The great BAF problem
13 Feb 2019 - by Lars Jensen
The focus on container carriers’ attempts to (re)introduce new bunker surcharges (BAF) in preparation for the 2020 low-sulphur rules is now getting into real-life discussions between carriers and shippers.
I have had the pleasure of speaking about this matter with both carriers and BCOs (beneficial cargo owners) over the last few months, and there is a genuine risk of an unproductive discussion between the two parties in general in the coming months. Both the carriers and the BCOs have some very valid concerns in relation to BAF – and there is no “magic bullet” to make all of these go away.
Let’s look objectively at the facts and positions of both carriers and BCOs:
Carriers are concerned that fuel prices will increase dramatically in 2020. The first batch of low-sulphur fuel derivatives for January 2020 has just been traded with a price spread of 200 USD/ton, providing the first tangible indication that the fears of substantial fuel price increases might very well be justified. The whole purpose of the exercise is to manage this risk.
Looking at the carriers’ total bunker fuel consumption tends to lead to estimates of 10-12 billion USD in added annual fuel costs. As the carriers over a 7-year period have “only” managed a cumulative profit of some 8 billion USD, it is clear that the overwhelming majority of these added cost have to be passed on in the supply chain.
To do this, carriers have chosen to (re)implement the BAF structures, and they have chosen different formulas with which to pass on the cost. This is in principle not much different than the situation before the oil price crash in 2015.
BCOs in general (but clearly not all) acknowledge a need to pass through the cost, but have some major concerns.
Issue number 1 is that quite a number of BCOs see the new BAFs as a means for the carriers to increase the rate beyond pure cost pass-through.
Issue number 2 is that the carriers’ BAF formulas are very different. This gives rise to two major concerns: One is the impracticality of having contracts with very different BAF structures. The other is that the wide diversity in bunker formulas leads many BCOs to believe that not all of these are fair and transparent.
In terms of issue number 1, this is to some degree quite straightforward. As the carriers are already implementing the BAF now and not in 2020, then it is a matter of looking at whether the implementation of the new BAF changes the all-in rate right now. If the oil price is stable, it shouldn’t. It does not matter whether the carrier implements a BAF of 100$ or 200$ right now. If you are paying 800$ all-in before the BAF, then after the BAF you are either paying 700$ or 600$ on the base rate and the rest in BAF. If you pay more, then the carrier has also raised the base rate. Whether a base rate increase is then justified or not is a commercial discussion unrelated to the BAF issue. A BCO who is worried that the carriers will use the BAF to also increase the base rate is better off getting the BAF formula in now before the anticipated jump in 2020. If they wait until we are in the midst of a jump it is much more difficult to ascertain whether it is also being used to raise the base rate.
In terms of issue number 2, this is where the BCOs partially have legitimate cause for concern, but the problem is of nature that is hard to fix.
The simple solution which some are promoting is to tell the BCOs to develop their own BAF formula and insist that their chosen carriers all use this. Clearly this makes it simple, transparent and – hopefully – fair for the BCO. But while it does solve issue number 2 from the perspective of the BCO, it creates two equally big problems.
If the BCO finds it impractical to deal with - say - eight different BAF formulas, what would be the challenge for a carrier in handling hundreds or thousands of different BAF formulas? Realistically no carrier is going to accept this approach except from a very limited number of BCOs providing them with extremely large volumes. As a side issue, the industry continues to struggle with poor invoicing quality – going down a path of individual BAF formulas for a large number of BCOs will inevitably make this problem much worse. This should not be seen as an “excuse” for the carriers (who should have fixed this issue years ago) – merely a practical statement of fact.
And then we arrive at the point of a “fair” BAF. What is fair?
Let’s make it very simple, because simplicity usually helps in bringing out the crux of the matter.
Take a carrier using 1 million tons of fuel on a trade lane. The shift to low-sulphur will cost them 200 million $. The trade is imbalanced, and the carrier ships 1 million TEUs on the head haul and ½ million TEUs on the backhaul. What is a fair BAF?
The carrier ships a total of 1.5 million TEUs, hence the BAF should be 133 USD/TEU, adding up to exactly 200 million $. This can be argued to be logical and fair.
The base freight rate is not the same on the head haul and the back haul – it never is. In this hypothetical example the head haul rate is 800 USD/TEU and the back haul rate is 400 USD/TEU. A ratio of 2:1. On this basis it could be said to be fair that the BAF also has a ratio of 2:1. In this case the head haul BAF would be 160 USD/TEU and the back haul BAF would be 80 USD/TEU, adding up to exactly 200 million $. This can be argued to be logical and fair.
Other ways of dividing the 200 million $ can also be devised.
In both of these cases, the carrier ends up charging exactly 200 million $ in BAF, precisely covering the cost increase.
And this is exactly the diversity we are seeing in the BAF formulas – the carriers have made different choices in the cost allocation, but that does not mean that some formulas are inherently more “fair” than others.
A head haul BCO would of course prefer the 1:1 split and pay 133$ in BAF, whereas the back haul shipper would prefer the 2:1 split and pay 80$ in BAF. In this case, the carrier would end up not getting their fuel cost risk covered, not an acceptable outcome for the carrier.
There are many more nuances than outlined above, and going into these would take many more pages of text or hours of workshops. This includes issues such as 20’ versus 40’ containers, size of vessels used, speed of vessels used, or vessels with and without scrubbers.
Reality is that there is a large fuel bill coming in 2020.
Reality is that if the price increase is of the magnitude the forward prices currently show, then the carriers cannot pay this – it must in the main be passed on to the shippers.
Reality is that there is no single objective truth on what is “fair”
Reality is that a carrier cannot practically cope with thousands of individual BAF formulas.
Reality is that in many trade lanes the carriers are legally prohibited from aligning their BAF formula to provide simplicity for the shippers (to some degree due to the successful lobbying for a repeal of the block exemption in 2008 by the shippers themselves).
Ultimately the majority of shippers will find themselves in a position where they either have to accept different BAF formulas from different carriers. Or, if the carriers fail in getting the BAF through (which is a distinct risk), the shippers will be in a situation where contracts without BAF are exceedingly unlikely to be of value if the carriers suddenly face a 10 billion $ loss – and consequently the concept of having a contract rate will cease to have meaning and instead it will be a de facto spot market.
I can certainly sympathise with the BCOs wanting a specific BAF for their specific business, but realistically this is only an option for a few very large BCOs.
Finally, let us not forget that it is not many years ago that the bunker fuel price was at 700 $/ton. At that point in time freight rates were higher, and carriers did indeed charge BAF in accordance with different BAF formulas. The only thing that is different this time around is that we are now expecting the jump in price to take place, and the market players have time to prepare for the transition.
Lars Jensen, CEO SeaIntelligence Consulting. Lars Jensen has 18 years of experience in the container shipping industry. This covers a combined period of eight years as director of driving and developing market intelligence and analysis for Maersk Line, Maersk Logistics and The Containership Company. Additionally he has for two years been CEO of the purely online container carrier Youship, while also developing and implementing eCommerce strategy in Maersk Line. He holds a Ph.D. in complex mathematical analysis in physics and has worked with technological innovation and modelling in the Oil & Gas industry.