The Price Of Distortion – Speculation And Alternative Trade Models In Coffee

After my recent posts on the Scandal of the C-Price, I reached out to Adam Kline, founder and CEO of Coffee Unified, for his insights. Adam has a career in the coffee trade: as an importer, coffee buyer, and now as a development entrepreneur in the coffee sector with Coffee Unified. We’ve edited our many emails and chats over the past few weeks to construct a Q&A format for this post.

Adam highlights the risks of speculative trading in coffee, and how this can drive price volatility.

PH: First, thanks for taking the time to walk me through the complexities of the coffee trade – I’m learning a lot from the exchange. You’ve challenged me with some great articles, forcing me to dig deeper into commodity markets than I was expecting.

Can you explain your understanding of what’s happening in the coffee market, to cause so much volatility in prices?

AK:

Thanks Paul! I’ve enjoyed reading the Coffeelands blog for many years and I’m excited to be a digital guest!  As for my understanding of the market, here’s a disclaimer:  I’m a coffee guy, not a commodities market expert.  My company – Coffee Unified – is a social enterprise that builds relationships to support specific sustainable development goals. So I’m not typically combing over supply and demand numbers or analyzing coffee futures charts. That said, for years I sat with a futures screen on my desk and was witness to some historic market changes and days of what can only be called “ridiculous” volatility.   Part of what I saw was an evolution of price dysfunction. Increasingly, the problem has felt very systemic, but many proposals (including your C-5 benchmark) are focused on treating the price symptom alone.

To more pointedly answer your question, supply and demand dynamics are a cause for the current low “C” market price, I’d never minimize that;  but so too are currency markets and, perhaps more  significantly: market speculation from giant hedge funds that have nothing to do with physical coffee.  For these funds trading in “soft”commodity futures,  the easing of regulation and the possibility of further deregulation provide for an open season on financial markets.

PH: Well, that takes us down the rabbit hole! Can you give more detail?

AK:

First, let’s cover the basics of physical supply and demand.  Not to be a bore, but we probably need it for context.  Usually we hear about global supply and demand in absolute numbers that include both arabica and robusta.  It’s important to break those numbers down rather than talking about them together. You’ve already gone over some of this in recent posts, but, for our purposes, it’s key to remember that we are talking about the ICE Coffee “C”  futures contract, which is of course the world price benchmark for arabica coffee. (We can talk about how coffee finds its way into this system later.)

A quick summary:  according to the  International Coffee Organization, total arabica and robusta production in 2017/18 was roughly 165 million bags. Looking more closely, it is 102 million bags of arabica (an increase of 2.2% from the previous year) and 63 million bags of robusta (an increase of 11.7%.)  That’s a lot more robusta produced this year and it plays a big part when we combine our numbers together.

What we know about the split between arabica and robusta consumption is less clear and this really deserves more clarity.  Consumption growth averages very roughly at 2% per year and the ICO has 2017/18 consumption numbers at 162.23 million bags.  So, the take home is we have leftover coffee, and we see how much arabica by looking at warehouse stocks. (It’s interesting to note what countries represent the bulk of those carry over stocks. Here is a quick hint.)

In the 2018/19 crop cycle, Brazil will have a record crop – which seems to be the new norm – so there is true weight to fundamental pressure if we are taking these forecasted production numbers at face value. Since we are focused on the ICE Coffee “C” contract and its recent price lows, we should ask how much arabica alone is being produced and consumed to better understand where we need to go in terms of consumption …always “up,” I guess?

PH: Got it. There is excess coffee in the market (supply) – mainly from Brazil – so this drives prices down. That’s market fundamentals, and it makes sense. But that doesn’t seem to explain why prices have dipped so low that they threaten future supplies. That question is the purpose of these blog series. Can you describe how speculation can drive price volatility in the coffee market?

AK:

There’s a need to clarify the role of “speculation” in the coffee trade. (See this article for an excellent explanation). There are two main types of speculation: fundamental and technical.

