The New Market Reality

By Ric Rhinehart

At the recent SCAA Symposium, I had an opportunity to present some thoughts on the challenges facing our industry as we come to grips with a new market reality. It occurred to me that there are really three fundamental value propositions for which we are responsible and that our task is to ensure that these three propositions are clear and substantive. In truth there is nothing new in this thinking, but as an industry we have been, at best, reluctant to address these issues.

The three value propositions I am referring to are:

• Coffee must be a valuable activity for all of the actors in the production cycle.

• Coffee must be a reasonable investment activity for the financial sector.

• Coffee must be a valuable and rewarding consumer experience.

The economics of coffee are complex and compelling. The product is largely consumed in the wealthiest countries in the world, with the US, Japan and the EU together consuming well over 75 percent of the world’s production. Coffee is produced in some of the poorest nations on earth and fluctuating coffee prices and the challenges of small-scale agricultural production have fostered a cycle of rural poverty that has proven difficult to break. The total retail market for coffee worldwide is in excess of $100 billion, yet producing countries see just a 16 percent share of this total. Traditional smallholder producers began to abandon coffee as a cash crop during the low market price years between 2000 and 2007 and many will never return to this activity. The children of the rural poor are increasingly electing to urbanize in a search for work and a higher standard of living.

Meanwhile, those on the consuming side of the equation have continued to profit from increasing consumption, a changing pattern of purchases which has dramatically increased the dollar value at retail, and a generally increased standard of living in wealthy Western economies all the while enjoying the added benefit of extraordinarily low prices for raw coffee. The net result of the vagaries of the coffee supply chain is that for many coffee farmers, particularly smallholders, coffee production is not an economically sustainable activity. In some areas, such as Brazil, coffee farming can be a highly rewarding business. Thus, we can continue to expect growth in Brazil. In other areas, including those that produce high quality washed arabica coffees, the economics are much more challenging, even at current record high prices. In order to ensure that coffee farming will continue in many of the traditional producing regions we must be certain that it is an economically viable activity.

The complexity of coffee economics is persistent throughout the supply chain, not just at the producer level. In coffee, cash is injected into the supply chain at the point of intermediation. That is, both farmers and roasters are dependent to a large degree on loans from exporters and importers. This is most true for the smallest and least sophisticated operators, be they farmers or roasters/retailers. Large, highly sophisticated operators on either side are much more likely to have access to cash from traditional sources such as banks and capital markets. Small farmers are dependent on intermediaries for cash to carry them from crop to crop, and small roasters have traditionally used generous terms from importers to finance their equally generous terms to retailers.

All of this access to credit has largely been in the hands of exporters and importers and has been distributed throughout the coffee supply chain in the form of pre-financing for farmers and 30-day-plus terms to roasters. As prices have gone up rapidly in the past year, the ability of traditional intermediaries to finance supply chain activity has been dramatically impacted. Cash has been constrained in two critical ways.

First, the absolute value of a coffee contract has doubled. A year ago a container of coffee at a price level to New York would have cost an importer roughly $50,000. Today the same container has a value of $100,000. In simplest terms, that means our importer can finance half as many containers as he could a year ago if his credit line has not increased. This is further complicated by the needs of risk management. Any intermediary who hopes to stay in business has to put on a hedge in order to manage risk, and the cost of margin calls in a rapidly increasing market has further sapped the credit lines of exporters and importers. As a result, less cash is available to provide the financing activities that coffee has traditionally carried on, and suddenly roasters are subjected to the double impact of rising costs and shrinking credit. Meanwhile farmers are unable to capitalize on the increased value of their product because their traditional lenders—namely exporters—are unable to muster the necessary cash for both hedging and purchasing activities.

Commercial banks look on the whole enterprise as an increasingly risky business. Futures prices swing wildly as commodities attract liquidity. They see credit lines strained to the hilt, contract defaults and bankruptcies looming in the future, and a physical coffee market paralyzed by fear and uncertainty. Banks hate fear and uncertainty, and their reaction is to further withdraw from the market at a time when cash is most desperately needed.

Of course the cost of all this must ultimately be passed on to the consumer. Even though coffee roasters have as a matter of course been slow to raise prices, eventually they must. The end result is a higher price point for coffee, despite declarations by CEOs of large companies or the trepidation of the small roaster and retailer. The wealthy western consumer, already challenged by rising fuel costs, record unemployment, tightening consumer credit and stagnant wages is faced with yet another value matrix to negotiate. Talking heads in the mass media are quick to point out the cost of a daily coffee habit and to equate giving up coffee with financing a child’s education at any Ivy League school.

So what are we to do? How can we as an industry act to preserve our future? The answers lie in developing the value propositions outlined above. I see three key responses that are necessary:

• Invest in supply chain-strengthening activities at key points of intervention.

• Influence financial institutions assessment of risk and reward in coffee markets.

• Differentiate, add value, and create a memorable coffee experience.

