volatile and could change on a daily or weekly basis, subject to changes in all the factors that impact freight rates.
5. Freight rate levels offered: Contractual rates are generally negotiated at a level lower than spot rates since the logic is that if shippers can guarantee to the carrier a steady flow of volumes for the whole year (so the carrier is thus assured of revenue for the duration of the contract and a certain level of capacity utilisation is guaranteed), they can offer a more attractive rate in lieu thereof. In the case of spot rates, since the business is completely transactional and there is no customer stickiness or long-term relationship, carriers generally try to maximise their revenues and profit therefrom by offering the highest rates possible.
6. The flow of cargo – in terms of regularity/ no seasonality effect: Contractual rates are suitable for cargo that is regular / has limited seasonality effect (where the volumes do not vary significantly basis seasons and are more or less consistent the whole year round). The importance of this factor is that it helps the carrier plan their vessel movements for forthcoming months, provides revenue visibility, and improves the quality of their forecasts, so they can adopt an agile approach towards pricing depending on the amount of capacity they need to fill. Cargo which is highly prone to fluctuations based on seasonality (such as winter clothing or mango exports from India in summer) or occasion-specific cargo (such as Christmas decorations or back-to-school items), are some products that are moved on spot rates.
7. Space and equipment guarantees – from the carrier end: From the Carrier’s end, a contractual rate implies a corresponding commitment to providing assured equipment and space on their vessels/ services. In reality, however, there might be contingencies or market-level changes due to which a carrier might not be able to provide space/ equipment. For spot rates, the rates already take into account the supply-demand equation and are offered after evaluating capacity utilisation on vessels and availability of equipment, wherefore, space and equipment availability is generally not an issue.
8. Minimum quantity commitment – from the shippers’ end: Shippers entering into a contract generally commit a certain minimum quantity of volumes that they will offer to the carrier during the duration of the contract. In a lot of instances, due to unforeseen events over the course of the year that might disrupt production and transport flows, shippers might not deliver the cargo committed. In the case of spot rates, the very ad hoc nature of business precludes anything in the form of a quantity commitment. Since rates are requested as and when shipments come up, the probability of the cargo volumes not materialising is not very high.
9. Quantity of volumes involved: Contractual rates are generally negotiated by bigger shippers, who control large volumes, enough to present an attractive business opportunity to carriers, who will therefore be incentivised to offer lower rates. For spot bookings, the volumes are generally not as high, or even if they are high, it is typically in one lot or spread over a very short time frame).
10. Applicability of rates – to all shippers or a single customer: Contract rates are unique to each customer, as they are negotiated with each individual customer desirous of entering into a contract with the carrier. These rates are dependent on a number of factors such as commodity, corridors, annual volumes, equipment type, etc. Spot rates, on the other hand, are the current general rates prevailing in the market and are offered to all customers who approach the carrier. While shippers will do their best to negotiate on spot rates as well, the final rate will not be very different from the average spot rate, wherefore shippers with spot bookings can be said to have a reasonably uniform rate, with minor fluctuations depending on specific causes.
11. Confidentiality of rates: Contract rates come into effect on the basis of the contract signed between the shipper and carrier. Since the contract is a confidential document and the rate negotiations and other terms are commercial information whose circulation is restricted, it obviously follows that contractual rates are highly confidential in nature. Spot rates, however, since they are market-driven, are common knowledge to all players in the market.
12. Rebates linked to volumes/ cargo commitments/ MQC: To attract a greater number of bigger and more loyal customers, who will deliver more business in the long run, Carriers try to make contractual terms even more lucrative by implementing various rebate schemes whereunder shippers are entitled to rebates per container, subject to meeting certain volume criteria. In the case of spot rates, since it is ad hoc and non-recurring business, carriers do not offer rebates.
13. Suitable for which type of shipper: Contract rates are suitable for bigger manufacturers and traders who have sizeable volumes throughout the year and trade internationally. In contrast, shippers who seek spot rates are generally smaller and have limited international movement.
Carriers generally attempt to strike a strategic balance between the proportion of cargo moved under spot rates and under contract rates. There is no fixed or suggested ratio for spot-to-contract volumes. The proportion of spot to contract cargo depends on a number of factors, such as Carriers’ long-term strategy, the markets/ customer segments they intend to target, the proportion of chartered to owned vessels, the trades they are serving, transactional vs partnership approach etc.
The underlying logic that guides Carrier behaviour is the intent first to sign contractual cargo that fills a sizeable proportion of their overall capacity. This provides the carrier with assured volumes and revenue visibility for the rest of the year. Once the carrier has assured themselves of minimum business, they have the flexibility to play in the spot market and try to sell the remaining space to spot shippers at rates that are higher than the average contractual rates.
If a carrier is focused on building long-term commercial relationships and intends to adopt a partnership approach with potential customers, the obvious option for them is contractual rates. Likewise, if a carrier prioritises the maximisation of revenues and profits in the short term at the expense of steady business relationships, it will opt to carry more spot business.
In a bull market or when demand exceeds supply, where spot rates are rising, carriers might prefer to do more spot business, while in a stable market scenario, they might sign more contractual cargo.
The shippers’ perspective is obviously the inverse of what the carrier is. The determinant factors of whether a shipper opts for contract rates or spot rates are more clearly defined than is the case with carriers.
