Hedging, The C-Market, and New Opportunities
The following is an edited transcript of Season 4, Episode 2. The opening of the podcast, when Mark revisits The Exchange #32 topic “From Hobby to Business,” has been removed to shorten the transcript, which has also been edited throughout for clarity.
Mark: I do think that there's part of this topic that can be applicable to smaller roasters as well, in both a positive and negative manner.
Todd: I mean, luck favors the prepared, let's say, right? So you have to sort of be, even if you don't find access to these tools in your current operations, you have to become fluent to kind of grow yourself in that direction. And beyond that, we actually will be announcing a new approach that we're going to be taking as a business, which is going to open these tools to what traditionally might not have been an accessible space in terms of volume. I think a lot of roasters, myself included in my experience prior to getting into the green world, I would have self-identified as someone who did not have access to this type of option, both literally and figuratively. I was roasting below a certain amount of coffee. And so, Covoya as a company, we are reorienting this side of our program to actually serve small to midsize roasters with options for price fixation and hedging that we'll talk about at less than container load volumes. And we'll get into that. And that's pretty exciting. So, so if you're a small to midsize roaster, don't tune out.
Mark: Tune in because there's going to be a surprise at the end that will benefit you greatly.
Todd: We're doing the thing. We're doing the thing and we want to break down the walls, as they say. So let's start with the question. What is a hedge, Mark? You're a seasoned investor beyond the coffee world. What is a hedge? How do you look at it? And then bring us to how you would describe to a new coffee buyer, what is out there in terms of a hedging strategy for, broadly speaking, someone who's in the coffee business?
Mark: Sure. You and I had a conversation a couple of days ago about how you talk about this with customers, and it was refreshing to hear that we somewhat approached the conversation in the exact same way. I always wonder how people talk about this, like how they pitch this idea. So I'll give you the pitch that I give people.
Coffee is priced using two factors. One is the market price at any given time, and that's constantly moving. And the other pricing is the differential price of whatever coffee you're talking about buying. So if you ask what is the price of UGQ Columbians today, you're going to get a differential price of a certain level. Now, if you wanted organic or if you wanted 84 plus or, you know, women's grown, those are going to be additions to the differential price to get you to a larger differential price. And so often you'll hear as, you know, if you're in the trade and I'm now speaking to midsize roasters, you'll hear this is plus 70 or plus 60 or whatever the number is. And people, if they're new, they'll just nod like they know what we're talking about. What we're saying is it's plus 60 cents in addition to the market price whenever you decide to pull the trigger. So, today the market was sitting around 1.90. Plus 60 would be a total price of 2.50 that we're offering this coffee to you. It's the combination of the two.
Most roasters assume, newer roasters, that those two prices are in tandem and they are locked in the minute you say yes. That's not the case. Those two prices can be locked in at different periods of time. And that's what truly hedging is about, using that the time lapse. In a perfect world, you want to buy when the market is low and when the differentials are low. That's rarely the case. They don't often stay low at the same period of time.
Todd: Yeah, because ultimately the original owner and seller of the coffee is paid outright. So if I'm selling coffee originally, if I'm the original owner of the coffee and I'm achieving an outright price and the market is very low, then relative to the market, the differential that I'm selling at would be high, right? Ideally. The arc of time would allow you to separate those two things and take advantage of the one being low counter to the other and vice versa. Hedging is drawing boundaries around risk. You can even apply the sort of visual of a hedgerow around a house. You have a border that limits space. So hedging as terminology is simply limiting or outlining risk and limiting its space. So we talk about this market, you've identified diffs and how they relate to this market, but what is it and why is anyone using it anyway? If the original coffee owner sells the coffee flat, and the final coffee buyer has to buy the coffee flat, what is the utility of this market in the middle? Why is it there and why does it get to dictate so much within the middle?
Mark: It doesn't have to if you want to deal with outright price coffee on both sides of the spectrum. In the purest sense, that is just supply and demand and what the market will bear. As a producer, if you can get somebody to agree to an outright price that covers your cost of production and some profit and future growth in a perfect world, I would leave that alone. The reality is that you're not living in a vacuum in this world. The rest of the world is operating in a very dynamic market that's moving around and it allows within that movement opportunities to either sell coffee at higher prices, if you're a seller, than you would normally ask or buy coffee at lower prices than you would normally be able to have access to and neither party is affected by that. They all are dealing with themselves in their own bubble. And so in a perfect world, you could have a relationship with a producer where they are selling coffee at a very high price and you are buying that coffee at a very low price and you're both getting your just desserts or having your cake and being able to eat it as well, if you understand the risks involved in playing that game.
