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No Longer an Exclusive Rich-Boy Game? :

An Analysis of the Potential Small Scale Coffee Producers to Manage Risk Using Futures and Options on Commodities Markets


by O.Rose-Del Adewebi
 

 

The Wall Street Journal, Boston Globe , and the Economist as well as many other media outlets of record were all in  consensus when they declared the onset of coffee crisis in October 2001; farmgate prices had sharply dropped reaching a thirty-year low of $0.39 per pound in This price was below the cost of coffee production at the time, listed at USD 0.60 per pound.(Economist 2001) Price declines are not such an uncommon occurrence, but what is more troubling is that the cash market for coffee suffers from high price volatility. For a more detailed look please see Appendix 1: Cash Price Variation.   Coffee producers , who are mainly located in developing countries , are highly vulnerable to price risk in the cash market , yet their profits in relation to their risk exposure has been steadily declining.  In a 2001 study conducted by the European Fair Trade Association (EFTA)- an organization that promotes the sale of products that ensure price security for marginalized commodity producers- the general finding was a declining share of trade revenues from coffee remained in the coffee producing countries. Although the international coffee market has grown from $30 billion annually in the 1980s to $55 billion in 2001, in aggregate coffee producers have seen their share drop from $10 billion to $7 billion in 2001 (Renkema 59).

From the perspective of the small producer, their received cash prices  have not always been this volatile and had been stable up until 1989 ;although the data does not fully support this. Please see Appendix 2) Measures of Volatility.  A price regime devised in 1962 by the International Coffee Association setup an agreement between coffee producing countries and coffee consuming countries. Its aims were to stabilize the market and provide a minimum price of coffee to cover the cost of production. The main mechanism for price stabilization was an export quota  system that was distributed among its members. The results of the ICA can be called mixed at best, at worst unsuccessful according to existing price data.  At best, the ICA managed to guarantee a minimum price but because not all coffee producing and coffee consuming countries were members of the regime a dual market developed. Eastern European and Middle Eastern countries were able to import coffee cheaply and under the price floor set by the ICA, especially by importing from newer country producers who were not party to the agreement. 

 

In order to maintain the price floor, the ICA managed to recruit the newer producers as members, but it still wanted to maintain the same level of export restraint. So that this aim could be achieved ICA architects proposed a redistribution of the quota among its members. Naturally those producer countries who had been exporting in the international market for a long time objected to sharing their quota with newer members. This issue as well as producer country-consumer country debate strained the agreement and led to its disintegration on July 4th, 1989.  As a result producer countries rushed to export all of the stocks they had held for so long so that they could take advantage of the still high cash prices. This rush placed downward pressure on the cash market prices leading to a crash in 1992. Soon after boom- bust cycles prevailed in the market (Appendix 1a: Cash Prices 1982-2001). An attempt to reverse the downward trend by resorting to export quotas was established by the Association of Coffee Producing Countries (ACPC) in 1993, yet it has been largely unsuccessful, barring the price spike occurring in 1997 due to coordinated export restraints.

Since the fall of the ICA, coordinated attempts to establish price stabilization regimes have been largely unsuccessful and there has been a general move away from such attempts as market and trade liberalization have become top items on the world agenda. Yet for small-scale farmers and producer countries whose export revenue is highly dependent on coffee . Price uncertainty presents them with severe constraints. On the local microeconomic level, high prices are an incentive for producers to plant new coffee trees and maintain existing ones. When the plants mature the increased supply sold works to push prices down. Low prices serve as a disincentive for plant maintenance and, subsequently,  the quality of exported coffee beans. On the macroeconmic level, countries with a high dependence on coffee suffer from fluctuations in their national incomes ,which serve to limit financing of education, social services, debt, etc. Additionally, it is believed that the national income fluctuations that cause price uncertainty are strongly and negatively correlated with investment (Claessens 6). Put together these factors serve to hinder economic growth.

 

            Given the facts that farmers are facing the lowest cash prices in twenty-years, price uncertainty , and price stabilization regimes are ineffective in curbing this volatility what can be done? Recently there has been a strong movement toward the use of financial derivatives in the coffee sector  in order to mitigate these risks. The question this paper poses is: can small-scale[1] farmers/producers directly use futures and options to reduce their risk exposure effectively? . The initial position that this paper takes is no, due to the following reasons


[1] Small-scale producers are defined as those with land plots of 25-100 acres.

