Coffee trade: a basic lesson on the economics of the price of coffee

Story by Charles Beelaerts In the year 2000 one financial commentator suggested that coffee was of such great significance in the world economy that units of currency should be expressed in terms of a cup of coffee. Well over 2.3 billion cups of coffee are consumed in the world every day, with most consumption taking place in industrialised countries, although over 90 per cent of coffee production takes place in developing countries. In Brazil, for example, the world’s largest coffee producer, over 5 million people are involved in the cultivation and harvesting of coffee plants. A Myth Dispelled?
Since the early-1970s there has been a myth circulating that coffee is the second most traded commodity in the world after oil. The myth was reinforced by Mark Pendergast in 1999 in his book Uncommon Grounds: The History of Coffee and How It Transformed Our World. But ,10 years later, Pendergast wrote that he thought he was wrong and so was everyone else who repeated the myth. His explanation covered several pages and it is too intricate to reproduce here, but one piece of evidence he referred to is that aluminium, coal and wheat futures contracts are all traded more actively than coffee since the mid to late-1990s. If you look only at agricultural commodities and use the United Nations Comtrade figures, coffee comes in seventh after wheat, cotton, meat, milk, leather and sugar. However, there is no denying one thing: coffee is indeed the second most valuable primary commodity exported by developing nations and in excess of 100 million people depend on it for a living. Coffee Markets and Trade Finance
Those at the beginning of the coffee supply chain, such as growers and millers, have the least amount of capital yet they are in the most need of finance. Typically they need to access loans between $10,000 and $1 million, which has been described as a banking no-man’s land. A solution for them lies in forming cooperatives and seeking finance from the Finance Alliance for Sustainable Trade (FAST). FAST’s mission is: “To ensure the continued growth of sustainable production and trade by increasing the number of producers in developing countries who successfully access affordable trade finance.” FAST has 156 members in 36 countries. Members of FAST include Rabobank, Triodos Sustainable Trade Fund, Transfair USA and Root Capital. Together, members of FAST provide finance for the “missing middle”, specifically infrastructural finance of greater than $5 million, small and medium enterprise finance of $20,000 to $5 million, and microfinance of less than $20,000. For example, Root Capital raises money from investors in the United States at 2.5 per cent per annum interest and lends it out at 9.5 – 12 per cent per annum interest. In 2010 it covered approximately 75 per cent of lending costs with interest income and it expects to break even in three years. So far Root Capital has lent $235 million to 305 rural businesses in 35 countries with a 99 per cent repayment rate and it expects to triple annual lending by 2013. One of Root Capital’s biggest investors is Starbucks.   Nevertheless, credit in the coffee sector is tight with FAST estimating that there is a deficit of $780 million between the annual financial needs of growers and millers and the funds available from socially-oriented lenders based in Europe and North America. This shortfall serves to prevent growers and millers from being fully accommodated and to increase the costs of coffee production through higher interest rates. One effect of this is that landowners have been encouraged to put coffee growing land to alternative use such as the production of illicit drugs. Also, if world coffee prices fall, an increase in the default rate on loans can be expected, which would jeopardise further financing activities. Another result of a fall in world coffee prices would be that those companies that sell it to consumers would benefit including Starbucks, Kraft Foods (Maxwell House), The JM Smucker Company (Folger’s), Nestle, Sara Lee, Tim Hortons, Peet’s Coffee and Tea, and Dunkin Donuts. However, the impact of tight global credit markets in itself has not impacted on coffee any more than any other commodity and the current market for coffee is not uniquely reliant on the availability of trade finance. It is in the interests of the companies mentioned above to have open credit accounts with exporters so that they can delay payment of invoices for as long as possible, for instance 180 days. An alternative which is preferred by exporters is to have a letter of credit whereby payment is made when the conditions laid down in the document have been met. Ideally exporters would prefer payment in advance, but this is not usually available. An alternative to a letter of credit which is simpler, faster and less costly is a documentary collection (D/C). It is suitable where a trade relationship is established and there is a stable export market. The exporter retains title to the goods until the importer either pays the face amount on sight or accepts the draft to incur a legal obligation to pay at a specified later date. To be clear, current coffee prices are close to a 14-year high mainly because of supply shortages due to adverse weather conditions in coffee growing areas, rather than because of tight credit markets Determinants of Prices
