Signals through the fog

Logistical disruptions are pushing apparent demand away from real demand, exacerbating the bull-whip effect

Over the past eight months, freight rates have risen rapidly. While bulk freight rates have risen too (in particular for the smaller ships), the increase is much sharper for containers, where spot prices have risen five to 10 times on some major routes. There is a shortage of container-ships as well as containers, and ship-building orders are surging.

This adds to the signals from surges in prices of coal, natural gas, steel, copper and aluminum in giving an impression of strong global demand for goods and of extreme shortages.

But while end-demand for goods has been above normal in the US, almost everywhere else it is well below pre-pandemic trends (we discussed this in an earlier Tessellatum: “The Food, the Switch and the Wardrobe”, June 1). Thus, not surprisingly, even though the US is more import dependent than others, container-shipping volumes globally are in line with prior trends, growing just above 3 per cent a year versus the non-coviddisrupted 2019. Even US retail sales are now correcting rapidly back to trend as consumption switches to services with mobility restrictions easing.

Freight rates generally move in-line with freight volumes, and while they do get disconnected occasionally, that is usually when capacities are close to full. Given meaningful spare capacity before the pandemic, this appears unlikely. So why then are we seeing these shortages? We believe this is because the number of trips a ship can make in a year has fallen.

Container-ships on average make around 7.4 trips a year: With a total carrying capacity of about 23 million TEUS (Twenty-foot Equivalent Units; a unit of measurement of container freight volumes), they carry 170 million TEUS annually. This implies that the average trip takes around 50 days. This has lengthened abruptly due to two reasons, in our view.

First, Covid-19 protocols at ports have meant several extra days while loading or unloading, as international travel rules necessitate testing of the ship’s crew. At some ports there can be two tests — once while entering the port and another before the ship goes to the dry dock — each taking up to two days even if all tests are negative. If a crew member tests positive, the lag extends. Further, some terminals at busy ports have had to temporarily close operations due to some employees getting affected by Covid-19, though most have restarted now. There are also restrictions placed on ships on the basis of the nationality of the crew manning the ship, and the last stop.

Second, while the growth in global container freight is not abnormal, its geographical spread has been so. In a normal year, 40 per cent of containers are destined for East Asia, and around 20 per cent each for Europe and North America. However, of the additional container volumes shipped in the first half this year, 45 per cent were headed to North America and 40 per cent to Europe. As the fiscal handouts given by the US and the EU are much larger than elsewhere, this is not surprising, but has pressured some ports more than others. With the American West Coast being the closest to East Asia from a sea-shipping perspective, the ports at Los Angeles and San Francisco are the most overloaded, even as East Coast ports are less congested. Shipping routes like Shanghai-to-rotterdam and Shanghai-to-los Angeles are seeing the steepest increases in freight-rates.

This skew has also created a problem of movement of empty containers back to where they can be filled up again. Los Angeles, for example, has seen imports spike even as exports decline, necessitating abnormally high handling of empty containers. A shortage of in-land logistical capacity in the US has also meant that empty containers are getting stranded away from ports, and thus going temporarily out of circulation.

As a result of these factors, 30 per cent of container-ship capacity is currently anchored, versus just 20 per cent a year back. According to the latest Global Liner Performance report, vessel schedule reliability dropped to just 36 per cent in July, from an average around 80 per cent in 2019; average delays have now stretched to seven days, with several companies seeing lead times rise by two to six weeks.

For businesses in the US and the EU preparing for the important holiday season sales later this year, this uncertainty is triggering diversification of suppliers and double-and triple-ordering. When firms decide on the levels of inventory they need to hold, the “inter-arrival period”, or the time between two replenishing shipments, is an important factor (put simply, if a shop gets just one truck per month, it must hold inventory for at least a month’s sales). The uncertainty in shipping timelines can cause firms to try to hold more inventory than normal.

This is a classic intensification of the supplychain bull-whip, where apparent demand seen by upstream component and raw material suppliers disconnects completely from the downstream real demand for finished goods.

Like a melee caused when someone breaks a queue, this volatility has very few winners, if any. The confusing signals emerging in variables like inflation can trigger policy errors: For example, due to freight-rate hikes, goods with low-value-to-weight ratios are seeing costs rise 10-30 per cent, which if passed through, would account for 0.5 per cent of US inflation. For some goods, the hike in prices also means a drop in demand. The lack of containers or ships could mean component shortages, or worse, goods that do not reach the customer in time and thence lose value.

Shipping may remain disrupted for another six to nine months, until vaccines or infections cause a large enough population to have Covid-19 antibodies, the build-up for the late-2021 holiday season in the US and the EU ends, or countries coordinate to standardise regulations so the regulatory friction at ports eases. The regulations are ad hoc, keep changing as the spread of the Covid-19 variants ebbs and flows, and are out of the influence of international forums, imposed and enforced as they are by local/national governments.

Like ripples in a pond once a stone is thrown, volatility is likely to continue even after the freight disruption ends. An unwinding of the bull-whip is also disorderly, like seen in iron ore prices falling by $100 per tonne within a few weeks, and more recently, the prices of memory chips falling sharply. As the accumulated high-priced inventory passes through the supply-chain when current prices are lower, it can again cause heavy losses and disruption. Companies, investors as well as policymakers may need to keep these trends in mind as they chart a path through this fog.