International Maritime Organisation

International Maritime Organisation The impact of transport costs on trade Robin Smale Simon Baptist March 2011 robin.smale@vivideconomics.com +44 844 8000 254, +44 7823 329054

The effects of shipping costs on trade How shipping costs affect markets for iron ore, grain and oil economic impacts of cost increases on transport and product markets the impact on freight rates of higher bunker prices on selected routes Capesize iron ore shipping container shipping the impact of higher freight rates on selected trade and product markets iron ore in China a selection of other commodities and markets conclusions

The magnitude and distribution of impacts within and across markets can be described In the longer term a change in fuel costs will alter patterns of trade as the competitiveness of producers in different locations changes Figure 2 This illustration shows how the burden of costs is distributed for a fuel cost increase costs borne by consumers costs borne by overseas producers due to loss of quantity costs borne by ship owners costs borne by overseas producers due to loss of profit margin revenue raised or payments to fuel suppliers gains to overland producers due to change in quantity gains to overland producers due to change in profit margin Source: Vivid Economics 3

The cost pass-through of increased freight rates into product prices varies across products and markets This is driven by import market share, maritime cost share and the intensity of competition Factors that determine cost passthrough are: Table 2 Cost pass-through can range from around 10 per cent to over 100 per cent how freight rates respond to increased bunker price; share of maritime transport costs within product prices (a function of distance and efficiency); and the ability of maritime importers to pass on costs to local consumers in turn, this depends upon the share of imports in the local market, the cost structure of local and importing firms, and the intensity of competition Product market Wheat South Africa Cost passthrough (%) 10 40 Product market Iron ore China* Cost passthrough (%) Wheat Kenya 50 75 Furniture EU 60 90 Wheat Algeria Barley China 10 25 Rice Philippines 52 50 75 Apparel EU 10 40 5 20 Crude oil South Korea* Crude Oil US* 111 73 Maize Saudi Arabia 90 100 *the estimates for these markets were made with a detailed quantitative model, while the others are estimates based on market research Source: Vivid Economics 4

The effects of shipping costs on trade How shipping costs affect markets for iron ore, grain and oil economic impacts of fuel prices on transport and product markets the impact on freight rates of higher bunker price on selected routes Capesize iron ore shipping container shipping the impact of higher freight rates on selected trade and product markets iron ore in China a selection of other commodities and markets conclusions

Singapore bunker fuel price $/tonne Bunker price exhibits substantial volatility over time Figure 3 Bunker price generally rose until mid-2008 before falling sharply; bunker price for Singapore is presented and the relationship is similar for other bunker sources 700 600 500 400 300 200 100 1990 1995 2000 2005 2010 Date Source: Vivid Economics and Clarksons data 6

Capesize ore freight rate $/tonne The spot freight rate on the Brazil to China iron ore route peaked in 2008 Figure 4 Volatility in spot iron ore freight rates has been increasing over time and movements in freight rates are similar across routes, suggesting a global market for Capesize vessels 100 80 60 Brazil to China 40 20 Australia to Rotterdam 1990 1995 2000 2005 2010 Date Source: Vivid Economics and Clarksons data 7

log Spot freight rate ($/tonne, Capesize Brazil to China) Higher bunker price is associated with higher spot freight rates on the Brazil to China iron ore route Figure 5 The relationship between spot freight rates and bunker price is positive but there is substantial volatility 4.5 4.0 3.5 3.0 2.5 2.0 1.5 4.0 4.5 5.0 5.5 6.0 6.5 log Bunker fuel price ($/tonne, Singapore) Source: Vivid Economics and Clarksons data 8

Container freight rate ($/TEU)/Bunker price ($/tonne) Container freight rates show a different pattern to the freight rates for bulk commodities Figure 6 Container freight rates on front-haul and back-haul routes do not always move in tandem 2000 Asia to EU 1500 1000 EU to Asia 500 Singapore bunker price 1993 1998 2003 2008 Source: Vivid Economics and UNCTAD data 9

log Spot container freight rate ($ per TEU, EU to Asia) Bunker price appears correlated with the EU to Asia container freight rate, but there is a lot of variation Figure 7 Bunker price appears to be a smaller influence on freight rates for containers than for the bulk commodities 7.0 6.8 6.6 6.4 4.5 5.0 5.5 6.0 6.5 log Bunker fuel price ($/tonne, Singapore) Source: Vivid Economics and Clarksons data 10

The elasticity of the freight rate to bunker price is found to differ across shipping markets It is estimated using statistical analysis of past data the equations as estimated include a range of other variables in addition to fuel price global fleet size for the relevant vessel type = shipping supply total global trade in the cargo = demand for shipping volume of trade on connected container routes climatic effects for grain markets Table 1 Shipping market A 10 per cent increase in the fuel price would increase the selected freight rates by between one and ten per cent Vivid Economics estimates (average for all routes) UNCTAD estimates Panamax grain 0.19 N/A Capesize ore 0.96 1.00 Containers 0.12 0.19-0.36 VLCC 0.37 0.28 Source: Vivid Economics and UNCTAD (2010) 11

Domestic production accounts for two-thirds of the Chinese crude iron ore market by weight The low iron content of domestic ore means China is nevertheless dependent on imported ore for half of its iron requirements Figure 8 Proportion of Chinese market for non-agglomerated iron ore by producer country, average 2005 07 gross weight adjusted for metal content 2% 15% 3% 21% 66% 8% 8% 1% 50% 12% Australia India Brazil South Africa Iran Russia China Land producers Other 12% 2% Source: UNSD COMTRADE database, US Geological Survey 13

