Coffee Memo | Rob Talks Inverted Market Ep. 3

Episode Summary
In this episode, Rob Stephen delves into the inverted coffee market and its impact on the coffee futures market. He discusses the implications of fluctuating coffee prices for importers and roasters, focusing on the challenges posed by the current coffee market trends. The conversation highlights the concepts of backwardation and contango, and how these phenomena affect the c market coffee dynamics. Strategies for navigating these complexities are emphasized, showcasing the importance of thorough planning and effective communication in an unpredictable market marked by rising costs.

Episode Notes

• Overview of the Inverted Coffee Market
• Exploring Backwardation and Contango in the Coffee Futures Market
• Effects of the Inverted Market on Coffee Roasters
• Addressing Challenges in Coffee Sourcing and Coffee Price amid Market Trends
• Strategic Approaches for Coffee Businesses in the Coffee C Market
• Conclusion and Insights for Future Coffee Market Trends

MIKE FERGUSON: Welcome to Coffee Memo, a podcast where we talk about coffee industry news and current affairs. This is episode three, and we are once again in the studio with Covoya’s Managing Director, Rob Stephen. The topic for this episode is the inverted market. To begin with, what even is that and what does it mean to our business as a coffee importer? And more importantly, what are the possible implications for coffee roasters?

So, Rob, our topic today is the inverted market. And I think I need to start off with a confession. It was probably… I was working in the coffee industry for over 20 years before I was even remotely aware of the concept of an inverted market. Maybe because the last time we saw an inverted market was the year before I got into coffee. So, it's only been in recent years that we've actually been living in an inverted market that I've come to understand some of the implications for our business and our suppliers and our customers. I know I'm not alone, so I'm hoping you'll walk us through a freshman class in backward days… backwardation. It's a word you don't want to say too fast.

ROB STEPHEN: Yeah, no, and I will say don't feel bad. I've been in coffee a number of years as well and only knew that it was a possibility. And you heard the old-timer traders talk about how when they first got started, it was the kind of thing, you know, that was, that they had experienced. But I mean, I grew up basically trading in a carry market, which is one that's not inverted, where coffee in the future costs more than coffee now. It's the way sort of it's supposed to be.

MIKE: And that's called the contango? Contango, okay.

ROB: Contango.

MIKE: Contango, okay.

ROB: I would say that, for example, I went to a coffee symposium sort of thing in Europe last year, and the head of a big trade house who everyone knows and respects said, “well, the last 15 years have been coffee trading for dummies.” Now it's getting real. Yeah. You know, and as I've looked back on this last year, he's absolutely right. 100%. It's been the most challenging trading environment of my career and then I would say of people who are even older than me and probably have retired have probably never seen a year as difficult as this sort of last 12 to 18 month period.

MIKE: Okay. In the last 15 years, he's talking basically pre-pandemic, post-price crisis.

ROB: Yeah, I mean, the number of factors that are facing the coffee market right now are simply overwhelming. Even for people who are very, very good at this. Everyone's in this sort of throw up your hands kind of environment where I should know what's going to happen next and I don't. Yeah. Right. And so, if anyone out there is feeling overwhelmed, you've got it exactly right… Is the way I would look at it.

MIKE: So, what is the inverted market?

ROB: Yes, so what is it and more importantly, how does it affect you. You, being the listener who I suspect is a roaster or somebody on the on that end of the coffee trade. And It's a it's a long answer that I'll try and make in as many digestible parts so that we can make it make sense.

So first of all, what do we mean by an inverted market? What we mean by an inverted market is if you look at a trading screen or if you look at the listing of the different futures contracts that are available the ones that is nearby, in this case this would be the December 25 Coffee C-futures market price is the most expensive. And then as you move forward into the future, March, May, July, September, next December, those get increasingly less in price. Normally, in all the time that I've been in trading, there would be more. And what is the price in the future? It's a reflection of risk and uncertainty. And so basically what the market is saying is that the most risky and uncertain time is now. And in the future, we would expect there to be less things wrong, more coffee available, more coffee in the right place.

MIKE: We expect or we hope?

