Coffee prices: The top 10 most important drivers

1) Concentrated production

There are two main commercially grown types of coffee beans: Arabica, which accounts for 70% of the world’s coffee, and the Robusta bean which is far cheaper and easier to grow. The largest producer of coffee is Brazil accounting for about one-third of global production and about half of the worlds arabica output. The second major producer is Vietnam, accounting for just under 19% of global output and around half of robusta production. This concentrated output means that supply disruptions in one or both of these countries can have a significant impact on the price of coffee.

2) Substitution to cheaper beans

The robusta bean is far cheaper and easier to grow than arabica, but it has a bitter taste compared with the more expensive bean. This usually means that the price of robusta is much lower than the higher quality arabica bean. However, whenever the price spread between the two beans becomes very large then coffee manufacturing companies may start to substitute more of the cheaper bean into their blend. The incentive to do this is greatest when consumer demand is at its weakest.

3) The price of substitute products

Although many of us would say that caffeine is an essential first thing in the morning, if not all through the day there is more than one way to get it. Until recently the only substitute products was tea but now caffeine rich energy drinks are competing with coffee for attention.

4) The weather

Coffee is a tropical commodity. This makes it more susceptible to tropical weather events like El Niño. The timing of El Niño can have a big impact on whether the impact is positive or negative to supply. The warm weather that El Niño brings in June to August aids the arabica coffee harvest as the crop solidifies and warmer weather protects against the spread of the roya fungus (which thrives in wetter conditions). However, drier El Niño weather in December to February may have negative impacts on the next arabica crop, helping to support coffee prices as the event continues.

5) Disease

La Roya, or leaf rust is a deadly fungal disease rust has plagued farmers for more than a century. When a tree gets infected by it, its leaves produce a brown, thin powder when scratched, pretty much like iron rust. The disease decolours the bush’s leaves from a bright green to a brownish yellow. In the end, the tree loses all its leaves, as well as its ability to produce beans.

If left unattended, the disease can have dramatic consequences. In the late 19th Century, Sri Lanka, the Philippines, and other countries in Southeast Asia were the major exporters of coffee in the world. In a matter of decades, the disease meant they practically stopped growing it.

6) Flowering cycle

Brazilian coffee growing has traditionally followed a cycle of huge biennial swings, with an “on” year of large production followed by an “off” year of low output for arabica. However, these fluctuations have diminshed over time.

The expansion of coffee plantations in the northern areas of Brazil, which are less prone to frosts, has mitigated damage from cold weather. Meanwhile increased use of irrigation has minimised crop losses due to droughts while also helped coffee trees to recover faster from the stress of bearing a large crop. Finally, better fertilisation has also helped plants recover after bean production while plant breeding has led to more drought resistant trees.

7) Currency movements

Given Brazil’s position as the dominant producer of arabica coffee its exchange rate can have a significant impact on the price of coffee. A decline in the value of the Brazilian currency, the real increases the incentive for Brazilian farmers to increase output for export while at the same time reducing their production costs.

8) Stocks

As with all commodities, low levels of stocks indicate strong demand, weak supply or a combination of the two. In addition, low stocks provide very little in the way of a buffer in case of disruption to future harvests.

The split of inventories between exporting and importing nations is viewed as an indicator of coffee price potential. It indicates the level of urgency, and willingness to pay up by importers.

9) Emerging market demand

Growing demand in emerging nations as per capita incomes rise – consumption of coffee in China has doubled in the last five years. Even in countries like Vietnam that are net exporters of coffee but have traditionally been tea drinkers there is a switch towards more coffee consumption.

10) Speculation

Coffee like many other commodities is traded on futures exchanges. Although futures markets serve a valuable function by transferring risk from those who do not want it onto those that are able and willing to take it one there is a risk that at least for short periods of time the price doesn’t reflect the underlying fundamentals.

