Tuesday, January 20, 2015

This article appeared in The Edge on June 16th 2014
Will you be paying more for your coffee soon? The answer lies in hedging tactics

In our everyday lives of coping with financial markets and home life, we need our coffees to keep us going. But brewing in the corner is a steady, dramatic rise in coffee prices since the start of the year. Chart 1 shows prices of the DEC 2014 Arabica coffee futures listed in the ICE Futures in the U.S. Since January, the prices have increased by over 50% !

Chart 1
Source: ICE, USA

A futures price reflects thousands of market players’ (hedgers and speculators who buy and sell the contracts) reactions towards the expectation of the spot coffee prices in the future.  Taking the example of the KCZ12 futures contract above, the expectation is that the price of coffee by end-December will be 177.95 cents per pound. In comparison, the spot or physical price is gathered by agents from numerous localized auction markets in coffee producing countries. Futures tend to be a
preferred source for commodity prices than the spot market for its better liquidity, standardization and stability of market conditions.

The main explanation for the rising coffee prices in 2014 is the coffee-leaf-rust epidemic in Central America compounded by a severe draught that swept Central America and Brazil.
Although coffee prices have been increasing since January, we only gradually feel the hit now as retailers and coffee outlets run down their old coffee stocks. It is almost definite that we will be paying more for coffee in supermarkets and coffee stations… but wait, there may be some exceptions.

JM Smucker (SJM), one of the leading coffee roasting companies worldwide, announced an increase in its retail coffee prices by an average of 9%. However, Starbucks said it had locked in its coffee costs for 2014 as well as 40 per cent of its needs for the 2015, and was insulated from the impact of this year’s price surge. [Source: Financial Times, June 3, 2014] How can this be? Apparently, reports claim that Starbucks practices long term hedges with its coffee bean prices.

Commodity hedging with long-term forwards and futures contracts
Commodity suppliers as well as manufacturers can protect from price volatility by entering into forwards and futures contracts. For example, in the case where the commodity is coffee, a coffee manufacturer like Starbucks buys long-term futures contracts from the exchange at a certain price to fix the cost it will pay for the coffee. If the futures contract rises in price, the buyer will profit on the contract. This profit will offset the higher price the manufacturer pays for the coffee in the spot (physical) market.
Besides futures contracts, coffee manufacturers also enter into forward contracts with planters directly. At the expiry of these forward contracts, the planter will deliver the coffee to the manufacturer at the fixed price agreed at the time the contract was entered into.
Why long term contracts? Long-term contracts are preferred to enable the planter to fit their hedge directly into the harvest time of the commodity when it needs to be sold, or for the manufacturer, when the commodity is needed in the factory.

Difficulties in performing a hedge
Hedging commodity prices has some challenges that market players continue to tackle with. The first and most common issue is basis risk. Basis is the difference between the price of the spot and the price of the future. For example, if we buy a futures contract at 170 cents (per pound) when the spot is at 175 cents per pound, the basis is 5 cents. [Note: one futures contract in the ICE is 37,500 pounds] As the futures price move, so will the spot price; but the prices need not move at tandem. Say the futures price rose to 178 cents and we decide to sell the future to realise the gain of 8 cents. At that time, say the spot price of coffee moved to 185 cents. We would have made a profit of 8 cents per pound with the futures contract but we have to spend 10 cents more to buy coffee in the spot market. We managed to hedge the rising cost of coffee in the physical market but only with 80% accuracy. This is a real problem faced by hedgers. Fortunately hedges can counter this risk with basis swaps offered by investment banks.

The second issue is low liquidity in long term futures contracts. In the absence of a liquid market, the player pays a wide spread between buying and selling his contract. To deal with this issue, some hedgers prefer to rollover short-term futures contracts. This means if a buyer, in January, wants to hedge his cost twelve months forward for December, instead of entering into a single 12-month futures contract, he enters into a 3-month contract (which is more liquid). Come March, he sells the March contract and enters into another 3-month contract that expires in June. He keeps on rolling over as such, until he arrives at the December contract. Although he achieves better liquidity, he faces rollover risk where if the prices of 3-month futures keeps on increasing throughout the year, he ends up paying a higher fixed price for the commodity.

The third issue is the challenge in hedging costs when price volatility lasts for too long. A hedge is very effective when prices are volatile for a certain time then goes back to normal. But in situations where price volatility stays, worse still, if the price climbs gradually for a long time, then futures contracts will get more expensive and hedgers will ultimately have to absorb the price increase. Off course this hinges on the cause of the price climb; in the case of coffee, the question will be, is it just a temporary combination of bad weather and a plant disease… or is it a permanent outcome of the well known (but often ignored) global climate change.

Conclusion

If Starbucks can keep the price of coffee down for consumers by hedging, we question why the other manufacturers could not do so. The art of hedging has been practiced in the commodity market for hundreds of years. However the practice is still under utilised. With the pressure of sudden rising prices in agricultural commodities in many parts of the world due to natural calamities, many industries may now start to consider hedging their costs to keep competitive and survive in the new world.

3 comments:

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