This presentation explores two oft-confused elements of coffee roaster position management: exposure to green coffee market prices, and green coffee inventory management.
2. Position Management – Who Cares?
1. The market is on a ferocious bull run
“I sure hope we bought lots of coffee when prices were lower…
what’s this going to do to my P&L this year?”
1. The market is dying, looks like it could go to zero
“I hope we don’t get stuck with too much high priced coffee….will
we be competitive? Will our customers who locked in prices be
competitive?”
3. The plant just shut down.
“WHERE ARE THOSE GUATS?”
3. Position Management
1. Risk Management -- Managing Exposure to Market
Prices
“I don’t want to bet the company’s fortunes on our ability to call the
market correctly every year.”
1. Inventory Management
“Prudent inventory management should not cause extreme price
exposure”
Manage risk and inventory separately. They do not overlap
5. 4 Myths
What Matters
Having a strategy
Measurement/Data
“Hidden” risks derived from market price moves
Having a futures account
I. Managing Exposure to Market Prices
6. Myth 1: “We only buy specialty coffee so we
have no exposure to market prices”
Source: J Ganes Consulting, LLC
Guatemala SHB FOB Price vs C Market
2004 -- 2008
60
80
100
120
140
160
180
CentsperLb
C Mkt
Guat SHB
7. Myth 2: “You’re a roaster therefore you are
always short”
What is your true position before any hocus pocus?
Short: profit from a down market
Long: profit from an up market
Neutral: Market has little impact on results
True position can differ by business segment
Hedge: Used to offset true position
8. Myth 3: “I got a ton of inventory on hand so I
can turn off the screen for at least a week”
Combines independent items: inventory levels and market
exposure.
Use of physical coffee to manage market risk is expensive
and inflexible
9. Myth 4: “The most important thing is how
much priced coverage we have”
If you maintain constant priced coverage…
Must buy replacement every day
So how does it matter how long you are*?
*OK it matters a little:
Length of coverage will determine WHEN today’s purchases
will hit your P&L
Impact of Market structure…in a normal market will pay extra
for distant coverage approx. 1 cent/Lb per month (Arabica)
10. So What Matters
When do you add coverage
When do you draw down coverage
A disciplined approach, informed by your market view but not
wholly dependent on it
11. Priced Coverage Matrix
New York Coffee Futures Example
(coverage in weeks) Market View
Market Price Bearish Neutral Bullish
< 72 13 – 15 16 – 18 19 – 21
72 – 106 11 – 13 14 – 16 17 – 19
106 – 121 9 – 11 12 – 14 15 – 17
121 – 154 7 – 9 10 – 12 13 – 15
> 154 5 – 7 8 – 10 11 – 13
Assumes reversion to the mean
Within a price range, target longer when bullish, shorter when bearish
For a given view, extend at low prices, draw down at high prices
12. Estimated Colombian Diffs:
Volatile but Within a Tighter Range
Source: ICO Indicators and 2nd
position NY Futures used to estimate differentials. YMMV.
Monthly average futures has a range of 240 cents, estimated Colombian diffs
80 cents.
13. Differential Coverage Matrix
Colombian Example
(coverage in weeks) Market View
Market Price Bearish Neutral Bullish
< 5 15 – 22 22 – 28 26 – 40
5 – 8 13 – 18 16 – 21 17 – 30
8 – 14 10 – 15 12 – 14 15 – 28
14 – 23 9 – 12 10 – 12 13 – 20
> 23 8 – 10 9 – 11 11 – 13
Source: ICO Indicators and NY Futures used to estimate differentials. Monthly Averages used. YMMV.
Policy matrix on differential coverage is normally limited on the short end due
to length of physical pipeline
14. How to Calculate Coverage
What is included in price coverage?
