Narco commodities – the economics underpinning the trade in illicit drugs

“I’m a decent man who exports flowers.” – Pablo Escabar

In South America, farmers, typically poor and land scarce often have little alternative source of income other than to grow coca leaves – the raw material for the cocaine trade. The farmers typically operate on low margins, but must also bear the substantial economic risk of their crop being destroyed.

Authorities in the region (supported and encouraged by the United States and other major drug consuming countries), have sought to eradicate the coca crop. Either yanking it up by the roots, burning the fields in which it is grown, or spraying it from the air with weed killer. The logic behind the assault is that simply by reducing the supply of coca, the narco supply chain will be cut off from their raw material, in turn making it less profitable and thereby cutting the amount of illicit drugs entering overseas markets.

However, as crop have been destroyed, farmers have either planted more bushes in place of those lost, or migrated to more lenient jurisdictions elsewhere. For example, a crackdown in Peru in the 1990’s triggered a coca-growing boom over the border in Colombia. When the crackdown was reciprocated in Colombia, farmers migrated back to Peru. In Latin America this is known as the ‘cockroach effect’.

This migration also results in environmental damage. As farmers move into new areas, deforestation is left in its wake. Given the high risk that they may be moved onto pastures new there is little incentive for farmers maintain the environmental sustainability of their current planting area, nor restore those areas that they need to leave.

Advocates of the eradication programs contend that by raising the cost of growing coca farmers these costs should be passed onto the end consumer, prompting drug users to reduce their consumption. However, according to the United Nations, global demand for cocaine has been broadly stable with the number of people regularly using cocaine estimated to be broadly unchanged. The consumption of any addictive drug is seen as a necessity to the end user, and so even a dramatic increase in price will do little to impact consumption. For those with no legal way of funding the increase in illicit drug expenses, the only alternative for many is to resort to crime.

The hour glass

Stable demand coupled with cuts to supply should – according to the laws of economics – lead to higher coca prices for farmers in Colombia, and higher cocaine prices for consumers based in the US, Europe and in other end markets. All that disruption costs farmers dearly after all, a cost they would ideally want to recoup. In theory, the increase in costs will be past along the supply chain and onto the end consumer.

The narco supply chain is very unusual. Shaped like an hour glass, it is highly disaggregated at the top and the bottom, yet highly concentrated in the middle. Once South American farmers have harvested the coca leaves they are sold to low tech preliminary refiners. After it is processed it is then passed onto high tech sophisticated laboratories which manufacture the refined cocaine. At each step in the supply chain additional value is added, and so the price of the product escalates quickly.

The next stage is logistics. This is the heart of the supply chain where, what are more known as ‘trafficking groups’ or ‘cartels’, move the finished product from producing countries to consuming countries. As the product gets closer to the end consumer the value of the product rises – evading the police and other threats (rivals) doesn’t come cheap.

Economic theory suggests that a shortage of coca from one region (perhaps due to eradication efforts by authorities) should cause an increase in the price of coca in neighbouring regions, incentivising farmers in the unaffected region to grow more coca. However, after gathering coca price information from different parts of Colombia (areas that had seen crops eradicated and areas that had not been targeted), two economists working with the University of Maryland and New York University found that there was almost zero impact on the price of coca.

The cocaine supply chain is an example of a monopsonist market structure – this distorts the normal laws of economics outlined above. In the same way that a monopolist can dictate prices to its consumers by having no one else to buy from, a monopsonist can dictate prices to its suppliers by having no one else to sell to. The drug cartels – sitting at the centre of the hour glass – have the best of both worlds, control over feedstock and cost, and control over delivery to, and the price charged, to the final consumer.

In his book, Narconomics: How to Run a Drug Cartel Tom Wainwright demonstrates that despite the “war on drugs” pure cocaine prices have been stable for decades: “In the United States, a gram of pure cocaine today costs about $180. (A typical gram bought on the street costs about half that, because it is only about 50 percent pure). That is roughly what it has cost for the past two decades,” he follows that, “Cartels play a role more like that of large supermarkets, buying produce from farmers, processing and packaging it, and then selling it on to consumers.”

Think of the dominant grocery retail chain in your own country. To be successful they typically squeeze their suppliers as much as possible, and tie them into an exclusive supply agreement. The same arrangement works across other industries too. For example, in the United States, Tyson Foods Inc have successfully extracted value from the chicken business (despite its natural boom-bust cycles), by tightening the screws on farmers who have no one else to sell to.

