Modern Coffee Trading

by

By Dan Bolton

Speculators got clobbered in August. It was the first time since February that the big hedge funds had been long on arabica. A net long means that the number of positions which benefit when prices rise greatly outnumbered short bets, an indication of bullish sentiment.

“Speculators enthusiasm proved misjudged as front month arabica prices fell 4%,” according to Bloomberg. Prices continued their plunge to a 19-month low.

By September futures were on the rise again thanks to a decision by Brazil’s central bank to shore up the Brazilian real after falling 50% to a record low of 4.25 reais per dollar. In contrast, during 2014 coffee was the world’s best performing commodity as prices soared by 49%.

The 15-month global commodities free fall has made 2015 a nightmare for traders with the World Bank predicting markets will hit rock bottom in the second half of 2015 before rising in 2016.

The Bloomberg Commodities Index has dropped 50 % since its 2011 high making commodities the year’s worst-performing asset class.

The boom cycle is over.

Rising demand

However the fundamentals driving coffee are far different than most commodities where demand is slack.

The International Coffee Organization (ICO) projects a 25% increase in consumption during the next five years.

The expanding middle class in China and India as well as domestic markets in Brazil, Colombia are drinking coffee like never before. Economists label the seemingly inexhaustible demand for coffee “inelastic.” 

Economist Julio Sera, senior risk management consultant at INTL FC Stone, explains that market volatility arises for many reasons foremost of which is “supply/demand disequilibrium.”

In a presentation on the Economics of Coffee to the National Coffee Association last year Sera said that much of the uncertainty (aside from El Niño weather conditions, crop disease, and currency fluctuations) arises from a high variance in estimates of global production.

He illustrated his point with 17 different estimates from reputable sources that vary by millions of 60-kilo sacks.

Commodity traders learn to accommodate many variables but setting prices and meeting demand is greatly complicated when neither buyers or sellers can accurately predict supply.

Dwindling inventories

ICO predicts a rebound of 6.4 million bags for the 2015/16 harvest but issued a note of caution this summer as consumption is expected to reach record quantities drawing inventories to their lowest level in several years.

The Brazilian export agency Conab reports private stocks in Brazil, which has the largest reserve, are less than 15 million bags. Coffee exports are down 5% for the year with prices averaging $1.21 a pound for August.

ICO warned that warehouse levels in most producing countries are waning and will not be sufficient to cover production shortfalls.

With an eye to the weather as the strongest El Niño since 1950 develops, ICO said that if production fails to meet expectations the market could be highly susceptible to a rapid surge in prices, as was the case in March 2014 and early 2011.

Legacy traders

 European coffee traders with a century or more perspective like Volkart Brothers (Volcafe Group) and Bernard Rothfos (acquired by Neumann Kaffee Gruppe) reap the benefits of relationships and infrastructure improvements at origin dating to the colonial period. They dominate the trade.

NKG and Volcafe Group combined serve about 25% of the global coffee industry. Conservation of biodiversity in coffee growing regions and the export business are perfectly compatible.

ECOM Agroindustrial Corp. founded in 1935, completes the list of the world’s top three coffee merchants. The Sao Paulo-based firm is one of the largest coffee millers with 50 offices and earnings greater than $4 billion. ECOM handles more than 12 million bags of coffee annually.

“The long established, traditional traders are firmly integrated into origins with heavy investments into milling-assets and storage-facilities in producing countries,” observes Wolfgang Heinricy, formerly with Louis Dreyfus Commodities and a past managing director of Bernhard Rothfos in Hamburg, Germany. Firms were deeply vested “seeking to enhance value adding functions in producing countries, rather than remaining an asset-light service provider,” said Heinricy.

The market has changed from old-fashioned relationship-building and salesmanship to “cool and rational corporate and investor efficiency that is focused on short term cash profit and less about value creation,” according to Heinricy.

He cautions that market moving speculation and bets based on analyst conclusions about the inefficiency of markets are “dangerous.”

“New market participants are attracted by the volatility and inefficiencies of soft commodities like coffee, acceleration and exaggeration is the result,” he said.

Heinricy sees a risk to the roasting industry “as both its supplier categories will care less about them, selfishly seeking a profit. The relationship between the supply chain and final roaster may become less comfortable and more opportunistic, less accountable. Industry customers will have to watch out with whom they want to associate in the future, and carefully evaluate the value propositions still offered,” he said.

In our coverage this month STiR Tea & Coffee takes a close look at coffee trading with a feature on modern traders from Norway whose Nordic Approach makes them direct sales conduits for roasters, delivering micro-lots from farms they visit regularly.

“The whole idea is to build bridges between the producers and the roasters,” writes trader Morten Wennersgaard, co-founder of Nordic Approach. “That’s why transparency is so crucial. Having two parties, in both ends of the chain, engaged makes everything worthwhile. We are often bringing clients with us to origin, and it makes any project we do much more meaningful. It proves that all the hard work from everyone involved is worthwhile.”

ALSO: A New Approach to Trade

And for the largest traders, STiR explores commodity trading risk management (CTRM) systems, a high-speed, real-time means of tracking every transaction from the palm of your hand.

ALSO: Mobile Commodity Trading Software 

Risky Business

Coffee trading is volatile and margins are thin. There are so many ways to lose money in the blink of an eye that traders rely on automated software to recognize risk and convert it into a profitable opportunity. Here are four common types of risk defined by Generation 10, a software company specializing in commodity trade risk management.

Market risk: The risk of a change in the value of a financial position due to changes in the value of the underlying components on which that position depends, such as commodity prices and currency exchange.

Credit risk: The risk of not receiving promised payments on outstanding investments because of a default by the borrower.

Operational risk: The risk of losses resulting from failure to perform due to inadequate or failed internal processes, people and systems or from external events.

Liquidity risk: The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimise loss.