The tale of two canals – game theory in action

The tale of two canals – game theory in action

What comes to your mind when you think about the Suez and Panama Canals? Marvels of engineering? An exotic waterway thousands of miles away? Revenue cash cows for two nations?

Whatever you might think about them, these two man-made canals play a very strategic role in international shipping and trade. And they do produce revenue for their owners to the tune of approximately $6bn in the case of the Suez Canal and nearly $2bn in the case of Panama Canal. That is some serious cashflow and any moves that affect how this revenue is generated are closely scrutinised by national treasuries and the companies that use the canals to transport cargo between far-flung markets.

Even though separated by thousands of miles, the two canals are in fierce competition with each other. In their battle for customers, they employ the tit-for-tat strategy familiar to all students of economics and business. In case you are wondering, the tit for tat mathematical game theory relates to a game called Prisoner’s Dilemma. In general terms, the strategy involves cooperating the first time and after that always repeating your opponent’s last move. The weapon of choice for the canals playing this game: infrastructure improvements and pricing.

The loudest salvo on the infrastructure front came from the Panama Canal. By deciding to enlarge their locks, Panama Canal attempted to change the economics of shipping goods from Asia to US East Coast. It also opened better routes for oil and gas transports leaving the US for energy hungry markets in Asia. After the dust settles, the Panama Canal will be capable of handling ships up to 14,000 teu (in practice less, as there are draft limitations). That is still smaller than what the Suez can handle, but nonetheless, it offers better economics to the carriers, than the old Panama passage.

The Suez Canal appeared unperturbed on the infrastructure front. In 2014, it committed itself to spend $4bn on dredging and widening the waterway to allow two-way traffic on the entire length of the canal. This will offer efficiencies to ultra large container vessels and making the passage faster and more efficient.

The pricing component of the tit-for-tat strategy got even more interesting. In preparation for the increased traffic, the Panama Canal offered the carriers a carrot in the form of a simple loyalty program: carry cumulative capacity of over 1.5 million teu over 12 consecutive months and receive a 14% discount from the base rate. For the carriers unable to get up to 1.5m teu, there were two lower thresholds offering lesser savings, but savings nonetheless. All in all, annual savings to the carriers could be in the range of $4m to $10m annually.

The Suez’s response came swiftly. It decided to blunt the incentive carrot offered by the Panama Canal. Coincidentally, it already had an incentive scheme offering deep tariff discounts to discourage carriers from testing going around the Cape and skipping Suez all together. While such a strategy would require the carriers to add one more vessel to their rotations, the threat of doing so was sufficient for the Suez to keep the discounts for much longer than originally intended.

The longer term pricing strategy became clearer over the last few days, as Suez entered into negotiations with major carriers on the stored value account scheme. Users of public transport are quite familiar with programs like Oyster card in London or Octopus card in Hong Kong. You put your money into the account up front and every time you take the journey, a fare deduction is made from the stored value card. Once it drops below a certain minimum, the account must be topped up. In exchange for your money up front, you receive some discounts on fares, thus making everybody reasonably happy.

In the case of Suez, such stored value accounts would equal the estimated cost of carrier passages over a three or five year period. To sweeten the deal, the Suez reportedly offered carriers discounts of about 3% on passage tariffs. Since the Suez’s tariffs collected from the three largest container carriers amount to about $1.5bn per annum from the total of about $6.3bn, the 3% represents substantial savings. An obvious benefit to the Suez as a result of such a deal is cash in the bank up front. If the move is associated with protection from any rise in tariffs, it could represent an even stronger financial incentive for the carriers.

While the scheme appears to be a no-brainer, there is more to it than meets the eye. The carriers have to decide on two things. First question relates to their cost of capital. Should they put 3-5 years of money’s worth into Suez’s piggy bank, or should they keep it in their bank or invest and earn some dividends, while eschewing the discount? The second question relates to having flexibility in network redesign. 3-5 years is a long time for the network and allocation of vessels to the rotations. After all, the Panama Canal could be the game changer and the cargo flows could render US East Coast deliveries through Suez inefficient. That would force the Suez to keep the tariff discounts in place for much longer than envisioned by Suez.

The ball is now in Panama’s court. Will they sweeten the loyalty deal to carriers, or will they defend the current program and insist that the carriers are already getting a good deal in shorter transit times and more efficient passage reservation system? Could they work out new loyalty scenarios that could tie pre-payment deposits in Panama Canal accounts? After all, cash today is more valuable than cash tomorrow. I don’t think we will have to wait long for the answer to this vexing question.

The pricing tit-for-tat played by the canals have impacts reaching further afield to the transhipment-oriented ports, especially the ones located in the Gulf of Mexico. Their ongoing investment splurge has already created transshipment overcapacity and kept ports’ revenues and margins under pressure. Further expansion of the existing ports and the arrival of new player in form of Cuban investment in development of Mariel could only deepen the cut throat competition.

As you see, the consequence of the pricing decisions taken by Suez and Panama needs to be carefully watched by both carriers and ports, as each will benefit, or suffer, differently. As for us, the junkies of mathematical games and mathematical optimisation on plans and decisions, we will rejoice in the study of the strategies employed by the canals and the results that follow.

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