Large firms, both domestic and foreign, supply most of the Chinese iron ore market Chinese state-owned enterprises as a whole hold a larger market share than any foreign company The three largest iron ore producers account for about a third of the Chinese market and half of imports. Rio Tinto is the largest private supplier to the Chinese market. Figure 9 Proportion of Chinese market for non-agglomerated iron ore (adjusted for metal content) by controlling interest 14% 24% 25% 48% 16% 7% 12% 9% Rio Tinto (Australia) Vale (Brazil) BHP Billiton (Aus & Brazil) Chinese state-owned Chinese collective and private Other foreign 15% 30% Source: InfoMine, UNSD COMTRADE database, US Geological Survey. Note proportions are estimated from aggregate import figures due to lack of data on destination of production from individual mines and companies. 14

It costs around twice as much to ship ore to China from Brazil than from India or Australia Chinese iron ore has a much lower metal content than imported ore Table 5 Freight rates for iron ore are converted into an equivalent freight rate per tonne of metal Country of origin Clarksons freight rate to China ($ per tonne) (2005 to 2007 average) Metal content of ore (%) Implied freight rate ($ per tonne of metal) Australia 16.26 62.5 26.02 Brazil 38.83 65.9 58.92 China - 32.9 - India 20.18 64.0 31.53 Iran 22 (assumed) 48.2 45.64 Rest of the World 35 (assumed) 58.9 59.44 South Africa 27.12 63.2 42.91 Source: Vivid Economics calculations from Clarksons and the US Geological Survey data 15

Cost pass-through of increased shipping costs is estimated to be between 50 and 60 per cent Chinese producers increase their market share by around 13 per cent Table 6 A 10 per cent rise in the cost of bunker fuels increases the average freight rate to China by around $3 per tonne of metal Initial Final Change Spot market including Chinese state-owned firms Market Size (million tonnes p.a.) 412.3 407.7-1.13% Price ($ per tonne) 111.9 113.5 1.42% Domestic market share 46.0% 59.6% 13.64% Land-based market share 46.3% 60.2% 13.92% Sea-based import market share 53.7% 39.8% -13.92% Average added cost for sea importers ($ per tonne) Cost pass-through for sea importers 3.07 51.7% Source: Vivid Economics calculations 16

Profit margins for foreign producers fall by up to $3 per tonne of metal, while those for Chinese producers rise by around $1.50 Foreign producers with less production and which are further away suffer greater falls in export sales Table 7 Reductions in profit margins are smaller but those in export volumes are larger if state-owned Chinese firms do not participate in the spot market Origin Original market share (sales in China) Change in market share in percentage points Change in margin ($ per tonne of metal) Spot market including Chinese state-owned firms Australia 29.4% -0.9% -0.9 Brazil 8.3% -2.4% -4.1 China 46.0% +13.6% +1.6 India 11.2% -6.5% -1.4 Iran 0.4% -0.4% -2.8 Rest of the World 2.7% -2.7% -4.1 South Africa 1.6% -0.9% -2.7 Source: Vivid Economics calculations 17

Producers who are smaller and further away are more affected Australian producers suffer a smaller decrease in export sales and profit margins than Indian or Brazilian producers Indian firms suffer greater output losses than Australian or Brazilian ones because Indian mines are smaller and have higher costs Australian producers suffer smaller reductions in profit margins and output than Brazilian producers because of the shorter sea route most of the increase in Chinese production is because the small privately owned mines increase output aggressively as the rise in price improves their competitive position significantly as their original margins were very small if the small Chinese firms are not able to expand output, or if control of iron ore production in China is less diffuse than is presumed, then the impact on foreign producers will be less in the extreme case where small Chinese mines could not increase output, then cost passthrough would be close to 100 per cent and there would be minimal loss of Chinese sales in exporting countries 18

Higher fuel prices will change transport and trade patterns; with the extent of changes depending upon the market Any burden is shared between shippers, cargo producers and cargo consumers in different proportions across markets Table 8 Higher fuel prices will lead to higher freight rates, and some of this cost will be passed on in the form of higher product prices for the cargo carried Shipping market Elasticity of freight rates to bunker price Cost pass-through of freight rates into product prices market per cent pass-through Capesize ore 0.96 China iron ore 52 Containers 0.12 VLCC 0.37 Panamax grain 0.19 EU furniture 60-90 EU apparel 10-40 US crude oil 73 South Korea crude oil 111 Wheat South Africa 10 40 Wheat Kenya/Algeria 50 75 Barley China 10 25 Rice Philippines 5 20 Maize Saudi Arabia 90 100 Source: Vivid Economics calculations 20

Conclusions The impact of higher bunker fuel prices differs markedly across different cargo types and geographical markets a ten per cent increase in bunker fuel prices will increase freight rates by between one and ten per cent for the vessel types and routes which formed part of this study the rate of cost pass-through of higher freight rates into product prices ranges from nearly zero to over 100 per cent depending upon the nature of the market it is important to consider the competitive structure of the market under analysis and not assume that any increase in freight rates will be fully passed on to consumers long term changes in the price of fuel will lead to shifts in the global pattern of trade and the demand for shipping; although in many cases the magnitude of the impact will be small 21