By Julio Sera, INTL FC Stone

For those of us who wake up each morning in pursuit of the perfect cup of coffee, success often depends upon our ability to control a number of simple variables. We can buy the most freshly roasted beans we can get our hands on. We can precisely calibrate our grind to match our preferred brewing method (press, drip, etc.). And we can make sure our water temperature remains within the optimal brewing range. Of course, there are a multitude of other variables, too. But if we get these basics right, the rewards can make our whole day better.

A similar multitude of variables goes into the ultimate price of our perfect cup. The difference here, however, is that we have nearly no control over any of these variables. Worse, many of them are often highly changeable and unpredictable, which can lead to considerable volatility in world prices. As a result, it can be easy for many folks in the coffee trade, from producers to roasters to retailers, to feel at times that they are at the mercy of the markets – especially lately.

So what are some of the major drivers of this volatility?

Let’s start with the weather. It’s no secret that weather conditions in a given growing season can significantly affect harvest volumes and crop quality. These variables affect both supply and demand – and prices.

Most of us can probably remember the sharp spike in Arabica prices that followed the severe drought in 1986. The effects of the drought in 2013-2014 are still being felt in Brazil, the world’s largest coffee producer. Right now, we’re in the midst of one of the strongest El Niños on record, and wewon’t know its impacts on production for months.

Speaking of Brazil, the production forecasts coming out of that country are also playing a role in driving some of the current coffee market volatility. The range between some of the high-end supply forecasts (issued by private analysts) and the low-end forecasts (issued by the Brazilian government) has been as wide as 13 million bags in some instances. That’s approximately the equivalent of the entire yearly production of Colombia, the world’s second largest Arabica producer, and third largest producer globally. This level of uncertainty in the forecasts creates “noise” in the marketplace, which can increase volatility in prices.

Persistent volatility in the currency markets may also be driving coffee price volatility. Stretching back to 2012, the US dollar has risen steadily against nearly all major world currencies – due to the U.S. economic recovery and speculation that the Federal Reserve would raise interest rates (which it finally did in December 2015). The end result has been to drive down the prices of dollar-denominated commodities (of which coffee is one) globally.

Currently, coffee prices are near their five-year lows. Conventional wisdom might suggest that this benefits roasters and consumers, while harming producers and perhaps providing an incentive to curtail production. However, the strength of the US dollar versus the currencies in top producing countries like Brazil, Colombia and Indonesia mean that producers in those countries are netting relatively more money in their local currencies for each bag of beans sold in US dollars. Thus, the incentive is to increase production, and by extension, supply – despite low prices.

In short, market dynamics don’t always “follow the book.” In fact, the sheer complexity of the global marketplace can make them extremely counter-intuitive.

How long will today’s market dynamics persist?

Nobody knows for sure. And with that uncertainty comes risk – even if current conditions seem like they’re aligned in your favor.

Fortunately, opportunities exist for nearly all market participants to protect themselves against price volatility, using effective risk management strategies. And contrary to what some might think, risk management isn’t about looking at all of the factors above and correctly “guessing” what will happen.

Risk management today is much more akin to buying insurance to protect against negative turns of events. When used properly, it can also create opportunities to gain market advantages. For example, roasters can use risk management tools to set their own prices, which in turn can enable them to create custom-tailored buying and selling programs for customers – months ahead of their competitors.

This example is just a taste of what’s available with an informed risk management strategy. I plan to share more when I present at the NCA 2016 Annual Convention on Friday, March 18. I hope to see you there.

In fact, if you mention this blog post, I may even buy you a cup of joe.

Julio Sera is a Senior Risk Management Consultant and Risk Manager with the FCM Division of INTL FCStone Financial Inc. Comments in this article are market commentary and are not to be construed as market advice. Trading is risky and not suitable for all individuals.

Image: Giphy