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Coffee Trading / Hedging


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Coffee Trading / Hedging

  1. 1. Coffee Trading & Hedging Basics David Joelson iRely LLC
  2. 2. Purpose: Improve our Customer Understanding <ul><li>Provide General Background on Coffee Supply Chain </li></ul><ul><li>Articulate keys to trader success to put system capability into business context </li></ul><ul><ul><li>Distinguish between traditional commercial traders and specialty </li></ul></ul><ul><li>Explain trading & hedging process in detail to improve </li></ul><ul><ul><li>Futures Market Definition </li></ul></ul><ul><ul><li>P&L and Cash Implications </li></ul></ul><ul><ul><li>Basic Hedging & differential trading </li></ul></ul><ul><ul><li>Hedge “rolling” </li></ul></ul>
  3. 3. Contents <ul><li>Coffee Trading Basics </li></ul><ul><ul><li>Coffee Supply Chain Overview </li></ul></ul><ul><ul><li>Supply Chain Transactions </li></ul></ul><ul><ul><ul><li>Commercial </li></ul></ul></ul><ul><ul><ul><li>Specialty </li></ul></ul></ul><ul><ul><li>Summarize: Keys to success in trading </li></ul></ul><ul><li>Futures Market </li></ul><ul><ul><li>General Concept </li></ul></ul><ul><ul><li>Simple Transaction – P&L and Cash Implications </li></ul></ul><ul><ul><li>Hedging Examples for Traders </li></ul></ul><ul><ul><li>Price Fixing Techniques with suppliers/customers </li></ul></ul><ul><ul><li>“ So you want to be a Trader” Quiz </li></ul></ul><ul><li>Market Structure and Hedge Rollover </li></ul><ul><ul><li>Normal and Inverted Markets </li></ul></ul><ul><ul><li>Using the ‘Carry’ – example & results </li></ul></ul><ul><li>Appendix: Aligning Contract Months to Futures Months </li></ul>Confidential
  4. 4. Coffee Trading Basics Supply Chain Overview Commercial Transactions Specialty Transactions
  5. 5. Coffee Supply Chain Overview <ul><li>Producers grow the coffee cherry </li></ul><ul><ul><li>Mills process the cherry to final (pre-roasted) form called “green coffee” </li></ul></ul><ul><ul><li>In origin, coffee can be traded in-between state of dry cherry or pergamino </li></ul></ul><ul><ul><li>Mills can be owned by farmer cooperatives, exporters, or independent operators </li></ul></ul><ul><li>Exporters mill, sort, blend, transport, register, and otherwise prepare coffee for export </li></ul><ul><li>Importers typically pay exporters when coffee is on ship and perform logistics (importing, delivery) </li></ul><ul><li>Roasters buy from importers on various terms, roast and blend the coffees and sell </li></ul><ul><ul><li>Some roasters buy direct from origin “FOB” </li></ul></ul><ul><ul><li>Some large roasters have their own trading arms </li></ul></ul>
  6. 6. Typical Large Commercial Transaction <ul><li>Jan 1: Large roaster buys 3,000 bags/month Brazil Arabica from Importer/supplier, July – December Delivery, of well known standard quality </li></ul><ul><li>March 1: Importer buys June ship Coffee FOB Brazil from exporter to meet first delivery, expecting 2 cents/lb profit if nothing goes wrong </li></ul><ul><ul><li>By June, exporter (supplier) puts 3,000 bags into 10 containers and ships. </li></ul></ul><ul><ul><li>Bill of Lading sent to importer who pays exporter (coffee still afloat), or perhaps his bank pays </li></ul></ul><ul><ul><li>Importer makes customs/FDA entry, pays ocean freight, and moves coffee off pier to a warehouse. Returns container. </li></ul></ul><ul><ul><li>July: Importer sends 10 samples (1 per can) to roaster who approves quality </li></ul></ul><ul><ul><li>Importer issues Delivery Order (DO) transferring ownership to customer (also physically delivers goods at the same time) and invoices roaster </li></ul></ul><ul><li>Roaster confirms weights & quality, can file claim </li></ul><ul><li>Profit on transaction: $8,000 </li></ul>
  7. 7. Challenges for Commercial Traders <ul><li>Knowing total risk position – can be multi-location operation including origin exporting </li></ul><ul><li>Understanding the price-value relationship for all customers </li></ul><ul><li>Managing costs on razor-thin margins </li></ul><ul><ul><li>Fierce competition on price </li></ul></ul><ul><li>Managing large hedge position in volatile markets (cash) </li></ul><ul><li>Efficient use of credit: turning over lines of credit & extracting maximum profit from use of lines </li></ul><ul><li>Placating suppliers without taking huge risk </li></ul><ul><ul><li>Pressure to pre-finance </li></ul></ul><ul><ul><li>Price fixation terms </li></ul></ul><ul><li>Large customers drive unique terms </li></ul>
