Conversations in Price Risk Management: Shared-Cost Insurance

NYC prices for the previous 6 months.

“Price Risk Management is one of the most misunderstood topics of the coffee crop cycle.” This is how my conversation on PRM with Jorge Cuevas, the Chief Coffee Officer for Sustainable Harvest, began.

Sustainable Harvest has been training cooperatives and incorporating the use of price insurance for many of their client cooperatives. It’s part of a larger training and effort on their behalf to help the cooperatives manage exposure to risk. I had the opportunity to talk to Jorge about how this works and what makes the Sustainable Harvest model different.  This is a condensed and edited version of our conversation.

KK: So Jorge, let’s dive right into this. How does Sustainable Harvest help foster a PRM strategy within cooperatives?

JC: First of all, you have to understand what your risk exposure is. For every cooperative it will be different. There is no universal strategy. It starts with a misguided thinking that equates the cooperative to a large or medium farmer that can engage directly with the market to sell its coffee. That’s not really the case. The cooperative is a necessary intermediary that does not own the coffee it sells. If the price of coffee goes down, the value of the coffee as an asset on the farm goes down. It is the cooperative that has the contract to ship coffee in March, yet doesn’t own the coffee who faces the risk of not being able to meet this contract.

At Sustainable Harvest we try to mitigate this risk through structuring the contracts with the cooperatives. One option is to offer an open price contract. We have agreed to buy coffee, yet the price is open relative to the market and the cooperative can choose when to close. However this offers no stability to the farmer or the cooperative. The market is extremely volatile — it looks like an electrocardiogram. When we do PRM trainings, I show the farmers the price graph and ask them “Would you like this to be your monthly income?” No one can plan like this. You can’t pay your bills, you can’t repay your loans.  What we try to offer is price stability and then look for how they can continue to look for market opportunity.

KK: So, you’re looking to promote fixed price contracts, but making sure that cooperatives can still participate in the upside if the price moves higher?

JC: That’s right. We teach the cooperatives that price insurance is similar to car insurance. It has a premium, and it pays out only under certain conditions.

KK: In one of these PRM discussions I have had, price insurance was characterized as an insurance that you don’t really need. Like a lot of those add on insurances for rental cars, or for appliances at Best Buy. The suggestion was that focus needs to be on getting a price you are OK with, rather than becoming a speculator on the price.

JC:  I think there is a big difference between speculation and market participation. I agree completely with the idea of fixing and ensuring that you are covering your costs. However, we never lock in more than 35 percent of the total harvest of a cooperative. There is too much risk for the cooperative — weather doesn’t cooperate, price spikes up due to a drought in Brazil… see, there is an issue with human psychology here where you are always comparing the relative value to what other people are paying. In other words, say the price was… $5.00 a lb.  You would be happy – BUT only if it was 10 cents more than what others were getting. There is a focus on the relative price that everyone gets. This is why we need a benchmark — the NYC price. The price needs to be higher to what others are getting. We used to fight using the NYC price as the benchmark, but now we don’t — it’s the basis of our prices and we show the cooperatives that they will get the NYC, plus this premium for quality, plus the local differential, plus any certifications, etc. The price insurance ensures that the cooperative is participating in the market and insuring a relatively higher price.

KK:  How far forward can a cooperative fix a price with Sustainable Harvest?

JC: Two years.

KK: And that contract is protected then by price insurance. Say we agreed upon $1.45/lb…

JC:  Then we place a call option for a price above $1.45.  What happens next year if the price was $1.65?  The cooperative will not be able to collect their coffee, as the producers will not accept the $1.45 price for their coffee and the cooperative defaults on their contract and we default with our customers. It is an ugly scenario and one that no one wants to find themselves in. So this is why we put that insurance into place — to protect both the cooperative and the roaster from a default.

KK: So how do you decide the price level for the insurance? Let’s go back to my $1.45 example. NYC price today is $1.16, plus 15 cents for the Nicaraguan differential, plus 15 cents for my certification. At what price point do we place the price insurance?

JC:  That’s a great question.  We ask the cooperative, “What’s the price at which you lose your competitiveness?” In other words, they lose their competitiveness when they lose their ability to collect coffee from their farmers. Is the price $1.60?  $1.70? It will be different for different cooperatives. I need competitive cooperatives, who are competitive all the time in all markets.

KK: So in the Sustainable Harvest model, who pays for the price insurance?

JC:  Sustainable Harvest is the relationship coffee broker. Both sides pay for the insurance. We have done analysis that have shown that the risk of default and subsequent replacement costs for the roaster are much higher than adding the cost for the insurance. So if the cost of the price insurance is $0.05 per lb., the roaster pays 2.5 cents and the cooperative 2.5 cents.  Everyone sleeps easier at night, especially the cooperative manager, who has one of the hardest jobs in the world. They have to be a weatherman, a manager, a financial administrator, a marketer and whatever else needs to be done. That’s why this tool helps take away some of that burden.

KK: How much of your contracts are covered with price insurance?

JC: I’d say 40 to 50 percent of our contracts. If the contracts are for less than three months, we don’t cover them with insurance. It makes no sense.

KK: So, how does the logistics of the price insurance actually work?  Who do you use as a broker?

JC: We use Intl FC Stone and it’s done through the Sustainable Harvest account.

KK: Wow, that makes it really easy for everyone. I think a limitation for adoption of the use of options is that cooperatives had to put cash up front into an account.

JC:  Yeah, SH puts up the cash. No cooperative or roaster has to pay until the coffee is delivered. Then it appears as part of their costs on each side. Or if the insurance paid out, then it’s included as part of the payment to the cooperative.

KK:  Thanks JC for your time and thanks for sharing the details of how you’ve made this work for both the cooperatives and your clients.

JC: No problem. Great talking to you.