Funds in coffee price vulnerability
From the July 2012 issue.
Much of the recent roller coaster ride of coffee prices has been blamed on funds. A look at recent history of fund participation highlights their role in price vulnerability.
Coffee price roller coasterAt the height of the coffee crisis in 2001 and 2002, when Arabica futures had crashed to historic lows of just 38 US cents per pound, investment funds made a collective exodus from what was clearly becoming an unattractive market. Some traders joined in the departure, along with many investment banks that gave up on coffee analysis all together.
Coffee producers, roasters and other industry participants found themselves stuck to deal with a market that, day by day, was to grow more complicated and confusing. A decade later, many still struggle to explain what’s going on.
“We have had days where the market moved 15 cents and that’s crazy,” says Carl Leonard, Vice President of Green Coffee at New Orleans-based roasters Community Coffee. Leonard’s comments sum up much of the general sentiment about the modern-day coffee futures market.
“Not only do you have to watch the fundamentals but you have to watch news on what’s going on in the world, because today world investment sentiment will tell you more about which way the market is going to fly,” Leonard tells GCR.
While it’s understandable that factors like fluctuations in oil prices make coffee prices vulnerable – due to the significant energy-dependent share of the cost of coffee production – recent activity in low per-capita coffee consumers like Greece or China are unexpectedly affecting the market.
Much of the heated debate has focused on who and what is to blame, and to what degree speculative fund trading and investment bankers are the culprits. Some traders and brokers reject that argument, saying the element of speculation has always been a driving force in the futures market.
“Any time the funds have pushed their liquidation either up or down we have seen an impact, but I don’t think you can blame the funds for the vulnerability we are seeing in the market today,” says Hernando de la Roche, Senior Vice President of Miami-based financial brokerage firm INTL Hencorp Futures, LLC.
Today’s coffee market is being increasingly described as “the new market”, as it’s been opened up to an almost unlimited number of factors that are impacting current price movements. These factors extend from the US dollar’s impact on currency fluctuations in producing countries, growth forecasts for China’s giant emerging market, the Euro debt crisis in Greece and Spain, and even the nuclear disaster in Japan.
Starbucks CEO Howard Schultz spoke out last year as a vocal critic of larger funds on the market. When coffee prices hit record highs in May 2011, he told The Telegraph that: “Through financial speculation – hedge funds, index funds and other ways to manipulate the market – the commodities market is in a very unfortunate position.” Schultz was not alone in blaming larger funds positions for the erratic swings in the market.
However, as with any market dominated by futures and options trading – which by their core definition are based on, and driven by, speculation – the story is far more complicated. A look at the changing roles funds have played in the coffee trade over the past decade goes a long way in explaining some of these changes.
Following on from the coffee crisis in the early 2000s, by 2005 producing countries were slowly starting to recover. Many growers focused on improving quality in order to boost then sluggish coffee consumption figures.
Coffee prices had recovered to between US$1.05 and $1.20 per pound. The recovery in coffee prices, however, also saw the return of funds into the coffee and other commodity markets. International investment banks and financial companies such as Morgan Stanley rushed back to covering coffee through a newly re-established commodity analysis divisions. The commodity boom was on the up, it would seem, no one wanted to lose out on.
“Everybody wanted to get in, they couldn’t wait to get in, and we had never before seen that type of involvement,” says Jack Scoville, Vice President of futures brokers The Price Group in Chicago.
The next three years saw a period of massive buying, with fund positions growing bigger and bigger. At the peak of fund participation in the Arabica market, coffee hedge funds held a net long position of 56,000 positions – the equivalent of around 14 million bags of coffee, according to data from the U.S. Commission of Traders Report (COT).
Index funds at the time were almost exclusively trading long positions. COT figures show that at the same peak, index funds were 63,000 positions long – the equivalent of 15.8 million bags. This means that total fund-held long positions accounted for 30 million bags of the coffee moving around the market, the equivalent of the combined annual production from Colombia, Peru, Mexico and all of Central America.
“By 2008 it just got crazy because everybody was so long that the massive commodity bubble popped,” says one senior physicals trader in the New York market.
When the US economic crisis hit in September 2008, global money markets started crashing and even the most basic fundamentals such as supply and demand seemed to have become oblivious to any market direction.
Although the funds were holding such large positions, Scoville says: “That really didn’t drive prices higher because there was a lot of selling going on.” He adds that this supported that volume of trading, although the way the money involved was handled changed.
“What the funds have been able to do, and what the industry was never able to do before, is to bring more people to the table and take out a lot of the smaller guys. What happens is that the swings get bigger and the swings get more wild,” says Scoville. “As the market grew more risky, smaller players like farmers and retail customers, who before 2008 would purchase as little as one or two contracts, today have chosen to turn the money over to the professionals, which has given the funds much more money to control.”
