Hedging Against Rising Coffee Prices using Coffee Futures

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Contents

Hedging Against Rising Coffee Prices using Coffee Futures

Businesses that need to buy significant quantities of coffee can hedge against rising coffee price by taking up a position in the coffee futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of coffee that they will require sometime in the future.

To implement the long hedge, enough coffee futures are to be purchased to cover the quantity of coffee required by the business operator.

Coffee Futures Long Hedge Example

A coffeehouse chain will need to procure 1,000 tonnes of coffee in 3 months’ time. The prevailing spot price for coffee is USD 1,648/ton while the price of coffee futures for delivery in 3 months’ time is USD 1,600/ton. To hedge against a rise in coffee price, the coffeehouse chain decided to lock in a future purchase price of USD 1,600/ton by taking a long position in an appropriate number of Euronext Robusta Coffee (No. 409) futures contracts. With each Euronext Robusta Coffee (No. 409) futures contract covering 10 tonnes of coffee, the coffeehouse chain will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the coffeehouse chain will be able to purchase the 1,000 tonnes of coffee at USD 1,600/ton for a total amount of USD 1,600,000. Let’s see how this is achieved by looking at scenarios in which the price of coffee makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coffee Spot Price Rose by 10% to USD 1,813/ton on Delivery Date

With the increase in coffee price to USD 1,813/ton, the coffeehouse chain will now have to pay USD 1,812,800 for the 1,000 tonnes of coffee. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,813/ton. As the long futures position was entered at a lower price of USD 1,600/ton, it will have gained USD 1,813 – USD 1,600 = USD 212.80 per tonne. With 100 contracts covering a total of 1,000 tonnes of coffee, the total gain from the long futures position is USD 212,800.

In the end, the higher purchase price is offset by the gain in the coffee futures market, resulting in a net payment amount of USD 1,812,800 – USD 212,800 = USD 1,600,000. This amount is equivalent to the amount payable when buying the 1,000 tonnes of coffee at USD 1,600/ton.

Scenario #2: Coffee Spot Price Fell by 10% to USD 1,483/ton on Delivery Date

With the spot price having fallen to USD 1,483/ton, the coffeehouse chain will only need to pay USD 1,483,200 for the coffee. However, the loss in the futures market will offset any savings made.

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Again, by delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,483/ton. As the long futures position was entered at USD 1,600/ton, it will have lost USD 1,600 – USD 1,483 = USD 116.80 per tonne. With 100 contracts covering a total of 1,000 tonnes, the total loss from the long futures position is USD 116,800

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the coffee futures market and the net amount payable will be USD 1,483,200 + USD 116,800 = USD 1,600,000. Once again, this amount is equivalent to buying 1,000 tonnes of coffee at USD 1,600/ton.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the coffee buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising coffee prices while still be able to benefit from a fall in coffee price is to buy coffee call options.

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Hedging Against Falling Coffee Prices using Coffee Futures

Coffee producers can hedge against falling coffee price by taking up a position in the coffee futures market.

Coffee producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of coffee that is only ready for sale sometime in the future.

To implement the short hedge, coffee producers sell (short) enough coffee futures contracts in the futures market to cover the quantity of coffee to be produced.

Coffee Futures Short Hedge Example

A coffee producer has just entered into a contract to sell 1,000 tonnes of coffee, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of coffee on the day of delivery. At the time of signing the agreement, spot price for coffee is USD 1,648/ton while the price of coffee futures for delivery in 3 months’ time is USD 1,600/ton.

To lock in the selling price at USD 1,600/ton, the coffee producer can enter a short position in an appropriate number of Euronext Robusta Coffee (No. 409) futures contracts. With each Euronext Robusta Coffee (No. 409) futures contract covering 10 tonnes of coffee, the coffee producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the coffee producer will be able to sell the 1,000 tonnes of coffee at USD 1,600/ton for a total amount of USD 1,600,000. Let’s see how this is achieved by looking at scenarios in which the price of coffee makes a significant move either upwards or downwards by delivery date.

Scenario #1: Coffee Spot Price Fell by 10% to USD 1,483/ton on Delivery Date

As per the sales contract, the coffee producer will have to sell the coffee at only USD 1,483/ton, resulting in a net sales proceeds of USD 1,483,200.

