Coffee Futures: Investor Behavior Overwhelms Market Fundamentals

[Note from the author: This post is an interview with Andrew Sargent, the Director of the CRS Coffeelands program. Andrew and I have had an intense online discussion over the past month on my series of posts on the “Scandal of the C-Price.” We’ve re-constructed this exchange as a Q&A. It’s a long post, but worth reading to the end, as I feel Andrew has raised the bar on this discussion.] 

Paul Hicks (PH): Andrew, since my series of posts on the “Scandal of the C-Price” you and I have had a lively exchange about coffee prices. In some respects, we diverge on the analysis of the problem, and I’ve learned a lot from this exchange.  Can you explain your concerns about my posts?

Andrew Sargent (AS): Indeed, the discussion has been lively.  This is because this is a very critical problem that elicits a lot of emotion. I’ve also learned quite a bit, and I think the blog readership has as well…

For me, your posts have made a very important contribution to coffee sector dialogue because of where they come from: the field. It is very evident in your tone of consternation and outrage that this is a critical, urgent problem that is having immediate and severe effects on the well-being of poor and vulnerable people. The fact that it comes about without warning, without clear justification, and without remedy is even more maddening, and that is evident in your language. This is exceedingly important for us to hear in the consuming countries because, honestly, in the midst of a severe price crisis life goes on as it always has, with reporting focusing on the tragedy of our domestic political environment and the natural disaster of the moment. It’s quite easy to forget that there is a devastating economic shock resonating throughout the coffee world — and your posts address that quite powerfully.

Now, the value of your expressive language aside, I worry that the tone that occasionally intersperses the posts may not lead us to inclusive and constructive dialogue, but may instead cause some sector stakeholders to disengage and dismiss the very important content as mere ranting from development people that have worked with farmers their entire careers and don’t understand the coffee business.

Asserting that a “small group” is “exploiting the coffee market” and “concentrating wealth,” chastising “the worlds’ largest coffee companies and shrewd traders” for “[generating] massive profits,” etc. — these are all very strong, loaded statements, that lean towards an “us versus them” perspective.  I worry that such statements will alienate (or have already alienated?) those people who may feel targeted as part of the “oppressor” group, and will channel the intense emotion and consternation among the “oppressed” group into vitriolic bashing of an imaginary “coffee sector elite.”  And I don’t think that leads us to solutions.

You have said repeatedly that this is a misinterpretation, that this was not your intent, that you do not believe there is a “deep coffee state” intentionally manipulating the futures markets to impoverish farmers and farmworkers.  Can you elaborate further?

PH: I appreciate the comments and criticism. My aim with these posts is to spur discussion and find viable solutions. They are written to provoke, not to offend, but I see your perspective. My point is this: While some actors in the coffee market are doing quite well — large coffee companies and many traders — other people are very poor and highly vulnerable to volatility in the market (i.e. farmers and farmworkers). I believe coffee companies can and should do more to resolve dysfunction in the coffee market.

AS: Indeed, farmers are the most powerless, and once again this is one of the reasons your posts have been so important. I like your provocative style (it definitely got my attention). Let’s just hope it will result in engagement rather than disengagement of the “large coffee companies” and traders. I should also say that we shouldn’t scorn those who do well in the coffee business — because if companies don’t do well, they go out of business.

My other concerns about the posts are that they fail to explore the instruments of futures markets and price benchmarking, and the important role those instruments play in the coffee market. Unfortunately doing so requires explaining the basic principles, mechanics, and uses of futures markets, and since none of us are experts in financial derivatives, we risk creating more confusion and getting it wrong. I will make an attempt nonetheless…

Coffee as we know it is traded (i.e. bought and sold) on a physical market, i.e. the market for the real product. Coffee is one of many commodities that is also traded (bought and sold) on a futures market (multiple futures markets, in fact). What is bought and sold on the futures markets are contracts for future delivery of the physical product. Most of those contracts are liquidated before the delivery date, so in the end people are mostly just trading paper.

What you call “the C-Price” is the price on the Arabica coffee futures contract, referred to as the “C” market, or “New York.” It is currently traded on an electronic platform called the Intercontinental Exchange (ICE). It is indeed used as the world benchmark for [pricing of] Arabica coffee.

