Within international logistics, the choice between freight bookings on the spot rate or contract rate market is a pivotal decision that can significantly impact costs and operational stability.
The significance of this decision is more keenly felt in times of big changes in rates, such in January 2024 following the Red Sea diversion and again in May and June 2024 as it caused an early peak season.
Understanding the differences, benefits, and strategic uses the spot rate market against the contract rate market can help businesses optimise their logistics.
In this article we are going to define the spot and contract rate markets, sometimes called short- and long-term rates, and explore the benefits of each. We will then cover the key factors which should drive the decision over which is best for your business.
“The relationship between spot market freight rates and contract freight rates is important to understand, to make sure your business is getting the best deal. Those who understand the market dynamics here, will get the best deals.”
Gerry Power, UK Country Director, WTA Group
Defining the spot rate and contract rate freight markets
Spot Rate Market
A spot rate is a one-time price offered by a freight service provider for transporting goods from one location to another at a specific time. These rates are highly dynamic and fluctuate based on real-time market conditions, including supply and demand, geopolitical shocks, fuel prices, and seasonal factors. Spot rates are particularly useful for last-minute or irregular shipments.
Contract Rate Market
A contract rate is a pre-negotiated price set for moving freight over a specified period, typically six months to a year. These rates provide stability and predictability, allowing businesses to plan their logistics budget with more certainty. Contract rates are often based on projected freight volumes and agreed upon through negotiations between shippers and their logistics service providers.
Advantages of the spot rate market
- Flexibility: Spot rates offer the best flexibility, making them ideal for companies with irregular shipping schedules or unexpected increases in shipping volumes.
- No minimum volume commitment: As spot rates are a one-time quote for a single or group of shipments, there is no long-term volume commitment required. Perfect if shippers aren’t sure of future demand and want to keep total shipping costs low.
- Market responsiveness: Spot rates reflect current market conditions, which can be advantageous when market prices dip. This allows companies to capitalise on short-term reductions in freight costs. The spot rate market will drop below the contract market in times of low demand.
- Access to capacity: In tight market conditions, spot rates can provide access to additional capacity when contract spaces are fully booked, ensuring that shipments can still be moved without delay.
Advantages of the contract rate market
- Lower costs per shipment: Under normal market conditions, shipping goods under contract will result in a lower cost per shipment.
- Predictability and stability: Contract rates offer consistent pricing over the duration of the contract, which helps budgeting and financial forecasting. It’s peace of mind. This is particularly beneficial for companies with steady shipping volumes. It also reduces your exposure to when costs surge in the market due to external factors.
- However, logistics service providers will often insert clauses into contracts that mean unexpected disruptions, such as the 2024 Red Sea diversion, will result in price increases.
- Furthermore, in times of surging freight rates, shipping lines may also roll contract rate cargo onto a later vessel, to make space for higher-paying spot rate cargo. Which can compromise reliability.
- However, logistics service providers will often insert clauses into contracts that mean unexpected disruptions, such as the 2024 Red Sea diversion, will result in price increases.
- Priority access to capacity: Contractual agreements often guarantee priority access to carrier capacity, which is essential during peak shipping periods or when market demand surges.
- Strong relationships: Long-term contracts help foster stronger relationships between shippers and their logistics service providers, leading to improved service levels, better reliability, and enhanced collaboration.
The Red Sea disruption caused a 350% spike in freight rates in January 2024 compared with Q4 2023. Spot market volatility in action.
Credit: Xeneta
Figure 1 demonstrates the relationship between spot and contract rates on 40ft reefer containers between North Europe and the Far East. It shows how during the supply chain crunch of 2020/2021, caused by Covid, those on longer term contracts were protected from the higher prices.
However, as the graph moves into 2023, long term rates end up higher than short term. This is because in times of low demand, logistics service providers simply won’t sign long term deals that low.
So generally operating in the contract market protects from surges in freight costs, but in times of low demand, the cheapest possible rates are on the spot market.
Now that freight costs have surged in 2024, there is no doubt those on the spot rate market are paying higher rates than the contract market. However, when the market swings back to the shipper as is expected towards the end of 2024 or when the shipping lines begin reusing the Red Sea, the best rates will once again be spot rates.
Key factors influencing the choice between spot and contract rates
When choosing to purchase transportation on the spot or contract rate market, there are many factors which will influence your decision, including product type, seasonality, trade lanes, service regularity and more. However, there are 3 key factors which are a key driver for all businesses, which we will explore here.
Shipping volumes
To even consider the contract rate market, you need to be shipping significant volumes. Makes sense, as you will sign a minimum volume commitment. More shipments will increase overall costs, but lower your cost per container.
Companies with high and consistent shipping volumes benefit more from contract rates due to the predictability and potential cost savings from these negotiated lower rates. In contrast, companies with variable shipping volumes may find spot rates more advantageous to avoid paying for unused capacity.
Current market conditions
In a carrier’s market, where demand for containers exceeds supply, spot rates tend to be higher, making contract rates more attractive. Conversely, in a shipper’s market, where supply exceeds demand, spot rates may drop below contract rates, offering potential savings for shippers who can navigate the market efficiently.
Taking time to review market conditions is vital for any business assessing the long and short term rate markets.
Market forecasts
The wider economic forecast should be a big driver in choosing the contract or spot market.
If high interest rates are high and economic outlook bleak, then you can be reasonably confident that freight rates will dip. This would be a bad time to enter into a new contract agreement. Using the spot market until rates have dropped and strengthened your negotiating position could be preferable.
The reverse is also true. If the economic outlook is strong, or you forecast disruption on the horizon which will drive freight rates, it could be the best time to negotiate a new contract before rates go higher.
“There’s a whole host of factors which will influence a business decision of how to spread their risk across the spot or contract rate market. But understanding minimum volume commitments, the current market conditions and economic forecasts will leave you well prepared to negotiate good rates.”
Jade Blackburn, Head of Sales, WTA Group
Choosing between spot rate and contract rate markets in international logistics is not a one-size-fits-all decision. It requires a thorough analysis of many factors, particularly your shipping volumes, market conditions, and the broader economic forecast. Ultimately, the optimal strategy will vary based on the specific needs and circumstances of each business.
For large enterprises, spreading risk across both spot and contract freight rate markets is advisable. However, what percentages of your freight moves on the each market is an internal business decision.
By carefully considering all the relevant factors, businesses can make informed decisions that enhance their logistics operations against their supply chain KPIs.
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