Economies of Scale and Underepresentation: Futures whose underlying asset is coffee and options on futures are traded on the Coffee, Cocoa, & Sugar Exchange(CSCE) in New York’s Board of Trade(NYBOT) as well as the London International Financial Futures Exchange( LIFFE). The standard size of contracts on these exchanges is 37,500lbs. On average, the production of small -scale farmers ranges from 2000 lbs to 6000 lbs. per year. Additionally the financial derivatives trading market is dominated by eight large trading companies: Neumann Kaffee (Germany), Volcafé(Switzerland), Cargill (United States) and ED&F Man (United Kingdom) and Mitsubishi (Japan), Dreyfus (France), Aron (United States) and Esteve (Brazil/ Switzerland) (Renkema 60). Note that only one producing country ,Brazil, is represented. Together these firms have a market share of 56% (Renkema 61). Small producers are no match for these firms with large capital stocks and instant access to market information

Inadequate Access to Information:  Small-scale producers often are located in rural areas of the country, which often lack basic infrastructure that leads to market access. For example, in a 1994 study published in The New York Times  it was stated that within the main coffee growing region of Oaxaca, Mexico the number of telephone lines per 1,000 persons was 8.2. Access to clean water for the region was 14%. On the other hand the figures for all of Mexico was 26.6 lines per person, and 38% respectively (Hasnath).   As a result of this lack of infrastructure farmers are often dependent on middlemen to bring their product to the nearest port by vehicle. The middlemen usually pay the producer less than the going market rate in order to provide the transport service. This price is often arbitrarily set (UNCTAD Secretariat 29). Because the producer is so isolated from the market in which his goods are traded, he lacks the information to negotiate better prices. Successful hedging strategies require a sound knowledge of what Joost Pennings coins as

technical knowledge: prices, return ratios, transaction volumes, risk exposure, historical trends in basis and market volatility(10).  It is unlikely that that small -scale farmers in areas lacking infrastructure conducive to information transfer will access this knowledge.

 

 Lack of Credit and Market Access: The low production levels of the small-scale producer results in low liquidity which subsequently hinders their access to credit from traditional financial intermediaries. As a result they are vulnerable to predatory lending composed of higher than average interest rates as well as highly collateralized loans. The required margins for futures and required options premia may be prohibitive. For example, if a small-producer wants to trade futures he must pay a $2,800 initial margin and later a $1,110 maintenance margin; a total of $3,910 (NYBOT.org). As of October 25, 2002, producers of the El Milagro cooperative in La Libertad, El Salvador received $0.54/lb. Their anticipated production for the year is 15,000 lbs resulting in $8100 of revenue.(Ascencio). Paying the initial and maintenance margins would constitute 48% of the cooperative’s earnings. While the subsequent gains of using financial derivatives may outweigh the costs, it appears that initial costs may be too high.

 

CRITERIA FOR CASE STUDY EVALUATION

In order to evaluate the validity of the previous arguments and hypothesis, two case studies: Guatemala and Costa Rica   will be analyzed according to the criteria listed later in this section . At the end of each case study the effectiveness of the hedging scheme will be assigned a number between 1 and 5 (1 being the least effective , 5 the most). This number will be a result of the average of the scores assigned to each criteria. The conclusion section of the paper will constitute of an evaluation of the previous hypothesis.

EVALUATION CRITERIA:

§       Feasiblity: Is the scheme realistic for the producers/ farmers to use? Are the issues of prohibitive financing addressed by aid or credit? Did the scheme meet the producer’s specific needs (time preferences ,choice criteria, risk preferences)

§       Information Dissemination:  Did the farmers/producers  receive an adequate amount of technical information ,and did they understand the information and how to use it?

§       Level of Participation: Was the farmer/producer directly involved in the trading? If the trading was handled by a trading company, intermediary or government, how much input did the producer provide with regard his specific needs?

§       Level of Benefit:  Was the producer able to achieve higher utility and/or less uncertainty through risk reduction?

