Helileia Vastatrix and Coffee Futures

Over the past several months there have been a flurry of panicked press releases and hastily arranged meetings to deal with an outbreak of Helileia Vastatrix or more commonly
Coffee Leaf Rust or Roya. The International Coffee Organization calls it an epidemic, The Specialty Coffee Association of America calls it a devastating outbreak while the participants who trade Arabica Futures appear dismissive.  The purpose of this post is not to examine the degree or veracity of the claims, but to review how the Futures Market is treating the claims.

I have covered the incredible rise and fall of the C over the past few years, and have been critical of both the forces driving the price to unsupportable levels in 2010-11, and the efforts by large players to support the price in the face of price deflation. Last year in Portland at the Specialty Coffee Symposium a Costa Rican Official claimed a 30% reduction in harvest numbers for 2013 due to lack of pruning, planting and heavy rains. This year, the 30% number was again trotted out in reference to the Roya outbreak, and many reports of vast devastation were circulated. In both cases, the claims failed to move the price of the C in any significant way. Today the Futures Market Price for Coffee to be delivered in March of 2014 is $1.50.  There is no doubt that a 30% reduction in harvest numbers from affected producing countries would create a massive shortage of coffee worldwide, throwing Supply and Demand out of balance. The Shortage would drive prices up well beyond the $3 level we witnessed back in 2010-11 where there we no Supply or Demand shocks effecting change. So why has the price not moved up if the market believed and expected that the harvest would fall significantly. In order for there to be no impact resulting from a supply shock there would need to be an equal demand shock compensating for the reduced supply. In other words, demand for coffee would need to plummet (without a price increase causing it) at the same rate that supply decreases. That scenario is highly unlikely.

A quick glance at the Options chain going forward or the Futures pricing beyond Q1 2014 reveals a normal time premium (contingency for unexpected shocks) but nothing even remotely approaching numbers necessary to compensate for a huge supply shock. Again, the Market is expecting a price of approximately $1.50 for Arabica delivered in March 2014.  These are the numbers produced by the most sophisticated coffee traders and financial analysts in the world leveraging ALL of the known information regarding the arabica harvest. They read the reports on Leaf Rust, rain, pruning and planting...so what gives?

 I'm speculating (guessing) that the world of arabica traders doesn't believe the claims or severity of the outbreak or some combination of other factors. I'm concerned. As recently as last night I posted to my twitter feed a prediction that the price would break out of the narrow trading range it's been bound by when it breaches $1.44 spot. I have formed this opinion based on a conventional strategy used by chartists who view a 3% increase over the recent high within a narrow horizontal trading range as being a strong indicator of sustained upward price movement.  When this move happens it will be blamed on Leaf Rust, but don't believe it because leaf rust has failed to move the market to date.  The move will be driven by the price breaking through a key chart indicator, the search for alternative investment vehicles while the Equity Markets are falling, and relative weakness of the USD.

My advice is for all those involved to be careful when reading reports assigning specific numbers to harvest losses which are wildly speculative and often formulated with the intention of influencing market price.  Remember that the C is a zero sum game.  When the market functions rationally, a shortage (or perceived shortage) of supply always results in an increase in price thereby benefitting producers who are unaffected by any production problems.  Conversely, when there is an abundance of coffee in the supply chain, the prices drop and all parties are harmed.  Without diminishing any difficulties facing growers who are battling leaf rust, if there are significant supply shortages, the price will rise and growers unaffected by leaf rust will benefit from the price increase.

*NOTE:  The C, in the three trading days since I wrote this piece, pushed over $1.43, bristled at the breakout price and retreated strongly to (at present) $1.378.  I believe this validates my assertion that the  Market does not believe in the Leaf Rust narrative, and that the $1.44 price level is significant.  If over the course of the next few weeks the price retests the recent high of $1.43, the breakout price will reestablish at approximately $1.47.  Time will tell, but there is little doubting that currently Arabica Traders do not believe Leaf Rust will adversely impact Arabica Supply next year.

