The combination of earnings season and a strong tanker market has put freight derivatives squarely in the limelight. In the movie business, camera angles sometimes do not flatter the stars and starlets- so it is with "paper freight", where listed tanker companies have entered into sell swaps (ie selling FFAs) only to report a loss at the end of a quarter as positions are closed out or marked to the market. Indeed, Ole Slorer (the $150/ barrel prognosticator at a leading Wall Street firm) said that OSG: "…took the market by surprise with above expected losses on its freight derivative exposure."

Back in the days of freight futures, the predecessor of freight derivatives, my clients in those days were either private companies or, if they were listed, there was no FASB 133 (the accounting standard on hedging) and other regulatory scrutiny. Back in the day, OSG had a very private and secretive company called Maritime Overseas Corporation, which did all its bidding. In this era of hyper-reporting, twenty years later, OSG took a hit of $29 Million in the 2Q 2008 on freight derivatives. GMR was indicating a loss of approximately half this amount (roughly $5 Million realized and roughly $10 Million still sitting on the books).

Yet both companies will show increases in profits over the previous 2Q, in spite of the "losses" on the freight derivatives. GMR's 2Q net income grew from $14 Million last year, up to $20 Million.  At OSG, its half year net income rose from $163.6 Million to $199.4 Million.

In their road show presentations, the companies will sometimes talk about the sell hedges as being synthetic time charters, which puts the strategy behind these freight derivatives hedges into perspective. By definition, a shipping company  loses money on a sell hedge when the overall market goes up. And the loss must be reported per FASB 133. Most of the time, such losses end up described as "ineffective hedges" (who has a good regression program when you need it???) and stick out like a sore thumb.

But, here's a little secret. Shipping companies do not have to mark to market when they time-charter a vessel out. And, guess what? They "miss the market", ie they don't sell at the very very tippy top, most of the time. But, prudent risk management dictates that you "sell" in layers, with real judgment interposed on pure dollar cost averaging. Freight derivatives are actually  far more flexible instruments than time charters. But try telling that to the folks at the regulatory agencies who shape the look and feel of financial reporting and financial statements.

On a rainy day, I would love to go through financial statements for GMR, OSG and some of the bigger drybulk names, and try to mark various period time-charters to the market. Indeed, any C student in Commodities 101 knows that forward rates (ie period time charter rates) are way below spot rates, in the dry market. This "backwardation" has existed for some time. When the spot tanker market gets frisky, as it has been this year, you see the same types of curves- downward sloping as you move out in time from spot. This means that the TCE of spot rates would greatly exceed the period rate on, say, a two year outcharter. Of course, you need to explain Worldscale, and what fuel price was assumed, but we can save that for another blog.

Yet, in the dry business (and tankers too), companies are lauded for providing "revenue visibility", ie fixing all their tonnage in advance. If they were required to mark to market, and show "losses" (where the forward rate in effect is below the present spot rate) they would get crucified. Sub editors (that species of headline writers at shipping media) always focus on companies reporting a hedging loss, or softening the financial markets for a hedging loss about to be reported a/k/a providing guidance. And the actual writers, who should know better, dutifully parrot back the FASB 133 report. In all fairness, the shipping media's coverage of OSG and GMR's 2Q 2008 has implied that the spot market is strong. Both of these companies are doing fabulously, but that did not jump out of the page, however, when I read various accounts in the shipping press.

So, what should we do about all this? We could write to that august body, the Financial Accounting Standards Board (FASB) and recommend that shipping companies mark all their time-charters to the market- as proxied by one of the Baltic composites, perhaps. Alternatively, we could ask for a moratorium on FASB 133 for listed maritime companies. Or, more sensibly, we could probably ask some of the sell side analysts to look into such matters and provide an honest report card revealing the dark underbelly of "revenue visibility."  Otherwise, if you see a rainy day in the forecast for New York, please email me and remind me of the analytical chores that I volunteered for.