The evolution of prices through the drug supply chain provide another illustration of why efforts to target narco agriculture are a waste of time. Date outlined in the book Narconomics shows the meagre impact a change in the crop price has on the final delivered price. Three hundred and fifty kilograms of dried coco leaves (costing the drug cartels of Colombia $385) are required to manufacture one kilo of cocaine. Sold in Colombia this kilo of cocaine might fetch $800, but by the time it reaches the end user in the USA its price has ballooned to around $80,000 diluted (or over $120,000 pure). Seen this way, attempts to raise the price of the lowest value stage of the whole cocaine production value chain do not have any significant impact on the activities of the cartel, nor the price that the end user pays.

COVID is likely to have contributed to even more consolidation. Lockdowns sealed borders and meant that traditional land and sea transport routes to market were cut off. Meanwhile, border restrictions meant refiners were no longer able to get the cheap Venezuelan gasoline and precursor chemicals from Asia that are essential to turn coca leaves into cocaine. Prices for coca leaf in some parts of South America fell by as much as 73% – coca was no longer immune from boom and bust.

As lockdowns eased so coca prices began to rebound. However, the great coca crash of 2020 could leave an even worse legacy in its wake. Cartels involved in the transport and onward sale of cocaine to the end markets have also suffered due to COVID restrictions in major consuming markets. Only the strongest, most financially resilient are likely to survive. This may presage a consolidation in the narrow part of the hour glass. This may then lead to even greater control and power being forced onto the coca farmers of South America. Unless other legal markets recover fast, farmers may see that coca is their only route to stability, despite the dangers.

What about encouraging farmers to grow a profitable alternative instead?

Instead of wielding a stick in the form of eradicating illicit crops, many governments have resorted to the carrot approach by actively encouraging farmers to plant legal crops instead. Make it more profitable to plant legal agricultural commodities, so the reasoning goes, the drug cartels will have to pay farmers a higher price or otherwise lose them to the production of legal crops. If they don’t pay up then the supply of illicit crops will be curtailed.

A study by the US based think tank, the Center for Global Development (CGD) investigated the decisions farmers in Mexico go through when considering whether they should grow legal crops (for example corn), or narco crops (such as marijuana). The researchers found that corn farmers were easily tempted to switch to growing illicit commodities if the price of corn fell sharply, as it did in the 1990’s when Mexico joined the North American Free Trade Agreement (NAFTA) and the domestic corn market was opened up to competition from their northern neighbour. But as corn prices rose in the mid-2000’s there is some evidence that farmers switched back to producing corn, and so the decision does appear to have some asymmetry.

The experience in Afghanistan also offers lessons in the development of viable alternatives to narco commodities. Poppies are the primary cash crop grown by many of the country’s farmers. Opium is extracted from the poppies and is then used to produce much of the global supply of heroin. The estimated all-time high for opium production was set in 2017 at 9,900 tonnes, and accounting for around 80-90% of global supply, according to the U.N. Office of Drugs and Crime (UNODC). Estimated to be worth some $1.4 billion, opium contributes around one-tenth of Afghanistan’s Gross Domestic Product (GDP).

Ever since the US led invasion of Afghanistan in 2001 Western governments have tried to subsidise local farmers into growing alternative to poppies. More recently, saffron has established itself as a viable alternative to poppies for many farmers. That being said it still represents a tiny fraction of the opium market. While Afghanistan produces around ten thousand tonnes of opium per year, bringing in $3 billion for farmers, saffron production is a mere 16 tonnes saffron, netting $17 million for its farmers.

Ostensibly activity to curtail opium production has been about cutting drug related funding to the Taliban and any terrorist activities that it may support or harbour. The drug trade is estimated to account for up to 60% of the Taliban’s annual revenue, with illicit drug revenue thought to account for between $100 million and $400 million.

In 2021 the Taliban regained control of Afghanistan, but found a country on its knees with little in the way of financial resources to provide for its citizens. In August 2021 the Taliban announced that they would stamp out the production and trade in opium; raw opium prices quickly tripled to nearly £150 kilogram in the days following the announcement. In the absence of any other alternative funding, Afghanistan is likely to find it very difficult to kick their old drug habits.

It’s important to note that poppy farmers must weigh a myriad of factors in deciding how much crop to plant, including annual precipitation, the price of wheat (the main alternative crop to poppy) and saffron, and global opium and heroin prices. In recent years, renewable energy technology, especially solar panels have enabled farmers to reduce the costs involved with growing poppies, enabling water to be extracted from underwater wells. This reduced the risks for individual farmers from growing poppies.

Again the lessons are similar to Mexico. Legitimate crops are less easy to plant and are prone to much larger price volatility than illicit crops. For example, during the coronavirus outbreak in 2020 the price of saffron fell by 25-30%. The closure of hospitality venues and the curtailment of religious and festive ceremonies acros the globe reduced demand for the spice. Western governments had encouraged farmers in the region to cultivate saffron, rather than opium. But the knock-on effect of the decline in prices for Afghan farmers was that they increasingly switching back to opium.

