HardAssetsInvestor

Written by Edward Faubert  |

August 19, 2011

Does Brazil Still Hold The Key To Coffee Prices?

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Despite record crops globally and in Brazil, demand for high-quality beans fuels price rally.

Conventional wisdom among coffee traders has been that Brazil is the driving force for coffee prices — and with good reason. Historically, Brazil has been the world’s largest coffee producer.

However, the market could be changing.

Coffee prices, as measured by the benchmark ICE Futures U.S. contract, began an explosive bull run in mid-2010. From June 2010 to May 2011, coffee prices more than doubled, from $1.35 to over $3.00 a pound. Since topping out in May, prices have fallen approximately 30 percent. Fears of tight supplies for high-quality coffee drove premiums in the cash market up even faster. All this occurred despite a bumper crop out of Brazil.

According to the USDA, total world production of coffee for 2010/11 (October-September) will be 137.9 million, 60 kilogram bags. That’s a world record. Brazil accounted for 54.5 million bags, or almost 40 percent of the total. That’s a record crop for Brazil as well. But it didn’t prevent coffee prices from rising dramatically.

Not All Coffees Are Created Equal

There are two types of commercially traded coffee — robustas and arabicas. Robustas account for about 40 percent of world production. These are low-quality, discounted coffees that trade and are certified by the LIFFE, which is the futures exchange in London for robustas. Arabicas account for 60 percent of world production, of which there are two distinct types: washed and unwashed. Most, but not all, washed arabicas are traded and certified against the ICE futures contract.

Brazil produces a mix of arabica and robusta coffee, neither of which are tenderable against ICE futures. Still, exporters and importers hedge most coffee for export out of Brazil against ICE. As a result, ICE futures can rise or fall depending on the hedging pressures of Brazilian exports.

Total world production of coffee outpaced consumption during 2010/11 by about 4 million bags, and production is expected to outpace consumption again next year, although by a smaller amount. Total world ending stocks of coffee remain historically tight at around 26 million bags, leaving no cushion should there be a supply problems. Ending stocks reached a recent high of 47 million bags during the 2002/03 season, and the surplus pushed prices down to World War II levels.

What has propelled the ICE market is a perceived shortage of high-quality, washed arabica coffee. This type of coffee is exported mainly by Colombia, Mexico, Central America, Peru, plus a few other origins, and is the only type of coffee tenderable against the ICE futures contract. Demand for this coffee had been outpacing production.

Traditionally, much of the world’s demand for coffee came from large manufacturers such as Nestle, Kraft, Folgers and Douwe Egberts. They are all still big players. They operate in the retail category, and retail buyers — your average consumers — are very price sensitive. Consumers are quick to switch brands based on price, and can significantly reduce off-take by wasting less coffee while brewing it at home. As much as 20 percent of a pot of coffee made at home is often poured down the drain.

Despite the recent run-up in prices, demand has remained stronger than many expected.

The newest and growing trend in coffee consumption is with specialty and high-quality coffee. Specialty coffees are premium priced, often branded by the region, mountain or even the farm on which they are grown. They are not nearly as price sensitive. The resurgence of coffeehouses such as Starbucks and Peet’s, as well as the success of such retailers as Dunkin’ Donuts and Tim Hortons in Canada, has also spurred demand for high-quality coffee that is not as price sensitive. The average value of the coffee sold by the cup is only about 5 cents, so even a doubling of coffee prices can be easily recouped by modest pricing adjustments.