ROB: We hope. Right. It's so, I mean, the market is the consensus of everybody in it. It is, it is what buyers and sellers are willing to do business, what price they're willing to do business at. So, every price you see when the market is open is the last trade. It's the last time two people said, “yeah, I'll sell it at that price, and I'll buy it in that price.” So, it's a reflection of where the market is at this very moment. And what the market thinks is that right now is the most expensive time to buy coffee. And so that is what an inverted market is, is being in that situation. The distance in price between the different contract months is called the spread. So just to use an example, if coffee is $3 now, and in the next contract period, so it's $3 in December, it's not $3 now, it's a lot more, but if it was $3 in December, just use round numbers, and the next contract being March was $2.95, the spread is five cents.

MIKE: Got it.

ROB: Usually in a normal market in the markets that we all grew up in, the spread from the overall period of one year say December to December would be about 12 cents could be 15 cents 12-15 cents. Yeah, and it would be positive, right, it would be 15 cents more expensive in the contract a year forward than it is now. Now, the spread from December to December is about 60 cents.

MIKE: Yeah, and two years out it's a whole dollar.

ROB: Right and that's a huge amount of money, right? And so, what is the consequence to roasters for that. Well, it's sort of a trickle-down effect that's really more of like, an avalanche. So, if as an importer I have coffee that is hedged and it's unsold, I have to keep the hedge open until somebody buys it.

MIKE: Yeah, and just real quick…

ROB: I have to, when I buy coffee, I sell a futures contract. And that futures contract sits there until I close it on the other end by buying a futures contract. In order to do that, I need to sell the coffee. And just for reader edification, we do not make money on those futures trades. We just keep it balanced. If the market goes up on us, then we make money on the price. If the market goes down, we make money on the futures contract, but they all balance each other out to zero. That's called being square. That's called keeping a square book or staying hedged. Right? And that's what importers do. And the smart ones anyway. And so, but while I have that hedge open, waiting to sell the coffee, I can only keep it open while the contract that I've hedged is open in the market. So, if I have a December futures contract, at some point, as you get closer to December, that expires. You can't have a December contract anymore. They don't exist. So, you have to do what they call rolling, which is to get rid of your December contract and pick up a March contract. And when you do that, you have to pay the spread. Normally, it's not a matter of huge consequence. It's been one and a half cents. You can absorb that. You can put that in your price. Nobody notices. Nobody cares. It's a very relatively small amount of money. In this case, 10 cents is real money. And it's growing.

And so that means that for the privilege of having coffee available to sell in the future, the import community is paying these switches. So, they're being charged by the market, very large sums of money to hold coffee available to sell. So, that's going to end up in the price. So, that's what the inverted market means to you, is the privilege of having coffee unsold ready to be purchased at as you need it. It's just got much, much more expensive.

And so, larger roasters who can afford to do forward contracting are fixing their price now so that those extra rolls are not part of their purchasing.

I'll give you an example. If we were to buy, let's call it Mexican coffee that arrived in April, and there's a roaster that says, well, I want to be able to buy that from you year-round. So, I want you to buy enough so that next March, you still have some. That means I have to hold four rolls. So, that would add effectively 80 cents a pound to the project by the time we get to the table. So, I don't want to do that. And the roaster doesn't want me to do that. So, the net effect of that is that coffee as it lands will have every incentive to disperse very quickly. So, if you need coffee seasonally and you don't buy it when it arrives, the chances of it being available later will be very slim. Or, what's available will be available for a reason. Because maybe something is wrong with it or is highly suspect. Am I, are you with me so far?

MIKE: Yes. Yeah, I'm looking for what that means today for me as a roaster. I woke up this morning and the market's inverted. Rob told me the market's inverted.

ROB: So, well, I think in the short term, what does it mean? It means that you should, if you haven't got a forecast, if you haven't got a plan, the time to wait on that has passed. How much coffee do I need, and can I be decisive enough to not wait for things to maybe get better? Because options are getting, I don't mean options in the future sense, but I mean options for, just people and choices, are getting less and less.

