Hedging Against Rising Coffee Prices using Coffee Futures

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Hedging Future Coffee Prices, Speculators and Technology Blend-in

By Marvin G. Perez

No matter how you brew it, higher coffee prices are here to stay. How high and for how long will depend on several factors, ranging from dollar fluctuations to growers’ ability to improve output and possible regulation on speculators’ participation in commodity markets.

Careful What You Wish For

Over the last decade, the specialty coffee industry sought to lure the high-end consumer in order to boost that side of the global coffee business. The new consumer reacted positively to the messages from roasters and retailers about the superior quality offered by some coffee origins, with messages that borrowed from the wine industry about appellation, terroir and other characteristics.

In time, Ethiopia’s Yirgacheffe, Guatemala’s Antigua, Costa Rica’s Tarrazú, Colombian Supremo, Kenya AA, Brazil’s Cerrados, all have become household names for coffee connoisseurs and newcomers alike, in much the way Bordeaux and Sonoma are for wine lovers. For years, the specialty coffee industry wanted that.

Demand for those origins swelled in line with prices, and what was before only a wish, became a reality for industry players. This, however, also sowed concerns for near and future supply of premium coffees. Consumption and knowledge about coffee went hand-in-hand, and the profits were handsome, for almost everybody along the supply chain. But along came higher coffee prices.

Below is a chart showing arabica coffee prices from 2007 to April 2020, highlighting arabica coffee price’s abrupt ascent starting in June 2020, which caught many by surprise.

Speculators Under Scrutiny

Not everybody agrees that demand is outpacing supply, or at least at the pace that global prices would seem to suggest. Differentials for some coffee origins more than doubled, putting them out of reach for many buyers, reducing margins for many industry players. However, while many coffee companies appear to be striving amid difficult economic conditions, some top executives are blaming speculators (index, pension and hedge funds) for the uptrend in commodity prices. (The rally came to an abrupt change the second week of May amid broad-declines ahead of expectations that central banks would have no option but to raise interest rates to tame soaring inflationary pressure. India, Russia, China and Brazil have done so already.)

“I wish there was a lot more transparency involved in the process in which we could really understand what the index funds, the hedge funds are doing. It’s a very strange phenomenon,” said Howard Shultz, president and CEO of Starbucks, who’s recently been drumming that message during a world tour promoting his new book.

Echoing the views of many end-users of commodities, Schultz wants the regulators to wake up and smell the coffee and investigate. Some commodity analysts argue there’s little mystery about the high coffee price. Supply is being outstripped by demand especially in emerging markets.

Producing countries such as Brazil, India, Indonesia and Vietnam are experiencing rapid demand growth, reducing the amount of beans left for international buyers. This has sharply reduced coffee stocks at exporter and importing countries. Newer consuming markets such as tea-loving China and Russia have seen domestic consumption rise as well.

New Reality: Price Jump Amid No Major Weather Event

Traders appear to disagree over the size of shortages, if at all, and partially blame a new market reality of speculative money entering the equation across all commodities.

Over the last 30 years, coffee price spikes have come mostly on the back of weather-induced supply disruptions, like a Black Frost in Brazil in 1975, a drought in 1986, also in Brazil and another frost in Brazil in 1994, pointed out Oscar Schaps, managing director at INTL Hencorp Futures LLC

As the chart below shows, the latest price jump also came on the back of new factors, chief among them are the rising demand and lagging production, plus speculative money, as index and pension funds poured money into raw materials, seeking higher returns than those offered by equity markets over the last few years.

Weak Dollar, Qe2 Feeds Commodity Bull Run

To be sure, the latest commodity bull-run started in June 2020, when the U.S. Federal Reserve announced the second economic stimulus measure, known as QE2, for quantitative easing 2, buying billions of bonds to inject cash in the beleaguered economy.

The move pushed the dollar downward and that, mixed in with historic low-interest rates, have made it easy for investors to borrow money on the cheap to then invest it in commodities and other financial assets. QE2 weakened the dollar even further, making it cheaper for foreigners to play the dollar-denominated commodity markets as well.