 

CASE STUDIES:

GUATEMALA: HEDGED COFFEE LOAN PROGRAM

Guatemala’s coffee industry plays a prominent role in the economy. It accounts for 30% of the country’s employment as well as represents 30% of Guatemala’s exports (World Bank 44). The volatility of the cash market has serious repercussions for the economy due to the uncertainty in national income. Moreover , the volatility of the market produces the microeconomic disturbances discussed on page 2; small-scale Guatemalan producers are unable to access stable forms of credit nor can they establish effective planning programs.

As a response to the problems facing the producers, a non-profit organization named ANACAFE (Spanish acronym for National Association of Coffee), began the Hedged Coffee Loan Program in 1994. Approximately 60,000 producers from all parts of the country participate in this program , and by law all coffee producers have some inherent association(World Bank 44).  At its inception, the program addressed the immediate financing needs of farmers who suffered the most from the price crashes resulting from an oversupply in 1992/93. Prior to the fall of the ICA, the Guatemalan government had actively participated in a domestic subsidy program in order to establish a minimum price.

 

ANACAFE has since evolved into the premier intermediary and provider of information between producers and financial markets by providing specific technical advice regarding: farm production potential , credit opportunities,  costs and break-even analysis. ANACAFE has also managed to improve the information infrastructure surrounding the producers via cellular phone and country –wide interconnected computer terminals. The result is that a producer can receive real time market information in ANACAFE’s offices.

The most important ANACAFE program that ANACAFE administers is the Hedged Loan Program, which requires that a producer obtain a hedge contract before receiving loan. The average loan size is $20,000 and the typical hedging instrument used is a forward contract with an exporter. The rationale behind this requirement is to ensure the repayment of the loan even if cash prices decline. Producers also have the option of purchasing options from the exporter. Subsequently, the exporter sells futures or purchases options traded on NYBOT’s Coffee C Contract, to hedge against the possibility that the producer does not deliver the coffee.  On the delivery date, the exporter deducts the option premium from what is paid to the producer. Although, ANACAFE connects the producer and exporter with sources of financings, it does not participate in hedging transactions. This is a function left to larger trading companies such as ED&F Man or Volcafé. ANACAFE does charge a 1% servicing fee which is funneled back into research and development.

The World Bank, deems the program as successful as it has saved farmer/producers $2 million dollars in interest (World Bank 44) as well as has served to connect marginalized produce with the market in which they sell their goods.

 The evaluation with regard to the criteria established earlier in this paper is as follows:

 

Feasibility: 3 – The scheme is quite simple and financing is provided to producers so that the costs associated with hedging are not prohibitive. Yet, the issue of client-specific needs is not addressed fully, as it is really up to the exporter to offer hedging contracts to the producer. While timing of the contract can be negotiated, appears that the exporter has more power in the relationship as the producer is obligated to provide the exporter with supply according to the terms of the loan , but the exporter simply loses his reputation and association with the ANACAFE network if he does not fulfill the terms of the contract. It is more likely that the exporter would have better access to credit and markets than the producer, so the possible severing of this link would not have such disastrous effects for exporter. Yet the producer would suffer greatly.

Information Dissemination: 3.5 :  While the extensive telecommunications networks for real-time information mitigates the problem of geographical isolation and lack of infrastructure, the smallest and most marginalized producers are not cognizant of ANACAFE and its programs. According to the World Bank, the Hedged Loan Program serves the needs of medium-scale producers and cooperatives with several credit options the best.

Level of Participation: 2: An asymmetrical trading relationship exists between the producer and exporter as described in the feasibility section. A specialized trading firm handles the majority of the hedging transactions. Other than buying options , the producer has little direct participation.

Level of Benefit: 5:  Given the fact that small-scale producers are often subject to predatory lending, the aggregate interest savings of $2 million is one of the best aspects of this program.

Overall Score: 3.38 

 

COSTA RICA: ICAFE

Although the coffee sector does not employ as much of the population as it does in Guatemala, it still accounts for a significant portion of the economy. Coffee is the second most important export, accounting for 25% of export revenue (Economist 2001).

