By Jos Algra
Definition
With CLAC, we have just started publishing benchmarks again for differentials for several grades of coffee from different origins, to provide guidance for contract negotiation amongst others.
But what is a differential and what does it represent?
The shortest definition is that it is the result of the negotiation between buyer and seller, that represents the difference in the price of a particular origin and type of coffee, and the generic standard of the New York (Arabica) and London (Robusta) futures markets. But the differential is a container concept. That is, it encompasses different aspects.
Supply and demand, quality, consistency…
The differential is in the first place an expression of the coffee quality, as it is appreciated in the market. Since there are different markets, the differentials can vary by market for the same type of coffee. Related is the relative scarcity of a certain type of coffee. High-quality coffees that are highly valued in the market are scarce and have a higher differential than coffees with the same cup that are less scarce or are sold at a fixed price, well above the market price.
The consistency in the quality of the product and in the quality of the service on the part of the exporter also matter. It avoids the buyer having to sort out problems, saves costs and fines and he will reward the exporter for that, in addition to that it strengthens the medium-long term relationship between both parties.
Furthermore, the differential expresses the replacement cost, that is, how much the exporter must pay in the local market to replace the coffee and be able to offer it. It reflects local supply and demand compared to the futures price.
The differential can come at a premium or at a discount, because of the quality and of the supply and demand of a particular type and origin of coffee. That premium or discount can vary significantly due to extreme changes in supply and demand, but also due to a long-term trend that generates a structural change in the market. We are going to analyse that in the historical context of the last decades in the next blog.
In countries where domestic consumption is relatively high, it influences the local market price and through that the differentials. If the differentials are considered too low, producers and traders can momentarily switch more towards local sales. Prices for processed coffee are more stable than for raw coffee and the margins are higher than in exports.
Offsetting futures market trends, costs, values…
The differential also offsets speculative movements in the futures market. If the futures price goes down because the big speculators are betting on a price decrease, the differential will go up to cover the cost in the local market. If the price on the futures market rises due to speculation, but there is enough supply at source, the differential will go down. The sum of the futures price plus differential has to cover the local price plus the exporter’s costs and margin.
The differential may also vary by harvest period and shipment date. Old crop coffees generally have a lower differential than new crop. If there is enough supply, the spot and prompt shipment coffees will have a lower price, but if there is a lack of coffee, on the contrary, they will fetch a premium.
The differential also includes additional costs such as special preparation (for example type of fermentation, number of defects, bean size), special packaging such as grainpro or ecotac, the additional cost of transport for having to send the coffee to a different destination and, in the case of decaffeinated coffee, the weight loss due to the process.
The differential can additionally express values such as care for the environment, sustainability, corporate responsibility and social justice. It can be a regulated differential, as in the case of Fairtrade, or unregulated, as in the case of the Rainforest Alliance and organic coffee.
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But it does not need to be certified coffee, there are buyers who of their own free will pay a premium. That has a lot to do with marketing, the buyer shows through the price that he pays the values that the coffee represents, to convince the consumer to buy his product at a premium; in the end, it is the consumer who pays. This also leaves room for the seller to reinforce and add to the message, reinforce the values, relate them to impact, and thus influence the price the public is willing to pay.
Due to its weight in world coffee production (30–40% of total output, 60–70% of Arabica), Brazil largely determines the international price of coffee in general and of Arabica coffee in particular, via the ICE New York futures market in the mid- and long-term; in the short-term price is heavily influenced by speculation.
An example: the case of Colombia
Colombia, with 8–9% of the world coffee output and 15–20% of Arabica, does not have as much influence on the price of the New York futures market, but it is the largest producer of washed Arabica with 25–30% of the total, and that is expressed in the weight it has on the differentials of washed Arabicas.
This can be clearly illustrated by what happened to the differentials between 2008 and 2012. Due to a combination of factors (the impact of La Niña, the incidence of coffee leaf rust and problems with the renovation of the coffee plantations), production fell from 12.5 to 8.7 million bags in the 2008/09 crop and it took 5 years to recover.
The 2008/09 season began with a differential of +7/+16 for Excelso, the main coffee grade that Colombia exports. In December, when the country is in the middle of the main harvest, the price in the local market shot up and behind that the differential for Excelso, due to the replacement costs. It reached +98 in May in the fly crop known as the mitaca, which also did not provide a solution the lack of supply.
The hope in the market was that the problems would be resolved in the following 2009/10 harvest and the differential for Excelso fell to +24, but the lack of coffee was repeated and the differential rose again, this time to +77. It was not until the 2010/11 harvest that the differentials fell and consolidated in a range of +20/+40, although the problems in Colombia were not resolved until 2013/14. This was influenced by the fact that the price got up to almost 300 cents in New York in 2010/11.
The impact that this has on the differentials of other coffees is generated by substitution. The lack of coffee from Colombia was solved with coffee from Guatemala and other origins, the gap left by Guatemala is filled by Honduras and other countries and that space is occupied by Brazil. This changes the balance between supply and demand and the replacement cost in those countries. The Guatemala SHB differential rose from +8/+11 in October 2008 to +44 in May 2009, fell to +15 and in 2009/10 it rose to +58. That of Honduras HG from -4 to +20 in 2008/09 and +28 in 2009/10.
One can imagine what happened with many export managers in Colombia. Selling at +10 for future shipments and buying against +50, +70 and even +90 in the local market, to fulfil contracts, many lost their jobs. The risk of the base price at the futures market can be hedged, but the differential risk cannot be insured.
And what about the traders and the roasters?
They kept their arms crossed, covering their demand with purchases at the beginning of the harvest, buying coffee from other origins and from Colombia only sporadically, for example for single origin Colombian coffee that they launched on the market. With such high differentials in Colombia, volume was limited, which contributed to the price increase in New York in 2010/11, which in turn contributed to lower differentials, as can be seen in the above-mentioned chart.
In the next blog we will make, among other things, a historical analysis of some differentials and how they are related to changes in trends in consumption and in the coffee industry.
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