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Tuesday, January 26, 2021

An Insider's Guide to the Market

Coffee futures impact costs and profits for everyone in the coffee industry. The complexity of the market means predictions often seem inscrutable and opaque. As a Quantitative Trader with 11 years of experience in commodity futures markets (8 of which are in coffee specifically), Ilya Byzov is here to help make market analytics more approachable and show you how the market affects everyone – even if you don’t invest in futures, or only buy outright or Fair Trade coffees.

What are Coffee Futures?

If you are thinking 'I don't invest in the futures market, this doesn’t apply to me,” think again! Coffee futures are financial instruments, and they form the backbone of coffee pricing for the rest of the industry.

Futures contracts are agreements for coffee delivered at a specific time frame in the future. One of their main purposes is to protect farmers and roasters from future price shocks. This process is called ‘hedging’. Hedging is a complicated process that warrants an article of its own, but it is a process that, in the current market, helps roasters and farmers protect themselves from short and medium-term volatility and receive a stable price for their product.  

For roasters, higher futures prices directly affect the cost of all green coffee. Future prices directly affect coffees that are differentially priced. With differential pricing, the cost per unit of coffee is the market price plus or minus (+/-) the differential. Therefore, a 1 cent increase in the market price will translate into a 1 cent increase for buyers.

With differential pricing, market changes have far-reaching effects: nearly all commercial coffees and a significant portion of specialty coffees use differential pricing. 

Even if you are purchasing coffee using outright pricing or an ethical trade certification like Fair Trade, futures have an impact on the price you pay and that producers receive. If the market is high, outright prices will follow, and conversely, when the market is lower, outright prices are lower.

While Fair Trade (FT) coffees are somewhat removed from smaller price fluctuations; they are still affected by the futures market. When the market price is above the FT minimum, FT coffees are priced at market price + FT premium. Conversely, when the market price is very low, more producers want to produce & sell FT coffees, which often leads to overproduction and causes many producers to sell their (FT-certified) coffee on the commercial market (and in turn affects everyone through changing market prices).

Futures prices also play a significant role in determining income for almost everyone involved in production and export. Persistently low market prices affect the price exporters receive for green coffee. Then, adjustments in individual margins trickle down and affect actors throughout the supply chain, all the way back to producers.


How Forecasts Affect You

If you’re a roaster, green coffee is one of your largest variable costs. Since this cost is driven mostly by coffee futures prices, understanding how that might change in the future is critical for successful business planning.

As coffee professionals – we all want the coffee industry to be successful for generations to come. Farmer income and profitability is a core piece in ensuring the future of our industry.  Since futures prices are the main determinant of income for the vast majority of all coffee farmers, understanding these prices and how they change helps you – and people all across the coffee industry – better assess whether our supply chains are financially sustainable. Forecasting can also provide guidance about the best times and ways to your producers.

While these 4 indicators can provide analysts with a solid basis for forecasting market behavior, there are a multitude of other factors that need to be analyzed to get the best picture possible.

Coffee markets do not operate in a vacuum, a more holistic understanding of global financial conditions and trends in investment flows is critical to developing a well-thought-out market analysis. Given how many variables are involved, market forecasting is never 100% accurate.


The 4 Indicators that Impact Market Forecasts

Fundamentals

Simply put, “coffee fundamentals” is about analyzing the difference between total supply and total demand in a given crop cycle.

If there is more supply than demand, prices will trend lower as sellers need to offer more competitive pricing to stand out. If there is more demand than supply, prices will trend upwards as buyers compete to purchase enough coffee amidst an overall shortage.

This is a bit more complicated than it sounds though, because green coffee can be stored for up to 5 years (for use in commercial blends). That means that the total amount of coffee available for sale is not the same as annual production. As a new crop cycle begins, analysts forecast prices by comparing the expected demand to the expected supply (inventory + projected production – projected consumption).

Since we tend to see bigger fluctuations in production than we do in demand, an oversupply of coffee in one year can have spillover effects into the following years. If supply continues to be high but demand doesn’t change much from year to year, prices may trend downwards over several years as the balance of coffee increases.

Technicals

With technicals, analysts predict future price levels by analyzing current price levels and broad statistical trends. The goal is to pinpoint specific indicators that can yield investment strategies and develop more accurate ways to forecast future market responses to specific kinds of market stimuli.

Since the real world involves many factors affecting price at once, it is difficult to discern which stimulus led to a specific market response. Technical analysis aims to simplify these factors by looking at prices themselves instead of focusing on cause-and-effect relationships.

Because technical analysis indicators are easily available for many commodity markets, technicals are one of the easiest indicators to run. At the same time, they’re among the least reliable, so analysts typically use technicals in concert with the other indicators.

Positioning

Similar to technical analysis, positioning focuses on analyzing indicators and projecting how the market will respond. Rather than looking at external events, positioning looks at how other investors in commodities markets make investment decisions, what kind of decisions they are making right now, and how their decisions will affect the market.

There are several places where we draw information for positioning analyses. The most interesting set of investors are a special class of commodity asset managers called Commodity Trading Advisors (CTAs). Many large CTAs use momentum-based technical signals to inform their trades. By combining these signals with a solid understanding of positioning, one can forecast about how much buying or selling is expected at a specific futures price level in the near future.

Macroeconomic Analysis

Lastly, macroeconomic analysis, or macro, for short, focuses on broad-based economic and political events that affect all financial markets.

Is the world in a global recession? Is China looking to buy significantly more commodities next year? Will a newly elected president improve a country’s budget deficit or exacerbate it?

All of these examples do not affect coffee futures directly, but rather indirectly through money flows and currency rates. If some event stimulates broad based buying of commodities, coffee will benefit from that buying as well. If something in Brazil causes the Brazilian real to strengthen, Brazilian farmers will get less Reais for the same amount of coffee sold, perhaps leading them to hold out for higher prices.


Have More Questions?

Since forecasting markets involves so much analysis and interpretation, your sources and information matter. For those interested in following the market and learning more about market analytics, you can follow our weekly market report. If you’re interested in learning more about futures markets and how they work, I highly recommend starting with this article about commodities futures markets. I also recommend following the Bloomberg Commodity Outlook and searching Reuters for global updates, as well as reading the daily news summary from CCS Commodities.  

When it comes to how the market impacts your business and buying options, we’re always here to answer any question you may have. When events return, you can schedule in-person meetings with our team at conferences & events. In the meantime, you can get connected with someone on the market analytics team by reaching out to your trader.


About the Author

Ilya Byzov is a Quantitative trader based in Sucafina North America’s New York City office. He has 11 years of experience in commodity futures markets and 8 years in coffee specifically. Previously, he held positions in Market Risk and Coffee Research. In addition to his work in market forecasting and analytics, Ilya also works with commercial and specialty customers.

Ilya is extremely passionate about sustainable supply chains and believes that the coffee industry should be a leader in equitability and transparency among agricultural commodities.


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