A "C" Change

Today The Dow Jones Newswire carried a story which is the most significant development in Specialty Coffee in a decade.  The article indicated that a new Futures Contract specifically for Specialty Grade Coffee will begin trading next year.  As I have suggested in several previous posts including one 2 years ago (Delinking from the C Part I and Part II) and 1 year ago (The Shared Hedge), Specialty Coffee deserves and needs a special contract to more accurately set pricing and to insulate from the vagaries of the C which is fed and starved by speculation.
The establishment of the Specialty Coffee Futures Contract will necessarily (due to low liquidity/volume) trade with a much higher risk (Delta) premium than the C, as I suggested in the exchanged counterparty option contract of The Shared Hedge.  This new Specialty contract should act as a true hedge rather than a speculative vehicle and therefore appeal mostly to coffee growers, green merchants, importers and roasters leaving speculators huddled around the C where volume and liquidity provides safety should they need to wind up a contract to free up cash.  Mark my words...THIS IS HUGE!

How to Save $10,000 Scooping Coffee

A short post on a very important way to save A LOT of money if you scoop,weigh and sell coffee by the pound. Every scale has a margin of error which is posted on the front of the scale. Typically a scale might be accurate from 0-30 LBS x 0.01, or 0-60 LBS x 0.02

If you have a wholesale order of 50 x 1 LB and you weigh the bags individually each time you fill a bag, you need to multiply the margin times 50. On that single order, if using a scale with a margin of 0.02, you could potentially give away 50 x 0.02 = 1.00 LB
If you are a coffee wholesaler and do this many many times per year, with a volume of say 50,000 LBS/Year, you could be giving away 1,000 LBS/Year in scale margin error. If you sell your coffee for say $10/LB, you have given away $10,000.

The only way to weigh out an order of more than a single unit is to calculate the weight of the whole order, weigh out the complete order, and subtract the individual weight of each item as you package it. In this way, the margin of 0.02 is divided among 50 units, (50 x 0.02/50) instead of multiplied by 50 units. (50 x 0.02)

It is very important to remember that the scale doesn't know whether you are weighing out an 8, 12, or 16 ounce bag and therefore the margin of 0.01-0.02 is applicable to each unit if weighed individually. This means the potential loss/savings is greater if you package 12 oz bags and roast 50,000 LBS/Year because you would multiply the margin x 66,666 units and therefore have a cost/savings of 66,666 x 0.02 = 1333.33 LBS.

Try this packaging method even if only packaging 5 bags at a time and you have cut your potential loss significantly.

SquareUp

I can think of no other piece of equipment or software more important to a new and growing business than the cash management system.  The traditional options for new businesses range from a used or reconditoned cash register (+-$200) or cheap alternative (+-$100) found at your local office supply store to a fully supported touchscreen system run from a cpu with supported software (+-$5000).  When attending a Specialty Coffee event you are sure to run into one of several companies that offer products tailored to the coffee industry.

It was when attending a Specialty Coffee event in Anaheim in 2010 that I became aware of a new company called SquareUp which advertised discount credit card rates when using their tiny unique reader, turning your iphone or android device into a credit card processor.  In addition, SquareUp offers FREE software which runs and stores all of you transactions "in the cloud" from an Apple ipad with Square Reader plugged into the earphone jack.  This program is unbelievably easy to set up and customize with your own product photos, unlimited taxation rates, unbelievable back office real time programming and reporting...ALL FREE!  I registered for SquareUp immediatley, but since I live in Canada, needed to wait until they launched in Canada (launched Oct 24) to use the system in a practical way.  Note:  There are other similar systems including Shopkeep, which is very easy to use and very attractive to look at, but is limited in its taxation rates and has a monthly fee associated with it.

