The Department of Defense (DoD) is a large shipper of containerized cargo to worldwide ports in support of its overseas operations. The United States Transportation Command (USTRANSCOM) handles the combined shipping needs of all branches of the U.S. military, shipping approximately 300,000 containers per year between domestic ports and overseas locations in Europe, the Middle East, and Asia.
The long-term nature of USTRANSCOM’s shipping contracts with ocean carriers increases the risk that volatility in fuel prices and currency exchange rates will result in an unexpected windfall paid by the government. The agency sought Volpe’s research and analytical expertise to help increase fuel cost savings and maximize fuel efficiency.
Fuel prices and currency exchange rates can be volatile and can dramatically impact the cost of shipping cargo containers overseas. This is especially true of the “bunker fuel” burned by container ships in transit (deriving its name from the containers the fuel is stored in, called bunkers), as it makes up a large share of operational costs.
In order to budget for annual shipping costs, the government enters into contracts with ocean carriers that fix prices for one year at a time. However, government regulations require that bids be made at least six months in advance, resulting in prices that may be as old as 18 months when a shipment is made. In this case, government regulations allow for economic price adjustments that track an index of input prices and, where those inputs exceed certain thresholds, adjust the final net price.
USTRANSCOM needed economic price adjustment factors that would estimate “normal” price volatility outside of which the price is adjusted, estimate appropriate surcharges during periods of excess volatility, and allocate the risk between the shipper and the carriers.
Volpe’s team analyzed historical price data for fuel and currency exchange rates to estimate what range of price fluctuation is normal. To estimate the resulting cost adjustment, the Volpe team analyzed USTRANSCOM’s shipping data to determine actual vessels used for shipments and combined that list with a database of containership vessels and a voyage mapping tool to estimate the fuel burned in USTRANSCOM service. When input prices exceeded the normal range, the excess price was distributed among the shipment by the average fuel consumption, resulting in the Bunker Adjustment Factor (BAF), a surcharge paid per unit of cargo.
In addition to estimating actual fuel burn, the Volpe team incorporated economic input price and risk theory to add two factors that adjust the charge paid. The first factor, the Input Substitution Factor, recognizes that as fuel prices rise, carriers will minimize fuel consumption by adjusting their operation. The Volpe team found evidence that ocean carriers adjusted their operations and estimated a factor that compensates them for only a portion of the rise in fuel prices. As prices increase, the Input Substitution Factor reduces the payment and incentivizes carriers to economize on their fuel, resulting in a fuel cost savings to the government.
The second factor created by the Volpe team is a Risk Distribution Factor. The Volpe team found evidence that ocean carriers actively manage their own risk of exposure to fuel prices and are able to hedge against it while the government cannot. The Risk Distribution Factor, negotiated between the carriers and the government, recognizes that and shifts a portion of fuel price risk from the government to the carriers.
Finally, Volpe recommended changes to the procedure used by USTRANSCOM to benchmark fuel prices, likely reducing BAF payments paid by the government.
Volpe’s economic price adjustment factors give USTRANSCOM empirical research to use in their contractual negotiations with ocean carriers. These factors will result in a more predictable, stable price paid by the government while also incentivizing ocean carriers to maximize their own fuel efficiency.