Fundamental Speculation

The first type of speculation is “fundamental speculation” which relates to the physical supply and demand dynamic in a specific market, i.e. coffee.  With these folks, things like “weather” or “leaf rust” that affect actual coffee production create the volatility that make the market go up or down. This type of speculation can play a healthy role in providing commercial liquidity which allows some price insurance (by hedging) for commercial traders (farmers and buyers.) Looking at the world production and consumption statistics over the last 12 years or so (see below)  spikes and dips appear to more or less compensate for each other over time. We could argue about that in exact numbers, but pictures speak volumes. The point to underline here is that shifts in physical supply and demand should be self-correcting over time. But concerns like weather or production are no longer the biggest factors driving daily market volatility so the industry endures many false signals.

Source: ICO report:  “Coffee prices in August fall to 57-month low”, Figure 6, pp.5

Technical Speculation:

That leads us to technical speculation, or trading based on market chart patterns formed by the actions of other traders. These days, a majority of technical speculation is conducted by computers trading based on algorithms, in milliseconds. Typically market liquidity serves to smooth out volatility, but when high frequency trading is involved, things get disco.  Over the past decade, there has been a dramatic increase in technical speculation agricultural (soft commodity) markets. Perhaps not in the percentage of technical traders in relation to the number of fundamental traders, but certainly in the computational capacity of the machines used to trade.  There is plenty of evidence that this dynamic is leading futures pricing away from where fundamentals would put them. This article explains it like this:

“If technical traders base their decisions on other traders, and their numbers are increasing, the market becomes circular and self-referencing and runs the risk of disconnecting from supply and demand concerns altogether… Statistical studies have pointed to a breakdown in the causality between agricultural spot and futures prices, showing futures prices determining spot prices.”

So, in my novice opinion, recurring coffee price volatility is not due to “shrewd coffee traders trying to make a quick buck”, as you suggested in your post. It has much more to do with non-commercial technical speculation assisted by complex and confusing trading mechanisms (see the Iceberg Order, for example.) Add to this that high frequency trading is functioning in a grey area where regulation hasn’t caught up with the technology.

Technical speculation is the cause of extreme price volatility in the coffee market and it is a symptom of an issue within a much bigger system. Taken all together, call it the “commodity coffee complex.” The reality is that the commodity complex is how the vast majority of the world’s coffee is traded.  It’s also important to realize that this is not at all unique to the coffee market – the impact of managed money in soft commodities (food crops, especially) has been debated and analyzed at high levels since global food prices spiked in 2008 and 2011.

PH: What’s your take on alternative coffee trading mechanisms, like direct trade or fair trade? Is there a way around the commodity complex?

AK:

The commodity coffee complex is an absolute beast and we aren’t going to tame it into good behavior by circumventing it, nipping at its heels, or asking or shaming it to play nicely. Through the Nexus of coffee, Coffee Unified strives to build supply partnerships that affect positive and sustainable change.  Our networks are working to protect community watersheds and strengthen regional water security. Actually, some of that inspiration goes back to how you and I first met, years ago.  Coffee Unified adds value of direct to market partnership for growers working with water security and watershed conservation programs like CRS’ Blue Harvest platform. We are growing and trying to leverage interest in a number of countries. Above all, my goal has been to keep growers from having to sell coffee into that commodity complex where it is valued equal to coffee that is grown without regard to its impact on local watersheds or the people and critters that depend on clean and abundant waterways. It’s not the same kind of coffee at all is it?  So, it definitely shouldn’t be valued the same. I believe the way forward for us is in helping growers keep their coffee traceable. That’s one way.

There are also amazing companies that live and breathe sustainable supply chains and extol the virtues of flat priced coffee contracts.  These companies are often – and rightfully –  held up as examples of an ideal model on the Coffeelands blog. It’s awesome to see consumers resonate with that approach and understand what it means to support companies that purvey quality both in terms of cup and producer livelihood. With that idea though, we risk oversimplification when we say we are “doing something about it” since we choose not to play in the commodities pricing game. The inconvenient truth is, when we take a macro view of our industry, these exemplary companies and their thankfully woke consumers remain market anomalies. Being able to purchase coffee how you want is the absolute privilege of a buyers’ market.

