Understanding Physical Coffee Prices

It is a well-worn cliché to those of us in the #coffeeindustry to compare coffees to wines but it helps us convey to the lay-person the variety and depth of the #coffeemarket rather succinctly. Much like in the analogy of wine, the array of origins, qualities and preparations in #coffee not only creates a variety of flavor profiles but also a variety of pricing and availability.

The global coffee market captures this variability in pricing using a method shared with many other #commodities, we use a differential versus the #futures market. In this article we are going to examine coffee #differentials by looking at how coffee is priced globally, what makes them coffee differentials similar and different from other commodities and also, how we can use “diffs” to understand the global coffee market.

How Coffee is Priced

Coffee is an international soft #commodity grown in mountainous, tropical origins around the world, processed locally and exported around the globe, but primarily to “Western” countries with many “Eastern” countries favoring tea. International trading companies facilitate this flow from origin producing countries to destination markets with buying and processing facilities in origin.

When coffee traders refer to the price of physical coffee (as opposed to price of futures) we frequently refer to this as “basis price”, because it is priced “based” on the specific type of coffee and its physical location in space and time.

The buying operations buy coffee beans locally from farmers and local traders in various currencies, various stages of processing (ripe cherry, dried cherries, washed and semi-washed) but the standard is to convert the price into USD cents per lb for “green been equivalent” (fully processed) Arabica and USD per metric ton for Robusta.

This convention also helps the international traders to compare local basis prices to the global futures markets traded in NY and London in c/lb and $/MT respectively. The futures market is priced off of a “standard” certified coffee that represents central American “Mild” washed coffees.

Local basis prices of specific coffees differ from the generic price of the futures market by some amount and so this deviation is referred to as a differential.

For example a Colombian Supremo might cost $2.60 / lb. and if the futures market were trading at $2.00/lb then the differential would be +60c/lb. In coffee we usually talk about differential prices in terms of “plus” or “minus” a number (e.g. “plus sixty”), but in other markets the terminology might be slightly different. In cotton for example they refer to prices being “on” or “off “ (“sixty on”).

Physical coffee prices are most commonly thought of in cents / lb by the trade, but different origins have different local measurements that are more common (for example quintales and cargas in Latin America). Additionally, prices are quoted to local farmers in local currency. However, the different measurements and currencies are irrelevant for our purposes because they can all be converted to c/lb equivalent.

Physical coffee can actually be priced differentially in a contract that is comprised of two parts, a differential price and a futures price. However, locally in origin, this is rarely the case, with most prices quoted to the farmer in local currency and units. This c/lb equivalent is considered a “fixed” or “flat price” as opposed to the two part, differentially priced, “price to be fixed” contract.

Characteristics of Differentials

There are two primary ways that differentials behave that are important for our understanding of physical coffee prices.

The first is that differentials hold an inverse relationship to futures prices. This is a repeatable phenomenon that is well documented.

This relationship is also logical.

The users on both ends of the supply chain (producers and roasters) think of coffee prices in terms of a “flat price” (priced in c/lb). The consumer and producers costs are also both relatively static. Since the farmer has fixed costs, he or she will demand more money on the differential to compensate when futures prices are low, and he or she will be willing to give up more on the differential when futures prices are high.

The opposite is true of the roaster. When futures prices are high they cannot afford to pay as much on the differential and when futures prices are low, they are happy to apay a little bit more on the differential. This pressure from the end-users is what gives coffee differentials their inverse relationship with futures prices.

The second way that differentials are influenced is by the individual supply and demand of the individual commodity. Kenyan coffees for example are in relatively small supply and are highly prized for their flavor profile so Kenyan differentials regularly trade at a steep premium to futures prices. Vietnam robustas by contrast are grown prioritizing abundant supply with less focus on the cup quality and therefore often trade at a large discount to futures prices.

Beyond the individual characteristics of particular origins, the volatilities of that particular year’s supply and demand balance will also affect differential prices. This can create a unique scenario similar to the one that the world finds itself in now, where futures prices and differentials have actually been positively correlated.

We will look at how this happens in the next section, which tells how we can use price differentials as a trading signal.

How to Use Differential Prices

Normally, we can use differentials to give us an indication of the supply and demand balance for a particular origin. Loose or weak differentials indicate lack of demand and/or abundant supply while tight differentials indicate the opposite.

Typically, as noted above this relationship is inversely related to futures, however there is a situation where futures prices and differentials are positively correlated and this is a strong indicator of trending market. We just experienced this exact scenario very recently in coffee.

In this scenario, several of the world’s largest origins including the two largest

Arabica producers (Brazil and Colombia) both experienced major hits to supply. This simultaneously influenced differentials for those two origins and at the same time influenced global supply of coffee. This double impact to local and global supply is a great leading indicator of a trending market. In this case, this was an early sign of a strong bull market, but the opposite could also be true…very weak differentials of key origins combined with a drop in futures prices could indicate a bear market.

Where to Find Differentials

Finding accurate differential prices is a bit of a challenge because the liquidity in different qualities of coffees is not always available and not always transparent. The best source for differentials is from traders who are trading those particular qualities. Since they are actively buying and selling those coffees they are given serious bids and offers and will have insight into the actual availability.

Another good source for differentials is from price lists from various traders of coffees, but these may reflect the supply and demand of the individual trader supplying the price list rather than the global market.

A third option is to pay for differential prices from an information provider like Reuters or Bloomberg, but these companies are likely to prioritize having data over having accurate data.

The option that I use (and provide for free) is to use the ICO flat prices and subtract current futures market prices from them. This gives a good approximation of physical prices and won’t cost you anything. (To receive this report for free subscribe here)

Those of us who have spent some time in the coffee industry often bristle a little bit to think of coffee as a commodity. Some folks may even think of the “C” market as some kind of abomination that doesn’t capture the true value of coffee.

However, the function of the C market is not to value the unique variations of every coffee in the same way, but rather to value the general characteristics of coffee the same. This provides a common language for us to price coffee.

Differentials allow coffee producers and consumers to differentiate the coffee that they sell, or the coffee that they want by comparing it to a common understanding of generic coffee prices. In this way the futures market actually allows a variety of coffees to flourish based on their own merits.

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