The FFA Article (Forward Freight Agreements) Over the past two years, as the tanker and drybulk

shipping segments have moved to historically strong levels and remained firm, the long inchoate paper markets are beginning to blossom. Now, as traditional hedgers and speculators from the business have grown the markets, professionals from both the hedge fund and structured commodity financiers are taking a fresh look at a market that has been around since the mid 1990s. The dramatic growth is due to both a market strengthening, but, equally importantly, to an emerging availability of credit support, in the form of OTC clearing, that did not exist three years ago. The present forward markets owe their genesis to regulated futures markets in freight, with margining and clearing, at Londons Baltic Exchange, and later LIFFE. The legacy of these markets is the methodology for compiling daily broker quotes for per tonne movements, or for per day ship values, on individual freight routes, quoted mainly by the Baltic Exchange, but also on Platts for certain tanker trades. The forward markets were developed beginning in the mid 1990s, partly in response to difficulties in hedging and speculating using the baskets of sometimes uncorrelated individual routes. Market users who had been bedeviled by basis risk in replicating the financial performance of physical ships began to focus on route-specific quotes from the Baltic contained within its half dozen daily freight indices. Shipping brokers in London began the Forward Freight Market (FFA), building on developments in the energy markets, most notably commodity swaps tied to an ISDA contract. The first swap deals were pure over the counter (OTC) transactions, between shipping principals. In 2002, an exchange of differences contract was introduced by the FFA Brokers Association- the FFABA form. Basis risk might have been reduced, but counterparty risk, well known to owners and charterers in period time charters (a forward physical market hedging mechanism), was alive and well. However, the FFA arena was stung by defaults by a number of Scandinavian and Far Eastern freight operators, and one high profile player- Enron. The next phase in the evolution of shipping derivatives is the clearing of trades by a financial guarantor, in the form of the Norwegian Futures and Options Clearinghouse (NOS), closely tied to Oslo based International Maritime Exchange (Imarex), which started life five years ago as a screen based venue for freight trading. The authorized share capital of NOS, partly owned by Imarex, is NOK 150 Million (approximately US $24 Million), with another NOK 250 Million maintained through bank guarantees. Imarex is said to be planning in IPO in the coming months. Its list of 75 clearing members reads like a Whos Who of shipping, including listed companies such as Maersk, Teekay, Pacific Carriers and OMI Corporation, and oil companies including Hess and Sempra, Shell, Statoil and Conoco Phillips. The member roster also includes marquee financial intermediaries J. Aron (the commodity arm of Goldman Sachs) and Morgan Stanley and UK money centre bank Barclays. Reportedly, energy powerhouse NYMEX in New York, and a Greek consortium, are said to be looking at clearing of freight swaps, attracted by an overall freight derivative market with US $20 Billion of a turnover (tanker and drybulk trades), according to Imarex estimates. Press reports have also indicated that London Clearing House Clearnet (LCH- Clearnet), which cleared freight futures trades for LIFFE through the mid 1990s, was also looking at the freight market. The realm of structured finance in the energy commodities has also provided financiers with ways to unlock value from shipping company balance sheets. Market sources at Imarex and active intermediaries

