Why do index-linked contracts fail in ocean container shipping?

This series of blogs by Erik Devetak – Xeneta Chief Technology and Data Officer – will explore key reasons for failed index-linked contracts, but more importantly, how you can guard against adding to this list of failures.

The series will begin with “The Delayed Index”.

Xeneta has been helping shippers and service providers deliver successful index-linked contracts for more than a decade. This experience has taught us what makes an index-linked contract successful - but also why some are doomed to failure before the ink is dry.

An introduction to failed index-linked contracts

Index-linked contracts have become more popular in recent years thanks largely to massive market volatility since the Covid-19 pandemic. This is a very effective option for many supplier-shipper partnerships – but like any freight contract, when they fail it is both extremely costly and highly disruptive.

This series of blogs will explore the finer details of failed contracts with examples, but, fundamentally, the most common cause is ironically the most easily avoidable…

Index-linked contracts are doomed to failure if they do not have robust, clearly-defined parameters tracking against a reliable index.

Put simply, if an index-linked contract does not follow the market in this way, there will always be an incentive for one side or the other to push back against the freight rates being paid

A bold statement – delayed indexes will result in failure

There is good reason why “The Delayed Index” is chosen as the first theme in this series of blogs.

Here is a bold, yet simple and inarguable, statement – delayed indexes always fail.

Always.

A delay of one day is not a problem. A few days? Still most likely not an issue. But some indexes are delayed by weeks or months, undermining the fundamental principal of these agreements tracking the market in a fair and transparent way for all parties.

The reason for the delay is irrelevant. There could be understandable and unavoidable limitations to the index, but the end result is the same – a failed contract. If the price adjustment is lagging significantly, certainly by more than a week, this will cause friction between the parties that eventually leads to a complete breakdown in the agreement.

Delayed index failure – an example

To understand why a delayed index is terminal for these kind of agreements, let us build a simple model.

Assume a shipper has two possible ways of procuring ocean container freight - either on the spot/FAK market or with an index-linked contract. For the purposes of this model, the index-linked contract should be just a perfect representation of the spot market.

In a scenario where the index is not delayed, the buyer has no incentive to use the FAK rates. On the contrary, by following the index-linked contract, the buyer most likely achieves lower operational costs and quite possibly a more significant discount versus the spot market.

In a scenario where the index methodology is delayed, the index contract will have a very different price from the FAK rates.

The buyer always has an incentive to buy the lower of the two prices, whether that is on the index-linked contract or FAK rates. In a falling market, the buyer will look to spot/FAK rates, while in times of escalating FAK rates they will revert to the lagging index-linked rates.

The end result is a good deal for the buyer and a bad deal for the seller. But this is not how index-linked contacts should be viewed.

The truth is that, quite quickly, the seller will need to either raise the prices or walk away from the deal.

If either party perceive an index-linked contract to be unfair and not financially beneficial, how can it survive?

That is why this blog started with a bold statement - the deal will fail as either the seller will walk away or it will raise prices and the shipper will not want to commit any volume on an index that appears to have significantly higher prices than what can be achieved on FAK markets.

Life is never simple – and neither are index-linked contracts

Of course, the reality is not as clear cut as a hypothetical example in a blog. Buyers are unlikely to switch all their volume from one contract to another overnight, but they will adjust allocations.

This is how and why delayed indexes slowly and silently fail.

When you are signing an index linked contract make sure you choose an on-time and real-time index like Xeneta as your reference.

Leading shippers have moved on from RFQs. They use Xeneta Indexing to test contracts before signing, cut renegotiations, reduce disputes, and protect margins in volatile markets. See what indexing delivers on your lanes. Discover more about Xeneta Index Linked Contracts.