We can’t simply say that our 90-point specialty coffees purchased year-over-year on a flat priced basis are going to benefit the larger industry. Specialty coffee has also really evolved into an exclusive club. Specialty has competed itself to this very hard line that leaves many growers in the cold only to deal with the harsh realities of the commodity coffee complex. The positive impact of transparent and sustainable supply chains is real, but the business model also operates in kind of an insulated bubble.

Traceability and direct market access are part of a lasting solution and better pricing, ultimately.  But we also know there are millions of growers who are outside of this model; they are located in remote areas just praying that a middle man will show up next week to buy their 5 bags of coffee so they can provide for their family.  When the “coffee coyote” does finally show up, they are negotiating based on the SPOT “C” futures contract price and also in relation to the price of coffee in their local (internal) market.  The coffee they buy is sold on to a mill where it loses all transparency, then blended into a generic lot and sold at commodity pricing. In this instance, which is a majority of instances, the grower in our example will not benefit from your C5 priceaverage. Once again, we risk leaving too many farmers outside of our well meaning intention.  It’s important to remember that, to most coffee growers in the world, the beans lost to the commodity complex are no less important than our meticulously selected microlots.

The alternative benchmark price (the C5 you proposed), has some real merit, but again, it would only treat the symptoms of a broken market. It does not dig deep enough to cure the underlying problem.

PH: That’s a lot to absorb – and I appreciate the critique on the C5 proposal. Over the past few weeks, we’ve exchanged a lot of articles on the role of managed money in soft commodities, and it’s clear there are real policy and academic debates on this. We are definitely getting beyond markets 101. Where do you think the coffee sector needs to go from here?

AK:

Yes – and we’ve gone way past our 500 word target for this post! Sorry. Anyone still reading gets free beer next time they see me (while supplies last and conditions apply!)

The Way Forward:

If we really want to fix this “broken market,” we’ve got to commit – we’ve got to go beyond blogs, conference panels, and webinars. When the futures market suddenly spikes upward, we shouldn’t lose sight of where we are at now or where we were two weeks ago, as the case may have it.   Some steps we can take to address the symptom of low price on a more holistic and systemic scale:

• Do your homework. There’s no easy fix, and we need to do our homework. The articles linked in this blog post are a great place to start.

• The conversation of a “low price crisis” is much bigger than coffee alone and real change will address that fact. Technical speculation and high frequency trading impacts many “soft” commodities (e.g. coffee, cocoa, wheat, corn…) as well as the livelihoods of the farmers that produce these crops and the millions of poor families whose food security is directly impacted by price volatility. We need to take this conversation beyond “coffee” and approach the futures market price discussion from the lens of sustainable economic development.

• There’s plenty of market liquidity.  Coffee price volatility has more to do with lack of trading regulation in commodity markets. Yes, it’s a nasty word in some circles but we need to take a regulatory approach. We cannot be satisfied with patching over the holes in the coffee futures market. We need to engage people that understand these markets well enough to suggest viable regulatory fixes and then implement them.

• As an industry, we should be gathering our collective power to bring about systemic and inclusive change. Let’s get laser focused and not forget about the UN Sustainable Development Goals as a principle guide.

• If we are going to lean on the argument that fundamentals are still the key force driving market volatility and pricing, we need better accounting and forecasting of our physical supply.

• We need to engage the NCA, ICO, the SCA, and every association representing coffee growers in producing countries. We must advocate that they support regulation against high frequency trading used in technical speculation in “soft” commodities and address the fundamental issues of an unrestrained supply.

PH: Thanks Adam, I really appreciate the concrete actions. I’ve learned a lot from this exchange and looking forward to more.