  8. 8. Typical Specialty Coffee Transaction <ul><li>Importer travels to remote area of Malawi & finds 72 bags bird friendly, Utz Kapeh certified Fair Trade Organic coffee w/winey, slightly nutty flavor and the aroma of dried marigolds </li></ul><ul><ul><li>Pays $2.00/lb and contributes another 20 cents/lb to build a school in the village </li></ul></ul><ul><ul><li>Fair Trade organization collects 10 cents/lb for their trouble </li></ul></ul><ul><ul><li>Exporter is engaged for logistics and also sends pre-shipment sample back to importer. Cost to deliver to US, 10 cents/lb </li></ul></ul><ul><li>Importer places in warehouse in US, shares samples w/his customers, and sells for $3.50/lb, 3 bags at a time </li></ul><ul><ul><li>Issues delivery order to customer combining these 3 bags with 8 other types of coffee to make one half-container delivery </li></ul></ul><ul><ul><li>Cut invoice </li></ul></ul><ul><ul><li>Repeat process 25 times/day. </li></ul></ul><ul><ul><li>Often sales will cover multiple months (25 bags July-Dec) with actual deliveries as called for by the customer </li></ul></ul><ul><li>Profit on 72 bags Malawi: $10,000 </li></ul>
  9. 9. Challenges for Specialty Coffee Importers <ul><li>Low physical volume, high transactional load </li></ul><ul><ul><li>Each sales contract is likely have multiple qualities, prices, amounts; delivered and invoiced in multiple shipments </li></ul></ul><ul><li>Sample management – pre-shipment, on arrival, offerings to potential customers </li></ul><ul><li>Tracking inventory: what’s on hand, how much committed </li></ul><ul><ul><li>Are customers taking the coffee as committed? </li></ul></ul><ul><ul><li>What if another customer wants the coffee today? </li></ul></ul><ul><li>Efficient use of credit </li></ul><ul><ul><li>Do customers pay on time? Strain on importer’s financing capability </li></ul></ul><ul><li>Supplier delivery performance </li></ul><ul><ul><li>Often many customers impacted if one shipment is late </li></ul></ul><ul><ul><li>If quality is off there may be no other coffee to replace </li></ul></ul><ul><li>Risk position – adding up so many transactions into a coherent overall view </li></ul><ul><ul><li>Suppliers may want to buy price to be fixed but in very small (sub-lot) quantities </li></ul></ul>
  10. 10. In General: Keys to Trader Success <ul><li>Quality Management : understand customers & suppliers </li></ul><ul><ul><li>Sample tracking </li></ul></ul><ul><li>Cost Management </li></ul><ul><ul><li>Incorporate estimates into selling price </li></ul></ul><ul><ul><li>Track actual costs versus estimates </li></ul></ul><ul><ul><li>Costs vary by lane and also by customer </li></ul></ul><ul><li>Logistics Execution </li></ul><ul><ul><li>Exception reporting </li></ul></ul><ul><li>Risk Management </li></ul><ul><ul><li>Market exposure (reports and mark to market) – real time </li></ul></ul><ul><ul><li>Physical coffee exposure (reports) </li></ul></ul><ul><ul><li>Business Practices to minimize counterparty risk </li></ul></ul><ul><ul><ul><li>Fixation policy for suppliers and customers </li></ul></ul></ul><ul><ul><ul><li>Mark to market by counterparty </li></ul></ul></ul><ul><ul><ul><li>Hedge rolling against inventory </li></ul></ul></ul>
  11. 11. Futures Markets
  12. 12. Commodity Futures Market: ICE Coffee <ul><li>A futures market is an exchange where standardized futures contracts are traded for settlement on various (future) dates </li></ul><ul><li>Standardized contract terms include (ICE Coffee Market in this example): </li></ul><ul><ul><li>Size of each “lot” traded (37,500 lbs of coffee) </li></ul></ul><ul><ul><li>Quality specs (prime washed Arabica coffee….typically from Central America) </li></ul></ul><ul><ul><li>Terms (Delivered in store to an exchange certified warehouse) </li></ul></ul><ul><li>The price traded on futures market reflects the contract terms </li></ul><ul><ul><li>On each futures trade, participants only have to indicate who is buyer / seller, quantity, delivery