By Max Nicholas-Fulmer
The last time the New York “C” contract reached the levels we’ve witnessed over the last few months was 1997, when futures hit $3.20/pound. The impetus for that move was neither frost nor drought, but the simple fact that in February of that year the “Certified Stocks” of green coffee in bonded U.S warehouses shrank to an anemic 321 bags.
If you don’t know what the Certified Stocks are, it is useful to think of them as the gold in Fort Knox. This is the actual physical coffee that underlies the “C” contract. If you buy a contract and hold it until expiration, you will receive a delivery notice from the exchange that you are now the proud owner of 37,500 pounds of unroasted washed arabica coffee in a warehouse in New York, or New Orleans, or Hamburg (or a number of other specific port cities). Likewise, were you to “short” the market and stay short through expiration, you would owe the exchange the same amount of coffee. So it follows that if there is no coffee in the various exchange warehouses, prices have to rise until someone is willing to deliver it.
Guess what? The Certified Stocks, which stood at roughly 4.7 million bags only two years ago, are now around 1.6 million bags and dropping to the tune of 50 to 100,000 bags per month, with almost nothing being delivered.
But (you exclaim!), the “C” market is at a 14-year high, why is nothing being delivered? Because for the last three years, the price premiums for coffees like Colombian Excelso, Highgrown Honduras, and Mexican Prime Washed, which historically have hovered around even to the “C” and have thus formed the backbone of the Certified Stocks, have skyrocketed. In late 2009, Colombian Excelso was being offered at an astronomical 90 cents above the “C” market, since exporters oversold the crop. While premiums have receded over the last year, they still remain a solid 20 to 40 cents over on an FOB basis. So think about it: if you were a producer, an exporter or anyone who owned physical coffee, would you rather deliver to the exchange at $2.65/lb. (today’s NYC close), or sell it to a roaster at $3.50/lb.? Until the “C” gets so high that the exchange is the most attractive buyer—either because roasters stop buying altogether or because it isn’t worth a seller’s time to find one—the Certified Stocks will continue on their march to zero. While April and May have seen the first monthly increases since 2008, stock levels remain near historical lows.
Further complicating matters is the very real threat that climate change and industrialization pose to coffee production throughout the world. From Sumatra to Costa Rica to Kenya and everywhere in between, the weather has become far more unpredictable than it used to be. The normal pattern in Indonesia has the rainy season ending in November. This allows the flowering to “fix” and sets the stage for the next crop. This year, the rain has not stopped, which meant the requisite five- to six-day “spring” dry spell was nearly five months late. In Costa Rica, official estimates put the current crop at nearly one million bags less than normal as a result of excessive rains and the longer-term trend of growing areas being replaced by housing and development. Similar problems exist in Kenya, although there it is drought and the fact that many members of the younger generation of coffee farmers are abandoning the business for life in the cities. As a result, in the areas to the north and west of Nairobi—traditionally some of the best lands for producing the sweet, high-acidity profile that has come to define the origin—suburban housing developments are replacing coffee lands. The Kenyan Coffee Board has recently announced that auctions would be held only every two weeks instead of the normal weekly schedule, due to a lack of coffee coming into the market.
But what about the big guy? Brazil produced a record crop this year (although just how big it actually was is a topic of contention in some circles). If official estimates are to be believed, Brazil will produce a massive “down year” crop in 2011. Advances in agronomy and harvesting methods, combined with the coffee zones moving out of the frost-threatened southern areas, have allowed Brazilian production to flourish over the last 10 years. Steadily rising prices should allow production to continue increasing. At the same time, however, domestic consumption in Brazil has skyrocketed. According to recently published figures from ABIC and the ICO (the Brazilian and International Coffee associations), Brazilians will out-drink Americans in 2011, making Brazil not only the largest producer but also the largest consumer of coffee in the world. At issue as well is the fact that Brazilian consumer’s expectations about quality have followed those of their American counterparts. Witness the fact that on February 17th, the Brazilian government introduced quality standards (based on cupping!) to determine if coffees are marketable or not. Combine this increase in consumption with the relative strength of the Brazilian Real versus the U.S Dollar, which makes exporting coffee less attractive and selling internally more attractive, and one sees that more and more coffee will be staying in Brazil rather than getting exported to satisfy global demand.
On top of the very real supply threats facing the global coffee market, the now ubiquitous “commodity investor” is also pushing prices ever higher. Years ago, commodity speculation was the province of only the most well-heeled investors, and even they were discouraged by their banks from exposing themselves to the risks inherent in this most volatile of asset classes. Today, financial planners are encouraging regular people to allocate up to 25 percent of their 401k to commodity “baskets,” and Exchange Traded Funds (ETFs) have made nearly direct access to commodity markets possible for anyone with an E*Trade account. On top of that, endless cries for “deregulation” from certain politicians and their patrons in the financial sector have made it ever easier for huge investment firms to move trillions of dollars into and out of markets that were originally created to serve a very narrow interest: namely, the people who actually buy and sell the physical product.
While all of this does indeed raise the specter of a commodity “bubble” similar to what we saw in 2008, hoping for a global economic meltdown to lower your green coffee costs does not strike me as a sound business strategy.
If I had to place a bet right now whether coffee prices would halve or double in the next three years, I would have to take the possibility of a $5/pound “C” market very, very seriously. Even if such an explosion does not take place, the prospect of the “C” returning to $1.20/pound seems nearly nonexistent. Even more critically, the idea that the price of specialty coffee (independent of the “C”) will return to where it was even six months ago seems laughable. There are simply far too many factors lining up to send prices higher and not nearly enough to cause them to fall. It has never been more important to know how much coffee you use, what your operating costs are, and how much of a price increase you can absorb. Take a long hard look at booking at least a portion of your green coffee needs. While locking in prices at these levels is certainly hard to stomach, it is far better to be 20 cents wrong on the downside than $1 wrong on the upside.
Max Nicholas-Fulmer has coffee in his blood. Born into the industry he has worked as warehouseman, barista, sample roaster, futures broker, and importer. Since 2007 he has been a trader at Royal Coffee, Inc. He lives in downtown Oakland, CA.