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EASTBOUND MARKET SHOWS HEALTHY GROWTH AMID UNCERTAINTY

Fuel, equipment and intermodal costs continue to drive pricing.

A breakdown in cargo data collection at U.S. ports has made transpacific demand difficult to track throughout 2007, but it appears that Asia-U.S. container traffic grew on the order of 6.9% in the first half of the year, rising to around 8% for the first nine months, relative to the same period in 2006. Analyst forecasts predict, on average, similar or slightly higher cargo growth for 2008.

That's slower than the 9.6% growth posted for the full year 2006 (to 6.5 million 40-foot containers), but it nonetheless reflects considerable resilience among U.S. consumers, amid uncertainty over subprime mortgages, home values, tightening credit, high gas prices and a weak dollar.

Consumer confidence fell steadily in fourth quarter 2007, but largely based on pessimism about the economic environment six months out, not the current situation. As a result, spending has been slower this year, but hardly anemic. Retail sales growth forecasts, most in the 3-4% range, may turn out to be understated if job and wage growth remain slow but steady, disposable income and household net worth continue to improve, and the Federal Reserve decides inflation is a secondary concern for now and either leaves unchanged or lowers interest rates.

Predictably, imports of home furnishings and do-it-yourself home and garden supplies have slowed in the second half of 2007, as did construction materials. Toys were additionally hurt, to an extent, by product safety concerns but those sales have shifted in part to other market segments such as electronic games. Apparel imports remain strong, especially in the upmarket and teen categories. Home electronics, computers and health care products - most made in Asia - continue to report increased shipments.

Problem mortgages, compounded by securitization and sellling on of those assets, places an ongoing drag on the U.S. economy, but global markets are picking up the slack. U.S. firms with global exposure are likely to avoid recessionary impacts, as will their employees. At the same time, a weak dollar has driven significant export growth. Even if the U.S. sneezes, Asia is unlikely to catch the cold: the Asian Development Bank has upgraded its forecast for GDP growth throughout the region, based on expanding domestic markets and increased Europe trade.

Supply-Demand in Balance

Most credible industry analyst reports predict effective vessel capacity through 2008 within 1-2% of cargo demand in the transpacific market - a marked contrast to significant overcapacity seen in previous years. There are several reasons for this, despite a global market in which reported container ship tonnage has grown by 12-15% annually in recent years.

Analysts now widely acknowledge that rated vessel carrying capacity - the maximum number of containers that can be loaded onto a ship as rated and expressed in 20-foot container equivalents (TEUs) by shipyards building those vessels - is typically inflated. No 8,000-TEU ship will ever carry 8,000 20-foot containers. Capacity is moderated by multiple operational factors - the mix of container sizes aboard ship; balancing and weight limitations; visibility from the ship's bridge; load and discharge sequence; berth and channel drafts at most U.S. ports, and so on.

New 8,000-TEU, 10,000-TEU and larger ships being delivered to global carriers are not deployed in the transpacific market, but rather to the Asia-Europe and intra-Asia trade lanes, where demand growth is much higher and ports have the berth drafts and yard capacity to handle the larger vessels. The average vessel size deployed in transpacific service is 6,200-TEU, typically carrying fewer than 3,000 containers, due to port and terminal constraints. Average vessel size through the Panama Canal to the East Coast is even smaller - no more than a 4,500-TEU capacity, carrying fewer than 2,000 containers.

It will be at least another 3 years before U.S. port terminals raise their productivity from the current 5,000 TEU per acre per year capability to the 10,000+ needed to match current productivity levels at Asian ports and effectively handle import cargo growth expected over time. The Panama Canal is currently operating at or near capacity and is on a container ship reservation system that also commands premium transit fee pricing. U.S. railroads are insisting that they will not fund costly new network improvements - double track, locomotives, switching, inland yard expansions - that cannot either pay for themselves through the pricing structure or for which they cannot receive public support such as investment tax credits.

TSA lines anticipate a combined capacity increase of less than 4% in 2008 over 2007, much of that as new ships are deployed in Asia-Europe and intra-Asia, replacing smaller owned or chartered ships that are cascaded into the Pacific.

Cost Concerns

Transpacific container lines foresee a minimum 7% increase in basic operating costs in 2007, on top of an 8% increase that went mostly unrecovered in 2006. And that does not include marine fuel costs, which rose from an average $295 per ton at the beginning of 2007, to more than $500 per ton in November. Fuel today accounts for 50-60% of total transpacific sailing costs.

Long-term intermodal rail contracts signed in the late 1980s and early 1990s have come up for renewal. Intermodal has become the largest, and fastest-growing segment of rail business, surpassing even coal. It is also the costliest in terms of demand on rail service networks, and that has led to contract renewals at intermodal rail rates 25-40% abover previous levels. Most contracts are up for renewal in the 2005-08 period.

The trucking sector, meanwhile, continues to experience driver shortages and owner-operators leaving the business as hours of service and environmental restrictions add to cost burdens relative to low pay, especially for harbor-area and local shorthaul truckers. As the industry conslolidates, larger companies and unions have filled the vacuum left by the owner-operators and have raised trucking charges by 25% or more since 2005.

Higher intermodal costs are compounded by cargo and equipment imbalances. At the beginning of 2007, the ratio of import containers from Asia to outbound export loads was 2.8:1, meaning nearly three containers arrived at U.S. ports and traveled locally or moved inland for every one loaded return to Asia. As many as one in four containers moving through any major U.S. container port at a given time was empty, requiring the same documentation, handling and other costs as a loaded container but with no offsetting revenue. That situation has eased somewhat, as imports have slowed and favorable exchange rates have encouraged export growth. But the ratio is still likely around 2.5:1, incurring significant costs to retrieve empty containers from inland U.S. locations and reposition them to Asia where they are needed.

In this context, congestion becomes an even more pressing issue. Ocean carriers, terminals and railroads have all reduced free time allowances and raised detention and demurrage charges, to discourage cargo and equipment sitting too long in one place while in transit. And in Southern California, the PierPass incentive program to move cargo out of terminal areas at off-peak hours is complicated by a large number of shipper facilities unable to receive freight at night. These steps have improved terminal and rail yard utilization greatly, reducing much of the gridlock seen in 2004-05, but it has increased pressures on railroads to build inland trains more quickly, and it has spiked demand - and prices - for local trucking and warehouse services.

Several other potentially major cost elements are unknown at this time: Cargo security compliance, as cargo scanning, harbor worker identification cards, radio frequency identification and other technologies are mandated and rolled out; environmental compliance as vessels, trucks and yard equipment switch to cleaner fuels and electric power; and continued development of information systems to manage shipment visibility and time-definite services.

Marine fuel costs, as mentioned, have risen by 40% in 2007 alone. At more than half the total operating cost of a sailing, that means a 20% increase in operating overhead relating solely to fuel. Prior to the rapid rise in fuel prices, individual carriers had at times mitigated TSA fuel surcharge benchmarks which tracked monthly price fluctuations at key transpacific loading ports. Over time it became difficult to reintroduce the concept of a separate bunker fuel surcharge allowed to float over the term of a service contract, in accordance with the TSA formula. But as rising fuel prices threaten to influence service decisions, lines are now insisting on breaking out the bunker surcharge from base freight rates and allowing it to adjust automatically over the contract term in order to recover fuel costs more quickly as they rise - and return savings to customers more quickly, as prices fall.

Addressing these costs are critical as ocean carriers continue to advance in the direction of time-definite service, expanded port calls, service and equipment guarantees and real-time supply chain visibitlity that customers are demanding in the Asia-U.S. market.

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