JANINA GRABS examines the market actions which led to historic coffee price lows in August and September in Issue 07 of 25 Magazine. [Editor’s Note: After going to print, we regrettably found a proofing error in paragraph two of page 24 that could affect readers’ understanding of the premise set out by the author. The figures are correct below.]
If one of your daily rituals is to look up the stock market price of coffee on the “C market,” these past weeks have been a rollercoaster ride. Prices – tumbling since 2014 – dropped precipitously in August and September of this year, bottoming out at US$0.95 per pound. Producers balked at this development, which constituted the lowest price for Arabica coffee in 12 years; a feeling of panic permeated the sector. As the industry scrambled to find responses, prices rallied in a similarly unpredictable move, and currently (at the time of writing in mid October 2018) stand at around US$1.20/lb. As we take a breather, let’s debrief: what happened? How does the stock market affect coffee prices in the “real world”? How much of the current coffee price crisis is due to speculation? And are there ways to tame the price volatility in the C market?
The Futures Market
Green coffee is considered to be an agricultural commodity, so can be traded on commodity markets. Commodities, by definition, are goods that are relatively nonperishable, storable, transportable, and interchangeable. In these terms, one bag of Brazilian, Arabica grade one, fair-to average quality coffee will be pretty much indistinguishable from another bag of the same. Because of this interchangeability, it is possible to buy and sell coffee not just in person, but also on the commodity market: Arabica coffee is traded on the New York International Commodity Exchange (NY ICE).
On the exchange, it is not technically containers of coffee being traded, but futures contracts – contracts constituting the commitment to accept delivery of a specified quantity of coffee, at a specific port of entry, at a specific point in time. Thus, if today you buy one Dec. ’18 contract, you commit to accepting the delivery of 37,500 lb. of green coffee by December 31 at one of eight ports around the world – unless you sell that contract again first. Similarly, you can sell a futures contract in the understanding that you will deliver 37,500 lb. of green coffee to somebody else by December 31 – again, unless you buy another contract to cancel out what you owe. In practice, the vast majority of futures contracts are closed out (by taking an opposite position) rather than delivered physically. By the same token, a much larger volume of coffee is traded back and forth than actually exists in the physical market.
But if we are not going to use the futures market to buy and sell actual coffee, why is it so important? In short, because the futures market helps us discover the “spot price” in the physical market. If you are a roaster requiring 250 bags of green coffee in December, you could either buy futures contracts for 250 bags, to be delivered in December, or just buy 250 bags of coffee in the physical market on November 30. If futures prices were radically higher than spot prices, traders could make a lot of money by, for instance, selling a futures contract and buying coffee in the physical market to fulfill that delivery. Under this logic, futures prices tend to align with spot prices as their contract delivery date approaches. They are thus seen as a good predictor of what the “real” price of coffee will be in a few months’ time, which is why many buyers and sellers use the C price as a baseline for their contracts.
Market actors can also use the futures market to lock in a price by “hedging”: if you are planning to buy 250 bags of coffee in November, but do not want to gamble on its price, you can buy the equivalent volume of coffee futures in October (say, at US$1.20/lb.) and sell them again in November (at US$1.30/ lb.). Though you will buy your physical coffee at that November price (at US$1.30/lb.), you will be able to factor in your US$0.10 profit from your futures hedge, resulting in you having effectively locked in the October price (US$1.30 – US$1.20 = US$0.10/lb.) for a November purchase. These two core functions – price discovery and hedging – allow futures markets to smooth the exchange of international commodities, making global trade possible.
Market Actors and Volatility
So why do we see so much volatility in coffee prices? Here, we need to distinguish between two factors: the “fundamentals” of supply and demand and volatility due to the behavior of stock market actors.