Previous episodes

Gold prices: The top 10 most important drivers

Silver prices: The top 10 most important drivers

Natural gas prices: The top 10 most important drivers

Copper prices: The top 10 most important drivers

Livestock prices: The top 10 most important drivers

Sugar prices: The top 10 most important drivers

Cocoa prices: The top 10 most important drivers

Palladium prices: The top 10 most important drivers

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Shining a light on extractive industries: An interview with Åsa Borssén from Raw Talks

I recently had a chance to talk to Åsa Borssén from Raw Talks. By interviewing influential players in the resources industry and publishing them on their video platform Raw Talks are trying to make the resources sector much more transparent. In this interview you will learn more about why governments struggle so much with managing resources and what steps they are making to change things for the future. We also talk about what investors in resource companies should think about when allocating their capital to resource dependent countries, both now and in the future.

Could you explain a little about Raw Talks and who you seek to influence?

Thanks very much for having me on Materials Risk! We started RAW Talks about two years ago and it’s been a thrilling journey so far backed up by our sponsors at the Inter-American Development Bank and the German BGR. RAW Talks is a first-of-its-kind video platform where we publish interviews with thinkers and practitioners on issues of natural resources and development.

Our mission is, and has been from the very beginning, to provide everybody open and free access to specialist knowledge and new ideas on how natural resources can support economic development. Too often, this discussion takes place behind closed conference doors or in specialised academic journal. By bringing the conversation online we work for a more inclusive and broader debate.

Why do governments struggle with managing resources?

This is a reoccurring theme in our interviews. In a video early this year, I asked our Editor-in-Chief, Nic Di Boscio, the same question. He gave some very interesting insights.

First, we have to recognise that resource management is multifaceted. Governments tend to struggle with some aspects in particular. One such case is dealing with the revenue cyclicality that comes from price volatility. With fluctuating prices, it is very difficult to understand the value of your assets, and you may think you are richer than you actually are, and end up spending more than you can pay for, taking on excessive debt and so on. Price volatility also has budgetary implications: it becomes very difficult to do economic planning when your revenue stream fluctuates.

But it is not only governments that struggle with cyclicality. While we tend to be very impatient with governments failing to surf the price wave, the truth is that companies struggle too. We saw a lot of value destroyed in the last commodity boom, with companies grossly overpaying for assets or missing opportunities.

It is one of the ironies of the extractives sector, Nic says, that the public sector is under political pressure to consume, when they should to be saving (which is when prices are high); and the companies are under investors pressure to save, when they actually should be investing (which is when prices are low).

What steps are governments taking (if any) to avoid extractive industries contributing to a new ‘resource curse’? Which countries are adopting the right policies?

I was at a UNU-WIDER conference recently, and Joseph Stiglitz was among the speakers. He said, we know how to manage the resource curse, but the lessons have not yet been learned by most countries. That being said, there are countries that have managed their resources well, or at least some aspects of the resource agenda.

We polled our guests, asking them to highlight one country that has managed an aspect of the agenda particularly well.  There are several interesting surprises, but Chile, Norway and Botswana get most of the votes. Then the question remains, are the experiences of these countries transferrable to other countries? Can you replicate the success of, say, Norway?  Paul Stevens put it bluntly: “To replicate the Norwegian experience you would have to start with five million Norwegians”. It is a fascinating clip, I highly recommend everybody to watch it.

Here I can’t help mentioning our interview with Graham Davis, from the Colorado School of Mines. He makes a strong case against the Resource Curse Theory. In his research, he finds no evidence that resource economies grow at a slower rate than non-resource economies, and argues that in the long term they tend to be better off.  His recommendation is to embrace the resource sector as a vehicle for growth. With this claim, he strongly challenges the long-established wisdom in this field. Controversial, and very powerful.

Cyclicality is a fact of life in commodity markets and investors will always think this time is different. Is there any evidence to suggest that come the next cycle things will be different for countries dependent on resources?

One of the first interviews we released was with David Humphreys, former Chief Economist of Rio Tinto and Norilsk, and a brilliant resource economist. He had released a book right before the interview called “The Remaking of the Mining Industry”, where he explains why the latest boom was different from others (i.e. China), but also just how much it was a manifestation of the cyclical nature of the industry. He cautions us all: “Beware of the paradigm that shifts”.

