Coffee Trade: New York
Coffee Exchange
There are two markets for coffee: the cash
market and the futures market. The cash market is the
market today. It is the price you would pay for coffee
today if you could receive it today. The futures
market is used to help determine the price for future
deliveries. It is used to purchase a contract today to
guarantee a future shipment of coffee. More
importantly, however, the futures market for commodities like coffee is used to help protect against the
wild variations that occur due to coffee market speculation.
The latter reason will be explained in further detail
through the help of an example.
Futures Market: Coffee Exchange Analysis
Assume it is currently May and assume the
“C” market price for July shipment is at 95 cents/lb.
Now pretend that today a coffee producer sells two units of
coffee (1 unit = 37,500 lbs) to a coffee roaster or importer
for 5 cents/lb over the “C.” The coffee traded is Class
3 (Exchange Grade) Guatemalan coffee to be shipped to New
York. The 5 cents/lb premium is paid to cover the price of
storage and insurance to carry the coffee for two months
(May-July) until the delivery month (July). The two parties
agree on 100 cents per pound for two units of Guatemalan
Class 3 coffee to be delivered in July.
Now imagine it is early July and consider
two hypothetical scenarios:
1) The happy buyer / frustrated coffee
producer scenario: A frost occurs July 2nd in
Brazil and coffee prices skyrocket to 150 cents/lb. Due to
the aforementioned contract the producer must still sell his
coffee at the previously agreed upon 100 cents/lb and
therefore loses $37,500 (37,500 lbs x 2 units x 0.50 cent
loss) compared to what the seller could have received had he
or she sold the coffee today.
2) The broke buyer / pleased coffee
producer scenario: A frost that was expected to occur in
Brazil did not and there is a huge excess of coffee on the
market. Prices in July drop to 60 cents/lb. Due to the
aforementioned contract the buyer must still pay 100
cents/lb of coffee and therefore loses $30,000 compared to
what he or she would have paid for the same exact coffee
today.
In either case someone wins big and
someone loses big. The risk is too severe for anybody whose
livelihood is based upon this system. Therefore the coffee
market was established to provide a system by which people
could hedge against loses in the cash market.
Let’s go back to our previous example
and ignore the hypothetical scenarios for now. The coffee
producer produced two units (+2) of coffee and sold two
units of coffee (-2). His or her net coffee volume is zero,
but price gain is $75,000. The coffee buyer produced
nothing, but bought two units of coffee. The buyer’s net
gain of coffee is +2 units, but he or she loses $75,000.
This is a somewhat mathematical look at any common purchase:
an exchange of money for a product. But rather than taking
the risk of facing either of the two previous hypothetical
scenarios, both the buyer and seller take an extra
precaution.
Since the producer sold two units of
coffee at 100 cents/lb, he or she would also place an order
for two units of coffee at the same time for 100 cents/lb.
Therefore the producer maintains his or her 2-unit surplus
of coffee, but has made no money.
Since the coffee buyer bought two units of
coffee at 100 cents/lb, he or she would also sell two units
of coffee at the same exact time for 100 cents/lb. Therefore
the coffee buyer or roaster has a zero net gain of coffee
and a zero loss of cash.
No one has gained or lost anything at this
point. The coffee producer sold his coffee and bought
somebody else’s coffee for the same price. The coffee
buyer (roaster or importer) sold some coffee only to buy
back an equivalent coffee at the same price. However, the
coffee producer prefers money rather than coffee in payment
for his or her coffee, and the coffee buyer does not really
have any coffee to sell since he or she is not a producer.
Then why did this somewhat backwards-sounding transaction
occur?
Imagine again a scenario 1 change in the
market. A frost occurs on July 2nd and coffee
prices skyrocket to 150 cents/lb. However, this time the
producer is both pleased and disappointed (i.e. unaffected)
by the change in the market. The producer again loses
$37,500 compared to what could have been made had he or she
sold the coffee today (early July), but since the producer
also acted as a buyer and bought two units of coffee at 100
cents/lb he or she made $37,500. The total loss is zero. Now
consider the coffee importer. Again the importer is happy
since they profited $37,500 from their purchase, but since
they also sold coffee at 100 cents/lb versus the 150
cents/lb they could get today they also lost $37,500. The
same result will occur for scenario 2. Neither the coffee
producer nor the coffee importer was affected by the
variation in the market.
When the coffee producer feels the time is
right, he or she can then sell the extra two units of coffee
to finally turn a cash profit, and during the course of one
of these transactions the coffee importer must not sell
coffee so that they may finally have the surplus of coffee
that they need to distribute it to the coffee roasters.
These transactions will typically occur on the cash market
and not the futures market. Only 1% of the future contracts
that are actually made take place.
This is the general idea of how a market
works. Let’s look into the previous explanations a little
more closely.
1) The price set in May of 95 cents/lb of
coffee for a July shipment was not determined arbitrarily.
The price is determined in the following manner: hedgers and
investors gather in the trading area (“the pit”) of the
New York Coffee Exchange (NYCE) where an open outcry auction
system occurs. Hedgers can place bids to buy or offers to
sell coffee until the buyer and seller mutually agree on a
price (called “price discovery”). This is how the price
at that moment is fixed and explains the fluctuations seen
throughout the day.
2) Trading takes place from 9:15 AM to
1:32 PM (EST) M-F.
3) Deliver months are March, May, July,
and September. This is why the nearest neighboring
delivery month is used to set the current cash price.
4) The basis is the difference between
today’s price and the futures price for the nearest
deliver month. For instance in our example the buyer bought
the coffee for a 5 cent premium in May over the July futures
price. This extra five cents is called the basis and is used
to pay for the storage and insurance during the two months
before it is shipped. As it gets closer to July the future
price and current cash market price converge since storage
and insurance are no longer an issue.
5) The price also depends on where the
coffee is shipped. New York shipment is at par with the NYCE
price for that month. New Orleans and Miami demand a 1.25
cents/lb discount, whereas San Francisco shipment has a
discount of 0.75 cents/lb. The seller determines the
delivery point.
6) The quality of coffee also affects the
premium or discount paid for a coffee. There are five
classes of coffee:
a) Class 1. Specialty Coffee – 0-5
defects.
b) Class 2. Premium Grade – 6-8 defects.
c) Class 3. Exchange Grade – 9-23
defects. This is the grade traded on the NYCE. Class 1 and 2
demand premiums to this price, whereas Class 4 and 5 coffees
demand discounts.
d) Class 4. Below Standard Grade – 24-86
defects.
e) Class 5. Off Grade – More than 86
defects.
7) The producing country also determines
the differential paid. Costa Rica, El Salvador, Guatemala,
Kenya, Mexico, New Guinea, Nicaragua, Panama, Tanzania, and
Uganda are at par (basis). Colombia has a differential of
plus 200 points (2 cents/lb). Honduras and Venezuela have
differentials of minus 100 points. Burundi, India, and
Rwanda deliver at discounts of 300 points, whereas Dominican
Republic, Ecuador, and Peru deliver at minus 400 points.