By delivery date, the coffee futures price will have converged with the coffee spot price and will be equal to USD 1,483/ton. As the short futures position was entered at USD 1,600/ton, it will have gained USD 1,600 – USD 1,483 = USD 116.80 per tonne. With 100 contracts covering a total of 1000 tonnes, the total gain from the short futures position is USD 116,800

Together, the gain in the coffee futures market and the amount realised from the sales contract will total USD 116,800 + USD 1,483,200 = USD 1,600,000. This amount is equivalent to selling 1,000 tonnes of coffee at USD 1,600/ton.

Scenario #2: Coffee Spot Price Rose by 10% to USD 1,813/ton on Delivery Date

With the increase in coffee price to USD 1,813/ton, the coffee producer will be able to sell the 1,000 tonnes of coffee for a higher net sales proceeds of USD 1,812,800.

However, as the short futures position was entered at a lower price of USD 1,600/ton, it will have lost USD 1,813 – USD 1,600 = USD 212.80 per tonne. With 100 contracts covering a total of 1,000 tonnes of coffee, the total loss from the short futures position is USD 212,800.

In the end, the higher sales proceeds is offset by the loss in the coffee futures market, resulting in a net proceeds of USD 1,812,800 – USD 212,800 = USD 1,600,000. Again, this is the same amount that would be received by selling 1,000 tonnes of coffee at USD 1,600/ton.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the coffee seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling coffee prices while still be able to benefit from a rise in coffee price is to buy coffee put options.

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What Is Coffee Hedging & How Does It Impact Producers?

Coffee trading can seem intimidatingly complicated. You may have heard reference to futures markets and hedging, but do you really know what they are?

And when low coffee prices make the news, do you understand why are they have fallen? What do drops in the C price mean for producers? Let’s take a look into the world of coffee trading and find out more about its impacts.

Understanding The Different Coffee Markets

Broadly speaking, there are two ways to buy and sell green coffee: the cash market and the futures market .

The cash market for green coffee is generally defined as the physical exchange of coffee being bought, sold, and delivered. Producers, exporters, importers, traders, and roasters all participate in the cash market.

In other words, the cash market is trading at its most basic level: coffee is sold at a certain rate based on its value at the time.

A scoop of green coffee beans. Credit: Neil Soque

You might think of the cash market as for immediate purchases, but this isn’t always accurate in the coffee industry. It can refer to an immediate purchase (known as spot purchases) or used for a forward contract, which is when a buyer commits to purchasing coffee for years to come.

For example, a roaster may commit to buying a fixed amount of coffee of a certain cupping score for the next four years and agree to pay a specific percentage above the international coffee price at the time of harvest. This would be a forward contract on the cash market. The majority of physical exchange of coffee occurs through forward contracts.

Trading in the futures market is different. It means paying or receiving prices that don’t necessarily reflect the coffee’s current value. When parties sign a futures contract , they agree on a specific price to be paid in the future, regardless of the coffee’s market rate at the time of harvest or delivery.

This kind of contract comes with conditions. Futures contracts are between licensed participants on government-regulated platforms such as the ICE in New York (also known as the C market), which trades Arabica, and LIFFE in London for Robusta. The ICE and LIFFE set the price of coffee, which is known as the C price. They also stipulate that green coffee can only be traded in lots of 37,500 lbs.

Handling coffee as a commodity has some obvious flaws. All coffee is treated as a uniform product, regardless of quality, origin, or cost of production. Consider the different infrastructures among coffee-producing countries and the range of coffee beans produced. Does this seem like an effective way to buy and sell coffee?

Coffee cherries on the branch. Credit: Devon Barker

Why Trade in The Futures Market?

So if the futures market doesn’t reflect the actual value of the coffee at the time of its delivery or reflect the costs of production, why do people trade this way?

Buying green coffee on a differential-based price (a certain amount plus or minus the C market price) always involves risk. The C price can fall and lead to the devaluation of the coffee. It could also increase after purchase, providing more income for the buyer. But it’s a fundamentally unstable and risk-based way to buy and sell.

A futures contract means that both buyer and seller know the price ahead of time. They can make business decisions and investments based on it. Some people also trade in the futures market to take advantage of dips in the C price. When it falls, they sign a futures contract to lock in future coffee at today’s low price.

Futures contracts mean that producers have a guaranteed price, which can be beneficial if the C price then drops. But it can be devastating if production costs go up because the C price is not linked to real life costs of production. A producer could be locked in to selling their coffee at a loss.