Priced purchases
Green Inventory (if priced) and Work in Process (green basis)*
Finished Goods (green basis)*
Futures and delta-equivalent options
Differential Coverage – Inventory* plus open purchases
Recommendation: convert Tonnage to Weeks using annual
average consumption
*If LIFO accounting, anticipated year-end inventory is not included in coverage
16. Hidden Risks Associated with Markets
Risk Market Condition Mitigate Risk
Supplier defaults causing
replacement at much higher price
Rising Market • Defer pricing until
shipment (hold futures)
• Track M2M by supplier
Supplier ships late/not at all
disrupting operations
Rising Market
(usually)
• Alternative blends
• Awareness of spots
• Early warning signals
(e.g. no pre-ship sample)
Lack of spot coffees to handle
unanticipated needs
Inverted market
( = scarcity & rising
prices)
• Alternative blends
• Sales lead times
• More inventory
Customer orders exhibit “adverse
selection” depending on the market
Moving Markets • Track customer sales &
enforce contracts
Quality Risk Extreme markets • Pre-shipment samples
Operational Risk: A Yacht called
“The Unable”
Moving Markets • Get educated
• Segregate duties
• Spot checks
17. Futures Account: Should you have one?
Advantages
Concentrated orders
Reduce counterparty risk – hold your own futures
Improve control
More techniques available – options, swaps, switches
Protected by SEC/Exchange rules
Role of clearinghouse – Mark to Market fully funded
Disadvantages
Initial & variation margin – risk of cash outflow. However:
Variation margin (for a long position) is required in falling markets …
when less cash is required to finance inventory
In rising markets, variation margin will generate positive cash
Increasingly complex accounting
Cost of broker commission (small)
19. Inventory Management
Conflicting objectives
Ensure supply
Keep inventory low (cash/quality/leanness)
Challenges
Uncertain demand
Forecasts become less accurate at the lowest levels
Long/variable supply line
20. Tip: Classify Green Types for Inventory Management
Green Type General Characteristics Strategy
Unique
Limited supplies
Seasonal
Few or one supplier
No substitutes
Expensive
Unique: cup or story
Strong strategic reason for being
Hi inventory target when
its available
Monitor quality
Monitor sales closely
Seek substitutes or
complementary products
Common
Plentiful supplies
Multiple suppliers
Substitutes
Available all year
Used in many products
Tighter inv. target
Leave 15-20% room in
position
Watch the spots
21. Tip: Weekly supply chain or “S&OP”
meetings
Focus on Data
Identify & Understand Variances
Sales
Production
Green usage
Especially Watch Unique Items
Example: Explore why we used so much more Colombian
Coffee than planned last week. Is this a real change in
requirements or just a shift between weeks?
22. Purchasing Terms: What is optimal for
you?
Terms Coffee Price Cash
Required
Admin Effort
FOB Origin Lower Higher Higher
C&F/CIF
Ex-Dock
Ex-Whse./Del’d
Vendor Managed
Inventory (VMI)
Higher Lower Lower
Within these choices, still need to clarify other terms such as:
•Quality rejection terms
•Payment terms
•Buyer influence on sourcing: Relationship coffees? Preferred shippers?
•Rules/costs around taking coffee late
R E S P O N S I B L E F O R I M P O R T I N G
23. Benefits & Costs of VMI
Benefits to Buyer
One time cash (reduced inventory)
Less admin effort
Suppliers have increased flexibility
Costs
Supplier charge for holding coffee
Premium for delivery timing uncertainty
Reduced competitive bidding
Notas do Editor
Today we’re going to talk about Position Management
So I’d like to ask you – as a roaster (or imagine yourself such) – when you think about your position, what do you think?
What is it/ what comprises it? What’s in it?
Why does it matter/what business questions does it answer?
“Who cares” about position management and more to the point, what do they care about depends on what is happening at the moment
First click – apart from wishing we bought more (it’s never enough), impact on P&L and costs is top of mind
Second Click – now the same guy who a moment ago wished we bought more wishes we bought less. And asks important questions. Clearly these two events and concerns are two different sides to the same coin
Third click – Now this you’ll notice is an altogether different coin. It has not to do with markets and prices, but supplies. Note the panic in the voice.
First click
One of the themes from today is we are going to try to keep these two coins separate as much as possible
Market exposure
Inventory management
Here is the exception
You are also exposed to moves in differentials, but managing that does impact your flexibility / ability to manage inventory
However the vast majority of price exposure is not differential, is market. And you can still manage the vast majority of differential exposure without mucking up the inventory plan
Simple rule – do not cover more than 80% of differentials in advance of when they are available for prompt shipment.
