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February 26, 2021      5 Minute Read


‘Milds’ Intrigue: The Price Quandry Facing Farmers

catalina gomez

Carlos De Valdenebro

North American Managing Director

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About 3 months ago, while I was still in charge of Caravela’s Colombian operations, a group of farmer partners from the southern part of the country called me with a simple question; “Are prices going to remain high, or should we take advantage of the current market?” I answered the same way that I have for the last 10 years: “If I knew the future, I would be very rich and working from a beach”.

All jokes aside, as conversation continued farmers kept mentioning – quite rightly – that in 2020 Colombian internal prices were the highest they’d been in over years, so their interest in what the future might hold was understandable. Their next questions were, “Why are prices so high currently, and is this happening everywhere?” And, “How will this affect specialty coffee producers?” Pandora’s Box had been opened, and I’m sharing with you that conversation and analysis.

 

Let’s set some basic definitions:

  • The C-Market: or most commonly known as the futures market is where the global price of coffee is determined every single day by traders at the New York Stock Exchange/ICE. Its ticker is KC followed by the 5 terminal months¹ in which coffee can be delivered to a certified warehouse, as long as it meets the different quality standards set by the exchange.
  • Differential: Futures contracts are standardized in terms of the quality and quantity of a given commodity. Because of this, the futures price is representative of a typical range of qualities of commodities, and therefore is an average price. Depending on the specific product, there is a differential that adjusts the final price to the specifics of a certain origin/quality, which can be over or under the C-Market price. The over/under is primarily defined by the quality of the product, followed by internal supply and demand forces that push such differentials up or down (i.e., Colombia, because of its high quality always has a minimum premium of 400 basis points [+$0.04/lb] while Brazil has a minimum discount of 600 basis points [-$0.06/lb]).

That means that if the C-Market is at $1.00 then a Colombian coffee would at the very least always get paid $1.04/lb while a Brazilian coffee would get $0.96/lb

The following question from our farmers partners was: “Then why is the internal differential for the lowest quality now at 5,000 basis points ($0.50 /lb) now instead of the 400?”

 

Getting Confused? Hang in there. 

The C-Market may set minimum premiums and discounts, but market forces – supply and demand – set the final differential to be paid for a specific origin during a period of time. If Colombia suffers a drought which severely reduces supply, the differential for Colombia will increase more (and more quickly) than the differential for coffee from Peru or Honduras.  If Guatemala experiences a bumper crop one year, the differential for Guatemalan coffee will decrease vs other origins to reflect the increase in supply.

While these are the basic market mechanics, in practice things are often far more complicated. Despite every origin and every coffee being distinct, the interconnection of the market means that harvest outcomes can impact prices far beyond the borders of the origin(s) in question. In layman’s terms that means that if Guatemala has a bumper crop, a farmer in Peru might face reduced differentials, as roasters who normally buy from Peru might be tempted to replace some or all their inventory with Guatemalan coffee given more attractive prices, so they expect some sort of reduction in price from Peru.

So, what happened with the price question? By the end of 2019 and early 2020 Honduras had one of its smallest crops in years with a 20% drop, equivalent to a deficit of about 1.4 million bags of coffee. This created pressure on importers and roasters to find substitutes for the lost volume. Therefore, demand for milds (washed Arabica coffees from South and Central America) started increasing in these regions.

Then COVID-19 happened. Early in the pandemic, stores in the US quickly ran out of paper towels and toilet paper, not because there was an actual shortage but because everyone anticipated a shortage. In coffee, from February through April the demand spiked once again, driven by a fear of limited supply and lockdowns disrupting the supply chain, putting ever more pressure on differentials.

Why didn’t the C-Market react to this? Because in the 2019/2020 harvest Brazil had a record crop of over 70 million bags, 50 million of which were Arabica. If the C-Market does not react to supply/demand fundamentals, differentials will, as observed in the graph below.

 

Washed Arabica Differentials (2013-2021)

 

Source: EDF Maan

But how does this relate to specialty coffee, given that specialty farmers sell mostly on fixed price or on very high differentials? Nothing and everything all at once.

Most of the specialty coffee farmers that Caravela works with prefer to sell their coffee according to mid- and long-term commitments, where price is fixed based on a certain quality to be delivered. The few who do play the futures market have prices 50% to 300% above the prices that commercial farmers receive. However, there is a catch.

As with any free-market practice, benchmarking and price discovery are processes that occur almost in real time by the different actors. On one end you have specialty farmers and on the other end commercial farmers. The price at which commercial coffee is bought and sold is communicated via TV, radio, and newspapers almost daily, given the high liquidity of this type of coffee. In the smartphone era, coffee growers communicate with their friends through WhatsApp, knowing easily which buyer is paying the highest price in the market.

Source: FNC.

On the other hand, specialty farmers tend to have longer term relationships where price discussions occur a few times a year, allowing them to focus on producing the expected quantities and qualities. When their commercial coffee-producing neighbors start seeing 30% to 100% price increases (as seen in the graph above), the investments made by specialty farmers (and their unique and focused hard work) does not seem well compensated anymore. This is when the benchmarking and price discovery kicks in again, and price expectations increase. To give you an idea, in 2020 we lost 15% of the growers we worked with in Colombia in 2019, probably to commercial buyers paying good enough prices with less quality demands.

The pace at which price expectations increase for specialty coffee growers is slower than on commercial farmers. But the heightened expectations eventually materialize, pushing roasters sooner-rather than later to review their prices paid – if they want to secure the coffees they want.

So, what does the future look like? There are bullish signs everywhere: droughts in Brazil that occurred between July and September 2020 look certain to cause a 20-30% drop in the 2021 Brazil harvest. The Honduras harvest in 2021 will surely remain below 2019 levels. Minor damage from hurricanes in Central America will dent quality and volumes there. And the harvests in Colombia and Peru seem to have plateaued. All these negative factors affecting the supply of washed Arabica coffee mean that prices paid for coffee are surely poised to go up in 2021, either via high internal differentials or a bullish C-Market correction.

With that in mind, I told our farmer partners to focus on securing the current prices, continuing with long term planning, and contracting to guarantee the sale of at least 60-70% of their production to like-minded roasters, leaving 30-40% of their volumes exposed to market fluctuations with the assumption they can secure a home for it relatively quickly.

I would probably recommend the same to any roaster. But again, if I knew the future, I would be very rich and working from a beach.

 

________________________________

¹For example: KCH21, KCK21, KCN21, KCU21, KCZ21.

2 Comments

  1. Fredy León

    Carlos que buen artículo…! pero sin tener la bolita 2021 tendrá presión alcista, mi pregunta es, el consumidor final de café especial estará dispuesto a pagar por este incremento ? o tendrá que diluirse entre el comercializador y el tostador , quien lo asumirá ?

    Reply
  2. Rutilio Cruz

    Excelente articulo me encanto, tan claro la explicación del comportamiento del mercado.

    Reply

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