If you are a coffee roaster or a consumer-facing brand, it could be easy to assume that a futures hedge gives you all the protection you need. After all, prices and volatility are currently very low. Hedging on the futures market provides comprehensive coverage for your value chain, right?
The reality is that the particulars of the current environment may have us primed for a rapid return of volatility. If that happens, futures hedging alone may leave critical gaps in your risk management strategy and allow your competitors to secure a better margin – enabling them to undercut you on price and gain share with your customers.
Examining the particulars of this market, it becomes clear that some flexibility can be a good thing. Structured solutions may be able to help you hedge in ways that futures positions cannot.
Today’s market: volatility brewing?
As we know, prices and volatility in the coffee market have been at historic lows for some time. Meanwhile, money managers or funds have built up very large short positions.1 These substantial positions could amplify price moves. An uptick could cause funds to begin buying back contracts, which could create a feedback loop of even faster increases and buybacks.
What could trigger that first step up in prices? With mixed performance from global equities so far in 2018, money managers may sooner or later begin to seek returns in new venues. Expect commodities to be on their short list of targets. Every few years, institutional investors, banks and others are drawn into commodities markets looking for yields.1 Even now, we are seeing that happen in hard commodities, and agricultural could well be next. When they start to move money into new asset classes, especially commodities with smaller global supplies like coffee, it might have a sizable impact on prices.
Weather also could light the fuse. Frosts or drought in key growing regions can quickly reverse sentiment and cause prices to skyrocket. The September timeframe will be a key window for weather news that could rattle markets.
Spotting gaps in your risk management strategy
It is understandable why coffee roasters and consumer brands seek to mitigate the risk in their value chains through futures hedging. If you are long in physical supply, going short in futures is a time-honored hedge. And in normal markets, it can work well to protect against the majority of the risk you face.
But as we have seen above, we are not necessarily in a normal market.
Given the potential for a rapid return of volatility and a run-up in price, rigidly locking in your margins at the wrong time – with no flexibility – may leave you at a disadvantage. Minutes can make a big difference, never mind days or weeks.
If your competitors secure even slightly better margins, they will have more options as they seek to market their products, discount price points, and grab the attention of the consumer who is making a purchasing decision in the supermarket aisle or the shopping center.
Margins are great, and you need to make your budget. But getting locked in too tightly can leave a gap that others can employ to outflank you, potentially using a few cents to cripple your growth.
Structured solutions for greater flexibility
Before volatility arrives, a sound risk management strategy will assess all options and determine what alternative solutions may work best for you. This takes the guesswork out of hedging at just the right moment, which can be hard for anyone to do when volatility is high.
Structured risk management products can protect you from downside movements and help keep you competitive, so you have more optionality than a traditional futures hedge provides regardless of exactly when you need to buy or sell.
Although predictability is a mainstay for many end users of coffee, and futures markets are a good means to achieve that, a little flexibility may give you that last boost you need while protecting you against blind spots.
- S. Commodity Future Trading Commission’s Commitments of Traders report