High Prices Jolt Coffee Market

By Marvin G. Perez

Rising food prices are eating into corporate earnings, and the coffee industry is no exception.

For seasoned traders paying the current price above $2.30 for a pound of Arabica beans this may not be so shocking, especially if they lived through the price spike to $3.18 a pound seen in 1997. But for younger entrepreneurs who entered the growing specialty market over the last few years, the price rally has jolted many.

Are prices heading towards $4 or $5 a pound? Or will world farmers, enjoying the highest quotes in more than 13 years, start producing enough coffee to meet growing demand?

COMMODITIES UP

Rising world population and living standards have fueled demand for premium coffees among affluent young professionals in emerging markets like Brazil, India, Indonesia and China. This has been supplemented by sustained demand from North America and Europe consumers.

On the supply side, erratic weather patterns, highlighted by heavy rains across major growing regions in Colombia, Central America and Indonesia, have limited coffee production.

Overall, demand for raw materials is at record levels, pushing prices for everything from petroleum to basic grains. This has attracted speculative involvement in commodity markets, while a volatile dollar and the eventual Brazilian entry into the world’s elite coffee club have added intrigue, if not uncertainty, across trading desks as well.

FOOD INFLATION 

The Reuters/Jefferies Continuous Commodity Index, which is comprised of 19 raw materials, from oil to sugar and cocoa, rose 13 percent in 2010. The index has bounced from losses incurred during the financial crisis of 2008, and is now trading near its historical highs, brewing inflationary pressures.

The average U.S. price to buy a pound of ground coffee rose to $4.47, up 22 percent, or 80 cents a pound, from a year ago, according to recent December data from the U.S. Bureau of Labor Statistics. Starbucks Corp., Folgers Coffee and Kraft Foods are few of the companies that have raised prices several times in the last year.

The food industry is planning gradual price hikes to help expand profits in 2011. But its pricing power, especially at the low end, remains limited. It doesn’t help that average U.S. gas prices are inching back up above $3 a gallon, adding to the squeeze on household budgets.

“Shoppers are likely to be more resistant than ever to higher prices, more willing to trade off to lower priced choices and more aware of where and when these changes have to be made,” wrote recently Michael Sansolo, a food analyst in Chicago, wrote recently. “Today’s tough competitive situation is only likely to get tougher.”

FUNDAMENTALS: BRAZIL SAVIOR OR VILLAIN

Arabica coffee prices soared 77 percent in 2010 touching a 13-year high of $2.4225/lb. For 2011 the global balance may yield a deficit between 4-6 million bags, mostly of Arabicas. Inventories of washed-Arabicas at warehouses of the IntercontinentalExchange Inc. (ICE), are now at eleven-year lows, after dropping for 27 consecutive months. This may continue until there’s a solid bounce in production, say observers.

The low supplies prompted the ICE exchange late last year to include washed and semi-washed Arabica beans from Brazil to its list of grower nations for the benchmark “C” contract, joining origins such as Guatemala, Costa Rica and Ethiopia.

The move, opposed by the Specialty Coffee Association of America, is widely expected to boost liquidity in the market when it takes effect in March 2013. Supporters say the measure will actually encourage Brazilian farmers to boost quality, easing futures shortages of premium coffees. Critics fear the country will flood the market with lower grade beans, threatening the already questioned (but recently revised) grading standards at ICE.

Elsewhere, Colombia’s future output remains a puzzle given the country’s failure to bring up yields over the last three years to the averages above 12 million 60-kilo bags picked few years ago. In 2011, the country could harvest again less than nine million bags, a figure still subject to weather developments.

NEW PRICE FLOOR BREWING

Arabica prices are likely to set a new price floor above historical averages of $1 and $1.10 a pound, notes Carlos Henrique Brando, a Sao Paulo-based Brazilian entrepreneur and consultant, who has worked with the International Coffee Organization to boost global demand for coffee.

With currencies at key producing Arabica countries such as Brazil and Colombia  strengthening sharply over the last few years, reducing returns for growers, prices had to go up to entice farmers to keep producing.

“The new price floor to be achieved after production grows in response to the current high prices will have to be higher, probably much higher than historical averages to account for the weaker dollar,” he said.

VOLATILITY

A large percentage of the commodities price gains came courtesy of a weaker dollar, which started falling in August last year after the US Federal Reserve announced further quantitative easing, including the purchase of $600 billion in US assets to inject money into the economy.

The move weakened the greenback, enticing oversea buyers to procure more dollar-priced commodities. If history is any guidance, this correlation will continue in 2011. According to Bloomberg data, over the last five years, commodities have moved in the opposite direction of the dollar in 18 out of 22 quarters. Historical charts also show that big price spikes are typically followed by higher output, in a continuum cycle of price boom and busts.

REGULATION  

Searching for higher returns, speculators—including pension and hedge funds—have poured money into commodities in recent years, contributing to the uptrend. But according to government data, speculators actually decreased their long positions held in coffee, when prices went from 160 cents to 200 cents a pound in the second half of 2010, indicating that fundamentals, as shown by soaring cash market differentials, drove the spike.

Traders will be watching closely what type of action is taken in Washington, if any, to limit speculator involvement in commodities. The Commodity Futures and Trading Commission, CFTC, is expected to address the issue in the first quarter of 2011.

GOOD NEWS 

The good news is that countries such as China, Laos and Peru are growing as suppliers in the new decade. For example, China recently announced investments of $450 million in coffee to boost production of Arabica beans in the Yunnan province, hoping to boost output from the current 38,000 tons to 200,000 by 2020.

According to the International Coffee Organization, 2010 earnings for coffee exporting countries will be the highest on record, above $16 billion, potentially bringing more investments to coffee farms and better crops. Top producer Brazil is expected to harvest almost 45 million bags in 2011/12, the highest output ever for an “off” cycle crop, the result partly attributed to better earnings. In 2012/13, the country may reap between 55 million and 60 million bags, a record crop that may ease supply shortages.

Marvin G. Perez is a business writer and consultant and has been covering world financial markets for almost 15 years. He has been a guest speaker at CNBC Business News Channel in New York and a frequent speaker at top world commodity conferences in the U.S., Latin America and Europe. His articles have appeared on Dow Jones Newswires, where he worked for six years; on weekly financial Barron’s, The Wall Street Journal and several international newspapers as well as on online- based news outlets, including SuagrNetwork and CoffeeNetwork. He can be reached at marvingperez@gmail.com.

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