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COFFEE PRICES – IS PAYING FARMERS MORE THE ANSWER?

In July 2019 Fairtrade International wrote an article titled “There is only one way out of the global coffee crisis… Pay more.”

I remember reading it at the time and thinking it had a rather simplistic view of the problem. Of course – pay more for your coffee and farmers lives would improve! Can it be so simple? I think the problem requires a bit more thought and a look at some basic economic theory.

In this article, we’re going to argue that the overall negative impact is as much from price volatility as it is from the price level itself. In October 2019, the Olam Coffee CEO wrote an article, then picked up by the Financial Times about the need for price stability. The FT wrote ” the small price premiums on sustainable and certified coffee fails to alleviate the problems arising from price volatility.” and Olam’s Coffee CEO called for a “Price Stabilisation Fund”.

Introduction into Price Volatility in the Coffee Market

This 12 minute video explains some of the key concepts of economics in the coffee industry in a very approachable way.

Can the Cup Price of Coffee Help the Farmer?

Would paying more for our coffee at the shop result in a better life for the farmer? Let’s examine some factors:

  1. There would need to be a way to ensure the value went back to benefit the farmer directly – something that is proving tricky, with the exception of Direct Trade which we examine later. (tell me if you know of a blockchain app, etc. that is working at scale).
  2. History has proven the economic theory that when prices increase, more farmers plant crops, and soon supply increases. As supply increases, there is downward pressure on prices.
  3. The problem isn’t only low prices, but price volatility, which in turn is caused by several factors that are hard to control, e.g.
    1. Climate and weather
    2. Disease
    3. Labour issues
    4. Political issues
    5. Logistical issues
    6. Stock or Inventory levels

The COVID 19 Pandemic is a unique crisis in that it has caused multiple price shocks. Social Distancing has stopped transport; as a result, some countries stockpiled, and there may be labour issues in different parts of the supply chain. 

There is a further potential source of risk and price shock within the coffee industry, as a limited number of large buyers seek to serve their own commercial considerations and satisfy shareholders.

Serving commercial interests and shareholders is not necessarily the evil thing it’s sometimes present as. People forget that these companies employ lots of people, something they can only do when they are making a profit. Shareholders are not only fat cats, but also pension funds that a lot of retired folks rely on.

But I digress. Any of these above issues can cause a ‘Price Shock’ to the system. Because the coffee commodity is in-elastic, an impact in any single area cannot be adjusted or compensated easily, or at all.

Coffee prices are set daily on the New York Stock Exchange in something called the C Market. This price, set daily, is what many small farmers will get paid by their local cooperative or national association.

The role of the financial markets in coffee prices and the plight of coffee farmers is a contentious one. Some people blame the financial markets for the price volatility, for which it certainly has some blame to shoulder. Yet, it also creates a market for the majority of trade. But it has serious problems and limitations, one of which is the way the C Market price is influenced by coffee futures.

A Brief Explanation of the Futures Market

Some articles have been written about the futures market, and what role they might play to stabilise commodity prices. Futures were, after all, invented with commodities in mind. If you’re not familiar with how futures work, here’s a somewhat simplified explanation by way of some examples.

A coffee farmer prefers a guaranteed modest profit rather than taking the risk of losing money, even if it means he misses out on potentially higher profits. To make this happen, a speculator could offer the farmer a fixed guaranteed price for their crop over a period of time (say six months). The farmer is pleased because they lock in a price where they know they make a profit. 

The speculator owns the risk that prices will be lower when the crop is harvested in six months. In this case, he will have a contract to buy the crop from the farmer at a higher price than he can sell it for, and he will lose money. But, if the price goes up over those six months, the farmer still gets paid the agreed amount, and the speculator pockets the additional profit.

Coffee Futures Vs Options

There’s often confusion over futures and options. A coffee future is a contract to buy the underlying crop in the ‘future’ at a price specified today. An Option is as it sounds, an option to buy (or sell) that crop in the future for a specified price. The option costs money, and if you don’t take it up (because the price went against your bet), you lose 100% of the money paid for the option.  Options allow a speculator to ‘gear’ up their investments to a scale of multiples vs a futures contract, but the risk is higher.

