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2007 Logistics Rate Outlook: Opportunity Knocks

Market forces that favored carriers and buffeted shippers last year are changing. Skilled transportation buyers may find an opening to negotiate more favorable deals

By Elizabeth Baatz, Contributing Editor -- Logistics Management, 1/1/2007

Pricing power wielded by carriers with ruthless command in 2005 and 2006 is likely to shift in shippers' favor in 2007.

One sign of better days to come: Truckload shippers are already hearing more humility in their carriers' voices as capacity loosens up. After experiencing difficulties getting capacity and paying premium prices in 2005 and 2006, shippers started reporting late last year that their carriers were offering price cuts.

More good news: Capacity is not expected to strongly affect air cargo pricing in 2007. But that's tempered by the fact that the price of jet fuel will still play a role in determining overall pricing, particularly the surcharges airlines pass on to their customers.

This shift won't yield a bountiful buyer's market in every mode, however. Shippers who rely on rail, for instance, will continue to face strong rate hikes. Unwary parcel shippers, moreover, could get tripped up by new fees that don't show up in base rates. And ocean shippers negotiating annual contracts can expect to duke it out with carriers that are determined to compensate for last year's low rates.

As has often been said, economic forecasting is not an exact science, so our predictions are subject to change. But looking ahead at what 2007 has in store for shippers, it appears that conditions are ripe for some negotiating opportunities. The likelihood that the economic slowdown and soft oil prices will continue, coupled with the long-term threat of another logistics logjam like the port and rail problems of recent years, make this 2007 rate overview required reading for anyone who's listening for the sound of opportunity knocking.

Economics 101

Some economists are predicting a possible recession or significant slowdown in growth, while others think the economy will remain strong. That means readers need to be prepared for two very different scenarios: continued tight capacity and high rates, or capacity opening up and rates heading downhill as a result of declining demand. The latter is a double-edged sword. Lower rates are great for your logistics budget, but if your company is one of those experiencing less demand for its products, the impact of falling sales revenue could outweigh the benefits of rate reductions.

Before examining the rate outlook and key logistics challenges in detail, let's look at what the economists are saying, starting with Gene Huang, chief economist at FedEx. Huang is the only logistics industry representative on the Blue Chip Panel, a group of 50 business economists who collect and publish monthly forecasts in the Blue Chip Economic Indicators newsletter.

Huang believes the economy is entering a slowdown that will be very different from the slowdown of 2000–2001. "Profit is very strong now, and it was negative then," he says. "Also, operating rates are stronger and the labor market is tighter." In sync with his peers, Huang forecasts real GDP (gross domestic product, adjusted for inflation) will grow 2.6 percent in 2007 after a 3.3 percent gain last year.

The most optimistic GDP forecast on the Blue Chip panel comes from Prudential Equity Group, which predicts 3.1 percent growth, meaning the economy will remain strong. On the other end of the spectrum, Merrill Lynch Economics forecasts only a 1.9 percent gain, in league with the 25 percent of the panel members who believe that a recession is in the cards this year.

Figure 1

In other words, there's no clear consensus and for good reason. "The economy is on a knife's edge," says Randell E. Moore, executive editor of Blue Chip Economic Indicators. "Any exogenous shock could tip us into a recession." Despite that uncertainty, an average of the Blue Chip predictions last year produced a forecast for 2.5 percent GDP growth in 2007 (see Figure 1).

Moore believes the risk of a recession is rising because house prices are falling and builders are reporting more cancellations by new home buyers. At first glance, that might seem unimportant if you're not involved in the construction industry. But commodities like wood, gypsum, and cement, as well as housing-related products such as appliances and floor tiles, together account for 6 percent of all freight volumes in the United States. So not only could a housing bust set off an economic recession, it could also create a challenge for companies that provide transportation services.

For truckload carriers and their shipper customers, though, a housing slowdown might come with a silver lining: laid-off construction workers could become truck drivers and help alleviate the driver shortage.

Housing trends may be troubling for the economy in the long run, but the outlook for fuel costs will have a more immediate impact on logistics. As oil prices rise,

Figure 2

carriers raise fuel surcharges in an effort to recoup their own soaring costs, so any significant increase in oil prices will be felt in shippers' wallets sooner or later.

