Despite record crops globally and in Brazil, demand for high-quality coffee beans fuels a price rally.
Conventional wisdom among coffee traders has been that Brazil is the driving force for coffee prices — and with good reason. Historically, Brazil has been the world’s largest coffee producer.
However, the market could be changing.
Coffee prices, as measured by the benchmark ICE Futures U.S. contract, began an explosive bull run in mid-2010. From June 2010 to May 2011, coffee prices more than doubled, from $1.35 to over $3.00 a pound. Since topping out in May, prices have fallen approximately 30%. Fears of tight supplies for high-quality coffee drove premiums in the cash market up even faster. All this occurred despite a bumper crop out of Brazil.
According to the USDA, total world production of coffee for 2010/11 (October-September) will be 137.9 million 60-kilogram bags. That’s a world record. Brazil accounted for 54.5 million bags, or almost 40% of the total. That’s a record crop for Brazil as well. But it didn’t prevent coffee prices from rising dramatically.
Not All Coffees Are Created Equal
There are two types of commercially traded coffee - robustas and arabicas. Robustas account for about 40% of world production. These are low-quality, discounted coffees that trade and are certified by the LIFFE, which is the futures exchange in London for robustas. Arabicas account for 60% of world production, of which there are two distinct types: washed and unwashed. Most, but not all, washed arabicas are traded and certified against the ICE futures contract.
Brazil produces a mix of arabica and robusta coffee, neither of which are tenderable against ICE futures. Still, exporters and importers hedge most coffee for export out of Brazil against ICE. As a result, ICE futures can rise or fall depending on the hedging pressures of Brazilian exports.
Total world production of coffee outpaced consumption during 2010/11 by about 4 million bags, and production is expected to outpace consumption again next year, although by a smaller amount. Total world ending stocks of coffee remain historically tight at around 26 million bags, leaving no cushion should there be a supply problems. Ending stocks reached a recent high of 47 million bags during the 2002/03 season, and the surplus pushed prices down to World War II levels.
What has propelled the ICE market is a perceived shortage of high-quality, washed arabica coffee. This type of coffee is exported mainly by Colombia, Mexico, Central America, Peru, plus a few other origins, and is the only type of coffee tenderable against the ICE futures contract. Demand for this coffee had been outpacing production.
Traditionally, much of the world’s demand for coffee came from large manufacturers such as Nestle (NSRGY.PK), Kraft (KFT), Folgers and Douwe Egberts. They are all still big players. They operate in the retail category, and retail buyers — your average consumers — are very price-sensitive. Consumers are quick to switch brands based on price, and can significantly reduce off-take by wasting less coffee while brewing it at home. As much as 20% of a pot of coffee made at home is often poured down the drain.
Despite the recent run-up in prices, demand has remained stronger than many expected.
The newest and growing trend in coffee consumption is with specialty and high-quality coffee. Specialty coffees are premium priced, often branded by the region, mountain or even the farm on which they are grown. They are not nearly as price-sensitive. The resurgence of coffeehouses such as Starbucks (SBUX) and Peet’s, as well as the success of such retailers as Dunkin’ Donuts (DNKN) and Canada-based Tim Hortons (THI), has also spurred demand for high-quality coffee that is not as price-sensitive. The average value of the coffee sold by the cup is only about 5 cents, so even a doubling of coffee prices can be easily recouped with modest pricing adjustments.
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There is also growing demand from developing countries. Brazil is expected to consume 20 million bags of coffee next year, almost as much as the 24 million bags consumed annually in the U.S. Consumption is growing at about 1% in developed countries but 4% in developing countries.
Looking forward, the USDA expects total world production of coffee next year to decline slightly by 3 million bags. A normal off-year cycle will reduce Brazil’s arabica crop, but production increases are expected from other origins. The recent rise in coffee prices is a tremendous boon to coffee producers, and many will be inclined to put more trees into production.
Higher prices have also encouraged farmers to use more fertilizers and pesticides, and this should have a positive effect on yields. According to the USDA, Colombia’s crop is expected to jump by 1 million bags next year to 10.5 million. Total world production of non-Brazilian arabicas is expected to be around 43 million bags, roughly the same as anticipated demand — all of which will temper any future price hike by keeping supplies of high-quality coffee roughly in balance with demand, while tending toward surplus in the longer term.
ICE futures have mostly traded in contango, with steep cash-and carry discounts for the nearby positions. This will likely remain the case until the certified stocks are drawn down further.
Bullish sentiment on ICE futures also benefited from the general run-up in commodity prices, although speculative participation at the moment is limited. The total open interest is currently around 107,000 lots, which is considered moderate. (One lot is equal to 37,500 lbs. of coffee, roughly 250 bags of 69 kilos each, all of which fits neatly into one 20-foot shipping container.)
Although not yet significant in global coffee trading, there are a couple of coffee ETFs available. The Dow Jones-UBS Coffee ETN (JO) issued by Barclays iPath, and the Pure Beta Coffee ETN (CAFE), also issued by Barclays iPath. Both are based on futures contracts.
Looking further down the road, beginning in March 2013, Brazilian washed arabica coffees will become tenderable against the ICE futures contract. Brazil has traditionally been a producer of mostly unwashed coffee and currently produces only about 4 million to 5 million bags of the washed variety.
The questions for market participants are how many more bags will Brazilian producers decide to wash and what impact that will have on ICE futures prices.