Todd: Yeah. You cannot determine that that is the outcome, but in an ideal world that outcome is possible. Just today I was putting together three containers of business where the seller actually was able to sell us the coffee at a higher outright price than the buyer was obligated to buy it because of their respective fixations. And because of our hedge, which is effectively an equal but opposite interaction with the current holder of coffee future trade, which is the Intercontinental Exchange in New York City, we were able to recognize the appreciation of the future, counter but equal to the depreciation of the coffee in this case. Which is a little bit mind melting if I moved too quickly there.
So there is this intermediary market. We talk about the market, we talk about the C. That is a literal place. It is a literal market. Coffee has been traded in future form, the future obligation of taking delivery of coffee and or selling coffee and delivering has been something since 1882. The I.C.E., the Intercontinental Coffee exchange took over in 1986. Everything went digital as of 2000. This is something that's accessible to anyone. You can Google ICE coffee futures. You can see all of the details, the terminal months, current trading levels, etc. But the reason we do this is because it allows us exactly that, right? We, as the intermediary, can offer to the seller to choose the price, the moment they price their coffee against that market, the same but the opposite way that we allow the buyer to.
This is such a heady topic and I feel like we're already deeper and more jargony than is probably useful in lots of ways. So, so we're dialing in on hedge. We've talked about hedge as a strategy for limiting risk. We've talked about it as a border protecting the home. In this case, we're trying to draw a border around the amount of risk around coffee price. That risk to a seller is the risk of pricing decreasing, and for a buyer it is exactly counter, the risk is that price goes up. And so to what you were saying earlier, Mark, we can interact with a person one to one directly and have an outright price and buy outright if that supply chain is limited in scope and function. That can work and it can be that simple.
But often the nature of how the trade works is far more complicated. Even just adding the dimension of time to the equation adds a tremendous amount of risk as it relates to pricing. So one huge part of why the futures market exists is so that buyers and sellers can predict pricing into the future exactly as the namesake indicates. The tool is there. If I'm a roaster and I know that my total volume for an origin or a product is X amount, I can predict and use the instrument, like the future price fixation to limit the overall change in my price, and that's not for the whole price of the coffee because I have the futures portion, which in today's market, you said we're right around 1.90 today. So let's stay with that. If I have a $3 coffee total outright, about two thirds of that price is in the future and about one third is in the differential if we look at it through that lens. If I can, for next year at whatever volume I'm doing, fix my pricing and it's similar, then I'm essentially removing the question for 60 % of my final pricing. So if I have to go out and do sales at wholesale or I have to bid new contracts, I can do that with significantly less risk. Similarly, if I'm a seller, I can fix what 60 % or even a larger percentage of my overall price might be with confidence that I know at least a baseline of what my revenue is going to be.
Mark: I would argue that the producer probably has more information because they have a better sense historically on where differentials are going to be and have a very clear understanding of total price that they're going to be given for their product versus a roaster who doesn't have that historical perspective, necessarily, on a differential. For them, it's still kind of the open box that moves around. I think when you try to pitch this strategy to roasters that aren't comfortable or this is a new world, the differential piece seems like it could be as volatile as the market. But outside of extenuating circumstances, COVID being one of them, that’s not usually the case.
Todd: How and why are companies like ours interacting this way and offering these options to sellers and buyers? Why do we use these mechanisms? We have built a case for why a seller would want to engage the market, i.e. to achieve fixation at the highest possible level within their delivery timeframe. A buyer wants to fix at the lowest possible level within their delivery timeframe. But why would a Covoya or a similar company offer these options in the middle besides the fact that it's often in the best interests of the seller and of the buyer? Why would we exist there?
Mark: Most roasters of a mid to like somewhat large size don't want to go through the cost and hassle of having their own futures account through a broker, a futures broker. That ties up a lot more money to do it on their own. And if you're a smaller producer, you don't necessarily want that either. So we allow these players to participate in our arena. We don't really make money on that movement. We're selling physical coffee, but our collective book is large enough to allow players to come in and participate with us. If you're an extremely large roaster, you could have your own futures account and not waste your time with someone like us. And that does happen, but for people below that, it makes a lot more sense to work through an importer and not have to have a large futures position on your own.