Futures Scenario 1

A speculator buys coffee from a farmer for a guaranteed price of $111 in six months. Six months later, the price of coffee is $113. The farmer receives only $111, and the speculator is able to buy it for $111 and sell it on immediately for the market price of $113. The farmer has missed out on some profit, but they’re happy because they knew what their profit would be and could make plans based on that income.

Futures Scenario 2

A speculator buys coffee from a farmer for a guaranteed price of $111 in six months. Six months later, the price of coffee is $109. The farmer receives their $111 as guaranteed, and the speculator can only sell it on for $109, making a $2 loss. The farmer is happy; they have not had to burden the loss. The speculator has lost around 2% on the transaction. Most speculators will have strategies to ‘hedge’ their bets so that they minimise downsides.

Coffee Trading Exchanges

Arabica Coffee Futures are traded on ICE the Intercontinental Exchange. A trade might be for 37,500 pounds of green Arabica beans, settled upon physical delivery of the beans to a designated port. Robusta coffee futures which used to be traded on (the London International Financial Futures Exchange) LIFFE is now also part of ICE

But the futures market itself deals in commodity beans and is not an option for a smaller business, or those trading in speciality green beans. It serves the big companies, and even then, the behaviour of the futures market is unpredictable.

Anyone who read Michael Lewis 1989 classic ‘Liars Poker‘, also knows that if you’re big enough, you can move the market to suit your own purposes, and even break national banks, as George Soros did in 1992 when he went up against the Bank of England, and won. So alas, we can’t count on common sense or facts alone to drive the price of coffee futures, and coffee futures influence the C Market price.

The Price Stabilisation Fund Idea

So, putting up prices isn’t the answer, and commodity futures aren’t the answer. What can we try to do? Perhaps the answer lies in several approaches, some are practical and achievable in the short term, and others are more strategic and will take time.

The suggestion from OLAM’s Coffee CEO in their statement last year makes sense to me. They suggested the creation of a fund that subsidised farmers, but in a novel way. 

“I believe it is time to seriously look at implementing a price stabilisation fund that will subsidise farmers when prices are low for reducing production capacity over the short-term, while helping them mitigate the long-term impacts of climate change.”

OLAM Coffee CEO

Specifically, the fund tackles the economic supply and demand problem of direct support without controls. If prices go down and you subsidise the farmer in the traditional way, they continue to produce coffee, creating more supply, putting further downward pressure on prices until the fund runs out of money.

Instead, the idea behind this fund is to fund farmers in times of low prices, but not to pay for production, but to pay for reinvesting into the land, to improve production in future crops. This is simple enough to work and could be implemented without waiting years.

Direct Trade

Another approach we’re seeing more often now both in the coffee and cocoa sectors is direct trade. Roasters are forming relationships with farmers directly, and building a relationship with them that allows farmers to reinvest in things like washing stations, and education on selection.

Union Coffee – Direct Trade in Action

An exemplar of the Direct Trade model in the UK is Union Coffee. A statement on their website as a “Message from Our Founders” summarised the problem.

We started Union Hand-Roasted Coffee in 2001, after years of witnessing the impact of volatile markets on the lives of coffee farmers.

Union Hand-Roasted Coffee Founders

They claim the following benefits when buying Direct-Trade coffee as a consumer.

1. You can find out exactly where, how and by whom your coffee is produced.

2. The farmer receives a fair, sustainable price. Always covering the cost of production, in 2018 on average 48% above minimum Fairtrade price and 69% above the world market price.

3. Your coffee comes from farmers committed to sustainable agricultural practices and labour rights.

4. You get access to unique coffees. Through our direct sourcing and long-term relationships, we can discover exclusive, hard-to-find gems.

5. You are guaranteed to drink a delicious cup of 100 per cent Arabica, speciality coffee.

Research

Strategically, we are all familiar with the threat posed to the industry by climate change. The work done by World Coffee Research based in California is essential to helping find variants that will be less susceptible to climate change and disease.

I love their website, which is a treasure trove of information, the invaluable research they publish and the transparency in how they go about it. I also take note on their about page, which companies support them and which are noticeable by their absence.

Conclusion

The problem has been profound for several years, but we can’t expect the general public to provide the answer on their own through increased prices. Besides, the issue as we can see is complex and requires a multi-faceted approach using finance, economics, new business models and scientific research to form a combined approach that works both in the short term and longer term.

What do you think?

Written by Nick Baskett

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