Wednesday, January 26, 2011

What’s behind the coffee trade (part 1)

Lately it seems that coffee prices are steadily climbing. To really understand what’s happening, we have to understand the market, how prices are decided upon and how this affects those involved, especially those who are often overlooked—the coffee farmers.

Coffee trading 101

In order to get the big picture, we first need to take a look at how trading works. For those of us who are neophytes in the rules of the trade, we’ll start with the basics.

Coffee prices, and therefore coffee farmers’ income, are affected by a number of factors, such as world market prices, climatic issues, supply and demand, speculation, political unrest, transportation costs and a host of other often unpredictable variables.

Coffee is most often traded in the form of futures contracts through the Intercontinental Exchange (ICE)—previously called the New York Board of Trade—and the London International Financial Futures and Options Exchange (LIFFE). These are the institutions that determine the price of coffee on a minute-by-minute basis.

A futures contract is an agreement to buy or sell an item on a specified date in the future at an agreed upon price. Each futures contract covers 37,500 pounds of green coffee. Note that roasted coffee or ready-to-drink beverages are different products requiring different contracts.

Futures contracts allow both buyers and sellers to manage their risk in a market that can often be volatile. That being said, most coffee farmers do not have the financial resources to take a position in the futures market and often lack the skills to manage that position.

One of the more recent and influential factors in the coffee market is speculation. Before the deregulation of the 1990s, speculation had a place in the commodities market. It was reigned in because classic laws of supply and demand still controlled market prices.

Then, as a result of the tireless efforts of banks, hedge funds and politicians, regulations were systematically discarded, leaving us with an all but imaginary market in food speculation, controlled by people who have little to do with agriculture.

John Vidal’s article in The Guardian succinctly explains the effect of speculation. It is estimated that between 70 and 80 percent of the food market is now speculation. This means that when we get word that Brazil is experiencing heavy rains and mudslides, the price of coffee would normally go up about $1 per bushel, according to Mike Masters of Masters Capital Management, as quoted in Vidal’s article. But, thanks to a speculative market, that price jumps up to $2 to $3 per bushel.

Recently, a wave of investors has had a disproportionate influence on prices within many of the commodity trading markets. These speculators, who often have no commercial interest in the industries in which they invest, are able to infuse large amounts of capital into the market in the hope of making a large, short-term profit. Because they never intend to take physical possession of any of the products in which they invest, they are able to turn a profit on market movements in either direction. This takes markets outside of the realm of simple supply and demand and makes them much more unpredictable.

What we have then, are groups of farmers working to produce coffee for an extremely volatile market that is even more so today due to the intervention of speculators that may or may not have anything to do with the coffee trade. It becomes clear who benefits from the system and who is often left behind.