Shippers primarily make this decision based on the degree of supply chain reliability they intend to achieve, counterbalanced by considerations of freight procurement costs and the total cost of ownership. The magnitude of stability in overall supply chains that a shipper would target will basically depend on the nature, scale, scope, and geographical diversification of their business.
Export-oriented businesses with large manufacturing capacity will, of necessity, need to prioritise supply chain integrity to ensure the smooth functioning of their business and ensure that their inventory pipeline is always adequately stocked to meet forecasted demand. Should this fail to fructify, the repercussions for the sippers can be catastrophic, resulting in missed sales opportunities, reduced revenue, loss of goodwill and reputation, and the risk of losing market share to more agile competitors.
It is for this reason that such shippers will take a long-term partnership view and look to enter into strategic relationships with reputed carriers, who can guarantee service levels, global network, shipping capacity, and equipment availability. In these circumstances, shippers will often be amenable to paying a slight premium in return for space commitments.
On the other hand, small and medium-sized businesses whose manufacturing is on a relatively lower scale or whose operations are primarily geared towards domestic consumption will typically not have regular cargo to ship to overseas markets. Their maritime transport requirements will be ad hoc, depending on whether and when they receive orders from overseas buyers and retailers, which ipso facto means that it is not a viable option for them to enter into long-term contracts.
These shippers will instead have to approach carriers as and when they have an international consignment, for which the carrier will quote spot rates. The only possible leeway the shipper might get in terms of rates would depend on the size of their consignment and the amount of open space that the carrier has to fill.
Apart from this broad categorisation, shippers attempt to strike a balance between reliable services and their overall transport costs by trying to ship a certain portion of their cargo on spot rates. So, a shipper will first estimate the inventory levels that they need to ensure at all times and sign a contract covering this proportion of their overall production.
Thereafter, depending on the criticality of the goods or raw materials and the time criticality, shippers will aim to transport the remaining cargo on spot rates, trying to secure the lowest possible rates, depending on market conditions.
It is to handle such complex decisions and ensure the optimal balance between business continuity and costs that most big manufacturers have invested in separate supply chain and transport planning departments.
Correlation between Spot and Contract rates
There is a direct correlation between spot and contract rates. When negotiating contractual rates during the contracting season, the prevailing spot rate levels are used as a benchmark to negotiate contract rates (of course, bearing in mind the future outlook and forecasts for freight rate developments and capacity infusion).
To illustrate with the help of a recent example, when global supply chains were roiled by supply chain disruptions of unprecedented magnitude post-Covid (in 2020 and 2021), capacity was scarce (as vessels and equipment were absorbed due to congestion) while demand increased. Due to this combination of factors, spot rates shot up to over 10 times their historical average rates.
And even then, shippers weren’t guaranteed space or equipment. In this situation, certain carriers like Maersk Line had the foresight to sign multi-year contracts with shippers at rates which were lower than the then-prevailing spot rates but still higher than the historical average contractual rates.
This ensured that in the event of an inevitable cooling of the market, while spot rates are now back to pre-Covid levels, carriers can still reap the benefits of higher contract rates, thus having insulated their bottom lines from a return to normalcy for spot rates – at least for the duration of the contract.
Similarly, as of today, we are in the midst of the annual TransPacific contracting season, where shippers are anticipating further falls in spot rates, and hence delaying the conclusion of contract signings; the rationale being that the more they wait, the more the chances that spot rates will fall lower, in which case they will be in a stronger position to negotiate even lower contractual rates with Carriers.
Another common situation is where there is surplus capacity in the market while demand growth is at a more modest pace, thereby exerting downward pressure on freight rates. This is an advantageous situation for whippers, as they not only can avail of low rates but also do not have to face the risk of capacity shortages. Since there is surplus capacity in the market, shippers can play the spot market, approaching multiple carriers as and when they have cargo ready to ship and negotiating lower rates.
Current Spot and Contractual Rate Scenario
Since shipping markets have, by and large, reverted back to normal now, supply chain pressures have dissipated rapidly, and the extreme congestion that afflicted most ports across the world has now cleared.
The balance of power has now firmly shifted back in favour of shippers, and they no longer have to rely on contracts for assured space. Given this, shippers once again are in a position to balance spot and contract rates to their benefit.
Carriers, on the other hand, have – after making record profits since 2020 – are now finding themselves in a position where the capacity infusion is compelling them to compete for cargo, which inevitably involves dropping rates. While the super profits made over the last 3 years have provided carriers with a financial cushion, and as the high-rate level contracts signed in 2021 and 2022 are now due for renewal, they find themselves staring at the prospect of lower levels of both spot and contract rates.
The short and medium-term outlook for the shipping industry looks downbeat at the moment.
The new ordering spree that most global carriers embarked upon as part of their capacity augmentation initiatives will cause a massive influx of capacity over the next 2 to 3 years. Demand is expected to remain tepid, as recessionary pressures have caused a slowdown in discretionary spending, further exacerbating the situation.
Carriers are thus challenged on two fronts; increasing supply and declining demand, which has caused fright rates to erode drastically.
Due to this, it is extremely plausible that markets will continue to remain soft, giving shippers the option of relying more and more on spot markets and eliminating the need to rely extensively on contract rates.
Source: Marine Insight