Coffee trading can seem intimidatingly complicated. You may have heard reference to futures markets and hedging, but do you really know what they are?
And while falling coffee prices make the news, do you understand why are they so low? What do drops in the C price mean for producers? Let’s take a look into the world of coffee trading and find out more about its impacts.
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Bags of coffee beans. Credit: Julio Guevara
Understanding The Different Coffee Markets
Broadly speaking, there are two ways to buy and sell green coffee: the cash market and the futures market.
The cash market for green coffee is generally defined as the physical exchange of coffee being bought, sold, and delivered. Producers, exporters, importers, traders, and roasters all participate in the cash market.
In other words, the cash market is trading at its most basic level: coffee is sold at a certain rate based on its value at the time.
A scoop of green coffee beans. Credit: Neil Soque
You might think of the cash market as for immediate purchases, but this isn’t always accurate in the coffee industry. It can refer to an immediate purchase (known as spot purchases) or used for a forward contract, which is when a buyer commits to purchasing coffee for years to come.
For example, a roaster may commit to buying a fixed amount of coffee of a certain cupping score for the next four years and agree to pay a specific percentage above the international coffee price at the time of harvest. This would be a forward contract on the cash market. The majority of physical exchange of coffee occurs through forward contracts.
Coffee cupping. Credit: Neil Soque
Trading in the futures market is different. It means paying or receiving prices that don’t necessarily reflect the coffee’s current value. When parties sign a futures contract, they agree on a specific price to be paid in the future, regardless of the coffee’s market rate at the time of harvest or delivery.
This kind of contract comes with conditions. Futures contracts are between licensed participants on government-regulated platforms such as the ICE in New York (also known as the C market), which trades Arabica, and LIFFE in London for Robusta. The ICE and LIFFE set the price of coffee, which is known as the C price. They also stipulate that green coffee can only be traded in lots of 37,500 lbs.
Handling coffee as a commodity has some obvious flaws. All coffee is treated as a uniform product, regardless of quality, origin, or actual costs of production. Consider the wildly different infrastructure among coffee-producing countries and the range of coffee beans produced. Does this seem like an effective way to buy and sell coffee?
Coffee cherries on the branch. Credit: Devon Barker
Why Trade in The Futures Market?
So if the futures market doesn’t reflect the actual value of the coffee at the time of its delivery or reflect the costs of production, why do people trade this way?
Buying green coffee on a differential-based price (a certain amount plus or minus the C market price) always involves risk. The C price can fall and lead to the devaluation of the coffee. It could also increase after purchase, providing more income for the buyer. But it’s a fundamentally unstable and risk-based way to buy and sell.
A futures contract means that both buyer and seller know the price ahead of time. They can make business decisions and investments based on it. Some people also trade in the futures market to take advantage of dips in the C price. When it falls, they sign a futures contract to lock in future coffee at today’s low price.
Futures contracts mean that producers have a guaranteed price, which can be beneficial if the C price then drops. But it can be devastating if production costs go up because the C price is not linked to real life cost of production. A producer could be locked in to selling their coffee at a loss.
Coffee bags at a roastery. Credit: Devon Barker
Buying futures contracts is described as hedging. This term means strategies that reduce risk in a market with price volatility. It includes trading on the futures market but there are also other ways to hedge.
Artur Ornelas is a trader and handles operations at Minasul, a Brazilian specialty coffee cooperative. He tells me that hedging is used to reduce and control exposure to risk.
“One can offset potential price risk, while chipping away potential larger gains,” he says. “Hedging should be done to guarantee a profit margin, to eliminate the effects of price fluctuation on the results of a company or producer, knowing that once placed you should not expect to gain or lose anything different from that.”
Inspecting coffee beans. Credit: Devon Barker
How Does Hedging Affect The C Market?
The international market rate for green coffee is known as the C price. This price is affected by supply and demand. When supply increases or demand falls, the price goes down. When demand increases or supply decreases, the price rises.