The SquareUp system simply requires an ipad, a Star TSP143LAN receipt printer, and a cash drawer which engages off the impulse sent wirelessly to the printer.  SquareUp recommends a Vasario 1416 or 1616 drawer.  It is wise to also include an ipad stand capable of rotating to face the customer for signatures (done on screen).  All included the complete cash management system should cost less than $900 with NO MONTHLY FEES.  While Square requires a wireless internet connection, the ability to go mobile and run the transactions from your iphone or android device is a useful option should internet become unavailable for short periods.http://www.squareup.com

The SquareUp system generates revenues by charging an industry best $2.75% per credit card transaction, which in many cases, can save the business owner thousands of dollars per year.  The processed funds are normally deposited into the business owners account within 48 hours, confirmed by an email from SquareUp.  The only downside to the SquareUp transaction model is it's lack of a debit card capability, which in Canada represents approximately 40% of all transactions.  Even so, for the new business owner the benefits derived from the free software and backup, inexpensive hardware, traceability by remote, and back office real time programming, makes the choice of SquareUp Register cost effective and sensible.

SquareUp also provides the retailer the ability to go paperless by emailing or texting receipts, and also using the retained addresses to offer loyalty benefits without customers needing to carry punch cards.  The ability to delight customers by managing their rewards and receiving immediate text receipts cannot be underestimated.  Further, the act of signing their names on screen using their finger is also a novel and special experience for customers who unintentionally participate in the future of financial transactions and are sure to share this experience with their coworkers and family.

Finally, by registering with SquareUp, each business is listed online in the Square Directory where businesses can post their menus, hours of operation, photos and a store locator.  Square has also launched a new Mobile Phone Cashless Payment System named Square Wallet.  At checkout, Square Wallet recognizes your mobile device and your name and photo appear on the register screen.  The cashier simply confirms the photo is of the purchaser and the transaction is completed.

I know I appear to be a little biased here, and I even believe my company was the first to perform a Square transaction in Canada, but this blog is dedicated to helping businesses to save and make money in the coffee business and I am truly impressed with the product and service.  That said, I feel the need to declare that I have not been paid or compensated for such a glowing review, but after running SquareUp in our own cafes for the past month, I highly recommend SquareUp for new and established businesses for its ease of set up and use, cost effectiveness, relatively cheap hardware, free software, industry leading processing rates, quick deposits, remote tracking of sales, robust reporting options, and  marketing potential through the directory, loyalty program management and ability to delight customers.  For now, SquareUp is only available in the United States and Canada, but the company indicates that they plan to launch in many new countries in 2013.  *Note: All of the photos included in this post were taken directly from the SquareUp site http://www.squareup.com 

The 5M's Redux

While roasting away the hours there is a period of time after the next roast is loaded and ready, and before first crack, when I can divert my thoughts to things that interest me.  After I completed and published my last post I contemplated the limitations of my binary declaration that each of the 5 M's plus Water be declared as either acceptable/unacceptable.  As I described in my previous post, this yields the equation 2^6=64 different possibilities each time a barista approaches the espresso machine.

Upon further reflection I've decided that declaring something as acceptable/unacceptable is not appropriate since:

• acceptable does not adequately describe perfection in any or all elements
• the spectrum of acceptable may be mathematically described by a differential equation and therefore assigning even 2 extra descriptors to each of the 5 M's plus Water is not unreasonable.
• unacceptable is clearly definable, and once the threshold is crossed, the degrees of unacceptability is moot.  

Therefore, what I am proposing is to assign two further designations to each of the 5 M's plus Water that reflect acceptable faults which individually do not fatally flaw the espresso.

For example:

• Grind

1. Perfect
2. Too course but acceptable
3. Too fine but acceptable
4. unacceptable

• Water

1. Perfect
2. Too Soft but acceptable
3. Too Hard but acceptable
4. unacceptable

• Blend

1. Perfect
2. Too fruity but acceptable
3. Too flat but acceptable
4. unacceptable

The others can be fleshed out and debated as to what would adequately describe acceptable opposing variables, but I believe including two extra designations is a better reflection of the possible outcomes when a barista attempts to make an espresso.

If the inclusion of two extra descriptors are accepted then the new equation becomes:

4^6= 4096 

This means there are 4096 possible outcomes each time a barista attempts to make an espresso.

This greatly increases the number of possibilities for espresso outcomes but I think is helpful to put in perspective how difficult it is to make a perfect espresso, and even how unlikely it is that one ever gets made.  While this statement is no doubt going to raise some eyebrows, remember, that if even one of the variables is less than perfect, then necessarily the beverage is not perfect.

