Coffee Prices: Why They May Continue To Decline
March 11, 2019 / Leonardo Zalum
In a talk with the CEO of Lamco Spa, Olam International’s wholly owned Italian coffee trading subsidiary and Italian coffee market leader with a 16% market share, we touched base on various topics, including the current coffee spot price. In particular, the spot price of coffee has been increasingly variable and has recently hit a 13-year historical low, with the possibility of seeing a further decrease.
Olam is one of the youngest players in the physical commodities business but is nonetheless one of the world’s largest suppliers of cocoa beans, coffee, cotton, and rice. To understand the industry, it is important to be familiar with its transformation process, that is, its transformation through time, referring to the storage of raw materials, transformation through space, shipping activities, and direct product transformation, for example, coffee bean roasting.
The accumulation of assets has become a key factor to be successful in the business, as space transformation through the use of logistics is no longer enough to keep a company profitable. As of today, to remain a relevant market player, a firm needs to have direct control on the whole supply chain meaning a firm needs to own the right facilities and assets as to be able to carry out the whole transformation process, thus being diversified enough in case of economic shocks. To keep up with the industry Olam has decided to implement a restructuring plan and in particular, the plan is aimed at focusing on its most profitable businesses: cocoa, nuts, and coffee.
Coffee is a developed country beverage, thus big coffee players are targeting and expanding in emerging economies (Starbucks is opening a new store in China every 15 hours). While this may all be true, we’ll see that coffee prices are not moving accordingly with supply and demand fundamentals.
Large volumes of coffee production around the world are putting farmers under increasing stress, this year: Brazil (60 million bags) and Vietnam (40 million bags) cumulatively accounted for roughly 40% of worldwide robusta type coffee production. Overall, total world production stands at 170 million bags per year which is yielding a 10 million bag excess in supply. What this results in is an increase in inventories which will ultimately have to be sold the next season: this surplus, being cumulative over the years, is preventing market changes.
Furthermore, even though future harvests will be reduced in order to balance both sides of the market, coffee supply reacts slowly to price variations, hence the output will take time to decrease. When farmers produce at a loss, they first cut back on inputs, pesticides, and other farm-related expenses. The next step is often to cut back on education or other family expenses before eventually cutting back on necessities such as food. In extreme cases, farmers will abandon farming altogether. While this disinvestment process can happen quickly in the short term, for the situation to be reversed and investment to pick up again in education and technology, the expected time horizon is longer as these are long term growth factors.
Why is the risk of a further fall in the spot price still present? Is the current devaluation reflecting the actual surplus or is the market overreacting? It’s important to keep in mind that the current value of the New-York futures market for coffee, the main hedging tool used by the biggest physical traders, is much higher than the annual production, 16 to 17 times bigger. Bearish bets have driven coffee futures down. The volume of speculation by non-physical traders is important enough to distort market equilibriums, hence the fair price for both the farmers and the buyers. It is obvious that the activity of foreign actors such as hedge funds should be regulated, this would balance powers for an important commodity that guarantees the livelihood of 25 million producing families in the world. On the downside, as on the upside, markets overreact because of the role speculators play, trying to predict harvests and consequently acting in the futures market.
Governments of exporting countries are discussing drastic measures to control the market, but these are most likely going to be unsuccessful considering the discontinuation of the International Coffee Organization price regulation, an agreement signed by producing and consuming countries aimed at setting international coffee prices through the implementation of quotas by the participating members. The discontinuation of the ICO exporting quotas was followed by a fifty percent price decrease in less than five years.
Agricultural trading has been practiced for many centuries and will continue to be practiced for centuries to come, this being said, to nurture the healthy growth of the market, appropriate institutions and regulations should be put in place to allow the correct functioning of market forces and guarantee livelihood of those people depending on this ancient trade.