First and foremost, we must address the issues of economic, social and environmental sustainability for the activity of producing coffee. This includes substantial investment in research and development at the source of supply. The coffee industry has traditionally been a very poor investor in its own future because it has not had to invest. Producing country organizations have made investments in basic research and in plant breeding and agronomy within the constraints of their own economies. Equipment manufacturers have invested in developing new technology for harvesting and processing coffee. Governments have invested in agricultural extension programs and in dissemination of best practices for small producers. Until recently, this has been enough. But as external pressures on coffee cultivation converge we are feeling for the first time the inadequacy of our R&D investment and the threat to our future supply of coffee. Climate change, land use pressure, rising labor costs and food security issues have combined with the historical challenges of smallholder farming to create a new reality that demands intervention from the side of the business that has the 84 percent share. Private investment by large stakeholders is on the rise, but no single company can hope to make the kind of significant commitment necessary to make substantive progress in dealing with these new pressures.

The coffee community, led by investment from the consumer side, must take an active role in funding the basic research necessary to develop long-term solutions to the problems faced at the farm level. There is a tremendous opportunity at hand for the industry to leverage its investment with government agencies, NGOs and donor organizations around the world that recognize that addressing the issues of smallholder farmers is key to alleviating chronic poverty. Other commodity-dependent industries have recognized the need for this kind of coordinated investment and a variety of structures are already in use for driving this activity.

On the agricultural research side, the Collaborative Research Support Program (CRSP) model is a proven winner in driving both basic and applied research and acting as a complement to private research efforts. Coffee finally has a CRSP of its own through the newly launched Global Coffee Quality Research Initiative. Look for progress in agricultural research, plant breeding and capacity building over the next five to twenty years from this effort, but be certain that funding for this must continue to come from our industry.

The cocoa trade has led the way in other development issues with the launch of the World Cocoa Foundation (WCF). The WCF was formed for the express purpose of driving a sustainable supply chain through public/private partnerships and provides a focal point through which governments, NGOs and donor organizations can direct their resources. Coffee is long overdue for an entity like this that concentrates efforts, relieves redundancy and shares results effectively across a broad range of interest groups. The Foundation is committed to the “…purpose of promoting social and economic development as well as environmental stewardship…”  The time is now for coffee to organize its collective energies in a similar fashion.

On the financial front, the coffee industry has a number of opportunities. Traditional efforts by trade associations and intergovernmental agencies to position the industry as a viable economic model should continue and should be supported with greater urgency. But the coffee business also needs to demonstrate a greater level of maturity and discipline. Marginal players at every stage of the supply chain have been supported by the very loose terms of de facto credit agencies of the industry. Coffee intermediaries were complicit in twenty years of unlikely generosity as they allowed the markets to finance credit, storage and risk management at nearly zero cost. The onset of an inverted futures market revealed in short order the unsustainable nature of this kind of off the books credit.

Coffee businesses, particularly on the consuming side, need to be realistic about their sources of credit and manage their businesses accordingly. Many small and medium roasters have used the credit provided by importers to finance not only their own growth but also to finance the businesses that are their end users. Restaurants and retailers have happily accepted equipment loans, extended credit terms and unchanging prices and excellent margins for decades. Roasters will have to come to grips with a more realistic assessment of their own credit worthiness as well as instill a discipline around customer finance. Demonstrating an appropriate business sensibility, maintaining margins, managing risk and creating real value are the hallmarks of a sustainable business and will go a long way to convincing banks (and capital markets) to factor out some of the risk premiums attached to coffee.

At the end of the day, the consumer must pay for coffee in order for our business to thrive. To date consumers have demonstrated some remarkable tendencies that we should take note of. First, coffee remains one of the most price-inelastic of consumer goods. Consumption has remained steady in the face of price increases, and even in the depths of the financial crisis consumption experienced some venue shifting but no real decrease. Conversely, there is a mountain of evidence that lowering price does not increase consumption. Still, we seem to miss the two key revelations here. One is that consumers will happily pay for coffee within the scope of the current value equation, and two is that those consumers will only continue to drink coffee if it tastes good.

Interestingly, coffee roasters seem to live in near constant fear of a major downturn in consumption if prices go up, regardless of evidence to the contrary. The same roasters spent over a decade trying to stimulate consumption by lowering price (and quality) only to see a constant and persistent downturn in per capita consumption. In spite of this well documented experience a new exercise in chasing price down by sacrificing quality seems to be taking place in parts or Europe and Asia. Undoubtedly the results will be the same—an overall decline in consumption.

We would be far better served to reposition the value of coffee in ways that are resonant with the consumer. These include producing a better quality product (one that tastes better), as well as producing a better experience (one that feels better). We might also dedicate more effort to making coffee an interesting experience. Getting consumers interested in the product and then allowing them to take their own journey of discovery will go much farther than our current pedantic approach to coffee education.

Finally, we need to focus our efforts on providing contextual clues to the value of coffee. Great ambiance, attractive settings, and good-looking products all contribute. We must move out of the fast-food service style and into a more genteel and complete service to establish a new value proposition. Most of all, we must allow the consumer to easily differentiate coffee quality and thus coffee value.

Ric Rhinehart is the executive director of the Specialty Coffee Association of America. He has more than twenty years of experience in the coffee industry, and has designed, developed and produced a wide range of coffee and tea products. He has considerable experience in developing manufacturing and packaging capabilities, and has traveled extensively as a green coffee buyer.