ICO economic report: Exploring prices
Econometric analysis confirms a stable long-term relationship between futures and producer prices, but what is the role of the trading market?
International coffee prices have been experiencing a downward trend since December 2016.
The International Coffee Organization (ICO) composite indicator reached 98 US cents per pound in September 2018, the lowest price recorded in almost 12 years, since October 2006.
The current low level of coffee prices imposes short- and long-term challenges for the global coffee sector and its stakeholders. In the short term, the earnings of coffee growers are severely affected, impacting the most vulnerable, and potentially increasing poverty and deprived living conditions. Low prices also lower the incentive to invest in coffee plantations today. The resulting under-investment, combined with the impact of climate change on productivity and the rise in global demand at 2 per cent per year, represents a threat to the availability of coffee in the long term.
Conscious of the risks that low coffee prices pose for the short- and long-term sustainability of the coffee sector, member governments of the ICO approved the Resolution 465 during the 122nd session of the International Coffee Council (ICC) in September 2018. Resolution 465 gives the ICO the mandate to implement a series of actions to address the challenges of the current low prices. One such action already underway is the ICO’s research into the determinants of price movements and volatility, and the impact of trading activities at the coffee futures market on coffee spot prices.
As part of this analytical work, an ICO study published in August 2018 titled ‘The role of the coffee futures market in discovering prices for Latin American producers’ – a result of collaboration between the ICO and Georg-August University of Gőttingen, Germany. This research was presented to the ICC in September 2018 on the suitability of futures markets as a basis for decision making for coffee growers.
Combining ICO coffee market data with advanced econometric methods, the study examines the role of futures markets as a price discovery mechanism in six coffee-producing countries in Latin America: Brazil, Colombia, Guatemala, Honduras, El Salvador, and the Dominican Republic.
The econometric analysis of the price data confirms the existence of a stable long-run relationship between futures and producer prices, indicating that both series react to the same set of external information on the market. The analysis of the role of the futures market as a price discovery mechanism has provided mixed results.
In Brazil, Colombia, and the Dominican Republic, local producer prices appear to incorporate new information faster than the futures market. This can be attributed to factors such as the size of the market (Brazil, Colombia), the existence of a sufficiently liquid exchange in the country (Brazil), and strong domestic consumption (Brazil, Dominican Republic). In Guatemala and Honduras, however, the New York futures market indeed dominates price discovery, suggesting that producers in these two countries may benefit from making their decisions based on futures contracts price information.
For the forthcoming 124th session of the ICC in Nairobi, Kenya, in March 2019, the ICO Secretariat is preparing an additional study, titled ‘Coffee futures markets: the role of non-commercial traders’. The objectives of this new research includes analysis of the development of trading indicators in the Arabica and Robusta futures markets over time, and the identification of a potential influence of speculative activity on the behaviour of spot coffee prices.
The presence of financial investors in commodity markets has increased significantly over the past two decades. Volumes traded at futures markets rose faster than the global production of most commodities. This phenomenon has been coined as the ‘financialisation’ of commodity markets.
Coffee is not alien to this phenomenon. From 1994 to 2018, the volume of futures contracts traded almost tripled in the Robusta futures market and rose five-fold for Arabica. Over the same time period, output of Arabica grew by 64 per cent, while Robusta production rose by 144 per cent. This supports the hypothesis that the coffee market has been subject to a significant process of financialisation over the past two decades, with an inflow of capital comparable to that of the market for grains, prior to the sharp increase in grain prices in 2008.
Using proprietary data on coffee spot prices and trading indicators, combined with data obtained from the Intercontinental Exchange and the United States Commodities Futures Trading Commission, the ICO Secretariat is using time series analysis to evaluate the causal link between speculative activity and spot prices.
Statistical tests have been computed in an initial set of 23 econometric models associating spot coffee prices for Arabica and Robusta with six indicators of speculation: monthly volume of futures contracts, monthly open interest in futures contracts, the ratio of volume to open interest, the ratio of long and short positions held by non-commercial traders to total reportable positions, and the index traders’ net positions (long-short).Initial results of these causality tests seem to show no clear evidence of a long-term predictive power of speculative activity for Arabica prices (Colombian Milds, Other Milds, and Brazilian Naturals).
In the case of Robusta, some indication of a long-term influence of speculative activity on price behaviour is found. The ICO Secretariat is currently performing further 4047 tests of short-term causality.
The final results will be presented to ICO Members at March’s International Coffee Council. Figure 2 is a snapshot of the first results of those short-term causality tests. It indicates that monthly open interest of futures contracts exerted some influence in the behaviour of Robusta coffee prices between March 2004 and October 2006, and between April 2012 and November 2015.
These initial findings seem to confirm that speculation might influence spot prices in short periods of time, but not in the long term. This conclusion is consistent, for example, with the body of literature on the 2008 price crisis in the market for grains. The results also suggest that in the long run, fundamentals such as demand trends and supply shocks prevail as determinants of price developments.
This article is written by Dr Marcela Umaña, an Economist at the International Coffee Organization (ICO). The ICO works through international cooperation to strengthen the global coffee sector and promote its sustainable development in economic, social, and environmental terms. Its member governments represent 98 per cent of the world’s coffee production and over two-thirds of world consumption, providing a unique forum for the global coffee community.