Here is what we’ll cover
What is missing is specific tool chest items – options, swaps, exotics and so forth. Those are important but in the time we have today we want to put context around a strategy rather than different tools available to execute the strategy
Thanks to Judy Ganes!
This covers about 4 years of data – c mkt and Guat SHB prices based on Judy’s survey
You don’t have to be a statistician to see the correlation
C market range was about $1
Guat SHB diff range was about 15 cents
So from a price/risk standpoint, you might say that ~85% of your risk is around the C Mkt
15% around the coffee itself
Now there is no doubt that some coffees do not correlate – COE, top quality etc. Fair Trade when prices are low,. But for the most part, coffee prices do move with the market, as I think you are pretty aware
Title only
I used to hear this all the time
And it made me think, what is the meaning of the word “short.” or “long”
And any trader will tell you the answer: if you are short, you make money when the market goes down. And vice versa long.
First click: so your true position would be if you did no hedging hocus pocus at all
Short – many processors…you make more money when your costs are lower
Long– poster child for a true long must be….Exxon Mobil. When oil is up, they make a fortune!
Neutral – market doesn’t matter. Maybe all your costs get passed thru to your customer
Click (explain)
Click: so before you even think about what should be your hedging strategy, you have to think first – what is your natural position.
It is I feel and expensive and risky way to manage price exposure by loading up on inventory.
Yes you reduce differential exposure if you are certain that diffs will strengthen
- but you give up ability to manage inventory and deal with changes in demand/production requirements
- and we have already seen that diffs move much less than futures prices
If I have 8 weeks coverage and maintain that every day
And you have 24 weeks coverage and maintain that every day
Then we are both in the market every day buying one day’s worth of coverage, at the market. We are doing that exact same thing, doesn’t matter how long we are, right?
OK two caveats
*Length of coverage does impact
1. Timing: when today’s fixation hits P&L – and this is not unimportant
2. Cost: will vary due only to market structure (cost of hedging) – in normal carry market, shorter coverage costs less because you are buying the nearby futures position. This difference in cost is relatively small compared to the ups and downs of the market, but it is real
So if its not how long you are, what is it?
(click)
On Title
Now I would like to share with you an approach to priced coverage. This method assumes Blood Sweat & Tears famous “Spinning Wheel” theory of commodity markets – what goes up, must come down. Those who question the band’s commodity cred call it “reversion to the mean”
Above shows 5 quintiles of data going back to Jan 1, 1992, about 21 years
We have been through these quintiles 57 times since Jan 1, 1992. Actually we’re on 58 right now
19 times in the middle range. 10 times exited up, 9 times down. 50/50
In these next ranges, 14 (lower) & 15 (higher) times respectively. 50/50
Market exits these ranges 2/3 of the time back to the middle, 1/3 of the time to the extreme
But after all these are quintiles – the market spends as much time in one as another. Once the market ends up in the extremes, on average it stays there longer. But don’t ask me how much longer because there’s only a 4-5 data points per extreme and the range around the average is very wide! For example, average time in highest q. is 10 months, but the range is 3 weeks to &gt; 2 years!
& has two principles
You buy more when prices are lower and less when they are higher
You buy more when you think the market is going up, less when you think its going down
This can apply to any commodity – futures market, cash – for which you have some historical price data. The data you see above is purely illustrative, not especially for any particular market. Same is true of the coverage, not a recommendation, these are just numbers
[Click]
This matrix provides coverage targets for a given market level and a given view. Now we have already discussed that length of coverage doesn’t matter, so what’s important is the dynamic that occurs when the market moves or your view changes
Start with looking at historical prices – 20 years in this case – and create 5 “quintiles” of historical price levels. In this example…[column 1]
Now there are two principles here:
We want to get longer when prices are low…so compare top row (13-21) to bottom row (5-13)
We want to get longer when we are bullish (and vice versa) – pick any row
Incidentally, if we are into one of those lengthy stretches in the extreme quintile which we are convinced is here to stay, we do have over 1000 days of data so we know something about the quintiles above 154…. To 166, 177, 197, 236, and to infinity & beyond
Data from Jan 1992 until Mid 2013
Note that futures (on the left axis) had a range of about 240 cents while diffs, about 80 cents.
