Chartering Strategy in Liner Shipping Companies

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1 Journal of Shipping and Ocean Engineering 4 (2014) D DAVID PUBLISHING Ken Chow 1 and Yui Yip Lau 2 1. Parakou Shipping Ltd, Hong Kong 99907, China 2. Hong Kong Community College, The Hong Kong Polytechnic University, Hong Kong 99907, China Abstract: In recent years, the world economic situation and container shipping industry has been fluctuated drastically, which has complicated the liner shipping companies operation. The conventional issue of overcapacity due to the equipment battle, and the destructive competition have further stimulated the operating intricacy within the container sector. That would be interesting to explore the chartering strategies of CMA CGM (Compagnie Maritime d Affrètement Compagnie Générale Maritime) in such a volatile market as any capacity adjustment dictates a line s profit line. Nevertheless, the usefulness of ship chartering is not only confined to the operational level but also the strategic level. Throughout the analysis of CMA CGM s fleet trend, fleet deployment as well as chartering activities, it can illustrate the above concepts and observe a little bit further about the strategic movement of CMA CGM. Key words: Chartering strategies, CMA CGM, capacity adjustment, liner shipping companies. 1. Introduction Shipping is defined as a mode of transport to move cargo between two geographical points. Shipping can be named as one of the world s most internationalized industries [1]. Since the 1960s, shipping is fundamentally transformed by intermodalism, technological innovations, complex supply chain management and the expansion of international trade [2]. In general, shipping is divided into tramp shipping and liner shipping. Liner shipping is a capital intensive industry. LSCs (liner shipping companies) need to invest large capital in their vessels, containers and equipments, as well as bear high operating cost including insurance, maintenance & repair, stores & consumables and manning. Additionally, liner operations need a minimum number of ships to operate, as well as the cargo volume is determined by macro-environment. Thus, LSCs are easy to suffer a loss and take a high risk of operations [3, 4]. From the economic perspective, liner shipping is Corresponding author: Yui Yip Lau, MSc, research fields: maritime transport, port planning and maritime education. classified as the oligopolistic market structure which is characterized by the existence of a few sellers and inter-firm rivalry [5]. According to Ref. [4], other characteristics of the oligopolistic liner shipping industry include (1) high entry barriers to new comers due to huge capital investment; (2) little difference in service; and (3) a few carriers that account for the majority of total supply. Recently, LSCs has significantly increased attention from global traders, trade associations and government [5]. Ref. [4] pointed out that there were two contemporary issues that need to be explored in the liner shipping area. One argument is that the LSCs face intense competition in the globalized liner shipping market. The other point is the over-capacity. The over-capacity leads to lower freight rates. As a result, the liner shipping is characterized by low profit margin due to over-capacity. The level of capacity utilization depends on the growth of containerized cargo, the speed with which existing operators introduce new and larger vessels into liner shipping service, and the level of exits of operators from the market [4]. The economy-sensitive industry like container

2 186 shipping, of course, has witnessed the overwhelming volatility in the market. In-between, emerging economies such as Asia has experienced a tremendous expansion in container trade. The container export volume of Asia, on average in is almost 2.6 times than that of Europe and North America. Hence, Asia is turning into another major shipping centre. On the other side, although the import volume is much weaker in Europe, it maintains a steady growth pattern amongst Most of LSCs have implemented different strategies to cope with unpredictable and challengeable business environment. LSCs generate the profitability and hedge the risk through the appropriate chartering strategy at the right time. In the shipping business, chartering is the interaction between the charterer and the ship owner. In order to maintain the vessel in a good order and condition, the charter [5] has summarized six key chartering policy in the liner market including (1) provision of high quality transport services; (2) compliance of a shipping company with international regulations of safety management; (3) reputation and image of the ship-owner in the market; (4) low cost sea transport operations; (5) satisfactory cooperation with personnel and crew; and (6) sound information system for shippers. 2. Case Investigation In this paper, we illustrate CMA CGM (Compagnie Maritime d Affrètement Compagnie Générale Maritime) as our case study to discuss how the LSCs adopt the appropriate chartering strategies in a dynamic shipping market. CMA CGM is the world s third largest container shipping group and number one in France. By now, CMA CGM is operating over 170 shipping lines, 650 offices and agencies in more than 150 countries. The business network of CMA CGM is truly global with core focus on Europe Far East, Africa, Far East North America and Latin America trades (source: The following table shows the competition relationships in LSCs. In our study, we assume T or S represent the possibility of the increase or decrease on the value of the chosen strategy, it either will be positive (T) or negative (S). The above decision matrix provides the possible consequence of CMA CGM s chartering decision and other LSCs chartering decision. If CMA CGM increases the (both chartering in and new building), and the rest of LSCs (here we define the market s aggregate net increase in percentage of TEUs (twenty-foot equivalent units) capacity) go in the same way, the market freight will fall due to the oversupply of capacity. This phenomenon can be reflected from the circumstance that LSCs order the new vessels 2 years in advance. It was predicted that there will be significant increase in cargo volume. Thus, LSCs placed a large number of vessels so as to grasp the opportunity. However, the increasing rate of cargo volume is lower than LSCs expectation. As a result, supply has increased while freight rate has decreased. This consequence (P) leads to lose-lose situation for both parties as costs have to be casted to the additional capacity, as well as freight rate decreased. It would be considered to be the worse combination in a loss of profit. Another possible consequence is that if one party increases the and the opponent decides to the opposite way, whosoever increases the capacity will gain the market share and the opponent will suffer. (T > S) concluded that the market share has increased and the average cost has lowered which will be discussed on Fig. 1. Table 1 The competition relationships in LSCs. The rest of LSCs remain CMA CGM remains Freight rate and market share remain (R) CMA CGM market The rest of share decrease (S) LSCs increase Rest LSCs market share increase (T) CMA CGM increases CMA CGM market share increase (T) Rest LSCs market share lost (S) Supply increase/freight rate decrease (P)

