Coffee’s Rally Forces Traders to Seek Alternative Hedging Plans
Coffee prices have been on a tear and for the traders who buy, sell and ship beans around the world this means navigating additional risks. They’re turning to alternative ways to hedge prices and avoid or delay the cash crunch caused by volatile moves.
Futures prices for arabica beans — the variety favored for high-end brews — have gained around 70% in New York this year, breaking past the highest levels in more than forty years. Big price swings are a regular feature.
When prices move too high, too fast, exchanges or brokers that manage a trader’s positions require more collateral, or margin, to maintain sold futures hedges that have become unprofitable. With millions of bags of coffee held in stock or transit, that can mean billions of dollars in margin calls when there’s a big price move.
For a trader with cargo on a ship or awaiting final payment from an end-buyer, margin calls can drain their cash position quickly. Increasingly they’re turning to options and off-exchange solutions to avoid paying more collateral, or simply doing less business, according to traders and brokers.
The moves show how liquidity pressure is mounting in a market dominated by small players who aren’t prepared for these massive calls for cash. That’s contributed to further swings in prices with less on-exchange liquidity. Cocoa, the other hot commodity of the year, has experienced similar problems.
“It’s a seriously turbulent time and it’s very, very difficult for traders,” said Kit Gulliver, a director at UK-based coffee traders Origin Commodities Ltd. and Dragon Commodities Ltd. “You have to change the way you approach these things. Just sitting there doing what you used to is a recipe to bleed cash.”
Traders need to hedge coffee when they transport it from growers in countries such as Brazil, Vietnam or Guatemala to buyers largely in Europe and the US. When a trader commits to buy physical coffee at exchange-related prices they usually sell futures to protect, or hedge, against the value of that cargo falling. A consultant in top grower Brazil estimated as much as $7 billion of margin was called in the coffee market during November.
Banks have for some time offered big groups products known as “liquidity swaps,” where for a fee the bank essentially holds a client’s hedges for a set time. The structures mean that traders can avoid the associated margin calls until cargoes are delivered, although they may eventually have to pay up if prices don’t come down by the time their agreement ends.
In the recent coffee bull run, brokers and financial service groups have also been offering the product to smaller clients, according to traders.
“There’s definitely been an increase in requests for these products,” said Albert Scalla, senior vice president of trading at StoneX Group Inc., adding that the firm offers liquidity swaps on a limited basis to clients.
Traders also use the swaps to mitigate other forms of collateral like initial margin needed to place hedges, he said.
Repurchase or “repo” agreements are also becoming more important for the industry. Here, traders sell their bank or broker the actual coffee cargo, getting temporary cash and avoiding the pressure of moving prices. They then buy back or repurchase the cargo with additional agreed interest at an allotted time.
“There has been a lot of off-exchange activity, whether it’s banks doing liquidity swaps or actually buying physical from the trade and selling it back to them later to free up some cash,” said Drew Geraghty, a soft commodities broker at TP ICAP Group Plc.
Still, if the growing inventories in ICE warehouses are any indication, a last resort is simply trading less and reducing the amount of coffee held in transit.
That’s not to say it’s not a profitable time to be in the market. Louis Dreyfus Company said in its first half financial report in September that its coffee division’s results were a highlight and had improved in part due to better originating margins.
