Why Farmers Don’t Benefit Long Term From Future Market Rallies

Whenever I show a chart of the coffee market since the 1990s until today to university students, I am often asked “why don’t farmers take advantage of high prices to sell more”.   It is something that I think we, as an industry, should think harder about. These golden opportunities, like what we witnessed in 2022, don’t come around so often and could be used as a tool to help close the farmer living income gap. This, combined with some new industry initiatives, could potentially move the needle for farmers eking out a living with coffee production.

SCTA 2019

In October 2019, I participated in a panel discussion as part of the Swiss Coffee Trade Association conference in Geneva.   Everyone was upset with the price of coffee.  Prices of the NY “C” market had remained below $1.40 USD/lb. for twenty-seven straight months and had reached 95 cents. Hedge funds were carrying record short positions and even roasters were not pleased with the reputational risks associated with such depressed prices.   Roberto Velez, the CEO of the Colombian Coffee Federation at that time, spoke with the passion of a Southern Baptist minister and told all the participants that they were simply dreaming if they thought progress could be made on social and environmental issues if farmers did not first have economic viability to continue producing coffee.  

I was asked by the moderator what could be done to help farmers. I responded that unfortunately, that ship had sailed and only through roaster and retailer charity, to pay more than the coffee was worth basis the market price, could most farmers be helped. However, I then pivoted to my key message, which was that the coffee industry should collectively start working on a pre-competitive basis to build a game plan for the next time “C” prices were above $2.00/lb. to help farmers mitigate future depressed price periods. Since discussing pricing opens up an actor’s exposure to antitrust regulatory concerns in commodity trading, pre-competitive means you discuss frameworks that can be used but not specific pricing plans or policies to be enacted (meaning prior to competing with each other on price).

One of our roaster clients responded. They stepped forward and offered to pay above-market pricing for purchases for 2020 and 2021 to support a specific supply chain of young farmers. I viewed this as a positive first step and greatly appreciated their leadership position on farmer income, even though they never publicly mentioned their generosity.   

What none of us anticipated was that during 2021 Brazil would have its first major frost in over 20 years and that futures prices would soar.  The market then proceeded to spend over an entire year above $2.00 and went as high as $2.60 at its peak in February 2022.   

The youth farmers collectively defaulted on their 2021 deliveries to us and our client. 

2022

With prices oscillating between $2.10 and $2.40 most of the year, I had the chance to speak to many of the same people who were champions of farmer economic viability in 2019.  

Traders and processors usually agree with farmers on a price for coffee ahead of the actual delivery and sometimes even before the harvest. At the time the price is agreed, they sell a futures contract to hedge themselves, meaning if the futures market rallies, the value of the coffee purchased goes up in value, but the sold futures contract loses an equal amount of money.  Vice versa for a falling coffee futures market.

With the fast and dramatic rally in prices after the frost in Brazil, all “forward delivery” coffee agreed upon pre-frost from farmers was at price levels significantly lower than its current value.   However, traders were in a bind because their futures sold to hedge the coffee were losing the same amount of money.   Since they wouldn’t receive the physical coffee for a period of time, banks limited how much they would finance of future contract losses. This caused a squeeze on trading houses and exporter cash liquidity.  Many were solely focused on not running out of money and staying in business.   Should Brazil have had a second frost in 2022, I do not believe any trade house would have had the liquidity to endure a rally to $4 or $5 in a short time frame.

Roasters were simultaneously dealing with their own challenges.  Many had locked in final product prices to retail channels for a certain duration but were suddenly faced with high container rates, expensive differentials, increasing interest rates and soaring packaging costs that all squeezed their margins.

Farmers and coops had turned bullish as they read media pieces talking about the massive shortage of coffee in the world and how high prices were here to stay.  They also knew that La Nina was still around, and further weather issues couldn’t be ruled out.  Therefore, they weren’t in a rush to sell.

International development organizations, aid groups, government groups and others were all sympathetic to my idea to use options and over-the-counter structures to help farmers lock in prices into the future.  I worked out a specific game plan where we could guarantee farmers a minimum fixation price (plus/minus the differential for quality) of $1.80/lb. for 2023, 2024 and 2025.  The “cost” of locking in the guaranteed floor price was that farmers would have to accept a defined maximum fixation price of $3.20 during the same time period.  In my mind, the tradeoff made a lot of sense.

However, I quickly discovered in real-time what was keeping this from turning into reality: 

1. Derivative instruments are complex and not well understood, even by highly educated professionals working in our industry.  As a result, none of the participants in my meetings had the ability to quickly execute the trade idea. Participants needed to first be educated on how the potential price mechanism would work, then have internal meetings to discuss and agree on how to move forward.  This was expected to take up to six months.  

2. Everyone asked which farmer network or coops should be approached.  It wasn’t clear who would be ideal targets for a fixed price mechanism.  Once identified, helping them understand how it would work simply would take months if not years of time.    