such as London based Clarksons point to two important uses of FFAs in shipping finance- the use of FFAs as part of a lenders security package, and as an instrument for financial institutions to protect their own portfolios. One major shipping lender, Royal Bank of Scotland, had reportedly been acting as a market maker for its borrowers, accessing the market as a principal and then selling positions to its clients. According to FFA market sources, at least one large Continent shipping bank recently accepted an FFA contract whereby an owner purchasing a second hand vessel was able to lock in two years worth of revenue. Much like the time honored practice where a shipowner would assign a period timecharter to a bank, the owner executed an FFA commitment to receive two years worth of cash inflows, settled monthly at levels tied to one of four timecharter routes quoted daily by brokers who produce the Baltic Panamax Index. Usually, monthly settlements are derived by averaging daily broker quotes over the last five business days in a month. Cla rkson Securities Pierre Aury, pointed out that in this type of deal, the owners still have the flexibility to take advantage of peaks in spot rates. This deal was described as a belt and suspenders situation, using ISDA type documents. Mr. Jaap Kalverkamp, who oversees worldwide ship finance at Netherlands based Fortis Bank, acknowledges that his institution has allowed owners to use FFAs instead of timecharters, as part of a security package tied to financing the purchase of vessels in the present high market. He cautioned that the FFA market, where many deals are done directly between parties, still presents counterparty (credit) risk, and that the tenors typically only extend beyond a year or so. The market is not without its growing pains, as users have still not arrived at one standard contractual instrument. Of the several thousand swap deals done annually in the marketplace, most are tied to the FFABA contract, or to a master Imarex contract that is tied to a daily position recap. Documentation for some transactions is based on contracts incorporating many ISDA type features. The FFABA and Imarex contracts are also used for options transactions. Mr. Morten Erik Pettersen, an ex commodity banker from the Nordea organization, who now handles Business Development at Imarex, describes the FFA contracts as very suitable for use in connection with structured finance, although Mr. Pierre Aury, of Clarksons Securities in London, said that the ISDA based on contract is probably fit better in a structured deal. The deals done with the intermediation of a clearing house are subject to margining rules of the clearing house- presently NOS, but soon to include NYMEX and possibly the LCH- whose rosters of members include the cargo side of the tanker trades. According to Mr. Pettersen, the margining at NOS follows a risk based approach originally developed at the Chicago Board of Trade- the SPAN model. Using highly sophisticated algorithms, margining levels include a base amount and then a variation amount based on the volatility and price levels of positions in the market place. But, indicative of the immature nature of the market, the NOS itself has seen the difficulties of volatility in the freight market, with at least one clearing member defaulting on margin calls during the volatile Spring of 2004. NOS has been attempting to increase its capital base, dwarfed in comparison to behemoths such as NYMEXs Clearport system or LCH Clearnet. In 2004, Clearport handled an estimated 14 Million swap and other energy derivatives, in crude oil, refined products, natural gas and electricity. Fortis Banks Mr. Kalverkamp says that Clearing will become helpful as a new credit tool. If the market is going to get broader, clearing will be a requirement. The advent of the OTC clearing business since 2002, a post Enron development, could have a profound impact in shipping finance, where counterparty risk has always loomed on the horizon. After the Enron debacle, large banks expected to fill the OTC credit void, however it was the futures industry clearing institutions that gained the lead. Fast forwarding to a world where energy clearing house becomes the credit intermediaries behind FFAs, tied to well recognizes broker quotes, a wealth of potential new tools for shipping bankers is unfolding. FFAs offer more granularity and can be better managed than timecharters, in providing requisite coverage for a vessels forward earnings. Even though the all parts of the drybulk market have seen both unprecedented levels and volatility, the tanker market, and coal trades, are likely to be the real growth areas, due to a twenty year legacy of energy futures and derivative markets, and the burgeoning OTC trades in coal that support FFA shipping activities. Both Mr. Pettersen and Mr. Aury (who logged time at Enron before its collapse) described freight derivatives as supporting a missing link between disparate markets in the underlying commodities, creating both hedging and arbitrage opportunities. For example, the differential between the Brent and WTI

oil markets are tied together by several Europe and North Sea/ US East Coast tanker trades quoted daily by Baltic Exchange broker panelists. Likewise, Atlantic and Pacific coal markets, where cargoes move in Capesize lots, are tied together by vessels chartered on routes quoted each day by a set of dry cargo panelists. With increased transparency for listed shipping companies, market volatility has caused eyebrows to be raised as listed companies have reported gains and losses from freight derivative trading- particular if FFA activities loom large in relation to overall turnover. In 2004, Hong Kong based Jinhui Shipping (with total revenues of US $216 Million) startled analysts with a loss of $62 Million on FFAs , while Italian trader Coe Clerici booked a gain of nearly $100 Million (2003 shipping revenue of $263 Million). Frontline (which owns approximately 30 % of Imarex) recorded a $17 Million loss on marking positions to market in 3Q 2004, in contrast to modest gains of less than $1 Million in the other quarters, all very tiny in relation to $1.8 Billion annual revenues. In spite of seemingly big numbers, some principals view the market as still immature. Mr. Peter Evensen, an ex JP Morgan Chase banker and now CFO of Teekay Shipping (an Imarex clearing member), which claims to move more than 10 percent of the worlds oil, in the 4Q 2004 Conference Call to investors, in response to questions about the firms likely tanker FFA activities and a $13.8 Million hedging loss (contrasted with $2.2 Billion annual revenues), said, It is not a hugely liquid market in the freight futures market for tankers. The margining system inherent in the clearing schemes, has provided a catalyst for marking freight positions to the market. The mark to market discipline, borne out by emerging accounting standards, will prove useful in assessing risks of lending to shipowners, and analyzing their published results. Citing another paradigm shift brought on by FFAs, Fortis Banks Kalverkamp pointed out that, now when we analyze shipping company credits, we must also look at FFA positions, in addition to ship charters and debt, when we do our risk assessments. We must be very careful. Freight derivative trades are subject to the mark to market accounting implicit in International Accounting Standard (IAS) 39, applying to countries in the EU, and to SFAS 133 in the United States. An unfolding development is the announcement by blank check company International Shipping Enterprises, which raised $182 Million net, effectively as a blind pool, that it had entered into an arrangement to purchase dry bulk stalwart Navios Corporation from its private owners for $607 Million. Navios re-invented itself in the 1990s as a merchant in freight, where physical ships, contracts, and derivative instruments such as FFAs were viewed as interchangeable. The huge price tag on Navios speaks to the role of freight derivatives in creating value for shipping companies, and is a harbinger of the growing importance of the market in paper freight.