Nonetheless, other market fundamentals have also contributed to the price increases (including three consecutive poor crops in Colombia, the world’s top mild arabica producer), while weather woes have contributed to smaller crops in India and Indonesia.

On the demand side, consumption not only grew in importing countries and regions, like Europe, the United States and Japan, but more importantly, it jumped within the producer countries that are the source of raw materials for international buyers.

Although world coffee producers are enjoying the best prices since 1997, global supply of the commodity isn’t likely to improve dramatically in the face of better quotes as farmers worldwide face a series of hurdles and are likely to keep supply restricted over the next couple of years, with a possible jump in supply by 2020.

Costs On The Rise, Aging Tree Population

Market participants expect the supply of premium coffees to stay tight as an aging tree population, soaring commodity and labor costs, foreign exchange volatility and other factors are likely to keep a lid on world coffee production over the coming years, offsetting the benefits brought about by higher prices.

The Guatemalan Case

Take Guatemala, one of the top suppliers of premium coffees. During the low-price induced crisis seen at the beginning of the 21th Century, local producers reduced significantly production of lower-grade washed-prime coffees, while concentrating efforts on strictly hard beans and others that pay higher prices. The country has had a hard time regaining past production levels.

According to Juan Luis Barrios, director at Guatemala’s National Coffee Association, Anacafe, labor costs for coffee producers have risen nearly 200 percent since 2001, while coffee prices had only risen 50 percent over that period (excluding the spike seen since June 2020). This disparity limits the farmers’ availability to increase investments in coffee.

In addition, an aging tree population also points to steady or falling production over the next few years, a development taking place in other Latin American and African countries.

Currently, 35 percent of Guatemala’s coffee park is 15–25 years old, meaning trees are already beyond optimum production years, while another 25 percent is older than 25 years, making it difficult for the sector to boost annual production, which has remained steady around 3.5 million 60-kilo bags per year.

New Price Floor In The Making

As a result, specialty coffee industry participants will have to adjust to a new price reality, where a new price floor is likely to settle at far higher levels than those seen over early in the last decade, says Carlos Brando, president of P&A Marketing and a highly regarded industry consultant based in Minas Gerais, Brazil.

The impact of strengthening currencies at some producing countries against devaluation in others has set off a competitive environment, unlike anyone seen before.

Colombia, Brazil and Guatemala have seen their currencies appreciate or stay firm sharply against the U.S. dollar, while others like Ethiopia and Nicaragua saw their currency lose ground versus the greenback, triggering a price war amongst exporters.

There’s been “a weakening of main currencies…and an uneven strengthening of currencies in producing countries,” affecting producer earnings and competitiveness, noted Brando during a presentation at the 2020 SCAA Expo.

The effects have been felt by both the arabica and robusta markets. In the Robusta market, Vietnam, Uganda and Ivory Coast have all seen their currencies depreciate against the U.S. dollar, the currency used to price commodities traded in New York and Chicago.

Meantime, India, Indonesia and Brazil have seen their currencies gain versus the dollar, reducing their earnings as well.

Brando is in the camp that argues for a higher price floor so that it induces more investments from growers, many of which only get a small fraction of the coffee prices, and are not benefitting from the price spike this year as many had sold their products when prices were between 150–170 cents and not nearly the $3 a pound seen over the last two months.

He highlights that world consumption has been growing 2 to 2.5 percent annually, and at a much higher rate in producing countries, while rising living standards across emerging markets, combined with new products such as single-serve have also pushed home consumption upward.

As the dollar remains weaker, a new price floor would have to set above historical averages, for both arabica and robustas, but with a greater effect possibly on arabica, which are more expensive to produce. The disparity in robusta prices versus arabicas has led many roasters to change blends, adding other origins into the mix, but their ability to add robusta is somewhat limited by consumer preferences, say sources.

Brazil Taming Biennial Cycle With Technology

But there’s hope on the way. Brazil is taming its biennial cycle of a low crop followed by a big one, the feat accomplished with technology, better pruning and husbandry. This, says Brando, may have significant impact on the future supply of coffee. He argues that other countries could improve production if prices remain relatively high, encouraging for growers to invest in their farms.

Production To Rise 2020–15?