And so, I think we end up in a situation where the roasting community is in one of the worst situations it's been on the buyer side that I can remember. It's really pessimistic, right? There's tariffs everywhere. There's really high prices. There's shrinking choices and credit lines are getting tighter. There's inflation. There's all sorts of pressures on consumers. It's extremely difficult.

MIKE: We end up where we've ended up often in different podcasts. Talk to your trader. But also the painting-like-Pollock roaster... Not going to work. Actual planning involved at this point. Right. Actual thinking of forward.

ROB: Yeah, I mean, you I hate having this conversation only in that it takes the romance out of what we do. But, simplification is a really solid strategy right now. If you are the kind of coffee purveyor that likes having 20 different varieties and all these different, that means you have to do small quantities of everything. That really creates, I think, a difficult situation. Being able to rationalize that and have less and instead be more intentional with the things that are really special, especially if you can buy those on a direct, or a flat price kind of environment. I think this is the time to sort of batten down the hatches and ride through this storm with the most lean and optimal environment you can, you know, not environment, but plan.

MIKE: When you're saying “simplify,” I think you're talking about your offerings and do more with less. But in practical terms, really practical terms, what does that mean?

ROB: Again, and I'm not trying to be a downer, but because we're in such a complicated environment, we talked last show about what's going on in Brazil and the knock-on effect that that will have on other origins being available, right? So, we're already starting to see extreme interest in the upcoming Central American crop from all sorts of roasters, right? And not just from the US either, in Canada, but also in Asia and also in Europe.

The EUDR, the European Union Deforestation Regulation, is creating a need for coffees from the Americas in Europe as well. And so, there's going to be a lot of strain on people trying to get those coffees. Brazil coffees won't come into the US. And so what is going to be left? And it's kind of an open question. What can you use and what will be left? What do you do right now? You look at all that environment and you say, “I need to have a plan. What's the minimum viable product I can get through the next year with? And where will that come from? And who has it? And who is willing to offer it to me?” That would be what I would write on the notepad and then go out and start to get those questions answered.

MIKE: I mean, I know we talked about Africa. How is that looking?

ROB: Well, when you read the report of what's going on in each of these sort of African coffee trading environments, the picture doesn't get any better. You know, there's a lot of African governments that are either have nationalized their coffee trading infrastructure or in the process of doing it or, it's sort of semi-controlled. And it's very difficult for coffees to sort of entrepreneurially come to the market. It's difficult. There's coffees on offer, but you have to be selective. And I think that has been really interesting for me, has been how decisive we've had to be. And I mean quickly, decisive. And it's much easier to be quickly decisive if you sketched out all your options. Decisive will look different for different people. I have a trading business to run, so I'm going to be looking at the variables that will make my business successful. But if you're a roaster, you're going to have different variables.

You're going to have cashflow considerations to take into account. You're going to have space constraints, something you've talked about before in your blog. And you're going to have what you've built your brand on and what your customers come to accept from you. So, you're in this environment where prices are out of control, uncertainty is really high, the availability of coffee that you've always taken for granted may not be a thing. So, if there was ever a time to sort of rip a blank page on the notepad and sketch over what are we going to do right now? I would say it's now.

MIKE: And I just, from a communications perspective, would just remind roasters to tell their customers what's happening. Talk to them and let them know. I mean, one of the great lessons that Dunkin' Donuts always taught us was that coffee drinkers like their coffee, no matter what they say or what makes the news, they like it to taste the same.

ROB: They like it to taste the same. Yeah. Yeah. Different is a four-letter word. Yeah. As we said, when I worked there. So.

MIKE: If your coffees that you're roasting are going to change, now is the time to start communicating to your wholesale accounts.

ROB: Right and you couldn't possibly tell them it's going to change until you know what it's going to change to. So, that's where the real planning comes in. I think talk to your trader at all your suppliers, keeping in mind that as much as your options are shrinking, your trader's options are shrinking, right? And there's a number of reasons that it's shrinking. It's not just the availability of coffee, but it's the availability of working capital, which I'd like to talk about in our next episode.

MIKE: It's a date.

ROB: It's a date, but I think that we're in a situation where no one's happy and everyone's hands are tied.