Three Misconceptions About the Market

This Article At A Glance

This year, the coffee market is trading with more volatility than we’ve seen in the past. Prices have been approaching highs not seen since the 2022’s rally following the fallout from the Brazil frost.

The futures market isn't perfect but what Ilya Byzov, Head of Research & Quant Trading a Sucafina, has learned is that the market is still the best option we have. When we focus on the wrong problems of the market – these misconceptions we have about the way it doesn’t work – we're missing the problem, which is that there are inefficiencies and inequalities of information. Ilya shares 3 common misconceptions about the futures market and key takeaways we can learn from understanding these misconceptions.

• While the market isn’t unfair to all producers, the biggest inequality in the market, according to Ilya, is the disparity of information and opportunity for producers to hedge.
• The presence of speculators allows futures prices to have a greater range so that roasters can hedge at the lower end of the market while the producer could hedge with a future sale near the top of the market.
• Trade houses have limited visibility in speculator actions.

Three Misconceptions of the Futures Market

When I first started working in the commodities industry, I was an eager college grad with a degree in economics and a lot of impatience to see the theories of Adam Smith and Milton Friedman play out in real world scenarios. While I’ve witnessed firsthand the consequences of the collapse of the Soviet Union in the 1990’s (6-hour lines to buy a pair of jeans!) and have certainly seen my share of real world failures of planned economic systems, I’ve also learned it’s not that simple. In my 15 years in commodities and a dozen years in coffee, I’ve seen many market scenarios that have not worked as perfectly or as efficiently as they would have on the chalkboard of Robert Shiller’s financial markets course. I’ve learned is that the market is not perfect or (even) always efficient, but it is the best option we have. When we focus on the ‘fake’ problems of the market – these misconceptions we have about the way it doesn’t work – we're missing the problem, which is that there are inefficiencies and inequalities of information. These misconceptions are (as compiled through several conversations with mainly specialty minded colleagues):

1. That the market is unfair to all producers;
2. That speculators are bad for the market;
3. That exporters and importers always know which way the market is going.

Is the Market Unfair to All Producers?

Producers grow all the coffee we drink but the size of their farms varies greatly. The smallest producers in East Africa or Papua New Guinea have gardens with just a few hundred coffee trees. In Brazil, where 41% of all coffee is grown, the largest producerhas approximately 5,500 hectares of land (just slightly smaller than the island of Manhattan) and the average farm size is  50 hectares.

For producers, the higher the futures market price, the better. Producers are a permanent seller into the market, even if some are too small to have the capacity to sell futures. The biggest disadvantage is that not all producers have 50 hectares of land nor a marginal cost of production of under $1/lb.

As the world’s largest producer by a significant margin, Brazil is the driver of futures market prices. Smaller producers have to compete within that reality. This means that they may have to compete on different terms. The hope is that differentiating factors in cup quality and/or unique attributes can set smaller producers apart from Brazil, and prices they will receive will adjust via higher differentials to compensate. However, even if competition can be ‘leveled’ to a degree, it doesn’t necessarily mean equal access to capital and information for all players in this market.

Until the 1980s, roasters were mostly large corporations with strong access to capital and information provided by multiple suppliers.  The ability to forecast consumption and buy futures forward to hedge continues to give  larger roasters a significant advantage over the farmer. I believe that this is the biggest inequality in the market, which can be partially solved through facilitating pre-financing for smaller farmer groups and helping them sell coffee a year or more out. However, a risk of defaulting on coffee commitments remains an issue.

While the market is often unfair to small producers, not all producers are struggling. In Brazil and Vietnam, large farms are profiting immensely. This is mainly because they achieve economies of scale but it is also because their size, affluence, and education enables them to operate in the futures market by hedging, just like large roasters do. 

Are Speculators Bad for the Market?

Next is the issue of speculators, or market participants who do not trade coffee on the physical market via hedging but rather try to make money by anticipating price moves. Currently, participants with no interest in the physical coffee market comprise 58% of the open interest in the coffee futures contract. However, not all speculators are the same. over the past 2 months, it's easy for players who are active in physicals (i.e. trading actual coffeee) to blame the speculators for the crazy volatility. Indeed, recent buying by speculators largely contributed to market volatility. A historical analysis suggests that if speculators removed their current long position from the market and went flat, the market would fall around 40 cents/lb.

So, who is this additional 40 cents of speculative support in the market benefiting? Well, the producer of course. Speculator interest in coffee futures tells the producer that their coffee is more valuable, giving them a premium they would otherwise not have.

Of course, the speculator is not benevolent, and the position they hold in futures is not always long. While right now the producer is getting 40 cents extra for their coffee, it could go the other way and they could be getting 40 cents less because of speculative participation expecting too much supply. Here, of course, the producer suffers, but the roaster benefits.

This brings me to my main point, which is that the speculator, with an ever-changing position dynamic, helps set the price and provides liquidity to the market. In a volatile year like this one, this can benefit both producer and roaster. The lowest traded price in the year was 179.20 while the high was 236.04. Without speculators, this price range would have been narrower.

The presence of speculators allows futures prices to have a greater range so that roasters can hedge at the lower end of the market while the producer could hedge with a future sale near the top of the market. Of course, the trick is getting the timing right and having coffee on hand to sell if you’re a producer.

Do Importers and Exporters Always Know Which Way The Market is Moving?

The last misconception is that the trade house or importer always knows which way the price is going. A corollary of this misconception is also that all trade houses have the same view on the market. After all, most trade houses do a similar job in having full-time staff (like myself) whose job is to compile production and trade statistics, forecast demand flows and make estimations on what price will do. The opportunity to visit most major coffee origins, compile production statistics and gain a reliance of valuable sales data gives trade houses a leg up in understanding the market. However, trade houses have limited visibility in speculator actions. Many hedge funds also have agronomy divisions and analysts looking at the same information.

Finally, even our best estimations could be wrong, and the market moves against our expectations. Macroeconomic surprises, outsized weather events and non-economic decision making can also have greater influence than the supply and demand of coffee .

These complexities can sometimes even baffle experienced market participants, especially when they involve questions or problems related to equity and transparency. Despite its challenges, I do believe that the market still offers the most efficient and transparent outcome for global trade.  One of the best ways to make fairer market outcomes is to create more equitable access to education and access to information. This is especially important for smallholder producers, whose lives depend on coffee and whose livelihoods can be significantly improved by having a wider understanding of market dynamics. Interested in more market content? Here are some of our previous pieces. 

The Power of Differentials

An Insider's Guide to the Market

Man Vs. Machine

Keep an eye out for new content in the coming months. 

Ilya Byzov is the Head of Research & Quant Trading based in Sucafina North America’s New York City office. He has 14 years of experience in commodity futures markets and 11 years in coffee specifically. Previously, he held positions in Market Risk and Coffee Research. In addition to his work on 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.