While it is not relevant for our mostly specialty-oriented readership, it is important to understand that there is a second, major coffee futures market for Robusta coffee, also referred to as “London” or “LIFFE” and also traded on ICE (see here). It is the global benchmark for the pricing of physical Robusta Coffee.

The “C-Price” reflects supply and demand for Arabica coffee futures contracts. This is supposed to be, and frequently is, highly correlated with supply and demand for physical coffee. But it’s not always correlated, and in fact it has become increasingly uncorrelated in the past 15 to 20 years. This is an important point, which we discuss later (in this post, and in future posts).

Why do futures exist? Per the U.S. Commodity Futures Trading Commission (CFTC), futures markets exist to enable “commercial or institutional commodities producers or consumers… to reduce the risk of financial losses from price changes.” In other words, for buyers and sellers of physical coffee, futures provide an instrument for hedging against — i.e. managing — price risk. Their purpose is not to “smooth out price volatility,” as you suggested in your post. Rather, they exist in order to allow some market actors — not all, but some — to better manage that volatility, and to reduce the risk of financial losses from that volatility. They are very important instruments used extensively by coffee traders, producers (large ones), and roasters. They are a good thing. And they currently serve this important function, and have served this important function for decades, even though the futures market has changed drastically in the last 20 years. In other words, they are working quite well, and as they are supposed to.

PH: Great. I’m with you up to this point. And I agree that futures contracts, and markets, are necessary. But let’s not be naïve about this. Markets are constructed. They aren’t forces of nature, like gravity. People build markets, set rules, and set-up exchanges based on these rules. My point is that the C-Price is not working very well, and it should be possible to fix the market in ways that benefit farmers and farmworkers.

AS: A laudable goal that I share, but I would rephrase your statement to, “improve the coffee market, including the futures market, in ways that enable all participants to benefit, especially those participants that are the neediest and the most vulnerable: farming families.”

This goes back to avoiding an “us-versus-them” approach. Those large coffee companies and many traders are not the problem. More importantly, they need to be part of the solution, not targeted as “the bad guys.” They are not willfully or unintentionally “doing quite well” at the expense of farmers, and we should seek a market in which they can still do quite well at the same time farmers are doing well. I would guess you agree with me there?

PH: Yes, let’s make the markets work well for everyone in the long-run, and I believe that involves sharing risk and value more equitably.

AS: Now, quickly on the ‘C’ market: Your statement implies that the ‘C’ market either works or doesn’t work. You imply that because farmers are poor and prices are volatile that “the C-Price is not working very well.”  But this is not the purpose of the C contract, or any futures contract, for that matter. Its purpose is, as above, to enable some (not all) coffee market actors “to reduce the risk of financial losses from price changes.” That’s all. Its purpose is not to reduce price volatility. Its purpose is not to make farmers less poor. Its purpose is not to equitably distribute profits from the coffee business between large, profitable coffee companies and poor farmers. Its purpose is not to provide a price risk management instrument to everyone. To criticize it for not doing so is to misunderstand it.

Note also that futures markets themselves do not make commodity prices more volatile. In fact, commodity prices are volatile by nature. Just look at price volatility for vanilla and black pepper and cloves and any number of other commodities where there are no futures instruments. Neither the C contract nor the RC (Robusta) contracts themselves are causing extreme price volatility. Instead it is the actors participating in those markets that are causing the volatility.

You make two very important points in your above reply. First, you state that “futures contracts are necessary — and good.”  That was not evident in your posts (recall you talked of trying to “break” the C-price). My concern was that the target of your posts has been “the C-Price,” which can be interpreted as bashing the instrument of futures markets in general, bashing the use of a price benchmark, or bashing the ‘C’ contract in particular.

My argument is that the ‘C’ contract itself, as an instrument, is not the problem. The problem is, rather, the functioning of that instrument, the current mechanics of that instrument. I worry that, whether it was your intention or not, your posts could be interpreted as calling for the abolition of the ‘C’ contract and the use of the ‘C’ as a price benchmark. That kind of discussion will result in disengagement from anyone who knows and understands the instrument of futures markets. And I assert that it’s a purely philosophical discussion anyway (not to take away from philosophical discussions, which are enlightening and enjoyable), since the coffee sector will not abandon the KC (Arabica) or the RC (Robusta) contracts, and will not stop using them as price benchmarks.

