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Reflections In A Cup: Irrational Exuberance In The Coffee Market

Irrational Exuberance In The Coffee Market


June 16, 2008
By Stuart Daw

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On the day of this writing, August 2, 2005, the market for arabica
coffee on the NYBOT rose by around 4.5 cents (US), which translates
into around 6.5 cents roasted in Canadian funds.

On the day of this writing, August 2, 2005, the market for arabica coffee on the NYBOT rose by around 4.5 cents (US), which translates into around 6.5 cents roasted in Canadian funds.
 
The reasons seem to be twofold; the five per cent “decrease” in Folgers’ price to the retail trade, and the information from Brazil indicating that this year’s harvest, which had been predicted to be 32-million bags, now may only turn out to be 30-million bags. These issues deserve a closer look.

Why would the market immediately react to the Folgers announcement the way it did? The reason is to be found in one of the basic laws of economics: the lower the price, the higher the demand. This is known as the “flexibility of the demand curve.” Of course no two products have exactly the same demand curve; their response to changing prices.

Coffee is an example of a product whose demand curve is quite inflexible, meaning it is not very responsive to price changes. The fact that over one third of all coffee in North America is consumed away from home contributes to this situation, as foodservice prices for a cup of coffee do not respond quickly to coffee cost changes either.
 
At 60 cups to the pound, a 50 cent bump in coffee costs is less than one cent per cup, so there is no need to panic in an era of 75 cents and much higher per cup, retail. Of course, cynics claim that when coffee costs fall, foodservice types never follow suit – that cup prices never fall.
 
The majority of trading in commodity coffee is not done by roasters, the people who actually handle the product, but by speculators, the commodity funds that have no direct concern for coffee as such, and would just as soon be dickering in oil, corn, or pork bellies.
 
So when they see Folgers dropping prices by five per cent they remember what their college profs taught them about supply and demand, they get excited and start buying, for they assume Mr. and Mrs. Homemaker will immediately increase their personal coffee drinking habits. And all this on the same day that Brazil issues a pessimistic report about coffee production.
 
Add to that the knowledge that world consumption is rising at around one per cent annually, and that consumption of everything including coffee is escalating in China, and traders in their excitement are likely to reach for their bottle of valium.

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As for people actually physically handling coffee, no two market segments behave the same, which can confuse the public, depending on which segment of the coffee industry they are in. At the retail level, one must realize that a roaster such as Folgers does not have to carry large inventories of green coffee to “protect” its customers; shoppers at that level simply get hit with increased prices in retail stores almost at the moment green costs rise. Similarly, when green prices fall, that same roaster can reduce prices just as quickly, while gaining some media coverage by virtue of the free public announcement.

The “away from home” roaster, however, must acknowledge his customers’ need for planning price changes, so traditionally provides for three or more months of inventory. Thus notice of changes from those roasters will represent a much longer lead-time. This is a lot less convenient than changing prices immediately upon hearing of action in the market. On a rising market, such roasters may be running three months behind in raising prices, and likewise, on a falling market, in lowering them.
 
Meanwhile an unthinking or unsympathetic foodservice customer, on hearing of a Folgers decrease, may utter the old cliche, “What have you done for me lately?”

On the issue of Brazilian production, the current harvest is now over half in, so changes in poundage estimates at this late date are a bit surprising. And anyway one must always be a bit skeptical about the coffee news emanating from that country, where producers are not famous for their optimism about production numbers. It is not in their best interests to be so.
 
Having said all of the above, the nervousness and unpredictability of this market moves us to apologize in advance should, on some as yet unknown pretext, the market fall five cents tomorrow.