Remarks by

Albert A. Pierce

Executive Director
Transpacific Stabilization Agreement (TSA)

before the
Footwear Traffic and Distribution Conference

Clearwater, FL / May 9, 2006

Long Beach, CA / March 6, 2006

Shipping lines saw remarkably strong cargo growth in the transpacific market during 2005, but not without operational and cost challenges. Container traffic grew 13.2%, from 5.2 million 40-foot containers (FEU) in 2004 to 5.9 million last year.

At the beginning of 2005 TSA took a very lonely position, forecasting 10-12% growth. Most industry analysts had forecast 7-8% and some predicted even slower growth – China’s economy would overheat… either its currency would collapse or protectionist sentiment in Congress would boil over… energy, steel shortages and domestic unrest would halt production… U.S. consumers would hit their credit limits, the housing bubble would burst, high fuel prices would keep them huddled around their heaters over the holidays.              

None of that happened. China trade appears to be moderating, as most of us assumed it eventually would. But the trend is toward slower growth, not decline. And the expected narrowing of our trade deficit will not come from fewer imports, but rather from increased exports. It’s worth noting that China’s first quarter economic growth exceeded earlier government forecasts.                

China export growth to the U.S. has in fact slowed – to a “mere” 3.7 million FEU, roughly 63% of the total transpacific market. Shipments this year were up “only” 23.5% from 2004. The momentum hasn’t stopped in 2006, either. PIERS figures for the first two months of the year show 20% average cargo growth from Asia and 24% from mainland China. Add in Hong Kong lifts and the figures are even higher. Four months into the year, TSA member lines were reporting utilization in the mid-90 percent range on the West Coast and close to full utilization through the Panama Canal.          

In recent months, Beijing has dialed back on new plant approvals and raw materials imports, shifting its focus from export promotion to encouraging domestic demand and public spending on infrastructure, environmental mitigation and housing construction. These are healthy steps aimed at keeping the export economy from overheating, and looking beyond exports for job creation. They do not alter the new baseline that has been established for cargo demand out of China.   

Southeast Asia, meanwhile, has taken over some low-end manufacturing such as apparel, footwear, furniture, plastic plumbing fixtures and appliances, and exports from Malaysia, Indonesia, Vietnam and the Philippines have posted healthy growth. Japan and Korea have also begun to increase exports of automotive products, electronics and telecommunications, paper products, specialty chemicals and other products. Declines posted by Hong Kong and Taiwan reflect the ongoing migration of heavy industries in those countries to mainland China.               

The $64 billion question, you might say, involves U.S. demand. Admittedly, the American consumer could look better on paper. The nation’s savings rate is minus 0.7%. Combined U.S. household debt is $11.4 trillion, almost 19% of total household income. The government isn’t doing much better, with a $318 billion budget deficit that’s 2.6% of GDP, and a $726 billion trade deficit that’s 5.8% of GDP. The U.S. trade deficit with China alone in 2005 reached $202 billion, and China holds an estimated $265 billion in dollar-denominated debt.              

There is a bright side, however: First quarter 2006 retail sales were up more than 8% over January-March 2005 totals. April Consumer confidence reached the highest level in four years despite high fuel prices, and business spending growth is on the rise. Unemployment is at 4.7%, interest rates and inflation remain manageable and the Fed may tighten rates once more at most this year.

As to concerns about the housing market: Rising home prices and low interest rates prompted homeowners to extract more than $600 billion in equity during 2004 and 2005, through refinancing. They only spent about a third of that, however. And when they spent it was on second homes… on improvements and expansions that added value to their existing homes, including home furnishings, consumer electronics, building supplies and other major imports from Asia… and on paying off higher interest credit cards.              

From all indications we’re seeing, consumers are slowing down… they’re looking for value… they’re paying cash… but they’re not necessarily finished.

That is why China is planning and building port capacity to handle 130 million TEU by 2020, and is halfway through a program to complete a 55,000-mile national highway system linking inland and coastal regions. It’s behind the consolidation and intense global competition among port terminal operators in Asia, the Indian Subcontinent, Panama, Mexico and the U.S. Gulf Coast. And it’s why global container carriers are adding new ship capacity for the future.               

A relatively small number of ships in the 8,000-TEU range have been delivered so far, with more to follow over 2006-2008. All will be deployed in the east-west trade lanes, mainly the transpacific and Asia-Europe. Some analysts and press reports have suggested the potential for considerable overcapacity in the Pacific. To get to that assumption, you have to believe first that cargo demand will slow markedly, and second that an 8,000-TEU ship can – and must – sail close to full for the sailing to be profitable.