Every time a futures contract is signed, it demonstrates demand and affects future supply. So the sale of futures contracts directly affects the C price.
But it’s also important to take into account who is trading coffee on the futures market and why. Artur tells me that the C market is divided into groups: traders in the coffee industry (producers, merchants, roasters, etc), who make up around 36% of the market, swap dealers who comprise 14%, managed money, which makes up about 35%, and other parties that make up around 15%.
The first group are people who actually use the coffee and are hedging to reduce risk. Managed money uses the futures market for speculative purposes – that is, they buy and sell coffee in the hope of making profit and have no intention of actually possessing the coffee. They do this on behalf of clients, including investment funds and banks.
Swap dealers use the futures market when creating commodity swaps, a complex financial deal that offsets risk and may result in profits. Like managed money, swap dealers do not intend to use the coffee.
Producers at a cupping in Guatemala. Credit: Devon Barker
Because coffee is handled as a commodity, it is linked to other commodities. Traders who use the market as a financial tool may also consider coffee in relation to wheat, iron, gold, or other commodities.
Investors use numerous commodity markets worldwide to trade in purely financial transactions, rather than physical trades in which the actual goods are delivered. And because traders buy and sell whatever seems attractive on that specific day, the C price fluctuates a lot.
So the majority of market activity is in the hands of players outside of the coffee industry. But all the activity affects the global price of coffee.
A man sews coffee bags. Credit: Devon Barker
What Does The Futures Market Mean For Producers?
The C price is not linked to the cost of production, and this has a real impact on producers. Smallholder farmers can be hit hard by price fluctuations while the rest of the supply chain enjoys healthy margins. If the C price dips, producers are left with a tiny profit margin or none at all.
Artur tells me that the C market has become too big for the coffee industry alone. “Non-coffee industry participants are the majority of the C market,” he says. “This brings a lot of liquidity to the market, enabling any participant to buy and sell when in need. This is a very important role.”
“But [speculation] also moves prices around a lot faster and allow prices to be uncorrelated with physical market fundamentals such as crop size, climate changes, cost of production, etc.”
Large cooperatives have access to the market and contribute to that 36% of traders with ties to the industry. But most producers don’t create enough volume to participate. Instead, they make sales based on the C price on the day they’re logistically able to sell. And as we know, that varies depending on the actions of traders each day.
This means that producers are unable to predict the price that they will sell their coffee for. A system designed to ensure price stability instead causes greater instability for the producers most at risk.
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A producer on a coffee farm in Guatemala. Credit: Devon Barker
Smallscale producers are excluded from the market because they don’t produce the minimum 37,500 lbs required by the ICE. But for producers who can access the market, such as large cooperatives, there can be some benefits.
Artur says that the futures market is an essential tool for more efficient management by producers. “It allows the producer, in times of exaggerated highs or too low prices, the tools to increase their profits or to diminish his losses,” he says.
“It allows profit margin setting, provided that the producer adequately controls their cost of production. Knowing the cost per bag, the producer can keep track of prices in the futures market, aware that they can now define their profit margin for the crop already harvested or, especially, for future crops.”
“All this provides the producer with the means to plan their production, costs, and investments, provided that future prices adequately pay for their costs and risks,” he tells me.
Learn more in Rethinking The C-Price: Should We Change How We Price Coffee?
A cupping session. Credit: Devon Barker
Coffee trading is a complex topic and futures contracts are just one aspect of it. They can be used by buyers to reduce risk, but at what cost? Hedging may seem like a smart financial choice, but it’s important to fully understand its impact on all parties involved in the coffee supply chain.
Found this interesting? Check out Green Coffee Pricing Transparency Is Critical (And Complicated)
Written by Sunghee Tark and Hazel Boydell.
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The post What Is Coffee Hedging & How Does It Impact Producers? appeared first on Perfect Daily Grind.
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