Monday, January 17, 2011

The Rise in Coffee Prices.


Many of you by now have already heard reports of rising coffee prices in conjunction with rising commodity prices as a whole. Over the last four months, coffee prices on the New York exchange have risen some 75%. Many roasters have already started raising prices, and for the rest of us it is only a matter of time. I have to admit a certain amount of denial in these rising prices, hoping against the market that prices will begin to fall, but it seems the longer I wait, the higher the prices go. The last couple of days have seen a leveling off of sorts but few in the industry expect prices to come down soon, if ever.

What's up with that?

Lemme esplain:

For the better part of the period from just after the Second World War coffee prices were held stable by a program called the International Coffee Agreement, administered by the International Coffee Organization. The ICO was a member organization of coffee producing countries and coffee consuming countries. These member countries agreed to quotas set by the ICO of how much coffee producing countries could export and how much consuming countries could import. The program was initiated after WWII in an effort to boost and stabilize coffee prices in an effort to curb terrorism. It was observed that there was a direct link between countries with high rates of poverty and militant movements ( I know, crazy huh?), Since many of these same impoverished countries were coffee exporting countries the agreement sought to raise and stabilize these same countries via raising and stabilizing coffee prices paid by consuming countries.

The program worked well by any measure, the only hiccups occurring when Brazil would have a particularly devastating frost and threaten overall supplies. Even still, prices tended to correct rather quickly and remain consistent year to year. This was good for traditional coffee farmers since they could reasonably expect coffee prices to remain the same year to year so investing into future harvests could be done with relative security.

During the 1980's there was increasing pressure on the ICO to disband the agreement. This effort was largely driven by the largest consumer country, the USA, where a rising tide of market ideology abhorred any efforts to control markets; and Brazil, where increasing technified farming practices resulted in large surpluses of coffee held in warehouses.

In 1988, the agreement collapsed and nearly overnight the prices of coffee lost more than half their value. It would take some ten years for Brazil to get rid of their excess coffee stocks, and adding to the oversupply, some ten million bags of coffee debris that formerly would not be considered suitable for export was now counted as part of the total supply of coffee.

Free Marketers heralded the change as good for everyone since it would get rid of those producers that were unable to produce efficiently in a competitive, open market. Such proclamations are parroted frequently in any discussion of world trade, ignoring the realities of production and unequal subsidization of industrial production over traditional farming practices.

Think of it this way, imagine if we decided that automobiles were a commodity. Now, for simplicity purposes, we would have to have only a few classes of autos to trade, based on generalities (the market hates specifics). So, lets say autos were divided into three classes: two door sedans, four door sedans, and trucks. Simple enough. Now, you decide you want to buy a two door sedan so you go down to your local Kia dealer and see that a two door there sells for $10,000, which is what you expect because you have been following the two door market for some time now, watching production and sales numbers. No problem. If you want to sell or buy a two door, $10k is the price. Then you wander on over to the Ferrari dealer to check out what they have in the two door department. Hey cool! The market says that if Ferrari wants to sell two door cars, then they have to sell them for $10k! Awesome!

So, how many Ferrari's do you suppose will be made next year?

Just as Brazil's effect on the market began to wane, another country came to the fore as a leading producer of low priced coffee. Vietnam, in a project largely subsidized by USAID, became the second largest exporter of coffee in the world in just a few short years. The coffee is the cheap, Robusta variety favored for commercial producers, especially instant coffees.

The net effect has been chronic undervaluing of coffee for over twenty years, leading to the Fair Trade movement and other efforts to boost prices for desirable coffees, for it was the good tasting, high quality coffees that we have seen steady erosion in availability. Moreover, countries where the IMF have imposed strict policy adjustments, especially in Africa, have seen their coffee production nearly collapse.

With coffee production reaching peak limits in Brazil and Vietnam, and climate change, increasing aridification and desertification , these pressures are placing concerns on the global capacity of coffee production.

There is another factor at work here: computerized trading. The reality is that most of coffee traded on the exchange is done by non-coffee agents. Over the last ten years, computerized trading has played a larger role in volume trades and now these programs are taking into account fundamentals along with market movements. Okay, let me unpack that.

Close to 90% of the buying and selling of coffee on the commodities exchange is done by speculators. They are essentially gambling with the price of coffee, up or down. Increasingly more of the trades are being done by computer programs that watch the market prices. When prices are lower they are programed to buy and when they are higher they sell, an oversimplification, but you get the general idea. Now, these programs are taking into account actual production forecasts and other hard information coming from producer countries. Seems they have discovered that the production of better coffees (known as the "C" market) is in a decline.

This is happening at a time when investors are increasingly looking for "real" things to invest money in, rather than imaginary "financial instruments" that were the rage right up until the whole financial collapse. So, some of this is technical, as they say in the trade, some of this is fundamental. In other words, some of it is the players and some of it is the supply.

Will coffee prices come down? Not likely. At least not to levels they have been. But let's face it, we have been buying Ferraris for Kia prices for probably too long.