Global financial markets are driving price volatility in asset prices in developed and emerging economies alike. This is especially the case for the commodity market for green coffee. In the last two decades, many commodity markets worldwide are experiencing the financialisation of commodity markets, creating extreme price volatility. Coffee is no exception.
Here we aim to discuss the interrelationship between coffee market fundamentals and its price volatility within the global financial markets. With the limited data available to us, we also aim to further speculate the implications of the global coffee price volatility on the Australian coffee sector.
Background of Coffee Economics
Un-roasted coffee as green coffee is one of the most traded agricultural commodities in the world. It had played an important role in many developing economies, as it had been the second most valuable commodity exported by these countries from 1970 to circa 2000 (Talbot, John M, 2004). Today coffee is still a major agricultural commodity contributing to economies like Ethiopia, Brazil, Colombia and Vietnam.
There are two primary types of coffee, Arabica and Robusta. The two varieties are distinctive in terms of their flavours, growing conditions and therefore prices. Arabica coffee tastes sweeter and softer, and is often cultivated in Latin America, eastern Africa, Arabia or Asia (Clifford & Willson, 1985). Brazil is the world leader in green coffee production with most of its production being Arabica. It is perceived by consumers as of higher quality and therefore preferred by developed countries with specialty coffee industries such as the States and Australia alike. Arabica coffee futures contracts are traded in New York.
Robusta coffee is mostly grown in western and central Africa, southeast Asia and to some extent in Brazil (Clifford & Willson, 1985), with Vietnam being the largest producer of Robusta coffee and the second largest coffee producer in the world (International Coffee Organisation, 2019). With twice as much as caffeine, Robusta coffee has a bitter and harsher taste with a stronger body. Although easier to grow and more resistant to diseases, Robusta is considered to be more of an inferior product compared to Arabica. Robusta coffee is often used in lower quality commercial products such as supermarket coffee and instant coffee. Robusta futures contracts are traded in London.
Consequently, Arabica coffee is of higher demand and is generally priced higher than Robusta. As at March 2019, 62% of total global coffee production was Arabica in comparison to Robusta at 38%. Pricing wise, Robusta was traded at 73.28 US cents per lb, 21.14 cents lower than the global price composite (International Coffee Organisation, 2019).
Coffee Price Crisis?
The green coffee price was at its 10 year low in 2019 amid fear of a global coffee crisis. According to the International Coffee Organisation (ICO)’s April 2019 Market Report, the average monthly green coffee price was at 94.42 US cents/lb, the lowest since July 2006. This price was actually lower than estimated farmers’ production costs in many countries. According to a report published by Cravela, a Latin America specialty coffee direct trade company, the average cost of production per pound of commodity coffee for small lot holders (less than 3 hectares) was USD$1.35 across 6 Latin American nations.
Source: Financial Times
Even though as the size of the land increases, the production cost per pound decreases. Given the majority of coffee farmers are small producers, the low price of coffee puts most coffee producers and therefore the future of coffee at risk. Whilst small lot coffee farmers have a slim or negative profit margin, they are extremely vulnerable to price volatility and other threats (Hicks, 2018). Furthermore they will not be able to invest further into the coffee production, or worse they may choose to substitute coffee plants with other crops. As a consequence, the future of coffee across the value chain suffers.
Real Economy in Coffee
Many argue that the green coffee price is highly volatile and that the volatility is detrimental to the sustainability of the coffee industry. To better understand this volatility, we need to look at both the real economy and financial economy in the coffee sector.
The real economy consists of producers, exporters, importers, traders and roasters (Hicks, 2018), purchasing, selling, transacting and delivering physical goods. This is also how the majority of higher quality and specialty coffee is traded. The immediate settlement of these transactions can also be defined as cash markets, as opposed to futures markets. The real economy tends to reflect closely to market fundamentals such as the rule of demand and supply.
Besides the market fundamentals of demand and supply, there are a number of factors that should be taken into account when examining the volatility and the potential price crisis. Currency exchange rates for example can have significant impacts on the trade of coffee. Being the largest exporter of coffee in the world, Brazil is experiencing increasingly weaker currency against US dollars. While coffee price is measured in US dollars, the depreciation of Real encourages Brazilian coffee export. Consequently Brazilian coffee producers are incentivised to release their stocks to the international market (ICO, 2019), further increasing the global supply and therefore contributing to the low coffee price in 2019.
Source: Financial Times
Global warming is also an important factor affecting agricultural commodity price volatility worldwide. With the rising temperatures and more extreme weather conditions, coffee becomes increasingly vulnerable to diseases, pests, and drought, while productivity and quality both fall (World Coffee Research, 2019). This is evident in the recent surge of green coffee prices due to the worst draught in Brazil in nearly a century, resulting in the first supply shortage in the coffee market in four years (Hamer, A. & Terazono E. 2021).