month, and price. All other “terms” are defined by the standard exchange contract. </li></ul></ul><ul><ul><li>Commercial contracts for coffee may have a different price than the futures price to reflect differences in terms or risk vs. the exchange standardized contract </li></ul></ul><ul><li>The market reflects the actual value of the commodity because each seller (“short”) has the option to deliver physical coffee in compliance with the contract. </li></ul><ul><ul><li>The end of each futures month has a “delivery period” reserved for this function </li></ul></ul><ul><ul><li>Every “short” must either buy back the position or delivery coffee to exchange </li></ul></ul><ul><ul><li>For every short position, there is a long position…so when a trader with a short position delivers coffee to the exchange, a trader with a long position is notified by the exchange and must buy that coffee </li></ul></ul>
  13. 13. Transaction Example <ul><li>Buy 1 lot of Coffee May Futures at 130.00 US Cts per Lb </li></ul><ul><li>Sell 1 lot of Coffee May Futures at 131.00 US Cts per Lb </li></ul><ul><li>Profit = 37,500 Lbs x 1 Cent/Lb = $375 (less commission) </li></ul>Cash Implications <ul><li>When I buy (or sell) 1 lot, my broker will require initial margin. For example, $2,000 per lot </li></ul><ul><li>My broker is protected in case the market moves against me* by $2000/$375 = 5.33 cents </li></ul><ul><li>If the market moves against me, I will be required to post additional margin (“Variation Margin”). Typically, variation margin in coffee will equal $375/lot/penny move. </li></ul><ul><li>If the market moves for me, then broker pays me cash </li></ul><ul><li>*If I am long, market up is good and market down is bad. If I am short, market up is bad and market down is good </li></ul>Illustrative
  14. 14. Hedging Can Cost Money <ul><li>Coffee trader has 100,000 69 KG bags in Inventory </li></ul><ul><ul><li>100,000 x 69 x 2.2046 = 15.2 Million lbs </li></ul></ul><ul><li>These are hedged with a short futures position </li></ul><ul><ul><li>15.2 million lbs / 37,500 lbs per lot = 406 lots </li></ul></ul><ul><li>If there is a frost in Brazil and the market goes from $1.30/lb to $2.50/lb, how much variation margin will be required to finance the hedge? </li></ul><ul><ul><li>Market up 120 cents/lb </li></ul></ul><ul><ul><li>Each cent/lb is $375/lot </li></ul></ul><ul><ul><li>Margin call = 406 lots x 120 cents x $375/cent = $18.3 Million </li></ul></ul>Note that this money all comes back when the coffee is sold at high prices based on $2.50 futures. But in the meantime, trader must finance the margin calls.
  15. 15. Hedging Example: Buy fixed price and Sell Price to Be Fixed <ul><li>Importer Buys 550 69-KG bags (83,665 Lbs) Guatemala Strictly Hard Bean Washed Arabica coffee April shipment for $1.50/Lb FOB when ICE May Futures are at $1.30 </li></ul><ul><ul><li>Sells 2 lots May at 1.30. Therefore, he “owns” the coffee at +20 Cent premium to futures. </li></ul></ul><ul><ul><li>His cost to move coffee to Europe is 7 Cents/Lb, where he hopes to sell for +35 cents to make an 8 Cent profit. </li></ul></ul><ul><ul><li>This coffee is of much higher quality than prime washed coffee, so it should sell for a substantial premium to futures prices </li></ul></ul><ul><li>Importer then sells coffee to a customer for May Delivery at +35 Cents differential versus May futures. </li></ul><ul><li>When May futures drop to 1.00/Lb, customer calls and fixes price at $1.35/Lb (100 + 35). Importer buys back 2 futures lots at 1.00. </li></ul><ul><li>Results of this transaction? </li></ul>
  16. 16. Hedge Example Results (Market dropped to 1.00)
  17. 17. Discussion <ul><li>Why did trader have to hedge his purchase? What would have happened had he not hedged? </li></ul><ul><li>In previous example: </li></ul><ul><ul><li>Bought at + 20 Cts/Lb, Costs were 7 Cts/Lb so total cost = 27 Cts/Lb </li></ul></ul><ul><ul><li>Sold for + 35 Cts/Lb </li></ul></ul><ul><ul><li>But profit was only 5 Cts/Lb, not 8 Cts/Lb. Why? </li></ul></ul><ul><li>Instead of going down, what if market went up? Where is profit and where is loss (physical coffee and futures)? </li></ul><ul><li>(See next slide for illustration of same transactions except market went higher to $1.50 instead of lower to $1.00) </li></ul>
