Freight Transportation Contracting Under Uncertainty UCI-ITS-WP-08-2

Uncertainties in transportation capacity and costs pose a significant challenge for both shippers and carriers in the trucking industry. One way to hedge these uncertainties is to use concepts from the theory of Real Options to craft derivative contracts, which we call truckload options in this paper. In its simplest form, a truckload call (put) option gives its holder the right to buy (sell) truckload services on a specific route, at a predetermined price on a predetermined date. The holder decides if a truckload option should be exercised depending on information available when the option expires. Truckload options are not yet available, however, so the purpose of this paper is to develop a truckload options pricing model and to show the usefulness of truckload options to both shippers and carriers. Since the price of a truckload option depends on the spot price of a truckload, we first model the dynamics of spot rates using a common stochastic process. Unlike financial markets where high frequency data are available, spot prices for trucking services are not public and we can only observe some monthly statistics. This complicates slightly the estimation of necessary parameters, which we obtain via two independent methods (variogram analysis and maximum likelihood), before developing a truckload options pricing formula. A numerical example based on real data shows that truckload options would be quite valuable to the trucking industry. Tsai, Saphores and Regan 2 INTRODUCTION Trucking is the dominant mode of freight transportation today, and, according to a recent forecast by the American Trucking Association, its share of the nation’s freight pool will increase: it is forecasted to reach 70% by 2018, up from 69% in 2006 (1). The trucking industry is divided into two sectors: private carriage and for-hire. Figure 1 presents the structure of the trucking industry. The value of services provided by private carriage was approximately 45% of the trucking market in 2006 (2). Since private carriage refers to trucks and drivers owned and operated by shippers, this sector is not included in the trucking contracting market. We therefore focus on the for-hire sector, which accounted for approximately 55% of the market, of which 87% came from truckload (TL) and 13% from lessthan-truckload (LTL) services. In order to procure for-hire services, shippers either write longterm contracts with carriers, usually for one or two years, or outsource to common carriers that mostly operate in spot markets. A spot market is where shipments are handled on a one time load-by-load basis. It is used by almost all shippers and carriers to some extent. Spot market contracts are relatively short term contracts that serve unfilled or urgent demands. They have short lead times, volatile market prices and typically no prior contractual agreements. Typically shippers and carriers participate in spot markets on a “per job” basis. Spot markets, or in online marketplaces, are increasingly being used to match shipper demand and carrier capacity, because of the ability to generate market prices in real-time. Hence, a spot market is the best means to procure truckload services for unexpected and urgent delivery. However, a truckload service price in the spot market is typically much higher than the long-term contract price. In addition, the availability of truckload services, in terms of time and volume, is not guaranteed to satisfy unexpected and urgent needs. Dealing with orders that require rapid, accurate, and reliable delivery challenges shippers at a time when the volume for this type of orders has significantly increased due to the adoption of demand responsive logistics. While shippers are concerned with guaranteed truckload services to satisfy uncertain demand, they increasingly depend on spot market procurement, which results in higher transportation costs. FIGURE 1 Structure of the Trucking Industry Trucking Industry Private (45%) For-hire (55%) Truckload (87%) LTL (13%) Long-term