Todd: To the same end, we buy coffees and offer them spot. We essentially have our shelves, at any given point, with so many products on them and we use the same risk management hedge tools to manage costing on our end, or to allow us to offset if a coffee ships in March and is worth a certain price in the relative global marketplace at that moment, if by the time it lands in May, say it's coming 60 days on the water from a far point, if the market has depreciated, had we the opposite future obligation with the ICE, that would have appreciated the same but opposite amount. We can essentially sell that coffee at the current market price without losing that value, or even sell it at replacement cost forward, which allows you to either recover that value or sometimes you take a hit when you sell them replacement costs because the coffee forward to replace that is cheaper than what you bought it for. But you understand where you have to be on pricing to be competitive.
What's the most compelling opportunity, for any roasters listening, as you engage your importing partners, ourselves hopefully as well as anyone else you're working with? This is never a right, but it's a privilege as your relationships build and trust builds to have access to these tools and as volume allows. But from where you sit, Mark, what are the most compelling conversations to have from a roaster standpoint? What should you be asking about? What are the tools that present the most value in securing your physical coverage, meaning I have enough coffee that my suppliers are obligated to deliver to me that I can fulfill the contracts I have or the sales I anticipate.
Mark: I'll give you my elevator pitch and it's pretty straightforward. A lot of times I'll talk to a roaster and they'll say, man, the market's really low, I wish I needed coffee right now. That usually opens the conversation. Well, you will need it a year from now or you will need it six months from now and you can take advantage of this lower market. That opens up the dialogue. If I see that they don't operate this way, I'll usually bring the topic up. But the topic is very simple. Let's just say you as a roaster, go through one container of Columbia a year for your main stock blend. It's something you use year in, year out. You need it no matter what. You're watching the market and you see it go up and down and up and down and you're trying to physically buy that coffee when the market's down and you say, I want to buy it. That is one way. The reality though is, the market's always trying to reach an equilibrium. It's always working hard to do that. If the market starts to really come down, all of a sudden you start to hear the differentials are rising because it's trying to get this threshold of cost of goods and profit. If you're just waiting to buy and lock in on any given day, you're basically always playing with an equilibrium. But if you need a container of Columbia by the end of the year, I can offer you one of two things. One is if the market is really high right now, I can just buy the contract because the differentials have fallen because the market's so high. So we're going to buy a contract, one of these containers. I got you a market level of plus 30, let's say.
Todd: A differentials you mean.
Mark: A diff, but it's an unfixed contract. It's sitting wide open. Between now and when you need this coffee, you have that much time to lock in the market. Your job now is to just wait for the market to be at a level that you're comfortable with. One thing you need to get out of your mind is, you're rarely if ever going to hit the bottom of the market. So that's not where we need to really focus. What we need to focus on is where, if we fixed it, are you guaranteed to make a profit as a roaster? If you're guaranteed to make it at this level, this is a great time to call me and say, buy the futures to balance that contract. Like I said earlier, the market's at 1.90. Let's say it dropped to 145 and you say, okay, let's do it. All of a sudden you have 1.75 coffee versus you could have been paying 2.20 if you would have locked it in at the 190 level.
So that's one way to do it. The other way is if you see this giant drop in the market and you know you need that container of Columbia, so you buy the future. Let's say it drops to 1.45. Again, you buy that paper contract and you could literally apply it to anything you want between now and when that contract is due. So if you bought a December future, let's say, you have until November to take possession of coffee early, lock in a coffee, and you could sit there on the sidelines. So while that market was at 1.45, let's say back here in March, and throughout the year it's climbing, climbing, climbing, and then differentials are falling, falling, falling. You could say, hey, what are prices in Columbia right now for this coffee I need? Oh, they just dropped to, you know, the plus 30 level. Great. Let's do it. So then I apply that differential to that future. And again, you bought a 1.75 coffee when you could have been sitting at, you know, 2.20, 2.32, 2.40 a pound coffee. That, in a nutshell, is how it works.
Everyone's going to say, what's the catch? I'm not selling a timeshare. There's no big hook. The only catch is you have to apply this future to something and you have to do it by the date that you bought. So if you bought a December future, you have to fulfill it before December expires. That would be in late November. That's the only catch. You can't say, let's forget it or I changed my mind. You physically own a future or you physically own an unfixed contract that at some point you have to fix. That's it. There's no other catch other than those two factors. That is the part of the risk you mentioned earlier, Todd. You've got 60%, roughly, of your contract taken care of when you buy a future. Now you're just waiting to deal with the other 40% to lock it in. It's a pretty safe bet versus just buying it spot and locking it in today. You don't know, did you pay too high in the future or did you pay too high on a diff? But somewhere you probably paid too high. Now COVID was the worst because what you had was a rising market, when theoretically, diffs should fall, but you had rising differentials and you had rising shipping rates. So you just got the one two punch from all three sides. That's where things can be worst case scenario in hedging and where a fixed outright price coffee can make more sense. But at that point, you start to worry about default risk and, you know, people knowing that they can make more money by going out in the market and selling.