By early January, the price of crude oil had fallen off its $77 peak to about $58 per barrel. How far oil prices will fall in 2007 is anyone's guess. "The Department of Energy and the consensus outlook is that crude prices will drift down to about $50 over the next two years," says Jim Haughey, economist with Reed Business Information, LM's parent company. "That implies the national average price of gasoline [will be] solidly under $2 [per gallon], from the current $2.14," he adds. Edward M. Wolfe, transportation analyst at Bear, Stearns & Co., however, predicts a less-volatile trend, with West Texas crude oil prices settling at around $65 per barrel in 2007 and 2008 (see Figure 2).

In light of that general economic outlook, let's take a look at where freight rates are likely to go in 2007.

Trucking: More Capacity

Lower fuel prices are good news for most of us, but could spell trouble for LTLs (independent trucking companies-Less than Truck Loads). "Our sense is that generally LTL carriers make money on fuel surcharges, and that earnings for LTL providers would be hurt by sustained lower fuel costs," Wolfe says in a recent report.

Fuel costs aside, a slow economy could deliver negotiation leverage to truckload shippers. "I view the truckload market as having excess capacity until May or June 2007," says Stephens Inc. stock analyst Thomas S. Albrecht. He predicts that average TL rates will move up or down by 1 percent or less if the economy slips into a recession.

Tom Sanderson, president of Transplace, a third-party logistics company owned by some of the nation's largest motor carriers, agrees that capacity has shifted in favor of shippers. He expects TL rates, exclusive of fuel surcharges, will rise by less than 2 percent if the economy should soften, or by about 4 percent otherwise. Accordingly, he says, "Now is a good time to use a formal bid process to lock in truckload service, capacity, and pricing for 2007."

Not only are LTLs losing revenue as fuel prices drop, but they're also facing competition from FedEx and UPS, which have entered that market. FedEx Freight has grown at almost twice the rate of the overall market, not by cutting prices but by raising the bar on service and technology, says Wolfe. Still, downward pressure on pricing remained strong in 2006, and shippers expect that trend to continue.

Paul C. Svindland, a director at AlixPartners in New York, foresees moderate rate hikes this year. "I expect subtle increases in LTL rates this year, similar to those of 2006, but large shippers should be able to fight off any increases," he says. Wolfe, however, predicts LTL pricing will be flat or down modestly in 2007, with fuel surcharges also flat or down on a year-over-year basis.

Rail: Rate Hikes Likely

The rail industry will continue to enjoy plenty of pricing power. There are now only two U.S. Class I railroads in the Eastern United States and two in the West, down from four Western and three Eastern carriers during the last business cycle. Wolfe points out that the major railroads "have acted like responsible duopolies, with all parties more focused on yield, productivity, margin, and return on capital than on volume and revenue growth." That's fortunate for investors but means rate hikes will not abate.

A recent survey of shippers by the investment firm Morgan Stanley suggests that rail rates will be up 6.4 percent in 2007. Rail contracts, especially for coal, chemicals, and intermodal shipments, tend to be multiyear rather than one-year or spot contracts. Many contracts, primarily those for coal and international intermodal shipments, have been underpriced, says Morgan Stanley analyst William J. Greene. "The lack of adequate rate escalators and fuel surcharges for these long-term contracts means the rate increases upon renewal will continue to grow," he says.

One reason why rail companies have enjoyed so much leverage in setting rates is the unabated growth of imports from Asia. Intermodal traffic has grown more than 30 percent over the past four years, due in large part to the surge in imports from China. None of the analysts interviewed for this article sees this trend turning around in 2007.

Air: Jet Fuel Prices Rule

The two most important factors in air cargo pricing will continue to be fuel costs and capacity/demand on major trade lanes. On average, jet fuel represents more than 30 percent of airlines' operating costs. When fuel costs rise, airlines pass that extra expense on to their customers in the form of surcharges, so shippers would do well to watch jet-fuel prices. In 2006, those surcharges hit 60 cents per kilo higher than the base rates in some cases. As oil prices have declined, carriers have dropped surcharges; at this writing, most were around 50 cents per kilo.