Most U.S. ports do not yet have the 50-foot channel and berth depths to receive an 8,000-TEU ship fully loaded today. Despite significant productivity improvement at U.S. port terminals, industry still has a long way to go before matching the 12,000-TEU per acre – or greater – throughput capacity of Asian ports. U.S. terminal operators have introduced automation and process changes, raising productivity to around 7,000 TEU per acre in the best cases.

Class I railroads in the U.S. have not allocated the locomotive, crew and rail car capacity needed to meet current intermodal growth trends. The margins are lower than for their coal, agricultural and other product lines that are also seeing growth; the volume of containers into and out of port corridors already creates network imbalances; and they are not yet able to efficiently allocate and share track among intermodal, passenger and carload rail traffic.

We’ve seen frequent rail embargoes out of port centers in both the U.S. and Canada… delays at on-dock rail facilities… and longer lead times to assemble longer trains for movement inland. At the same time, rail intermodal traffic overall grew 5.6% during 2005 but international container rail traffic grew by more than 7%. Nearly 8 million ISO marine containers moved inland via rail last year – 58% of total rail intermodal lifts. 

The intermodal supply chain in the U.S. is now so tight that any inland service disruption due to bad weather, a derailment, even a crew change in a remote area, can add days to the end-to-end transit time. New deepwater terminals, a wider Panama Canal, and expanded rail and highway access will ease these stresses over time, but those improvements are still years off.

Global carriers are looking for two advantages in the Pacific right now – scale and integration. We’re in the midst of a cycle of consolidation, whether through mergers and acquisitions or through reconfiguration and strengthening of alliances. This in turn is bringing about consolidation of terminal operators on a global scale, with a few large mega-carriers operating their own terminals to their own specifications, while large third-party operators may dedicate “common user” terminals to members of a particular alliance or other affiliated group of carriers.

Shippers can expect real benefits from this consolidation and from the new capacity coming onstream. Carriers have already made important productivity gains through load planning and sequencing… diversification of West Coast gateways, and expansion of all-water services… and participation in DC bypass and transload strategies to expedite inland cargo, lower shippers’ costs and better manage marine equipment. They’re working with accounts to offer new 10-day express service strings from more China ports, and to spread out shipments to off-peak times – of the day, of the week, of the year.

These improvements will likely, over time, form the basis of a new service standard for container shipping.  But they will not come cheap.

Transpacific container lines foresee a minimum 7% increase in overall operating costs in 2006. That includes a 25% increase in inland rail and truck costs, and an 11% increase in equipment repositioning costs. Ocean carriers, as lead logistics providers and customers of the railroads and motor carriers, will be directly exposed to much of the cost associated with inland intermodal transit – locomotives, crew, rail cars, new track and switching, tunnel and bridge clearances, fuel surcharges, truck replacements and retrofits,  rising truck driver salaries overall plus higher costs from hours of service rules, and so on.

They will also be paying to reposition record volumes of empty containers in a trade that is approaching a 3-to-1 imbalance in traffic favoring inbound cargo and equipment. Of the 20.6 million containers that moved through West Coast ports alone during 2005, more than 6 million of those were empty units. Most entered the U.S. loaded, from Asia. After delivery of the cargo, returning equipment incurs handling, local inland and port drayage, maintenance and repair, long haul rail transport and other costs.

As it now stands TSA lines believe effective vessel capacity in 2006-07, given the constraints I’ve outlined, will outpace cargo demand by no more than 3-4% overall. During the peak season that gap could vanish. We’ve tracked first quarter versus third quarter volumes for the past few years in an effort to measure peak season spikes. The average spike over 2001-2005 has been 26% and in 2005 it was 28%. That in turn triggers sharp increases in repositioning costs when equipment is needed most. In recent years it has also triggered rail and truck embargoes, as empty returns were competing for space with West Coast export and domestic bookings. The delays incur costs as well, if stranded containers must be stored, and new or leased containers be arranged in Asia.

While vessel charter and equipment leasing costs have leveled off in recent months, many container lines remain locked into three-year deals, at high rates and terms agreed to during an emergency situation. Finally, after securing chartered ships and leased equipment to meet customer demand for all-water services, carriers saw an immediate 37% jump in their roundtrip sailing costs through the Panama Canal last year. Last May the Canal Authority began assessing the same fees for westbound empty return equipment transiting the Canal as for eastbound loaded containers. Another fee increase took effect this month, and one more is scheduled for May 2007.

Drewry Shipping Consultants estimates that a 7% rise in operating costs could wipe as much as $700 million from carrier bottom lines in 2006. Add in the higher equipment and cargo handling costs from new vessels, service strings and a conservative 8% Asia-U.S. cargo volume growth, and the aggregate cost increase to carriers this year could reach $2.4 billion.   

