Conversations in Price Risk Management: Smallholders vs. Cooperatives

ICE futures prices as of Monday, January 11 at 10:24 a.m. EST.

During the last months of 2015, I posted a number of conversations regarding price risk management (intro; part 1; part 2; part 3) all with the goal of understanding the topic and how we might better use these tools to protect cooperatives and other farmer associations. Today I want to pick up the thread for the new year by exploring how PRM might differ for individual farmers.

So how does the approach to price risk management differ for individual farmers versus that of a cooperative? As I have been (slowly!) getting a better sense of how price risk affects cooperatives in the coffee sector, the distinction is becoming clearer.

A single farmer, large or small, is the owner of all of the coffee they are selling. If the price increases, the value of their asset (coffee on the bush) increases. If the price decreases, the value decreases. The distinctions and gradients are due to the relationship that the farmer has with the market and how this relationship is mediated.

If a farmer can only sell cherry to the passing middlemen, then the spot price of the coyote is the price s/he will receive. If the farmer has any sort of relationship with an exporter, they may be able to determine on which date/price they will commercialize their coffee, within a certain time frame. Others still will be able to fix prices forward for future harvests. In terms of mitigating their own exposure to price risk, understanding what their costs of production are remains the first and primordial step.

In this post, I’m talking to Emilio Baltodano and John Gardina, of the Mercon Coffee Group about how individual producers can mitigate their exposure to price risk.  In Nicaragua, the Mercon Group exports under the local name CISA Exportador.

As usual, this interview is edited and condensed for clarity.

Q: John and Emilio, thanks for taking the time to talk to me today. Let’s get straight into it. What services do you offer to your producers to help them with PRM?

A: A select group of farmers can hedge. Basically they get to make the decisions about when they want to sell. It’s a service that we provide. The biggest risk that we face is the default risk — the risk that the contract is not fulfilled. So this service is one that we usually offer to clients we have done business with for multiple years [author’s note: this means that the coffee sits in the warehouse, and is still technically the property of the farmer. When the spot price of coffee – NYC + differentials – reaches a price that is acceptable to the farmer, they “sell” the coffee to the exporter at that time.]

Q: What about the use of options? Is this something you promote or offer to your clients?

A: Clients can buy options on their own. A select group of clients use it.  It’s not something that we actively promote among small farmers. Options are sophisticated and can be costly. We think it’s better to look at price and to determine what price you need to be able to protect your business. We tell the farmers to know what your costs are and at what price covers those costs. In the long run, the market will typically provide a farmer a window to price at levels that cover your cost and generate a healthy income. Pricing at the right time and levels should be their primary focus. Therefore, we’re not strong advocates for using options as the main method for managing price risk. If used correctly, options can complement a sound pricing strategy, but in the long run, it’s an insurance cost that you don’t really need and it turns into another fixed cost for the farm.

Q: Basically you are saying stop trying to time the market and focus on what you can control.

A: Exactly.  Rather than focusing on what you didn’t get, you can focus on what you did get and do a better job planning and improving the farm and the outputs of the farm — things that you can control. The learning curve is too high with options. The costs are high and the pricing is really complex. We promote a smart price strategy with our producers that starts with knowing your costs.

Q: One potential issue here is that only some of your clients can get fixed price contracts. If fixing prices forward is really the best PRM for individual farmers, how can we offer this to more farmers, especially smaller farmers?

A: It starts with trust.  We only offer this service to farms that we have been working with for years and we know can or will comply with the contract. The risk on our side is the risk of defaulting on the contract to a buyer.

Q: Thinking about how we could get some of the farmers (that CRS works with) to be able to work with fixed price contracts, could we put a guarantee fund that addresses this risk for you? Traditionally we use these funds to serve as guarantees for loans, but perhaps we could repurpose this for contracts and the fund could deal with any contract defaults.

A: If there were funds that could guarantee against a potential default, we don’t see why we couldn’t do this with farmers with whom we don’t have a relationship.

Q: Thanks guys. The risk faced by individual farmers is very different than that faced by cooperatives and therefore calls for a different approach and different tools.