             In Costa Rica, the coffee sector is regulated by ICAFE (Spanish acronym for Costa Rican Coffee Institute) which is a government body. Producers/farmers do not sell their coffee directly on the market, rather all their coffee is sold to a mill- company which dries and packages the coffee beans- of their choice. ICAFE regulates the price of coffee sold in the domestic market by distributing a quota among the country’s 98 mills (Claessens 160). As for coffee for export, ICAFE contracts this task among 27 export firms who are given permission to buy from the mills  (Claessens 160). In addition to ratifying all export contracts, establishing quotas and regulating sales, ICAFE regulates profit margins. This role of ICAFE has significant implications for the risk each group (growers, millers and exporters) are exposed to.

            The hedging scheme in Costa Rica is delineated by the delivery date.  Each party in the trading chain – grower, miller, exporter faces certain risks before and after the delivery date. A producer and a given mill are connected by a general contract, which provides the producer an advance from the mill in exchange for a delivery commitment. This advance is usually granted at the beginning of the crop year (October). While this advance provides the producer with a minimum price floor, he still faces a large amount of risk because he does not know the possible price path that coffee could follow. When a producer delivers he receives a price determined by the following equation:

Pg  =   Pr – Cm -  α(Pr-Cm)  -  τp  ,

where Pg= grower price,  Pr=Price received by processing mill from the exporter , Cm = Processing cost per lb., α = percentage return to mills fixed by ICAFE, τp= tax on return administered by ICAFE (Claessens 163). So the initial advance serves as a buffer against a drop in coffee prices over the crop year, but because this initial advance is not as high as the possible price drop over the crop year.

            As for the millers, their risk frontier is minimized by the regulations placed by ICAFE. Yet the main risks that millers are exposed to are associated with the initial advance and the price they receive from the exporter, known as a precio riele  (Claessens 163).  ICAFE prohibits the mill from forcing the producer to repay the initial advance. If the advance is too high, above 30% of expected value of the coffee, there is a risk of return loss if sales do not cover the advance. Conversely, the miller could incur losses if the advance is too low because producers will choose to sell to millers with more competitive advances (Claessens 163). This catch is compounded further by the precio rieel,, which is not regulated ICAFE. Note that the mill return (α) is a function of the precio riel- processing costs, hence an increase in the advance , or an unfavorable exporter price will have negative effects on the miller’s return. In recent years millers have worked to mitigate this risk exposure by buying put options when they pay the producers (Claessens 168). The target strike price is that of the initial advance. If  market prices fall below the advance, the miller can exercise the option to establish a price floor.

                In Costa Rica the main beneficiaries from the use of hedging instruments have been the exporters, as a result of two main reasons. Primarily, the exporter faces a higher risk than the producer or the miller because they are not insulated from exchange rate or international market risk. Since the fall of the ICA in 1989 there has been no global price stabilization regime so the exporter is at the mercy of the market. Secondly, while the returns to the exporter are regulated by ICAFE, the exporter’s potential losses are not due to the lack of a global price regime. In this case the price received by the exporter from a foreign buyer is determined by the following equation: Pr =ePx* - β(ePx*-Cx)- eτx* where ePx*= the world price of coffee expressed in Costa Rican currency, colones, β(ePx*-Cx) is the miller’s return which is a function of the world price- the exporters costs and eτx = tax administered by ICAFE (Claessens 163). The largest exporter in Costa Rica (FEDECOOP), which accounts for 40% of Costa Rica’s coffee exports, has recently used futures transactions to mitigate its risk exposure. FEDECOOP has a long position in the physical market, takes the opposite position- selling futures- in order to offset losses in the physical market if the world price of coffee falls before FEDECOOP enters a contract with an overseas buyer (Claessens 168).

 

With regard to the criteria established earlier, the evaluation is as follows :

Feasibility: 3: Because the Costa Rican government’s regulations establish a structured vertical domestic market all participants are included. Yet the regulations do not necessarily reflect all of the participants’ utilities.

Information Dissemination: 1: Unlike ANACAFE’s network, ICAFE provides no market information. Rather the information provided is associated with possible returns. Because the returns of each participant are dependent on the world price of coffee and its path, a high amount of price uncertainty remains in the system. Moreover, millers and exporters are responsible for their risk management strategies.

 Level of Participation: 1: The only hedging option available to small producers is the initial advance allotted by the miller, which is dependent on the precio real and world prices. Hence the same asymmetry exists here as in the ANACAFE case. There is more room for the producer  exhibit  more control of the process if government controls are relaxed.