The weather has had the most pronounced effect on coffee prices over the past 15 years. In June 2010 it was announced that the output of coffee in Colombia was set to increase by 25 per cent due to dry, favourable conditions. Then by the beginning of December rain had flooded 200,000 hectares of Colombian land and triggered a mudslide that killed 40 people. As a result coffee output was revised downwards by 18 per cent although still an increase on previous years. Likewise in Indonesia the La Nina weather pattern has been responsible for damaging the coffee crop. An increased rainfall reduced production yields as well as growers’ ability to dry the coffee beans after harvest. The heavy rainfall also raised infestations of the coffee bean borer beetle which usually only feeds on Robusta fruit, but which affected Arabica crops as well. As a result, Indonesian total coffee output is expected to fall by about 15 per cent. Consequently, there is a shortage of good quality coffee. For example, it was reported in February that coffee prices in Tanzania were close to lifetime highs because of tight supply. Tanzania is Africa’s fourth largest coffee producer after Ethiopia, Uganda and Ivory Coast. Consumption
On a per capita basis, the largest coffee consuming country is Finland. However, more coffee is consumed in the United States than any other country. In the United States the population drinks about one-third the amount of tap water they ingest. Coffee prices have increased steadily since 2005 and the global financial crisis (GFC) made only a temporary dent in the increase. However, the GFC did make a difference to some coffee consumption patterns. For example, McDonalds introduced McCafe in 2008 to compete with Starbucks on price and it had a good deal of success. Since then the market for specialty coffee has settled down and the consensus among financial commentators is that there is room for both in the market. In this regard it is worth noting that the coffee which McDonalds uses in McCafe is made by Starbucks. Outlook
Low inventories of coffee beans combined with production write-downs ensure that coffee will be in short supply for the foreseeable future. Forecasts for output in 2011–12 are higher, especially in Brazil because it is an “on” year, but the certainty of supply in general is subject to the vagaries of the weather. For those at the beginning of the supply chain finance is a major cost and there is no easing of interest rates in sight because of an annual shortfall in funds. Should the price of coffee fall as supply catches up with demand, margins will become narrower for coffee producers and some will go out
of business because, even when coffee prices are high, few are able to save. Those further along the supply chain are not as sensitive to tight credit markets as they have access to international finance and intermediaries such as banks are more conditioned to providing capital to them. Also, there are avenues such as letters of credit, open accounts and forfaiting which are not available to the majority of coffee producers. Trading Coffee Futures on the New York Mercantile Exchange (NYMEX) • On the NYMEX a futures contract is a financial contract obligating the buyer to purchase an asset, in this case Arabica coffee, at a predetermined future date and price. Alternatively they can sell the contract for cash. At the same time the seller is obligated to deliver Arabica coffee on the same terms or sell the contract to someone else for cash.
• Coffee futures on the NYMEX are deliverable in March, May, July, September and December. Each delivery month has a different ticker. For example, if a contract is to be delivered in March 2011, the ticker is KCH1 where KC is the ticker for coffee, H is the symbol for March and 1 is the last digit in the year 2011.
• One futures contract on the NYMEX is 37,500 pounds.
• Tick size is the minimum amount by which the price of a contract can rise or fall; it is .05 of a US cent or $0.0005. This is equivalent to $18.75 per contract. One US cent per pound equals $375 per contract.
• There is no daily limit to the extent to which prices can rise or fall.
• Coffee futures contracts can be traded 23 hours a day, five days a week.
• You need to lodge an initial margin of at least $4,158 and maintain a margin of at least $2,971.
• On 15 February 2011 a futures contract for Grade 3 washed Arabica due for delivery on 21 March 2011 changed hands at $2.599 which is considerably higher than the ICO’s Composite Index on 15 February 2011. Source: New York Mercantile Exchange