As a few coffee origins – notably Brazil and Colombia, for Arabica production – contribute a high share of overall world production, coffee has a long history of relatively dramatic price changes. A drought or frost in Brazil one year may dramatically reduce world supply, but good growing conditions and high yields the next may produce a record output. Given that demand is relatively stable, such drastic changes in output will directly lead to price spikes (in the case of shortages) or slumps (in the case of oversupply). This is what happened in the current crop year, as Brazil achieved the highest yields ever recorded (29 bags/hectare, as compared to 25 bags/ha in the previous year). As an additional factor, the Brazilian currency (the real) had depreciated in anticipation of contentious national elections.
This made Brazilian coffee even cheaper in dollars than in previous crop cycles, contributing to the price slump. Still, given the known demand and supply, market analysts were stumped when prices fell below one US dollar per pound.
The quick downward trajectory of C market prices between July and September 2018 is likely due to another factor: speculation.
One does not need to be in the coffee trade to be allowed to buy and sell futures contracts on the commodity exchanges. In theory, speculators – those that buy and sell futures for short-term gains – are necessary to provide enough “liquidity” to the market (that is, enough people interested in trading at any given price) to make price discovery possible. However, too much speculation can lead to price movements on the C market that are entirely decoupled from the market fundamentals. For instance, the price drop in July and August led many speculators to predict that prices would continue to fall. In the futures market, one can capitalize on such a prediction by selling futures at the current price in the hope of buying them back at a lower price. Many speculators did this, thereby artificially increasing the supply of coffee futures on the C market. Their bet on price decreases thus became a self-fulfilling prophecy. Towards the end of September, as Brazilian polls gave greater odds to the election of Jair Bolsonaro and the real regained some of its value, the trend turned and speculators started to close out their positions. This greater demand for coffee futures led to the increase in price to present levels.
Such short-term volatility is insignificant for buyers and sellers that can sit out turbulent times and wait for price stabilization. Unfortunately, many small-scale coffee producers are not in that position. Individual producers that sell cherry or wet parchment coffee to intermediaries have a 24- to 48-hour window from harvest to sales before quality begins to become affected. Producer groups and cooperatives, in turn, increasingly face “price-to-be-fixed” contracts that only specify a tradable quantity and delivery date and take the C market price of a given month (e.g. Dec. ’18) as price reference.
In these cases, market movements that have little to do with fundamentals, and even less with costs of production, influence the final prices that producers will receive. These prices in turn determine whether they will break even or not. Indeed, even the current prices of US$1.20/lb. lie far below production cost for a majority of coffee farmers.
What can be done to address these challenges? To lift coffee prices to a level that covers production costs for non-industrialized farmers, it is likely necessary to address the fundamentals – that is, better balance supply and demand through supply management initiatives such as output quotas. Yet, even without such structural changes, a number of possible steps would allow us to dampen the adverse effects of short-term price volatility.
More restrictions should be put on speculation in the C market, given the deleterious livelihood outcomes especially for smallholder farmers. Further, market actors – especially in the specialty sector – should reflect whether they really need the C market as a price reference, or whether other alternatives exist.
For example, initiatives like “Transparent Trade Coffee” share pricing information among direct trade roasters and specialty coffee consumers. They have created a preliminary document, Transaction Guide for Specialty Coffee Purchases , which provides data-driven pricing guidance for future specialty coffee negotiations. Another interesting approach is the use of the multi-year mean of the C price (an average C price, calculated across the past five years ) as an alternative benchmark for planning and negotiating coffee contracts.
However, any initiatives like these that make use of shared cost or pricing information should not be undertaken without the advice of expert antitrust/monopoly council, as US and EU competition laws and directives can create significant risks in this area. Although it’s tempting to argue that supporting a buying price is fundamentally different to supporting a selling price, current case law does not support this distinction, even within the context of specialty coffee: many existing initiatives currently function within “grey” areas of antitrust/monopoly law.
One thing remains certain: if the C market is not fulfilling the functions for which it was created – to assist price discovery and allow for price stabilization through hedging – we need to create new instruments that do. ◊
JANINA GRABS is a visiting researcher at the School of Forestry and Environmental Studies at Yale University in New Haven, US and PhD candidate in Political Science at the University of Münster, Germany.
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