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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.



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