Demand for specialty coffee has roasters leaving futures exchanges

Coffee disconnect is brewing

Demand for specialty brands has roasters leaving futures exchanges

By Julie Wernaw

The Wall Street Journal

August 6, 2015

A worker separates coffee cherries in Brazil. Specialty-coffee buyers 

are turning to unusual pricing plans, using alternative benchmarks, 

even directly investing in producer farms. 

PHOTO: PATRICIA MONTEIRO/BLOOMBERG NEWS

Consumer demand for better-tasting coffee is splitting the coffee market in two.

A growing number of coffee roasters that deal in small farm-produced and best-flavored coffees are leaving the traditional, and more volatile, futures market, which they say has become so disconnected from their business models that it is no longer useful to manage risk.

The rise in demand for specialty coffee, now one of every two cups in America, has upended the coffee market as producers are choosing to invest directly with farmers and take the investment risk alone rather than experience the sharp price volatility in the futures markets—traditionally used as a hedging tool against price fluctuations.

Traders worry that the cocoa market will follow suit as consumers increasingly demand highly specialized beans in their chocolate bars. Changing demands of consumers already upended the tiny frozen-concentrated orange-juice market, which had a huge decline in futures-market participation over the past decade with a consumer shift toward premium orange-juice varieties and away from processed foods.

The price of arabica-coffee futures has grown more volatile over the past few years, affected by everything from an extreme drought in Brazil, the world’s largest coffee producer, to sharp currency fluctuations and higher participation from speculators who rushed into commodities after the 2008 financial crisis. Arabica-coffee beans are considered better quality and better tasting.

Hedge funds and other speculators now represent 22% of bets in the coffee market, compared with 16% a year ago, according to data from the U.S. Commodity Futures Trading Commission. Merchants and producers who deal in coffee futures now make up 38% of the market, against 46% last year.

Producers such as Chuck Patton, owner of Bird Rock Coffee Roasters in San Diego, have extricated themselves from the exchanges in the past three to four years. When Mr. Patton started buying coffee in 2008, all of his purchases were hedged through the exchange; now just 10% to 20% of his coffee comes from brokers dealing in the futures market.

“The specialty-coffee market is really operating independently from the futures market,” Mr. Patton said. “Prices are lower in the futures market, and I’m paying the same to my direct trade farmers as I did last year. What we are basing all of our decisions on is quality first.”

Over the past three years, coffee has been the second-most-volatile commodity on the Bloomberg Commodity Index behind only natural gas. Buyers say using the coffee futures’ benchmark isn’t worth the risk of losing lucrative producers or quality when coffee futures rise or fall.

Specialty-coffee buyers instead are turning to unusual pricing plans to negotiate deals, using alternative benchmarks, and even directly investing in producer farms to ensure consistent quality and loyalty.

Wholesale coffee buyers benefit from these programs because consumers pay $5 more a pound on average for the privilege of drinking better-tasting coffee that comes with a story that connects them with the farmer, according to an Emory University analysis.

Specialty-coffee prices rose 12.5% year over year in the second quarter, to $21.94 a pound, according to the Specialty Coffee Retail Price Index. The most-active arabica-coffee contract on the ICE Futures U.S. exchange fell 24% to $1.324 a pound over that period; it settled Thursday at $1.2425 a pound.

The Intercontinental Exchange Inc., also known as ICE, owns and operates 23 regulated exchanges and marketplaces including futures exchanges in the U.S., Canada and Europe.

The specialty-coffee market disconnect from the futures market has led to the creation of new benchmarks to determine how much a farmer should be paid. Peter Roberts, academic director of the Social Enterprise program at Emory University Goizueta Business School, developed an index that tracks 60 “blue chip” coffee brands in an attempt to bring transparency to growers and buyers working outside the futures market.

Agreements between farmers and roasters are often based on an email or a handshake. Other growers and buyers are using benchmarks based on taste and quality to begin negotiations.

To be sure, coffee-market watchers say they don’t see exchange-traded coffee going away. The number of outstanding contracts in the coffee-futures market is up 56% since 2006 as more coffee is consumed in the world.

While big brands such as Dunkin’ Donuts have recently begun testing coffees from more select origins such as Guatemala and Colombia, futures prices remain essential in order to execute the kind of large-scale purchases, and hedging, necessary to cover their needs.

Chris Fuqua, vice president of marketing and global consumer insight for Dunkin’ Donuts, said the large company doesn’t see a place for small-batch coffees that differ in availability from franchisee to franchisee.

Still, more and more premium grades are trading at prices that don’t change based on what is happening on the exchanges, says Carlos Mera, senior commodity analyst at Rabobank Group in London.

At the same time, long-term price agreements are becoming more common, said Stephen Vick, coffee buyer at Blue Bottle Coffee in Oakland, Calif.

“Every origin is completely different. The needs of that origin are different,” Mr. Vick said. “A lot of times, it’s a matter of finding the farms first and figuring out the supply chain later.”

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Write to Julie Wernau at Julie.Wernau@wsj.com