For most of the past 20 years, coffee has been the world’s second most traded commodity after oil. It is considered one of the top five commodities in the world, not because of the overall value of the market, but because of the volume of contracts traded.
Community Coffee’s Leonard says that much of these additional contracts have come from the shift in the U.S. money markets, following a highly expansionary monetary policy implemented across both industrialised and developing countries since the American sub-prime mortgage crisis first broke in 2008.
“Speculative investors are not following fundamentals. With the Euro situation, investors started to move the dollar to places of safety, and commodities were still looking as a safe bet, so money was moved out of stocks and into commodities,” says Leonard. “What you see now are these same investors moving their money back to the US money markets and treasury bills, which look to be the best bet in an unsafe world, and so as the dollar leaves the market, the market falls.”
In addition to larger hedge funds, coffee markets have also seen smaller investments coming back from rapidly growing Index funds and “while oil is a major part of the Index funds and coffee is a lot less, coffee is a little bit of a part of that too,” says Leonard.
Another issue that sparked significant changes to the market was the start of the US sub-prime crisis coinciding with a rise in the premium for Colombian beans. Six months into the crisis, that premium would reach historic highs, peaking at US$1.10 per pound.
These price fluctuations were also accompanied by a shift in supply sources. When production problems first started in Colombia, expensive premiums forced many roasters to reduce their dependency on coffee from the South American nation, and turned to an alternative supply from Central America.
“But then the Central American premiums soared to over 30 cents and the roasters went to Brazil instead. When the Brazilian premiums also got expensive, roasters started to look into Robustas. That move is what really changed the entire supply chain, because at the end of the day, the market will be driven by what is available,” says the New York physicals trader.
Robusta prices have benefitted from the increased demand in that market, with the differential against Arabica narrowing significantly in recent months. Arabica prices have been under pressure since the beginning of the year, following the expectations of a new big 2012-13 crop from the world’s largest grower Brazil. Some traders and analysts say, however, that pressure on Arabica prices will depend to a large extend on how soon and how aggressively the Brazilians start selling their new crop.
“On the fundamentals side, everyone was waiting to sell and waiting for better prices,” says de la Roche, adding: “Then the Real [Brazilian currency] started increasing the pressure on selling, as it went from about 1.65 against the [US] dollar at the beginning of the year to above 2.0. That was a good price for the Brazilians, so they started selling.”
After scaling down their participation in coffee markets in April and May this year, overall fund activity was, by early June, back to near-record short positions of 21,398 lots, or the equivalent of some 5.35 million bags, according to COT data.
This position has many believing a rally could happen at any time, because of the significant short positions up against a market depleted by stocks, which has increased the transparency of core fundamentals.
“At the end of the day you just can’t roast contracts. The funds are perfectly well aware of this and sooner rather than later they are going to have to start covering their positions,” says veteran analyst Luiz Suplicy Hafers, the current Director of the Coffee Department for the Brazilian Rural Society (SRB).
Five years of deficit in the world supply-demand balance have led to drawbacks of close to 35 million bags, with European stocks falling to 10 million bags in June this year from over 17 million bags in June 2009. After touching a low of 1.25 million bags in September last year, just before the Central American 2011-12 harvest started, ICE certified stocks, meanwhile, have gone from over 5 million bags in 2009 to between 1.5 – 1.6 million bags in the last six months, while total US green coffee stocks has come down to 4.5 million bags.
“We have seen the stocks go extremely low, which is the biggest indicator of where the market is going to go now,” says Community Coffee’s Leonard.
The disturbing news for many is that there is no reason to expect current levels of market vulnerability to ease. Rather, the effects of globalisation and big emerging markets like BRIC nations Brazil, Russia, India and China are expected to continue to increase their influence on world markets. Coffee prices are most likely see only increasing fluctuations.
“It’s a very difficult market, but it’s a normal market rather than last year where we saw an inverted market. That means that at the moment the first position (contract month) is the lowest priced, and then the longer you go back the higher the price goes,” says de la Roche.
“Producers can take advantage of the back months and try to sell the 2012-13 crop against March or May, or even against the next crop for March/May 2014,” he says, adding that roasters “should be thinking about buying into harvest structures” where they benefit from the current low prices and can fix long-term contracts directly with producers.
For the time being, however, the market can expect to see some basic fundamentals transparency restored. Moving forward, continuing lower stocks are likely to see at least part of that new transparent balance persist. But, like it or not, the funds are here to stay.
“Funds are going to be there anyways, they are the speculators of today, that’s their nature and that’s just what we have to deal with,” says Scoville.