Supply and Demand for Shipping Freight

The price dynamics in the shipping freight market is rather complex and needs a detailed description, as the dynamics may affect the results from regression analyses. Stopford (2008, p. 115) argues that ten variables can describe the demand and supply side in the shipping market. These variables are presented in the table below:

Table 4 Ten Variables in the Shipping Market Model

Ten variables in shipping market model

Demand Supply

1. The world economy 1. World fleet

2. Seaborne commodity trades 2. Fleet productivity

3. Average haul 3. Shipbuilding production

4. Political events 4. Scrapping and losses

5. Transport costs 5. Freight rates

This table is adapted from Stopford (2008, p. 115)

The demand curve is characterized as inelastic for a given level of demand, because goods need to be transported from A to B almost regardless of the costs. The demand level can be explained by the five variables for demand listed in Table 4. Since 90% of world trade is done by ship transportation, a change in the growth rate of the world economy will severely affect the demand for seaborne transport. The shipping transportation industry is highly influenced by the business cycles, and these will lay the foundation of the shipping market cycles²². The shipping industry also relies on the global trading pattern. The rise of the Chinese economy might change the traditional routes, leading to a permanent shift in the demand curve. The

20 For a graphical illustration of crude oil qualities please see

http://www.chevron.com/products/sitelets/pascagoula/refiningprocess/distillationcolumn.html.

21 Centistokes is a measure of the viscosity (”thickness”) of the fuel oil.

22 Shipping cycles was introduced by Stopford (2008) and refers to the business cycles experienced in shipping.

demand for seaborne trade is also sensitive to political events such as wars and other political

“revolutions”, e.g. various wars between Israel and Egypt have temporarily closed the Suez Canal.

The supply side of the shipping market is influenced by the limitations in the world fleet in the short time horizon. If the capacity utilization moves against maximum, the need for newbuildings rises. Normally, it takes between 2-3 years before an ordered vessel is finalized²³. This time-lag leads to shorter periods of spiking freight rates. However, when the newbuildings enter the freight market, the rates are expected to drop. The supply of seaborne transport also relies on fleet productivity, where new technology can make the ships faster and the port time lower. Technology also affects the production of ships. Better production facilities might lower the delivery time on new ordered vessels.

Stopford (2008, p. 146) presents a diagram explaining the supply and demand for freight rates. A modified version of this diagram is presented below:

Figure 2 Supply and Demand Curves in the Shipping Market in the Case of Low Utilization

Figure 2 illustrates a situation where there is a lot of free capacity. The size of the total fleet of ships available is far greater than the demand, and the prices for freight are therefore rather low. Assume now a demand shock which causes the demand to shift from D1 to D2. The total use of ships measured in dwt moves from M1 to M2. The change in the price of freight is

23An analogy can be made to the housing market where the supply-curve in the short-run shares similarities with the shipping market. Construction of new houses takes time and will therefore cause short-term spikes in the housing prices.

comparatively small, increasing from P1 to P2. If the utilization had been higher, a proper illustration would look like Figure 3.

Figure 3 Supply and Demand Curves in the Shipping Market in the Case of High Utilization

Figure 3 clearly shows that a demand shock at the same size as the one described above will give a higher impact on the price if the utilization is higher. This is due to the convexity of the supply curve. When the demand increases from D1 to D2, the demand moves closer to the maximum capacity of the total fleet of ships. In the short term the total number of ships will be constant, and this will, combined with the inelastic demand curve, increase the price dramatically. When the agents in the shipping market discover the high demand for seaborne transport they will order newbuildings from the ship yard. As mentioned, the delivery time for a new ship is normally between 2-3 years. Therefore it will take time before the level of supply and demand reaches a long-term equilibrium. Figure 4 shows how the supply curve shifts to the right when the newbuildings enter the market.

Figure 4 Increased Supply Due to Newbuildings

The introduction of newbuildings makes the price drop back to levels that might be even lower than the long-term equilibrium. The long-term equilibrium is indicated by supply curve where the world fleet is constantly changing. In the long-term, the supply will meet the demand in such way that the price is equal to the marginal cost. When the utilization again is low, this might cause lay-ups and a higher level of scrapping. This example briefly describes the shipping cycle. The interaction between the four shipping markets is easy to see and the links to risk is sensible. The next section will go deeper in describing the key risks surrounding the shipping industry.