Brando, who has done extensive work to help the ICO in its efforts to boost coffee consumption, argues the effect on prices for the next global crop would limited, in the form of no pruning as growers don’t want to wait for new trees to develop and miss out on the high prices; there will probably be more irrigation applied and trees grown with less shade to expedite growth.

For the next two crops, more fertilization, better husbandry and renovation via pruning will have the desired effect of bigger crops, so that over the next three to four crops higher density planting in new areas (the most expensive option) could bring surplus production by 2020–15.

“There’s potential for sizable increases in production in Brazil in 2020 and 2020 with a possible supercrop by 2020,” Brando told SCAA attendees. He recalled that with Brazil and Vietnam sharing 25 percent of the world coffee area planted and 50 percent of world production, yield management will be critical as expansion of planted area is costly, highlighted by the lack of seedlings available.

The chart above illustrates Brazilian coffee production from 2001–2020, showing rising yields.

Finance English practice: Unit 34 — Futures

  • Complete the sentences below. Use the key words if necessary.
    • Commodity futures

    are agreements to sell an asset at a fixed price on a fixed date in the future. are traded on a wide range of agricultural products (including wheat, maize, soybeans, pork, beef, sugar, tea, coffee, cocoa and orange juice), industrial metals (aluminium, copper, lead, nickel and zinc), precious metals (gold, silver, platinum and palladium) and oil. These products are known as .

    Futures were invented to enable regular buyers and sellers of commodities to protect themselves against losses or to against future changes in the price. If they both agree to hedge, the seller (e.g. an orange grower) is protected from a fall in price and the buyer (e.g. an orange juiced manufacturer) is protected from a rise in price.

    Futures are contracts — contracts which are for fixed quantities (such as one ton of copper or 100 ounces of gold) and fixed time periods (normally three, six or nine months) — that are traded on a special exchange.

    Forwards are individual, contracts between two parties, traded — directly, between, two companies of financial institutions, rather than through an exchange. The futures price for a commodity is normally higher than its — the price that would be paid for immediate delivery. Sometimes, however, short-term demand pushes the spot price above the future price. This is called .

    Futures and forwards are also used by speculators — people who hope to profit from price changes.

    More recently, have been developed. These are standardized contracts, traded on exchanges, to buy and sell financial assets. Financial assets such as currencies, interest rates, stocks and stock market indexes — continuously vary — so financial futures are used to fix a value for a specified future date (e.g. sell euros for dollars at a rate of €1 for $1.20 on June 30).

    and are contracts that specify the price at which a certain currency will be bought or sold on a specified date.

    are agreements between banks and investors and companies to issue fixed income securities (bonds, certificates of deposit, money market deposits, etc.) at a future date.

    fix a price for a stock and fix a value for an index (e.g. the Dow Jones or the FTSE) on a certain date. They are alternatives to buying the stocks or shares themselves.

    Like futures for physical commodities, financial futures can be used both to hedge and to speculate. Obviously the buyer and seller of a financial future have different opinions about what will happen to exchange rates, interest rates and stock prices. They are both taking an unlimited risk, because there could be huge changes in rates and prices during the period of the contract. Futures trading is a , because the amount of money gained by one party will be the same as the sum lost by the other.

  • British English or American English?
    • aliminium
      • British English
      • American English

    • aluminum
      • American English
      • British English

  • Match the definitions with the words below.
    • 1. the price for the immediate purchase and delivery of a commodity — . . .

      Why Lower Coffee Futures Prices Won’t Translate to Cheaper Coffee for Consumers

      When an industry sees falling commodity prices, consumers usually expect that this will translate to lower prices for the goods they are paying for. That theory is routinely seen as fact when it comes to oil prices and what you pay per gallon at the gas station pump, but lower commodity costs often fail to ever result in lower consumer prices in many other areas.

      One particular instance where lower and lower prices don’t seem to make it down to a savings for Joe Public is in coffee futures prices. Starbucks Corp. (NASDAQ: SBUX) may have revolutionized the coffee business, and this has led a prime example of how coffee prices for consumers should never really expect to go lower when underlying price pressure is driving down the cost of the prices that are paid for coffee.

