What is a Bunker Hedge?
After my post on Forward Freight Agreements, someone sent me a message with a very good question:
“What if there is zero correlation between my freight route and any of the FFA markets?”
The honest answer is that you should not use an uncorrelated FFA simply because it is the closest contract available. That does not reduce your risk, it actually creates a speculative position.
However, it may still be possible to hedge part of the freight exposure. A meaningful component of the cost of moving a vessel is its fuel, known in shipping as bunkers.
A bunker swap is a financial derivative that allows a company to fix the benchmark price of marine fuel for a future period.
But “bunkers” is not one product, some of the main conventional bunker fuels include:
- VLSFO is very low sulphur fuel oil, with a maximum sulphur content of 0.50%.
- HSFO is high sulphur fuel oil, generally used by vessels fitted with scrubbers.
- LSMGO is low sulphur marine gas oil, typically containing no more than 0.10% sulphur and commonly used in Emission Control Areas.
The type of fuel used is an extremely important distinction.
Using the same example as yesterday - a trader needs to ship 20,000 mt of metal in three months, but no liquid FFA market correlates with the freight rate for that route.
They estimate that 400 mt of VLSFO exposure is embedded in the voyage cost and that the fuel will be priced against the Singapore index.
The Singapore 0.5% marine-fuel swap for that delivery month is trading at $600/mt, so the trader buys 400 mt at $600/mt. By the time the shipment takes place, the same benchmark averages $700/mt.
The higher bunker benchmark has added $40,000 to the voyage cost, but the swap has generates $40,000, offsetting that part of the increase.
If the total freight cost has risen by $70,000, the bunker hedge will not offset the remaining $30,000 caused by vessel availability, congestion, war-risk premiums or other route-specific factors. But this hedge wasn't designed to.
And if the vessel actually burns HSFO in Rotterdam, buying Singapore VLSFO wouldn't be the right hedge either. The fuel hedge therefore needs to match five things as closely as possible:
The fuel type, the location, the pricing period, the volume, and the price formula.
For container freight, this may mean matching the derivative to the shipping line's Bunker Adjustment Factor (BAF) formula rather than trying to estimate what the vessel itself will burn.
Too often freight volatility is accepted as an unavoidable part of physical trading. While you may not be able to hedge the entire exposure, that doesn't mean you should ignore the part that you can.