We asked him a question similar to yours, and he was somewhat pessimistic. He says there has been a significant amount of research going into how to better manage the windfall gains from commodity booms, but if you look around and see what countries are actually doing, they have not on the whole learned the lessons.

“Those who can’t remember the past are condemned to repeat it”. One of the problems is that the turnover of government officials is high, changing with the political cycles, and they rarely stay long enough to understand the industry fundamentals. However, we could say the same about some young industry analysts unfortunately.

Confidence in future assumptions over price and cost is important when making investment decisions that may stretch decades into the future. Are governments clear what the risks are and how difficult it is to forecast?

There is often an asymmetry between government and resource developers when it comes to price forecasting. Resource companies have more knowledge and experience and have more resources devoted to forecasting than most governments.

And then is the issue of politics. Ken Haddow said something relevant here: “the timescales involved in mining don’t always lend themselves very well to the political cycle”.  Whereas resource investments may not deliver value for many years after the initial investment, the constituents’ expectations go up as soon as the project is announced, and elected officials want to deliver on those expectations for political gains.

Which brings me to the concept of “The illusion of Prosperity”, coined by Professor Paul Stevens. He describes a situation where a country has made a large oil discovery and expectations rise to enormous levels, with media and the people expecting that everybody is going to have gold bath taps. The complication is that you think you are rich, but you are not.

Paul’s solution is in a government that dares to say, “look, we will be better off as a result of this discovery but we are not going to turn ourselves into a very wealthy society overnight”. Easier said than done for someone seeking to be re-elected. Interestingly, he also says there is a role here for the resource developer, which is to help governments develop the capacity to understand these issues better.

Why should individual investors care about the wider impact that extractive industries may be having on the country they are invested in?

Two words: risk and value. Companies are trusted to extract, process, transport and market resources that belong to nations. There was a time when resource companies could roam freely, assuming that paying taxes should do the trick. That is not the case any longer. Today, the best resources are increasingly in challenging operating environments, with high expectations from both government and the people, who want to see tangible benefits coming their way.  If you cannot be seen to deliver that, you will not be around for long. It is no longer the government’s sole problem.

We did an interview on the topic of social license to operate, with Daniel Litvin of Critical Resource. He describes a weak social license as projects facing strong social opposition. A weak license can lead to delays, interruptions, and in some case project shutdown – any investors’ nightmare. But the key point for investors is that you can mitigate these risks by understanding your project, and your operating environment, and by actively managing the potential challenges.

Thinking about sustainability specifically what risks do individual investors in commodities need to be aware of?

I am going to take a forward-looking perspective here.

In the oil sector, there is the big question around energy transition, and whether we are approaching the end of the oil era. Are consumers going to force a shift away from oil – and, if so, when? For those interested in the future of energy, I recommend an excellent RAW Talks interview with Seb Henbest of Bloomberg New Energy Finance.

As for mining, I’m coming back to our interview with David Humphreys (it is a really good interview!). He points out that mining has in the past tended to focus primarily on issues below ground, i.e. what is down there and how do we get it out? But increasingly, the industry is now focussing on all the issues above the ground: land access, waste management, water consumption, CO2 emissions. He says, “the draw on these other resource systems is potentially as big a constraint on future production as the availability of raw material in the ground”.

Community relations will continue to be critical. Consider the changes brought in by new technology. On the one hand, technological progress may lower the risk of environmental damages and improve health and safety. On the other hand, automation will reduce what resource companies can offer in terms of community benefits, i.e. local jobs and local content. We had this conversation with Jon Samuel from Anglo American. I think this is an area that will be increasingly important for companies in the future.

In recent years we’ve seen corruption scandals appear in a number of countries that rode the commodity boom – Brazil being a prime example. Does corruption go hand in hand with resource booms?

We discussed this question in depth with Daniel Kaufmann, President of the Natural Resource Governance Institute. Governance, transparency, corruption are all very important issues for the resource nations.