While 80 cents is still sufficiently volatile to say bankrupt a trader, its clear that taking position in Colombian diffs (with justification supported by data) is clearly less risky (and w less reward) than on futures. Similar to the SHB Guat example we saw earlier.
Differentials have less risk and also less reward than the futures, so it stands to reason that in most cases you would be inclined to be a bit longer when your view warranted
But there is a limit as to how short you can get – it is limited by the amount of time it takes to move coffee from origin to your location
Some people by the way have gotten around this by purchasing coffees “diff to be determined.” The trick is finding a basis to lock in the differential…
Also we are increasingly seeing people hedge Brazil differentials using the futures market in Brazil against New York.
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If we are going to talk about adding or drawing down priced coverage, we have to talk about what it is and how to measure it.
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Here’s an example of the Priced Coverage display
Fixed price coffees
Unfixed coffees
Futures
Delta equivalent options
Total priced exposure which is all of the above ex the unfixed coffees
Supplier default/out of business
If he owes you cheap coffee (cheap diffs)
If you have priced well it is even worse
If he holds futures for you that is lost too
Many companies place value limits on purchases to a supplier…but I feel better is mark to market by supplier. And you will limit m2m exposure by holding your futures because diff m2m is less. And it the limit is on value, you will frequently have to modify these limits with the market (unless the limit is so big you might as well not have it…..)
Spot coffees are a buyer’s best friend…knowing they are there is like going to bed with a big fuzzy warm blanket on
Customer adverse selection – for customers who lock in prices and commit to quantity of product. When customers lock in prices, like the forward pass in football, three things can happen and two are bad.
Quality Risk – normally quality not so much related here. High prices are good for growers. Low prices not so much – especially chronic low prices -- but usually in a given year, a big crop is a high quality crop. What I worry about – a sharp run up in prices where suppliers are scrambling to cover coffee and lower their standards. Or the psychology when prices are dirt cheap – how can you expect a BMW when you are paying Dodge prices?
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I am a fan of having your own futures account if you do a lot of price to be fixed business and can afford the potential cash outlay (which you can estimate/ project under various scenarios) Position limits can also help to put parameters around the cash need.
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Inventory management is not easy because
YMMV, but many find the 80/20 rule in effect…20% of the items generate 80% of the headaches and it wasn’t usually the biggest items – it was the unique ones
Now I know the lifeblood of some of your businesses is uniqueness – you seek it out, sell it, when its gone its gone and then you find something else to sell. But here’s I’m talking not about that but more about a product you sell year around that has a unique component, or is entirely a unique component
Click
So it makes sense to manage unique v common differently.
Typically these meetings will include sales, operations (production), green purchasing and maybe other purchasing, and finance
Start with sales and then production
Green usage example
Big order from Wal Mart
- versus we ran out of packaging material on what we wanted to run so we ran something else
In the former, the consumption of Colombian coffee will ‘stick.’ Not in the second
What is the optimum way to purchase?
We see roasters, all of them smart, buying all these different ways
And it is not only the ones with less access to cash who buy here on the right side.
The closer you buy to origin, the less you pay for coffee but you take on more cost, responsibility, and cash needs. Whether you can do it as efficiently as the importer is the question…or which tasks are best suited for you?
Factors to consider
What is your green cost % of revenue? Are you high margin/low volume or the reverse? This will help you figure out how much the higher cost of these techniques here on the bottom will bite into your returns
Your cost of capital or desired return on capital compared to what your suppliers will charge you for financing
Your ability/desire to get involved in deeper logistics
Ocean freight – do you have enough volume to negotiate a good rate or are you better off leaving it to the suppliers
Importing – the line of who does the importing is a big on, although there are plenty of firms around who would be happy to manage it for you
Whatever you decide, you will still have to consider these other items
OK so which outweighs…
Much depends on what is your green cost % of revenue
I guess I tend toward the old fashioned school, I like having multiple suppliers for safety and cost. And I always felt that I could do a better job managing my inventory – being passionate about inventory management if you can believe that – and that in the end, ultimate long run cost will be lowest where the best quality job is performed beginning to end.
But I am well aware that many of you work with specific suppliers for specific coffees anyway – part and parcel of some Coffee biz models – so for you this would be the logical next step in developing that partnership.
