What affects the price of coffee?

By Jack Purr — Purchasing Manager

 

What affects the price of coffee? Well, the simplest answer is supply and demand. Coffee is an agricultural commodity, and production changes will affect price. Simply put, lower production equals higher price while higher production equals lower price.

Simple right? Well, it’s actually not so cut and dry, and over the last decade the complexities and variables effecting price (especially the futures market price) seem to have been growing at an exponential rate. These days many things affect the “price” of coffee. Supply changes? Weather? Of course. Political changes, currency fluctuations? Definitely. Civil unrest, geopolitical tensions? Possibly. Confusing news headlines? Presidential tweets? Sure, why not. The truth is things that would seem to have nothing at all to do with coffee can move prices and impact the bottom line; it all boils down to mass perception or social mood.

Actual production changes will always have a direct impact on prices. The tricky part is where and when that impact will show. The way coffee trades is actually two markets in one. We have the C market (the futures or “flat price”) which is the visible price traded on the ICE exchange. The other aspect of coffee is the origin by origin differentials or “basis.” For some commodities, basis is simple (i.e. sugar is sugar) but for coffee there are many origins and qualities each with their own differential to be traded.

Over the last decade, production changes have become more and more directly reflected in differentials than in the C market. Looking at the below chart you can see that prior to the late 1990s any notable price spikes in the C market were a direct reflection of major production disruptions (frost in Brazil, drought in Central America, etc.). Over the last 20 years though, the production impacts are less severe on the C market and the more extreme price swings are products of “macro” factors.

For example, in 2008 the world’s number two producer, Colombia, saw production drop as much as 40 percent after a leaf rust outbreak. The C market did rally quickly, roughly 40-50 cents, but those gains were just as quickly retraced. The Colombian differential though surged to over 100 cents (premium to the C market where average is usually less than half that) and remained high for quite some time. The biggest surge in the C price over the last ten years (over $3 per pound in 2008) was Dollar-based and part of a broad based commodity rally.

This penchant for the C market to react more toward macro factors can be confusing and frustrating at times. It can also lead to poor hedging decisions as it can cloud the actual supply situation in the market. Recent months are a good example. Over the last three months C market prices have slowly eroded about 30 cents per pound. At the same time, the only real fundamental news in the market has been industry forecasts for the next production cycle. These forecasts vary a fair amount in actual numbers, but overall consensus is a roughly 10 percent reduction in global production is forecast, putting the global supply demand picture at a very balanced level. This comes after two consecutive cycles of small production deficits versus demand. So while this isn’t necessarily positive for prices (as long as nothing changes there should be enough coffee to cover demand), it certainly would not seem negative (there is virtually no room for any production problems). Yet the price continues to meander at lower levels which can lead to complacency in buyers and an increase in risk. Once the social mood focuses on the lower production the risk is for a rally, which given coffee’s history, could be violent.

So what about this “macro” picture? What drives it? Well, the answer is many things and those things are always changing. First, it helps to know a little about the players and how money flows. The biggest influence is invested money in the form of funds. These funds are often referred to as “specs” (speculative). Basically this is money in the market that has little interest in trading the actually physical commodity. Specs provide needed liquidity to the market but they also lend some confusion because of how they trade. Large percentages of speculative money is in the form of funds that trade broad-based baskets of commodities as percentages of their assets.

So for example if 20 percent of a fund’s overall assets are invested in crude oil and 3 percent are invested in coffee, a big event effecting crude (OPEC production, a bombing in the Middle East, etc.) can see a large change in a funds overall assets, which in turn could force them to trade coffee, in either direction, to keep their investment ratio at 3 percent. It may make no sense at all to the overall outlook for coffee but it is simply a function of money. The US Dollar is always a focus for the investment community as well but the relationship to coffee can change based on social mood.

For example, a strong US Dollar under fairly quiet geopolitical times can have an inverse relationship to coffee. The simple explanation is that a strong Dollar against the Brazilian Real for example allows producers to sell the C market more aggressively as they sell in Dollars and then buy the Real as their local currency. So a strong Dollar allows them to sell the C market at a lower level and still receive more Real for their product.

Yet, at other times the relationship can reverse. For example the Dollar is often seen as a barometer of social mood. A strong Dollar is seen as a reflection a positive outlook on the economy. This leads investors to be more likely to invest in riskier asset classes. Commodity funds see an inflow of cash and have to disperse that new money over their portfolio and a percentage makes its way into coffee. Honestly after 30 years focusing on this market I have seen a lot of things that don’t always make sense affect the futures market price. In the end, though, it all comes back to what mentality is driving the investment flow and that doesn’t even always make sense based on historical flows. The same situation can have a different price impact than in the past depending on any variety of factors.

So what is the answer to effective pricing? Tough call. For me, it has been technical analysis and chart patterns which can filter out the noise in a market, but that could be another lengthy discussion for another day. Overall it’s best to try and stay focused on the longer term and not get too caught up in the day-to-day emotion moving the market. In the end the physical commodity will ultimately dictate price. The best idea is to think about price as it fits within your needs and not about trying to necessarily buy the lowest possible level. Sure it’s great to boost the bottom line with a fortuitous market purchase but it’s worse to miss an effective price for being caught up in emotion that might be misguided. Discipline and objectivity are the best assets but also the hardest to act on. Emotion is the enemy of effective pricing. Try and find a filter for the noise and focus on the most important question, what is the best approach for my business? If $1.50 per pound is an effective price then buy it rather than listening to a little buzz in the market saying prices could touch $1.20. If you don’t have a strong opinion then buy a little of your needs once a month, or week or whatever. That approach would always keep you near the market and keep exposure to wide price swings minimized.

Coffee is one of the most widely traded and volatile commodities in the world. The changing landscape of trading can be difficult to keep up with, but the commodities team at S&D has decades of combined experience and is always in touch with the market and its day-to-day focus. We hope we can be a source of information and perspective and an asset to your pricing process.

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