Coffee bags at a roastery. Credit: Devon Barker

Buying futures contracts is described as hedging . This term means strategies that reduce risk in a market with price volatility. It includes trading on the futures market but there are also other ways to hedge.

Artur Ornelas is a trader and he handles operations at Minasul , a Brazilian specialty coffee cooperative. He tells me that hedging is used to reduce and control exposure to risk.

“One can offset potential price risk, while chipping away potential larger gains,” he says. “Hedging should be done to guarantee a profit margin, to eliminate the effects of price fluctuation on the results of a company or producer, knowing that once placed you should not expect to gain or lose anything different from that.”

How Does Hedging Affect The C Market?

The C price is the international market rate for green coffee. This price is affected by supply and demand . When supply increases or demand falls, the price goes down. When demand increases or supply decreases, the price rises.

Every time a futures contract is signed, it demonstrates demand and affects future supply. So the sale of futures contracts directly affects the C price.

But it’s also important to take into account who is trading coffee on the futures market and why. Artur tells me that the C market is divided into groups: traders in the coffee industry (producers, merchants, roasters, etc.), who make up around 36% of the market; swap dealers, who comprise 14%; managed money, which makes up about 35%, and other parties that make up around 15%.

The first group are people who actually use the coffee and are hedging to reduce risk. Managed money uses the futures market for speculative purposes – that is, they buy and sell coffee in the hope of making profit for clients including investment funds and banks.

Swap dealers use the futures market when creating commodity swaps, a complex financial deal that offsets risk and may result in profits. Like managed money, swap dealers do not intend to possess or use the coffee.

Producers at a cupping in Guatemala. Credit: Devon Barker

Because coffee is handled as a commodity, its trade is linked to other commodities. Traders who use the market as a financial tool may consider coffee in relation to wheat, iron, gold, or other commodities.

Investors use numerous commodity markets worldwide to trade in purely financial transactions, rather than physical trades in which the actual goods are delivered. And because traders buy and sell whatever seems attractive on that specific day, the C price fluctuates a lot.

So the majority of market activity is in the hands of players outside of the coffee industry. But all the activity affects the global price of coffee.

A man sews coffee bags. Credit: Devon Barker

What Does The Futures Market Mean For Producers?

The fact that the C price is not linked to the cost of production has a real impact on producers. Smallholder farmers can be hit hard by price fluctuations while the rest of the supply chain enjoys healthy margins. If the C price dips, producers are left with a tiny profit margin or none at all.

Artur tells me that the C market has become too big for the coffee industry alone. “Non-coffee industry participants are the majority of the C market,” he says. “This brings a lot of liquidity to the market, enabling any participant to buy and sell when in need. This is a very important role.”

“But [speculation] also moves prices around a lot faster and allow prices to be uncorrelated with physical market fundamentals such as crop size, climate changes, cost of production, etc.”

Large cooperatives have access to the market and contribute to that 36% of traders with ties to the industry. But most producers don’t create enough volume to participate. Instead, they make sales based on the C price on the day they’re logistically able to sell. And as we know, that varies depending on the actions of traders each day.

This means that producers are unable to predict the price that they will sell their coffee for. A system designed to ensure price stability instead causes greater instability for the producers most at risk.

A producer on a coffee farm in Guatemala. Credit: Devon Barker

Smallholder producers are excluded from the market because they don’t produce the minimum 37,500 lbs required by the ICE. But for producers who can access the market, such as large cooperatives, there can be benefits of trading in this way.

Artur says that the futures market is an essential tool for more efficient management by producers. “It allows the producer, in times of exaggerated highs or too low prices, the tools to increase their profits or to diminish their losses,” he says.

“It allows profit margin setting, provided that the producer adequately controls their cost of production. Knowing the cost per bag, the producer can keep track of prices in the futures market, aware that they can now define their profit margin for the crop already harvested or, especially, for future crops.”

“All this provides the producer with the means to plan their production, costs, and investments, provided that future prices adequately pay for their costs and risks,” he tells me.

Coffee trading is a complex topic and futures contracts are just one aspect of it. They can be used by buyers to reduce risk. But most producers have no access to this form of trade and its volatility can be damaging. Hedging may seem like a smart financial choice, but it’s important to fully understand its impact on all parties involved in the coffee supply chain.

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