Cost issues have been the primary focus of TSA lines during the past two years. Last year we charged a committee of the member lines to analyze cost trends in the transpacific, and we used the committee’s findings as the basis for an announced set of rate increases that varied by route segment. This year we went a step further: We ran a new analysis for 2006-07, and reported our estimate of minimal average cost impacts per container by route segment – $150 per FEU for West Coast and Group 4 shipments, $350 per FEU for intermodal moves, and $400 per FEU for all-water East Coast service.

We wanted to make it very clear that these dollar figures represented the known costs carriers would be facing in the coming year, before any profit – not a target general rate increase that is seen as a maximum to be bargained down. We also wanted to make the point that a number of unknown costs are on the horizon, such as the long-term costs of fee-based night gate programs at multiple ports, and future funding of large, public freight transport infrastructure projects.

Which brings me to the issue of surcharges. In the past several years carrier pricing has increasingly been split into two parts, base rates and ancillary charges. This is a less-than-perfect but practical solution to a thorny problem in our industry. When all of the various cost elements were folded into base rates, carriers would try to implement general rate increases based on rising costs.

Shippers, under mounting pressure from their corporate headquarters to trim transportation and logistics expenditures, demanded a breakout of these costs. How much were marine fuel prices rising? What effects were currency fluctuations having on local currency costs in Asia, relative to dollar-denominated freight rates? What were the terminal handling and documentation cost increases?

Some unanticipated costs had to be separated out, in charges for one-time occurrences in specific markets – labor stoppages, congestion, government fees and charges, and so on.

Over time, shippers have taken the reverse position that they want rate simplification and all-in charges. But for carriers, it’s a little late to put the genie back in the bottle.  Ancillary charges represent costs that continue to increase, and often on a volatile basis.  Without surcharge mechanisms, these costs could not be recovered effectively by carriers.  The alternative would be for carriers to build in high components for these costs which might or might not end up being accurate representations of the actual costs.

Fuel surcharges provide an obvious example. Container shipping is a high fixed cost business, and fuel is the number one cost component in a sailing. At the beginning of 2005 the per-ton price for marine fuel on world markets was $198. By mid-April 2006 it was $365, an increase of nearly 85% that added roughly $600,000 to the cost of a single transpacific sailing for a single carrier. Multiply that for the number of ships in a service string, the number of service strings per carrier, the number of carriers in the trade and, as was famously said once in a different context, “pretty soon you’re talking about real money.”

Last year TSA lines began assessing an inland fuel charge as their own internal inland transport and logistics costs increased and as rail, truck, port terminal and other partners began to feel the brunt of rising diesel fuel prices and began passing them on to ocean carriers. Average U.S. highway diesel fuel purchase prices, as tracked by the U.S. Department of Energy, began 2005 at $1.96 per gallon and, as of mid April 2006, reached $2.77, a 42% increase.

Beginning May 1 we moved to monthly adjustments of fuel surcharges, a move applauded by some customers and criticized by others. Those of you who have been in the industry long enough may recall that carriers did this in 1990 as well, when the first Gulf War and a halt in Iraqi supplies drove oil prices through the roof for a sustained period of time. If prices rise steadily over time and offsetting surcharges are adjusted quarterly, cost recovery never adequately keeps pace with the costs themselves – you’re always recovering the fuel prices of two to three months earlier. If the price rises are steep enough, costs can even begin to outpace the tiers of the calculation formula itself. And when prices begin to come down, and shippers see no relief until months later, it undermines the credibility of the surcharge.

Again, when you’re talking about thousands of sailings and millions of containers, the impacts of even small changes can be huge – especially in an industry characterized by high fixed costs, intense competition, and historic annual rates of return in the low single digits.

We simply don’t have a margin for error in today’s market. Some 90% of Asia-U.S. cargo moves under service contract; carriers can’t raise and lower all-in rates as costs dictate, yet costs must be quickly recovered as they surface. Fuel price spikes… rail and terminal free-time and detention… security compliance… terminal handling contracts… harbor and rail corridor user fees… extended gate hours programs… and a myriad of other cost elements on the horizon, simply can’t just be folded into the base rate structure.

Surcharges recover rapidly rising or unanticipated costs quickly for carriers, while keeping cost elements transparent for shippers. Let the market decide the value of container shipping services within the various commodity sectors – but let costs be recovered. The alternative is an erosion of service levels over time that will, unfortunately, be non-negotiable.

The transpacific supply chain is in a critical transitional phase. The flexible, integrated, efficient network we all envision is projected to be up and running late in this decade. Ocean carriers expect to play a key role in building and funding this network, but the cost must be equitably shared. Stay tuned.

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