  18. 18. Hedge Example Results (Market up to 1.50) In this case, the gain is on the physical side and the loss in the futures hedge. Because the transaction is underhedged, the total profit is higher, 10.1 Cents per Lb
  19. 19. Discussion – “Market Up” Scenario <ul><li>What if exporter fails to ship the coffee to the importer </li></ul><ul><ul><li>Why might exporter fail to ship? </li></ul></ul><ul><ul><li>What situation does the importer face now? </li></ul></ul><ul><li>How can the importer protect himself from this? </li></ul>
  20. 20. Price Fixing Techniques <ul><li>Price fixation – finalizing the price of a differential contract by applying futures market price </li></ul><ul><li>“ AA” (Against Actuals) Process </li></ul><ul><li>Roaster buys futures in his own account </li></ul><ul><li>Roaster transfers futures to importer’s account by in effect selling the futures from own account to supplier’s </li></ul><ul><li>Final price will be futures price transferred to importer (plus differential) </li></ul><ul><li>AA price is supposed to be set within range of the day’s market to avoid putting a heavy margin call on seller. It does not have to equal the price paid originally by roaster (difference = gain / loss in roasters account </li></ul><ul><li>Opposite process can occur with exporter…Exporter sells futures in his own account and then importer ‘buys’ them via AA to fix price </li></ul><ul><li>Direct Fixation Process </li></ul><ul><li>Roaster calls importer and instructs him to the Buy the market to fix the contract price </li></ul><ul><li>Exporter calls importer and instructs him to Sell the market to fix his contract price </li></ul>
  21. 21. Quiz: So you want to be a trader <ul><li>You have coffee in inventory, how do you hedge it? </li></ul><ul><ul><li>Buy or Sell Futures? </li></ul></ul><ul><ul><li>How would you calculate number of futures lots? </li></ul></ul><ul><li>How would you know what price to sell the inventory to achieve desired profit objective? </li></ul><ul><ul><li>Assume you own Colombian Coffee in the warehouse at $1.50/lb, with short hedge set at 1.25/Lb </li></ul></ul><ul><ul><li>Assume market is at 1.40 and you want to make a 5 Cent profit </li></ul></ul><ul><ul><li>Customer wants fixed price quote – what should you quote? </li></ul></ul><ul><ul><li>Customer wants differential price quote – what should you quote? </li></ul></ul><ul><ul><ul><li>(assume no additional costs to deliver coffee to this customer) </li></ul></ul></ul><ul><li>What action is required if: </li></ul><ul><ul><li>Customer accepts fixed price quote </li></ul></ul><ul><ul><li>Customer accepts differential price quote </li></ul></ul>
  22. 22. Trader Answers <ul><li>You have coffee in inventory, how do you hedge it? </li></ul><ul><ul><li>Buy or Sell Futures? SELL </li></ul></ul><ul><ul><li>How to calculate number of futures lots? # Lbs to be hedged divided by 37,500 Lbs (NY ICE). For Robusta, divide by 10 Metric Tons (London) </li></ul></ul><ul><li>How would you know what price to sell the inventory to achieve desired profit objective? </li></ul><ul><ul><li>Assume you own Colombian Coffee in the warehouse at $1.50/lb, with short hedge set at 1.25/Lb </li></ul></ul><ul><ul><li>Assume market is at 1.40 and you want to make a 5 Cent profit </li></ul></ul><ul><ul><li>Customer wants fixed price quote – what should you quote? $1.70/Lb </li></ul></ul><ul><ul><li>Customer wants differential price quote – what should you quote? +30 </li></ul></ul><ul><ul><ul><li>(assume no additional costs to deliver coffee to this customer) </li></ul></ul></ul><ul><li>What action is required if: </li></ul><ul><ul><li>Customer accepts fixed price quote Buy futures at 1.40 </li></ul></ul><ul><ul><li>Customer accepts differential price quote None </li></ul></ul>
  23. 23. Market Structure and Hedge Rolling
  24. 24. Market Structure <ul><li>Other than extreme market moves which can create ruinous margin calls, when it comes to futures markets, traders mostly care about the market structure, that is, the difference in value between the various futures months </li></ul><ul><li>In a Normal market, further-out futures months are priced higher than nearby months. This is generally a good situation for a commodity importer or trader. </li></ul><ul><li>In an Inverted market, the nearby months are priced higher. This is generally a dangerous situation for a commodity importer or trader. </li></ul><ul><li>Why? </li></ul>