Financial Economy in Coffee
Surrounding the real economy is the financial economy in which future coffee contracts are traded. In the financial economy, green coffee is considered to be an agricultural commodity as interchangeable, indistinguishable, and relatively nonperishable goods. Because of this interchangeability, green coffee can be traded in commodity markets such as New York International Commodity Exchange.
Future coffee contracts are not containers of coffee being traded but the commitment to accept delivery of a specific quantity of coffee at a specific port, at a specific point of time (Grabs, 2018). These futures contracts dealing in a minimum of 37,500 lb (one container worth of coffee) are generally placed by large companies such as Nestle looking to trade/hedge, or financial investors looking for short-mid term profits.
The presence of financial investors in commodity markets provides additional capital into the commodity markets. The role of the financial economy in commodity markets has become so significant in the last two decades – volumes traded at futures markets often rose faster than the global production of most commodities. While the ‘financialisation’ of commodity markets is not unique to coffee, it is estimated that the capital injection into coffee is comparable to that of the market for grain (Umana, 2019). This is evident in the volume of futures contracts traded from 1994 to 2018 whilst Robusta futures contracts almost tripled and Arabica rose five-fold. Over the same period, Arabica production rose by 64 percent and Robusta production increased by 144 percent (Umana, 2019).
The financialisation of coffee as a commodity is often perceived by many specialty coffee traders and organisations as negative. It is believed that the speculative trades contribute to the price volatility and therefore deemed as having negative and destabilising effects to the coffee producers and the coffee sector in general.
Besides enabling global trades possible and creating capital inflow into the sector, the futures market also performs two major functions: hedging and price discovery (Grabs, 2019). Through futures markets, coffee traders and farmers are able to reduce their exposure to financial risks through hedging. The futures market price can also be used as a price discovery mechanism in the spot market, as the futures contracts tend to align with spot prices as their contract delivery date approaches. They are therefore seen as an indicator of what the 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 (Grabs, 2019).
Flaws in Futures Markets for Coffee?
Despite the above valuable economic functions, many claim there are some fundamental flaws in this financial system. First of all, it may seem strange to some that coffee is considered as an undifferentiated commodity, whilst there are a number of coffee varietals with a range of processing methods creating a diverse range of flavours and tastes. It is important to note the existence of both specialty and commodity markets (Coleman, 2019). The primary market for coffee in the world is however a commodity one. As with most commodities, the quality of coffee is a minor consideration in the futures markets. The futures markets are simply not set up to incentivise high quality coffee production. Rather it values consistent large volume low cost mid-tier coffee (Coleman, 2019). This may have been one of the main contributing factors to the overall low perceived value of coffee.
Furthermore, many believe that the other major flaw in the futures market is the volatility it brings about. It is often suggested that the speculation in the futures market contributes to the high volatility in coffee price. While the volatility in commodity markets is not unique to coffee, we can look at a number of economic studies examining the role of speculation in commodity markets.
It is clear that speculators can influence the movements in the C price, and it is desirable for them to be able to do so. The real debate is whether speculation can force the C price to diverge, for any meaningful period of time, from what is justified on a fundamental basis; and whether speculations create destabilising effects in the commodity coffee market. (Devin et al, 2012)
Studies examining the link between speculation and volatility in commodity markets show that while it is empirically difficult to completely rule out a role for speculation in commodity derivatives markets to increase price volatility, there are strong grounds to conclude that speculation has not had a systematic long term impact on commodity price dynamics (Devin et al, 2012).
A more recent and relevant study has been conducted by ICO (2019) using statistical tests of time series analysis to evaluate the causal link between speculative activity and spot prices. It takes into spot coffee prices for Arabica and Robusta with six indicators of speculations: monthly volume of futures contracts, monthly open interest in futures contracts, the ratio of volume to open interest, the ratio of long and short positions held by non-commercial traders to total reportable positions, and the index traders’ net positions (long-short) (Umana, 2019).
The study shows, while there is a causal link between speculative activities at the futures markets and spot market prices for coffee in specific time periods, speculation does not have long term impacts on the coffee market and it is certainly not responsible for the recent downturn of the coffee market. In line with the body of studies on the 2008 price crisis in the market for grains, the results suggest that market fundamentals such as demand trends and supply shocks prevail in determining price behaviour in the long term (ICO, 2019).
There seems to be two schools of thoughts on the speculation in futures markets driving coffee price volatility. One believes that coffee price volatility is mainly contributed by speculation in the financial system and it is detrimental to the coffee sector. This is a view often taken and published by many specialty coffee organisations. However, the other school of thoughts with the view of speculation not having long term influence on the market for coffee is much more well supported by economic modelling and statistical tests. This view is also inline with economic studies of other agricultural commodities.
