Coffee Volatility

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By Dan Bolton

A year ago, in February 2016, coffee prices were near five-year lows. Coffee prices declined 20% in the first quarter. By November ICE contracts for arabica coffee futures were trading at two-year highs, reaching $1.79 per pound for March 2017 delivery. A few weeks later in December prices had fallen to $1.38 per pound.

The fact that coffee is one of the most volatile commodities is a given. Weather is unpredictable and therefore always a factor in pricing as it determines harvest volume and crop quality, simultaneously impacting supply and demand – but this cycle has given traders and roasters unusual variables to consider.

Rising risk

Risk is described as uncertainty that matters. Classic risk-management strategies are only now adjusting to uncharted vagaries of weather and the interconnectedness of the global economy.

• No one in Brazil remembers droughts occuring in January or February, yet for the past two years little rain has fallen and reservoirs are now dangerously low. Setbacks in arabica production could be temporary, the result of El Niño, but many fear a foreboding change in climate. Meanwhile robusta yields fell 40% in Brazil. On the other side of the globe Vietnam, the world’s second largest coffee producer after Brazil, is facing a 3 million 60-kilo bag shortfall.

• Currency fluctuations are counter-intuitive. The value of the US dollar has risen steadily since 2002. In fact the trend toward a strong dollar has accelerated against all the world’s major currencies, notably the British pound and Euro. Since coffee is a dollar-denominated commodity, falling prices would seem to benefit roasters and consumers at the expense of producers.

Why plant more to get less? In fact producers in Brazil and Colombia and Indonesia increased production despite low prices because they are actually netting more money in local currencies for every bag sold. Farmers and exporters have an incentive to draw down stocks, releasing coffee into the international market even as prices fall. While arabica production declined to a three-year low the Brazilian real depreciated by more than 50% last year sending exports to record levels.

• Political uncertainties are the latest unknown. In the near horizon the new US administration adds to global uncertainty. No one knows how to read Washington D.C. right now. The Trans-Pacific Partnership (TPP) looks doomed. NAFTA may be in jeopardy. Britain’s decision to leave the European Union has unsettled trade in the most important coffee market in the world. In Greece the long term economic malaise has significantly altered the market.

In March after coffee futures hit new lows the large index funds, what we call “passive investors” came back into commodities in a big way, explains Albert Scalla, vice president at INTL FCStone Financial, in Miami. “Suddenly 2016 became a positive for commodities and in the commodities basket the speculative side of the market came in hard for coffee,” he said.

Reports of trouble with supplies of the higher quality coffee from Colombia drove up prices but that prediction ultimately proved false. “Colombia turned in a very good crop,” said Scalla. “Then two mini-freezes in Brazil affected investor sentiment, but did little damage. Conilon became a factor as unfavorable weather in Vietnam could possibly take out 2-3 million bags at the same time the drought in Brazil has brought production down to 10 million bags (See Brazil, Pg. 42).

Since then the weather has turned for the better, he said.

Unpredictable predictors

Scalla said the #1 reason for coffee volatility is the lack of credible information. “That is our fault, the industry lacks transparency in logistics. The numbers that suppliers report are sometimes in question. Warehouse stocks of green coffee are a question mark. Stocks at main ports continue to increase as export totals fall. No one really knows how much coffee is produced or even how much is consumed,” observes Scalla.

 “Are we really growing on a 60-kilo bag basis or is consumption really only growing per cup or by aggregate value,” asks Scalla, citing National Coffee Association/StudyLogic data showing a steep year-to-year decline in single-cup servings per person. Capsules hold a small fraction (6-10 grams) of the amount of coffee used (and often wasted) in drip brewers. Big increases in the number of single-serve coffee drinkers signals an overall decrease in coffee processed by roasters.

“Essentially we have to question everything,” he said. “That is what creates uncertainty in the markets and uncertainty contributes to risk and risk eventually translates to volatility in prices,” he said.

Coffee prices

Arabica futures last traded above $2 per pound in October 2014, a price some argue is essential for the long-term sustainability of producers. The all-time high of $3.0625 was reached in May 2011. When adjusted for inflation the median price of coffee was $2.93 per pound during the period 1973-2000. It has since declined to an inflation adjusted $1.73 per pound for the period 2001-2014.

In his presentation at Sintercafe 2016 Scalla described three scenarios, for the first few months of 2017 each with a range of prices. He said that projections beyond six months are unreliable given the more than 20 variables FCStone takes into consideration when making forecasts.

In the first scenario prices rise to between $1.60 and $1.90 per pound due to speculators. Key assumptions include continuing weather concerns in Brazil with the harvest falling below 52 million bags; European stability with a weakening dollar and the widely held belief that globally demand is outpacing supply.

In the second scenario modest rains increase the harvest to 54 million bags in Brazil, the dollar remains stable and other origins maintain current production levels. Prices will range from $1.40-1.60 per pound through the early months of next year.

Scenario three assumes abundant rain with a Brazilian harvest greater than 55 million bags, a global excess of 5 million bags, currency devaluation, and troubles in Europe due to Britain’s decision to exit the European Union. Prices will fall to between $1.20 and $1.40.

The timing of crop estimates moves the market.

 In August professor Rodrigo Lanna da Silveira, who studied coffee futures contracts during 2004-14 found that “crop reports generally affect price volatility. The impact is particularly strong when they provide information following the flower periods in Colombia, Brazil, and Vietnam.”

His work with Fabio L. Mattos and Maria Sylvia M. Saes, was published in the Journal of Emerging Markets Finance and Trade.

Production estimates from reputable government, trade association and industry experts sometimes vary by millions of bags. Every weather report sends prices to the winds.

Risk management

Disruption in long-established patterns “cause trends to break down, to break up, or simply to break,” observes Richard Dobbs, director of the McKinsey Global Institute and co-author of No Ordinary Disruptions: The Four Global Forces Breaking all Trends.

“We work in a world in which even, perhaps especially, professional forecasters are routinely caught unawares. That’s partly because intuition still underpins much of our decision making.

“Our intuition has been formed by a set of experiences and ideas about how things worked during a time when changes were incremental and somewhat predictable... that’s not how things are working now—and it’s not how they are likely to work in the future,” writes Dobbs.

Precaution and protection

Given the sheer complexity of the global marketplace managing risk seems at best a guessing game but “risk management today is much more akin to buying insurance to protect against negative turns of events. When used properly, it can also create opportunities to gain market advantages,” INTL FCStone’s senior risk management consultant Julio Sera told attendees at the National Coffee Association convention last March.

One example is that roasters can use risk management tools to set their own prices, which in turn can enable them to create custom-tailored buying and selling programs for customers – months ahead of their competitors.

Risk management is protecting yourself against (or at least minimizing) potential damage. Proactively managing risk before harmful events entails a strategy built on a combination of risk reduction, risk transfer, and ideally risk avoidance.

Every participant in the coffee sector is concerned with the unpredictability. What distinguishes participants is how they react. Assessing the immediate impact and learning the long-term trends is the best means of limiting harm from things you can’t control.