  25. 25. Normal Market pays the Trader to Carry the Commodity <ul><li>Trader buys 1 May future at 133 and simultaneously sells 1 July future at 134.70 </li></ul><ul><li>In early May, he is notified by the exchange that he owns one lot of coffee for 133 </li></ul><ul><ul><li>His May long futures position has been replaced by actual coffee </li></ul></ul><ul><ul><li>He is still short July at 134.70 Cts/lb </li></ul></ul><ul><li>He tries to sell the coffee to a customer for more than 134.70 </li></ul><ul><li>If unsuccessful, he delivers the coffee to the exchange in late June for 134.70 </li></ul><ul><li>His profit (134.70 – 133 = 1.7 Cents per Lb) compensates for the cost to hold the coffee for two months…financing, insurance, and storage charges. </li></ul>
  26. 26. Inverted Market = Trouble for Traders <ul><li>What if you tried the “carry” tactic in the Sugar Market? </li></ul><ul><li>What is the market telling you about the availability of sugar? If you have sugar, what should you do with it? </li></ul>
  27. 27. Using the Carry for non-Exchange Coffee <ul><li>Most coffee is not exchange certified, but is still hedged on the NY ICE (Arabica) or the London (Robusta) exchanges </li></ul><ul><li>Typical Transaction: </li></ul><ul><li>Buy 250 69 KG bags Coffee FOB Feb Shipment for 1.50 </li></ul><ul><ul><li>Cost to import is 6 Cents, so total cost = 1.56 </li></ul></ul><ul><ul><li>Hedge by Selling 1 March at 1.30, so cost = +26 </li></ul></ul><ul><ul><ul><li>Before March “notice period,” traders “rolls” the short hedge to May </li></ul></ul></ul><ul><ul><ul><ul><li>Buy 1 March at 140 and Sell 1 May at 142 (2 Cents) </li></ul></ul></ul></ul><ul><ul><ul><li>Physical Market is saturated and spreads between months widen, so trader rolls hedge again all the way out to December </li></ul></ul></ul><ul><ul><ul><ul><li>Buy 1 May at 150 and sell 1 December at 159 (9 cents) </li></ul></ul></ul></ul><ul><ul><li>Finally, trader sells coffee for October delivery at Dec + 30 </li></ul></ul><ul><ul><li>Customer fixes price via AA and transfers Dec future to importers account at 142 (so final sale price is 142 + 30 = 172) </li></ul></ul><ul><ul><li>Dealer’s cost to carry the coffee since it arrived in March until October was 7 cents/Lb (storage, financing, insurance) </li></ul></ul><ul><li>OK Class – how much money did the importer make on this transaction? </li></ul>
  28. 28. Carry & Rollover Results – Trader’s View <ul><li>Cost of coffee </li></ul><ul><ul><li>Coffee price FOB + 20 Cts/Lb (over March futures) </li></ul></ul><ul><ul><li>Cost to import + 6 (ocean freight etc) </li></ul></ul><ul><ul><li>Cost to carry + 7 (storage, financing, insurance) </li></ul></ul><ul><ul><li>Total Cost +33 </li></ul></ul><ul><li>Switch gain </li></ul><ul><ul><li>March to May + 2 </li></ul></ul><ul><ul><li>May to Dec + 9 </li></ul></ul><ul><ul><li>Total Switch +11 </li></ul></ul><ul><li>Sale +30 (over December futures) </li></ul><ul><li>Profit + 8 Cts/Lb (30 + 11 – 33) </li></ul>Note that half of the profit came from the generous switch trades of 11 cents which exceeded the cost of carry (7 cents) by 4 cents. This is partly true because trader was able to sell coffee in October against December futures and avoided two additional months that he might have had to carry the coffee
  29. 29. Carry & Rollover Results – Accountant’s View
  30. 30. Appendix: Align ICE Futures Months to Contracts Price to be fixed contracts will generally be priced against the futures month per the above schedule. December Dec Delivery March December Shipment December Nov Delivery December November Shipment December Oct Delivery December October Shipment September Sept Delivery December September Shipment September August Delivery September August Shipment July July Delivery September July Shipment July June Delivery `July June Shipment May May Delivery July May Shipment May April Delivery May April Shipment March March Delivery May March Shipment March Feb Delivery March Feb Shipment March Jan Delivery March Jan Shipment Futures Month Contract Month & Position Futures Month Contract Month & Position