Both UPS and FedEx Express will reduce fuel surcharges for air and international shipments by 2 percentage points in 2007. But while carriers are bringing their fuel surcharges down, they're raising their accessorial charges to help offset any slowdown in volume. Shippers sometimes are unaware of these extra charges. "More and more is moving off the books and isn't quoted in the rate," says Ted Scherck, president of air industry consultants The Colography Group in Atlanta. The number of accessorials has nearly doubled over the past six years; in some cases, the cumulative increase in accessorial fees has dwarfed base-rate increases, he adds.

If capacity and demand on major trade lanes continue as they did in 2006, rates should remain fairly steady. Inbound volumes from Asia remain strong (although the growth rate is slowing), and trans-Atlantic volumes have been robust. But it's been widely reported that in 2006 shippers spread their cargo volumes out over the course of the year, so there was less competition for capacity during the normally frantic peak season and that means fewer shippers were paying premium prices to grab space at the last minute. Some of the bigger freight forwarders have locked in space on major routes with long-term contracts to ensure adequate capacity for their customers year-round. So it appears that capacity won't strongly affect pricing in 2007.

Ocean: Rates Could Rise

An oversupply of capacity has saddled the ocean liner market with declining rates. After three years of boom times, from 2003 to 2005, freight rates reacted excessively to a weakening supply/demand balance in 2006, says Neil Dekker, an analyst with Drewry Shipping Consultants in London. Drewry's containership review shows that average East/West freight rates for 2006 will be down 6.7 percent, and the research firm forecasts another 1.5 percent drop for 2007. This assumes that the decline in freight rates during the current downturn will total about 10 percent over the 2006-2008 period, with the sharpest decreases already behind us, Dekker says (see Figure 3).

Although Drewry's forecast calls for a slight rate reduction in 2007, ocean carriers say that they will raise their rates. Some large ship lines have announced that they will remove capacity from some trans-Pacific and Asia-to-Europe routes. They also plan rate increases to compensate for sharply rising costs, particularly in the prices they pay to railroads for intermodal container service. So shippers can expect a lot of pricing pressure when it comes time to renegotiate annual contracts. Whether or not the carriers will get what they want is still a question, however.

Figure 3

Underpinning all of this is the continuing trade imbalance, as full containerships dock in Long Beach but sail empty back to China. David Jacoby, president of Boston Logistics in Wellesley, Mass., is among the many industry insiders who believe this import/export gap will continue to widen in 2007. As a result, he forecasts, the cost of shipping from low-cost production centers in the Far East will keep rising.

Meanwhile, the prospect of a repeat of 2004, when port and rail systems were practically paralyzed by an influx of containers from Asia, continues to be a threat. "International trade is increasing faster than the capacity of ports, rails, and highways can handle," says economist Paul Bingham of Global Insight Inc. in Washington, D.C. Bingham produces the monthly Port Tracker report for the National Retail Federation (NRF). Port Tracker, which monitors and evaluates conditions at U.S. ports, was launched after the disastrous West Coast port shutdown and protracted freight backups of 2004.

Now the system is fluid, thanks to operational changes like adding labor and shifts at ports and adjusting hours of operation, says Bingham. But it would be a mistake for shippers to assume that their problems are over. "If ports and carriers are complacent assuming all will be okay if they do next year what they did this past year then they will fall flat on their faces," he says.

Will We Hear A Knock?

How much rate relief will there be in 2007? It remains unclear, especially as the outlook for the transportation modes differs significantly.

Boston Logistics' Jacoby is not optimistic about the prospects for intermodal transportation. "I can't see any fundamental reason why 2007 would end up being a year of great rate relief," he says. "The endemic problems of surging Asian imports and a logistics infrastructure threatened by congestion remain."

But many analysts are convinced that there will be opportunities for shippers to gain leverage in trucking and perhaps in air cargo this year. Overall, a decline in transport volumes will force carriers into a "less aggressive pricing posture" with all types of shippers, sums up The Colography Group's Scherck.

And that's why shippers should keep an ear to the ground: Conditions change, and economists' forecasts give us reason to believe that opportunity could come knocking sooner rather than later.

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Author Information

Elizabeth Baatz, a principal in the economic forecasting firm Thinking Cap Solutions, writes LM's monthly Price Trends column.

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