The second, very important point you make is the following: “people build markets, set rules, and set-up exchanges based on these rules.” Now we are getting somewhere! The current problematic mechanics of the KC contract — which, from what I can tell, are the reason prices are as low as they are right now — are a result of a change in rules in the early 2000s and a simultaneous and subsequent change in investor behavior, and could be resolved by new, well-designed, and well-targeted rules. We are making some progress here.

PH: Great points. You’ve helped me understand the market much better than when I wrote the first post. I’m persuaded by these two points: “The ‘C’ contract itself, as an instrument, is not the problem – the problem is rather the functioning of that instrument, the current mechanics of that instrument.” And: “It is the actors participating in those markets that are causing the volatility.” Would you agree that we need to fix the C-Price?

AS: Well, yes and no. I don’t think the futures market in general or the ‘C’ contract itself needs fixing. Those markets continue to work quite well as hedging instruments. To the extent that by “C-Price” you mean the ‘C’ contract, no I don’t think it’s flawed. But if by “C-Price” you mean the price that results from the current functioning of that instrument (which I think is what you mean) then yes, there is a big problem. This is a problem not just in coffee futures but in all commodity futures, and it comes down to one thing: too much managed money in the futures markets, and the fact that managed money is making prices move independent of the fundamentals.

What do I mean?  In an ideal world, prices on the futures market reflect the fundamental supply and demand conditions for the underlying commodity. So if there is a current or expected shortage in physical coffee, prices go up; and if there is a current or projected surplus in physical coffee, prices go down. This used to be what happened in the coffee market. In my days at Neumann Gruppe almost all offices had a poster showing 50+ years of the ‘C’ contract price, with all peaks and troughs annotated with the accompanying shock to the fundamentals (frost in Brazil, breakdown of the quota system, bumper crop in Vietnam).

At the moment (per my sources), we expect a record crop in Brazil and a 6-7-million bag surplus in 2018/19, and this has downward pressure on current and future coffee prices. However, that 6-7-million bag surplus is dwarfed by the net short position of “non-commercials” — those actors with no connection to the coffee business, i.e. investors — in the ‘C’ market, which is about 2-3 times as large (per those same sources). A large short position means there are more sellers than buyers (kind of), which has a downward pressure on prices. And, according to the people who know more about this than me, that’s what has pushed prices below $1 per pound. In other words, investor behavior has pushed prices to their near-record lows.

In your posts you bring up the intractable problem of price signals and production response — i.e. when prices are high farmers plant more, and when prices are low, people pull trees out of the ground. Due to coffee’s three-year maturity period, this results in a chronic boom-bust cycle of surplus/low prices and shortage/high prices. There is no easy solution to that problem, unfortunately. That problem aside, in the past those price signals were at least linked to fundamental supply and demand conditions. Now, prices move irrespective of the underlying supply and demand conditions, so farmers are getting the wrong price signals, or price signals that are arbitrary. And YES, that is a major problem, and YES, that needs fixing. This is something everyone in the trade has been talking about for almost two decades (since I was cleaning spittoons at InterAmerican), and an issue on which (I think) we could get broad consensus to do something — among poor and vulnerable farmers, “shrewd traders,” and “large coffee companies” alike.

Note that this problem is a real-life manifestation of the quote from Laudato Si with which you launched this entire debate: “finance overwhelms the real economy.” Managed money — i.e. the “non-commercials” in futures parlance, or “finance” per El Papa — is significantly influencing prices on the ‘C’ and RC contracts (and almost all commodities futures contracts), and “overwhelm[ing]” the influence of supply and demand for physical coffee, i.e. “the real [coffee] economy.” So, we have now come full circle.

PH: This is fascinating, and consistent with my recent conversation with Adam Kline. Thanks very much for the honest and critical debate this past month. I hope this debate gets us closer to viable, real solutions for the coffee market.

AS: I do as well, although imposing new regulations on a financial instrument that is now an important component of the investment portfolio for a large number of hedge funds, pension funds, and other finance industry actors is no small task (especially in a political environment where regulations are going up in smoke as fast as fires can be lit). My hope is that this discussion will help our readership focus its energy on the real problem — managed money in the futures market — as opposed to other things that will distract us from that problem and/or alienate some members of the coffee community, like the use of the ‘C’ as a price benchmark (even though we should dive deeper into that topic), or those big, bad coffee companies that turn a profit while farmers struggle.