“Resource richness”, as Daniel calls it, gives rise to particular challenges and one such challenge is the fact that it can be easily captured by elite groups, and this increases the chances of corruption taking place.

Did corruption increase during the last commodity boom? Yes, on average, according to the NRGI’s Resource Governance Index. Resource-rich countries also went backwards more generally in terms of governance during the boom years. And that is because incentives are perverse during these periods, meaning there is much more money involved, and opposition can be bought off. There are, however, many examples of countries that have done very well during the boom and come out of it stronger.

Where can my readers find out more about you and your research?

Join us online. We have our website, where you can read more about us and find our interviews. Then there is social media where you can follow us to keep up with our releases and discussions: You Tube, Twitter, and LinkedIn.

We regularly participate in conferences, such as Indaba or PDAC, to moderate live discussion. Typically, they are very fun and informative. You can keep track by following us on social media.

What are your plans for Raw Talks going forward?

I can’t say too much yet, but there are changes on the horizon – significant and very exciting changes! In a nutshell, more products, more regularity.

Fundamentally, however, we will remain the same: we will continue to work to discern the important from the anecdotal in the debate on extractives and development; and increasingly become a depositary of knowledge and information, fun and free for everybody.

Related article: A long term view creates opportunities for commodity investors: Interview with Mike Alkin

Related article: Positioning analysis in commodity markets: An interview with Mark Keenan

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What is commodity index re-balancing?

Every year around this time, the world’s commodity index managers go through the annual rite of re-balancing their mix, shifting ratios that can swing billions of dollars from one market to another. These mammoth products, which now boast hundreds of billions of dollars worth of funds after growing from nearly nil a decade ago, follow fairly clear formulas for deciding whether to add or subtract oil, wheat or copper from their plan.

The re-balancing typically requires selling contracts that have appreciated the most during the year, and buying those that have under-performed, in order to return to the set targets. Re-balancing typically occurs in January during a five-day business period. Other funds re-balance monthly or use different systems that avoid big shifts during the January roll period.

Based on 2018 year to date performance, the re-balancing would likely require selling star performers like wheat and Brent / WTI crude oil, and the purchase of downtrodden markets like sugar and zinc. Given the current large net short position in the futures market, sugar prices have perhaps the greatest potential to see a rebound, should the indexes be forced to buy.

Not something to necessarily preempt but to be aware of. The re-balancing is signaled well in advance and of course everyone in the market has some idea of how the re-balancing works too.

What is a commodity index?

A commodity index either invests in or tracks the performance of a group of commodities based on predefined rules. It is often the performance of these indices that is referred to in the media or when comparing commodity performance with other markets, such as stocks and bonds. Large investors often prefer a diversified approach, especially to commodities, given the high level of volatility that invariably goes with investing in individual commodities. Commodity index funds help investors to properly benchmark the performance and return of their investments.

The two major indices, as mentioned above – the S&P GSCI index and the Bloomberg Commodity index – have become the industry-standard benchmarks for investors in commodities. Investors either invest directly into the funds or through exchange-traded funds that track their performances. Furthermore, many local commodity fund offerings track one of the two commodity funds.

The S&P GSCI, established in 1991, is an index calculated primarily on a world production-weighted basis. It includes 24 physical commodities that are the subject of active, liquid, futures markets. The weight of each commodity in this index is determined by the average quantity of production and is designed to reflect the relative significance of each of the included commodities to the global economy. Based on this indexing the S&P GSCI is very heavily exposed towards the energy sector.

The Bloomberg Commodity Index (BCOM), previously called the DJ-UBSCI was established in 1998 and has a more diversified approach. This index comprises 22 physical commodities, all represented by active futures markets. No single commodity can comprise less than 2% or more than 15% of the index and no group or sector can represent more than 33%. The weightings for each commodity included are calculated in accordance with rules designed to ensure that the relative proportion of each of the underlying individual commodities reflects its global economic significance and market liquidity.

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