3. Some questioned whether it really made sense to provide farmers a floor price at $1.80 when the current market had spent over a year above $2.00.  There was a belief amongst some that recent prices were indicative of futures prices, even though the forward price curve was pointing to lower prices.

4. Given how many “delays” a.k.a. defaults had occurred in Colombia and Brazil, banks were spooked and didn’t want to take on additional forward exposure, even at what would be the all-time high future price of the coffee market.   In fact, many were worried about what would happen if Brazil had a second year of frost damage and the futures market went to $4.  They openly questioned whether farmers would honor the ceiling price, or would they default, like what had happened for 2021 deliveries?

All the above meant that few of the actors who bemoaned the low-price environment of October 2019 were in a position to help farmers lock in high prices for multiple years to mitigate the risks of a sell-off in the future.

The “collapse” finally came.   The coffee futures market did what it does and sold off aggressively, despite a bullish fundamental storyline and the possibility of an oversupply only coming in Q4 2023, if at all.   This took most market participants by surprise.  Prices sold off from $2.20 to $1.55, even more violently than usual.   This brought back sudden interest in hedging coffee above $2.00 but that has not happened as of the writing of this article.

Key Lessons

Everyone wants to help farmers (or at least talk about it at conferences) during a price crisis.   Margins are high, companies are flush with cash, banks are looking for extra ways to make money.   

However, as we have seen in 2021/2022, when large future market rallies occur, all that goes away.  The challenges mentioned above tend to freeze participants and nobody plans for the next farmer price crisis but rather goes into self-preservation mode.

What can we do about that?   Pre-competitive associations and international institutions should all spend more time working with members to discuss strategies that can be understood, agreed upon and implemented in quick order.   This may be done unilaterally via individual actors, on a country level with governmental groups or as part of a wider effort.   Planning is the key and laying the groundwork ahead of time is necessary.  Local governments could consider some kind of performance guarantee (default insurance) made available to supply chain actors and determine the qualifications for farmers to participate.

Farmer networks require even more financial literacy training.   Everyone understands that there are risks in the coffee business and helping farmers understand the importance of honoring contracts as a precursor for long-term price risk management is critical.  However, it is a two-way street.   When prices are high, farmers who have diligently honored their commitments should be the first to benefit from structures that ensure they can produce profitably into the future.

Lastly, I would point out something obvious.  Locking farmers into prices near or slightly above their cost of production makes no sense and only increases the risk for everyone.  Traders actually prefer to hedge in high futures markets because it reduces default risk and usually differentials are cheapest at the top.  Farmers also obtain the best fixation levels.  It is a true win-win for everyone.  Buying forward coffee is a valuable tool but should be reserved for exceptional periods of time when farmer profitability is at historically high levels (top 25% quartile)

Where Do We Go From Here?

Nobody knows what the market will do in 2023.   I never would have believed that Russia would invade Ukraine twelve months ago and that coffee would get sold off basis theories of demand destruction in those countries, which represent a tiny percentage of global demand.   But it happened.  Trying to predict the future is hard.

However, I will fall back to my same point made in October 2019.   We collectively or individually should already today be building a game plan for how to best help farmers mitigate market risk by providing price risk management during high prices and to grant them the space to get through the tough years.   Not every farmer will get this benefit, however. Converting short-term thinking to long-term partnerships is key to building long-term relationships on trust and being successful in our efforts

Additionally, I think we are in an exciting transition period.   There is a real opportunity for the price farmers receive to detach more from the “C” futures contract.   We can possibly re-imagine coffee pricing where the current norm of futures market plus or minus premiums for quality are just one component.  

Perhaps we can envision a pricing mechanism that also prioritizes sustainability. Premiums should pay for a) regenerative agriculture activities that lower carbon emissions at the farm and community level b) verified deforestation-free production that fully complies with human rights and c) farmer data required to back up all the responsibly sourced and carbon-neutral pledges being made.

My dream would be that we could approach farmers with multi-year price risk management plus reward them for their participation in our collective sustainability goals.  That way, they would have the certainty that if they commit to action and have it verified by specific groups, they would receive pre-determined premiums.  This could be linked to a digital wallet and be fully traceable using a blockchain or other automatic payment services.  This would create a payment to the farmers that was guaranteed while allowing us to move away from excel spreadsheets or databases that are manually updated and less trustworthy.

David Behrends has over twenty years of experience working in the coffee industry, working for several multinational corporations before joining Sucafina in 2015 as Managing Partner and Head of Trading and founding Farmer Connect in 2019.  Prior to working in coffee, he served as a Small Business Development volunteer in Bolivia with the Peace Corps and for an energy start-up company in Argentina.  David is a passionate believer that technology will be a key driver in the evolution of agriculture supply chains in the coming decade.  He is the proud father of a ten-year-old girl and enjoys live music and street art in his (rare) free time.