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 2011, highlighting arabica coffee price’s abrupt ascent starting in June 2010, 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 2010, 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 2014.

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 2010). 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 2011 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 2013–15?

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 2013–15.

“There’s potential for sizable increases in production in Brazil in 2012 and 2013 with a possible supercrop by 2014,” 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 2001–2010, showing rising yields.

Improvements in technology will be key for the South American giant to boost output that meets the growing demand for its coffees, Brando added. Until then, industry players will have to contend with higher prices, which could be brought down by a sudden strengthening of the U.S. dollar, signs of which are showing before this article goes to the press. In addition, future regulation of speculators could affect the price of your cup of Joe—but the latter is, at this point, more wishful thinking than reality. 

Marvin G. Perez, a business writer and consultant, has been covering world financial markets for almost 15 years. His articles have appeared in Dow Jones Newswires, weekly financial publication Barron’s, The Wall Street Journal and several international newspapers as well as on online based-news outlets. He can be reached at marvingperez@gmail.com or his blog followed at: topcoffeenews.com/blog