During a period of low prices like the one we are currently facing in the global coffee market, producers and trading houses are confronted with a conundrum. How do you strike a balance between over-committing your volume at the first sign of higher prices and missing out on a rally by waiting too long?
This challenge is complicated by structural changes in the coffee supply chain that are emerging even as we speak. Buyers are pushing longer credit terms back up the supply chain, leaving growers and trade houses worried about cash flow during the upcoming year. Credit terms for 270 days – or even 365 days – are becoming common.
Meanwhile, outside managed money (including funds) are maintaining record short positions in this market. For better or worse, funds act as a multiplying force in the market, meaning their very high level of shorts could amplify any move in prices.
With a growing consensus that global equities may be overvalued, commodities markets could very well see a strong influx of managed money as investors seek returns. This is already happening in metals and petroleum. Agricultural commodities – including coffee – may be the next destination for managed money, precipitating a rise in prices.
And of course, there is always the unknown of weather and its impact on production. Low prices put a check on production anyway. As this decreased production meets an expected two to three percent annual rise in consumption, now the fourth year in the current down cycle, it likely will cause a rise in prices.
In the midst of this uncertainty, it is important to define your coffee price risk management strategy before the market reaches a tipping point and prices go up. Then, when the change arrives – and it can arrive quickly, as we know – it is critical to maintain discipline and resist letting emotion throw you off course.
Because low prices cannot last forever, here are a few linked scenarios that producers and trade houses should consider and plan for in advance.
A cash influx
With global equities on an uneven footing during the first part of 2018, it would be no surprise to see money managers begin to look elsewhere for a return. This is an inevitable cycle that we in commodities see every few years. But just because we’ve seen it before doesn’t mean we should underestimate the impact.
Even a 1 or 2 percent move of managed money could mean hundreds of millions of dollars pouring into commodities like coffee. Unless there are offsetting fundamental signals – like an uptick in production or projections of sluggish demand growth – the entrance of this kind of money into the coffee market would almost certainly push prices upward.
A fund run
In this context, it is worth taking a closer look at fund positions. Because managed money as a group are exceptionally short right now, the first sign of a price rise could jar them out of their current position and cause them to buy back their contracts. The point at which this might happen is hard to predict, but when the market passes a certain threshold within the funds’ technical analyses, things could snowball quickly.
An even bigger credit crunch
If the market begins to run up and you are holding short positions, suddenly those positions could be working against you. You might face margin calls that significantly raise your cost of capital. Maintaining your hedges could cripple your cash flow.
Now imagine that this happens all up and down the coffee supply chain. Facing the same cash flow concerns, roasters and end-users of the commodity could push for even longer credit terms, putting producers and trade houses in a tough spot.
The solution: A disciplined strategy
Although the above scenarios may be worrisome, they can be overcome. The key is to define a strategy and stick to it. Do not let emotions drive your decisions, even in the face of extreme circumstances.
If you are upstream in the supply chain, this may be difficult. With prices having been low for so long, any increase of just a few cents may make it very tempting to lock in a price. But this may not be the level you want to sell all your volume at; acting too soon could cause you to miss significant additional upside. Cargill Risk Management offers structured products to help you get to the objective level you are seeking, so you are not watching the market every day and feeling jittery about every bump or dip in the chart.
Worries about credit and cash flow can also cloud decision-making. It is understandable after all, because you do not want market investors negatively impacting your ability to run your business. Here, again, a comprehensive plan is key. We work with individual clients to establish credit thresholds, which may provide a cushion against margin calls when the market moves.
At the end of the day, a well-defined risk management plan can give you assurance, no matter market conditions, and protection from letting emotions ruin your day.