It is noted that coffee itself is a unique agricultural product itself, and therefore the studies conducted for other agricultural products such as wheat and corn should be taken in consideration with this difference in mind. It is our opinion that in the long run the movement of C price is largely due to the market fundamentals of supply and demand, and the short term price volatility is largely contributed by speculation.
Smoothing Out Volatility?
It is argued by many coffee professionals that volatility has negative impacts especially on small producers. Short time price volatility creates insecurity and uncertainty in coffee production. Small producers selling cherry or wet parchment coffee to intermediaries usually have a 24-48 hour window from harvest to sales before the quality begins to deteriorate, and producer groups and cooperatives increasingly face accepting contracts with fixed prices referencing the C market price (Grabs, 2018). In these cases, small coffee farmers are most vulnerable to the low and volatile C price which often falls below production cost.
The question raised by many industry professionals is whether we are able to sustain the financial markets for coffee with less volatility. There are numerous proposals by academics and professionals as to address the C market and its volatility with intention to decrease small producers’ vulnerability to the C price.
Some call for the industry to adopt a voluntary price benchmark structure instead of using C price as a price reference in spot markets. One example is a C-5 model by taking the multi-year mean of C price over five years (Hicks, 2018). This however in our opinion does not address fundamental issues and structural flaws of the financial economy. Some take on a regulatory approach by calling for a price floor, a minimum legal price for coffee. Yet this would consequently result in supply surplus, when a price floor is set above an equilibrium price. It is therefore not a sustainable long term solution and is not a measure taken lightly by any governments.
There are also talks to introduce regulatory intervention into the futures market to stabilise the C price with stricter limits on positions held by non-commercial traders by increasing costs for non-hedging participation, imposing capital requirements, and a compulsory delivery on contracts, to name a few (ICO, 2019). This however limits the capital inflow into the financial economy and commercial traders require this additional inflow into coffee to hedge in order to reduce their exposure to risk. In the economic context, regulatory intervention limits the market’s potential to self adjust to its equilibrium and therefore creates an inefficient economic system.
We are with the strong opinion that solutions need to address the market fundamentals. Better transparency by improving the quality and timeliness of data is an important step towards addressing price volatility in the coffee sector. Price volatility in commodity markets is intimately linked to uncertainty. The lack of timely and comprehensive physical market data continues to hamper the efficient functioning of both physical commodity markets and related financial markets. (Devin et al, 2012) Joint Oil Data Initiative (JODI) is an excellent example of a data initiative established to improve transparency and address oil price volatility. There is much scope for international coffee organisations such as ICO or Specialty Coffee Association to pursue similar data and transparency initiatives for the coffee sector.
What Does This All Mean for the Coffee Sector in Australia?
Australia is well known for its high standard for coffee. Coffee culture in Australia is so strong that coffee is deeply integrated in our daily life. Coffee is also the most consumed beverages in Australia (Square, 2018). Businesses directly working with coffee including coffee distributors and coffee shops, who add value to green coffee, contribute 12 billion revenue (IBISWorld, 2019) to the Australian economy. Import wise, according to ICO (2019) Australia imported 1.92 million bags of green coffee (60kg per bag) in 2017-18. This equals about 115 million tonnes of coffee.
It is apparent that coffee is an important product in our daily routine, however we are amazed by the lack of data and transparency in the Australian coffee sector. During our research, we have come across limited statistics and data regarding coffee trading and pricing. This makes economic modelling or even assumptions difficult. This might be due to a number of reasons. For one Australia is not part of the International Coffee Organisation which incorporates and publishes up to date trade data of all its participating members. Furthermore major Australian coffee associations do not actively and directly promote transparency in the trade of green coffee.
There seems to be a disconnect between Australia’s hype about coffee and the coffee price crisis in the producing regions. While many coffee producers are emigrating to other crops as they are not able to make a living with coffee due to its oversupply and high volatility, it seems to have little cascading effect on the price of coffee as an end product. This disconnect is somehow understandable as Australian operators tend to absorb the price fluctuation and green coffee costs are only made out a small portion of your everyday flat white. This does not necessarily mean that the Australian coffee sector, either commodity or specialty, is sustainable in the long term. It could be just a matter of time until the cascading effect reaches the Australian coffee sector.
It is our opinion that to have a more sustainable coffee market, there needs to be a fundamental change on the demand side of the trade. There is a need for consumers to demand higher quality coffee and therefore raises the quality of supply in the producing countries. Higher quality supply means a higher price for coffee and potentially better earning for the quality producers. To create this demand from the consumers, there is a need for consumers to understand the values of higher quality coffee through transparency and data such as product traceability and pricing. There is therefore much scope for further discussion and study on better transparency and data in the Australian coffee sector.
First written and submitted by Joel CM Cheng in 2019 (edited in August 2021). Joel CM Cheng is the Founder and Director of Good Coffee Project. He is a MBA candidate at Macquarie University, and holds a Master of Design degree at USNW.
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