      According to some recent data from Dow Jones News, ICE futures trading in coffee had fallen by 2.7%, down to $0.9195 per pound, to start April off, even after funds in London have lowered their shorts on robusta prices with close to a 10% decline in the short bets last week. There is continued pressure in coffee prices based on fears of heavy supply as weather conditions globally are going to have plenty of rain in many key coffee-growing nations for a market that is already in oversupply. Dow Jones even showed that after coffee prices peaked in January at their yearly highs, coffee futures have dropped almost 16% to multidecade lows.

      There is a serious issue about why you should not expect Starbucks and other coffee retailers to be passing these lower prices down to the public. According to the 2020 Starbucks annual report, the company’s Global Social Impact strategy is targeting ethically sourced high-quality coffee where it can contribute positively to the communities Starbucks does business in and being an employer of choice are contributors to its objective. Other companies have adopted many of the same marketing and offering strategies for coffee and other beverages to compete in a Starbucks-dominated world.

      One additional issue to watch out for about coffee prices not falling is that Starbucks is selling an experience rather than just competing on prices. Sure, it has to be aware of competitors pricing, but it is the de facto leader of this segment outside of the culmination of independent coffee/beverage retailers and versus the plethora of fast-food destinations that sell coffee.

      Starbucks also noted that the price of coffee is subject to significant volatility, but it notes in that 2020 10-K report that the high-altitude arabica coffee of the quality sought by Starbucks tends to trade on a negotiated basis at a premium above the “C” coffee commodity price. The 2020 annual report further discusses coffee prices and hedging around its green coffee, as follows:

      We buy coffee using fixed-price and price-to-be-fixed purchase commitments, depending on market conditions, to secure an adequate supply of quality green coffee. Price-to-be-fixed contracts are purchase commitments whereby the quality, quantity, delivery period, and other negotiated terms are agreed upon, but the date, and therefore the price, at which the base “C” coffee commodity price component will be fixed has not yet been established. For most contracts, either Starbucks or the seller has the option to “fix” the base “C” coffee commodity price prior to the delivery date. For other contracts, Starbucks and the seller may agree upon pricing parameters determined by the base “C” coffee commodity price. Until prices are fixed, we estimate the total cost of these purchase commitments. Total green coffee purchase commitments as of September 30, 2020 were $1.1 billion, comprised of $996 million under fixed-price contracts and an estimated $166 million under price-to-be-fixed contracts. As of September 30, 2020, none of our price-to-be-fixed contracts were effectively fixed through the use of futures contracts. Most price-to-be-fixed contracts as of September 30, 2020 were at the Company’s option to fix the base “C” coffee commodity price component. Total purchase commitments, together with existing inventory, are expected to provide an adequate supply of green coffee through fiscal 2020.

      Labor issues are another huge factor at Starbucks and other retailers. Starbucks is known for offering competitive benefits or above-market pay in many instances, but health care costs seem to only go up every year, and the rising minimum wages in so many states will only act as pressure for higher wages at Starbucks and other retailers. As of September 30, 2020, Starbucks employed approximately 191,000 people in the United States alone. Some 183,000 of those employees were in company-operated stores and the rest were in support facilities, store development and roasting, manufacturing, warehousing and distribution operations.

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      If you have to pay $1.00 per hour more on average per hour of labor, that 191,000 pool of workers with a 35 hour week will cost a business an extra $6.685 million per week — or almost $350 million more per year based on a 52-week payout. Just in February, we showed how there might be as many as 40 million American workers who will get a pay hike from the rising minimum wage in the coming years.

      Even back in 2020, as coffee prices were rising, Starbucks was known to be hedging against the prices. And prior to that, the New York Times had even outlined how and why Starbucks’ prices were going up even as global coffee prices were in decline.

      Lastly, Starbucks and other retailers that sell coffee are rarely just considered to be “coffee shops” any longer. They are all food-and-beverage-oriented retailers that just want you to come to their stores and buy the offerings of your choosing. That’s bottled water, specialty coffee drinks, tea, even wine or beer, on top of fresh foods and pre-packaged food they all want to sell you.

      Consumers are unlikely to notice the falling coffee prices adding much in savings to their spending. That said, if coffee prices or other commodity prices used by these companies scream higher, they can expect to pay more.

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