In Peru meanwhile the traditional legal crop is coffee. However, growing coca is significantly less labour intensive than farming coffee. Farming coca is also beneficial from the perspective of a regular income for farmers. The coca crop hits maturity after a year and has a harvest cycle of three to four months. In comparison the coffee crop can only be harvested once a year.

Even if they are economically sustainable, substitute crops often introduce new problems. For example, in Colombia authorities have sought to replace illegal crops with palm oil. This may then result in increased deforestation as land is cleared to make room for plantations.

Legalisation is no panacea

In Latin America, the epicentre of the global drugs trade estimated to be worth $650 billion per year, governments are turning to more liberal methods and tightly regulated markets. These measures are aimed at making things more difficult for the middle part of the supply chain (the most profitable yet illicit part), while also making it more rewarding for those at the lower end, i.e. the farmers that cultivate the crops.

In Peru for example, coca leaf is traditionally used as a tea or chewed, similar to tobacco. It is also the world’s second-largest coca producer. In 2015 the country decriminalised the possession of cocaine for personal use (below a certain threshold), as well as introducing a tightly regulated legal coca market.

In 2009, the left-wing Bolivian government of Evo Morales (himself a former coca farmer), legalized limited coca cultivation. Research suggests that this legalization effort helped reduce violent conflict in Chapare, a major coca cultivating region, and helped to boost farming earnings relative to those from jobs in cocaine refining.

Coca growers collaborate with the government to enforce modest controls on cultivation through a program of “social control,” leveraging local capacity to allocate land access as an incentive to farmers to moderate cultivation within the legal limits for coca plot size. Legalization can open civic space for grower organizations to step in, which means traffickers and cartels, often run by criminals with no investment in local stability, are no longer the de facto source of local governance.

However, Morales departure from office in 2019 upon losing the election, led to a dramatic reversal in the Bolivian governments approach to the coca farmers. The right-wing, anti-coca government that replaced Morales declared a new era of coca eradication in addition to persuading farmers to embrace alternative crops – returning to the failed policies of previous administrations.

Meanwhile in Colombia, responsible for around 90% of global cocaine supply, proposals go well beyond what is happening in Bolivia or Peru. The Colombian government has proposed the development of a regulated legal market for cocaine. This includes coca leaf purchases by the Colombian government, which would then be refined and sold for public health use such as pain relief. It would not be sold for recreational purposes. As in Bolivia, this should result in greater stability for coca growers, now that the cartels are no longer the only buyer and then in doing so have a much greater stake in the governance of coca growing regions.

Could this result in countries such as Colombia being a great place to invest? They have the natural climate for growing these crops. If the legal and regulatory side of it can be sorted out then Colombia and places like it could be a great place to capitalise on the legalisation in narco commodities.

As of late 2020 only two countries have legalised the manufacture and consumption of cannabis for recreational use on a nationwide basis – Uruguay and Canada – while 11 jurisdictions in the US have similar freedoms. Mexico maybe the third country to join the list of nationwide legalisation.

The experience of legalisation in North America points to the development of a two-tier market in which the legal supply is reserved for large companies, while the illegal market continues to be supplied by informal farmers. Regulations tend to ask for sellers to be able to prove the origin of their crop. Other measures often focus on the need for high security. Both of these measures tend to be the preserve of large companies.

What have been the economics of the cannabis market since it was legalised in the US? After prohibition ended in the United States in 1933 it took distillers 15 years to meet demand. In the meantime, illicit suppliers filled the gap. Any attempt to introduce quotas below current market demand opens the door for the illicit market to supply the gap.

If (and its a big if) the trend towards legal, regulated markets in both producer and consumer countries continues then it’s possible that we will see a greater financialisaiton of organic narco commodities. This could for example include some element of risk management via futures markets. Although there are many, many hurdles to cross before it ever got to that level.

As the industry matures there is likely to be greater scrutiny on the provenance of the ingredients. This mirrors what is happening in conventional commodity markets where consumer pressure has led to greater monitoring of commodities through the supply chain, all the while checking for potential negative environmental, social or governance impacts. For example, during 2021 Mexican’s were reportedly willing to pay hefty premiums (~200%) for cannabis grown north of the border in California. The appeal for Mexican consumer being the higher quality and cache associated with cannabis sourced from California.

As with ESG ratings for conventional commodities there is a risk that the practice only makes matters worse – consumers pay a premium for a worthless claim, all the while feeling good about themselves when the problem has not gone away. Speaking to a British newspaper, a Colombian aid worker reported that claims of ‘fair trade’ cocaine were nonsense, “I’ve never heard of woke coke but I can tell you, no one in Colombia produces cocaine ‘ethically’.”

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