For farmers there is a clear advantage in using fixed pricing. They could set a price based on their cost of production plus a margin. This would make sure that they can be profitable with each transaction, allowing for re-investment in their farms and for some level of “wealth creation”. A fixed price contract would guarantee a margin. Farmers could then concentrate on improving quality, productivity and efficiencies to maximize profit.

For roasters fixed pricing would also be advantageous. A roaster could secure a supply of coffee beans at a known price, eliminating uncertainty in their costs. This type of sourcing would also help the roaster protect their margins, allowing them to concentrate on improving quality, productivity and efficiencies.

So, if there are advantages in both selling and sourcing at a fixed price, why do we have prices based on future contracts? Let’s first understand what a futures contract is and how it differs from a forward contract.

A forward contract is an agreement between a buyer and a seller, where each party commits to either selling or buying a pre-determined product at a pre-determined price at a specified time in the future. Simple. Let’s say a farmer wants to sell coffee for delivery in six months’ time, and a roaster wants to buy coffee at the same time. They agree on a price and sign a contract. This is very similar to what we defined as a fixed price contract above.

In the 17th century forward contracts started to be formalized as futures contracts were already being traded in exchanges. The first organized futures exchange began in 1710 at the Dojima Rice Exchange in Osaka, Japan. Futures contracts differ from forward contracts in that futures are standardized. Standard quantities, deliveries, qualities and so on allow for risk mitigation for both buyers and sellers. Futures are traded and settled in exchanges and clearing houses, while forwards are one-to-one deals.

In 1882 the Coffee Exchange was founded in New York. Today this exchange is part of Intercontinental Exchange (ICE) where future contracts for coffee are traded.

The price of Arabica Coffee is largely determined by the C contract, traded on the ICE. This price is determined by the supply and demand for coffee futures, which in turn reflects the fundamentals of the coffee market. The futures market is also influenced by a host of other factors such as the currencies of producing and consuming countries, macro-economic issues and trends, weather patterns, etc.

Are coffee futures tied to the actual cost of production? The answer is yes. If coffee futures prices drop below cost of production then farmers would stop producing, therefore creating a deficit in the market, which would push prices back above the cost of production. The opposite is also true that oversupply would lead to lower prices.

Are coffee futures tied to the cost of production of small holder, high quality producers? That is a different question and is the reason for having differentials. Differentials represent an adjustment to the C market to take into account individual considerations. However even under differential pricing farmers cannot adjust the differential to account for volatile changes in the C market. So, the farmer is also exposed to the market volatility. There is complete uncertainty of the selling price, until he can “fix the market”.

At Caravela we believe that fixed prices offer advantages to farmers and to roasters in the high-quality market. What is stopping us from moving in this direction?