Todd: You run the risk of somebody just not delivering on you because you locked it in too low. Or a quality risk, where I'm delivering to you at a price that's comparable to the open market, but the open market has less quality specificity or quality requirements, I could potentially process my coffee without as much discretion and sell more to the open market at the same price and potentially under deliver you on quality. Comparatively, I could deliver sample and take rejection and sell for higher elsewhere. So there's a lot of these dynamics that end up coming up in a time like that that are pretty wild.
Why is this historically been something that's so, I mean, the reputation of the futures market of the ICE and its impact on coffee is really bad. Why, if it allows the possibility for the seller of a coffee to sell that coffee at a higher price than the respective buyer ends up buying it and no one is missing out along the way, why is this bad? And that's not an implied answer. I mean, literally, why is the reputation the way it is? And is it fair? Is it as unforgiving as it's regarded to be? What do you think, Mark?
Mark: Well, I think that there's a couple of reasons why that reputation is justified. One is, I mean, the futures market is dealing with commodities, basic commodities. And I would argue, Mike could prove me wrong here, but the bulk of our listeners are not buying commodity exchange grade coffee. They're buying a specialty product with a lot of other bells and whistles attached to it. It could be certification. It could be cup quality markers, other things that it's not bulk exchange coffee. We're not talking about bulk sugar. It's not in that market. So the fact that the products that you and I are selling, have nothing to do with commodities in the scheme of things, makes it an unfair market because it's tying a specialty product that is not sold in bulk to a market that is very much tied to large swaths of commodities.
The second piece of it that I think is a fair hit is that the concentration of power is focused on New York and London and not in producing countries. And so the producers at a disadvantage because they lack the amount of market intelligence to know where things are going. And this I think is truer today than it was back when you were talking about the New York board of trade, because you have to understand the market now, the futures market, is not just about supply and demand. If that were the case, then the producer would have enough information to do quite well in the commodities market. A bulk of the futures market or the people that are playing in the futures market are not tied to coffee whatsoever. They're outside investment groups. They're people that are trading futures from other commodities to hedge. They could be in cocoa, they could be an orange juice, then they use coffee as a hedging mechanism. I would say three quarters of the futures market is not tied to physical coffee. And that makes the price fluctuations random or seemingly random because you'll read in market reports if you happen to read market reports, well, coffee rose today because gold is up. What does gold have to do with coffee? Well, it does because people that are investing are moving their investments around. And so now you have players outside of the trade in the trade and it makes it more of a casino than ever before.
Todd: Add to that the algorithmic trading impact where auto-fill contracts and limit orders accelerate motion.
Mark: Well, speaking of transaction, there are people that are trying to get their computers as close to ICE as possible geographically to get their trade in quicker. So by the speed of your landline, a millisecond off could make or break profit for you. So people are trying to be as close proximity to servers because they want the trade to happen immediately, the strike to happen immediately.
Todd: Yeah. Wild. Okay. So, all of this is good, lots of valid perspectives, lots of different positions from which to sit and look at these tools. Historically speaking, this isn't even a conversation for small to midsize roasters, right? We kind of acknowledged that earlier. Hey, this is great. Come talk to us when you can buy a container of coffee. Why has that been the case? And why should a small roaster pay attention beyond the fact that we're going to start opening this up to buyers of 50 bags or more?
Mark: Well, traditionally people have been locked out because a contract, a future equals 37,500 pounds of a given coffee. So if you're buying micro lots, this is irrelevant. You're not even buying a future to do this if you're buying a blender grade that would be tied to the market. If you're not buying a full contract, you can't buy half of a future theoretically. So that's why it's not relevant to smaller roasters. You could argue the case that if you cobbled together an entire container of different coffees in one country, you could make that a future, but that becomes very complex and many import companies aren't going to deal with that complexity. That would be the only real relevance where I think a smaller roaster could participate. But I have a feeling, Todd, you have some magical new but wait moment here that we're about to hear.