I'm curious to see what others think of this description of espresso and whether it is productive to think of it in these terms.

5M's: The Odds Are Against You

1. Mano dell'operatore (the hand) 
2. Miscela (the blend) 
3. Macinadosatore (the grinder) 
4. Macchina Espresso (the espresso machine) 
5. Manutenzione (maintenance) 
6. Aqua (Water: upside down M) 

2^6=64 

     One of the time tested axioms of espresso is the 5 M’s (plus Water) which each contribute to the creation of a perfect espresso. It is understood that a fatal fault in any of the 6 contributing factors necessarily leads to a flawed beverage. Treating each factor as a binary, and declaring it as either acceptable or unacceptable, we can confidently identify through simple mathematics that there are 64 possible unique results each time a barista attempts to make an espresso. 

2 represents the binary (acceptable/unacceptable) 
6 represents the 5 M’s plus Water 
2^6=64

 The perfect shot occurs when each of the 6 variables are determined to be acceptable. Any determination that one or more of the factors is unacceptable automatically makes the beverage fall somewhere on a scale from less than perfect (1 factor unacceptable) to horrible (all 6 factors unacceptable). It is understood that assigning a grade of acceptable/unacceptable is decidedly diplomatic in an industry replete with specialty coffee partisans, however it is productive and helpful to know how badly the odds are stacked against you when you approach the machine and how hopelessly unfair they are if your equipment and materials are sub par.

Mark to Market

Mark to Market is a term whose frequency of use increased in late 2008 with the collapse of complex derivatives and options based on ill advised mortgages to American home buyers. Basically GAAP (Generally Accepted Accounting Principles) compelled financial firms to reduce the value of paper they held at Book Value (Purchase Price) as market conditions deteriorated and residential real estate values plummeted. The concept of Mark to Market was created to determine the credit/debit status of Margin traders in the Commodity Markets but is important in valuing the contracts and commitments of coffee brokers and roasting companies (less so the inventory of retail companies).

Coffee growers, brokers and buyers typically use the Commodity price for coffee as a baseline to determine specialty coffee prices. An example would be where a Specialty Coffee is determined to be valued "C" plus a fluid amount depending upon quality (ie "C" plus $1.20). This method of valuing specialty coffee is a simple linear equation, easy to understand with a transparent and logical baseline. If a coffee was purchased at "C" plus $1.20 at harvest, and the commodity price falls after the date of the contract, the coffee is worth less and should be reflected that way in your balance sheet.

Most brokers continuously adjust their pricing with the rise and fall of commodity price...most.
One exception is the purveyors of ultra high end coffee. These coffees don't come to market through normal channels, and so there may be an argument to be made that it's value is delinked from the commodity price, however there is very little transparency or logic in this type of valuation. If the commodity price fluctuates freely and the price of ultra high end coffee remains constant, the value of high end coffee is arbitrary and based on purchase price rather than market conditions. Currently many ultra high end coffee sellers would have secured their inventory while the "C" was floating near historical highs in 2011. Beginning late 2011 coffee commodity prices began to deflate, theoretically reducing the value of all coffee under contract. The problem for newer brokers working on bank loans and margin is that they cannot reduce the value of their contracts without jeopardizing their debt to equity ratio displayed in the Balance Sheet. The reality is that the broker uses a formula to determine purchase price, whether it is a simple equation or differential calculus, there is a formula. If there is a formula to determine value at purchase, then the same formula should be used to reduce the value as the price of the underlying commodity deteriorates.

I have been sampling some self declared ultra high end coffees recently whose pricing is completely detached from the realities of our current market. While considering the value gap I came to the conclusion that the coffee was not poor quality but poorly bought, handcuffing the marketability going forward. It is clear to me that some of these coffees are looking for naive buyers who are captivated by scarcity and marketing material rather than realistic value propositions. My advise is to check your coffee prices as they track throughout this past year, if your prices haven't fallen for similar purchases at a rate that tracks the "C", then you are likely paying for your brokers mistakes and you need to make them aware of the inconsistencies. Paraphrasing Benjamin Graham, "Price is what you pay...Value is what you get".