 Level of Benefit: 3: The results are mixed. ICAFE’s regulations insulate producers from the greater risks that would be endured if allowed to sell directly to the market, yet the amount of return that producers can realize in this system are highly dependent upon the risk management skill of those higher in the chain.

Overall Score: 2

 

CONCLUSIONS:

            The initial hypothesis established earlier in the paper is accepted but with major modifications.  Both cases received average scores , because neither presented an optimal solution for the small-scale farmer with regard to the criteria established- information dissemination, feasibility, level of participation and level of benefit.  In the ANACAFE model, a semblance of control for the small farmer was lacking. While in the ICAFE model, an overly asymmetric relationship among participants in the coffee market combined with minimal information dissemination left much to be desired. While two cases cannot be accurately representative of all the hedging schemes available for small-scale farmers, the previous case studies do provide two endpoints on a continuum within which many others can be placed. The ANACAFE case underscores the importance of intermediary participation ,and is an example of a grassroots hedging scheme while Costa Rica’s ICAFE presents a more bureaucratic model.  For any model to approach an optimal model, it should combine the best parts of government regulation and grassroots efforts.

            The major modifications introduced to the hypothesis are as follows:

§         While it is not evident that small-scale farmers can directly use hedging instruments to reduce risk exposure, small-scale farmers can benefit from hedging in aggregate, i.e. joining a cooperative. Cooperatives, especially those that receive support from non-governmental(NGO) and non-profit organizations, often have improved market access, several options for financing and established networks for technical information dissemination, can pool their resources to reduce the aspects that hinder individual producers. Additionally it is likely that an individual participant within the cooperative system would have a higher level of participation, as cooperatives are organized in a highly democratic manner.

§         No hedging scheme would be successful without an intermediary, such as ANACAFE, an NGO or a bank, playing a prominent role. As in the ANACAFE case, ANACAFE was instrumental in connecting marginalized farmers to markets as well as to sources of credit using its relationships with local banks. Additionally, intermediaries serve as essential providers of information dissemination to all participants which increases the success of any hedging strategy.

§         Finally, while the government has a role in sector-wide hedging models, it does not need to be to the extent that ICAFE exhibits. In this case the government is using a substantial amount of resources to maintain prices which may utilized more efficiently elsewhere. If  sector-wide hedging transactions are handled by larger trading companies, a need for regulations against monopoly exists, yet the government does not need to operate a monopoly.

APPENDIX 1: Figures of Volatility

   1a) Cash Price Volatility over a 19 year period 

   Data Source: International Coffee Organization-www.ico org 

 

 

WORKS CITED

Ascencio, Alfredo Rumaldo. Personal Interview. Chicago:  25 October 2002.

Claessens, Stijn and Duncan ,Ronald C. eds. Managing Commodity Price Risk in Developing Countries. “Robert J. Myers: Strategies for Managing Coffee Price Risks in Costa Rica.” Baltimore: John Hopkins University Press, 1993.

“Coffee Crisis Hits Home.” The Economist. 27 October 2001. 14-17.

Hasnath, Syed Abu. GG 331: Political Geography: Infrastructure in Development. Class Lecture. October 2001.

New York Board of Trade-NYBOT.[Online] Accessed 1 December 2002. <http://www.nybot.org>

Pennings, Joost M.E. Research in Agricultural Futures Markets: Past Present and Future.  Presentation Paper: Wageningen Agricultural University: Netherlands. 8 June 2001.

Renkema, David. (2001).” Chapter 4:Coffee:The Speculator’s Plaything” Fair Trade Yearbook..European Fair Trade Association: Amsterdam.

World Bank International Task Force on Commodity Risk Management in Developing Countries. “Dealing With Commodity Price Volatility In Developing Countries: A Proposal For A Market-Based Approach.” Discussion Paper for the Roundtable on Commodity Risk Management in Developing Countries. World Bank. Washington, DC: 24 September 1999.

United Nation Commission on Trade and Development (UNCTAD) Secretariat. “Farmers and Farmers Associations In Developing Countries And Their Use of Modern Financial Instruments. Geneva: 10 January 2002.

 

 

 

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