Todd: Well, I just mean to say, right? The limit has been exactly that. It's 37,500 pounds that we would have to post against a future to allow us to play, so to speak. So, you know, we started years ago having to kind of cope with this in terms of managing our own risk when we would fill a container. You feel as though you're playing Tetris, putting all these small nano lots together. But we want, to the degree that we can, even for $5 coffees or more, we want to at least manage the risk of whatever the market would allow of that price, whatever futures level at any given time. That's more risk management than not if we do something. So we started to use a single future to cover multiple lots. And that's become very normal. And as buyers come into the market and buy from a spot, we have to elect how we aggregate those purchases and sales and how we cover those or don't cover those in terms of our futures trading. And often, you know, we see those impacts when we start talking about tens of bags, not just hundreds of bags. And as the buying marketplace, as the roasting world has become more and more fragmented, we have more and more hobbyists becoming small businesses. We have more small businesses finding niche business that they're happy to do and hyper profitable and excited to operate at what would be sort of traditionally too small of levels in terms of the volume of their business, but their margins are very big, right?
So, we see offering these tools as an opportunity that we're uniquely suited to offer where we can engage customers that might be up for buying 50 bags or more of coffee. And we want to offer the opportunity where they can lock that physical coffee at a differential and leave that contract unfixed, open, as you called it earlier, with the opportunity before the expiration of that terminal, they can come in and choose a price to fix. So, essentially, for core customers that we have been doing business with for long enough to build trust, you know, for folks who are ready to work collaboratively with us on coffees that they are sure to take, with terms that we've seen season after season that they're showing up, we want to throw out the requirement to be a box buyer or a full container buyer and we want to start offering these tools. So it's pretty exciting. I mean, I understand we're going to be the only larger trade house that will offer this to this space. And this is something in the coming weeks we'll start to be talking to our customers directly about. Certainly anyone who's listening who's interested, that threshold again is going to be 50 standard bags. So it's not accessible to everyone by any stretch, but that opens it up pretty widely, which is exciting.
Mark: Yeah, that's fantastic. And I would say that people listening, no matter who, as much as we work here at Covoya, as much as I'm a competitor to other import companies, any importer that knows what they're doing is more than happy to walk you through the ins and outs of this type of transaction in futures and assist you with all the tools you need to make an informed decision. It doesn't benefit us to get you to fix one way or the other. There is nothing in it for us. We want you to win because if you win, you're more likely to continue to buy from us. So we're certainly not in the business of steering you in the wrong direction because somehow it benefits Covoya. That couldn't be further from the truth. So this is a nice tool, a great tool. And for roasters that don't quite understand, you're participating in hedging whether you understand it or not when you buy coffee spot because when you buy you're still focusing on a differential that we're offering that coffee for. And the price we're offering you is tied to the price of the market that particular day. So what Todd is proposing here is that we're going to break that a bit and allow you to buy the differential and fix when it's advantageous to you, which I think is a pretty cool tool for anybody who wants to take the next step in their experience in buying coffee and starting to tip their toes into hedging.
Todd: And hopefully these extra seasons ahead of any growth and volume will allow for skill development and savvy that becomes a huge part of the success of these different companies. The more seasons in the field, the better. The sooner you can engage the tools that are really impacting the ebb and flow of trade in the space that you're operating, the better. So, as much as Mark tells you, and I do have to share this disclaimer, but as much as Mark will tell you on a one-on-one phone call that he knows where the market is going, where the future is going, you know we don't know. We don't know.
Mark: If that were true, I would not be working any longer. I would have already retired.
Todd: I can guarantee by the video feed I'm watching; Mark is not phoning in from a hammock on the beach anywhere.
Mark: No, nor a yacht. So, when Mike is writing the history books here at Covoya, is he crediting you with creating this strategy at Covoya? You are the one who nudge the powers that be to allow for this to happen?
Todd: I pulled on some strings just to get a message through, but I'd actually like to shout out Charley Requadt and Liesa Collins, who are the ones who are managing our structure and our aggregated futures position and will be the key vector for how we actually get this done. To be honest, they've been doing this as it relates to our spot trading. So it opens it up in a way that benefits our close customers like our core customers, and hopefully endears us to new, soon to be core customers. I just think it's awesome. So thank you to Leisa and thank you to Charley. Hopefully it allows for additional margin to be found for folks in the biz.
Mark: I think it's incredible. It's a cool tool and it will certainly put a lot more power in roasters hands in a very challenging market where on the roasting side profits are getting harder to make and this allows an ability to make even more money.