3 187 Fig. 1 Relationships between market share and the average cost 1. Furthermore, the increase of capacity lowered the average cost and thus contributed higher gross margin. From the microeconomics perspective, economies of scale are the cost advantages that LSCs achieve due to size. The fixed costs are spread out over more units of output because of a decreasing cost per unit of output as well as an increasing scale. LSCs operational efficiency is also significantly increased and thus, lower variable cost is attainted. For CMA s net value of the decision to increase capacity, we assume: The original market share of CMA = M The increased/additional market share = dm Total market share = Q The increased/additional capacity = dc The employment rate of increased capacity = y (> 0) It is therefore: 1 MR1 and AC1 represent the marginal cost and average cost before the increase of. MR2 and AC2 represent the marginal cost and average cost before the increase of ; In oligopoly, the market equilibrium will remain in E and therefore, the P is the gross revenue given the service provided in Q. D represents the demand curve in oligopoly which is also the average revenue; A represents the average cost before the increased given the service level in Q; B represents the average cost after the increased given the service level in Q. dm = dc y (1) The new market share of CMA to be : (M + dc y) P For CMA, the net value of increase capacity to be (T): NV CMA CGM 2 = (dc y + M) P M P (2) Moreover, for every unit increase of capacity, there shall be additional gross margin (the difference between A and B) For other LSCs, the net value to be decreased due to the increase of CMA s capacity (S): NVls 3 c = (Q (dc y + M)) P (Q M) P (3) It is observed that the option to increase capacity will gain additional value (which represented by the factor dc y P and the difference of A and B for the gross profit margin) where T is supposed to be optimistic option compared to S (which indicates that the option to be negative if any party choose not to increase capacity in elastic market). The last possible result is that when both parties decide not to increase the capacity, theoretically freight rate and market share will remain (R). In such case, the decision would be of no additionally positive and/or negative value. Understanding the above relation, it is believed that increase of the is the optimal chartering strategy for both parties (under elastic market) as it is the dominant decision under such circumstance. We assume the net value of the different consequence is in the following orders: Consequence of outcome: T > R > P > S The above order is based on the rationale that T and R represent the non-negative outcome in which T bears a positive value while R to be a neutral. In addition, P and S represent options in negative value in which P is believed to be with a less harmful effect than S as the negative effect will be shared by all 2 NV (net value) of CMA CGM after the increase of. 3 NV of other liner shipping company.

4 188 parties while S represents a specific party absorbs all the impacts. For any parties the decision of not to increase capacity the net value will be: NV = S + R (4) As the decision may cause two possible results, namely, either lose market share (if other parties increase the capacity) or the market share remain unchanged (if other parties remain the capacity unchanged). It is the combination of expected value of the decision. For any parties, the net value of increasing capacity decison will be: NV = T + P (5) As the decision may cause two possible results, namely, either gain market share (if other parties remain the capacity unchanged) or freight rate decrease (if other parties increase the capacity). It is the combination of expected value of the decision. Since T + P > S + R, it seems that increasing capacity will be the optimal result for any individual shipping line. Moreover, both parties are assumed to be maximizing its profit and they assume the component doing the same way. The above formula will be rewritten as followings: For any parties, the net value of increasing capacity decision will be (given that the opponent will always choose to increase capacity): NV = S (the possibility of remaining capacity unchanged excluded) For any parties, the net value of increasing capacity decision will be (given that the opponent will always choose to increase capacity): NV = P (the possibility of remaining capacity unchanged excluded) Since P > S, the choice of increasing market capacity will be the dominant strategy for CMA, and it is a Nash Equilibrium for the liner shipping for the current market. CMA CGM needs to increase capacity because the opponents are increasing capacity, in order to prevent losing market share, boost capacity is needed. The above discussion is supported by the Fig. 2. The last chartering strategy we found for CMA CGM is that large size vessel is preferred to be operated in CMA CGM s fleet. In the recent and future market, we believe the supply of the vessel will keep increasing in order to capture market share. Fig. 2 Change in capacity operated: Nov. vs Jan (Source: Ref. [1]).

5 189 For the cost, it is well recognized that larger vessel can lower down the cost, and thus increase the profit, but the story is not put to end at this point, we shall take a look at the both sides of the coin. First we would like to present the market structure of ship chartering market, which is shown below in Fig. 3. In Fig. 3, we can see that at the beginning, the supply curve is very flat, standing for the minimum operating/running cost for vessels, if the hire rate is lower than that, ship-owner will choose to lay up the vessel rather than charter out. In the recent and future market, we believe the supply of vessel will keep increasing, the freight rate may go down to the flat part of the supply curve. The next point we would like to present is the relation between the vessel size and the operating/running cost. When operating a large vessel, the average cost will be lowered, as the same cost can be shared by more containers and vessel running cost, i.e. port dues, custom clearance, manning cost, insurance cost, etc., economies of scale will be achieved. It is believed that in a linear regression analysis, the relation between the vessel size and the operating/running cost will be as follows: dminclsm, t r = rclsm, t a2lsm, t dslsm, t r + µlsm, t r r = 1, 2,, t 1 where, dminclsm, t r = the change of minimum cost that ship-owner to charter out vessels and operate it in liner shipping market at time t r; rclsm, t = the running cost in liner shipping market at time t; a2lsm, t = the scale for the increase/decrease of size of vessels against dminc; dslsm, t r = the change of unit of enlargement of vessel in liner shipping market at time t r; µlsm, t r = the residual (here we define it as the uncontrollable factor to dminc). (Although we don t have any sample data for this regression analysis, we believe this relation makes sense, so the correlation coefficient R will be > 0.) Fig. 3 Demand and supply determines the number of chartered vessels. Fig. 4 Chartering out in adverse market.

6 190 In the above provided relationship, when CMA CGM is operating large size vessels, they may benefit from the size in the form of size factor (a2lsm, t dslsm, t r) In adverse market, vessels are needed to be chartered out in order to minimize running. LSCs can charter out their vessels in better price/priority. When the economic situation is favorable, LSCs can still operate the vessels in low operating/running cost. The Fig. 4 shows the advantage of operating large vessel in case chartering out in adverse market. As mentioned above, larger size of vessels have lower transport costs per unit of cargo. In the Fig. 4, the supply of larger vessels has shifted downwards. Green area represents the additional benefit, as well as the difference between market and large shipping supply generates the size of benefit (a2lsm, t dslsm, t r). Vice versa, smaller vessels encounter tougher condition under the same market. This drives the smaller vessels into lay-up at anchorage. In case the market is good in the future, CMA CGM can operate the large vessels to minimize the cost and maximize profit by achieving economies of scale. 3. Conclusions The observations above basically tell the intelligence of CMA CGM to compete in container shipping market via fleet management and chartering in recent years. Under the current fluctuating market, it could see the effectiveness of those strategies to maximize profit and minimize loss at the right time, culminating in the outperformer of industry. Similar financial pattern is observed at CMA CGM s close rivals Maersk line. Probably it implies scale economies is not only manifested on cost saving, but also the growth of market power, which strengthens operator s earning ability from adjacent sectors and sustain the non-step improvement of operating fleet. Of course, the way of CMA CGM obtaining finance and the asset play would be other major sources to its prosperity. In the chartering practice, the decisions of ship owners are oriented to quality while the decisions of charterers are oriented to cost. During the chartering process, the charterer and ship owner involves exogenous factors and unpredictable risk (i.e., financial, social/psychological and political). Hence, charterer and ship owner implement the chartering policy in order to protect both parties interest and divide both parties roles and responsibilities [5]. In future, ship size will still be the major battlefield. The delivery of Maersk s Triple-E vessels in 2013 could prompt another storm like Daily Maersk at present moment. Market mechanism would be triggered to spin off the inefficient players. Nevertheless, CMA CGM would be the one enjoy the potential market consolidation in some future date but matching rival s act is also necessary to protect its territory. CMA CGM should keep increasing ship size and launch quasi- Daily Maersk service to join in the process of market mechanism. The outcome may be as fruitful as what Maersk expects: separating the shipping demand in high-paying and low-paying and so escape from the vicious cycle of container shipping market. References [1] Lun, Y. H. V., Lai, K. H., and Cheng, T. C. E Shipping and Transport Logistics. Singapore: McGraw Hill. [2] Lau, Y. Y., Ng, A. K. Y., Fu, X., and Li, K. X Evolution and Research Trends of Container Shipping. Maritime Policy & Management 40 (7): [3] Song, D. P., Zhang, J., Carter, J., Field, T., Marshall, J., Polak, J., Schumacher, K., Proshum, S. R., and Wood, J On Cost-Efficiency of the Global Container Shipping Network. Maritime Policy and Management 32 (1): [4] Yip, T. L., Lun, Y. H. V., and Lau, Y. Y Scale Diseconomies and Efficiencies of Liner Shipping. Maritime Policy and Management 39 (7): [5] Plomaritou, E. I., Plomaritou, V., and Giziakis, K Shipping Marketing & Customer Orientation: The Psychology & Buying Behavior of Charterer & Shipper in the Tramp & Liner Market. Management: Journal of Contemporary Management 16 (1):

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